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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

During due diligence, an investor notes that the manager refuses to allow direct contact with the prime broker or custodian, and provides only paper trade confirmations mailed days after trade dates. What is the best interpretation and response?

This is an operational red flag. Refusing direct contact with custodians and delaying paper confirmations prevents independent reconciliation of trades and holdings. The investor should demand independent verification and decline to invest if it is refused, rather than merely cutting the allocation.

  1. AAccept it, since paper confirmations are the industry norm for large managers
  2. BTreat it as an operational red flag and require independent verification, otherwise decline to investCorrect
  3. CReduce the allocation by half but skip further verification
  4. DRely on the audit opinion alone and proceed

Explanation

Blocking independent third-party verification and delaying paper confirmations prevent reconciliation of trades and holdings. Prudent practice is to insist on direct confirmation from custodians and brokers, and to walk away if refused. Halving the size or relying only on a weak audit leaves the fraud risk unaddressed.

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