[Senate Hearing 113-422]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 113-422

 
                ABUSE OF STRUCTURED FINANCIAL PRODUCTS:

                    MISUSING BASKET OPTIONS TO AVOID

                       TAXES AND LEVERAGE LIMITS

=======================================================================

                                HEARING

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON

               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS


                             SECOND SESSION

                               ----------                              

                             JULY 22, 2014

                               ----------                              

         Available via the World Wide Web: http://www.fdsys.gov

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        COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                  THOMAS R. CARPER, Delaware Chairman
CARL LEVIN, Michigan                 TOM COBURN, Oklahoma
MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
JON TESTER, Montana                  RAND PAUL, Kentucky
MARK BEGICH, Alaska                  MICHAEL B. ENZI, Wyoming
TAMMY BALDWIN, Wisconsin             KELLY AYOTTE, New Hampshire
HEIDI HEITKAMP, North Dakota

                  Gabrielle A. Batkin, Staff Director
               Keith B. Ashdown, Minority Staff Director
                     Laura W. Kilbride, Chief Clerk
                   Lauren M. Corcoran, Hearing Clerk


                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                     CARL LEVIN, Michigan Chairman
MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
JON TESTER, Montana                  RAND PAUL, Kentucky
TAMMY BALDWIN, Wisconsin             KELLY AYOTTE, New Hampshire
HEIDI HEITKAMP, North Dakota

            Elise J. Bean, Staff Director and Chief Counsel
            Robert L. Roach, Counsel and Chief Investigator
                         David H. Katz, Counsel
                        Ahmad Sarsour, Detailee
       Henry J. Kerner, Minority Staff Director and Chief Counsel
                Michael Lueptow, Counsel to the Minority
             Brad M. Patout, Senior Advisor to the Minority
                     Mary D. Robertson, Chief Clerk


                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Levin................................................     1
    Senator McCain...............................................     5
    Senator Johnson..............................................    44
Prepared statements:
    Senator Levin................................................    77
    Senator McCain...............................................    81

                               WITNESSES
                         Tuesday, July 22, 2014

Steven M. Rosenthal, Senior Fellow, Urban-Brookings Tax Policy 
  Center, Washington, DC.........................................     7
James R. White, Director, Tax Issues, U.S. Government 
  Accountability Office, Washington, DC..........................     9
Martin Malloy, Managing Director, Barclays, London, England......    24
Satish Ramakrishna, Managing Director, Deutsche Bank Securities 
  Inc., Global Head of Risk and Pricing for Global Prime Finance, 
  New York, New York.............................................    25
Mark Silber, Executive Vice President, Chief Financial Officer, 
  Chief Compliance Officer, and Chief Legal Officer, Renaissance 
  Technologies LLC, New York, New York; accompanied by Jonathan 
  Mayers, Counsel, Renaissance Technologies LLC, New York, New 
  York...........................................................    27
Gerard LaRocca, Chief Administrative Officer, Americas, Barclays, 
  Chief Executive Officer, Barclays Capital Inc., New York, New 
  York...........................................................    54
M. Barry Bausano, President and Managing Director, Deutsche Bank 
  Securities Inc., Co-Head of Global Prime Finance, New York, New 
  York...........................................................    55
Peter F. Brown, Co-Chief Executive Officer, and Co-President, 
  Renaissance Technologies LLC, East Setauket, New York..........    57

                     Alphabetical List of Witnesses

Bausano, M. Barry:
    Testimony....................................................    55
    Prepared statement...........................................   118
Brown, Peter F.:
    Testimony....................................................    57
    Prepared statement...........................................   129
LaRocca, Gerard:
    Testimony....................................................    54
    Prepared statement...........................................   114
Malloy, Martin:
    Testimony....................................................    24
    Prepared statement...........................................   111
Mayers, Jonathan:
    Testimony....................................................    27
    Prepared statement...........................................   129
Ramakrishna, Satish:
    Testimony....................................................    25
    Prepared statement...........................................   118
Rosenthal, Steven M.:
    Testimony....................................................     7
    Prepared statement...........................................    83
Silber, Mark:
    Testimony....................................................    27
    Prepared statement...........................................   129
White, James R.:
    Testimony....................................................     9
    Prepared statement...........................................    91

                                APPENDIX

Report by the Permanent Subcommittee on Investigations Majority 
  and Minority Staff entitled, ``Abuse of Structured Financial 
  Products: Misusing Basket Options to Avoid Taxes and Leverage 
  Limits,'' July 22, 2014........................................   135

                              EXHIBIT LIST

 1. a. GThe Fiction of Independence, charts prepared by the 
  Permanent Subcommittee on Investigations.......................   250
    b. GRentec Control of Palomino, excerpts taken from 6/24/2009 
  Barclays Memorandum to PwC. [BARCLAYS-PSI-139757-766, at 763-
  764, Exhibit #53, below.]......................................   252
    c. GMedallion Master Funds [RT-PSI-00363694].................   253
    d. GSignatories to Franconia-Rentec Investment Advisory 
  Agreement [RT-PSI-00396355, Exhibit #6, below.]................   254
       GSignatories to Mosel Limited Partnership Agreement [RT-
  PSI-00396411-412, Exhibit #8, below.]..........................   255
       GSignatories to Bass-Rentec Investment Advisory Agreement 
  [RT-PSI-00396321, Exhibit #35, below.].........................   256
       GSignatories to Badger Holdings Ltd. Partnership Agreement 
  [RT-PSI-00396313-314, Exhibit #4, below.]......................   257
 2. GInternal Revenue Service Generic Legal Advice Memorandum 
  (GLAM), released November 12, 2010, re: Hedge Fund Basket 
  Option Contracts (The contract does not function like an 
  option, and should not be treated as such.). [BARCLAYS-PSI-
  748148-158]....................................................   258

Documents Related to Renaissance Technologies (RenTec):

 3. GRenTec email, dated September 2008, re: Re-shuffle- Follow-
  up (I confirmed that there is no prohibition against end-of-day 
  transfers in our new MAPS documentation. We may reshuffle the 
  constituents of the underlying options at the end of the day, 
  at the current closing price. *** Mark Silber was going [to] 
  discuss with you the ability to optimize the end of day re-
  shuffle process in order to keep the number of position re-
  shuffles to a manageable amount and below the radar of DB.). 
  [RT-PSI-00068362]..............................................   269
 4. GRenTec/Deutsche Bank email, dated November 2008, re: DB 
  counteroffer (Daniel Koranyi wrote: . . . Colin points out that 
  the Optimal Execution paper supports our contention that any 
  portfolio they would find themselves having to liquidate would 
  be low-risk, and could be liquidated slowly if required. The 
  portfolio would be well diversified, market-neutral, and with 
  low liquidity imbalance . . .).  [RT-PSI-00368695-697].........   270
 5. GRenTec email, dated August 2011, re: US portfolio shift - 
  overrides? (Management has decided to shift some portfolio from 
  the Palomino loss-protected managed account to the Deutsche 
  (DBAG) loss-protected managed accounts. The total amount of 
  portfolio to shift, for now, is USD 4e9.). [RT-PSI-00364418]...   273

Documents Related to MAPS Transactions:

 6. GInvestment Advisory Agreement between Renaissance 
  Technologies Corp. and Franconia Equities Ltd., dated March 30, 
  2000. (Advisor is authorized, without further approval by or 
  notice to the Client, to make all investment decisions 
  concerning the Account . . .). [RT-PSI-00396351-355]...........   274
 7. GBarrier Option Transaction confirmation, dated March 14, 
  2012, between Deutsche Bank AG, London Branch and Franconia 
  Equities Ltd. (The Buyer has made an independent judgment of 
  the experience and expertise of the Investment Advisor. *** 
  Other than as provided above, Buyer agrees that it shall not 
  contact directly the Investment Advisor regarding the terms or 
  subject matter of this Transaction.). [DB-PSI 00123196-208]....   279
 8. GMosel Equities L.P., Limited Partnership Agreement, dated 
  October 26, 2007. ([T]he General Partner shall have complete 
  and exclusive responsibility for managing and administering the 
  affairs of the Partnership, and shall have the power and 
  authority to do all things necessary or proper to carry out its 
  duties hereunder.). [RT-PSI-00396394-413]......................   292
 9. GAmended & Restated Investment Advisory Agreement, dated 
  November 16, 2007, between Deutsche Bank AG London and 
  Renaissance Technologies LLC. [RT-PSI-00000914-931]............   312
10. GRenTec/Deutsche Bank email, dated December 2007, re: Buy 
  Back Request (We've been unable to maintain a borrow to fully 
  cover your following short position. Please confirm your 
  willingness to buy this position back as we're exposed to being 
  bought in (any cost/short sale fines will be passed on)[.] Due 
  to the illiquidity of this stock at present I must also ask you 
  not to short any more.). [RT-PSI-00004630-632].................   330
11. GRenTec/Deutsche Bank email, dated February 2008, re: UK MAPS 
  (However, what you describe faced some general objection where 
  DB could be argued to have been effectively fronting for an 
  unregulated fund . . . Not thought a good idea then and 
  following the Soc. Gen, fiasco i imagine there would be even 
  more twitching now.). [RT-PSI-00062957-959]....................   333
12. GDeutsche Bank Maps: New Process/Procedures As of May 15, 
  2008 (Portfolio rebalancing due to Option Exercise *** Rentec 
  Fund Operations group will reallocate the positions in the sub-
  account underlying the exercised option to the remaining 
  options based on their relative cash settlement amounts . . .). 
  [RT-PSI-00002319-322]..........................................   336
13. GRenTec/Deutsche Bank email, dated June 2008, re: Language 
  (Staggering options: You wish to stagger options once every 3 
  months. My suggestion is that you stagger options by NAV also, 
  so there is at least 6 points in NAV difference between 
  different options.). [RT-PSI-00054256-257].....................   340
14. GDeutsche Bank email, dated June 2008, re: What we need coded 
  on PEAS apart from guidelines (The anticipated leverage amt is 
  not randomly chosen. It is chosen so that the funding cost 
  (which we will call the ``optionality value'') on the long side 
  . . . is between 20%-25% of the initial premium (100 in the 
  above).). [DB-PSI 00010767-769]................................   342
15. GManaged Account Products, Option Account Profile, 94150051-
  DBAG MAPS Rentech Mosel Equities LP Option Account 1, As of 
  June 24, 2008. [DB-PSI 00001599]...............................   345
16. GDeutsche Bank email, dated June 2008, re: Tentative: MAPS 
  Working Group . . . (. . . if one option is near breaching the 
  barrier and they [RenTec] want to reallocate trades from that 
  options to others that are at capacity while still being under 
  the 33bn GMV [Gross Market Value] threshold. Based on prior 
  conversations they want to keep their flexibility around 
  allocations.). [DB-PSI 00025033-034]...........................   346
17. GGWA/Deutsche Bank email, dated July 2008, re: George Weiss 
  MAPS Investment Guidelines - PLEASE READ (Please transfer all 
  the positions mentioned in Rule 11 and Rule 12 to OGI account 
  from the MAPS account. *** He will be able to do the crosses 
  requested under Rule 11 & Rule 12 in the AM . . .). [GWALLC-
  PSI-0002504-505]...............................................   348
18. GRenTec/Deutsche Bank email, dated July 2008, re: Optionality 
  Value (While this formula will give a desired result at the 
  current interest levels, as interest rates increase (and we 
  could potentially require a longer dated option) the 
  Optionality Value could get prohibitively high even to the 
  point of exceeding the total amount of premium. I played around 
  with other formulas but still came up against the same 
  conundrum.). [RT-PSI-00046119-121].............................   350
19. GExcerpt of Deutsche Bank, GPF Business Development, CTB 
  Program Portfolio, September, 2008. (The object of this 
  initiative is to provide a New Multiple MAPS structure that 
  will more closely resemble a traditional options structure-
  premium risk.). [DB-PSI 00116157-160, 177].....................   353
20. GGWA email, dated October 2008, re: db maps account inbalance 
  (just got a call from db claiming we have too much net long 
  exposure in maps and want just to bring the portfolio back 
  within 5% exposure within a week . . . maybe we can cross some 
  position over to ybs next week). [GWALLC-PSI-0002328]..........   358
21. GDeutsche Bank/RenTec email, dated October 2008, re: DB/
  Rentec - Response to Issues Discussed on 10/16 (In any event, 
  expanding this to 20 Exchange Business Days does not work from 
  a tax standpoint. 20 Exchange Business Days to make a 
  termination decision under a 13-month option tilts the balance 
  strongly in favor of viewing the accrual of this termination 
  right into the effective conversion of the option into an 
  American style option.). [DB-PSI 00079017-021].................   359
22. a. GExcerpt of transcript of telephone conversation on 
  November 7, 2008, between Satish Ramakrishna and William 
  Broeksmit (Mr. Ramakrishna: [S]o that's the way option is 
  supposed to work . . . this is structured as an option because 
  Mr. Broeksmit: Yeah for tax reasons Mr. Ramakrishna: For tax 
  reason but the . . . option makes it clear that the premium is 
  only . . . commitment that the option holder has). [DB-PSI 
  00122458]......................................................   364
   b. GExcerpt of transcript of telephone conversation on 
  November 6, 2008, between Peter Brown and Satish Ramakrishna 
  (Peter Brown: [T]he models don't see the government 
  intervention but we do, and we are nervous that something could 
  happen. . . . So we have actually intervened and we do that 
  from time to time when things like this happen.). [DB-PSI 
  00122457]......................................................   365
23. GRenTec/Deutsche Bank email, dated December 2008, re: Test of 
  representations (It will be operationally feasible for DB to 
  create Designated Positions, both by not executing transactions 
  directed by the Advisor and by unwinding or liquidating 
  Effected Positions without the direction of the Advisor.). [RT-
  PSI-00236253-258]..............................................   366
24. GMaster Investment Advisory Agreement, dated December 15, 
  2008, between Deutsche Bank AG London and Renaissance 
  Technologies LLC (. . . supervise and direct the investment and 
  reinvestment of all assets in the Account, and engage in such 
  transactions on behalf of the Client's Account, in the 
  Advisor's discretion and without prior consultation with the 
  Client, subject only to the terms of this Agreement, in any and 
  all forms of securities or other property, . . .) [DB-PSI-
  00000001-047]..................................................   372
25. GDeutsche Bank/GWA email, dated February 2009, re: MAPs 
  comments (Loss of the cross collateralization (ability to 
  borrow against the excess equity) of the option. Historically, 
  we have been able to fund the operating expenses of our 
  business by borrowing against the excess equity value of the 
  option.). [DB-PSI 00033762-765]................................   419
26. GDeutsche Bank email, dated August 2009, re: RenTech MAPS (If 
  client started the day with maximum leverage (it has never done 
  so), longs would have to underperform shorts by 11% to burn 
  through capital and put us into non-recourse loss territory. We 
  have triggers in place that allow us to sieze control of the 
  portfolio at any point during the day if half of the capital is 
  depleted (ie, 5.5% long underperformance of shorts).). [DB-PSI 
  00006983-984]..................................................   423
27. GBarrier Option Transaction confirmation, October 8, 2009, 
  between Deutsche Bank AG, London Branch and Mosel Equities L.P. 
  (Buyer has made an independent judgment of the experience and 
  expertise of the Investment Advisor. Buyer agrees that it shall 
  not attempt to direct or influence the choice of investments in 
  the Basket.). [DB-PSI 00000181-209]............................   425
28. GDeutsche Bank/GWA email, dated October 2009, re: DB Options 
  - possible new development (. . . codification of the economic 
  substance doctrine which, if enacted, could have serious 
  implications with respect to the DB option transaction.). [DB-
  PSI 00036241-244]..............................................   454
29. GDeutsche Bank/GWA email, dated October 2009, re: DB/Weiss 
  MAPS option (Cross selling: DB will not allow Weiss to cross 
  sell positions held in the DB account to other prime brokers in 
  connection with its routine rebalancing activities.). [DB-PSI 
  00036700-701]..................................................   458
30. GDeutsche Bank email, dated November 2009, re: Rentec Mosel 
  EurOption #4 (Problem is they were targeting the 7X Init 
  Leverage again but that only gets us to a 16.6% Optionality 
  Val. We either need 8.45X Init Leverage or Libor + 133bps Term 
  Rate?????). [DB-PSI 00008625-627]..............................   460
31. GDeutsche Bank email, dated February 2012, re: Two Sigma 
  Follow-up (Non-recourse financing is one option (MAPS is just a 
  name for that) . . . ). [DB-PSI 00045265-266]..................   463
32. GDeutsche Bank email, dated September 2011, re: quick summary 
  on Rentec (Im hoping you have a rough idea of the situation re 
  the MAPS trades. In order to resolve the question of[:] - Owner 
  of option controlling the entire underlying - Option (really 
  the earliest version) looks like a margin account[.] I was 
  thinking of using a CPPI like structure[.]). [DB-PSI 00112132-
  133]...........................................................   465
33. GDeutsche Bank email, dated December 2011, re: Rentec (That's 
  the result of having a real option.). [DB-PSI 00112522-523]....   467
34. GDeutsche Bank email, dated December 2011, re: Rentec confirm 
  and IMAs (Please see below the changes to the Rentec confirm 
  suggested by U.S. tax. I note that some of these changes are in 
  response to changes suggested by Rentecs counsel, Winston & 
  Strawn. I have not been privy to such communications. I trust 
  you have been involved.). [DB-PSI 00020740-748]................   469

Documents Related to COLT Transactions:

35. GInvestment Advisory Agreement between Renaissance 
  Technologies Corp. and Bass Equities Ltd., dated September 1, 
  2002. (Advisor is authorized, without further approval by or 
  notice to the Client, to make all investment decisions 
  concerning the Account . . .) [RT-PSI-00396318-321]............   478
36. GBarclays Project COLT, New Product Proposal, dated May 28, 
  2002, (COLT provides an after tax benefit to these investors 
  through the conversion of their return from the fund from short 
  term capital gains (taxed at 39.6%) to long term capital gains 
  (taxed at 20%).). [BARCLAYS-PSI-212544-557]....................   482
37. GCorrespondence between Barclays and Financial Services 
  Authority re: PROJECT COLT, dated July 4, August 16, September 
  5, and September 13, 2002. [BARCLAYS-PSI-005241-243, 255-257, 
  260-261, and 258-259]..........................................   496
38. GBarclays Memo, dated August 22, 2002, re: SCM [Structured 
  Capital Markets] Approvals paper - Project COLT (COLT provides 
  an after tax benefit to these investors [RenTec] through the 
  conversion of their return from the fund from short term 
  capital gains (taxed at 39.6%) to long term capital gains 
  (taxed at 20%). This would be achieved by substituting the 
  Fund's direct execution of its trading strategy with a cash 
  settled call option over a Barclays proprietary account whose 
  performance substantially replicates the Fund's trading 
  strategy.). [BARCLAYS-PSI-212590-598]..........................   506
39. GLetter Agreement, dated September 30, 2002, between Barclays 
  Bank PLC and Bass Equities Ltd. (COLT Transaction). [BARCLAYS-
  PSI-212918-932]................................................   515
40. GBarclays Memo, dated April 4, 2003, re: SCM Approvals paper 
  - Project COLT (Renaissance II) (Palomino will not have any 
  credit risk or market risk in the transaction, due to the fact 
  that . . . its PB account is hedged by the Synthetic Call 
  Option and Prime Brokerage effectively has taken the downside 
  risk. The risk borne by Prime Brokerage is akin to the risks 
  taken in a normal collateralised [sic] Prime Brokerage 
  relationship . . .). [BARCLAYS-PSI-213947-953].................   530
41. GBadger Holdings L.P., Limited Partnership Agreement, dated 
  August 17, 2004. ([T]he General Partner shall have complete and 
  exclusive responsibility for managing and administering the 
  affairs of the Partnership, and shall have the power and 
  authority to do all things necessary or proper to carry out its 
  duties hereunder.) [RT-PSI-00396296-315].......................   537
42. GBarclays Capital Memo to SCM Approvals Committee, dated 
  September 3, 2004, re: Approvals paper-COLT V: Renaissance 
  Restructuring (The risk borne by Prime Brokerage is akin to the 
  risks taken in a normal collateralised [sic] Prime Brokerage 
  relationship, where the risks generally are confined to 
  catastrophic losses occurring over a short period of time.). 
  [BARCLAYS-PSI-004161-165]......................................   557
43. GIndemnity Agreement, dated October 1, 2004, among Barclays 
  Bank PLC, Palomino Limited, Badger Holdings L.P., Medallion 
  International Limited, Medallion Capital Investments Ltd., 
  Medallion Associates L.P., Medallion Fund L.P., Medallion USA 
  L.P., and Medallion RMP Fund L.P. [BARCLAYS-PSI-632877-904]....   562
44. GLetter Agreement, dated December 21, 2005, between Barclays 
  Bank PLC and Palomino Limited (COLT Transaction). [BARCLAYS-
  PSI-002879-896]................................................   590
45. GInvestment Management Agreement, effective October 1, 2004, 
  between Palomino Limited and Renaissance Technologies 
  Corporation ([T]he Manager shall have full discretion and 
  authority, without obtaining the Client's prior approval, to 
  manage the investment and trading of the Accounts . . .). 
  [BARCLAYS-PSI-574664-686]......................................   608
46. GBarclays email, dated April 2009, re: June Balance sheet 
  targets (Rentec wasn't comfortable with directly signing off on 
  the deconsolidation, as they didn't view this to be their 
  problem. They are now considering a proposal to include some 
  new language in their investment management document which 
  would require them to sign off should we seek to reconsolidate 
  at a later date.). [BARCLAYS-PSI-025382-383]...................   631
47. GBarclays email, dated April 2009, re: Colt (Marty Malloy 
  spoke with RenTec today and they have indicated that they are 
  fine with the proposal in principle, although they apparently 
  mentioned that their tax counsel would also be putting together 
  a letter agreement of some kind for us to review in the next 
  couple days.). [BARCLAYS-PSI-588643]...........................   633
48. GBarclays email, dated April 2009, re: Palomino letter, 
  attaching April 29, 2009 letter from Renaissance Technologies 
  to Barclays Bank re: Palomino Limited Investment Management 
  Agreement. (Please find attached a letter highlighting our 
  concerns and representations that Renaissance would like 
  Barclays to make in connection with the changes you are 
  contemplating for Palomino.). [BARCLAYS-PSI-326572-575]........   634
49. GBarclays/RenTec email, dated May 2009 (My guys have some 
  comments on the letter and would like to discuss with our 
  lawyers and Ed.). [BARCLAYS-PSI-285585-586]....................   638
50. GBarclays/PwC email, dated May 2009, re: Palomino to PwC 20/
  5/09 (. . . set up for the benefit of Renaissance, who are 
  exposed to the majority of risks and reward.). [BARCLAYS-PSI-
  328074-077]....................................................   640
51. GBarclays email, dated June 2009, re: Project COLT - articles 
  amendment (. . .restrict the activities of Palomino to those it 
  is currently engaged in under the COLT transaction.). 
  [BARCLAYS-PSI-577747]..........................................   644
52. GRentec/Barclays/Winston Strawn/OrrickHerrington/
  WalkersGlobal/ email, dated June 2009, re: Palomino Limited - 
  side letter (with attachments). [RT-PSI-00361844-847, RT-PSI-
  00361879-881, RT-PSI-00235499-500].............................   645
53. GBarclays Capital Memo, dated June 24, 2009, re: Palomino 
  Limited (RenTec controls the major activities of Palomino and 
  is exposed to substantially all significant risks and rewards 
  arising from the activities carried out through the PB 
  Accounts, being the only permitted activities of Palomino. 
  Consequently, under IAS 27.13 and SIC 12, BBPLC should de-
  consolidate Palomino from the date these proposed amendments 
  are effective because they give rise to a loss of control (IAS 
  27.32).). [BARCLAYS-PSI-139757-766]............................   654
54. GBarclays email and Memo, dated June 2009, re: Project COLT - 
  Orphan Note (It has been agreed with BarCap Finance and 
  Pricewaterhouse-Coopers (``PwC'') that, following proposed 
  amendments to Palomino's memorandum and articles of association 
  (the ``Articles'') and the giving of a covenant by Barclays, as 
  sole shareholder of Palomino, that it will not seek to amend 
  the Articles in the future without the consent of Renaissance 
  Technologies LLC (``RenTec''), Barclays will cease to 
  consolidate Palomino under IFRS.). [BARCLAYS-PSI-026163-165]...   664
55. GRenaissance Technologies LLC letters, both dated June 26, 
  2009, re: Palomino Limited (Barclays hereby further covenants 
  to Renaissance that it shall not make any amendments or 
  modifications to the Memorandum and Articles of Association of 
  Palomino after the date hereof without first obtaining the 
  prior written consent thereto of Renaissance . . .). [RT-PSI-
  00236651-655 and 00236914-918].................................   667
56. GLetter Agreement, dated June 26, 2009, between Barclays 
  Banks PLC, Badger Holdings L.P, Renaissance Technologies LLC 
  and Palomino Limited. [BARCLAYS-PSI-730031-032]................   677
57. GThe Companies Law . . . Memorandum and Articles of 
  Association of Palomino Limited, dated June 26, 2009. [RT-PSI-
  00234974-998]..................................................   679
58. GBarclays email, dated June 2010, re: Renaissance, attaching 
  Barclays Capital, Portfolio Analysis of Renaissance Portfolios, 
  CRA, dated June 2010. [BARCLAYS-PSI-330659-682]................   704
59. GBarclays email, dated May 2010, re: COLT XIX - Draft SCM 
  Approvals Notification (The options reference the value of 
  these PB [Prime Brokerage] accounts, which is equivalent to 
  them referencing the assets directly, and therefore there is no 
  leakage between the value of the assets . . . and the value of 
  the options. Thus, the net effect is that Barclays is extending 
  senior financing to RenTec.). [BARCLAYS-PSI-010082-083]........   728
60. GBarclays email, dated November 2010, re: Privileged - Colt 
  (This [the GLAM] is a detailed write up of Colt concluding it 
  doesn't work. We can discuss on MDs [managing directors] call 
  but I intend to reach out to RenTec and Ed Cohen this morning 
  to make sure they are aware. We will also confirm it does not 
  impact Barclays. The only issue for Barclays I could see is 
  some deemed wht [withholding] agent issue as the memo concludes 
  that RenTec are the legal owner of the stocks. To me this would 
  signal that IRS is inevitably going to litigate Colt.). 
  [BARCLAYS-PSI-748506-507]......................................   730
61. GBarclays Memo to SCM US Approvals Committee, dated October 
  3, 2012, re: COLT XXVII (The tax risk is assumed by the Client. 
  . . . The New Option Transaction does not meaningfully increase 
  Barclays' reputation risk in relation to the Option 
  Transactions, because writing a new option (or exercising an 
  existing one) should be viewed as the maintenance of a 
  longstanding structure.). [BARCLAYS-PSI-016946-947]............   732
62. GBarclays Memo to Tax Risk Committee, dated October 3, 2012: 
  re: COLT (There is a reputation risk for Barclays, especially 
  if the matter proceeds to court and the IRS's challenge and 
  Barclays' role become publicly disclosed.). [BARCLAYS-PSI-
  016951-952]....................................................   734
63. GBarclays email, dated October 2012, re: COLT SCM 
  Transaction/Important (The SCM US Approvals Committee recently 
  approved an option transaction in which US tax reputation risk 
  is an issue, and the Committee has engaged in the Tax Risk 
  Committee on the transaction.). [BARCLAYS-PSI-748590]..........   736
64. GBarclays Memo to Tax Risk Committee, dated October 12, 2012, 
  re: COLT (This memo explains the background to an investment 
  structure which has been in place for 10 years and explains 
  why, notwithstanding the publicity risk that Barclays is 
  subject to as a witness to the case if the Client proceeds to 
  litigate in court, we believe it remains an appropriate 
  transaction for Barclays to be a party to.). [BARCLAYS-PSI-
  018114-116]....................................................   737
65. GBarclays Memo to SMC US Approvals Committee, dated November 
  2012, re: Project COLT XXVIII (Renaissance Technologies) - 
  Approvals Notification (SCM has notified and received approval 
  from the following in relation to proceeding with the proposed 
  transaction: Tax, Finance, Credit Risk, Market Risk, 
  Regulatory, Legal, Compliance, and Operations.). [BARCLAYS-PSI-
  017091-093]....................................................   740
66. GBarclays email, dated November 2012, re: Palomino options (. 
  . . it was agreed that any exit from this structure would not 
  result in the 60 day notice would be given, rather there would 
  be more notice meaning that Reny would not have to close out 
  the option and suffer short term capital gains tax.). 
  [BARCLAYS-PSI-322103]..........................................   743
67. GBARCLAYS, New COLT Transaction, Transaction Review 
  Committee, December 2013 (A reputational risk may arise to 
  Barclays if the Original COLT Transaction proceeds to court or 
  is included in a public hearing. However, it is considered that 
  the New COLT Transaction does not meaningfully increase 
  Barclays' reputation risk in relation to the COLT Transactions, 
  especially as it eliminates the Rate Differential Benefit.). 
  [BARCLAYS-PSI-748587-589]......................................   744
68. GExcerpts of Securities and Exchange Commission Form 20-F, 
  Annual Reports for Barclays PLC, Barclays Bank PLC, reflecting 
  that Palomino was not controlled by Barclays:
      a. GFiscal year ended December 31, 2009;...................   747
      b. GFiscal year ended December 31, 2010;...................   749
      c. GFiscal year ended December 31, 2011;...................   751
      d. GFiscal year ended December 31, 2012; and...............   753
      e. GFiscal year ended December 31, 2013....................   755
      G(. . . they are excluded from consolidation because the 
  Group either cannot direct the financial and operating policies 
  of these entities, or on the grounds that another entity has a 
  superior economic interest in them.).
69. G7/22/2014 ``Post-GLAM Basket Option Contracts,'' Memorandum 
  to File prepared by the Subcommittee (summarizing Deutsche 
  Bank, Barclays, and RenTec involvement with basket options 
  after the November 2010 issuance of the IRS advisory memorandum 
  on basket options).............................................   758
70. GDocument Locator List and documents cited in footnotes to 
  Abuse of Structured Financial Products: Misusing Basket Options 
  to Avoid Taxes and Leverage Limits, the Report released in 
  conjunction with the Subcommittee hearing on July 22, 2014. The 
  Document Locator List provides the Bates numbers or description 
  of the documents cited in the Report and the hearing record 
  page number where the document can be located. Not included are 
  documents related to Subcommittee interviews, which are not 
  available to the public, and widely available public documents.   760


                     ABUSE OF STRUCTURED FINANCIAL


                  PRODUCTS: MISUSING BASKET OPTIONS TO


                    AVOID TAXES AND LEVERAGE LIMITS

                              ----------                              


                         TUESDAY, JULY 22, 2014

                                   U.S. Senate,    
              Permanent Subcommittee on Investigations,    
                    of the Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 9:35 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Carl Levin, 
Chairman of the Subcommittee, presiding.
    Present: Senators Levin, McCain, and Johnson.
    Staff present: Elise J. Bean, Staff Director and Chief 
Counsel; Mary D. Robertson, Chief Clerk; Robert L. Roach, 
Counsel and Chief Investigator; David H. Katz, Counsel; Ahmad 
Sarsour, Detailee (FDIC); Henry J. Kerner, Staff Director and 
Chief Counsel to the Minority; Michael Lueptow, Counsel to the 
Minority; Brad M. Patout, Senior Advisor to the Minority; 
Patrick Hartobey, Law Clerk to the Minority; Amy Dreisiger, Law 
Clerk; Michael Avi-Yonah, Intern; Adam Henderson, Professional 
Staff Member; Angela Messenger, Detailee (GAO); Joel Churches, 
Detailee (IRS); Mohammad Aslami, Law Clerk; Owen Dunn, Law 
Clerk; and Ritika Rodrigues (Sen. Johnson).

