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July 22, 2014 01:00 AM

Hedge funds, banks come under fire for basket options

Hazel Bradford
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    Julia Schmalz/Bloomberg
    Michigan Sen. Carl Levin

    Renaissance Technologies, Barclays Bank PLC, and Deutsche Bank AG were criticized Tuesday for misusing structured financial products to avoid taxes and banking leverage limits.

    According to a report issued by the U.S. Senate Permanent Subcommittee on Investigations, the two banks sold financial products known as basket options to Renaissance, George Weiss Associates and nearly a dozen other hedge funds. The proprietary trading accounts were in the names of the banks but were controlled by the hedge funds, which reaped trading profits but paid taxes at a lower long-term capital gains rate. The banks profited mainly by lending as much as 90% of the investment to the hedge funds, despite banking regulations limiting lending for stock trading.

    The highly profitable trades allowed the parties to claim “an unjustified lower tax rate and avoid limits on trading with borrowed money,” said committee Chairman Carl Levin, D-Mich.

    Senate investigators found that Deutsche Bank and Barclays Bank from 1998 to 2013 sold 199 basket options to hedge funds that used them to conduct more than $100 billion in trades. Categorizing the profits as long-term capital gains saved Renaissance an estimated $6.8 billion, the report found.

    “This moneymaker was built on an interlocking series of fictions,” Mr. Levin said at the Senate hearing where the report was discussed.

    Mark Silber, executive vice president, chief financial officer, chief compliance officer and chief legal officer for Renaissance Technologies, told the panel that the arrangements, also known as barrier options, were entered into “for substantial non-tax business purposes,” mainly to protect against losses when trading at high leverage. Mr. Silber noted the Internal Revenue Service has been investigating the tax arrangements of basket options for six years, with the firm's cooperation. “Ultimately, we expect to prevail,” he said.

    Barclays “feels strongly that this transaction was subject to sufficient … review,” Martin Malloy, Barclays managing director, told the panel.

    Mr. Levin argued the IRS should collect the billions of dollars owed for misclassifying profits as capital gains, and for federal banking regulators to penalize banks that avoid leverage limits. “Basket options were clearly a lucrative line of business for the participants,” he said.

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