Two global banks, Deutsche Bank and Barclays Bank, and more than a dozen hedge funds, such as RenTec, misused a complex financial structure to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt, a Senate Subcommittee investigation has concluded. The improper use of this structured financial product, known as basket options, is the subject of a 93-page report and 5 hours of testimony.
Please see the story and links to releavnt document and recorded webcast http://lawprofessors.typepad.com/intfinlaw/2014/07/hedge-funds-using-basket-options-to-recharacterize-income-as-long-term-capital-gain-bypass-leverage-.html
Based upon the Subcommittee investigation, this Report makes the following findings of fact.:
1. Profiting from Basket Options. Between 1998 and 2013, Deutsche Bank AG sold basket option products to 13 hedge funds, while Barclays Bank PLC sold them to one hedge fund, together leading to over $100 billion in securities trades and tens of billions of dollars in profits, most of which came from trades that lasted less than 12 months in duration, but were treated by the hedge funds as producing long-term capital gains. The basket options also produced financing, trading, and other fee revenue for the banks totaling $570 million for Deutsche Bank and $655 million for Barclays.
2. Turning a Blind Eye. Deutsche Bank AG and Barclays Bank PLC were aware of the questionable tax status of their basket option structures for many years prior to the issuance of the 2010 IRS advisory memorandum, but continued to sell the product.
3. Claiming Short-Term Trading Profits as Long-Term Capital Gains. Over a fourteen-year period from 1999 to 2013, one hedge fund, Renaissance Technologies LLC, held 60 basket option contracts for more than one year, used them to carry out an investment strategy utilizing hundreds of millions of trades, virtually all of which lasted less than 12 months, and characterized the vast majority of the resulting $34 billion in trading profits as long-term capital gains.
4. Ceding Control. Although the investments in the basket option trading accounts were held in the name of the banks, Deutsche Bank and Barclays routinely hired the option holder – the hedge fund – as the investment adviser for the accounts and ceded control of their accounts to the option holder, which traded the account for its own benefit.
5. Assessing Risk. Although Deutsche Bank and Barclays claimed the basket option structure was a valid derivative in part because it carried financial risk for the bank, Barclays downplayed that risk both internally and in reports to its U.K. regulator when it benefited the banks’ interests.
6. Avoiding Leverage Limits. By opening the basket option accounts in their own names and supplying their own funds to those accounts as financing for the trades controlled by their hedge fund clients, Deutsche Bank and Barclays enabled the hedge funds to attain a leverage ratio of as high as 20:1, despite the much lower federal leverage limit of 2:1 intended to prevent systemic risk.
7. Producing a Low Audit Rate. While, in 2010, the IRS determined that basket options were being misused and, in 2012, proposed additional tax liability for one hedge fund, the Government Accountability Office has determined that 99% of the tax returns filed by large partnerships with assets exceeding $100 million have not been audited by the IRS. This extremely low auditing rate may embolden large partnerships such as hedge funds to employ abusive tax structures.
8. Failing to Enforce Leverage Limits. Although federal financial regulators have long been aware that derivative and structured financial products, including basket options, are being used to circumvent federal leverage limits, they have taken little or no action to limit those practices and enforce the statutory limits on purchasing securities with borrowed funds.
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