               OPENING TESTIMONY OF SENATOR LEVIN

    Senator Levin. Good morning, everybody.
    In recent years, this Subcommittee has devoted significant 
time and effort to exposing complex financial arrangements that 
profitable corporations and wealthy individuals employ to avoid 
their obligations to pay all their U.S. taxes. We also have 
examined reckless behavior that has put the stability of the 
financial system--and by extension, the U.S. economy--at risk. 
Today's hearing brings those two themes together.
    Our focus today is on how two banks and a handful of hedge 
funds developed a complex financial structure to engage in 
highly profitable trades while claiming an unjustified lower 
tax rate and avoiding limits on trading with borrowed money. 
This structure worked well for the banks, which earned hundreds 
of millions of dollars in fees. It worked well for the hedge 
funds, which made billions of dollars in profits. But it did 
not work for average taxpayers, who had to shoulder the tax 
burden these hedge funds shrugged off with the aid of the 
banks. And it did not work for the financial system, which is 
still recovering from a devastating crisis brought on by excess 
risk and remains ill-equipped to withstand another shock from 
over leveraged financial institutions.
    In essence, today's hearing is about a series of fictions, 
one piled on top of another, fictions that major banks and 
their hedge fund clients used to avoid taxes and Federal 
leverage limits.
    The key financial product involved in these fictions is 
called a ``basket option.'' The basket options examined by the 
Subcommittee were developed and sold by two banks--Deutsche 
Bank AG and Barclays Bank PLC--to more than a dozen hedge 
funds. Together, the banks sold 199 basket options to hedge 
funds that used them to make over $100 billion in trades. Two 
of the largest basket option users were Renaissance 
Technologies, known as RenTec, and George Weiss Associates.
    Although there were minor differences in specifics, the 
basket option basics worked like this: The bank sold its hedge 
fund client a structured financial product, called an 
``option,'' whose payoff equaled the profits generated by a 
``basket'' of securities held in a designated account at the 
bank. The basket here is key. It was an open account with ever-
changing contents. Technically, the account and the securities 
it contained were held in the name of the banks in its own 
trading account. The hedge fund put up 10 percent of the cash 
needed to buy the securities, and the bank lent the other 90 
percent.
    This arrangement included a number of fictions which defied 
reality, but resulted in big profits for the hedge funds and 
the banks.
    First, though the structure was designed to create the 
appearance that the bank owned the assets in the basket option 
account, the hedge fund made all the trading decisions for 
those accounts--and in fact, used the bank's computerized 
trading system to execute trades in the account. RenTec 
estimates that its trading through basket options accounts 
averaged more than 100,000 trades each day, or about 30 million 
trades a year. Also, the hedge fund reaped all of the trading 
profits, even though the financial structure created the 
illusion that the bank owned the assets. The beneficial owner, 
the real owner, was the hedge fund.
    Now, second, the hedge fund's control of all the trading 
for the basket option account demolishes the fiction of a 
legitimate option. So the hedge funds set up new entities, 
which they controlled, to serve one function, and that was to 
act as the option holder. The hedge funds would then claim that 
their control of the option holder was totally independent of 
their role in making the trading decisions for the basket 
option account. Documents that we will explore today show the 
extraordinary lengths to which RenTec and the banks went to 
perpetuate the illusion that the option holder and trader were 
somehow independent, when in fact the hedge fund, RenTec, 
played both roles.
    The fictional option was structured so that it could be 
exercised more than 1 year after it was created. Under that 
structure, the hedge funds claimed that trading profits from 
the account were long-term capital gains and thereby qualified 
for the reduced long-term capital gains tax rate.
    The Tax Code gives long-term capital gains a reduced rate 
on the theory that it provides an incentive for investors to 
risk their capital on the kind of long-term investments that 
grow the economy and create jobs. The high-volume trading that, 
for example, RenTec conducted through its basket options does 
not meet that test. When securities are held for weeks or days 
or even seconds, it is surreal to characterize those trading 
profits as long-term capital gains.
    But that is what the hedge funds did. The banks and hedge 
funds used the fictional option structure to collapse millions 
of individual trades into one transaction, the execution of an 
option. As if by magic, the option structure transforms what 
would be short-term capital gains from an ordinary trading 
account into long-term capital gains subject to lower taxes. 
Subcommittee staff estimates, based on basket option profits 
that RenTec reported from 2000 to 2013, that RenTec avoided 
paying more than $6 billion in taxes that way.
    Now, that is a lot of money even by Washington standards. 
It would, for example, pay for almost two-thirds of the cost to 
replenish the Highway Trust Fund so that it does not run out of 
money next month and create havoc in road projects around the 
country.
    This is not the first time options have been abused to try 
to convert short-term trading profits into long-term capital 
gains. And that is why, in 1999, Congress passed a law in part 
to stop that practice, and that is Section 1260 of the Tax 
Code. The basket options at issue here were written to skirt 
Section 1260's prohibitions. But in 2010, the IRS warned that 
the type of basket options used here could not claim the lower 
long-term capital gains tax rate. Despite that IRS warning, 
Barclays continued to sell basket options to RenTec for another 
2 years, before finally revising its option product in 2013 so 
that the options expired in less than a year and could not be 
used to game the Tax Code. Deutsche Bank suspended its issuance 
of new basket options after the 2010 IRS warning, but continued 
to administer multiple basket option accounts already in 
existence. It also resumed offering them in 2012, although with 
a term of less than 1 year and a requirement that the option 
holder treat the profits as short-term capital gains.
    Tax avoidance through financial engineering is not the only 
problematic element here. These banks and hedge funds also used 
basket option accounts to circumvent regulations designed to 
limit systemic risks to the banking system posed by excessive 
leverage--that is, excessive lending to finance stock trading.
    The stock market crash of 1929 devastated the U.S. economy, 
not just by the collapse of thousands of stock speculators, but 
also by the failure of thousands of banks that had lent them 
money and could not collect on the loans. In the aftermath of 
the Great Depression, Congress enacted laws limiting the use of 
borrowed money to trade securities. Those limits are included 
in a set of ``margin rules'' that essentially prohibit U.S. 
broker-dealers from lending more than $1 to brokerage clients 
for each $1 of the client's own money in the account--in other 
words, for every $2 in a brokerage account, only $1 of that $2 
can be borrowed from the broker.
    Had the hedge funds involved in these transactions been 
using normal brokerage accounts, they would have been subject 
to the 2:1 leverage limit. But because the basket option 
accounts were opened in the name of the banks in their own 
proprietary trading accounts, it looked as though the money 
placed into those accounts was the banks' own proprietary money 
rather than money they were loaning to a customer. And this is 
another fiction. The banks and hedge funds pretended the bank 
funds were not loans, even though the hedge funds paid 
financing fees and posted collateral.
    So instead of complying with the 2:1 leverage ratio, the 
banks offered their hedge fund clients leverage as high as 
20:1. RenTec used the increased leverage to borrow billions of 
dollars for its trading strategies, which produced huge profits 
for RenTec, while the lending generated huge additional fees 
for the bank.
    But as we have learned over and over--in the Depression, in 
the 1990's collapse of the hedge fund Long Term Capital 
Management, and in the financial crisis from which we are still 
recovering--excessive leverage does not always produce profits. 
Sometimes it produces losses. And when huge losses happen, they 
can bring down not just a reckless borrower, but the financial 
institution that lent it money, and that failure can ripple 
through the entire financial system. While it appears the two 
banks the Subcommittee has examined have stopped selling basket 
options as a way to claim long-term capital gains rates, they 
are still selling these products as a way to avoid leverage 
limits--meaning our financial system and economy still face 
unnecessary risk.
    RenTec, through its Medallion Fund, used basket options to 
produce profits from 1999 to 2013 totaling more than $30 
billion. The banks charged financing, trading, and other fees 
that, over the same period, produced revenues totaling about 
$570 million for Deutsche Bank and $655 million for Barclays. 
Basket options were clearly a lucrative line of business for 
the participants.
    But this money maker was built on interlocking series of 
fictions. The key fiction is the option itself: the idea that 
this structure was really an option when, in fact, what it did 
was give hedge funds the profits from buying and selling assets 
in accounts that the hedge funds themselves controlled. It was 
fiction to treat the banks as the true owners of the basket 
option assets, when the hedge funds controlled and executed all 
of the millions of trades in the accounts, when the hedge funds 
paid the daily trading costs, and when the hedge funds reaped 
the profits. It was fiction to suggest that the borrowed money 
that financed the trades was considered proprietary funds of 
the banks rather than loans to the hedge funds. It was fiction 
to treat the profits from trades lasting days or even seconds 
as long-term capital gains deserving a reduced tax rate. And it 
was a fiction to pretend that hedge funds were not acting both 
as option holder and as trade decisionmaker. These were all 
fictions, but fictions with real-world consequences: they 
shifted billions of dollars in tax burden onto the backs of 
ordinary taxpayers, and they added billions of dollars in 
hidden risks to our financial system.
    Congress and financial regulators can and should work 
together to stop these abuses.
    The IRS should seek to collect taxes owed on billions of 
dollars in basket option profits unjustifiably claimed as long-
term capital gains.
    Federal financial regulators should make clear to banks 
that participating in abusive structures designed to avoid 
leverage limits and taxes is unacceptable and penalize the 
banks that do.
    The Financial Stability Oversight Council, working with 
other agencies, should establish reporting and data collection 
requirements to detect and to stop abuse of structured 
financial products to circumvent leverage limits that safeguard 
our economy.
    And, finally, Treasury, and the IRS should remove 
impediments to audits of large partnerships, like hedge funds, 
99 percent of which today escape IRS audits--meaning that we 
are largely blind to how many other hedge funds may be using 
structures of this type to avoid risk limits and taxes.
    These measures would help protect the interests of ordinary 
Americans who pay their taxes and who must pay the price for 
tax avoidance schemes. It is these same Americans who would 
bear the burden of economic devastation that unaddressed 
systemic risks can cause.
    I want to thank Senator McCain and his staff for their hard 
work in making today's hearing and our bipartisan report 
possible. The staff of this Subcommittee, majority and 
minority, through the years have been able to work together as 
one team, and I am very proud of them.
    Senator McCain.

              OPENING TESTIMONY OF SENATOR McCAIN

    Senator McCain. Well, thank you, Mr. Chairman, and one of 
the aspects of my term and tour here in the U.S. Senate is the 
relationship that you and I have developed over many years, and 
the work we do together, I think the people of Michigan and 
Arizona and the country are better off for it. I thank you for 
today's hearing, and today's hearing sheds light on how 
Renaissance Technologies was able to avoid paying more than $6 
billion in taxes by disguising its day-to-day stock trades as 
long-term investments.
    To accomplish that, Renaissance set up a ``basket option,'' 
which is an artificial structure, not available to ordinary 
consumers, that allowed Renaissance to legally classify its 
short-term trading profits as long-term capital gains, 
subjecting those gains to a substantially lower tax rate. 
Renaissance profited from this tax treatment by insisting on 
the fiction that it did not really own the stocks it traded, 
that the banks that Renaissance dealt with did.
    But the fact is that Renaissance did all the trading, 
maintained full control over the account, bore all the real 
risk, and reaped all of its profits. This setup allowed 
Renaissance to claim that profits from its day-to-day trades 
were actually long-term investments, thereby avoiding payment 
of billions of dollars in taxes.
    In reaction to Renaissance's use of this structure, the IRS 
opened an investigation and today is in the process of 
litigating the legal issues. It is not the Subcommittee's place 
to weigh in on those proceedings and determine whether the 
behavior in question was illegal. But this basket option 
practice, available to hedge funds but inaccessible to the 
average investor, needs to be fully examined and addressed. The 
biggest reason why it should be examined is the tremendous 
amount of taxes Renaissance was able to avoid paying by using 
this structure.
    In the course of its investigation, the Subcommittee 
learned that between the years 2000 and 2014, Renaissance 
exercised 60 long-term basket options with Deutsche Bank and 
Barclays, earning in the neighborhood of $34 billion in pre-tax 
profits and potentially avoiding over $6 billion in taxes.
    Mr. Chairman, those are very large amounts of money.
    Meanwhile, Deutsche Bank and Barclays happily took part in 
the basket options because they made hundreds of millions of 
dollars in fees from these transactions while incurring no 
actual risk--that is, until the IRS started to investigate. To 
protect themselves, Deutsche Bank in 2010 and Barclays in 2012 
decided to only offer Renaissance options lasting less than 1 
year so that all the profits from the options would have to be 
considered short-term capital gains.
    Large trading firms will always try to stay one step ahead 
of the game when it comes to pushing the envelope on the Tax 
Code to minimize paying taxes, and regulators will inevitably 
struggle to detect and stop new schemes as they arise. It is, 
therefore, critical that regulators use the resources they have 
in an efficient manner to target the most likely offenders.
    So whatever practical impediments currently disable the IRS 
from auditing large partnerships that use these sort of tax 
structures should be eased or eliminated. Doing so would allow 
the IRS to audit companies based on a careful assessment of the 
likelihood that a given company is engaging in activities that 
warrant an audit. This would differ from the current practice 
which focuses on the corporate form selected by that company, 
which has led to corporations being disproportionately audited.
    One thing is clear. Americans are tired of seeing Wall 
Street firms playing by a set of rules other than those that 
apply to ordinary citizens. Even as consumers worried about 
losing their savings in the 2008 financial crisis, Renaissance 
remained enormously profitable throughout by, among other 
things, utilizing the tax avoidance such detailed in today's 
hearing.
    When ordinary citizens make short-term trades, they get 
taxed at the short-term rate. When financial firms like 
Renaissance make short-term trades, they should not be treated 
any differently.
    The perception that Wall Street self-deals or plays by its 
own rules engenders a deep-seated distrust and cynicism among 
Americans that is neither desirable nor healthy for the Nation.
    I want to thank the witnesses for appearing before the 
Subcommittee today, and I look forward to their testimony. 
Thank you, Mr. Chairman.
    Senator Levin. Thank you very much, Senator McCain.
    I would like to now call our first panel of witnesses for 
this morning's hearing: Steven Rosenthal, Senior Fellow at the 
Urban-Brookings Tax Policy Center; and James R. White, Director 
of Tax Issues at the U.S. Government Accountability Office 
(GAO).
    I appreciate both of you being with us this morning. We 
look forward to your testimony.
    Pursuant to our Rule 6, all witnesses who testify before 
the Subcommittee are required to be sworn, so I would ask both 
of you to please stand and raise your right hand. Do you swear 
that the testimony you are about to give before this 
Subcommittee will be the truth, the whole truth, and nothing 
but the truth, so help you, God?,
    Mr. Rosenthal. I do.
    Mr. White. I do.
    Senator Levin. Our timing system today will work as 
follows: 1 minute before the red light comes on, you will see 
the lights change from green to yellow, giving you an 
opportunity to conclude your remarks. Your written testimony 
will be printed in the record in its entirety. We would 
appreciate your trying to limit your oral testimony to 7 
minutes. And, Mr. Rosenthal, we will have you go first, 
followed by Mr. White, and then we will turn to questions.
    Mr. Rosenthal.

   TESTIMONY OF STEVEN M. ROSENTHAL,\1\ SENIOR FELLOW, URBAN-
          BROOKINGS TAX POLICY CENTER, WASHINGTON, DC

    Mr. Rosenthal. Thank you, Mr. Chairman, Ranking Member 
McCain, and the Subcommittee for the opportunity to testify on 
the abuse of structured financial products. My name is Steven 
Rosenthal. I am a Senior Fellow at the Urban-Brookings Tax 
Policy Center. I am presenting my own views and not those of 
the Urban Institute, the Brookings Institution, the Tax Policy 
Center, or any other person.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Rosenthal appears in the Appendix 
on page 83.
---------------------------------------------------------------------------
    I have practiced tax law in Washington, DC, for over 25 
years. In private practice, I have regularly advised hedge 
funds and other investors on the tax treatment of derivatives. 
In the 1990's, I was a legislation counsel with the Joint 
Committee on Taxation, where I helped draft tax rules for 
financial institutions, financial products, capital gains, and 
related areas.
    Almost a century ago, Congress reduced the tax rates for 
long-term capital gains. Then ``long term'' meant holding 
assets for 2 years. Now it means holding assets for at least 1 
year. But for a century, regular tax rates have applied to 
gains on the sale of assets that have been held for a short 
term.
    I have been asked to evaluate the character of the gains of 
the Renaissance hedge funds based on my review of materials 
provided by the Subcommittee staff.
    The Renaissance hedge funds traded often, more than 100,000 
trades a day, more than 30 million trades a year, and they 
traded quickly, turning over their portfolio almost completely 
every 3 months.
    Because the hedge funds adopted a short-term trading 
strategy, we would expect their gains to be short term. But the 
hedge funds, with the help of Barclays and Deutsche Bank, 
wrapped derivatives around their trading strategy in order to 
transform their short-term trading profits into long-term 
capital gains.
    This tax alchemy purported to reduce the tax rate on the 
gains from 35 percent to 15 percent and reduced taxes paid to 
the Treasury by approximately $6.8 billion.
    I believe the hedge funds stretched the derivatives beyond 
recognition for tax purposes and mischaracterized their profits 
as long-term gains.
    Here is how it worked. The hedge funds did not buy, hold, 
and sell their stocks directly. Instead, the hedge funds 
arranged for the banks to buy, hold, and sell the stocks. There 
were two steps.
    First, a bank granted the hedge funds' general partner, 
Renaissance, the exclusive authority to select stocks to buy 
and sell for an account, when to buy and sell, and how to size 
and route the orders.
    Second, the bank agreed to pay the hedge fund the net 
profits from the trading of the stocks in the account at the 
bank. I will label this arrangement ``the basket contract.''
    To fund an account, a hedge fund might deposit, say, $10 
million. The bank also might contribute $90 million, which 
permitted up to $100 million to trade. The basket contract 
typically had a term of 2 or 3 years, but a hedge fund could 
demand the bank cash out a basket contract at any time. In 
fact, the hedge fund typically cashed out the basket contracts 
after more than a year in order to qualify their profits as 
long term.
    To protect against losses in excess of $10 million, the 
original deposit, a bank contract would automatically be 
knocked out--that is, liquidated--if the value of the account 
fell from $100 million to $90 million. But the banks also put 
in place protections to prevent the account from falling that 
much. In practice, no basket contract was knocked out, none of 
the 60.
    The tax law characterizes an arrangement based on its 
substance, not its form. In substance, Mr. Chairman, I believe 
the hedge funds possessed tax ownership of the stock in the 
accounts. The hedge funds, through their general partner, 
Renaissance, directed the buying and selling of the stocks, and 
the hedge funds profited completely from the trading.
    To establish tax ownership, the party's label does not 
matter. For example, the IRS treated a deep-in-the-money option 
as ownership of the underlying stock. That was because the 
option was so likely to be exercised the taxpayer effectively 
assumed the benefits and burdens of owning the stock.
    Similarly, I believe the benefits and burdens of the stock 
basket belong to the hedge funds.
    First, the hedge funds enjoyed the opportunities of gain 
from trading the stocks and incurred the burden of losses, at 
least until the bank stopped the trading.
    Second, the hedge funds earned the interest, dividends, and 
other income from the stocks, bonds, and cash in the account, 
and the hedge funds paid the financing, commissions, and other 
expenses from the trading.
    Finally, the hedge funds, through their general partner, 
Renaissance, selected the stocks to buy and sell for the 
designated accounts, when to buy and sell them, and how to size 
and route the orders. As a result, the investment arrangement 
simply rewarded the hedge funds for their own trading efforts.
    Moreover, even if the basket contracts were respected, the 
gains from the basket contracts must be recognized currently. 
The hedge funds changed the economics of the basket contracts 
when their agent, Renaissance, traded in the designated 
account. And modifying a contract materially is a taxable 
event. The deferral was inappropriate.
    As a result, I believe the IRS can and should challenge 
these strategies. But the IRS has limited resources to 
challenge the wide variety of derivative-related strategies 
which often are complicated and abstruse. So, in my view, 
Congress should address the taxation of derivatives 
comprehensively to reflect the income of derivatives more 
clearly.
    I believe the tax accounting for derivatives ought to 
follow financial accounting, which requires companies to mark 
to market the derivatives at year-end--that is, to report any 
income from derivatives as ordinary as if the derivatives were 
sold at the end of each year.
    Last year, Chairman Camp of the House Ways and Means 
Committee proposed to mark to market derivatives for tax 
purposes. I believe this step is overdue. It would greatly 
reduce the amount of time and energy that taxpayers and the IRS 
devote to the taxation of derivatives, an enterprise that is 
demanding far too many efforts in the most recent tax years.
    Thank you, and I am happy to take any questions.
    Senator Levin. Thank you very much, Mr. Rosenthal.
    Mr. White.

