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

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50 Just as RenTec treated the management of the MAPS and COLT option accounts as components of a larger investment strategy, so too did the banks view and treat the individual option accounts as if they were part of a single large investment pool at each bank rather than trading specific securities within each option contract. For years, neither RenTec nor the banks tracked the basket option trading activity on an option-by-option basis, instead pooling the assets and profits. It was not until 2008, that Deutsche Bank began tracking asset performance on a per option basis, while Barclays has never tracked performance on a per option basis. In late 2008, when Deutsche Bank revised the MAPS structure and limited the transactions to European style options that could be executed only on a fixed date, RenTec made clear its intention to use the MAPS accounts to maintain its access to cash on a short-term basis. RenTec did so by scheduling the options it purchased to produce exercise dates periodically throughout the year. RenTec then exercised those options on the pre-determined dates to obtain cash payments at regular intervals, and used the cash to support its business operations. This activity offers further evidence of the extent of the hedge fund’s control over the option trading activities and profits to meet its financial needs, in contrast to a passive option holder waiting to see how a capital investment might pan out. Each of these factors, RenTec’s control over the trading strategy and related activities, high-volume trading and account turnover, integration of the accounts into a larger investment strategy, and use of the accounts to produce regular cash payments supporting its business operations, contradict a depiction of RenTec as a passive option holder awaiting derivative gains. The option structure functioned instead as a vehicle for RenTec to conduct direct trades with leverage at much higher levels than available in normal margin accounts, to aggregate and defer its gains, and to avoid billions of dollars in short-term capital gains taxes. The structure functioned the same way for George Weiss Associates. (1) RenTec Utilization of the Basket Option Structure Because RenTec was the longest and largest user of basket options studied by the Subcommittee, and entered into options with both Deutsche Bank and Barclays, its use of the basket option structures will be analyzed first. (a) Disguising Trading Activity As An Option Although Deutsche Bank and Barclays established proprietary accounts for the basket options, purportedly to hold assets that would serve as a hedge to cover the option payoffs, those accounts actually functioned as if they were RenTec’s own prime brokerage trading accounts, with RenTec acting in the role of trader rather than option holder. The facts show RenTec had active and total control over the trading strategy and executions. Barclays, in an internal memorandum to its auditors, described RenTec as having so much control over the accounts that Barclays planned to remove from Barclays’ financial statements the shell entity, Palomino Ltd., in whose name the accounts and assets were held. Further evidence that the accounts did not function as true options, or likely even as derivatives, is that RenTec managed the MAPS and COLT basket option accounts as components of one large investment pool, journaling assets between option accounts, rolling assets from expired to new option accounts, and shifting parts
51 of its investment portfolio between different financial institutions. The resulting rapid asset turnover in the various option accounts meant that the options purchased by RenTec had no fixed assets and did not function as true options. The accounts existed simply to carry out RenTec’s algorithmic trading strategy. In the end, for all practical purposes, the accounts functioned as over-leveraged prime brokerage accounts controlled by the hedge funds to produce trading profits rather than as accounts controlled by the banks to provide a hedge against an option contract. (i) Controlling Trading Activity Although the basket option accounts were opened in the name of Deutsche Bank and Barclays, RenTec, and only RenTec, controlled the investment decisions and trading activity undertaken in each account. Since 2000, RenTec was named as the investment advisor for all of the accounts referenced in the 79 basket options it purchased from the two banks, of which 60 have been exercised by RenTec after the one-year mark. 285 As the investment advisor, every direction by RenTec to buy or sell an asset in a particular option account served dual roles: the resulting portfolio of assets served as the reference assets to determine the ultimate value of the option and hold the profits from executed trades and, simultaneously, each transaction provided the assets described by Deutsche Bank and Barclays as the hedges created for the option contracts. High Volume Trading. Trading records and other evidence indicate that RenTec used its discretion over the basket option accounts to conduct millions of high-volume trades for years. In response to a Subcommittee inquiry, RenTec calculated that it used the basket option accounts to conduct an average of between 26 and 39 million trades per year. 286 Another RenTec representative estimated that the company conducted from 100,000 to 150,000 trades per day with each bank. 287 Still another document, prepared by Barclays, indicated that RenTec conducted about 500,000 trades per day, describing it as a “very high frequency trader.” 