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It's weird because the Karma goes trhough an additional processing step, A-to-D conversion (I assume all processing in Empeg is done by DSP)- whereas from the HD it should all nicely stay in digital domain so if anything, it should sound worse.

Huh? What extra processing step? There isn't any A to D conversion that I know of.

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Another thing that has got me worried is that is seems that the Empeg damages MP3 files... Files that were fine in the past suddenly have excruciatingly loud clicks or bursts of screeches in them; always re-occuring at the exact same spot. How this happens, I don't know, haven't discovered a pattern. Putting the same file back on the Empgeg from the PC restores things. All my music is VBR Lame encoded; extreme setting); using both ID3 V1 and V2 tags.

There is a hardware fault with your empeg. I've had random pops and squeeks before and it was caused by a bad IDE cable.