  TESTIMONY OF JAMES R. WHITE,\1\ DIRECTOR, TAX ISSUES, U.S. 
        GOVERNMENT ACCOUNTABILITY OFFICE, WASHINGTON, DC

    Mr. White. Chairman Levin and Ranking Member McCain, I am 
pleased to be here for the hearing on structured financial 
products. A number of the entities offering these products are 
large partnerships, which we define as those with over 100 
direct and indirect partners and over $100 million in assets. I 
will describe them and the challenges IRS faces in auditing 
them.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. White appears in the Appendix on 
page 91.
---------------------------------------------------------------------------
    First, some background. Partnerships are pass-through 
entities that do not pay taxes but instead pass income or 
losses through to their partners to include on their own tax 
returns. Partnerships can be partners in other partnerships; 
that is, partnerships can be tiered, making tracking income 
through the tiers complicated. The number of partnerships of 
all sizes is growing, with a big shift toward businesses 
organized as partnerships and away from corporations. Between 
2002 and 2010, the number of all partnerships grew 45 percent 
to over 3 million while the number of corporations liable for 
corporate income tax decreased 14 percent to 1.5 million. Large 
partnerships grew even faster, tripling to over 10,000.
    Now I will describe large partnerships. According to IRS, 
many of these are investment funds, such as hedge funds or 
private equity funds. These funds may have hundreds of 
thousands of investors who are legally partners. When 
investing, the funds may create other large partnerships. For 
example, if a fund with a million partners invests in a small 
operating partnership, say in oil and gas, then the oil and gas 
partnership would now be large. The original direct oil and gas 
partners would be joined by a million indirect partners.
    Figure 2 on page 8 of my statement shows the sizes of large 
partnerships with almost 3,000 having more than 10,000 direct 
and indirect partners in tax year 2011.
    My next point is that IRS audits very few large 
partnerships and makes few changes when it does. For example, 
in 2012, the audit rate for large partnerships was eight-tenths 
of 1 percent, less than 1 percent. For large corporations, the 
audit rate was 27 percent, or 33 times higher. The few audits 
done of large partnerships were not very productive. Two-thirds 
resulted in no change to the partnerships' reported income. 
When adjustments were made, positive and negative changes 
roughly canceled each other out.
    Now I turn to IRS' audit challenges, which may explain the 
low audit rate and poor audit results.
    Tiers of partnerships create very complex income flows. An 
example is Figure 3 on page 9 of my statement. The audited 
partnership at the left earns income that passes through eight 
other partnerships before reaching the ultimate owner who is 
responsible for any tax. IRS has the challenge of tracking the 
income as it flows through the tiers and verifying that the 
amount and nature of the income is correctly reported. Are 
capital gains short or long term? Is income passive or non-
passive?
    IRS officials told us they have difficulty in identifying 
the business purposes of large partnerships and the source of 
income. And Figure 3 is a simple example with only 50 partners 
and 10 tiers. IRS said some have over a million partners and 
some over 50 tiers.
    While such complicated business structures can be used for 
tax evasion, I want to emphasize that they can also have 
legitimate business purposes, such as isolating one part of the 
business from the liabilities of another part.
    In addition to this complexity, IRS auditors said 
administrative procedures can make it challenging to finish an 
audit within the 3-year statute of limitations. The Tax Equity 
and Fiscal Responsibility Act of 1982, or TEFRA, was passed to 
correct problems with fragmented audits of multiple partners. 
However, auditors told us that TEFRA can hinder audits of large 
partnerships. One challenge is identifying the Tax Matters 
Partner, or TMP, who represents the partnership in an audit. 
IRS auditors told us that the process can sometimes take months 
with some partnerships using this as a delaying tactic to 
reduce the time available for the actual audit.
    Another TEFRA challenge is passing audit adjustments 
through to taxable partners. According to IRS, linking a large 
partnership to thousands of direct and indirect partners spread 
over many tiers is extremely burdensome and limits the number 
of audits that can be done. Furthermore, by the time an audit 
adjustment is spread over thousands of partners, the amount per 
partner may be so diluted that it is not worth passing through.
    To summarize, large partnerships are increasing in number. 
IRS audits very few and gets poor results when it does audit 
them. The complexity of both the partnerships and the audit 
procedures may explain this picture. We are still completing 
the review requested by this Committee and plan to issue a 
report this fall with more details and, if warranted, 
recommendations.
    Mr. Chairman, this ends my statement, and I would be 
pleased to respond to questions.
    Senator Levin. Thank you very much, Mr. White.
    Mr. Rosenthal, substance over form, a judicial doctrine 
permits the IRS to recharacterize a transaction according to 
its actual substance. The purpose of the doctrine is to prevent 
a taxpayer from calling a transaction something that it is not 
in order to avoid tax liability.
    Renaissance has asserted that its characterization of the 
basket option should be respected for tax purposes and that it 
should be entitled to long-term capital gains treatment because 
the basket option, they claim, was held for more than a year.
    It has asserted in part that it is entitled to this 
treatment because the transaction had a business purpose, 
including the claim that the transaction provided it with more 
leverage than could be obtained in a margin account.
    Now, does the claim of Renaissance that it had a business 
purpose answer the question of whether the structure was 
properly characterized as an option for tax purposes?
    Mr. Rosenthal. No, in my view, Chairman Levin, I do not 
believe the mere existence of a business purpose demonstrates 
conclusively that the labels affixed to the arrangement will be 
respected by a court of law.
    The key question in considering economic substance is what 
is the substance of the arrangement, not merely the form or the 
labels affixed by the parties to the arrangement. And here, in 
substance, in my view, the basket of stocks which was directed 
by the hedge fund--buy and sells--and controlled by the hedge 
fund, the benefits and burdens and the true owner of that 
basket of stocks in substance belonged to the hedge fund.
    Senator Levin. Now, you have reviewed in your testimony and 
I have reviewed in my opening statement what some of those 
actual facts were that constituted beneficial ownership. Would 
you agree that the hedge fund was the beneficial owner here?
    Mr. Rosenthal. Yes, I would.
    Senator Levin. And it received all the dividends from the 
trades as part of the option profits. The profits were 
Renaissance's. Renaissance executed tens of millions of trades 
in a year in that account. It was charged a financing fee on 
the amount that it borrowed for the account. It received the 
rebates for the orders that it sent to the stock exchange, and, 
again, it received all of the profits from its trading and was 
exposed to most of the risk, with the exception of catastrophic 
risk. And there were even safeguards in the agreements to limit 
that risk.
    Now, in connection with the transactions affected by the 
bank's basket accounts, it retained certain indicia of 
ownership, such as the legal title apparently; the right to 
vote shares--it is kind of hard to imagine voting shares when 
there are 30 million trades during a year, but, nonetheless, 
that right was retained--the right to lend shares out of their 
accounts to customers for fees.
    Now, how significant is it that the banks retained those 
indicia of ownership for determining who is the beneficial 
owner of the real transactions and the items that were in the 
account?
    Mr. Rosenthal. Not very significant, in my view, Mr. 
Chairman. The right to vote a publicly traded stock, a minority 
interest that was bought and sold within a few weeks, not a 
long-term holding, in my view is economically meaningless.
    The question of ownership is broader than mere form of 
title, and the courts repeatedly dozens and dozens of times 
have admonished taxpayers that mere semblance of title does not 
answer the question of true ownership of the property. To 
determine true ownership, you need to look broadly at benefits 
and burdens. Who benefited when the stocks went up? Who lost 
when the stocks went down?
    And you need to think about who actually receives the 
beneficial income, the income from the beneficial ownership of 
the stocks. And, most importantly, you need to think about 
control and when stocks were bought and when stocks were sold 
and who determined that.
    In practice, I must have reviewed dozens, if not hundreds, 
of derivatives for a variety of investors, and derivatives by 
their nature derive value from some other asset or some other 
indicium. But there are limits to when an arrangement reflects 
a derivative and when an arrangement reflects ownership. And 
here the hedge funds simply crashed through those limits. They 
undertook a direction of what to buy and what to sell. They 
picked up all expenses, including commissions. They effectively 
determined what the bank would hold. They purported--I read in 
the materials provided to me that the bank had discretion as to 
whether to follow the directions of the buys and sells or 
whether to maintain positions. But in 30 million trades a year, 
over 300 million trades, I did not hear of a single instance in 
which the bank simply followed through and recorded ownership 
of the stock in the account per the direction of the hedge fund 
acting through Renaissance, its general partner.
    So the question of ownership is a facts and circumstance 
question looking at all the facts. But here the key elements of 
ownership in my view point to the hedge fund owning the basket 
of stocks, not the banks, notwithstanding the nominal title 
that the banks purported to have of the stocks in the account.
    Senator Levin. Now, the banks gave Renaissance direct 
access to the market through their trading execution system so 
that Renaissance executed the trades as well as receiving the 
profits and the losses. They had the right under their 
contracts not to execute. But do you know of any circumstances, 
looking through these materials, where they did not follow the 
algorithm which was provided to it?
    Mr. Rosenthal. To my knowledge, the general partner, 
Renaissance, the hedge fund, would direct trades directly to 
the exchange. That direction would take milliseconds. There was 
no, as far as I could see, any practical way for the bank to 
intervene and stop that order from going to the market. And as 
a practical matter, there really was very little opportunity 
for the bank to take a position out of the account and sell it, 
understanding that the hedge fund might want to sell the 
position in a matter of weeks.
    The bank made a lot of fees merely accommodating the hedge 
funds. I do not think the bank had any interest in 
independently owning those securities in their account.
    Senator Levin. Now, one point, the banks suggest that the 
execution was simply--by Renaissance was simply a 
recommendation or a suggestion to the bank. Have you seen any 
evidence that this was a recommendation or a suggestion?
    Mr. Rosenthal. No, I have not seen any evidence of that.
    Senator Levin. Is there any practical way in which 30 
million trades a year could be 30 million recommendations? I 
think 100,000 trades a day, or more. Is there any practical way 
that that could be a recommendation or suggestion to the banks?
    Mr. Rosenthal. I cannot see it. I think you would need to 
ask the banks what mechanisms they had in place to reject the 
recommendation to buy or sell stocks.
    Senator Levin. And how often in 30 million purchases a year 
they did that?
    Mr. Rosenthal. In the documents that I saw and in the 
information provided to me by staff, I do not think they ever 
refused the direction of the hedge fund to buy or sell stocks.
    Senator Levin. The banks and Renaissance claim that 
Renaissance is independent from the fund when it is acting as 
investment advisor to the banks. Did you see any evidence that 
they are independent from their own funds when they are acting 
as investment advisor, the label given to it?
    Mr. Rosenthal. No, I did not see any evidence that 
Renaissance, the general partner of the hedge funds, was 
independent when it bought--when it acted to buy and sell 
stocks for the banks. Renaissance was the general partner of 
the fund, and I should just say in our financial structure, 
investment funds themselves do not have employees or computers 
or office equipment. They act through the general partner, and 
they incent the general partner to make money for them.
    So when Renaissance was managing the stock in the accounts 
at the banks, Renaissance was concerned in buying and selling 
stocks in order to make a lot of money for their partnership. 
They were compensated for that arrangement through fees, 
directly or indirectly, and they participated in the profits of 
the fund, which were staggering. I did not see any sign that 
Renaissance was taking into account the interests of the bank 
in buying and selling stocks for the account.
    Senator Levin. Now, they had the authority to execute 
trades without prior approval. That was in the contract between 
Renaissance and the banks. They used the banks' trading 
execution system to place and execute several hundred thousand 
trades a day to go into that so-called basket account.
    Now, why would it be important then for Renaissance to 
claim that these are recommendations rather than to acknowledge 
that they are actually executing trades in the banks' so-called 
basket account? What is the reason they make that claim?
    Mr. Rosenthal. Well, a key factor in tax analysis to 
determine who owns an asset is who controls the asset. And to 
the extent that the banks could assert that the hedge funds 
were not in control of the stocks in the account or the buying 
and selling of stocks in the account, that would bolster the 
argument that the banks and not the hedge funds were the owners 
of those stocks.
    Senator Levin. And they put in the contract documents that 
the bank could reject the trades. And would you agree that the 
reason that they put that in there is to give the appearance 
that the activity is not Renaissance's but the banks and that 
the bank is not a conduit for Renaissance's activity? Is that 
the reason that they would put that in a contract document that 
they had the right to reject the trade?
    Mr. Rosenthal. Senator, I did not understand that 
representation when I saw it in the documents. The 
representation is at odds with my understanding of both the 
facts and the law, including Delaware law of partnership. So I 
cannot say why they made that representation--perhaps wishful 
thinking. It is really hard for me to assess why the 
representation was there. But as a factual and a legal matter, 
I just do not see how Renaissance, the general partner of the 
hedge fund, was not directing, influencing, controlling the 
buying and selling of stocks in that portfolio.
    Senator Levin. Now, Renaissance is the general partner of 
the option holders, Mosel and Badger. These are entities that 
were stated to be the holders of the option. At the same time, 
Renaissance is the investment advisor to Deutsche Bank and 
Barclays to manage the basket account. The parties assert that 
Renaissance as investment advisor to the bank is independent 
when it is making investment decisions for the banks and is not 
influenced by the option holders, Mosel and Badger.
    Now, how can Renaissance be independent from the option 
holders when it is their general partner?
    Mr. Rosenthal. I cannot see that. Earlier in the year, the 
First Circuit examined a private equity fund that claimed its 
general partner, in managing its investments, was not acting on 
its behalf. And the private equity fund argued: Ignore the 
efforts of our general partner; we are not responsible for 
those efforts for tax purposes. And the First Circuit rejected 
that analysis, a very important decision, Sun Capital.
    I believe hedge funds, private equity funds, and others 
take a rosy view of what they are engaged in. When a 
characterization helps them, they advocate it. But as a legal 
matter, I just cannot see how when an agent of a fund furthers 
the fund's efforts to make money and that is the only objective 
of the fund, how the agent can disassociate its 
responsibilities to the fund and make money and assert that it 
is merely representing the bank when it is buying and selling 
stocks.
    Senator Levin. And so it cannot then, as a practical and 
real-world matter, be independent from the option holders when 
Renaissance is the general partner for those option holders?
    Mr. Rosenthal. Not in my view, sir.
    Senator Levin. Why would Renaissance and the banks set up 
that fiction, that the investors in Mosel and Badger are 
independent of the investment advisor that is making the 
investment decisions for the basket account? Why would they 
make that claim of independence?
    Mr. Rosenthal. From a tax point, if that assertion were 
true, that might help the argument that the banks actually 
owned other securities; that is, the investment manager of 
those securities, those stocks, if that investment manager were 
independent of the hedge funds and acting at the direction of 
the banks, that would help the argument that the banks owned 
the stocks. Again, I do not see, either under the facts or the 
law, how that independence could be true.
    Senator Levin. Mr. Rosenthal, would you take a look at 
Exhibit 53? \1\
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    \1\ See Exhibit No. 53, which appears in the Appendix on page 654.
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    Mr. Rosenthal. Yes, Senator, I have that exhibit in front 
of me.
    Senator Levin. OK. This is a June 2009 memorandum that 
Barclays wrote to its auditor, PricewaterhouseCoopers, PwC, 
concerning the deconsolidation of Palomino Limited.
    Now, Palomino is a Cayman Islands entity of Barclays which 
was created to--in my view, at least quite clearly create an 
appearance that Barclays is the owner of the basket account, 
where all the Renaissance trades were located and on which the 
option was based. This is also the same account where the 
profits that Renaissance earned on its trading done with 
Barclays was located. So that is Palomino.
    Now, this memorandum was written by Barclays Structured 
Capital Markets Group, which was responsible for developing the 
COLT basket option product, and it proposes to deconsolidate, 
to remove Palomino from Barclays financial statements.
    So did you review that document?
    Mr. Rosenthal. Yes, I did, Mr. Chairman.
    Senator Levin. The memorandum sets out a number of 
significant facts and conclusions about Palomino and its 
relationship to Barclays and to RenTec that I would like to 
review with you. First, take a look at page 7, starting with 
paragraph a.
    Mr. Rosenthal. Mr. Chairman, can you point--can you say the 
first few words? My document is not paginated.
    Senator Levin. Yes, mine is not either, and I do not know 
where the ``page 7'' came from, but let us--OK. It is the page 
that starts with the heading ``Consolidation Analysis.''
    Mr. Rosenthal. Yes, I have that in front of me.
    Senator Levin. OK. Now, on that page, in paragraph a., it 
says, ``Palomino was created solely to enable RenTec . . . to 
benefit (through the Badger Options and the Barclays' Options) 
from its long-short statistical arbitrage strategy in an 
efficient manner . . .'' So it was created solely to enable 
RenTec to benefit.
    Now, if you look at paragraph b., under ``Decision 
Making,'' it says that, ``As described in Section VII in 
relation to the IMA, the PB Accounts''--PB, do you know what PB 
stands for?
    Mr. Rosenthal. Prime brokerage.
    Senator Levin. ``. . . [prime brokerage] Accounts are 
controlled by RenTec,'' the key words there being the ``[prime 
brokerage] Accounts are controlled by Rentec.''
    The next paragraph I would like you to look to is under 
``Benefits,'' c., near the bottom of that page: ``RenTec is 
effectively entitled (through the Badger Options and the 
Barclays' Options) to 100% of the benefits from Palomino's 
trading activities less any prime brokerage fees paid to BCI 
and BCSL''--those are Barclays--``in respect to the . . . 
Accounts.'' Did you follow me on that?
    Mr. Rosenthal. Yes, I did.
    Senator Levin. They are entitled to 100 percent of the 
benefits from Palomino's trading activities, Palomino being a 
Barclays creation.
    Then on the next page, near the bottom, where it says, 
``Conclusion: Following the proposed amendments to the Articles 
and the entry into the Side Letter, RenTec controls the major 
activities of Palomino and is exposed to substantially all 
significant risks and rewards arising from the activities 
carried out through the [prime brokerage] accounts, being the 
only permitted activities of Palomino.'' And, again, Palomino 
is Barclays' creation.
    Now, if these factual representations to Barclays' auditors 
by Barclay are true, what does that say about whether the 
option basket is a true option?
    Mr. Rosenthal. If these representations were true, 
Renaissance, the general partner of the hedge fund, controls 
the basket of stocks, and as a consequence, the control is so 
large that I think one would need to conclude that the hedge 
funds, for which Renaissance is acting, own the stocks as 
opposed to Barclays. And that seems to be the point of this 
memo for accounting purposes.
    Senator Levin. And they would not have an option to acquire 
something they already own, presumably.
    Mr. Rosenthal. No. I am trying to wrap my mind around this 
fiction of having an option over something you already own. My 
view of the option is it reflects a contractual right to the 
basket of stocks in substance, and I think Pricewaterhouse, or 
at least Barclays in these representations to Pricewaterhouse, 
agrees with my intuition and my belief. And I believe that 
Pricewaterhouse itself ultimately allowed Palomino to be 
deconsolidated, which I believe signals that Pricewaterhouse 
thought that all vested control was in the hands of the hedge 
fund and not in the hands of Barclays.
    Senator Levin. And that it was not an option because they 
already controlled and owned it.
    Mr. Rosenthal. Yes, they, in effect, owned the stock, 
right.
    Senator Levin. Now, I would like you to take a look at 
Exhibit 68,\1\ if you would.
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    \1\ See Exhibit No. 68, which appears in the Appendix on page 747.
---------------------------------------------------------------------------
    Mr. Rosenthal. OK, I have that exhibit in front of me, yes.
    Senator Levin. OK. Now, this is an excerpt from Barclays' 
annual report contained in its public filings with the SEC. And 
if you look at Note 41----
    Mr. Rosenthal. I am turning to the back of the document. I 
only see Note 38.
    Senator Levin. At the top of the page it says 230, then it 
says, ``41 Investments in subsidiaries.'' It is for 2009. It is 
Form 20-F. Is that what you have?
    Mr. Rosenthal. I have a Form 20-F, yes.
    Senator Levin. For 2009 of Barclays PLC and Barclays Bank 
PLC.
    Mr. Rosenthal. I have that in front of me. Which page is 
that, and where does it start----
    Senator Levin. No, I do not have a page number. We have a 
note. Is that 230 at the top?
    Mr. Rosenthal. Oh, here, I found it on the second page, 
``41 Investments in subsidiaries.''
    Senator Levin. And 230 is the page number at the top?
    Mr. Rosenthal. I see that, yes.
    Senator Levin. Now, if you look down where it says ``41'' 
in small print there?
    Mr. Rosenthal. Yes, I see that.
    Senator Levin. It says, ``Entities where the Group's''--now 
this is Barclays filing with the SEC, right?
    Mr. Rosenthal. It appears to be so, yes.
    Senator Levin. OK. And then it says, ``Although the Group's 
interest in the equity voting rights in certain entities 
exceeds 50%, or it may have the power to appoint a majority of 
their boards of Directors, they are excluded from consolidation 
because the Group either cannot direct the financial and 
operating policies of these entities, or on the grounds that 
another entity has a superior economic interest in them.''
    So then it says, ``Consequently''--and these are the key 
words: ``Consequently, these entities are not deemed to be 
controlled by Barclays.'' And then it lists two entities: one, 
Palomino Limited. So it is representing to the SEC, it seems to 
me, that Palomino is not deemed to be controlled by Barclays. 
Is that what you read?
    Mr. Rosenthal. Yes.
    Senator Levin. Now, Barclays is claiming in its public 
filing that it does not control Palomino, which is what you 
have been testifying to this morning, because it either does 
not direct the financial and operating policies of Palomino or 
it does not have a superior economic interest in Palomino. 
Based on your review of the evidence that was gathered by this 
Subcommittee, who does control Palomino?
    Mr. Rosenthal. Well----
    Senator Levin. I mean, they are representing they do not 
control it. Is that a serious representation?
    Mr. Rosenthal. I think the hedge funds through their 
general partner, Renaissance, control the accounts in Palomino, 
just like I believe the hedge funds through their general 
partner control the accounts held directly under Deutsche Bank. 
And I think that----
    Senator Levin. Is this a serious representation when you 
tell the SEC that you do not control Palomino?
    Mr. Rosenthal. I believe so. I suspect it is true, too, 
but, I----
    Senator Levin. But is it also--I suspect it is true as 
well. In fact, our report says it is true.
    Mr. Rosenthal. Yes.
    Senator Levin. It is also something they are representing 
to the SEC that they do not control it.
    Mr. Rosenthal. Yes.
    Senator Levin. Part of their argument is that they do 
control it. I think we may hear that argument this morning.
    But in any event, they claim here that they do not control 
it, and what they are saying is the reason they do not control 
it is because they do not, it says here, they do not direct the 
financial and operating policies of these entities. They do not 
control, they say--excuse me. They do not direct the financial 
and operating policies of Palomino and/or another entity has a 
controlling interest. So is this not an acknowledgment in a 
very significant way to a Federal regulatory body that they do 
not direct the financial and operating policies of Palomino?
    Mr. Rosenthal. I would say yes, although there is the word 
``either'' here, and I do not quite understand this 
formulation, ``either cannot direct the financial and operating 
policies . . . or on the grounds''----
    Senator Levin. No, it does not direct.
    Mr. Rosenthal. Yes, it is--``or on the grounds that another 
entity has a superior economic interest in them.'' In either 
circumstance----
    Senator Levin. That another entity has a controlling 
interest in them. So on either grounds.
    Mr. Rosenthal. That is correct. Barclays is not viewed as 
controlling Palomino under this disclosure to the SEC.
    Senator Levin. All right. And if you look at the next 
representation for the year--that was 2011. In 2012, are they 
telling the SEC, if you look at--it is the same exhibit,\1\ 
2012, do you see there the same--it is footnote 38 in this 
case.
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    \1\ See Exhibit No. 68, which appears in the Appendix on page 747.
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    Mr. Rosenthal. Yes, I have footnote 38 in front of me.
    Senator Levin. And they say that they are excluded from 
consolidation. They are not even showing Palomino as being 
owned by them on their SEC form because they do not direct the 
financial and operating policies of these entities or another 
entity has controlling interest, for one or the other reasons, 
they are not even going to show ownership because another 
entity has a controlling interest or Barclays does not direct 
the financial and operating policies of Palomino. Right?
    Mr. Rosenthal. Correct, at the bottom----
    Senator Levin. And that is something you would agree with, 
from what you know.
    Mr. Rosenthal. From what I saw independently of the 
documents, I think this representation to the SEC is correct 
that Palomino was not controlled by Barclays. If you look to 
the economic and financial activities of Palomino, it was set 
up as a special purpose entity and only maintained accounts to 
facilitate the trading for Renaissance. And I think that these 
assertions, quite logically so, suggest that Renaissance 
controls that trading and those accounts, and not Barclays.
    Senator Levin. Yes, but at least Barclays sure does not. 
And that is what they have represented to the SEC. The same 
thing in--take a look at the next year, 2013. Here again, 
Palomino; country of registration or incorporation, Cayman 
Islands again. Can you see that is Note 38, this year. Do you 
see that?
    Mr. Rosenthal. Yes, I see the same words there.
    Senator Levin. They actually--it is slightly different 
words.
    Mr. Rosenthal. Oh.
    Senator Levin. I mean, same impact. They are excluded from 
consolidation. They do not want to even show them as owning 
this because the group, Barclays, does not have exposure to 
their variable returns, and these entities--that is Palomino--
are managed by external counterparties and, consequently, are 
not controlled by the group. Same effect, slightly different 
words. Is that correct?
    Mr. Rosenthal. Yes, thank you for highlighting those 
slightly different words. I actually think the only 
counterparty to Barclays here would be the hedge fund. I do not 
believe that Renaissance, the advisor, would be viewed as a 
counterparty. Normally the term ``counterparty'' is used in 
connection with a derivative, the ones who have the economic 
interest in the contract. So I think these words point more 
directly to the hedge funds.
    Senator Levin. Which is what you have testified to.
    Mr. Rosenthal. That is how I viewed the arrangement 
consistent with these descriptions, yes.
    Senator Levin. So they are representing to the SEC what you 
say is the real-world situation, that the beneficial owner of 
that account was Renaissance.
    Mr. Rosenthal. Yes, it appears to me that way, yes.
    Senator Levin. Year after year after year, that is what 
they say to the SEC.
    Now, the evidence shows that Renaissance on a daily basis 
made hundreds of thousands of these rapid-fire trades. That is 
an average, by the way, of three per second, using its trading 
discretion that it was given by contract in the banks' basket 
accounts. And I think you have testified to this in your 
opening statement, but I want to just ask you to expand a bit 
on it.
    Do you have a view as to--and you talked about a turnover 
in 6 months, I believe, was like 97--what was the turnover, do 
you remember?
    Mr. Rosenthal. The turnover in 3 months' time was about 87 
percent.
    Senator Levin. And in 6 months, do you have the number? I 
think it was 97, but at any rate----
    Mr. Rosenthal. Something like that.
    Senator Levin. Does that give rise to a fundamental or 
material change to the composition of the basket options so 
that these changes to the underlying positions should be deemed 
exchanges of property and, therefore, taxable events under the 
Code?
    Mr. Rosenthal. Yes, I believe so. I believe that that 
argument, though, only holds if the basket contract were 
respected. I think in the first instance, the basket contract 
combined with the investment management agreements reflect 
direct ownership of the underlying assets, and, therefore, 
gains and losses would be recognized at the time that the 
underlying assets were bought and sold. But on the chance that 
some court might disagree--that there is, in fact, a 
contractual right only to the return and not to the underlying 
assets--I think that contractual right has been fundamentally 
changed as the portfolio turns over. And so I think the hedge 
funds would have a very uphill battle to persuade either the 
IRS or a court of law that the gains that they reported as long 
term and deferred really were long term and deferred.
    Senator Levin. So this is a second reason why they would 
have a problem with--from a tax perspective--from what the 
claim of the long-term gain is.
    Mr. Rosenthal. Yes, a second and independent reason, yes.
    Senator Levin. I have a few questions for the GAO, but, we 
will now hear from Senator McCain.
    Senator McCain. I want to thank the witnesses. Could I say 
that there are many people who are watching this hearing, and 
there are many people like me that are not as familiar as you 
are with how this whole system works. So maybe for the record--
and, by the way, we will have to proceed on the assumption 
there is no such thing as a dumb question in my questioning 
you. How does this thing work? What is the technologically 
advanced algorithm? They employ real smart people. Just for the 
record, how does this whole system work that they have invented 
which allows them now to have nothing but profits throughout 
the entire time, no matter what the rest of the Nation and the 
world's economy does? Would you, for the record, Mr. Rosenthal 
or Mr. White, either one or both, explain exactly what is 
taking place here?
    Mr. Rosenthal. Well, we are at some handicap. These 
Renaissance funds were incredibly profitable----
    Senator McCain. This is a hedge fund?
    Mr. Rosenthal. A hedge fund, yes, that buys and sells 
stocks.
    Senator McCain. Right.
    Mr. Rosenthal. It pursues a strategy which has been 
tremendously successful, and understandably so, the funds were 
reluctant to share exactly what they did. But I think what they 
did was described as statistical arbitrage, and I am familiar 
generally with what statistical arbitrage entails. Statistical 
arbitrage entails trying to determine relationships between a 
couple of different assets and determine whether or not the 
price of one of the assets is out of kilter. Too low, you might 
buy; too high, you might sell.
    And so for instance, you might buy Ford Motor and sell 
short Chrysler depending on the price of steel. Maybe Ford uses 
steel more intensively in its manufacturing process.
    Senator McCain. And that decision is made by really smart 
people they hire that do----
    Mr. Rosenthal. Really smart people.
    Senator McCain [continuing]. Intensive study and 
investigation.
    Mr. Rosenthal. Really smart people.
    Senator McCain. And what does the use of algorithms--where 
does that enter into it?
    Mr. Rosenthal. Well, as I understand the algorithm, in the 
1990's one of these really smart people, a Ph.D. from Berkeley, 
created the algorithm which, as I understand it, is a 
collection of different strategies or pricing signals to 
determine what to buy and what to sell. And throughout, the 
Renaissance investment advisor, which has more than 200 to 250 
employees, including 90 Ph.D.s, math and science Ph.D.s, 
continued to tweak the model, search for pricing relationships, 
look for good investment opportunities, and they are very 
successful. They can spot pricing--mispricing that may be 
fleeting, days and weeks, and profit by it.
    Senator McCain. Now, is Renaissance one of the most 
successful of all hedge funds because of this?
    Mr. Rosenthal. I believe so, Senator, based on my Google of 
the company. They are tremendously successful, very profitable.
    Senator McCain. So basically they are not fundamentally 
doing anything wrong; it is just they are smarter than a lot of 
other analysts and hedge funds, etc.
    Mr. Rosenthal. Well, at its core, statistical arbitrage is 
a perfectly sensible and fair strategy to pursue, yes.
    Senator McCain. But the question here is: Are they paying 
their taxes that would be appropriate for the transactions they 
are engaged in?
    Mr. Rosenthal. Not in my view, Senator. In my view, their 
strategies fundamentally are short-term strategies. And at the 
start, Senator, in your opening statement, you described how 
the average investor looks at some of these arrangements and 
says, ``That is not fair. I cannot do that.'' And if you were 
to look to an analogy of what Renaissance funds did to what I, 
as an average investor might do, I cannot instruct my broker at 
the end of the year, after I have bought and sold stocks--IBM, 
AT&T and the like---I cannot instruct my broker, ``Please do 
not send me a 1099 listing the individual gains and sales from 
my stocks. Instead, please send me after a year and a day my 
net profits so that I can treat that net profit as a payoff of 
a long-term investment.''
    I cannot do that with my retail broker. My broker sends me 
statements that reflect short-term profits when I pursue a 
short-term strategy and long-term gains when I pursue a long-
term strategy, when I am fortunate enough to have a long-term 
gain. That is not what has happened here.
    Senator McCain. That is not what has happened here. So what 
has happened here?
    Mr. Rosenthal. What has happened here, in my view, Senator 
McCain, is that the hedge funds wrapped a derivative around the 
short-term trading strategies, that rather than view the short-
term trading strategies as being owned and the benefits passing 
through directly as sales occurred, those gains were simply 
accrued and reinvested in new positions and were only cashed 
out when the derivative that wrapped itself around the strategy 
was terminated and the gains passed through by the bank to the 
fund.
    And as I said, the funds took the view that by arranging 
the wrapper, this derivative, around the strategy, that the tax 
law would ignore the short-term nature of the trades underlying 
the derivative and look only to the longer-term contract. I do 
not think that would withstand judicial scrutiny, Senator.
    Senator McCain. Mr. White, I noticed you want to make a 
comment on this exchange here.
    Mr. White. Senator, yes, we did not at GAO review this 
particular transaction. I want to be clear about that. What we 
did review is IRS' ability to audit large partnerships, and 
many of these hedge funds, as I said in my statement, are 
structured as large partnerships. What we found, is IRS is 
hindered in its ability to audit these kinds of entities. One 
of the problems is finding these kinds of transactions. If you 
have a tiered structure, IRS auditors have the problem of 
finding the ultimate source of the income because what they 
need to do is audit the transactions such as this particular 
transaction that is the example today.
    The other problem that IRS faces is if they do find the 
transaction and make an audit adjustment, they then have to 
find all the partners in the structure to pass the change 
through to.
    Senator McCain. So what do we do?
    Mr. White. There are a couple of things that we are looking 
at. We are not done with our work yet. We will be issuing the 
final report in the fall. But there are some options here to 
simplify the audit process for IRS under the TEFRA rules.
    One problem that we cited, the auditors told us repeatedly 
they have problems finding the so-called Tax Matters Partner, 
the representative of the partnership with whom they deal with 
in an audit. Right now under the law, it is not required that 
that Tax Matters Partner be listed. The Tax Matters Partner, if 
it is listed, may not be a human being. It may be another 
partnership. And IRS auditors told us this can delay their 
audit work by months. And given the statute of limitations, 
they may run out of time to complete an audit. So that is one 
option.
    Another possibility is assessing the tax at the entity 
level, at the partnership level, and avoiding the problem of 
having to pass the tax through to the partners.
    Senator McCain. But right now, according to you, the IRS is 
auditing 0.8 percent of the large partnerships in the United 
States.
    Mr. White. Yes.
    Senator McCain. That is not exactly a deterrent to 
misbehavior.
    Mr. White. Especially when you compare it to the audit rate 
for large corporations, which is, as I said, 27 percent, 33 
times higher than 0.8 percent.
    Senator McCain. So, Mr. Rosenthal, we are really talking 
about de facto tax avoidance here. Is that correct?
    Mr. Rosenthal. I think that is correct, Senator. That is, 
we have a situation in which the hedge funds engage in very 
complicated transactions, and in this instance in ways that I 
do not think would withstand judicial scrutiny. But having the 
IRS find the transaction and having the IRS audit the 
transaction effectively is not going on. I believe from a prior 
GAO report the IRS stumbled across these transactions through a 
tip from the SEC. So there are real problems on the audit side 
from the IRS.
    I would say TEFRA was enacted in 1982, I believe, to 
simplify partnership taxation to make it easier for the IRS to 
conduct audits at the partnership level, yet to provide some 
information rights to the partners, to make sure the partners 
knew what was going on. The TEFRA rules, designed to simplify, 
in fact have created quite a mess. I worked on the reform of 
the TEFRA rules in 1993 when I was at the Joint Committee on 
Taxation. I think Mr. White is correct that further reform 
might be desirable. But my personal view is that is not the 
fundamental problem here.
    There are two fundamental problems, in my view: one is 
these derivatives are just so complicated and so opaque that to 
get the IRS to have the resources to sort them through----
    Senator McCain. Could I interrupt you there on the first 
one? Does that mean you rule out such transactions?
    Mr. Rosenthal. No. On the first one on how to view 
derivatives, I think they serve a valuable commercial purpose. 
Yet I believe what we ought to do is require derivatives to be 
accounted for as if they had been sold every year. Chairman 
Dave Camp of the House Ways and Means Committee examined 
derivatives closely and in his tax reform proposals recommended 
that derivatives simply be marked to market, that is, treated 
as if they are sold each year, and then that income or loss 
recognized each year. That would help immensely to try to 
neuter the complexity and the difficulties of the IRS in 
unraveling these derivative arrangements and would, in effect, 
come very close to the true income from the derivatives. And 
that was the approach that Chairman Camp proposed and then 
reproposed. I think that was a sensible approach.
    Senator McCain. Your second point? I interrupted you.
    Mr. Rosenthal. My second point is it is a question of 
resources, I think, in part to the IRS. As you suggest, 
Senator, a 1-percent audit rate for an increasingly large 
segment of our economy just invites the most aggressive 
behavior. And it is unfortunate--I have practiced for many 
years, and I have seen this scenario from so many different 
spots. You can find advisors who will write aggressive 
opinions; whereas, most advisors would not opine that a 
transaction works. You can find taxpayers which will take 
aggressive positions in circumstances in which many other 
taxpayers would not take advantage of a situation that they did 
not think was appropriate. And, in effect, what you have is the 
aggressive driving a race to the bottom, the competitive 
pressures amongst professionals and amongst taxpayers are only 
enhanced by the lack of enforcement and regulation by the IRS. 
And so the situation is very challenging.
    So, again, I would try to think of systemic ways to make 
the audit and the taxation of derivatives simpler, but then you 
also, in my view, need to give the IRS more resources to do 
their job.
    Senator McCain. Thank you.
    Thank you, Mr. Chairman.
    Senator Levin. Thank you. We are near the end of a vote in 
the Senate now, the first of three votes. I am going to run 
over there now and try to catch two votes together, and then I 
will probably just have to miss the third vote, because we are 
going to come back and continue to work through these. But I 
just want to make it clear that you agree, Mr. White, that the 
IRS has recently experienced budget reductions that do 
constrain the resources that are potentially available for 
large partnership audits?
    Mr. White. Yes. Its overall resources have been cut. 
Furthermore, what is going on here is you have this very rapid 
growth in large partnerships. C corporations are shrinking 
somewhat but not enough so that IRS could reallocate resources 
from those audits, which are productive audits. Audits of 
corporations bring in several tens of billions of dollars to 
IRS. So reallocating resources away from those audits to large 
partnerships does not seem to make sense.
    Senator Levin. All right. Thank you both. You two are 
excused. We are going to move to our next panel in probably 10 
minutes, so we will recess for 10 minutes.
    [Recess.]
    Senator Levin. The Subcommittee will come back to order. 
Now we will call our second panel of witnesses:
    Martin Malloy, Managing Director of Barclays in London; 
Satish Ramakrishna, Managing Director of Deutsche Bank 
Securities Inc. and Global Head of Risk and Pricing for Global 
Prime Finance in New York; Mark Silber, Executive Vice 
President, Chief Financial Officer, Chief Compliance Officer, 
and Chief Legal Officer of Renaissance Technologies LLC in New 
York; and Jonathan Mayers, Counsel for Renaissance Technologies 
LLC in New York.
    Thank you all for being with us this morning, and thank you 
for the cooperation of the banks and of Renaissance. We 
appreciate that.
    Pursuant to Rule 6, all witnesses who testify before the 
Subcommittee are required to be sworn, so we would ask you to 
please stand and raise your right hands. Do you swear that the 
testimony you are about to give before this Subcommittee will 
be the truth, the whole truth, and nothing but the truth, so 
help you, God?
    Mr. Malloy. I do.
    Mr. Ramakrishna. I do.
    Mr. Silber. I do.
    Mr. Mayers. I do.
    Senator Levin. We will be using a timing system today. 
About a minute before the red light comes on, you will see the 
lights change from green to yellow, giving you an opportunity 
to conclude your remarks. Your written testimony will be made 
part of the record in its entirety, and please try to limit 
your oral testimony to no more than 7 minutes.
    Mr. Malloy, we will have you go first, followed by Mr. 
Ramakrishna, then Mr. Silber, and then Mr. Mayers. Thank you. 
Mr. Malloy.

