LUXEMBOURG (Bloomberg) - HSBC Holdings plc.'s Luxembourg unit should compensate investors only if a local court finds the bank breached its custodial duties over a fund that placed assets with Bernard Madoff, the country's financial regulator said.

The Commission de Surveillance du Secteur Financier, in a statement on its website on Wednesday, ordered HSBC Securities Services in Luxembourg to review its internal rules "to fulfill all the tasks relating to its function" as custodian bank of local mutual funds "within a period of three months".

European custodian banks face increased scrutiny by the European Commission following the Madoff scandal. Investors in France, Ireland and Luxembourg, the world's second-largest mutual fund market after the US, are suing custodians, seeking the repayment of billions of dollars.

"This clearly shows that the custodian was not able to do its job correctly," said Erik Bomans, a Brussels-based partner at Deminor International, adviser to a group of about 600 investors.

HSBC's Luxembourg unit was custodian for Herald (Lux) US Absolute Return Fund, which was forced to dissolve because of Madoff losses.

The decision whether HSBC's unit "committed a civil tort which would oblige it to contribute, together with all other persons held liable" to pay damages "falls exclusively to the courts and tribunals", the regulator said.

"HSBC believes that it has complied with all its obligations as the depositary bank of the Herald Lux SICAV and agrees with the commission that it is exclusively up to the civil courts to determine the outcome of this matter," the London-based bank said in an e-mailed statement on Wednesday. "HSBC continues to believe that it has good defenses to any claims brought against it and will vigorously defend itself against any such claims."

Madoff, 71, pleaded guilty in March in federal court in Manhattan and was sentenced on June 29 to 150 years in prison for using money from new clients to pay earlier investors. He directed a multibillion-dollar Ponzi scheme from his now-defunct New York money management firm.

Luxembourg Finance Minister Luc Frieden in June said custodian banks for Luxembourg-based mutual funds, such as HSBC's unit, had "clear" obligations to compensate investors for Madoff-related losses.

HSBC, Europe's largest bank by market value, is facing investor complaints in Ireland for allegedly failing in its duties as custodian handling money in the Irish Thema International Fund plc. The European funds at issue are known as Undertakings for Collective Investment in Transferable Securities, or UCITS. Custodians manage cash inflows and payments to investors.

UBS AG is also being sued in Luxembourg over its role as custodian for two local funds, including Access International Advisors LLC's LuxAlpha Sicav-American Selection fund, which once had assets of $1.4 billion, and invested 95 percent with Bernard L. Madoff Investment Securities LLC.

The CSSF in a May 27 finding after its review into UBS's liabilities said the Swiss bank's local unit had to indemnify mutual fund investors "according to its obligations as a Luxembourg depositary bank, subject to valid and opposable contractual clauses to the contrary".

In its three-page statement yesterday, the regulator clarified its position further, saying that the final decision concerning contractual liabilities between private parties "can only be taken conclusively by a competent Luxembourg court".