Briefings

LEGAL & COMPLIANCE: Levin Hearing on Structured Finance Products

The Subcommittee hearing examined a set of transactions by hedge funds and banks that utilize financial engineering and structured financial products to avoid paying U.S. taxes on short-term capital gains. The hearing was centered on a 93-page report released by the subcommittee which found that over a dozen hedge funds misused complex financial structures to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt.

CONGRESSIONAL HEARING REPORT

COMMITTEE: Senate Homeland Security and Governmental Affairs

SUBCOMMITTEE: Permanent Subcommittee on Investigations

SUBJECT: Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits

DATE: July 22, 2014



Members Present:

Democrats: Subcommittee Chairman Carl Levin (MI),
Republicans: Ranking Member John McCain (AZ), Sen. Ron Johnson (WI)

Witnesses:

Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center
James White, Director, Tax Issues, US Government Accountability Office
Martin Malloy, Managing Director, Barclays
Satish Ramakrishna, Managing Director, Deutsche Bank Securities Inc
Mark Silber, Executive VP, CFO, Chief Compliance Office, Renaissance Technologies LLC
Jonathan Mayers, Counsel, Renaissance Technologies LLC
M. Barry Bausano, President and Managing Director, Deutsche Bank Securities
Peter Brown, Co-Chief Executive Office and Co-President, Renaissance Technologies LLC

Overview

The Subcommittee hearing examined a set of transactions by hedge funds and banks that utilize financial engineering and structured financial products to avoid paying U.S. taxes on short-term capital gains. The hearing was centered on a 93-page report released by the subcommittee which found that over a dozen hedge funds misused complex financial structures to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt.

Chairman Levin began by explaining financial structures which allow wealthy corporations to avoid paying all their U.S. taxes and participate in reckless behavior that destabilizes the financial system. Particularly he focused on Deutsche Bank AG and Barclays Bank PLC, who worked in tandem with Renaissance Technologies LLC (RenTec) to engage in highly profitable trades while claiming an unjustified lower tax rate and avoiding limits on trading with borrowed money. While this worked well for the banks and hedge funds, he said, these practices hurt average taxpayers who had to shoulder the tax burden these financial institutions shrugged off. Chairman Levin identified the key financial product in these operations as a “basket option”, an open account within the banks with an ever-changing portfolio of stocks and bonds bought at the discretion of the hedge fund. Chairman Levin included three points of issue in his report. First, though the financial structure was designed to create the appearance that the bank owned all assets in the basket option account, the hedge fund made all the trading decisions. Second, the hedge funds set up new entities which they themselves controlled to act as an option holder. Lastly, the option was structured so that it could be exercised more than one year after it was created – allowing hedge funds to qualify trading profits as long-term capital gains

The member question and answer focused on what Chairman Levin called, “a series of fictions, one piled on top of another.” Chairman Levin listed several points, saying that it was fiction to: 1) treat the banks as the true owners of the basket option assets; 2) suggest that the borrowed money which financed trades be considered proprietary funds of the banks; 3) treat the profits from trades lasting short periods of time as long-term capital gains deserving of a lower tax rate and; 4) pretend that hedge funds were not acting as both option-holder and as trade decision-maker.

Chairman Levin began by disputing the claim that the banks truly owned the basket option assets. He said that though the structure was set up to promote this view, the hedge fund was the entity in charge of making all trading decisions for that account, and moreover used the bank's computerized market trading system to execute trades in the account. He pointed to estimates made by RenTec that its trading through basket options accounts averaged more than 100,000 trades each day, or 30 million trades a year. The Senate investigation found that even though Barclays and Deutsche Bank used the options to build special accounts for their hedge fund clients in their own names, the hedge fund clients exercised full control of the assets and benefited from all the profits. Mr. Rosenthal supported the Chairman by saying ownership of an account should be assigned to the entity that benefits from any profits. The primary reason to pretend the assets belonged to the banks, Chairman Levin said, was to circumvent margin rules which prohibit U.S. broker-dealers from lending customers more than $1 to brokerage clients for each $1 of the client's own money in the account. Because the basket option accounts were opened in the name of the banks, however, they were able to offer hedge-fund clients leverage as high as 20-1 instead of the standard 2:1.

Mr. Rosenthal of the Urban-Brookings Tax Policy Center focused on how the basket option was structured so that it could be exercised more than one year after it was created. Under that structure, hedge funds claimed that trading profits from the account were long-term capital gains and qualified for the lower long-term capital gains tax rate. Mr. Rosenthal proved to be an ally for Chairman Levin when he called the options “tax alchemy” that helped the hedge funds incorrectly characterize what they were doing – in effect making millions of trades over a short period of time. Barry Bausano of Deutsche Bank disputed those claims and insisted that his bank's products were not tax-motivated and that it stopped selling versions that offered potential tax benefits after being publicly challenged by the IRS in 2010. Representatives of RenTec disputed the Senate report which said that most of the Renaissance trades were short term – some lasting only seconds – and should be taxed at 39 percent instead of the 20 percent rate for long-term capital gains. Witnesses from Renaissance maintained that options were held on average for at least 400 days from 2000 to 2009. “When securities are held for weeks or days or even seconds,” Chairman Levin said incredulously, “it's surreal to characterize those trading profits as long-term capital gains.” The Senate report estimates, based on basket option profits from RenTec reports between 2000 and 2013, that RenTec avoided paying more than $6 billion in taxes.

Finally, Chairman Levin focused on structures in which he said Renaissance created entities that had no employees, offices or equipment to place trades, but held accounts under the banks anyways. In each company's case, he said, Renaissance was the investment adviser. Mr. Silber and Mr. Ramakrishna of RenTec and Deutsch Bank respectively, maintained there was no wrongdoing. Mr. Silber said Renaissance played two different roles, controlling the entities but having different ownership structures. Mr. Ramakrishna said that while the bank knew the entities and RenTec were related, the bank took steps to ensure compliance with applicable tax and securities laws and regulations. Chairman Levin refused to accept this explanation and pointed out that the hedge fund's control of all the trading for the basket option account removed the function of a legitimate option. He admonished RenTec for setting up new entities to serve as the option holder and claiming that their control of the option holder was totally independent of their role in making the trading decisions for the basket option account. “RenTec is making a judgment on RenTec,” he reiterated. “Find me a dictionary where that is the definition of independence.”

Chairman Levin urged Congress and financial regulators to work to stop improper practices. He suggested: 1) The IRS seek to collect taxes owed on billions of dollars in basket option profits; 2) Federal financial regulators make clear to banks that participating in abusive structures designed to avoid leverage limits and taxes is unacceptable; 3) The Financial Stability Oversight Council establish reporting and data collection requirements to detect and stop abuse of structured financial products to circumvent leverage limits and; 4) Treasury and the IRS remove impediments to audits of large partnerships like hedge funds.