Madoff Ponzi scheme haunts HSBC, which faces $1 billion hit

• Key insight: A Luxembourg court ruled HSBC owes restitution to a Madoff investor fund, finding the bank was negligent in its custodial role.
• Supporting data: The $1.1 billion provision is expected to impact the bank’s CET1 capital ratio by approximately 15 basis points in its Q3 results.
• Forward look: HSBC will pursue a second appeal before the Luxembourg Court of Appeal to contest the ruling and the final monetary amount.

Overview bullets generated by AI with editorial review

HSBC announced this week that it would set aside $1.1 billion following an unfavorable ruling in litigation related to the massive Ponzi scheme orchestrated by the late financier Bernie Madoff.

The ruling, issued by a Luxembourg appeals court on Oct. 24, denied an appeal brought by HSBC related to a claim for restitution by Herald Fund, a Cayman Islands investment fund, which had placed investments at Madoff’s firm.

Herald initiated the lawsuit in April 2009. It held HSBC accountable, citing the bank’s custodial role over Herald funds channeled to Madoff Investment Securities.

Bernard Madoff, the mastermind behind the scheme, was arrested in 2008, convicted and sentenced to 150 years in prison. He died in 2021.

This month, the Luxembourg Court of Cassation (the small country’s highest court) partially ruled in favor of Herald’s demand for restitution, against HSBC. Herald believed it had purchased securities through Madoff’s firm, and the Court of Cassation ruled the bank owed the fund restitution for these supposed investments.

This court said the restitution would have to be made in the form of cash because Madoff had never actually purchased the supposed securities with Herald’s investment.

In addition to this restitution for securities, Herald also claimed HSBC held cash — roughly $500 million — that had not been transferred to Madoff Investment Securities and that was owed back to the fund. The Court of Cassation ruled against this claim on a legal technicality rather than a factual finding.

The lower courts in the case had found that HSBC acted negligently in authorizing Madoff’s firm to invest on Herald’s behalf despite internal concerns within the bank about Madoff.

The lower court found that serious doubts regarding Madoff had been raised inside HSBC even before the Herald Fund placed money in Madoff’s firm. Thus, the court deemed HSBC responsible to Herald for losses resulting from the liquidation, bankruptcy or insolvency of Madoff’s company, BLMIS.

HSBC will now pursue a second appeal before the Luxembourg Court of Appeal. If that appeal is unsuccessful, HSBC said it would continue to contest the final monetary amount required in follow-up proceedings.

Financial fallout for HSBC

In response to the judgment, HSBC announced it will book a provision of $1.1 billion in its third-quarter financial results. The bank expects this provision to impact the bank’s CET1 capital ratio by approximately 15 basis points.

HSBC cautioned investors that, due to the complexity and uncertainties involved in determining the final amount of restitution, especially given the pending second appeal, the eventual financial impact “could be significantly different.”

The $1.1 billion charge should not have an impact on operations at the bank, according to Lorraine Tan, director of equity research for Asia at Morningstar, who spoke to CNBC. However, it could weigh on sentiment slightly because investors had hoped the bank would be done with such write-offs by now.

Understanding the Madoff Ponzi scheme

The litigation stems from the multibillion-dollar Ponzi scheme perpetrated by Madoff through the investment advisory side of his firm.

The core mechanism of the Ponzi scheme involved Madoff soliciting funds from clients under false pretenses. He promised to invest the funds but intentionally failed to do so.

Instead, client funds were deposited into a single bank account. When clients requested redemptions or expected profits, Madoff paid them using money deposited by other, newer clients.

Madoff marketed a specific, fraudulent investment technique known as a split strike conversion strategy. He falsely claimed that his firm would:

• Invest funds in a basket of common stocks within the S&P 100 index.
• Time purchases opportunistically.
• During periods “out of the market,” invest client funds in U.S-issued securities such as Treasury bills.
• Hedge the investments by buying and selling option contracts related to the stocks to limit potential losses.

To conceal this fraud, Madoff created a vast infrastructure and hired employees to generate false and fraudulent documents, including monthly client account statements and trade confirmations reflecting fictitious transactions and inflated returns.
He also repeatedly lied under oath and filed false financial statements and filings with the Securities and Exchange Commission.

Madoff also transferred hundreds of millions of dollars between the U.S. firm and his London affiliate, partly to give the false appearance that he was executing securities transactions in Europe.

By his own admission, Madoff’s scheme operated from at least the 1980s until his arrest on Dec. 11, 2008.