Abuse of financial products by hedge funds

Today, I testified before the U.S. Senate Permanent Subcommittee on Investigations (the “Subcommittee”) on the abuse of structured financial products by hedge funds, in particular by the Renaissance funds. This is what I told the Subcommittee:

Almost a century ago, Congress reduced the tax rate for long-term capital gains. Then, long-term meant holding assets for two years–now it means one 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.

This Subcommittee asked me to evaluate the character of gains of the Renaissance hedge funds, and provided materials to help my review.

The Renaissance hedge funds traded often, more than 100 thousand trades a day, more than 30 million 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% to 15%–and reduced taxes paid to the Treasury by $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 fund’s 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, say, $90 million, which permitted up to $100 million to trade. The Basket Contract typically had a term of two or three 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, a Basket Contract would be automatically “knocked-out” (i.e., terminated), if the value of the account fell to $90 million. But the banks put in place protections to prevent the accounts from falling that much. In practice, no Basket Contract was knocked-out.

The tax law characterizes an arrangement based on its substance, not its form. In substance, 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 parties’ label of a contract does not matter. Rather, the benefits and burdens of ownership matter. For the stock basket, I believe those belong to the hedge funds. First, the hedge funds enjoyed the opportunities of gain from trading the stocks and incurred the burden of losses–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 paid the financing, commissions, and other expenses from the trading. Finally, the hedge funds, through 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.

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 from derivatives more clearly.

I believe the tax accounting for derivatives ought to follow financial accounting, which requires companies to mark-to-market their derivatives at year-end (i.e., 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 has been demanding increasing efforts in recent years.