  TESTIMONY OF MARTIN MALLOY,\1\ MANAGING DIRECTOR, BARCLAYS, 
                        LONDON, ENGLAND

    Mr. Malloy. Good morning.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Malloy appears in the Appendix on 
page 111.
---------------------------------------------------------------------------
    Senator Levin. Good morning.
    Mr. Malloy. I am Marty Malloy, and I currently serve as 
Managing Director and Head of Barclays' European Prime Services 
unit. From 1998 to 2008, I headed the equity finance team of 
Barclays' Prime Brokerage group. In this capacity, I oversaw 
the execution of the COLT transaction with Renaissance 
Technologies. In the last 18 months, I have met with the 
Subcommittee staff on several occasions in an effort to assist 
your review and analysis of the COLT transactions, and I am 
here today as a further continuation of my and Barclays' 
cooperation.
    Barclays and Renaissance first entered into the COLT 
transaction in the fall of 2002, and they were already a 
customer of the bank at the time. Renaissance proposed aspects 
of a structure that ultimately became COLT in connection with 
ongoing discussions regarding potentially expanding its 
business relationship with Barclays. Over the past 12 years, 
Barclays and Renaissance have entered into a number of COLT 
transactions.
    This is a commercial transaction from which Barclays earns 
fees in a number of ways. On options trades like this one, the 
bank realizes income from the spread on our execution of our 
principal trades. Additionally, Barclays benefited from being 
able to both pledge as collateral and lend out the securities 
held by Palomino.
    Before putting on the first COLT option and when subsequent 
options were considered and approved, Barclays subjected the 
transaction to an extensive internal review process and 
consulted with both internal and external regulatory and tax 
experts. The COLT transaction, like any transaction, poses 
certain risks to the bank. In particular, Barclays bears gap 
risk associated with being the holder of the basket of 
securities.
    For example, over a period of several days in August 2007, 
this portfolio, like others using a statistical arbitrage 
strategy, suffered higher than expected losses. The portfolio 
eventually rebounded, and the losses did not exceed the limit 
levels that would have triggered an automatic unwind of the 
transaction. These risks were mitigated by features of the 
transaction, including Barclays' right to unilaterally unwind 
the transaction if losses exceeded the amount of the premium 
paid by Renaissance on any existing options. There is also a 
monitoring system to oversee performance of the reference 
portfolio and certain limitations such as concentration and 
skew limits.
    While Barclays had the risks and protections I just 
described, the COLT transaction was unique in at least one 
important way in that it was non-recourse. In other words, 
unlike other transactions in which the bank provides financing, 
with the COLT transaction we cannot pursue legal remedies from 
Renaissance in the event the portfolio suffers losses in excess 
of the amount of premium paid.
    An issue raised by this Subcommittee is whether 
historically Renaissance has applied the correct tax rate to 
its earnings from the COLT options. The IRS issued generic 
legal advice in 2010, but to my knowledge, the IRS has issued 
no further guidance or decisions on these transactions.
    Although Barclays feels strongly that this transaction was 
subject to sufficient and significant internal and external 
review to ensure it complied with applicable tax laws and 
regulations, ultimately the question of what tax rate should 
Renaissance pay is a question to be resolved between 
Renaissance, as the taxpayer, and the IRS.
    I hope my testimony has been helpful, and I will do my best 
to answer the Subcommittee's questions. I should note that 
although I have been involved with many aspects of this 
transaction over the course of its execution at Barclays, I 
have not been responsible for the deal's day-to-day operations 
since May 2008. To assist the Subcommittee, the bank has done 
its best to collect as much information as possible related to 
this transaction and, therefore, at times, my testimony and 
answers will reflect not my personal knowledge, but what I have 
been informed of by others working at the bank.
    Thank you.
    Senator Levin. Thank you very much, Mr. Malloy.
    Mr. Ramakrishna.

TESTIMONY OF SATISH RAMAKRISHNA,\1\ MANAGING DIRECTOR, DEUTSCHE 
   BANK SECURITIES INC., GLOBAL HEAD OF RISK AND PRICING FOR 
            GLOBAL PRIME FINANCE, NEW YORK, NEW YORK

    Mr. Ramakrishna. Chairman Levin, good morning.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Ramakrishna appears in the 
Appendix on page 118.
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    Senator Levin. Good morning.
    Mr. Ramakrishna. My name is Satish Ramakrishna. I am 
Managing Director and Global Head of Risk and Pricing for 
Global Prime Finance in Deutsche Bank Securities. I am 
currently based in the New York office of Deutsche Bank, and I 
have been at Deutsche Bank for approximately 16 years.
    Before I became a risk manager in 2007, the job that I do 
now, I was an equity derivatives trader. I ran the structured 
products derivatives desk for Deutsche Bank in New York and 
later ran a derivatives desk in London. As a result, I have 
extensive experience performing quantitative analysis of equity 
derivatives, including pricing and evaluating the risk profile 
of various options. My colleague Barry Bausano and I have 
submitted detailed written testimony.
    I want now to briefly describe some of the specific 
features of the MAPS product at Deutsche Bank and provide some 
background on how and why we developed what we call ``New 
MAPS'' in 2008. Mr. Bausano will then provide you with a brief 
overview of the MAPS product in Deutsche Bank.
    MAPS was an option on a trading strategy. The option buyer, 
a hedge fund, paid a premium to Deutsche Bank to purchase the 
option. If the strategy did not generate gains in excess of the 
initial premium, the buyer simply paid for the costs and 
benefits of the option and received the remaining value in the 
option at maturity. However, if the strategy generated positive 
returns, the buyer received the amount of those returns, less 
the costs and fees for the option paid to Deutsche Bank. The 
bank engaged an investment advisor affiliated with the option 
holder to run the trading strategy within strict parameters and 
to purchase in short in the bank's own account the securities 
or positions that comprised the strategy as a hedge to the 
option.
    While the bank's exposure under the option was hedged, MAPS 
was not without risk to the bank, particularly absent the 
controls which we put in place. If the value of the securities 
held in the account fell below the barrier price of the option, 
the bank bore all losses.
    The extent of this risk became clear to me in August 2007, 
a few months after I joined Prime Finance as a risk manager, 
when hedge funds employing a statistical arbitrage, market-
neutral strategy experienced what has come to be known as the 
``quant quake.'' The quant quake demonstrated that such funds 
were riskier than believed because of the high correlation in 
the positions held by different funds employing similar 
strategies.
    As a result, in late 2007, I began to consider ways to 
provide the Bank with better protection if the value of the 
portfolio of securities the Bank was holding relating to MAPS 
suddenly dropped. At the same time, those in the bank's control 
functions, including legal, tax, and compliance, were assessing 
MAPS in light of ongoing dialog and observations concerning the 
regulations surrounding derivatives products. Those efforts 
were merged together as we at Deutsche Bank worked to 
restructure MAPS and develop ``New MAPS'' in 2007 and 2008.
    The MAPS restructuring included a number of changes. Let me 
highlight three of them.
    First, New MAPS included key risk reduction terms that 
provided the bank with certain rights at declining levels of 
account value and that required the investment advisor to 
follow a defined balanced and liquid investment strategy.
    Second, the New MAPS agreements further provided that the 
securities traded for each option would be held in separate 
sub-accounts and the options staggered in maturity for risk 
purposes.
    Third, New MAPS was changed from an American style to a 
European style option, which could not be terminated early 
without forfeiting a significant part of the premium.
    In addition to these changes to the product, we took steps 
to improve internal controls and apply intra-day risk 
management, thus better managing the bank's risk under New 
MAPS. I also ensured that the revised option price calculation 
accurately compensated the bank for its risks and costs. 
Pricing was done through the use of traditional option-pricing 
methods, and the strike price was adjusted so that the cost of 
the option and the financing cost of the portfolio were 
reflected in the strike price of the option.
    In sum, we priced New MAPS as an option, managed it as an 
option, and documented it as an option. We did so because MAPS 
was an option and the bank was compensated for and managed its 
risk accordingly.
    Thank you for this opportunity to speak to you today, and I 
look forward to answering your questions.
    Senator Levin. Thank you very much.
    Next will be Mr. Silber.

 TESTIMONY OF MARK SILBER,\1\ EXECUTIVE VICE PRESIDENT, CHIEF 
 FINANCIAL OFFICER, CHIEF COMPLIANCE OFFICER, AND CHIEF LEGAL 
  OFFICER, RENAISSANCE TECHNOLOGIES LLC, NEW YORK, NEW YORK, 
     ACCOMPANIED BY JONATHAN MAYERS, COUNSEL, RENAISSANCE 
              TECHNOLOGIES LLC, NEW YORK, NEW YORK

