JPMorgan Chase (JPM 0.62%) is on the verge of agreeing to a historic settlement with federal authorities over its relationship with Bernie Madoff. The bank may pay fines of up to $2 billion, while also agreeing to a deferred prosecution for violating the Bank Secrecy Act.

An earlier lawsuit against JPMorgan filed by Irving Picard, the court-appointed trustee tasked with recovering Madoff's clients' funds, provides a good indication of the charges facing the company. Picard notes that JPMorgan Chase was Madoff's "primary banker for over 20 years, and was responsible for knowing the business of its customers -- in this case very large customers." Additionally, the lawsuit alleges that JPMorgan "had everything it needed to unmask and stop the fraud -- it had unique information from which it could have reached only one plausible conclusion: Madoff was a fraud."

We believe Picard's evidence reflects very poorly on JPMorgan. Not only did the bank's actions possibly violate the law, but its poor due diligence and willingness to profit off Madoff's dubious activities suggest that the company's culture is deeply flawed.

We've summarized some of the most troubling pieces of evidence from Picard's lawsuit. We suspect that whatever evidence the FBI uncovered in its investigation was at least as thorough as what you'll find here.

1. JPMorgan Chase ignored years of red flags in Madoff's Chase bank account that he used for money laundering and Ponzi scheme payouts.

Banks are required to know the purpose of customer accounts and monitor them for suspicious activities, but JPMorgan Chase never halted or reported the suspicious activity in Madoff's so-called "703 account."

  • Over a roughly seven-year stretch from 1998 to 2005, the account made $76 billion in payouts to a single customer.
  • Madoff made odd repetitive transactions, oftentimes in a single day, frequently using handwritten checks. In 2002, the account made 318 payments of exactly $986,301 to a single customer.
  • In December 2001, the account received daily checks of $90 million from that same customer, who was also an important JPMorgan Chase client.
  • From 2004 to 2008, the vast majority of international wire transfers went to high- and medium-risk jurisdictions.
  • JPMorgan Chase earned an estimated half a billion dollars in fee revenue from Madoff's account.

2. JPMorgan Chase seems to have violated basic account monitoring and "know your customer" principles.

The activity in Madoff's account didn't appear to reflect any "legitimate business purpose."

  • Even though JPMorgan's algorithms should have identified lots of suspicious activity, its computers almost never issued any alerts. After Madoff was arrested, JPMorgan Chase compliance employees thought the omission odd, asking "Why didn't the DDA Account (xxxxx1703) alert ... ?"
  • The only time an account alert was issued, the reviewer couldn't even find a "know your customer" file for Madoff and stopped looking into the matter.
  • For more than 10 years, Madoff's Client Relationship Manager, Richard Cassa, was the 703 account's "account sponsor" -- the JPMorgan Chase employee responsible for monitoring Madoff's account and ensuring the bank understood Madoff's business. From the lawsuit, we learn that he essentially pleaded total incompetence:

When asked about his duties as a client sponsor at his Rule 2004 bankruptcy examination, Cassa responded that he did not even know what a client sponsor was, much less that he was the sponsor for Madoff's and BLMIS's [Bernard L. Madoff Investment Securities] accounts. He had received no training regarding his duties as a client sponsor and had taken no action to discharge those duties. When shown a document in which he had recertified that he had performed his duties as a client sponsor, Cassa stated that he did not have any recollection of the duties of a sponsor or of the recertification process.

  • When high-level executive Matt Zames questioned whether Madoff was running a Ponzi scheme (see No. 5 below), no one at JPMorgan Chase seems to have investigated Madoff's big JPMorgan Chase bank account, including Cassa, who knew of Zames' claim.
  • Even after JPMorgan Chase reported Madoff's Ponzi scheme to British authorities so that the bank could retrieve its own money in October 2008 without alerting any American authorities, JPMorgan Chase allowed Madoff to continue operating his account without any restrictions on it. Madoff was eventually arrested in December 2008.

3. JPMorgan Chase knew at least as far back as 2006 that Bernie Madoff funds were suspicious.

Around 2006, JPMorgan Chase began considering selling its own financial products based on Madoff feeder funds. Before selling these products to investors, JPMorgan Chase had to check out Madoff and the funds that the bank wanted to base its own products on.

