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

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client entered into a contract with the bank to purchase an “option” on the performance of an
unspecified basket of assets placed in a designated account. The referenced account was opened
in the name of the bank and operated as the bank’s own proprietary trading account. All assets
were purchased in the name of the bank.
To reduce trading risk, the option contract normally set a few basic parameters for the
assets that could be purchased for the account, but otherwise provided wide discretion over the
assets to be selected. The hedge fund was required to deposit into the account a cash “premium,”
which typically consisted of funds representing about 10% of the total capital to be invested in
the account and functioned as collateral for the account. The sponsoring bank financed the other
90% of the capital to be invested, and the hedge fund paid financing fees on that financed
amount. The designated account then used the funds from the premium and credit extension to
conduct trades until the option holder exercised the option. If at the time the option was
exercised, the securities in the referenced account had produced a profit, the bank had to pay
those profits to the hedge fund holding the option, after subtracting fees for certain trading,
financing, and other expenses.
In the basket option contracts examined by the Subcommittee, the bank always appointed
the general partner of the hedge fund client to act as the investment advisor for the trading
account holding the referenced assets during the duration of the option. Once appointed, the
investment adviser exercised complete control over the securities included in the option account,
designing its own trading strategy and using the bank’s own facilities to execute the trades. In
some cases reviewed by the Subcommittee, the investment advisor used algorithms to engage in
a high volume of trading, executing more than a 100,000 transactions per day. Many of those
trading positions lasted minutes, and the overall composition of the securities basket changed on
a second-to-second basis. One basket option account later reviewed by the Securities and
Exchange Commission (SEC) was found to have experienced 129 million orders in a year. In
other cases, the investment adviser purchased securities whose positions remained unchanged for
weeks, but all of the basket option accounts reviewed by the Subcommittee were dominated by
short-term trading involving assets held less than one year.
By acting as the investment adviser, the hedge fund – the option holder – became the
party that actually controlled the trading strategy, the timing of trades, and what assets were
selected for the referenced account. The hedge fund was also exposed to all significant rewards
and risks associated with the trading. The banks claimed that the hedge funds did not bear 100%
of the risk of loss, because the banks provided so-called “gap” protection in the event of a
catastrophic market failure. That risk was so small, however, that despite, for example, hundreds
of millions of trades that took place in the more than 60 basket options held by RenTec over a
decade, including during the worst financial crisis in a generation, neither bank was ever required
to satisfy a loss due to a market failure.
To further minimize the gap risk, the option contract contained several provisions
designed to limit trading losses in the account to the 10% premium provided by the hedge fund.
The key provision accomplished that objective by specifying a loss threshold – sometimes called
a “barrier” or “knockout” amount – which if reached would cause the option to cease to exist, or
“knockout,” and trigger the ability of the bank to liquidate the account assets.