    Mr. Silber. Thank you. Chairman Levin, and Members of the 
Subommittee, good morning.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Silber appears in the Appendix on 
page 129.
---------------------------------------------------------------------------
    Senator Levin. Good morning.
    Mr. Silber. My name is Mark Silber, and I appreciate the 
opportunity to present a brief opening statement on behalf of 
Renaissance.
    Renaissance's mission is to produce superior financial 
results by adhering to mathematical and statistical models in 
the design and execution of trading strategies. Our equity 
trading and advisory activities add liquidity to the markets, 
reduce inefficiencies, and improve capital formation. We have 
invested billions in the research that supports our models, and 
we have been very successful, but we know that past success 
does not eliminate future risk.
    I want to be clear: Renaissance's Medallion fund purchased 
barrier options from Deutsche Bank and Barclays for substantial 
non-tax business reasons. We would have purchased these options 
regardless of their tax treatment. I can confidently speak to 
our motivations for buying these options because I have been a 
part of the Renaissance leadership team for over 30 years.
    When we exercised a barrier option held for more than a 
year, we reported any gains resulting as long-term capital 
gains in accordance with current tax law. We reported short-
term capital gains on options held for less than a year. If the 
tax law relating to barrier options changes in the future, we 
will, of course, comply.
    Under current law, derivative instruments permit higher 
leverage than many other forms of investments. Again, if the 
rules concerning leverage change, we will comply.
    Medallion purchases barrier options to obtain a combination 
of leverage and loss protection that we have been unable to 
obtain through any other means. This is entirely permissible 
under current law. The Joint Committee on Taxation has 
recognized that derivatives are critically important tools in 
the risk management process and that, compared to actually 
stock ownership, derivative contracts typically afford a party 
much higher leverage than would be commercially possible or 
permitted by relevant margin regulations.
    Our options are not prime brokerage accounts with more than 
normal benefits. They come with a different bundle of rights 
and obligations. Owners of stock in prime brokerage accounts 
receive customer protections in bankruptcy and other benefits 
that we do not. For example, if one of our counterparties were 
to collapse or default, as Lehman Brothers and other large 
institutions have recently done, we would be a general creditor 
at the back of the line with no guarantee of recovering any 
portion of the value of the option. We have accepted these 
trade-offs in order to obtain greater leverage and loss 
protection that is not available in prime brokerage.
    The way in which we have used the barrier options also 
demonstrates that we were driven by business imperatives. The 
average holding period of the Deutsche Bank options from 2000 
through 2009 was around 450 days. For Barclays, it was around 
400 days. After the August 2007 Quant Quake, we exercised a 
Barclays option after only a few months, and then did so again 
in 2009 during the market turmoil surrounding the financial 
crisis. Today all of the new options that Medallion enters into 
have terms of less than 1 year.
    Like all prudent investors, we were also mindful of the tax 
consequences of our actions. This is entirely permissible and 
in no way negates the compelling business reasons that led us 
to enter into these transactions.
    As you know, the IRS has been reviewing these options for 
over 6 years now. Renaissance has been cooperating fully with 
that review and is working through the issue within the IRS's 
established process. Frankly, we wish things would move faster. 
Ultimately, we expect to prevail because we have complied with 
the law.
    We also note that Congress many years ago gave the IRS the 
authority, in Code Section 1260, to prospectively change the 
taxation of options like these, and it has not done so.
    We appreciate the opportunity to be here today to explain 
our transaction, and we look forward to your questions.
    Senator Levin. Thank you, Mr. Silber.
    Mr. Mayers.
    Mr. Mayers. Senator Levin, Mr. Silber's remarks were on 
behalf of Renaissance as a whole, and I will not be making a 
statement separately.
    Senator Levin. Thank you.
    OK. Let me first ask you some questions, Mr. Silber. In the 
basket deals with Deutsche Bank, RenTec used two different 
entities to purchase the options: Franconia and then later on 
Mosel. Franconia was a Bermuda corporation, and it was used by 
Renaissance to be the option buyer in 20 basket deals between 
2000 and 2007.
    How many employees did Franconia have?
    Mr. Silber. None.
    Senator Levin. Who controlled Franconia?
    Mr. Silber. Renaissance as the general partner.
    Senator Levin. Now, take a look at Exhibit 6,\1\ if you 
would.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 6, which appears in the Appendix on page 274.
---------------------------------------------------------------------------
    Mr. Silber. I have that exhibit.
    Senator Levin. If you take a look at page 1, it is stated 
that RenTec was authorized without further approval by or 
notice to the client--that is Franconia--to make all investment 
decisions concerning the account. Is that correct? Do you see 
that?
    Mr. Silber. I am looking for it, but I believe that is 
correct.
    Senator Levin. OK. Now, in terms of RenTec's control over 
Franconia, if there were any doubt, take a look at the 
signature page. Who signed that agreement for Renaissance?
    Mr. Silber. I did.
    Senator Levin. And who signed on behalf of Franconia?
    Mr. Silber. I did.
    Senator Levin. So you are signing that deal with yourself. 
More significantly, Renaissance is signing a deal with itself, 
and the company is such a shell that you, as an executive 
officer of RenTec, sign all of the papers.
    Now, the next entity RenTec used in these basket deals was 
Mosel. Am I pronouncing that correctly?
    Mr. Silber. Yes, Senator.
    Senator Levin. Mosel was a Delaware partnership and has 
been used by RenTec to be the option buyer in basket options 
between 2007 and 2010. It has also entered into all of the 
short-term deals that RenTec and Deutsche Bank have entered 
into since 2012. How many employees does Mosel have?
    Mr. Silber. None.
    Senator Levin. And who controls Mosel?
    Mr. Silber. We do as general partner.
    Senator Levin. Take a look at Exhibit 8,\2\ if you would.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 8, which appears in the Appendix on page 292.
---------------------------------------------------------------------------
    Mr. Silber. Yes, sir.
    Senator Levin. This is a copy of the Limited Partnership 
Agreement for Mosel. RenTec is Mosel's general partner. 
According to page 6 of the agreement, the general partners, 
subject to the terms and conditions of the agreement, ``shall 
have complete and exclusive responsibility for managing and 
administering the affairs of the Partnership, and shall have 
the power and authority to do all things necessary to carry out 
its duties hereunder.'' Do you see that language?
    Mr. Silber. Yes, Senator.
    Senator Levin. OK. Now, look at the signature pages 15 and 
16. Who signs for RenTec?
    Mr. Silber. I did.
    Senator Levin. And who signs for all of the partnerships 
that are the limited partners?
    Mr. Silber. I did.
    Senator Levin. Full control by RenTec. RenTec's general 
partner Mosel is also the agent of Mosel. Is that correct?
    Mr. Silber. We are the general partner of Mosel.
    Senator Levin. Are you the agent of Mosel?
    Mr. Silber. As general partner, we had all the authority 
and responsibility for the activities.
    Senator Levin. Now, I want to explore some of the fictions 
that I have referred to in some detail, and we are going to do 
so by looking specifically at the option deals involving RenTec 
and Deutsche Bank. What the bank and the hedge fund want is to 
create a reality, an alternate reality, in which RenTec can 
borrow lots of money from Deutsche Bank to make millions of 
short-term trades while both avoiding leverage limits and 
RenTec also claiming long-term capital gains rates. And the 
vehicle to create that alternate reality is a basket option 
that derives its value from a basket of securities that sit in 
a Deutsche Bank account, but that RenTec can change the mix of 
the assets in the basket as it wishes.
    The idea, however, of a hedge fund holding an option whose 
value derives from an account that that same hedge fund 
controls would be absurd, to have an option on yourself. So to 
maintain the fiction of a real option, RenTec creates an entity 
that it owns, Franconia, to hold the option. RenTec controls 
the Deutsche Bank account. The created entity Franconia holds 
the option on the account. That supposedly sets up a wall 
between the entity controlling the trades and the entity 
controlling the option. But on even the most cursory 
examination, that wall crumbles. These two entities are one 
entity, as we can see from the chart in front of us.
    Now, Mr. Silber, take a look at Exhibit 7,\1\ if you would. 
It is a confirmation document for one of the basket deals 
between RenTec and Deutsche Bank in 2002. Do you see where the 
heading there is ``Deutsche Bank,'' and it says, Franconia, it 
is addressed to Franconia Equities.
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    \1\ See Exhibit No. 7, which appears in the Appendix on page 129.
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    Mr. Silber. Yes.
    Senator Levin. Care of Renaissance Technologies.
    Mr. Silber. Yes.
    Senator Levin. OK. Franconia, again, the RenTec-controlled 
shell, is the option buyer. Deutsche Bank is the seller.
    Now, if you look at one of the representations made in this 
document on the bottom of page 10, Article (v), there is a 
representation in that article that the buyer--that is 
Franconia--has made an independent judgment of the experience 
and expertise of the investment advisor. The investment advisor 
to Deutsche Bank is RenTec, who we have already seen is the 
investment advisor for Franconia, wholly owned by RenTec, who 
owns it and controls it. Franconia has no employees.
    Now, how can Franconia be able to make an independent 
judgment of RenTec?
    Mr. Silber. I am missing--I am sorry, Senator. I see where 
the seller----
    Senator Levin. At the last line, ``The buyer has made an 
independent judgment of the experience''----
    Mr. Silber. ``. . . and expertise of the investment''--that 
is correct. Franconia is an investment vehicle owned by 
ultimately the beneficial owners of the fund, Medallion fund, 
which was the owner of Franconia. RenTec is an individual--is 
an independent entity which acts as Investment Advisor to both 
Medallion and Franconia.
    Senator Levin. Right. So how can Franconia make an 
independent judgment of the experience and expertise of RenTec? 
It was created by RenTec.
    Mr. Silber. It was.
    Senator Levin. It has no employees.
    Mr. Silber. That is correct.
    Senator Levin. So how does it make an independent judgment?
    Mr. Silber. We as the----
    Senator Levin. Who makes the judgment at Mosel?
    Mr. Silber. Renaissance----
    Senator Levin. I am sorry. At Franconia. Who makes the 
judgment?
    Mr. Silber. Renaissance acting as the general partner with 
duties to the--fiduciary duties to its investors, is speaking 
on behalf of those investors with regard to RenTec, the same 
entity, in its role as investment advisor.
    Senator Levin. So RenTec is making a judgment on RenTec.
    Mr. Silber. It is.
    Senator Levin. OK. If that is your definition of 
``independence,'' I would like to find a dictionary--send me a 
copy of the dictionary that has that kind of a definition of 
``independence,'' making a judgment on yourself.
    So take a look, if you would, please, at page 11\1\ of that 
same document. And then in the second paragraph there, under 
``Investment Advisor,'' it says, ``Other than as provided 
above, Buyer agrees''--that is Franconia--``that it shall not 
contact directly the Investment Advisor''--that is RenTec--
``regarding the terms or subject matter of this Transaction.''
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    \1\ See Exhibit No. 7, page 11, which appears in the Appendix on 
page 279.
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    How is it under any definition conceivable that the Buyer, 
Franconia, with no employees, will not contact directly the 
Investment Advisor that creates it regarding the terms or 
subject matter of this transaction? How is that possible?
    Mr. Silber.I agree. I do not understand--that sentence may 
not have been relevant to this transaction.
    Senator Levin. But it is highly relevant, trying to create 
a fictional wall. I am just asking you: How is it conceivable, 
under what definition is it possible that Franconia, with no 
employees, agrees that it will not contact the investment 
advisor, which is RenTec, regarding the terms and subject 
matter of this transaction? Would you agree that is not 
feasible, physically?
    Mr. Silber. In this circumstance, I think you are correct.
    Senator Levin. All right. Now, Deutsche Bank in 2008 
revised its basket option product called ``MAPS,'' and Mosel 
then replaced Franconia as the option buyer on behalf of 
RenTec. Please take a look at Exhibit 27.\1\ If you look at 
page 21, this is the agreement now between Deutsche Bank and 
Mosel Equities care of Renaissance. This is the confirmation, 
so-called, for a basket deal in 2009. This is after the 
restructuring of MAPS. There is a representation, if you would, 
on page 21 near the top, end of paragraph (v), the ``Buyer''--
so now it is Mosel--``agrees that it shall not attempt to 
direct or influence the choice of investments in the Basket.''
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    \1\ See Exhibit No. 27, which appears in the Appendix on page 425.
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    The investment advisor to the Deutsche Bank account, the 
entity making the decisions for the trading account, is RenTec. 
The company controlling Mosel is RenTec. RenTec is the agent of 
Mosel. So how can Mosel represent to Deutsche Bank that it will 
not attempt to direct or influence the choice of investments in 
the basket when Mosel and RenTec are really the same entity? 
How is that possible?
    Mr. Silber. Senator, Renaissance is playing two different 
roles in this transaction. With regards to the option, it is 
recommending trades for the reference basket, and with regard 
to Deutsche Bank, we are recommending and initiating trades for 
their hedge portfolio.
    Senator Levin. Would you agree that Mosel and RenTec are 
the same entity?
    Mr. Silber. They are not the same entity. They are both 
controlled by Renaissance, but they have different ownership.
    Senator Levin. Well, Renaissance controls Mosel.
    Mr. Silber. Renaissance manages and has control of the 
activities of Mosel.
    Senator Levin. And so Mosel is controlled by Renaissance.
    Mr. Silber. On an activities basis, that is correct.
    Senator Levin. So Mosel is now agreeing it will not attempt 
to direct or influence the choice of investments in the basket, 
but the entity that controls it will.
    Mr. Silber. I think Renaissance is----
    Senator Levin. Renaissance controls it.
    Mr. Silber. Renaissance----
    Senator Levin. They are going to make the decisions.
    Mr. Silber. And when we make the decision----
    Senator Levin. But then Mosel is saying, Mosel will not do 
it, the person that owns us, the entity that owns us is going 
to do it. The problem is it does not say that anywhere here, 
does it?
    Mr. Silber. No, it does not. Renaissance does not own 
Mosel. It controls Mosel.
    Senator Levin. It controls Mosel.
    Mr. Silber. So Renaissance----
    Senator Levin. So Mosel is telling Deutsche Bank, we are 
not going to make a recommendation, but the entity, it does not 
say, that controls us is going to make the recommendation, 
right?
    Mr. Silber. In its role as advisor to Deutsche Bank, that 
is correct.
    Senator Levin. OK. Now, Mr. Ramakrishna, you signed this 
document on behalf of Deutsche Bank. And you are familiar with 
the operation of the basket deals.
    Mr. Ramakrishna. Yes, sir.
    Senator Levin. Do you think it is possible that Mosel, 
totally controlled by RenTec, could not be influencing the----
    Would you agree that RenTec not only influenced the choice 
of investments, it made the decision on investments. Would you 
agree to that?
    Mr. Ramakrishna. I think we did realize that the option 
buyer and the investment advisor are affiliated.
    Senator Levin. Not affiliated. That RenTec controls Mosel. 
You knew that.
    Mr. Ramakrishna. We knew there was a relationship. I cannot 
speak to the control feature. It is not something I am an 
expert on.
    Senator Levin. But now that you know that Mosel is owned by 
RenTec, does it make any sense for Mosel to represent to you 
that it is not going to be making any decisions relative to 
what is in that basket? It does not add parenthetically, but 
the entity that owns us is. RenTec controls Mosel. So Mosel is 
telling you, Deutsche Bank, we, Mosel, we are not going to make 
any recommendations to you. But what they do not add in that 
agreement is, the entity that owns us is going to make those 
decisions. Doesn't that change the whole nature of the 
contract? If they said that, the facts are that RenTec owns 
Mosel. You are told in this contract Mosel represents to you, 
Deutsche Bank, that it is not going to make decisions relative 
to what is in that basket, right? That is what it is telling 
you.
    Mr. Ramakrishna. Senator, I am not an attorney, and I am 
sure the word ``control'' means something special.
    Senator Levin. It means what it says. You signed the 
agreement, didn't you?
    Mr. Ramakrishna. Yes, I did, sir.
    Senator Levin. Did you understand what you were signing?
    Mr. Ramakrishna. I think I did, yes.
    Senator Levin. And did you understand that Mosel, which 
signed the agreement with you, owned by RenTec, representing to 
you that it is not going to make decisions, did you understand 
that the entity that owned it, RenTec, that owned Mosel, was 
going to be making decisions? Did you know that when you signed 
it?
    Mr. Ramakrishna. We definitely knew that the two were 
connected----
    Senator Levin. No, but did you know that RenTec--when you 
were told in this agreement--was represented to you that Mosel 
was not going to be making the decisions. Did you realize and 
understand that RenTec, the party that was making the decisions 
in its agreement with you, owned Mosel? Did you know that?
    Mr. Ramakrishna. I do not think I knew personally if RenTec 
owned Mosel, but I do know that the two were strongly 
connected.
    Senator Levin. Senator Johnson.
    Senator Johnson. Nothing right now, Mr. Chairman.
    Senator Levin. OK. Let me just ask you, Mr. Silber, the 
entities that were involved in the Barclays-RenTec basket deals 
were similar to the ones that were involved with the Deutsche 
Bank-RenTec deals. In the deal with Barclays, RenTec used two 
different entities to purchase the basket options. Bass 
Equities was a Cayman Island company that was used by RenTec to 
be the basket option buyer in eight basket deals between 2002 
and 2004. Badger was a Delaware partnership and has been used 
by RenTec to be the option buyer in 31 basket options between 
2007 and 2012.
    Now, Mr. Silber, you signed all the formation papers for 
all the parties. RenTec controlled Bass and Badger, and RenTec 
was the investment advisor for the Barclays option account, 
which was held in the name of a Barclays special purpose entity 
called ``Palomino.'' Is that correct?
    Mr. Silber. Yes, Senator.
    Senator Levin. OK. And you were the investment advisor to 
Bass and Badger. Is that correct?
    Mr. Silber. Yes.
    Senator Levin. By the way, Senator Johnson, whenever you 
are ready, let me know. I would be happy to yield to you, 
because I have been going on for some time.
    Senator Johnson. Unfortunately, I missed the first part.
    Senator Levin. OK. Mr. Mayers, a critical event regarding 
the question of who controlled the bank accounts occurred in 
2009 when there was a change in the Articles of Association of 
Palomino, which is the Bermuda entity that Barclays used to 
hold the account related to the basket transactions. And it was 
followed by a side letter that effectively gave Renaissance 
power to approve changes to Palomino's Articles of 
Incorporation.
    So we have a situation here where Palomino's activities 
were restricted to those that it was currently engaged in by 
that side letter. Basically Palomino was restricted to basket 
option transactions with Renaissance and could only use 
Renaissance as the investment advisor to the Palomino account.
    Mr. Mayers, I believe you told Subcommittee staff that 
RenTec wanted to make sure that it could mitigate as much as 
possible the chance that Barclays could unilaterally undertake 
some activity that could void the investment management 
agreement and possibly terminate the option because RenTec 
wanted to preserve the access that it had to the leverage 
financing. Is that correct?
    Mr. Mayers. Senator, in the context of the discussion with 
your staff which you are referring to, I advised that by the 
time I got involved in the side letter discussions, the reason 
for them had been--it had already been decided that it was 
going to be done. My role at that time was to review the 
documentation to see how it affected the rights and obligations 
as far as the option transactions were concerned.
    In reviewing those documents, the first thing that I 
noticed was that it did not negatively affect these rights and 
obligations, and as you correctly refer--as you correctly 
state, I was thinking that there may be a benefit in that side 
letter. I have since gone back and can see no way where that 
benefit can accrue.
    Senator Levin. Now, back to Mr. Malloy, Barclays had 
discussions with Renaissance about changes to the Articles of 
Association. Is that correct?
    Mr. Malloy. Yes.
    Senator Levin. And the problem was that since Barclays was 
the sole shareholder of Palomino, Barclays could always go back 
and eliminate the restrictions in Palomino's Articles of 
Association. So in order to ensure that the restrictions on 
Palomino would stay in place, RenTec and Barclays entered into 
a side letter. Would you take a look at Exhibit 55,\1\ please?
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    \1\ See Exhibit No. 55, which appears in the Appendix on page 667.
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    Mr. Malloy. Yes.
    Senator Levin. Now, this side letter, at the second from 
the last paragraph, addressed to you, Mr. Malloy, by 
Renaissance Technologies, signed by Mr. Silber, stipulated that 
the amendments to Palomino's articles would not change the 
obligations and duties that Barclays and Palomino had to RenTec 
regarding the basket transactions. In addition, the side letter 
said the following, and this is what I am reading to you from 
that second from the last paragraph: ``Barclays hereby further 
covenants to Renaissance that it shall not make any amendments 
or modifications to the Memorandum and Articles of Association 
of Palomino after the date hereof without first obtaining the 
prior written consent thereto of Renaissance; provided that the 
Investment Management Agreement has not been terminated by 
either Palomino or Renaissance.''
    So what you do is you give Renaissance veto authority over 
Palomino's entire Articles of Association. That is a huge sign 
of RenTec's control. Not only does it have contractual and 
functional control over the accounts of Palomino; it also now 
has veto authority over the details of the organization's 
charter.
    Mr. Malloy, this was one of the factors that Barclays used 
to justify the deconsolidation of Palomino in its financial 
statements in 2009. Is that right?
    Mr. Malloy. Yes.
    Senator Levin. Now, when Barclays deconsolidated Palomino, 
which means it removed Palomino from its annual financial 
reports, and when it removed it from its financial statement in 
2009, Barclays took the position that Palomino is controlled by 
RenTec. Barclays' reasons for taking this position were laid 
out in a June 2009 memorandum that it wrote, Barclays wrote, to 
its own auditor, Pricewaterhouse. So if you would take a look, 
please, at Exhibit 53.\2\ This is a memorandum that was written 
by Barclays' Structured Capital Markets Group, which was 
responsible for developing the basket transactions.
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    \2\ See Exhibit No. 53, which appears in the Appendix on page 654.
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    Now, I reviewed the reasons in depth with the first panel, 
the reasons given, and the full list is, again, available here 
for all the reasons that it represented what it did. So I am 
just going to summarize the reasons that Barclays gave to its 
auditor for wanting to deconsolidate Palomino. Here are the 
reasons:
    The trading activities of Palomino are managed solely by 
RenTec such that RenTec can obtain the majority of the benefits 
from Palomino's activities;
    The prime brokerage accounts are controlled by RenTec;
    RenTec effectively is entitled to 100 percent of the 
benefits from Palomino's trading accounts;
    RenTec is exposed to 100 percent of the risks from 
Palomino's trading accounts.
    And this is the conclusion which you can see to that 
document. It is on page 139764, so that is the Bates number 
there, do you see that? ``Following the proposed amendments to 
the Articles and the entry into the Side Letter, RenTec 
controls the major activities of Palomino and is exposed to 
substantially all significant risks and rewards arising from 
the activities carried out through the [prime brokerage] 
accounts, being the only permitted activities of Palomino.''
    ``Consequently,'' Barclays--which is BBPLC--``should de-
consolidate Palomino from the date these proposed amendments 
are effective because they give rise to a loss of control.''
    So now you are representing--you, being Barclays--
representing to your auditor that, from the date of those 
amendments, Barclays no longer controls Palomino. Is that 
correct? That was the representation in that letter to 
Barclays' auditor. Is that correct?
    Mr. Malloy. Mr. Chairman, I think there is a number of 
points----
    Senator Levin. But did I read it correctly?
    Mr. Malloy. You read the statement that is in there, but I 
think you actually have to look at different aspects of this 
particular documentation.
    Senator Levin. OK.
    Mr. Malloy. To put it into context, this is a document 
between accountants going back and forth over European 
accounting standards, and if we take some of the components 
that you talk about where you mention the risks, there are 
several spots within this documentation that actually 
highlights that, as I mentioned in my opening statement, that 
Barclays is exposed to the gap risk. So this is, when we are 
looking at this particular language, it is from an accounting 
perspective, Mr. Chairman, that they are starting to talk about 
the control component.
    I would observe that control is more a conclusion. If we go 
back to the----
    Senator Levin. Well, what was the conclusion that Barclays 
gave to its auditor?
    Mr. Malloy. This is a conclusion from an accounting 
standards perspective. Palomino----
    Senator Levin. You mean it did not control? You are saying 
that it controlled it for accounting purposes but not for tax 
purposes? Is that what it says in here?
    Mr. Malloy. Palomino was deconsolidated for accounting 
purposes. It was still consolidated, though, for regulatory 
purposes.
    Senator Levin. Well, let us look at the regulatory 
purposes. Look at, if you would, Exhibit 68,\1\ the statement 
to the SEC.
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    \1\ See Exhibit No. 68, which appears in the Appendix on page 747.
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    Mr. Malloy. Yes.
    Senator Levin. Your annual report to the SEC in filings, 
you have excluded Palomino from consolidation because Barclays 
does not direct the financial and operating policies of these 
entities or does not have a superior economic interest in 
Palomino because Barclays either cannot direct the financial 
and operating policies or, on the grounds that another entity 
has a superior economic interest in Palomino. Now you are 
talking to the regulator, right? You are saying we are not 
going to consider Palomino part of us anymore, it is excluded 
from consolidation. This is what you are reporting to the SEC. 
Is that correct? In Exhibit 68, do you read that, on page 230?
    Mr. Malloy. Yes.
    Senator Levin. ``. . . these entities are not deemed to be 
controlled by Barclays.'' And what is one of the entities? 
Cayman Islands-owned Palomino. So now you are talking to the 
regulators. Was that statement true?
    Mr. Malloy. As I understand it, Mr. Chairman, this is an 
outcome from the analysis that was done on the accounting, so 
for the accounting standards, under that definition of the 
accounting standards associated with it, yes. I would point 
out, though, that----
    Senator Levin. Yes, what? That the statement was true.
    Mr. Malloy. I do not know of any factual inaccuracies in 
the memo that was submitted to PwC.
    Senator Levin. Well, my question is: Is the representation 
to the SEC that the entities are not deemed to be controlled by 
Barclays, was that a true statement to the SEC? That is my 
question.
    Mr. Malloy. Mr. Chairman, I am not an accountant----
    Senator Levin. No, I am asking you whether or not this 
statement to the SEC was correct. That is all I am asking. It 
is not an accounting statement. It is a factual statement that 
you made to the regulator. ``These entities''---now we are 
talking about Palomino--``are not deemed to be controlled by 
Barclays.'' That is a very direct question.
    Mr. Malloy. I am sure the statements that we made to the 
SEC are accurate. I was just pointing out it is from an 
accounting standard, Mr. Chairman.
    Senator Levin. So it is accurate for an accounting purpose, 
but inaccurate for what other purpose?
    Mr. Malloy. No, I am not suggesting that these are 
inaccurate statements going to our regulators.
    Senator Levin. Well, you are saying it was accurate here, 
but it was not accurate for some other purpose. So where was it 
inaccurate?
    Mr. Malloy. What I am pointing out is when you are doing 
some of the analysis that are going back, when you start 
talking about some of the language that is associated with it, 
the language could mean different things to different aspects, 
one from an accounting perspective, one from a tax perspective.
    Senator Levin. So in other words, you did not tell the SEC 
that we do not control this for SEC purposes, but we are going 
to claim we control it for tax purposes? Did you tell that to 
the SEC?
    Mr. Malloy. I am not aware of exactly----
    Senator Levin. Did the SEC refer this to the IRS?
    Mr. Malloy. I became aware later that it did, yes.
    Senator Levin. So take a look at Exhibit 68, 2010, same 
statement: ``These entities,'' including Palomino, ``are not 
deemed to be controlled by Barclays.'' 2011, same statement: 
``These entities,'' again Palomino, ``not . . . controlled by 
Barclays.'' Year after year you are representing to the 
regulator these entities are not controlled by Barclays.
    But then it is interesting. You say in Exhibit 68--take a 
look, if you would, at the 2013 representation to the SEC. You 
are saying, if you look on the third paragraph under Note 38--
--
    Mr. Malloy. I am sorry, Mr. Chairman?
    Senator Levin. Sure, Note 38, Exhibit 68. This is now the 
2013----
    Mr. Malloy. OK.
    Senator Levin [continuing]. Representation to the SEC, 
Fiscal Year ended December 31, 2013.
    Mr. Malloy. OK.
    Senator Levin. The third paragraph, do you see that? It 
starts, ``An interest in equity voting rights,'' do you see 
that paragraph?
    Mr. Malloy. I do.
    Senator Levin. And at the end it says, ``However, certain 
entities are excluded from consolidation because the Group does 
not have exposure to their variable returns.'' And then it says 
the following: ``These entities are managed by external 
counterparties and consequently are not controlled by the 
Group.'' Not controlled by Barclays. That is, again, Cayman 
Island-registered Palomino Limited.
    So, again, Barclays does not control it, you are 
representing, but someone else, an external counterparty, 
manages it. Who is that?
    Mr. Malloy. I believe what we are referring to here is the 
structure of the overall option where Renaissance----
    Senator Levin. No, but who is the external----
    Mr. Malloy [continuing]. Was the investment manager as part 
of that. But I think it is also worth pointing out, though, Mr. 
Chairman, that we talk about this whole concept, Barclays still 
was 100 percent owner of Palomino.
    Senator Levin. Yes, I know that----
    Mr. Malloy. We still did all of the capitalization of 
Palomino. We managed all of the financing. We took all of the 
collateral that we had the full rights to use that Renaissance 
was never even aware of. So I think it is important that you 
look at different aspects of the overall structure to see who 
is acting in which capacity.
    Senator Levin. Yes, I could not agree with you more as to 
who the beneficial owner was of this account, who got the 
profits and losses, who made the decisions on what to buy. All 
of the key indicators of ownership point right to RenTec. In 
fact, that is the purpose this account was set up, was to 
service RenTec. In fact, you can make a claim that you 
represented--that we did not control it to SEC, but really we 
still owned it legally. You claimed that you are the beneficial 
owner of Palomino?
    Mr. Malloy. We are the beneficial owner of the reference 
accounts and the asset----
    Senator Levin. No, not the reference accounts. Are you 
claiming that you are the beneficial owner of Palomino?
    Mr. Malloy. Palomino is a 100 percent wholly owned 
subsidiary of Barclays.
    Senator Levin. Do you claim you are the beneficial owner of 
the account that Palomino ran, of that basket account? Do you 
claim to be the beneficial owner of that basket account?
    Mr. Malloy. Yes, we are the beneficial owner of the assets 
in that account.
    Senator Levin. OK. Now, for each of the options, for more 
than 10 years, Renaissance used Barclays' software system, 
right?
    Mr. Malloy. Yes.
    Senator Levin. It gave direct access to the stock market. 
RenTec executed tens of millions of trades per year in 
Barclays' Palomino accounts. Renaissance received the stock 
dividends from all those trades as part of the option profits. 
It was charged commissions and trading costs by Barclays for 
each of the transactions that it executed. It was charged 
finance fees by the bank to borrow shares for its short selling 
activity in the Palomino account. It was charged a financing 
fee by the bank on the amount that it used for leverage in the 
account. Renaissance even received the rebates from stock 
exchanges for the orders using Barclays' execution system that 
it sent to the stock exchange. Is that true, what I just said?
    Mr. Malloy. In general, yes.
    Senator Levin. Now, when Renaissance sends a marketable 
order using your software system to the stock market, 30 
million--or, I guess--yes, 30 million a year between the two 
banks, about 15 million per bank. It is executed in a 
microsecond, is it not? In a second or less? Orders are 
executed----
    Mr. Malloy. The order----
    Senator Levin. In microseconds.
    Mr. Malloy. Right, again, just to maybe back up and explain 
how it worked.
    Senator Levin. OK. And the same was true, Mr. Ramakrishna, 
for Renaissance activities at Deutsche Bank. Is that correct?
    Mr. Ramakrishna. Did you say microseconds?
    Senator Levin. Yes, these orders were executed in 
microseconds.
    Mr. Ramakrishna. Usually--I mean----
    Senator Levin. There are 15 million of these orders a year 
at your bank, right?
    Mr. Ramakrishna. Yes. The orders were sent through our 
slower system initially, which was in the range of a few 
milliseconds. Microseconds is a thousand times smaller, so not 
on that level.
    Senator Levin. And who placed the orders?
    Mr. Ramakrishna. They were placed by RenTec.
    Senator Levin. Renaissance.
    Mr. Ramakrishna. Yes in Deutsche Bank's name.
    Senator Levin. In your name. And, Mr. Malloy, did 
Renaissance receive all the profits from the trading reflected 
in the Palomino accounts when it closed out the account?
    Mr. Malloy. Renaissance via the option did get the 
performance of the overall portfolio, yes.
    Senator Levin. OK. Was the same true, Mr. Ramakrishna, for 
Deutsche Bank?
    Mr. Ramakrishna. Sorry. I think I missed exactly what----
    Senator Levin. OK. Let me repeat the question. Did 
Renaissance receive all the profits from the account which was 
run by Deutsche Bank? So here we are talking about Deutsche 
Bank's account, which held the stocks which were directed and 
ordered by RenTec. Did RenTec have most of the risk for those 
stocks?
    Mr. Ramakrishna. RenTec had the risk up to the premium that 
they paid for the option.
    Senator Levin. Exactly.
    Mr. Ramakrishna. Beyond that, Deutsche Bank took all the 
risk.
    Senator Levin. You never took a loss on any of these 
purchases, did you?
    Mr. Ramakrishna. Honestly, Senator, we did not take a loss 
on any of these accounts owing to proactive risk management.
    Senator Levin. I understand----
    Mr. Ramakrishna. We had other trades----
    Senator Levin. But there were 30 million buys in these two 
banks, and you guys did not take a loss on any of those buys, 
right?
    Mr. Malloy. No, we did not take a loss on----
    Senator Levin. So you have 15 million buys ran through you 
to this account, profits and losses all belong to RenTec, they 
did the ordering, and you guys did not lose a penny on any of 
30 million buys, and that was all RenTec's risk, right?
    Mr. Ramakrishna. Senator, there was a lot of careful 
selection of----
    Senator Levin. I know it is carefully done. I am asking 
you, did you lose a penny on any of 15 million buys?
    Mr. Ramakrishna. No.
    Senator Levin. Did you lose a penny on any of 15 million 
buy?
