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

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securities as collateral for the loan. One analyst summarized the policy reasons for imposing the
margin rules as follows:
“(1) to ‘prevent[ ] the excessive use of credit for the purchase or carrying of securities’;
(2) ‘to protect the margin purchaser by making it impossible for him to buy securities on
too thin a margin’; and (3) to ‘prevent undue market fluctuations and help stabilize the
economy generally ….’ In short, margin rules were created to protect individual
investors, the market, and the economy as a whole.” 426
A number of representatives indicated that Deutsche Bank, Barclays, RenTec, and
George Weiss viewed achieving leverage beyond the limits of Regulation T as a major business
objective for entering into the basket options. 427 In a 2012 letter to the IRS, for example, RenTec
described its past use of leverage and how the basket options provided more leverage than it had
achieved in any other setting:
“Leverage … is restricted by the U.S. Federal Reserve’s Regulations T, U, and X,
commonly referred to as the ‘margin rules.’ The margin rules limit the extent to which
brokerage customers can borrow against the stock positions that they own. …
A brokerage account in which an investor can trade stocks utilizing money borrowed
from the broker is referred to as a ‘margin account.’ A margin account can be opened in
connection with a prime brokerage arrangement. Under the relevant Federal Reserve
Regulations, if a Renaissance fund were to seek to obtain leverage by trading long and
short positions in such a prime brokerage margin account held at a U.S. broker-dealer, it
would be able to achieve leverage of no more than 2:1. That is, in order to hold $100 of
long positions and $100 of short positions, the Renaissance fund would have to have
invested $100 in the account.
To achieve greater leverage, Renaissance made use of a ‘joint back office’ or ‘JBO’
arrangement. This involved qualifying one of Renaissance’s investment funds as a
registered broker-dealer in its own right, trading for its own account. As a result, the
fund was exempt from the margin rules and was instead subject to the SEC ‘net capital’
rules …. This amounted to a leverage ratio limit of approximately 7.6:1 428 (i.e., with
$100 of equity the fund could hold approximately $335 of long positions and $335 of
short positions.) Renaissance’s fund that had a JBO arrangement during 2005 and 2006
had an average leverage ratio of 4.6:1 during those years, with a peak leverage ratio of
6.4:1.
In the late 1990s, Renaissance began discussions with DB [Deutsche Bank] regarding the
possibility of purchasing options from DB that would give Renaissance funds highly
leveraged exposure …. DB was initially prepared to make leverage of up to 16:1
426 “Leveraged ETFs: The Trojan Horse has Passed the Margin-Rule Gates,” 34 Seattle U.L. Rev. 299, 310, William
M. Humphries (Fall 2010) (omitting citations).
427 Subcommittee interviews of Frederick Doucette, GWA (5/23/2014), Peter Brown, RenTec (6/3/2014), Satish
Ramakrishna, Deutsche Bank (5/16/2014) and Martin Malloy, Barclays (5/1/2014).
428 RenTec informed the Subcommittee that in its original submission to the IRS, it transposed the numbers
describing the permissible leverage of a JBO arrangement and incorrectly listed it as 6.7:1, but is providing
corrected information to the IRS.