March 18 (Bloomberg) -- HSBC Holdings Plc, Europe’s biggest lender, was warned twice by auditors that entrusting as much as $8 billion in client funds to Bernard Madoff opened it up to “fraud and operational risks.”
KPMG LLP told the London-based bank about the risks in 2006 and 2008 reports. The firm was hired to review how Madoff invested and accounted for the funds, for which HSBC served as custodian. KPMG reported 25 such risks in 2006, and in 2008 found 28, according to copies of the reports obtained by Bloomberg News, which was allowed access to them on the condition they not be published.
Twenty-five “fraud and related operational risks were identified throughout the process whereby Madoff LLC receive, check and account for client funds,” KPMG said in the 56-page report dated Feb. 16, 2006. The limited controls in place “may not prevent fraud or error occurring on client accounts if management or staff at Madoff LLC either override controls or undertake activities where appropriate controls are not in place,” according to the report.
A 66-page KPMG report dated Sept. 8, 2008, cited 28 risks and described them in the same words as the 2006 document.
Irving H. Picard, the trustee liquidating Bernard L. Madoff Investment Securities LLC, sued HSBC and a dozen feeder funds for $9 billion in December in U.S. Bankruptcy Court in Manhattan. The suit was partly based on the KPMG reports and alleges the bank knew of concerns Madoff’s business was a fraud and didn’t protect investors. KPMG’s reports haven’t been made public. Picard has filed more than $50 billion in so-called clawback suits to compensate victims.
In the reports, KPMG didn’t present evidence the risks it identified had materialized or that it found signs of actual fraud, and said HSBC had told the firm “no allegations of fraud or misconduct have been raised.”
HSBC confirmed hiring KPMG in 2005 and 2008 to review Madoff’s firm, adding it now believed Madoff had tricked the auditors. “It appears from U.S. government filings that Madoff and his employees foiled these reviews by, among other things, providing forged documentation to KPMG,” the bank said in an e-mailed statement.
“KPMG did not conclude in either of its reports that a fraud was being committed by Madoff,” HSBC said. “HSBC did not know that a fraud was being committed and lost $1 billion of its own assets as a victim.”
HSBC Spokesman Patrick Humphris, KPMG spokesman Mark Hamilton and Amanda Remus, a spokeswoman for Picard’s lawyers Baker & Hostetler LLP, all declined to confirm the authenticity of the reports obtained by Bloomberg.
At the time of the first report, HSBC was custodian for eight funds that had invested $2 billion with Madoff, KPMG said. By 2008, the bank was custodian for 12 funds with as much as $8 billion invested.
“We continue to believe that we have strong defenses to the claims made against us and we will defend ourselves,” the London-based bank added.
Madoff, 72, pleaded guilty to using money from new investors to pay old ones and is serving a 150-year sentence in federal prison. Investors lost about $20 billion in principal.
In the list of risks in KPMG’s report, number 2 was that “BLM embezzles client funds,” using the initials as shorthand for Bernard L. Madoff. To prevent it, KPMG recommended in both 2006 and 2008 that HSBC “establish a process to monitor monthly statements” and reconcile them with contributions from clients.
KPMG didn’t perform tests to check that risk.
The 2006 report listed fraud risk number 5 as “client cash is diverted for personal gain” and risk number 18 as “trade is a sham in order to divert client cash.” It went on to say there were concerns “Madoff LLC falsely reports buy/sell trades without actually executing in order to earn commissions” and “BLM falsifies accounting records which are provided to HSBC.”
KPMG reviewed samples of trades and account statements for both its 2006 and 2008 reports to test the risks and detected no discrepancies, the reports said. Even so, the firm suggested HSBC “consider undertaking a periodic review which includes tracing a sample of client trades back to the bulk order.”
HSBC declined to comment on individual risks cited in the reports, citing the pending lawsuit.
In prefaces to the reports, KPMG said it wasn’t hired to audit Madoff LLC and based its reports on information Madoff and his staff provided, which wasn’t independently verified.
HSBC units in Bermuda, Luxembourg and Dublin acted as custodian for 12 funds including: Pioneer Investment’s Primeo Select, Bank Medici’s Herald (Lux) and Thema International, as well as Herald USA, Alpha Prime, Lagoon Investment, Senator, Kingate Global, Defender and Global Investments.
The bank was also sued in Ireland and Luxembourg by investors over Madoff investments.
In its 2010 annual report, HSBC said that by Nov. 30, 2008, the aggregate value of those funds was $8.4 billion, including fictitious profits Madoff reported.
HSBC said that it was impossible to estimate the range of potential liabilities that could arise from lawsuits including Picard’s, adding that “they could be significant.”
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