    Mr. Malloy. No. That is not to say we did not have risk, 
though, Mr. Chairman.
    Senator Levin. I understand the risk that you are claiming. 
I am just saying you did not----
    Mr. Malloy. No, we did not.
    Senator Levin. For 10 years, tens of millions of buys, you 
did not lose a penny on any of the buys. I understand the risk 
you took, which never panned out. You never lost on any of that 
risk. But, nonetheless, that is not my question.
    Now, Mr. Malloy, isn't it the case that for the options, 
the COLT options, that were written on a basket of securities 
that were held by Palomino and that RenTec determined the 
composition of and the overall investment strategy, is that the 
case? They determined the composition of the basket and the 
overall investment strategy.
    Mr. Malloy. Yes, they made the decisions of what to 
purchase and sell.
    Senator Levin. The options were written on the basket of 
the securities that were held by Palomino. Is that correct?
    Mr. Malloy. Yes.
    Senator Levin. OK. To both you, Mr. Malloy and Mr. 
Ramakrishna, your banks' profits from the options came from 
financing and transaction fees. Is that correct?
    Mr. Ramakrishna. Senator, we charged in excess of what we 
would normally charge for financing and transaction fees.
    Senator Levin. But that is where your profits came from.
    Mr. Ramakrishna. The revenues came from that, yes.
    Senator Levin. And, Mr. Malloy?
    Mr. Malloy. Yes, we also were able to--in this particular 
transaction, we had profits that came from the ability of the 
use of the collateral.
    Senator Levin. Right.
    Mr. Malloy. We could use that for securities lending, and 
that also was as part of the revenue stream.
    Senator Levin. Right. Did the banks, either of your banks, 
from these tens of millions of trades that were executed every 
year in your accounts for the option basket and from the 
billions of dollars of profits earned in those accounts, did 
your banks receive any of the profits from the trading activity 
after you deducted what was owed to Renaissance?
    Mr. Malloy. No. The trading activity that occurred, the 
account would be up or down, losses or gains on any individual 
day. But Barclays did not receive any of the performance, no.
    Senator Levin. Is that true, Mr. Ramakrishna, with your 
bank?
    Mr. Ramakrishna. Mr. Chairman, the----
    Senator Levin. Is what he said true with your bank?
    Mr. Ramakrishna. The payoff of the option was indeed the--
--
    Senator Levin. No. I am just asking you whether it's true? 
If you cannot answer, it is OK. What he has just said, was that 
true with Deutsche Bank?
    Mr. Ramakrishna. I would like to just qualify it with one 
extra statement, which is that, for instance, when you have a 
trade from a customer, you may have crossing profits because 
you are able to cross internally. That sort of profit would not 
be recognized as Renaissance's profit. That would be Deutsche 
Bank's profit. But, otherwise, the account determined what the 
option value was, which is what Renaissance got back.
    Senator Levin. Now, to both of you, Renaissance is using 
the bank's trading execution system to place and execute by 
itself, several hundred thousands trades a day that go into the 
basket account. The banks do not even get involved. Renaissance 
has direct access to Barclays' and Deutsche Bank's trading 
platforms to place orders. These orders go out directly to the 
exchanges in microseconds or seconds. If they are marketable 
orders, they get executed immediately.
    Renaissance was purportedly your investment advisor, but 
they were given by contract discretionary authority to execute 
trades so they could execute trades, which they did, by the 
millions in the banks' Palomino accounts and the banks' account 
without prior approval of the bank. Is that correct, Mr. 
Malloy? They could execute the trades without prior approval?
    Mr. Malloy. No.
    Senator Levin. They could not?
    Mr. Malloy. No.
    Senator Levin. Did you approve 15 million trades during 
these years?
    Mr. Malloy. No. What we did is you have to have a process 
that puts in place----
    Senator Levin. You approve the process.
    Mr. Malloy. No, if I could----
    Senator Levin. Sure.
    Mr. Malloy [continuing]. There is actually a process that 
actually goes in place. As you rightly pointed out, there are a 
lot of transactions that are going through there, so your 
ability to look at that, you look at the accession-based 
processes. So what we had in our particular systems is we had--
in this particular transaction, there was a disproportion, and 
the majority of the trading activity had to be done through our 
infrastructure so we had control of that. We have the ability 
to block that on a name-by-name basis. We have the ability to 
put that in a restriction as far as the overall notionals. And 
we monitor the basket as it is going intra-day. And that is not 
to say that on the next day, even though it is going from a--in 
a fashion of quick execution after the fact, and we have done 
that several times, where we did not like a particular security 
through restriction and the like and asked them to take it out.
    Senator Levin. All right. How many times did that happen?
    Mr. Malloy. On the restrictions of names? That is on a 
daily basis.
    Senator Levin. No. How many times did you veto anything in 
their purchases?
    Mr. Malloy. From an execution point of view, I do not 
recall. It was after the fact, Mr. Chairman.
    Senator Levin. All right. How about Deutsche Bank?
    Mr. Ramakrishna. Senator, the way in which Renaissance 
traded through us, given that they are a technologically 
forward organization, we did not intercept every single trade 
and approve or disapprove it. We had very strict guidelines in 
place for portfolio composition, diversity and liquidity, and 
the concentrations in various names, plus we had a restricted 
list. All this was supplied to them at an updated point of time 
several times a day, and they would have to conform to those 
restrictions. So we did not at any point actually go back and 
revisit trades because we did not have to. Those trades would 
be banned by definition.
    Senator Levin. All right. You had already set what the 
conditions were, but 30 million trades went through without you 
stopping any of them from going through?
    Mr. Ramakrishna. We had exception policies in places, which 
would basically make sure that trades that should not go 
through did not go through.
    Senator Levin. OK. And so you had about 15 million trades 
that went through without exception. Is that correct?
    Mr. Ramakrishna. We had lots of trades that went through 
after they passed the vetting.
    Senator Levin. How many trades were stopped by your 
guidelines?
    Mr. Ramakrishna. Given that the restrictions put in place 
prevented trades that should not have gone through, all I can 
tell you is that Renaissance took great pains to make sure that 
we had no exceptions, and we had very few exceptions. I cannot 
think of any in my own tenure there.
    Senator Levin. OK. So of the 15 million trades at your 
bank, the guidelines did not stop any of those trades. Within 
your guidelines, they made the decision, they made the 
purchases and sales. Is that correct?
    Mr. Ramakrishna. Exactly. They never violated the 
guidelines, yes.
    Senator Levin. OK. So your guidelines never stopped any of 
these millions and millions of decisions that they made. Is 
that true also with Barclays, Mr. Malloy?
    Mr. Malloy. What I would say, Mr. Chairman, is we actually 
stopped the transactions that did not fit into the guidelines 
ahead of time.
    Senator Levin. Yes, well, in other words, you said 
guidelines----
    Mr. Malloy. No, but we restricted the names before they 
even got into execution.
    Senator Levin. And how many times did that happen over the 
years?
    Mr. Malloy. Every day.
    Senator Levin. So you actually stopped them from making 
purchases every day.
    Mr. Malloy. We would block in our system----
    Senator Levin. Your system blocked, you said?
    Mr. Malloy. Yes.
    Senator Levin. OK. If it was inside of the investment 
guidelines, all of the trades would go through. Is that 
correct?
    Mr. Malloy. If it was inside the investment guidelines, 
yes.
    Senator Levin. OK. And you would agree----
    Mr. Malloy. As a normal course of business, because it 
reduced our risk associated with the hedge.
    Senator Levin. I understand. But you had agreed on what 
those guidelines were.
    Mr. Malloy. Yes.
    Senator Levin. OK. So they had agreed to guidelines, and 
they lived by the guidelines. And if they did not, the purchase 
would have been caught.
    Mr. Malloy. I am sorry?
    Senator Levin. The purchase would have been prevented, the 
transaction would have been prevented if it violated the 
guidelines.
    Mr. Malloy. Yes.
    Senator Levin. And that would be by their own algorithm or 
something you put in place?
    Mr. Malloy. It depends upon what aspect of the investment 
manager that they are referring to.
    Senator Levin. OK. Did they basically buy those 15 million 
shares that went through your system through an algorithm?
    Mr. Malloy. As I understand it, yes.
    Senator Levin. Is that true with you, too, Mr. Ramakrishna?
    Mr. Ramakrishna. I believe that they used an algorithm, 
yes.
    Senator Levin. Was that their algorithm?
    Mr. Ramakrishna. The algorithm that they used decided what 
they wanted to buy and sell.
    Senator Levin. Whose algorithm was it?
    Mr. Ramakrishna. It was presumably Renaissance's algorithm.
    Senator Levin. Do you know whose algorithm it was?
    Mr. Malloy. Renaissance, as I understand it, yes.
    Senator Levin. Did they share their algorithm with you, by 
the way?
    Mr. Malloy. They have not.
    Mr. Ramakrishna. Sadly, no.
    Senator Levin. Decidedly not.
    Mr. Ramakrishna. No, they have not.
    Senator Levin. Senator Johnson.
    Senator Johnson. Thank you, Mr. Chairman. I apologize for 
missing the earlier panel and the testimony here.
    We are obviously drilling down to some fairly detailed 
levels, and I would kind of like to just pull back a little bit 
and try and get a little bit simpler understanding of something 
that is probably pretty complex.
    But to followup on the Chairman's questioning there in 
terms of basically hiring a manager to manage a portfolio 
within the banks, do you have examples of other managers that 
you use similarly to manage certain funds in your banks, Mr. 
Malloy?
    Mr. Malloy. In this particular transaction, we only had one 
counterparty that we did this in, and within the prime 
brokerage space, no, I am not aware of another example of that.
    Senator Johnson. No, I am talking about just other managers 
do other mutual funds that your bank holds for your customers. 
Is there another--do you hire another manager to do something 
similar? I am not saying really high-frequency trading like 
this based on an algorithm, but just a manager to manage 
portfolio stocks for your customers.
    Mr. Malloy. I really could not speak across the bank. I 
would not be surprised if there was one, but I am just not 
aware of one.
    Senator Johnson. Mr. Ramakrishna, does Deutsche Bank have 
something similar to that?
    Mr. Ramakrishna. In the Asset Management Division, we 
definitely have external managers who are often hired to manage 
portfolios for customers. We have a couple of external managers 
on our own platform, which are going to be phased out very 
soon, which manage money for us.
    Senator Johnson. Other than the frequency of the trades and 
the number of stocks they buy and sell, is there any real 
difference between how your relationship is with those managers 
versus with Renaissance?
    Mr. Ramakrishna. They also run portfolios of similar, maybe 
a little smaller size, with a large number of names. And they 
may not use the same algorithms or the same frequency of 
trading, but they do trade a lot.
    Senator Johnson. But, again, your guidelines in terms of 
how you deal with those managers, is it similar or identical? 
In other words, you hire them to manage a particular fund you 
make available to a potential customer, and you are selling a 
mutual fund that could be bought and sold with a capital gain 
attached to it?
    Mr. Ramakrishna. I would characterize the rules they use 
for Renaissance as much tighter. We had constraints on 
liquidity, concentration, size of position, which stocks they 
could actually trade, sector concentrations, country 
concentrations, that we would never put on any other manager 
because at some level that is their strategy and if they want 
to run it, it is fine. The reason we ran these portfolios this 
way was because of the risk we ran in this portfolio.
    Senator Johnson. But, again, the guidelines in terms of how 
you manage your manager, the different guidelines, but is it 
similar--I mean, you have a similar--you have guidelines that 
you work with the manager to manage your portfolio of stocks or 
bonds or options or whatever type of investment vehicle there 
is? Again, I am just trying to find out if there is something 
similar to Renaissance in terms of structure, not necessarily 
in terms of frequency of trade?
    Mr. Ramakrishna. Not really, no.
    Senator Johnson. So this is pretty unique?
    Mr. Ramakrishna. It is pretty unique, yes.
    Senator Johnson. As I was studying this and getting 
prepared for this, what this appears to be is a question of 
form over substance. Is that a basically true statement, Mr. 
Malloy? The form of how you structured this deal versus the 
actual substance of what is happening?
    Mr. Malloy. Again, the way in which this was structured is 
as an option. It has those features in it. I do not know if I 
actually understand the question.
    Senator Johnson. Let me just ask: To what extent has this 
been adjudicated in any kind of tax court or through the IRS? I 
have some memorandums passed. Is this really being looked at? 
Do you think this is going to eventually go before a tax court?
    Mr. Malloy. As I understand it, there is an ongoing--it is 
a better question, obviously, for probably Renaissance, but----
    Senator Johnson. OK.
    Mr. Silber. Thank you, Senator. Yes, as I said in my 
opening statement, the IRS has been--we have been in 
conversation with the IRS for about 6 years now on this. They 
have had full transparency. They understand the structure very 
well, and we are in the midst of that process. We are hopefully 
going into the appellate level of the IRS shortly.
    Senator Johnson. So has this gone before a tax court at 
all? You are saying the appellate level. You are still working 
through----
    Mr. Silber. Not yet, no. We are still working through the 
administrative process.
    Senator Johnson. OK. Mr. Malloy, an earlier question by the 
Chairman was really talking about control. And there are 
different levels of control based on tax versus accounting 
standards versus potentially SEC. How many different bodies do 
you have to comply with in terms of determining whether, for 
example, Barclays would control a particular entity?
    Mr. Malloy. I think it really comes down to what aspect of 
the transaction you are going to. From my lens, when I think 
about control, it is who ultimately has--who is the beneficial 
owner of the assets and whether you can actually use the 
assets.
    Senator Johnson. The point I am trying to make is, 
grappling with some of the different issues, there are criteria 
to determine whether the IRS is going to take a look at this is 
a controlled entity or versus whether accounting standards 
determine that.
    Mr. Malloy. Right.
    Senator Johnson. And they are not always the same, correct?
    Mr. Malloy. Correct, although you have the advantage 
there--I am neither an attorney or a tax attorney, but as I 
understand it, yes.
    Senator Johnson. Mr. Ramakrishna, can you speak to that? 
How many different bodies do you report to that you have to try 
and comply with in terms of determining whether or not a 
particular group is under control of your bank?
    Mr. Ramakrishna. Senator, as a risk manager and the person 
who would take the first hit if there were a loss in this 
portfolio, it was very clear to me that we had ultimate control 
because we were the ones who were going to bear the brunt of a 
catastrophic loss. We did give the investment manager 
permission to trade in the account, and we had an option whose 
delta was essentially managed by this investment manager. But 
it was very clear to me that if there was a loss, it would be 
on my head and on Deutsche Bank's head, not in the investor's 
court.
    So in my mind at least, control was very settled. I do not 
know the legal ramifications of what control means for other 
organizations. I am sure there are accounting and tax 
standards. I do not know them, though.
    Senator Johnson. OK. Mr. Silber, do you know the point I am 
trying to make here? I am not trying to judge whether or not 
this was a controlled entity. I am just trying to point out, in 
trying to comply with whether it is the tax authority or 
whether it is the SEC, whether it is just basic accounting 
standards, how many different bodies provide different 
standards and different criteria for determining--to make these 
judgments whether something is truly an option or whether it is 
under your control? Do you understand the point I am making?
    Mr. Silber. Yes, I understand, Senator. We are nowhere near 
as diverse an entity as either of the banks here, but we 
ourselves are subject to multiple levels of regulatory review 
and filings, many of--from the IRS, the SEC, we are regulated 
by the CFTC, we have ongoing filings, many of which have 
different definitions. You used the example of ``control.'' 
That is important in some of the filings and not in the others. 
Even something as simple as assets under management, under our 
U.S. general accounting statements filings versus Form PF, 
which we now file with the SEC regularly, definitions of 
similar words will differ across--for different purposes for 
different agencies. Tax standards usually are different than 
accounting standards. Those are the ones that I am most 
familiar with. But we have a variety of reporting regimes that 
we file under, and the definitions are not always consistent.
    Senator Johnson. So suffice it to say it is very difficult 
to comply----
    Mr. Silber. We do our best----
    Senator Johnson [continuing]. With all the different 
standards, with all the people you report to?
    Mr. Silber. I would not say it is difficult. We put a lot 
of time into it. We do comply. But sometimes it is very hard to 
compare two sets of filings and try and get them to reconcile. 
They may be using different definitions. So as I say, I use the 
example of assets under management, for example, should be 
fairly straightforward English. Different purposes will give 
different results, and both will be correct under the 
applicable rules.
    Senator Johnson. So I am really trying to drill down in 
terms of what is the appropriateness of these transactions of 
this relationship. Really you are going to have to--if it is a 
tax issue, you really have to go through the tax authorities 
and take a look at exactly their rules versus if we are going 
to go through accounting standards and reporting, you are going 
to have to go through the SEC and figure out--it is a little 
more difficult in a setting like this where we are talking 
sometimes at cross purposes about different standards between 
different agencies. Is that basically correct?
    Mr. Silber. Yes, I believe so, Senator.
    Senator Johnson. OK. I have no further questions, Mr. 
Chairman.
    Senator Levin. Mr. Ramakrishna, I think you just said that 
Deutsche Bank gave permission to Renaissance to trade in 
Deutsche Bank's accounts. Is that correct?
    Mr. Ramakrishna. Yes.
    Senator Levin. You just said that? You gave them the right 
to execute----
    Mr. Ramakrishna. In Deutsche Bank's name, yes.
    Senator Levin. In your name.
    Mr. Ramakrishna. In Deutsche Bank's name, yes.
    Senator Levin. OK. And is it not true that they had 
discretionary--``they'' being RenTec--has total discretion, 
full discretion and authority without obtaining your prior 
approval to manage the investment in the trading of the 
accounts? Is that true? Both of you.
    Mr. Ramakrishna. I will take it first, sir. Given the 
constraints we had placed on them, which were maintained on 
their systems electronically, under those constraints, yes.
    Senator Levin. All right. The constraints were agreed to, 
and then within those constraints, Deutsche Bank had the full 
discretion and authority without obtaining your prior approval 
to manage the investment and trading of the accounts. Is that 
correct?
    Mr. Ramakrishna. Yes. Under those constraints, yes.
    Senator Levin. Is that also true for Barclays?
    Mr. Malloy. Subject to the Investment Management Agreement, 
but----
    Senator Levin. Of course.
    Mr. Malloy. Yes. I would not characterize it, though, as 
``unfettered.'' We looked at those transactions, we monitored 
it in real time.
    Senator Levin. How about full discretion?
    Mr. Malloy. I would not say ``full'' because it was subject 
to restrictions under the Investment Management Agreement.
    Senator Levin. You would or would not?
    Mr. Malloy. I would say it was restricted under the 
Investment Management----
    Senator Levin. Would the words ``full discretion'' be 
accurate?
    Mr. Malloy. Subject to the Investment Management Agreement, 
they had discretion.
    Senator Levin. Full discretion?
    Mr. Malloy. Not unfettered discretion, Mr. Chairman.
    Senator Levin. I am just asking you, did they have full 
discretion or not within the agreement that you reached?
    Mr. Malloy. If they stayed within the guidelines, they 
could make the transactions. They had full discretion to deploy 
the portfolio----
    Senator Levin. I asked you three times did they have full 
discretion within those guidelines?
    Mr. Malloy. Yes.
    Senator Levin. You hesitated to say ``full discretion.''
    Mr. Malloy. The only reason I hesitated is because we do 
have some restrictions within there and I can step in. That is 
my only hesitation----
    Senator Levin. OK. Other than they had to operate within 
the guidelines, they could buy and sell anything they wanted, 
right?
    Mr. Malloy. Yes.
    Senator Levin. And they did 15 million times, right?
    Mr. Malloy. There was a lot of activity that went through 
the accounts, yes.
    Senator Levin. OK. And that was within the guidelines they 
had full discretion and authority, is that right, without your 
prior approval, within those guidelines?
    Mr. Malloy. Within the guidelines.
    Senator Levin. That you two had agreed to.
    Mr. Malloy. Yes.
    Senator Levin. OK. Is that true with your bank, Mr. 
Ramakrishna?
    Mr. Ramakrishna. Yes.
    Senator Levin. OK. Now, if they operated within those 
agreed upon guidelines that they had agreed to with you, since 
they had full discretion, the decisions as to what to buy and 
sell as theirs. Is that correct, Mr. Malloy?
    Mr. Malloy. Yes.
    Senator Levin. Mr. Ramakrishna.
    Mr. Ramakrishna. It is probably hundreds tens of thousands, 
hundreds of thousands [securities] that their algorithm could 
choose. Within those guidelines, that decision was theirs. Is 
that correct?
    Mr. Ramakrishna. Yes, sir, about 6,000 securities.
    Senator Levin. Six thousand?
    Mr. Ramakrishna. Securities, roughly, yes.
    Mr. Malloy. Yes.
    Senator Levin. OK. So within those guidelines, among those 
6,000 securities, it was their discretion, and they were not 
making recommendations to you then, were they? Within those 
guidelines?
    Mr. Malloy. They would make the recommendations and then 
execute on our behalf to hedge----
    Senator Levin. Well, wait a minute. I thought they had full 
discretion within those guidelines.
    Mr. Malloy. They had the full discretion to make the----
    Senator Levin. Buy and sell within those guidelines.
    Mr. Malloy. To buy and sell within the guidelines.
    Senator Levin. That they had agreed to.
    Mr. Malloy. Yes.
    Senator Levin. OK. If they were not within those guidelines 
when they made those decisions, using your platform, that was 
not a recommendation to you. They made the decision within 
those guidelines, within that number of 6,000 securities or 
whatever it was, that was their discretion, their decision. Is 
that correct?
    Mr. Malloy. Yes. We still had the legal right, although, as 
we discussed----
    Senator Levin. You did not exercise it.
    Mr. Malloy. We did not exercise it until after the fact in 
many instances, yes.
    Senator Levin. Mr. Silber, you have been listening to this 
testimony about when you operated within those guidelines, as 
you had agreed to, that you had full discretion under the 
contracts. Is that correct?
    Mr. Silber. Within the guidelines, yes.
    Senator Levin. All right. And if you operated within the 
guidelines, you considered that that decision as to what to buy 
and sell was yours. You had full discretion?
    Mr. Silber. Yes.
    Senator Levin. And your algorithm that you put together 
would pick and choose. is that correct?
    Mr. Silber. Was put together by our group.
    Senator Levin. By your group.
    Mr. Silber. Yes.
    Senator Levin. The algorithm would pick and choose----
    Mr. Silber. That is correct.
    Senator Levin [continuing]. Among those 6,000 securities? 
Is that about what it was?
    Mr. Silber. Approximately.
    Senator Levin. But within those guidelines, it was not for 
you to make a recommendation, it was for you to make a decision 
as to what to buy. Is that not true, your algorithm?
    Mr. Silber. We had the authority to act--to make the 
decisions for the reference basket, which was the important 
criteria for options. At the same time, we were making the 
recommendations, which I referred to as almost always executed 
for the hedge account for the banks.
    Senator Levin. So if you operated within the guidelines----
    Mr. Silber. Yes, then it would be----
    Senator Levin. Then it was your decision.
    Mr. Silber. For the initial investment, yes.
    Senator Levin. The initial investment. What does that mean?
    Mr. Silber. It meant that the banks in either case had the 
ability--I do not know if they ever exercised it--to have 
changed the--de-levered--I am sorry, excuse me, wrong 
language--to remove their hedge or to hedge in a different 
manner. The purpose of our exercise----
    Senator Levin. They had the authority, but they never 
exercised it. Within those guidelines that you had agreed to, 
there may have been 6,000 securities that you had the right, 
the discretion to buy and sell, within those guidelines?
    Mr. Silber. They were placed into the account.
    Senator Levin. And the decision was yours within those 
guidelines?
    Mr. Silber. Our firm's, yes.
    Senator Levin. Your firm's, of course.
    Mr. Silber. Yes.
    Senator Levin. So they are not a recommendation to them. 
Within those guidelines. Would you agree?
    Mr. Silber. Correct.
    Senator Levin. OK. Mr. Malloy, take a look, please, at 
Exhibit 36.\1\ This is a Product Proposal for Project COLT, 
which is the project we are talking about. That is the basket 
option project. This was dated May 28, 2002. Your name is on 
it, so I assume you are familiar with it. And if you look at 
page 3, if you look at page with Bates number 2-1-2-546.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 36, which appears in the Appendix on page 482.
---------------------------------------------------------------------------
    Mr. Malloy. Yes.
    Senator Levin. At the bottom. Let me read this to you: 
``COLT''--that is what we are talking about here--``is 
targeted''--this is your product proposal, 2002. It is 
``targeted at those Funds with a high proportion of US 
individual investors, stable year-on-year returns and 
strategies involving short-term trading. This gives rise to 
significant short-term capital gains for the investors 
regardless of whether or not they are invested in the fund for 
the shorter or longer term.''
    Then it says on page 4, ``COLT provides an after-tax 
benefit to these investors through the conversion of their 
return from the fund from short-term capital gains (taxed at 
39.6%) to long-term capital gains (taxed at 20%).'' Did I read 
that right?
    Mr. Malloy. Yes, you did.
    Senator Levin. Now, was this a product being proposed for 
Renaissance?
    Mr. Malloy. The initial structure for COLT, yes, the 
initial and subsequently only client was Renaissance.
    Senator Levin. All right. So what you were in your proposal 
saying is that this proposal had an after-tax benefit through a 
conversion of their return from the fund from short-term 
capital gains taxed at 39.6 percent to long-term capital gains 
taxed at 20 percent. That was obviously an important part of 
your proposal.
    Mr. Silber, back in 2002 this was a pretty important part 
of their proposal. Hey, this is for Renaissance, we can 
convert, short term into long term, it is like magic. Do you 
still say that was not something that crossed your mind back in 
2002?
    Mr. Silber. I am not saying that it did not cross our mind. 
Once we had initiated the structure with Deutsche Bank, we came 
to realize that they had the potential for a favorable tax 
treatment, so we certainly were aware of it. But I cannot speak 
to this internal Barclays document.
    Senator Levin. And wasn't this part of the proposal that 
was made to you?
    Mr. Silber. No, I have never seen this----
    Senator Levin. No, I am not saying that this is written, 
but when you were discussing this with Barclays, are you saying 
that they never mentioned to you the tax benefits in 2002?
    Mr. Silber. Actually, I believe we actually proposed a 
structure of this to Barclays. They did not market it to us.
    Senator Levin. OK.
    Mr. Silber. Deutsche Bank did market the structure to us. 
It was a product that they had already used, and they had not 
used the tax benefits as a selling point at all.
    Senator Levin. Deutsche Bank never did. And Barclays was 
marketing this to you, weren't they?
    Mr. Silber. We actually had suggested it to them, so----
    Senator Levin. After you suggested it to them, because you 
already had one with Deutsche Bank, where did they get this 
language from?
    Mr. Silber. I do not know.
    Senator Levin. You do not know. So this was never discussed 
with Barclays?
    Mr. Silber. Not to my knowledge, no.
    Senator Levin. OK. Barclays, did you ever discuss this with 
Renaissance? It was in your proposal. Did you ever discuss the 
tax benefits with Renaissance in 2002?
    Mr. Malloy. I will answer the question two ways, Mr. 
Chairman. I was not personally involved with covering the 
account at that particular time, but as you can--so I am not 
sure exactly what the first exchange was. I subsequently did 
cover the account from a relationship perspective. But it was 
clear within the bank, though, that there was a tax benefit 
along with other benefits in the structure.
    Senator Levin. So take a look, if you would now, at Exhibit 
42.\1\ This is a product approval memorandum for the same 
basket option. We are looking at page 3.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 42, which appears in the Appendix on page 557.
---------------------------------------------------------------------------
    Under the term ``Economics and Economics Drivers. Fund 
Benefit. US individual investors of the Fund would obtain a 
post-tax benefit if the Call Option is exercised after 12 
months because all of the gain on the Call Option would be 
treated as a long-term gain for US tax purposes and would 
therefore be taxed at 15% as opposed to 35%.''
    Does that look familiar?
    Mr. Malloy. I am not familiar with this particular 
document.
    Senator Levin. But is this a Barclays document?
    Mr. Malloy. Yes. It appears to be, yes.
    Senator Levin. And take a look, please, at Exhibit 37,\2\ 
that Barclays wrote to its regulator, and this is on page 1, on 
``Background,'' right in the middle of page 1: ``This 
transaction is designed to provide hedge funds with a tax-
effective means of undertaking the business and for Barclays it 
would generate both a structuring fee and additional volume for 
the prime brokerage business.'' So you told your regulator back 
in 2002 this was designed to provide hedge funds with a tax-
effective means.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 37, which appears in the Appendix on page 496.
---------------------------------------------------------------------------
    Mr. Malloy. We were very transparent in this particular 
transaction----
    Senator Levin. You were very aware of it.
    Mr. Malloy. And very concerned as--and one of the 
advantages, there was a tax advantage along with others, yes.
    Senator Levin. Now, Mr. Ramakrishna, when MAPS was 
restructured in 2008, was Deutsche Bank concerned that the old 
structure, the MAPS structure, would not be respected as a 
derivative or more specifically as an option for tax purposes? 
Was that one of your concerns in 2008?
    Mr. Ramakrishna. Mr. Chairman, my initial concern was 
purely devoted to risk issues. There was a parallel 
conversation going on between lawyers in tax and legal, which I 
was not privy to, which I gather developed around restructuring 
the transaction. It is probably a----
    Senator Levin. Was there a question in these conversations 
with your tax people, that there was a concern that the old 
MAPS, the old approach, might not be respected as a derivative 
or it might not be respected as an option for tax purposes? Was 
that a concern?
    Mr. Ramakrishna. I have no idea, Mr. Chairman.
    Senator Levin. OK. But if it were not respected as a 
derivative, then it would lose the tax benefits that was 
offered. Is that correct?
    Mr. Ramakrishna. I presume so, yes.
    Senator Levin. OK. And that benefit was turning short-term 
capital gains into long-term capital gains. Is that true? That 
is what the tax benefit was?
    Mr. Ramakrishna. That was the tax benefit, yes, sir.
    Senator Levin. OK. And are you saying, again, to make sure 
I understand your answer, that one of the reasons that this was 
restructured was to address the concern over the tax benefit, 
that it was one of the reasons? Is that what you said? Or you 
do not know?
    Mr. Ramakrishna. I do not know. The reason I was involved 
was because of a risk reason that I raised.
    Senator Levin. All right. You heard conversation about 
concerns as to whether or not there would be a tax benefit 
under the old structure, you heard conversations about that?
    Mr. Ramakrishna. Certainly not, Senator.
    Senator Levin. Did you ever have conversations with a man 
named Brocksmit?
    Mr. Ramakrishna. Yes, sir.
    Senator Levin. And in that conversation, did you indicate 
to him that tax reasons were one of the reasons for this 
structure?
    Mr. Ramakrishna. Senator, I had several conversations----
    Senator Levin. No, in one of the conversations.
    Mr. Ramakrishna. Yes. The conversation I had was most about 
explaining the risk issues.
    Senator Levin. I understand. That is not my question.
    Mr. Ramakrishna. Yes. In the course of the conversation----
    Senator Levin. Did you tell him that one of the concerns 
was whether or not there would be a tax benefit under the old 
structure? Did you tell him that?
    Mr. Ramakrishna. In the conversation he mentioned that as a 
benefit, and I agreed with him, and I said there were other 
reasons, too.
    Senator Levin. That is fine. You agreed with him in that 
conversation.
    Mr. Ramakrishna. Yes, sir. It was one part of a large 
conversation.
    Senator Levin. A minute ago you said you had never heard of 
that.
    Mr. Ramakrishna. I think you had asked me if I had heard 
anybody from tax and legal talk about it. I did not do that. 
This was also a conversation----
    Senator Levin. Well, who is Mr. Broeksmit?
    Mr. Ramakrishna. He was head of risk and optimization of--
--
    Senator Levin. So you heard from someone in your own 
division that there was a concern about whether the tax benefit 
would really be there under the old structure.
    Mr. Ramakrishna. Mr. Broeksmit was not in charge of----
    Senator Levin. Not in charge of. What division was he with?
    Mr. Ramakrishna. He was at a central level head of risk 
across the bank.
    Senator Levin. Fine.
    Mr. Ramakrishna. Across the corporate bank.
    Senator Levin. Fine. Did you hear from him that there was a 
concern about whether the tax benefit would be there under the 
old structure?
    Mr. Ramakrishna. I did not hear it from him that he was 
concerned about tax risk.
    Senator Levin. You had a conversation, you said, with him 
in which the question as to whether the tax benefit would--is 
solid in the old structure.
    Mr. Ramakrishna. No, that was not a conversation I had. It 
was a conversation which said what are the benefits of the 
transaction, at which point I gave him the benefits, and he 
mentioned tax benefit as one of them.
    Senator Levin. So you heard him say----
    Mr. Ramakrishna. He did say tax benefit was one of the 
benefits, yes. He knew as well as I did.
    Senator Levin. We thank you, all four of you. We appreciate 
your being here, and your cooperation with our Subcommittee, 
and this panel is excused.
    Let me now call our last panel of witnesses for today's 
hearing: Gerard LaRocca, the Chief Administrative Officer, 
Americas, for Barclays, Chief Executive Officer for Barclays 
Capital Inc., in New York; Barry Bausano, President and 
Managing Director of Deutsche Bank Securities and Co-Head of 
Global Prime Finance, in New York; and Peter Brown, the Co-
Chief Executive Officer and Co-President of Renaissance 
Technologies in East Setauket, New York.
    We thank you for being with us today, and we also thank you 
and those with whom you work for, for your cooperation with 
this Subcommittee.
    Pursuant to Rule 6, all the witnesses who testify must be 
sworn before this Subcommittee, so please stand and raise your 
right hand. Do you swear that the testimony you are about to 
give will be the truth, the whole truth, and nothing but the 
truth, so help you, God?
    Mr. LaRocca. I do.
    Mr. Bausano. I do.
    Mr. Brown. I do.
    Senator Levin. Were you here before? Are you familiar with 
our timing system we have been using? Well, if not, let me 
repeat it. About a minute before a red light comes on, you are 
going to see the lights change from green to yellow. That gives 
you a chance to conclude your remarks. Your written testimony 
is going to be printed in the record in its entirety. Please 
try to limit your oral testimony to no more than 7 minutes.
    Mr. LaRocca, let me call on you first.