288 While RenTec executives repeatedly told the Subcommittee that the company simply “suggested” or “recommended” trades to the banks for their hedge accounts, 289 it is difficult to credit that description of RenTec’s actions given that it had the trading authority and electronic means to execute actual trades through the option accounts at its discretion and without consultation with the banks. Another factor is the sheer volume of trades that were actually executed on a minute-to-minute basis each day; it is difficult to understand how all of those 285 See chart, “History of COLT Options,” prepared by Barclays, BARCLAYS-PSI-748604. See also untitled chart prepared by Deutsche Bank, DB-PSI 52583-85. Six of those options remain outstanding. 286 See 6/27/2014 letter from RenTec’s outside legal counsel to the Subcommittee, “Response to Renaissance Follow Up Questions,” PSI-Renaissance-37-000001-007, at 004. These large figures appear to be corroborated by an SEC examination report that calculated, for the one-year period from April 1, 2008 to March 31, 2009, that RenTec executed approximately 129 million orders. “Examination Report for: Renaissance Technologies LLC (801- 53609),” prepared by the SEC, SEC_RT13_001971-993, at 972. [Sealed Exhibit.] 287 See 6/27/2014 letter from RenTec’s outside legal counsel to the Subcommittee, “Response to Renaissance Follow Up Questions,” PSI-Renaissance-37-000001-007, at 004. 288 11/18/2008 memorandum prepared by Barclays, “Renaissance Technologies Corp Prime Services Brief on existing BarCap relationship and legacy Lehman relationship,” BARCLAYS-PSI-018701-704. 289 Subcommittee interviews of Jonathan Mayers, RenTec (5/28/2014) and Mark Silber, RenTec (6/10/2014).
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United States Senate PERMANENT SUBC
Page 3 and 4: ABUSE OF STRUCTURED FINANCIAL PRODU
Page 5 and 6: ABUSE OF STRUCTURED FINANCIAL PRODU
Page 7 and 8: 3 client entered into a contract wi
Page 9 and 10: 5 Although the Subcommittee does no
Page 11 and 12: 7 4. Ceding Control. Although the i
Page 13 and 14: 9 II. BACKGROUND This chapter provi
Page 15 and 16: 11 dealers and sets the margin requ
Page 17 and 18: 13 exercising the option. 33 The fi
Page 19 and 20: 15 Since the hedge fund’s gain or
Page 21 and 22: 17 managed account which, in the ca
Page 23 and 24: 19 corporation, and are instead tre
Page 25 and 26: 21 The abusive derivatives used pri
Page 27 and 28: 23 over form doctrine is that the t
Page 29 and 30: 25 securities in the basket. 95 It
Page 31 and 32: 27 Jürgen Fitschen and Anshu Jain
Page 33 and 34: 29 as the consolidation point withi
Page 35 and 36: 31 Financial Officer, Chief Complia
Page 37 and 38: 33 as U.S. persons, among other typ
Page 39 and 40: 35 which was initially designed by
Page 41 and 42: 37 Barclays COLT Options. In 2002,
Page 43 and 44: 39 C. Development of MAPS and COLT
Page 45 and 46: 41 the trades were placed and execu
Page 47 and 48: 43 option accounts. 254 In other wo
Page 49 and 50: 45 Because the investment advisor,
Page 51 and 52: 47 changed the formula used to calc
Page 53: 49 D. Analysis of Basket Option Cas
Page 57 and 58: 53 The financing charges and transa
Page 59 and 60: 55 Removing Palomino, a shell corpo
Page 61 and 62: 57 • RenTec is effectively entitl
Page 63 and 64: 59 Barclays’ SEC filing also incl
Page 65 and 66: 61 accounts established in the name
Page 67 and 68: 63 (ii) Constantly Changing Asset M
Page 69 and 70: 65 selection was at the discretion
Page 71 and 72: 67 Percentage Allocations. Because
Page 73 and 74: 69 protection. 357 He explained tha
Page 75 and 76: 71 The technique that RenTec used w
Page 77 and 78: 73 In addition to moving assets fro
Page 79 and 80: 75 (a) Facilitating Tax Avoidance B
Page 81 and 82: 77 Mr. Haas’ description of the 2
Page 83 and 84: 79 legal opinion from outside couns
Page 85 and 86: 81 available to Renaissance pursuan
Page 87 and 88: 83 as their hedge fund clients - th
Page 89 and 90: 85 continuing with the Option Trans
Page 91 and 92: 87 Within the bank, some executives
Page 93 and 94: 89 Attempts to Develop New Structur
Page 95 and 96: 91 IV. SYSTEMIC CONCERNS In its Gen
Page 97: 93 as publicly traded partnerships,
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ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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