What Did Chase Know, and When Did It Know It?

The Madoff trustee’s lawsuit against JPMorgan Chase (a k a, at least in this suit, JPMC) reads like no other lawsuit I have read. It begins this way:

NATURE OF THE ACTION
“‘But the Emperor has nothing on at all!!!’ said a little child.”
Hans Christian Andersen, The Emperor’s New Clothes

“For whatever it[']s worth, I am sitting at lunch with REDACTED [JPMC Employee 1] who just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a [P]onzi scheme.”
REDACTED[JPMC Employee 2], REDACTED risk officer, Investment Bank, JPMC, June 15, 2007

1. The story has been told time and again how Madoff duped the best and the brightest in the investment community. The Trustee’s investigation reveals a very different story — the story of financial institutions worldwide that were keen to the likely fraud, and decidedly turned a blind eye to it. While numerous financial institutions enabled Madoff’s fraud, JPMC was at the very center of that fraud, and thoroughly complicit it in.

Thoroughly complicit? That is strong language. It is one thing to say they should have known, or that they were suspicious but did not do the work they should have done to confirm those suspicions. The suit says both of those things, and seems to have evidence to back them up. It also has evidence that anyone in the bank who looked at Bernard L. Madoff’s bank account transactions could have noticed money was not coming in from sales of securities, and money was not going out for purchases.

But complicit means a willing partner. JPMorgan Chase says that is nonsense, as Diana Henriques reports.

Does the trustee have evidence of that? The best you can say is maybe.

Here’s what is clear. JPMorgan Chase sold structured products that enabled customers to get triple the yield Madoff was generating, less some fees of course. It then invested in hedge funds that had Madoff managing their money, known as Madoff feeder funds. For the bank, it was a riskless investment strategy, or so it seemed.

But in 2008 the bank grew more and more alarmed. In September — the month Lehman Brothers failed, you may recall — the bank got what it viewed as threats against it if it liquidated its investment, and reported that to British authorities. In that report Chase said it was skeptical about the legitimacy of the Madoff operation. The threats did not come from Mr. Madoff, but from a customer who had bought the products from Chase and resold them to its own customers.

Here is where it gets really interesting. JPMorgan Chase did move to cash in all of its investments, although the fraud blew up in December 2008, before it received the last $35 million. Another excerpt from the suit, with BLMIS referring to Bernard L. Madoff Investment Securities:

In redeeming its investments . . . JPMC left itself fully exposed with regard to its structured products. JPMC was still required to pay its investors based on the returns generated by the BLMIS feeder funds, which were generating positive returns when the market was down. But for JPMC’s suspicions about fraud at BLMIS, this move would have been counterintuitive.

Two things stand out. First, JPMorgan Chase no longer had a riskless strategy. If it turned out Madoff’s returns were genuine, it stood to lose a lot of money since it would have to pay the investors in the structured products. Second, the suit refers to the bank’s “suspicions.” That is a very different word from “complicit.”

The evidence in the lawsuit clearly shows that people at JPMorgan Chase saw red flags, and that others saw an opportunity for the bank to make money if it ignored the red flags. An internal memo written later — after the fraud was disclosed — states that the risk of fraud “was considered at the time to be a remote likelihood.”

After Lehman went broke on Sept. 15, there was a flight to riskless investments everywhere. Had JPMorgan Chase taken out its own money, it would be easy to believe that, despite its suspicions, it did not really know anything. But its haste, given the exposure it faced if Madoff was not a fraud, certainly raises questions.

JPMorgan Chase says it will “defend itself vigorously against the unfounded claims brought by the trustee.” I look forward to the trial.

Addendum: This was corrected to fix the spelling of Hans Christian Andersen. The error was by the writer; the name was spelled correctly in the suit.