 TESTIMONY OF GERARD LaROCCA,\1\ CHIEF ADMINISTRATIVE OFFICER, 
 AMERICAS, BARCLAYS, CHIEF EXECUTIVE OFFICER, BARCLAYS CAPITAL 
                    INC., NEW YORK, NEW YORK

    Mr. LaRocca. Good afternoon, Senator.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. LaRocca appears in the Appendix 
on page 114.
---------------------------------------------------------------------------
    Senator Levin. Good afternoon.
    Mr. LaRocca. I am Gerard LaRocca, and I serve as the 
Americas Chief Administrative Officer of Barclays Bank. You 
have asked us to assist the Subcommittee in its review of 
certain issues related to the COLT transaction.
    As with other complex transactions, from the outset of 
COLT, the bank undertook a comprehensive review and approvals 
process to ensure that the transaction received proper 
scrutiny. This included review by the bank's tax, regulatory, 
risk, and legal departments, as well as a review by at least 
seven different law firms over the life of the transaction. 
Barclays disclosed its participation in the transaction to our 
auditors and regulators, here in the United States and the U.K. 
We did not take this matter lightly and were ultimately 
comfortable engaging in the transaction.
    The question raised by the Subcommittee seems to be: What 
is the proper tax rate to apply to profits earned by 
Renaissance through the exercise of its options?'' This is a 
matter to be handled between Renaissance, as a taxpayer, and 
the IRS. It is my understanding that the question has not been 
answered definitively.
    You have asked me to discuss the impact of the 2010 IRS 
advisory memorandum known as a GLAM, including the bank's 
decision last year to change the tenor of the options going 
forward. All of this did not occur in a vacuum. Like other 
financial institutions, Barclays has faced numerous challenges 
in recent years. Our bank has endeavored to meet these 
challenges head on, and at times resolving them has resulted in 
significant changes, both in process and in personnel at the 
bank. Today we have new leadership and feel strongly we are 
moving in the right direction, transforming the way we do 
business.
    In 2012, Barclays had launched Project Mango, an internal 
review of our investment banking operations, and also 
commissioned Sir Anthony Salz to conduct an independent review 
of Barclays. Finally, Barclays embarked on the TRANSFORM 
program, an internal review aimed at establishing the 
conditions necessary for the bank's long-term success, 
including the implementation of the 34-point road map for 
change detailed in the Salz Report.
    As part of TRANSFORM, the bank adopted five overarching tax 
principles that we now apply to all transactions. These are:
    Transactions must support genuine commercial activity;
    Two, they must comply with generally accepted custom and 
practice;
    Three, they must be of a type that taxing authorities would 
expect;
    Four, they must only involve financially sophisticated 
customers;
    And, five, transactions must be consistent with our purpose 
and values.
    It is against this backdrop that we considered what impact, 
if any, the GLAM should have on our participation in the COLT 
transaction.
    In December 2010, Renaissance made a routine request to 
enter into a new option. In light of the GLAM's recent 
publication and prior to moving forward, we consulted with 
Renaissance and again with our own legal advisors regarding the 
impact of the GLAM. After extensive internal consideration and 
consultation with external advisors, Barclays approved the 
issuance of a new option. We agreed to continue to monitor 
relevant IRS announcements going forward.
    In February 2013, the bank issued its new tax principles 
and undertook a review of all existing transactions, including 
COLT. As noted, one of the principles provides that Barclays 
will not structure transactions of a type different than tax 
authorities would expect. The end result of our review was a 
decision that, going forward, we would limit the tenor of any 
new COLT options to a period of 11 months. The IRS had not made 
a final determination as to the appropriate tax treatment. 
However, the bank made a proactive and voluntary choice to 
shorten these options to ensure we met the tax authorities' 
expectations. This was a decision that brought the transaction 
into conformity with our newly adopted tax principles. By doing 
this, the bank committed not only to following specifically 
applicable laws, but also to refrain from engaging in 
transactions that, while legal, might not meet the expectations 
of the relevant tax authorities.
    Therefore, any questions the Subcommittee may have about 
these transactions do not relate to the Barclays of today or 
the Barclays of the future. These are transactions from the 
past, about which we are awaiting a final determination as to 
the proper tax treatment.
    Thank you for the opportunity to provide this testimony. I 
look forward to answering the Subcommittee's questions.
    Senator Levin. Thank you very much.
    Mr. Bausano.

   TESTIMONY OF M. BARRY BAUSANO,\1\ PRESIDENT AND MANAGING 
  DIRECTOR, DEUTSCHE BANK SECURITIES INC., CO-HEAD OF GLOBAL 
               PRIME FINANCE, NEW YORK, NEW YORK

    Mr. Bausano. Good afternoon, Chairman Levin.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Bausano appears in the Appendix 
on page 118.
---------------------------------------------------------------------------
    Senator Levin. Good afternoon.
    Mr. Bausano. My name is Barry Bausano. I am currently 
President of Deutsche Bank Securities Inc. and Co-Head of 
Global Prime Finance Business. After growing up in a suburb of 
Detroit and coming east for college, I am now based in the New 
York office of Deutsche Bank and has worked there for 
approximately 12 years.
    My colleague Satish Ramakrishna has already discussed some 
of the specific features of our MAPS options. I want to provide 
you with an overview of the product and Deutsche Bank's 
involvement with it.
    I would note that Mr. Ramakrishna and I have submitted 
written testimony, which I would request be entered into the 
record, and you can find a more comprehensive discussion of 
these subjects in the written testimony.
    Senator Levin. It will be made part of the record.
    Mr. Bausano. Thank you.
    Derivative financial instruments are a critical component 
of global finance as they allow participants to alter risk and 
the distribution of returns relative to holding the underlying 
investments. Deutsche Bank strongly believes that it acted at 
all times responsibly, indeed proactively, in its ongoing 
consideration of MAPS in the light of evolving views regarding 
the regulatory landscape surrounding derivative products, and 
that its conduct demonstrates a strong commitment to be well 
within the bounds of the law.
    MAPS was not a tax-motivated product. It provided clients 
with significant non-tax advantages as compared with other 
products. Let me briefly discuss what I view as the three most 
significant of those advantages.
    First, Deutsche Bank was comfortable providing the option 
buyer with greater leverage at the fund level than it would 
have allowed in a traditional prime brokerage relationship.
    Second, the MAPS option limited the client's downside risk 
to the premium it paid to purchase the option.
    Third, the client could pursue its trading strategy 
anonymously because any market transactions associated with the 
trading strategy were made in Deutsche Bank's own name.
    On the bank side of the equation, MAPS provided the bank 
with greater visibility, risk controls, and operational 
protections relating to the underlying trading activity than 
existed for a prime brokerage account. The bank imposed 
significant constraints on the investment advisor strategy, 
required the advisor follow a defined and balanced investment 
strategy.
    The bank also had specific contractual rights to require 
the investment advisor to reduce its leverage and for DB to 
take over the management of the portfolio and to assume control 
and liquidate the positions being traded by the investment 
advisor if the value of the portfolio fell beneath certain 
benchmarks. The bank owned the securities in its own account 
and had complete visibility, ownership rights and controls over 
that account, and the bank earned a premium for selling the 
option.
    The MAPS product does involve symmetric and economic 
exchange of risks and benefit for both the bank and its client.
    I understand the IRS expressed concerns with a particular 
type of barrier option contract and the potential for 
associated long-term capital gain treatment as set forth in an 
IRS Generic Legal Advice Memorandum, or GLAM, issued November 
12, 2010. Importantly, in 2010, Deutsche Bank was not entering 
into any barrier option contracts as described in the GLAM. 
Indeed, the bank had ceased offering a product based on 
agreements similar to the ones described in 2008, when, in 
consultation with outside counsel, we independently 
restructured our MAPS product. Despite having no knowledge of 
any IRS intention to release the GLAM, Deutsche Bank 
proactively addressed virtually every factor considered in the 
GLAM approximately 2 years before its issuance. The 
restructured Deutsche Bank product is now referred to as ``New 
MAPS.''
    It is important to note the limited scope and use of New 
MAPS at Deutsche Bank. From 2008 through today, Deutsche Bank 
has entered into New MAPS options with only one client, Mosel 
LP, a RenTec affiliate. And even with that one client, Deutsche 
Bank entered into only one long-term option following the IRS' 
issuance of the GLAM. That option was negotiated prior to the 
GLAM and entered into on the business day following its 
issuance, and only after Deutsche Bank conferred with outside 
counsel to confirm that New MAPS was not the same structure as 
the product described. Indeed, and importantly, shortly after 
issuance of the GLAM, Deutsche Bank reassessed its 
participation in barrier option contracts. Despite its belief 
that New MAPS was in compliance with applicable laws and 
regulations, Deutsche Bank decided that it did not wish to risk 
being associated with any controversy over the tax treatment of 
MAPS. Therefore, it decided to cease entering into any New MAPS 
transactions with a duration of more than 1 year.
    Deutsche Bank has affirmatively and proactively undertaken 
steps to ensure compliance with applicable tax and securities 
laws and regulations. While the Subcommittee has raised 
important questions about tax policy in this area, we did our 
best at all times to ensure compliance with the laws and 
regulations as written and understood by the subject matter 
experts at the time. I do note that it is a widely accepted 
principle, one that the Subcommittee report acknowledges, that 
tax consequences differ among various financial instruments. 
New MAPS, which was an option, was treated by Deutsche Bank in 
accordance with the tax rules relating to financial derivatives 
at all times.
    In sum, with respect to MAPS, Deutsche Bank initiated steps 
to ensure that its conduct was well within the boundaries set 
by applicable legal requirements. As of today, neither the IRS 
nor any court or regulator has found that a New MAPS option or, 
indeed, any Deutsche Bank MAPS option, did not qualify as a 
derivative for tax, securities, or any other purpose. Deutsche 
Bank believes strongly that it acted appropriately in entering 
the New MAPS options when it did and that it acted 
conservatively and responsibly when it decided to stop entering 
them for business reasons after the issuance of the GLAM.
    Thank you for this opportunity to speak to you today, and I 
look forward to answering your questions.
    Senator Levin. Thank you very much.
    Mr. Brown.

TESTIMONY OF PETER F. BROWN,\1\ CO-CHIEF EXECUTIVE OFFICER, AND 
CO-PRESIDENT, RENAISSANCE TECHNOLOGIES LLC, EAST SETAUKET, NEW 
                              YORK

