July 17 (Bloomberg) -- Barclays Plc and Deutsche Bank AG face scrutiny over their sale of products to a hedge-fund firm that allowed it to skirt borrowing limits and avoid taxes, according to people with knowledge of the matter.
The U.S. Senate Permanent Subcommittee on Investigations plans a hearing next week on what it calls abusive transactions by financial institutions, according to a notice from the panel. The companies, which aren’t named in the notice, are Barclays, Deutsche Bank and hedge-fund manager Renaissance Technologies LLC, the people said. Representatives for each of the firms plan to testify at the July 22 hearing, the people said.
The investigation is another blow for Antony Jenkins, chief executive officer of London-based Barclays, as he seeks to restore the firm’s reputation after it became the first lender to be fined for rigging Libor. For Deutsche Bank, the hearing comes less than four years after the Frankfurt-based lender paid $554 million to avoid unrelated U.S. criminal charges involving the sale of tax shelters.
Kerrie Cohen, a spokeswoman for Barclays, declined to comment, as did Renee Calabro of Deutsche Bank; Jonathan Gasthalter, who represents Renaissance; and Gordon Trowbridge, a Senate subcommittee spokesman. The people with knowledge of the matter spoke on condition of anonymity because they weren’t supposed to reveal information before the hearing.
Led by Carl Levin, a Michigan Democrat, the subcommittee often examines legal business practices with an eye toward policy reform and isn’t able to impose penalties. Recent hearings have focused on tax-avoidance maneuvers by Apple Inc. and Caterpillar Inc.
Next week’s hearing will focus on a series of transactions known as barrier options between the banks and Renaissance, the East Setauket, New York-based hedge-fund manager founded by billionaire James H. Simons, the people said. The tax benefits allegedly generated by the options are the subject of a dispute between Renaissance and the Internal Revenue Service, the people said. Bloomberg News reported on the transactions last year.
Taxes aside, the transactions enabled Renaissance’s Medallion fund to borrow as much as $17 for every dollar of its own, more than it would be allowed to in a traditional margin- lending relationship, the people said. Federal Reserve rules prohibit stockbrokers from lending more than $1 for every dollar of client money. Hedge funds are typically able to borrow as much as $5 or $6 for each of their own dollars through specialized arrangements with banks.
In one version of the barrier-option transaction described in a public 2010 IRS memorandum, Barclays bought a pool of securities and paid Renaissance a nominal fee to manage them. At the same time, Barclays sold a two-year option to the hedge fund that transferred any gains or losses from the pool to Medallion, minus financing costs. The memorandum doesn’t name the hedge fund or the bank, whose identities were confirmed by the people with knowledge of the matter.
Because Barclays, not Medallion, was the legal owner of the assets, the option transformed the hedge-fund investors’ short- term trading profits into long-term capital gains, which are taxed at a lower rate. The IRS, which says the option arrangement is a ruse and that Medallion was the real owner of the underlying assets, wants Medallion investors to pay the higher rate, the people said.
Barclays held the Renaissance securities in a subsidiary, Palomino Ltd., one of the people with knowledge of the matter said. Securities filings over the years show bets by Palomino on stocks including QLT Inc., a Canadian drugmaker; Wolseley Plc, a plumbing supply company based in Switzerland; and the U.K. publisher Johnston Press Plc. One set of filings from 2009 identifies Palomino as managed by Renaissance.
Palomino first appears in Barclays’s 2006 annual report, as a consolidated subsidiary of the company incorporated in the Cayman Islands. Beginning in the 2009 report, Barclays changed course and put Palomino on a list of companies that aren’t consolidated with Barclays’s financial statements because a third party controls or owns them. Palomino was listed as an unconsolidated subsidiary in last year’s report.
Jenkins, 53, has pledged to overhaul Barclays’s culture after the 290 million-pound ($497 million) fine for rigging the London interbank offered rate. Since taking over two years ago, he has struggled to put the bank’s legal woes behind him.
Barclays had to set aside almost 4 billion pounds to compensate consumers who were sold payment-protection insurance that didn’t cover them or that they didn’t need. In May, the bank was fined 26 million pounds after a gold trader at the firm cheated a client and artificially suppressed the price of one of the world’s most widely traded metals. Last month, New York’s attorney general accused the bank of lying to clients to drum up interest in a private trading venue, known as a dark pool.
The lender is also being probed by regulators over whether it properly disclosed 322 million pounds of payments to Qatar’s sovereign-wealth fund as part of a 7 billion-pound fundraising during the financial crisis, a move that helped the bank avoid a government bailout.
As part of his review of the bank’s activities, Jenkins last year published a new set of “tax principles” meant to guide his bankers’ work with clients. He also closed a Barclays unit that advised clients on tax planning that had been criticized by British politicians as encouraging tax avoidance.
The Renaissance option trades were arranged by that unit, according to a person familiar with the matter. As part of its implementation of the principles last year, Barclays decided to stop offering barrier option trades that provide tax benefits, the person said.
Deutsche Bank sold options to Renaissance similar to the ones furnished by Barclays, according to the people with knowledge of the matter. Deutsche Bank also sold a similar structure to an investment vehicle run by George A. Weiss, the Hartford, Connecticut-based philanthropist and hedge-fund manager, the people said. Stephen Labaton, a spokesman for Weiss’s firm, declined to comment.
Representatives of Weiss’s hedge fund aren’t scheduled to take part in the hearing, one of the people said.
The IRS was tipped off to the use of the option arrangements after examiners from the Securities and Exchange Commission learned about the practice in 2008, according to a report from the Government Accountability Office.
After the IRS laid out its case against the technique in the October 2010 memo, Deutsche Bank stopped offering versions of the option arrangement that provided a tax benefit, one of the people said.
That December, in an unrelated case, Deutsche Bank paid a $554 million fine and entered a deferred prosecution agreement with the U.S. Attorney’s office in Manhattan in connection with its sale of illegal tax shelters to wealthy individuals. The shelters had been the subject of a 2003 investigation by the Senate subcommittee.
Simons, a former mathematics professor, pioneered the use of advanced mathematics and computer algorithms to identify profitable trades at Renaissance. The firm now manages about $25 billion, including its Medallion fund, which is mostly run for its own employees.
Medallion has one of the industry’s best investing records, returning more than 35 percent annualized over 20 years. Simons, 76, now the firm’s chairman, has a net worth of more than $15.5 billion, according to the Bloomberg Billionaires Index.
His more-than $9.5 million of donations during the 2012 election cycle made him one of the top Democratic contributors, according to data compiled by the Center for Responsive Politics. The hedge fund’s co-CEO, Robert L. Mercer, is a top Republican donor.
--With assistance from Jesse Drucker in New York and Robert Schmidt and Richard Rubin in Washington.