Two giant global banks helped at least a dozen hedge funds skirt full tax payment on more than $100 billion worth of stock trades, according to a new congressional investigation made public Monday.
The probe by the Senate Permanent Subcommittee on Investigations will be the subject of a daylong hearing on Tuesday and also spells more trouble for the embattled Internal Revenue Service.
At issue is whether complex financial deals arranged by London-based Barclays Bank PLC and Germany’s Deutsche Bank AG deliberately helped hedge funds skirt U.S. tax laws for financial advantage and bend rules designed to protect the financial system from excessive borrowing to finance speculative bets.
The IRS in 2010 issued a warning against the financial instruments at question in the Senate probe, but roughly four years later, no additional tax money has been collected from the hedge funds involved, Senate investigators said.
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Hedge funds are private investment vehicles for uber-wealthy investors, and their steep costs to join effectively lock out ordinary Americans. They are often partnerships, whose investors are partners who reap the tax savings afforded by the scheme.
The Senate report alleges that Deutsche Bank and Barclays conspired with the hedge funds to create a complex investment vehicle that gave the appearance of being a brokerage account like those used by ordinary Americans who play the stock market.
The difference, however, is that these accounts, called “basket options,” involved billions of dollars in rapid and constant computerized trading. The hedge funds, the report said, were taking short-term profits but being taxed as if they were ordinary investors holding stocks for a year or longer. They were taxed at a rate of 15 percent to 20 percent instead of the rate of ordinary income, which is as high as 39 percent.
In a news conference detailing the complex scheme, Committee Chairman Carl Levin, D-Mich., said the banks and a number of hedge funds established “sort of an alternative universe” in which there were large volumes of trading taking place in minutes, days and months. Most transactions happened in six months or less, but the profits were treated as if the hedge funds were holding the securities for periods of a year or more_ long enough to claim the lower tax rate for capital gains.
The scheme took place from 1998 to 2013, according to congressional investigators, and came even as the two banks were being investigated for other wrongdoing.
Deutsche Bank was already under a non-prosecution agreement with the Justice Department on other matters, and Barclays was under investigation by U.S. and British regulators for what later was shown to be manipulation of the London Interbank Offered Rate. LIBOR is a key global lending rate that sets the lending rate for many U.S. mortgages and car loans.
Although more than a dozen hedge funds were known to have used at least 199 “basket options,” the Senate panel narrowly looked at two of the largest funds _ Renaissance Technology Corp. LLC and George Weiss Associates.
Other hedge funds that purchased “basket options” from the two banks are Ballentine Capital Management, Deephaven Capital Management, SAC Capital Advisors, Talon Capital LLC, Provident Advisors LLC, MFT Limited, Analytic Investors Inc., Riverside Asset Management LLC, 646 Advisors LLC and Northern Asset Management.
The scheme worked like this: The two banks opened a proprietary trading account, which had constantly changing assets within these accounts. It had the appearance of being an account controlled and operated by the banks, when in fact the hedge funds selected the assets within the accounts, executed the trades and reaped the profits. In return, banks were paid a flat fee.
The “option” portion refers to the fact that the hedge funds had the right to purchase the “option” on the performance of a basket of assets. This is similar to how investors can take out options to buy, at a predetermined price, contracts for future delivery of oil or a company’s stock. It is a right but not an obligation to buy an asset at a predetermined price.
But “basket options” involve a troubling question: Why would a hedge fund buy an option on its own trading activity?
“It would be absurd,” said Levin, noting the only reason is for the tax benefits it provided.
Banks and hedge funds worked together to create a “series of fictions,” he said. One was that banks owned the accounts. Barclays actually stopped listing “basket options” activity in its financial statements as of 2009, arguing profits belonged to the hedge funds.
The instruments also skirted rules against excessive debt used to take risks. Most hedge funds invest seven or eight times the cash they actually have, a process called leveraged investing. Under the basket options afforded by Barclays and Deutsche Bank, the hedge funds could leverage at a ratio as high as $20 for every dollar they had. This sort of excessive debt used for speculative bets is what brought down investment banks Bear Stearns and Lehman Brothers and led to the 2008 financial crisis.
The IRS had no immediate comment on criticism by Levin, who complained that after issuing a Generic Legal Advice Memorandum, dubbed a GLAM, in 2010, there has been little enforcement action or collection of taxes owed.
“As far as we know, that’s about it,” he said.