  • A market risk officer who visited the feeder funds shared his worries,

I do have a few concerns and questions: 1) All trades are generated by Madoff's black box trading model and executed by Madoff. It's not clear whether [the feeder fund] has any discretion or control over the autopilot trading program. ... 2) Is it possible to get some clarification as to how the fund made money during times of market distress? ... how did they manage to get better than 3M T-Bill returns? ... For example, from April to September 2002, the S&P 100 Index is down 30%, cash yielded 1%, and the Fund was able to generate over 6% returns.

  • After quite a bit of stonewalling about a fund's relationship with Madoff, a risk employee found that "They have position level transparency once a month with 1 week delay, but don't run risk analysis and don't have the know-how of how to do this. ... It doesn't look pretty."
  • Here's what they knew about Madoff's auditor, Friehling & Horowitz:

A quick check found that they are not registerred [sic] with the Public Company Accounting Oversight Board, nor are they subject to peer reviews from the American Institute of Certified Public Accountants. Additionally, they have no website to provide background on their organization.

4. Despite its suspicions, JPMorgan Chase went ahead and sold to its customers financial products based on Bernie Madoff feeder funds.

Most of the funds JPMorgan Chase created and sold to investors used borrowed money to magnify the returns from Madoff funds. By March 2007, JPMorgan Chase had $100 million worth of Madoff products it was structuring in the pipeline and was thinking of creating an additional $100 million to $200 million.

The products were to be so profitable that at one point JPMorgan Chase employees calculated that "[b]ased on the overall estimated size of [our Bernie Madoff] strategy, it would take [a] ... fraud in the order of $3bn or more ... for JPMC to be affected."

  • James Coffman, a credit risk manager, told bankers they needed to do more due diligence on Madoff in order to go above a $100 million limit. So on March 30, Richard Cassa, who was responsible for monitoring Madoff's bank account, and members of the Risk Management Division spoke with Madoff. Even though the products JPMorgan wanted to create would have led to increased investments in Madoff's fund, Madoff told them he disliked banks structuring products on his strategy and was not willing to let JPMorgan Chase engage in "full due diligence."
  • Nevertheless, JPMorgan Chase's Equity Exotics team put together a "Transaction Approval Package." Noted transaction weaknesses included "investors, sub-Custodians, auditors etc rely solely on Madoff produced statements and have no real way of verifying positions at Madoff itself," and "[f]raud -- given the significant reliance on BLM for verification of assets held, and no real way to confirm those valuations, fraud presents a material risk."
  • In June 2007, Equity Exotics began preparing proposals for another $825 million in investments in the funds -- raising the total exposure to $1.32 billion -- an amount that the group acknowledged was in "significant excess of both individual as well as aggregate single manager limits." Coffman anticipated "a major head on collision with the business that wants to do an infinite amount of this activity with much less oversight."

5. JPMorgan Chase sold more Madoff-based products to customers after ignoring internal warnings that Madoff was running a Ponzi scheme.

  • On the day JPMorgan's Hedge Fund Underwriting Committee met to consider selling another $825 million in Madoff-related products, John Hogan, JPMorgan Chase Investment Bank's chief risk officer, noted:

For whatever its [sic] worth, I am sitting at lunch with Matt Zames [a high-level trading executive] 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-he said if we [G]oogle the guy we can see the articles for ourselves-Pls do that and let us know what you find out. 

  • Jane Buyers-Russo, head of the Broker/Dealer Group, didn't seem to make uncovering the truth a major priority: "please have one of the juniors look into this rumor about Madoff that Hogan refers to below." (The junior analyst found and speculated on an irrelevant news article about a proposed change in SEC regulations.)
  • Hogan warned:

Mr. Madoff will not allow us to conduct any due diligence on him directly and we are forced to rely on the diligence of third parties. ... I told Bobby [Magee] and Neil [McCormick] we don't do $1 bio 'trust me' deals and we need to do our own due diligence on Madoff or this wasn't going to happen.

  • But after a phone call with Madoff, Hogan agreed to allow $250 million. Here's how he explained the decision afterwards:

[T]here's no math or magic around it -- you know, a lot of what we do is more art than science, so I would like to tell you that I have prepared a model that told me 250 is the optimum number, but -- you know, that's not the way it works in reality, and so I just use my best judgment to come up with that number.

