Bank Accountability

Deutsche Bank, Target of Probes, Adds One More in U.S. Hedge Fund Investigation

Deutsche Bank has comeunder scrutiny for helping hedgefunds to avoid taxes. Soucre: DPA.
Deutsche Bank has come under scrutiny for helping hedge funds to avoid taxes.
  • Why it matters

    Why it matters

    As Germany’s largest bank, Deutsche Bank’s health is critical to that of the European financial system. While the bank remains well-funded after raising €8.5 billion ($11.6 billion) in fresh capital last month, it is facing a flurry of legal bills that are hurting its bottom line.

  • Facts

    Facts

    • Deutsche Bank reported a 34 percent drop in net income in the first quarter, in part related to legal settlements. It reports second quarter results next week.
    • Deutsche Bank has set aside €2 billion for future legal costs, though some analysts estimate the total cumulative cost could be as high as €5 billion.
    • The U.S. investigation into hedge funds is part of a broader effort to crack down on tax avoidance on Wall Street. Some European officials have complained that the United States is unfairly targeting European banks.
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    Audio

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Germany’s largest bank has once again come under the scrutiny of authorities, this time for allegedly helping hedge funds in the United States avoid paying as much as $6 billion ($4.5 billion) in taxes on trading profits and skirting regulations on borrowing for more than a decade.

Deutsche Bank and London-based Barclays bank reportedly earned $1 billion from the scheme, which is under investigation by U.S. tax authorities and was the subject of a 93-page report this week by U.S. senators Carl Levin and John McCain. The banks insisted they were operating within the law.

Mr. Levin, the long-serving Michigan Democrat, called for any loopholes to be closed, lost taxes to be recouped from hedge funds and for the banks to be penalized for their involvement. He labeled the scheme “a series of fictions, one piled on top of another – fictions that major banks and their hedge fund clients used to avoid taxes and federal leverage limits.”

 

Senators Carl Levin and John McCain. Source: Bloomberg.
Senators Carl Levin and John McCain. Source: Bloomberg.
Senators Carl Levin and John McCain are reviewing a report on the hedge fund scheme. Source: Bloomberg.

 

The accusations can be added to a growing list of legal probes facing the German banking giant and wider financial industry, especially from the United States. The investigations range from the manipulation of financial benchmarks on interest rates and currencies to doing business with countries under U.S. sanctions. The U.S. Federal Reserve Bank of New York is also targeting shoddy reporting of quarterly results, the Wall Street Journal reported Tuesday.

The increased scrutiny of European banking practices by U.S. regulators has come under fire from some government quarters in Europe. French officials have been especially vocal after BNP Paribas paid a fine of nearly $9 billion for skirting a U.S. embargo on Iran. Germany’s response has been more muted so far, though this could change if the country’s major banks face heftier fines in the future.

“The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do.”

Senator John McCain

Deutsche Bank, which is already in the middle of a restructuring, reported a 34 percent decline in net income in the first quarter of this year, partly related to legal settlements. It has set aside about €2 billion for further legal disputes in the coming years, though financial analysts have estimated the eventual legal bill could be as high as €5 billion.

The latest investigation involves a complex financial instrument known as a basket option that the banks set up as trading accounts for their hedge fund clients. The baskets allowed hedge funds to pool their short-term trading profits and record them as long-term capital gains instead. Long-term trading profits are taxed at 20 per cent in the United States, while short-term profits are taxed at 35 per cent.

“The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do. Hedge funds cannot be allowed to have an unfair tax advantage over ordinary citizens,” Senator John McCain said.

The Federal Reserve New York accused Deutsche Bank of sloppy financial reports in December 2013. Source:  DPA.
The Federal Reserve New York accused Deutsche Bank of sloppy financial reports in December 2013. Source: DPA.
The Federal Reserve New York accused Deutsche Bank of sloppy financial reports in December 2013. Source: DPA.

 

The instruments also allowed hedge funds to skirt regulations on how much money they can borrow in order to speculate, because the baskets were created in the name of Deutsche Bank and Barclays rather than in the name of the hedge funds themselves, the U.S. report said.

Officials from Deutsche Bank, Barclays and the hedge funds involved in the most recent allegations – notably Renaissance Technologies – insisted they had not broken any laws in testimony before a subcommittee of the U.S. Congress on Tuesday.

“There should be no question that Deutsche Bank did its best to ensure compliance with the laws and regulations as written and understood by the subject matter experts at the time,” said Barry Bausano, president of Deutsche Bank Securities, the U.S. arm of Deutsche Bank involved in the allegations. “We do note, however, that it is a widely accepted principle that tax consequences differ among various financial instruments.”

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