ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

37
Barclays COLT Options. In 2002, RenTec introduced the basket option concept to
Barclays. 211 According to RenTec, Barclays initially approached them to expand Barclays’ U.S
based business. RenTec told the Subcommittee that, because RenTec wanted to spread its
counterparty credit risk with multiple banks, 212 it agreed to do business with Barclays, but only
if the bank could develop a basket options type structure. 213 Contemporaneous internal Barclays
communications indicate that RenTec pushed Barclays to create its own basket options structure,
informing the bank that it would move its accounts elsewhere if Barclays did not provide it with
a basket options structure. 214 To accommodate RenTec, Barclays created the COLT structure,
which used a separate Barclays entity, Palomino Ltd., and a two-tiered options structure to
execute trades for RenTec. 215 Since 2002, RenTec has purchased from Barclays a total of 31
basket options with terms exceeding one year, involving trading assets with a total initial
notional value of about $62 billion and profits totaling about $18.3 billion. 216
Options After 2010 GLAM. In late 2010, the IRS issued its Generic Legal Advice
Memorandum (GLAM) advising that basket options were not true options and could not be used
to treat short-term trading profits as long-term capital gains. 217 In response, Deutsche Bank
placed a moratorium on issuing new basket options, but continued to administer multiple existing
option accounts. In 2012, Deutsche Bank resumed offering basket options, but used a revised
version whose term lasted less than one year and whose contract required the option holder to
report any gains as short-term capital gains. 218 In contrast, even after the 2010 GLAM, Barclays
continued to offer basket options to RenTec until 2013, when it also revised its basket options
contract to offer only short-dated options with term lasting less than a year. 219
According to information supplied by RenTec to the Subcommittee, in 2012, the IRS sent
what are commonly known as “60-Day Letters” to RenTec, notifying the hedge fund that the IRS
intended to disallow long-term capital gains treatment of basket option profits from option trades
lasting less than 12 months and proposing an assessment of additional taxes for certain tax years.
RenTec responded with what is known as a “Protest of the 60-Day Letters,” indicating that it
211 7/31/2002 “Confidential: Project COLT,” new product proposal, product sponsors Jonathan Zenios, Jerry Smith,
Martin Malloy, and Mark D’Andrea, BARCLAYS-PSI-212559-566.
212 The counterparty credit risk in this circumstance was the risk that the bank would be unable to pay its obligation
to the hedge fund.
213 Subcommittee interview of Mark Silber, RenTec (6/10/2014).
214 See, e.g., 7/31/2002 “Confidential: Project COLT,” prepared by Barclays product sponsors Jonathan Zenios,
Jerry Smith, Martin Malloy, and Mark D’Andrea, BARCLAYS-PSI-212559-566, at 561.
215 As detailed below, the options involved three Barclays entities, Palomino, BBPLC, and the New York branch of
Barclays PLC, as well as a RenTec subsidiary, Bass Equities Ltd. Later, Bass was replaced with another RenTec
entity called Badger Holding LP. Subcommittee interview of Martin Malloy, Barclays (5/1/2014).
216 See undated chart, “History of COLT Options,” prepared by Barclays, BARCLAYS-PSI-748604. These figures
do not include eight options that were exercised within a year or four options that have not been exercised to date.
Notional value for the Barclays accounts was derived by multiplying the premiums by 10 as the premiums
represented 10% of the notional value based on Barclays Investment Management Account.
217 10/15/2010 memo, “Hedge Fund Basket Option Contracts,” Internal Revenue Service, BARCLAYS-PSI-
748148-58.
218 6/30/2014 briefing by Deutsche Bank attorneys to the Subcommittee.
219 12/2013 “Barclays Powerpoint,” prepared by Barclays, Barclays-PSI-748589.