6. JPMorgan neglected to report Madoff to American law enforcement ... even after it told a British financial authority that the bank was retrieving its own Madoff investments because he was a fraud.

  • When JPMorgan tried to get its money back from one of Madoff's dodgy feeder funds, the fund threatened an investment banker that its "Colombian friends" would "cause havoc," telling him, "we know where to find you."
  • JPMorgan Chase complained to British authorities about the threats and explained that the bank wanted money back because it had long suspected Madoff's business wasn't legitimate:

Ultimately, the bank reached the same conclusion it had reached during its initial due diligence efforts in 2006 and 2007; JPMorgan was unable to obtain [look through] transparency at the Feeder Fund level, did not have access to the identities of the counterparties to Madoff's OTC options, did not fully understand the relationship between the broker-dealer and the investment advisor, and noted the fact that the custodians did not actually hold the assets.

  • In an October 2008 Suspicious Activity Report to the British authorities, JPMorgan wrote:

JPMCB's [JPMorgan Chase Bank] concerns around Madoff Securities are based (1) on the investment performance achieved by its funds which is so consistently and significantly ahead of its peers, year-on-year, even in the prevailing market conditions, as to appear too good to be true -- meaning that it probably is; and (2) the lack of transparency around Madoff Securities' trading techniques, the implementation of its investment strategy and the identity of its OTC option counterparties; and (3) its unwillingness to provide helpful information. As a result, JPMCB has sent out redemption notices in respect of one fund, and is preparing similar notices for two more funds.

  • While JPMorgan successfully redeemed all but $35 million of its own investment in Madoff, the bank didn't close down Madoff's JPMorgan Chase bank account that he used for laundering funds and operating his Ponzi scheme, nor did it report Madoff to American authorities or law enforcement.
  • Employees were urged to keep quiet about why they would no longer offer Madoff feeder funds to prospective investors: "Without disclosing too much, [JPMorgan Chase] got rid of all the Madoff feeder[s]."

7. Following Madoff's confession, the JPMorgan Chase employees responsible for due diligence weren't exactly surprised he had been a fraud.

  • "Return seems a little too good to be true," and the fraud "wasn't completely unexpected but the scale of it is still a shock."
  • "We've got a lot wrong this year, but we got this one right at least -- I said it looked too good to be true on that call with you in [September]. Despite suspecting it was dodgy I am still shocked to see this happen so suddenly."
  • Others wrote it was "statistically impossible" for Madoff to have produced such consistent returns.
  • Michael Cembalest, the chief investment officer at JPMorgan Global Wealth Management, emailed Private Bank customers to inform them that the Private Bank had decided not to invest with Madoff because it had "never been able to reverse engineer how they [made] money" and Madoff's fund "did not satisfy [their] requirement for administrative oversight."
  • According to the bankruptcy trustee, Cembalest's email noted a long list of red flags:

(a) Madoff served as his own prime broker, custodian, and investment advisor; (b) Madoff utilized a three-person accounting firm in Rockland County [N.Y.], which was "almost unheard of for a fund of that size"; (c) while Madoff feeder funds were audited by large, well-known accounting firms those audits did not cover BLMIS; (d) the Private Bank's due diligence team was not allowed to meet Madoff; Madoff did not charge fees for his money management services (essentially leaving billions of dollars on the table); (f) the volatility of Madoff's returns was only 2.5% over the preceding seventeen years, a period which included some of the most volatile capital markets history; and (g) Madoff's fund "lost money in only 2 of 214 rolling quarterly periods since 1990.

  • Another credit risk officer added, "Perhaps best this never sees the light of day again!!"

Is JPMorgan worthy of our trust?
If Bernie Madoff has taught us anything, it's that trust is central to the relationship between investors and their financial institutions. Without trust, the whole system falls apart.

In recent months, JPMorgan has seen its trustworthiness called into question by a wide array of investigations and settlements. And the Madoff deal promises to be one of the most damaging of all to the company's reputation. JPMorgan's stakeholders should insist that restoring the bank's reputation becomes the primary goal of the firm in 2014 and beyond.