    Mr. Brown. Good afternoon, Chairman Levin.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Brown appears in the Appendix on 
page 129.
---------------------------------------------------------------------------
    Senator Levin. Good afternoon.
    Mr. Brown. My name is Peter Brown. I am the co-CEO of 
Renaissance Technologies, a company that manages investment 
portfolios with computer programs that are based on complex 
models of the financial markets.
    As my colleague Mark Silber discussed in his testimony, 
barrier options have been extremely important to Renaissance's 
business objectives by providing our fund with both leverage 
and loss protection. These go hand-in-hand, because when 
trading with leverage, a single mistake can be disastrous for 
our firm.
    On an unlevered basis, our models would produce modest 
returns with very low volatility. Therefore, we can responsibly 
increase our leverage to produce stronger returns. But in so 
doing, we must protect ourselves from the catastrophic losses 
that might occur should we encounter a Black Swan event outside 
of our previous experience. The world is littered with 
financial institutions that have failed after putting too much 
trust in their models--institutions that did not account for 
the unknown unknowns.
    We are determined that Renaissance not suffer such a 
demise. The barrier options we use provide precisely the 
protection we need.
    While we have been well aware of Black Swan risks since 
Long Term Capital Management collapsed in 1998, for me 
personally the wake-up call came on March 13, 2000. Up to that 
point, our models had been performing exceptionally well. Then 
the dot-com bubble burst, and in a very short period we took 
very large losses. We worked non-stop for days trying to 
understand where things had gone wrong.
    It turned out that we had positions in Nasdaq stocks which 
our models thought were hedged by positions in NYSE stocks. It 
just never occurred to us or to our models that these markets 
could diverge so rapidly. Not having slept for days and being 
incredibly distraught by the losses, I offered to resign, but 
my boss at the time rejected my offer, telling me, ``You are 
now far more valuable because you now know never to put your 
full faith in a model.''
    Six months later, we entered into our first barrier option. 
Not only do these options protect us from model failures, they 
also protect us from programming errors like the one that led 
to the demise of Knight Capital in 2012. If we did not have 
loss protection, then with over a million lines of code in our 
system, we too could face the risk of massive losses from a 
simple software bug.
    I have not yet had the opportunity to review your staff's 
report as closely as I would like. I appreciate the time it has 
taken to prepare and the policy issues it raises. But I will 
note that I was surprised to see the report characterize the 
risk from which these options protect us as ``small,'' 
apparently because of our historical track record.
    I have worked with extraordinary scientists my entire 
career, building large and complicated models that are embedded 
in large and complicated computer programs. If there is one 
lesson I have learned, it is that models and computer programs 
can go horribly wrong. Mortgage models at Fannie Mae and 
investment banks had spectacular 50-year track records until 
the 2008 subprime crisis. For 35 years, money market funds were 
considered risk-free, until the Reserve Primary Fund broke the 
buck. The list goes on and on.
    The single biggest mistake we can make is to be so 
confident in our models that we have no fear of the risks we 
did not see coming. That is why loss protection is so important 
to us.
    We understand there is an active debate on how best to 
reform the Tax Code and that proposals are being made to mark 
all derivatives to market and to tax all capital gains at the 
same rate. I will only point out that if there were no rate 
differential between long-term and short-term capital gains, 
the Tax Code would be far simpler, far more certain, and far 
more fair.
    I want to thank you for the opportunity to speak on behalf 
of Renaissance, and I am happy to answer any questions you may 
have.
    Senator Levin. Thank you very much, Mr. Brown.
    Mr. LaRocca, will you please take a look at Exhibit 53? \1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 53, which appears in the Appendix on page 654.
---------------------------------------------------------------------------
    Mr. LaRocca. I have it in front of me, Senator.
    Senator Levin. Thank you. This is the document we have been 
talking about this morning. It is the representation that 
Barclays made in 2009 to PricewaterhouseCoopers, PwC, its 
independent auditor. And the representation was here, if you 
look near the bottom of page 64--those are the last two letters 
in the Bates numbers--the conclusion is that, ``RenTec controls 
the major activities of Palomino and is exposed to 
substantially all significant risks and rewards . . .'' Was 
that statement true?
    Mr. LaRocca. I see the language, Senator. There is 
qualifying language in the PwC memo.
    Senator Levin. I mean, it does not change that conclusion. 
This is the conclusion. You have got all the qualifiers in 
advance, ahead of the conclusion, and then it says here, 
``RenTec controls the major activities of Palomino . . .'' 
Palomino is the entity that you guys created.
    Mr. LaRocca. It controls the trading activities, Senator.
    Senator Levin. It says it ``controls the major 
activities.''
    Mr. LaRocca. I know what it says, Senator, but it controls 
the trading activities. The securities lending is controlled by 
Barclays. The financing is controlled by Barclays. So they 
control----
    Senator Levin. But the major----
    Mr. LaRocca. They did control a major activity. That was 
their role, investment manager, Senator.
    Senator Levin. Right. So they controlled the major 
activities. This is what was represented to PwC. It is exposed 
to substantially all significant risks. Was that true?
    Mr. LaRocca. Up to the premium, Senator.
    Senator Levin. I am just saying it is exposed to 
substantially all significant risks. I know there was a risk 
after the premium was used. We know that. It never was reached, 
but we know what the risk was. Ten years it never was reached, 
but still, theoretically it could be reached, and you guys 
protected against even that possibility. That is OK. You have 
got a right to protect yourself. When you tell your auditor 
that--substantially all significant risks and rewards arising 
from the activities are RenTec's, my question is: Was that 
true? That is my question.
    Mr. LaRocca. Senator, it is true that RenTec controlled the 
trading activities and controlled the substantial risk. That is 
why we were able to deconsolidate Palomino, Senator.
    Senator Levin. It was not control the substantial risk. It 
was exposed to substantially all significant risks. That is 
what was written. Was that true?
    Mr. LaRocca. With the exception of gap risk, Senator, that 
is correct.
    Senator Levin. OK. So substantially all significant risks 
were taken by RenTec.
    Now, you then made a report--``you'' being Barclays--made a 
report annually to the SEC, and if you will take a look at 
Exhibit 68,\1\ you will see those reports. They are the past 5 
years. And in that report, you stated that Barclays does not 
control Palomino. Were you here this morning when we went 
through these?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 68, which appears in the Appendix on page 747.
---------------------------------------------------------------------------
    Mr. LaRocca. Senator, I heard the discussion this morning.
    Senator Levin. Take a look at Exhibit 68, if you would, 
then, starting with page 230. This was a note to the account 
file with SEC for the year ending December 31, 2009. And what 
you told the SEC, if you will look at the end of the first 
paragraph in Note 41, ``these entities''--you are referring to 
the Cayman Islands-incorporated Palomino, is one of the two 
entities you are referring to--``are not deemed to be 
controlled by Barclays.'' Was that true when you told that to 
the SEC?
    Mr. LaRocca. Yes, Senator, for accounting purposes that is 
100 percent true.
    Senator Levin. And did you tell the SEC that you really do 
not mean it for other purposes?
    Mr. LaRocca. Senator, I do not know what specifically was 
said to the SEC. It does not surprise me that these regulatory 
filings are consistent with the correspondence that we laid out 
in PwC. That should not surprise us, Senator.
    Senator Levin. It does not surprise me at all. What 
surprises me is that you are waffling on the question of 
whether or not Palomino was controlled by Barclays. You 
represented it was not.
    Mr. LaRocca. Senator, I am not waffling on the question, 
Senator----
    Senator Levin. Well, you are waffling because you are 
saying for some purposes it was controlled. For other purposes 
control means something totally different. If that is not a 
waffle, I do not know what is.
    Mr. LaRocca. Senator, we own the entity. We con--the 
results are reflected in our annual report in the footnotes. We 
comprise the board. We have risk. We shared in some revenues, 
Senator.
    Senator Levin. I am talking about what you represented to a 
regulator at the SEC.
    Mr. LaRocca. Senator, this representation to the SEC says 
that Barclays did not have control of the trading activities.
    Senator Levin. No, it does not. It says the entities---you 
are talking about Palomino, is managed by external 
counterparties and consequently are not controlled by you. You 
do not say for trading activities. You just say they are not 
controlled. You did not qualify it here.
    Mr. LaRocca. Senator, I will agree with you, Senator, that 
is what this says.
    Senator Levin. You will agree with me that I read it 
correctly.
    Mr. LaRocca. Correct, Senator.
    Senator Levin. And you will agree with me that it was not 
limiting what was meant by they are not controlled----
    Mr. LaRocca. I agree there is no qualifying in this report, 
Senator.
    Senator Levin. That is progress. That is year after year 
after year, right? I will not go through them all, but Exhibit 
68, the same words essentially for 2010, 2011, 2012, 2013. 
There is a slight modification in the words, but it is 
essentially the same.
    So now, in your statement, you indicate that the question 
of the proper tax rate to apply to the profits earned through 
Barclays' basket transaction is ``a matter to be handled 
between Renaissance, as a taxpayer, and the IRS.'' But now I 
would refer you to Exhibit 38.\1\ This is a Barclays document, 
2002, August 22. The third paragraph, it says, ``COLT''--that 
is what we are talking about here today--``is targeted at those 
funds with a high proportion of US individual investors, stable 
year-on-year returns and strategies involving short-term 
trading. This gives rise to significant short-term capital 
gains for the investors regardless of whether or not they are 
invested in the fund for the shorter or longer term.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 38, which appears in the Appendix on page 506.
---------------------------------------------------------------------------
    Then come the key words: ``COLT provides an after-tax 
benefit to these investors through the conversion of their 
return from the fund from short-term capital gains (taxed at 
39.6%) to long-term capital gains (taxed at 20%).''
    So this is what you are selling to Renaissance. This is 
what is in your project.
    Now, do you have any responsibility at all, to your clients 
in terms of representing that there are certain magic ways of 
converting short term into long term? Don't you think that you 
have a responsibility to determine whether or not you are 
aiding and abetting a fiction?
    Mr. LaRocca. Senator, I would not characterize this as 
``fiction.''
    Senator Levin. If it were a fiction, do you think that you 
should be responsible for avoiding it?
    Mr. LaRocca. Senator, I would not characterize this as a 
``fiction.'' We have a responsibility to our clients to assist 
them with transactions and ideally to do them in a tax-
efficient way.
    Senator Levin. ``Tax-efficient,'' what does that mean?
    Mr. LaRocca. Senator, we do not have clients who call up 
investment banks and tell us, ``We would like to do a 
transaction, and we would like to pay the maximum amount 
possible.''
    Senator Levin. Of course. I would hope not.
    Mr. LaRocca. The phone would never ring, Senator.
    Senator Levin. I agree. So now you are targeting funds, 
like RenTec--that is the target here--and you are saying that 
one of the major benefits is that you can convert, to use your 
words, short-term gains, which are taxed at 39 percent, to 
long-term gains, which are taxed at 20 percent. You are holding 
that out as an advantage. Is that correct?
    Mr. LaRocca. Senator, we did not target Renaissance. They 
approached us with this structure. This is an internal 
approvals process where we are being very transparent to all 
the decisionmakers about the tax elements of the transaction, 
Senator.
    Senator Levin. But in your own words here, you are saying 
that Renaissance--who I believe is the only user, the only 
basket option that this was aimed at. Is that correct? That 
Palomino was aimed at? That was aimed at Renaissance. Is that 
correct?
    Mr. LaRocca. Senator, this correspondence says we would 
target funds, but we only executed the transaction with 
Renaissance.
    Senator Levin. OK. And you say that it provides the benefit 
of converting something. And are you saying that that was never 
mentioned to Renaissance?
    Mr. LaRocca. Senator, I do not cover the account, Senator. 
I am not aware of the dialog. I would--I believe both parties 
understood the tax benefits associated with these barrier 
options.
    Senator Levin. But it was targeted at funds that were 
involved in short-term trading. Is that correct? By your own 
document, it was targeted at those funds that involve short-
term trading strategies.
    Mr. LaRocca. Senator, I would not know if----
    Senator Levin. That is your own words.
    Mr. LaRocca. Senator, this is an internal approvals 
correspondence.
    Senator Levin. Does that make it less or more accurate?
    Mr. LaRocca. It does not, Senator.
    Senator Levin. Is it accurate or not?
    Mr. LaRocca. Let me respond, Senator. You asked me if we, 
in fact, targeted funds, right?
    Senator Levin. Right.
    Mr. LaRocca. My response was I do not know. We only 
executed with Renaissance. This suggested that, if approved, we 
would target additional funds. Whether we, in fact, put this 
product in front of other clients, I do not know Senator. I am 
not a salesperson. I do not, in fact, know the answer to that 
question.
    Senator Levin. Was this targeted at funds such as 
Renaissance?
    Mr. LaRocca. The structure was brought to us by 
Renaissance, Senator.
    Senator Levin. Is COLT targeted at funds such as 
Renaissance?
    Mr. LaRocca. Not to my knowledge, Senator.
    Senator Levin. OK. Then I am reading from your document: 
``COLT is targeted at those funds with a high proportion of 
U.S. individual investors . . . and strategies involving short-
term trading.'' You are saying that was not targeted at RenTec?
    Mr. LaRocca. Senator, I have said that RenTec brought this 
structure----
    Senator Levin. I understand. RenTec brought it to your 
attention. But I am asking you, was the structure which 
resulted after they came to you asking you to design a 
structure, which you then offered to them, I am asking you, was 
that structure targeted at those funds--I am reading your 
Barclays document.
    Mr. LaRocca. Senator, it was targeted at RenTec.
    Senator Levin. That is what I am saying. And those funds 
involve short-term trading, have a strategy involving short-
term trading, and this provides an after-tax benefit to 
magically convert short-term to long-term gains. But the point 
is this structure that you created after RenTec asked you to 
offer them a structure, this was targeted at RenTec, and you 
were aware of the fact that it would provide an after-tax 
benefit like I described.
    Mr. LaRocca. Yes, Senator, that is----
    Senator Levin. All right.
    Mr. LaRocca [continuing]. Absolutely correct. I was 
confused and thought you were asking if we had targeted other 
funds other than RenTec.
    Senator Levin. All right.
    Mr. LaRocca. And I am not aware of that.
    Senator Levin. Now, in November 2010, the IRS issued a 
generic legal advice memorandum, a GLAM, advising that basket 
option transactions similar to what Barclays was using should 
not be treated as an option for tax purposes. That same day, an 
employee of Barclays sent an e-mail to his colleagues 
recognizing the GLAM was describing the Barclays basket 
transaction. That did not stop you, Barclays, from continuing 
with the transaction. Over the next 2 years, from late 2010 to 
late 2012, Barclays entered into another nine basket option 
transactions with Renaissance. Renaissance gained about $4 
billion from six of those transactions, and three are still 
ongoing.
    Now, in light of the GLAM, this seems to be a pretty 
aggressive position that Barclays took. Why is it that you 
dismissed the position that the IRS put out in the GLAM and 
continued to proceed with so many of those transactions?
    Mr. LaRocca. Senator, we took the GLAM very seriously. At 
the time of the receipt of the GLAM, we again consulted with 
our external advisors as well as our internal experts and felt 
that the GLAM was not the law; it was an IRS view and 
perspective. We consulted with our accountants. In fact, I 
would point out, in a paper we submitted to the Committee, 
there is a document from PwC which is skeptical of the IRS 
analysis and conclusion, Senator.
    We continued to monitor for IRS bulletins, but we made a 
decision at that time that the transaction was appropriate and 
that we would continue.
    Senator Levin. OK. Now, that IRS GLAM says the following 
about hedge fund basket option contracts: ``This memorandum 
addresses certain contracts styled as options in form but 
acting like direct ownership of the underlying property and 
substance. This memorandum should not be used or cited as 
precedent.'' And here is what it says, its conclusion--I assume 
you take IRS conclusions seriously. Do you?
    Mr. LaRocca. Absolutely, Senator.
    Senator Levin. Here is the conclusion: Let me read you what 
the issue is because it fits like a glove to what these banks, 
your two banks were doing. ``Where a taxpayer, a partnership, 
entered into a contract styled as an option to purchase a 
basket of securities that the taxpayer's general partner also 
actively managed and controlled while the contract remained 
open, and with respect to which the taxpayer had opportunity 
for full gain and income and substantially all risk of loss, 
one, whether the contract should be treated as an option for 
tax purposes; and, two, whether the taxpayer should be treated 
as the tax owner of the securities.''
    Now, that is about as accurate a description of what was 
going on here as I can read. We tried very often to describe 
this in our report and in my opening statement, and I cannot do 
much better. Here is the conclusion:
    ``One, the contract does not function like an option and 
should not be treated as such.''
    ``Two, a contract that provides a taxpayer with dominion 
and control over a basket of securities the opportunity for 
full gain and income and substantially all of the risk of loss 
provides to the taxpayer beneficial ownership of the securities 
for tax purposes.''
    Were you aware of this?
    Mr. LaRocca. Yes, Senator, I was.
    Senator Levin. All right. Now, I would hope that that would 
be taken seriously, but here is what happened: For 2 years, you 
continued to sell these basket options.
    And then in July 2012, following a number of investigations 
into Barclays' business practices and its participation in tax 
avoidance structures, Barclays undertook an independent review, 
known as the ``Salz review,'' and the objective was to review 
Barclays' business practices. The review was critical of the 
bank's culture, describing it as ``winning at all costs,'' and 
finding that it took a ``robust position with regulators and 
followed the letter rather than the spirit of the rules.''
    Were you in attendance at a meeting in October 2012, Mr. 
LaRocca, at which Barclays decided to approve another COLT 
transaction?
    Mr. LaRocca. Yes, I was, Senator.
    Senator Levin. If you take a look, please, at Exhibit 
61,\1\ this is the minutes of the Structured Capital Markets 
Approval Committee at Barclays, and the topic of the meeting 
was consideration of a new COLT transaction. Some of the key 
points that were made during the discussion that led to the 
approval of a new COLT option--this is now October 2012, after 
the Salz review was undertaken. This is what the key points of 
the discussion were, according to the notes:
---------------------------------------------------------------------------
    \1\ See Exhibit No. 61, which appears in the Appendix on page 732.
---------------------------------------------------------------------------
    The option was recommended for approval, again, the same 
basket option. Why? ``The tax risk is assumed by the client.'' 
Right off the bat, tax risk is assumed by the client.
    ``There is a reputation risk for Barclays, especially if 
the matter proceeds to court.''
    ``The New Option Transaction does not meaningfully increase 
Barclays' reputation risk in relation to the Option 
Transactions, because writing a new option (or exercising an 
existing one) should be viewed as the maintenance of a 
longstanding structure.''
    Now, you were the chairman of this meeting, Mr. LaRocca. 
You knew about the GLAM. You knew there was reputational risk. 
You knew that the Salz review had started and was reviewing the 
business practice because Barclays had been subject to tax 
investigations. But you still recommended that the transaction 
be approved.
    You were then and now are the most senior executive in the 
United States, Barclays. At a minimum, shouldn't you have been 
concerned about the reputational risk to the bank, approving 
the same option after the GLAM had been issued on this--the IRS 
could not be clearer in the GLAM. At any rate, you decided we 
are going to approve it anyway. Shouldn't you have been more 
concerned about the reputational risk to your bank at that 
time?
    Mr. LaRocca. Senator, I was very concerned about the 
reputational risk of the bank.
    Senator Levin. And should you have recommended continuing 
on that course?
    Mr. LaRocca. Senator, looking at the same document, you 
will see the actions I took as chairman. Again, we look for 
reaffirmation of our legal opinions and our external advisors. 
We spent a considerable amount of time. I escalated this issue 
to members of our Executive Committee, Senator. I also 
recommended that this transaction be reviewed by our 
Reputational Risk Committee. I was very much aware that the 
Salz review was underway, and we concluded, Senator, at this 
point in time that we should continue the options.
    Senator Levin. I know you concluded it, but basically the 
IRS had spoken, and Barclays said, ``So what?'' Now, that is an 
aggressive--that is what we call an ``aggressive tax 
position.'' And it was taken after all of these events which we 
have described had occurred. When the IRS in a GLAM just 
describes it, it is precisely what you guys were doing, and 
says, as it did, that this is not an option and this is not 
going to be recognized as long-term capital gains for tax 
purposes, your committee--you are the chairman--still 
recommended that you go ahead with another one. Why? Because 
you are already at risk, what is a little more risk? I mean, 
just the fact that somebody has been used repeatedly and then 
challenging by the IRS, what kind of argument is it that, well, 
we have done it before, we will continue doing it? That is not 
a good argument in terms of reducing reputational risk. Quite 
the opposite, it seems to me.
    Mr. LaRocca. Senator, the IRS has not yet made a decision 
on what the appropriate tax treatment is. When we have 
consulted with our external experts--legal, tax accounting--
they raised serious questions regarding the analysis that 
underpins the GLAM.
    Senator Levin. The IRS describes GLAMs as ``providing 
authoritative legal opinions on certain matters such as 
industry-wide issues.''
    Mr. LaRocca. Senator, I hope the GLAM----
    Senator Levin. I do not think you take it very seriously. I 
got to tell you, if you are really worried about reputation, 
given all the problems that Barclays has, and given the fact 
you got a GLAM from the IRS and it is right on point describing 
exactly what you are doing and it says this is not an option--
--
    Mr. LaRocca. Senator----
    Senator Levin [continuing]. It would seem to me a caution, 
if you are worried about your reputation, you would say, 
``Whoa, let us hold off on this thing, folks.'' That is what 
caution does. That is what concern about reputation does. It is 
not--we have been doing this for years. So what? We will 
continue to do it in the face of a GLAM. I do not consider that 
to be concern about a bank's reputation.
    Barclays then in 2013 initiated a bank-wide effort called 
``Project Transform'' to ensure that the bank no longer offered 
or participated in abusive tax shelter products. Barclays' 
counsel informed the Subcommittee that as a result of Project 
Transform, Barclays developed a number of principles, including 
in the tax area. One of these principles is that Barclays will 
not engage in transactions that will not meet expectations of 
the relevant tax authority. At that point, you revised the 
COLT, this option, to make sure it could not be used to argue 
that the gains are long-term capital gains. You changed that in 
2013 after another project of yours adopted a principle saying 
do not engage in transactions that would not meet expectations 
of the relevant tax authority. If you had adopted that earlier, 
you would not have issued those later options. Is that correct?
    Mr. LaRocca. That is correct, Senator.
    Senator Levin. OK. Now, you have got some existing basket 
transactions, do you not?
    Mr. LaRocca. Yes, we do, Senator.
    Senator Levin. There are three of them, I believe, and they 
do not conform with the new policy, and the contract with 
Renaissance allows for the unwinding of those contracts. Why 
not unwind them? Under the policy you have adopted--as a result 
of Project Transform--new principles, we are not going to 
engage in transactions that will not meet the expectations of 
the relevant tax authority. But apparently you are going to 
continue to participate in transactions that do not meet that 
expectation because you have not unwound those three existing 
basket options. Why not unwind them?
    Mr. LaRocca. Senator, we have made the decision to not 
enter into any new transactions, Senator.
    Senator Levin. I understand. But why not unwind existing 
transactions because they do not meet the expectations of the 
relevant tax authority? Why not unwind them? You are allowed to 
under the contract.
    Mr. LaRocca. Senator, we are allowed to unwind them, and we 
have not looked at the historical transactions that we approved 
prior. So the decision----
    Senator Levin. Maybe you ought to. What do you think?
    Mr. LaRocca. We will take it under advisement, Senator.
    Senator Levin. Thank you.
    Let us see. Mr. Bausano, you have testified that Deutsche 
Bank engaged in a major restructuring of its MAPS product--that 
is this basket option transaction--and you engaged in a major 
restructuring in 2008. This ties in with what we had heard, our 
staff had heard from Mr. Haas, who was the global head of 
Deutsche Bank's Prime Brokerage Division, and from your counsel 
who represented to staff that Deutsche Bank had concerns 
whether the old structure would be respected as an option for 
tax purposes. So in 2008, Deutsche Bank undertook an effort to 
make MAPS look more option-like. I believe your Global Prime 
Finance Division described the MAPS restructuring project as an 
effort to ``provide a new multiple MAPS structure that will 
more closely resemble a traditional options structure.''
    Now, I want to just explore one example of that concern 
that you had that caused you to engage in that restructuring.
    Before the restructuring, Deutsche Bank paid Renaissance a 
flat advisory fee which was well below industry standard fees 
for an investment advisor. So did you make the change in the 
fee structure to make this transaction look more option-like?
    Mr. Bausano. We restructured the option on the basis of two 
parallel tracks:
    The first, as was described by Mr. Ramakrishna, was a 
concern about the risk profile and the higher risk associated 
with gaps in the cluster of statistical arbitrage strategies as 
evidenced in the summer of 2007, August 2007.
    The second parallel push was a combination of concerns in 
the evolving regulatory landscape as communicated to me through 
my internal control functions--legal, tax, compliance, et 
cetera. You know, our view is that this has a significant 
number of option features and it is clearly an option. The idea 
that you have an asymmetric payout where your risk is limited 
to the premium you have paid, you have an upside convexity to 
leverage and performance if you succeed is to me the key 
hallmarks--it is a contract with a duration and an expiry, are 
all things that are hallmarks of an option.
    Senator Levin. Did you offer the increase to Renaissance 
without being prompted by them?
    Mr. Bausano. I was not part of those negotiations.
    Senator Levin. Do you know whether or not Deutsche Bank----
    Mr. Bausano. I do not know which side proposed that.
    Senator Levin. Well, then, let me ask you the question 
again. Was the shift, change in the fee done in part in order 
to make the transaction look more option-like?
    Mr. Bausano. I do not know what the negotiation went on. I 
was not part of it.
    Senator Levin. I am not asking you about what the 
negotiation. I am asking you whether the change in the fee from 
a flat fee was done in part to make the transaction look more 
option-like. That is what I am asking you.
    Mr. Bausano. I really do not think so. I think it reflected 
what the standard investment advisor agreement to a fund would 
have been.
    Senator Levin. OK. Prior to the 2008 restructuring, did 
Deutsche Bank have any indications that the old MAPS structure 
would not be respected as an option? Do you want me to repeat 
the question?
    Mr. Bausano. No. Before 2008.
    Senator Levin. Before the restructuring.
    Mr. Bausano. Before the restructuring. Not to my knowledge.
    Senator Levin. You had no indications that the old MAPS 
structure would not be respected as an option?
    Mr. Bausano. No. As a matter of fact, to this date no court 
or regulator or statute has disqualified it as an option, 
either old or new.
    Senator Levin. That is not what I am asking, whether a 
court or regulator has--I am asking you, was there an 
indication from any source that the old MAPS structure would 
not be respected. You answered it, we did not hear from a 
regulator or court. That is not my question.
    Mr. Bausano. To my knowledge, no. However, I am aware that 
my control functions were in regular conversations with all of 
the external regulatory constituencies on an ongoing basis.
    Senator Levin. How about internally?
    Mr. Bausano. Internally we discussed----
    Senator Levin. Was there any evidence internally, attorney 
discussion internally to that effect?
    Mr. Bausano. That it would not be respected? Not to my 
knowledge.
    Senator Levin. Was that question ever referred by you to a 
law firm for an opinion on it?
    Mr. Bausano. I am sorry. Repeat again?
    Senator Levin. Was that issue ever referred to a law firm 
to give you an opinion on that question?
    Mr. Bausano. I am aware we had a ``should level'' opinion 
on that.
    Senator Levin. Was that before or after the restructuring?
    Mr. Bausano. I do not have the specific date, but I know it 
was early in the life cycle of the trade.
    Senator Levin. Do you know whether it was before or after 
the----
    Mr. Bausano. I do not know.
    Senator Levin. Deutsche Bank entered into a non-prosecution 
agreement with the Department of Justice stemming from its 
involvement with abusive tax structures, and under the non-
prosecution agreement Deutsche Bank promised to stop 
participating in and implementing fraudulent tax shelters and 
agreed to bring to the attention of the Department of Justice 
``products or transactions that may run afoul of U.S. Federal 
income tax laws, rules, and regulations.''
    Now, Mr. Bausano, in your written testimony, you said that, 
``It bears noting that the bank discussed the MAPS product with 
the Department of Justice, the IRS, the SEC, and the 
independent expert Deutsche Bank retained as part of the NPA. 
All of the discussions took place well before this Committee 
began its investigation. Indeed, the bank communicated with the 
independent expert about MAPS at a meeting on February 3, 2011, 
and discussed the MAPS product with the Department of Justice 
and the IRS at several meetings in 2012 and 2013.''
    You stated in your testimony that Deutsche Bank discussed 
this matter with the SEC. My question to you is: Weren't those 
discussions initiated by the SEC as part of an SEC examination 
of MAPS?
    Mr. Bausano. You know, I was not part of that conversation. 
My secondhand knowledge is it was part of an examination, but 
that is arm's length.
    Senator Levin. Arm's length or secondhand?
    Mr. Bausano. Secondhand.
    Senator Levin. So secondhand you say you heard that this 
discussion with the SEC came as part of an SEC examination. Is 
that correct? That is what you heard secondhand?
    Mr. Bausano. As part of my preparation for this 
conversation, I was made aware of that.
    Senator Levin. OK. Are you aware of the fact that the SEC 
referred Deutsche Bank's activities to the IRS because the 
basket option strategy was being used to turn short-term 
capital gains in the portfolio into long-term capital gains and 
the options were being exercised after 1 year, thus subjecting 
the returns to long-term capital gains tax? Were you aware of 
the fact that because of that claim that there was a long-term 
capital gain that the SEC referred this activity to the IRS? 
Were you aware of that?
    Mr. Bausano. I was made aware of it as part of my 
preparation.
    Senator Levin. The first time that Deutsche Bank 
communicated the MAPS program to the Department of Justice was 
in 2012. Deutsche Bank did not disclose its MAPS program to the 
Department of Justice when it was negotiating the non-
prosecution agreement in 2010. Is that correct?
    Mr. Bausano. I was not part of that negotiation. I learned 
about the NPA upon its settlement.
    Senator Levin. OK. Were you aware of the fact, however, 
that Deutsche Bank did not disclose this MAPS program to the 
Department of Justice when it was negotiated the non-
prosecution agreement in 2010? Even though you were not part of 
it, were you aware of that?
    Mr. Bausano. As part of my preparation, I have heard that. 
I have no knowledge.
    Senator Levin. No personal knowledge, but you were informed 
of that? As part of your preparation, that is what you were 
informed?
    Mr. Bausano. That prior to the-could you repeat what I----
    Senator Levin. I will. Were you informed that the first 
time Deutsche Bank communicated the MAPS program to the 
Department of Justice was in 2012 and that it did not disclose 
the MAPS program to the Department of Justice when Deutsche 
Bank was negotiating the non-prosecution agreement with the 
Department of Justice in 2010?
    Mr. Bausano. I am not specific on the date of the 
conversation with the DOJ. I am aware that the judgment of the 
negotiators in the NPA was that it was not shared at that time.
    Senator Levin. OK. Are you aware that Deutsche Bank went to 
the Department of Justice with the MAPS matter, disclosed it to 
the Department of Justice, only after the Federal Reserve Bank 
of New York, which had been examining MAPS, expressed concerns 
and instructed the bank to go to the Department of Justice?
    Mr. Bausano. My understanding is that the independent 
expert that was in Deutsche Bank at the behest of the DOJ was 
informed of MAPS, and it was our presupposition that, as the 
direct conduit to the DOJ, that would have been passed through. 
When we learned that was not the case, we informed them 
directly.
    Senator Levin. And then when you informed them directly, 
was that after the Federal Reserve Bank, which had been 
examining MAPS, expressed concerns and instructed the bank to 
go to the Department of Justice?
    Mr. Bausano. I am not aware of the specifics of that.
    Senator Levin. OK. Was there any concern within Deutsche 
Bank that to continue with the New MAPS after signing the non-
prosecution agreement might put the bank in violation if it 
continued with that transaction?
    Mr. Bausano. With the New MAPS?
    Senator Levin. Yes. Was there any concern within Deutsche 
Bank that to continue with the New MAPS after signing the NPA 
would be a violation--or could be a violation?
    Mr. Bausano. Well, we had moved to a less than 1-year only 
posture by that point, I believe.
    Senator Levin. OK. Now, when Deutsche Bank put a temporary 
halt to MAPS transactions in late 2010, it still had three 
basket transactions outstanding in 2011. They all lasted a year 
or more after the GLAM. Why didn't Deutsche Bank cancel those, 
unwind those? As I just asked Mr. LaRocca, you had the right to 
do so under the basket contracts. Why not do it?
    Mr. Bausano. We felt that in an abundance of caution to 
cease the product was appropriate and it was what we did. The 
ones that were extending we felt that they were at that point 
and continued to be legal and legitimate transactions and 
elected to honor the terms of those transactions to their 
conclusion while not pursuing any further.
    Senator Levin. I understand that, but you decided not to 
continue to issue these contracts because of various concerns 
which you had. Why not unwind the contracts which you had since 
you were allowed to do that? Under the contract you could have 
unwound these. These were obviously finally of concern to you. 
It took a whole lot of years to get there, but nonetheless, you 
finally reached that point. So why not do what you were allowed 
to do under the contract, and that is to unwind contracts which 
are problematic? And your answer is that you did not. But why 
didn't you? Did you think about it? Did you consider it?
    Mr. Bausano. It was the business judgment that we were 
being sufficiently aware of and respectful of the guidance we 
had gotten both from the legal, regulatory, and guidance 
perspective by ceasing to go on, and that the balance of risks 
was we would be better served to keep the contract as we had 
originally negotiated it with the existing clients. So we were 
aware of it, and we thought we were being especially and 
deliberately respectful of the changing regulatory landscape 
already.
    Senator Levin. I think you may have been wrong in terms of 
the New MAPS as it related chronologically to the NPA.
    Mr. Bausano. OK.
    Senator Levin. The NPA was 2010, and I think you said that 
you had no concern there about whether the New MAPS would be 
compliant with the NPA. But wasn't the NPA in existence before 
the New MAPS was put in existence?
    Mr. Bausano. I do not believe that is correct. I have a 
chronology that has been submitted to you----
    Senator Levin. OK. Let me rephrase it because I was 
inaccurate, my phrasing. You moved to an 11-month term in 2012, 
I believe, to make sure that the option when exercised could 
not be claimed to be a long-term capital gain. Is that correct? 
That was 2012, I believe.
    Mr. Bausano. I have April 2012 as the first New MAPS 
shorter dated.
    Senator Levin. But the NPA was in existence in 2010.
    Mr. Bausano. Right. New MAPs was struck in 2008.
    Senator Levin. In 2008. But your short options--your 11-
month option was not put in place until 2012, and so the 
question is: Were you concerned after the NPA about that issue? 
And if so, why didn't you change to the short option, the 11-
month option, before 2012?
    Why did it take you so long?
    Mr. Bausano. The New MAPS structure was fully--ready?
    Senator Levin. I am ready.
    Mr. Bausano. We were fully advised internally by our 
control functions--legal, credit, tax, compliance, and external 
advisors--at the time that it was compliant and well within the 
boundaries and well within the area of ambiguity and, 
therefore, thought it was safe to proceed.
    Senator Levin. All right. So, in other words, Mr. Brown, in 
your statement, you say that the reference portfolio for each 
option was generated by Renaissance's trading algorithm, and 
you make it sound like the selections were made by a machine 
with no human intervention. Now, your scientists and your 
experts are continually looking for inefficiencies in the 
market, and when they find something new, as I understand you 
in your testimony, they try to adjust the computer model and 
incorporate that into the algorithm, and that will affect the 
decisions that are generated. It could also have an impact on 
what positions are bought and sold. So there is a lot of 
ongoing human involvement in this process. Is that correct?
    Mr. Brown. That is correct.
    Senator Levin. And how many employees are there at RenTec?
    Mr. Brown. I think roughly 300.
    Senator Levin. And of these employees, how many work part-
time or full-time on the algorithm strategy that supports or 
supported RenTec's basket option transaction?
    Mr. Brown. Well, on the strategy, 50 or so.
    Senator Levin. OK. And these would be employees with 
backgrounds in mathematics, physics, and computer science?
    Mr. Brown. That is correct.
    Senator Levin. The employees that worked on the overall 
strategy to identify market inefficiencies in order to take 
advantage of them I assume did this on an ongoing basis. is 
that correct?
    Mr. Brown. Yes.
    Senator Levin. And how frequently were they identifying 
these inefficiencies and modifying the inputs that go into the 
overall strategy? Was that a frequent occasion?
    Mr. Brown. Well, most of the modifications involved 
maintenance, changes to--the system has a million lines of 
computer code, and when you have a million lines of computer 
code, it has to be maintained. Interfaces change. I do not know 
if you are counting those kinds of changes.
    Senator Levin. No. Just when they tweak the algorithm.
    Mr. Brown. I'm sorry. What was the question? How many 
people work on----
    Senator Levin. No. How frequently were you doing that? Was 
that a daily change?
    Mr. Brown. No.
    Senator Levin. Weekly? Monthly?
    Mr. Brown. No, more like weekly.
    Senator Levin. OK. So every week there would be roughly?
    Mr. Brown. One or two changes, roughly, on average.
    Senator Levin. In the algorithm?
    Mr. Brown. Yes. The algorithm has been developed over 25 
years. It probably has a thousand man-years of work into it. It 
is very mature at this point. It is very hard to make 
significant improvements. So these are minor changes typically.
    Senator Levin. But you have 50 people working on this. 
There is a lot of human involvement in RenTec in this----
    Mr. Brown. Oh, that is not all they do. We trade 
commodities, futures----
    Senator Levin. I know that, but I specifically asked you 
the question for this particular process, this basket option 
process, how many were working full-time or part-time on the 
strategy that supported RenTec's basket option transactions?
    Mr. Brown. I think my answer is accurate.
    Senator Levin. OK. So we will stick with 50. That is fine.
    Mr. Brown. I mean, roughly. I do not know----
    Senator Levin. That is fine, about 50. That is a lot of 
people, a lot of human intervention. Wouldn't you agree? Fifty 
people working on these basket options? OK. I will let it speak 
for itself. You do not have to agree with it.
    Mr. Brown. OK.
    Senator Levin. That is a lot of expertise.
    Now, did RenTec personnel intervene in the strategic to 
respond to market events?
    Mr. Brown. Well----
    Senator Levin. You know, like during the Greek crisis.
    Mr. Brown. Oh, sure.
    Senator Levin. RenTec----
    Mr. Brown. We made a strategy--what happened--about the 
Greek crisis, for example, if you like, what happened there is 
that we were concerned at that time that Barclays had a lot of 
exposure to Greece.
    Senator Levin. And so you could shift billions of dollars 
of its portfolio, for instance----
    Mr. Brown. No. That is not what happened.
    Senator Levin. Well, could you?
    Mr. Brown. Could we have?
    Senator Levin. Did you shift any money from Barclays to 
Deutsche Bank?
    Mr. Brown. Shift money? No.
    Senator Levin. OK. Did you direct more of the sales orders 
to one bank and more of the purchase orders to another--to the 
other bank?
    Mr. Brown. Yes, we made a change to the process that 
distributes portfolio among the options, so the algorithm 
produces a bunch of trades and produces a portfolio, and more 
or less of it can go to different options. So prospectively 
going forward, we made a change so that we would tend to put 
more portfolio with Deutsche Bank and less with Barclays.
    Senator Levin. And that was some of the type of work that 
your 50----
    Mr. Brown. That is correct.
    Senator Levin [continuing]. Experts would do? And so with 
the human intervention in this process, this affects what 
positions are bought, sold, and how long they are held. Is that 
correct?
    Mr. Brown. Yes. As I said, the changes are modest, but yes.
    Senator Levin. Who changes the models? Human beings? What 
did you just say?
    Mr. Brown. Changes are modest.
    Senator Levin. Changes their Models?
    Mr. Brown. Small.
    Senator Levin. You make changes in the models?
    Mr. Brown. There are modest changes in the models.
    Senator Levin. Modest changes in the models by these human 
beings.
    Mr. Brown. That is correct.
    Senator Levin. This algorithm was not just making changes 
by itself. It took human beings to make changes.
    Mr. Brown. Sure. The human beings wrote the code.
    Senator Levin. Good. And changed the code?
    Mr. Brown. That is correct.
    Senator Levin. Tweaked the code and once or twice every 
week changed----
    Mr. Brown. On average.
    Senator Levin. On average, OK. When you made these changes 
in the algorithm, did you consult with the banks?
    Mr. Brown. No.
    Senator Levin. Is the algorithm RenTec's proprietary 
strategy?
    Mr. Brown. It is.
    Senator Levin. Do the banks ever change the algorithm?
    Mr. Brown. No.
    Senator Levin. Now, you have about 300,000 transactions 
executed in the banks per day for RenTec's basket contracts. 
Were these submitted in the form of recommendations or 
suggestions to the banks?
    Assuming they met the guidelines, of course, which you had 
already agreed upon. But were these submitted, 300,000, 
approximately, transactions in the banks each day for the 
basket of contracts, were they submitted in the form of 
recommendations or suggestions, but were they automatically 
sent to the market providing they met the guidelines which you 
had agreed to?
    Mr. Brown. So they were most commonly sent to the banks' 
trading systems.
    Senator Levin. All right.
    Mr. Brown. And if they--sometimes they were rejected. Not 
very often. And, otherwise, they went to the market. That is 
correct.
    Senator Levin. And not very often would mean if they did 
not meet the guideline?
    Mr. Brown. I think that is the only--the only ones I know 
of where, you know, the restricted list had been changed and we 
were not aware of it, that kind of thing. Those are the ones I 
know of.
    Senator Levin. All right. So there was an agreement, there 
were guidelines, a restricted list, whatever you want to call 
it. If it did not meet that, then it would not go to market.
    Mr. Brown. That is my understanding, yes.
    Senator Levin. And that did not happen very often.
    Mr. Brown. No, it did not.
    Senator Levin. How many times?
    Mr. Brown. I do not know how many times----
    Senator Levin. How many times in a year?
    Mr. Brown. A few.
    Senator Levin. A few in a year.
    Mr. Brown. I would guess. You know, I am not----
    Senator Levin. I know.
    Mr. Brown. I am guessing there.
    Senator Levin. To the best of your ability, you are 
guessing a few times a year?
    Mr. Brown. Yes. I mean, you know, if it is 20, it would not 
surprise me. If it is three, it would not surprise me. In that 
range.
    Senator Levin. All right. That is out of 30 million a year.
    Mr. Brown. I have not done the multiplication, but that is 
probably correct.
    Senator Levin. That is not multiplication. That is a 
question of fact.
    Mr. Brown. Well, I do not know if it is 30 million or 35 
million or 40 million. It is millions, many millions.
    Senator Levin. Tens of millions.
    Mr. Brown. Yes.
    Senator Levin. It could have been three or five or ten 
times it did not meet the guidelines.
    Mr. Brown. That is correct.
    Senator Levin. I am going to conclude. We have a vote on 
here now, so let me just end with a few remarks here.
    The situation that we have looked at here over a year or 
more is where an armada of law firms and hedge funds and 
financial institutions have devised financial structures that 
in substance are far from what they pretend to be. A series of 
fictions is created to create one big fiction, and that is to 
gain advantages which otherwise could not be obtained.
    Now, the structure the Subcommittee has explored today is 
an example of what we have been doing for many, many years 
looking at these structured transactions just to see how tax 
avoidance works in this country. The companies that engaged in 
the basket options and the law firms that support them ignore 
the realities of the transactions that they are engaged in by 
employing a structure that seeks to portray the activities as 
something from what they really are, and they hope that those 
that are reviewing the transactions will not catch it.
    Now, those who complain about the complexity of the Tax 
Code should look at these examples of tax avoidance and tax 
abuse and realize that it is this kind of gamesmanship that 
drives the complexity in the Tax Code, because the IRS is 
always trying to catch up and clarify that the fictions that 
are concocted are not in compliance with the law. If the 
parties that use these fictions and these structures want the 
tax system to be more straightforward and clear, they should 
end the gamesmanship. That is the issue that underlies what the 
Subcommittee has been addressing. I hope the regulators and 
Federal agencies will take note and try to address the larger 
issue that has been posed here. I hope members of the financial 
and legal communities will do that as well.
    The structures that we have examined today have real 
consequences because they offload billions of dollars in taxes 
that are shrugged off by hedge funds onto the backs of ordinary 
American taxpayers. They add billions of dollars in leverage to 
the U.S. financial system, and it does not have to be this way. 
The IRS can audit hedge funds and collect taxes that were not 
paid. The SEC can stop basket options from being used to 
circumvent leverage limits. The Financial Stability Oversight 
board, working with other agencies, can impose new reporting 
obligations to detect and stop hidden leverage through 
derivatives. Congress can amend TEFRA to remove obstacles to 
IRS audits of large partnerships like hedge funds.
    Congress could go further and adopt the proposal of my 
colleague from Michigan, Congressman Camp, and tax all 
derivatives at the end of the year on their market value. That 
would short-circuit a lot of the games.
    Option baskets are being misused and abused to dodge taxes 
and to circumvent leverage limits, and we are going to continue 
as long as I am here to do everything I can to stop these 
abuses.
    We end the hearing with thanks to our witnesses for their 
cooperation with our Subcommittee, and we stand adjourned.

    [Whereupon, at 2:55 p.m., the Subcommittee was adjourned.]

                            A P P E N D I X

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