[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
Printed for the use of the
Committee on Homeland Security and Governmental Affairs
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89-882 WASHINGTON : 2014
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20402-0001
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.
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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.
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\1\ The prepared statement of Mr. Malloy appears in the Appendix on
page 111.
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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.
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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.
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\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.
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\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.
---------------------------------------------------------------------------
\1\ See Exhibit No. 7, which appears in the Appendix on page 129.
---------------------------------------------------------------------------
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.''
---------------------------------------------------------------------------
\1\ See Exhibit No. 7, page 11, which appears in the Appendix on
page 279.
---------------------------------------------------------------------------
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.
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\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.
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\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.
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\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.
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\1\ The prepared statement of Mr. LaRocca appears in the Appendix
on page 114.
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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.
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\1\ The prepared statement of Mr. Bausano appears in the Appendix
on page 118.
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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.
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\1\ The prepared statement of Mr. Brown appears in the Appendix on
page 129.
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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\
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\1\ See Exhibit No. 53, which appears in the Appendix on page 654.
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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?
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\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.''
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\1\ See Exhibit No. 38, which appears in the Appendix on page 506.
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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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