RBC Wash Sale Scheme Allegations: U.S. Regulators Accuse Bank Of Using Sham Futures To Gain Advantage

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Royal Bank is defending itself against what it calls "absurd" allegations from U.S. regulators. | CP

TORONTO - Royal Bank is defending itself against what it calls "absurd" allegations from U.S. regulators that it engaged in hundreds of millions of dollars in sham futures trades to reap tax benefits on its holdings of company stocks.

The Commodity Futures Trading Commission lawsuit filed Monday against Canada's biggest bank (TSX:RY) says Royal also concealed the true nature of the trades and made false statements to a futures trading exchange.

The activity, so-called "wash trading", is an illegal stock trading practice in which an investor simultaneously buys and sells shares in a company through two different brokers, usually to avoid taxes. Wash trading is illegal in the United States according to futures laws.

The CFTC said the bank's trading strategy was devised to gain Canadian tax credits on its holdings of U.S. and Canadian company stocks. It said the strategy was created and carried out by a group of executives at the bank. However, the agency's suit didn't name any individuals.

"A fundamental purpose of the futures markets is to provide an arm’s-length mechanism for market participants to discover prices and shift risks associated with products traded in those markets," said David Meister, the director of the CFTC's Division of Enforcement.

"As we allege, RBC not only designed and executed a wash sale scheme that undermined that purpose, it went a step further and misled the exchange into believing that its conduct was lawful."

Royal defended its position in a statement late Monday saying that it consulted stock exchanges and the commission itself for guidance when the trades were made and there was no objection from either.

"Given no objection to the trading activity by either the exchange or the CFTC in 2005, it is absurd to now claim these trades were either fictitious or wash sales," it said.

Royal Bank said it "proactively contacted the exchange to seek its guidance" before making any trades — a move it claims was fully documented, transparent and reviewed by the CFTC.

"RBC's trading was permissible in 2005, and it is permissible today under the CFTC's published guidance," the bank added.

"This lawsuit is meritless and we will rigorously defend ourselves against such baseless allegations."

Royal Bank also noted that it did not consider the situation to be material.

CFTC said it is the largest case it has brought against so-called wash trades, which cancel each other out. The agency alleged that Royal Bank made the trades in stock futures contracts from 2007 to 2010 with two foreign subsidiaries.

The transactions weren't "at arm's length," as required by law, and reported by the bank to the exchange, the agency said.

An arm's length transaction is one done at a price that would prevail if the buyer and seller were unrelated. The federal rules allow futures trades between companies and subsidiaries, but only if they are done on an arm's length basis.

The CFTC is seeking unspecified fines and damages in its civil lawsuit filed in federal court in Manhattan.

In the court filing, the CFTC alleged that a small group of senior RBC staff prearranged the transactions with affiliated operations and then made the block trades through the OneChicago electronic exchange.

The CFTC claims that RBC knew the trades didn't carry any risk, and that it would "reap large tax benefits" through the transactions.

"RBC gave these unlawful trades the appearance of being the result of independent decisions by its branches and subsidiaries to buy and sell futures contracts when, in fact, they were controlled by a small group of senior RBC personnel," the filing said.

"Unless restrained and enjoined by this court, RBC is likely to engage in the acts and practices alleged in this complaint, or in similar acts and practices."

None of the allegations have been proven in court.

Banking analyst Brad Smith said legal disputes like this are typical of the banking industry.

"You're constantly doing things that in hindsight someone can come along and conclude differently," he said in an interview.

"Reputationally, it's got to be a disappointment for them (Royal Bank) to have that going out from the future commission. The reputation for Royal Bank, as for all financial institutions, is critical."

CIBC analyst Rob Sedran also highlighted the bank's reassurance that the allegations were non-material.

"If it's not financially material, I suspect any lasting valuation impact will be limited," he said.

There were two types of futures trades the bank engaged in that corresponded to two different Canadian tax benefits, the CFTC said. One benefit allows Canadian companies that hold U.S. stocks that pay dividends to get a tax credit for the U.S. dividend tax they pay.

The other tax benefit allows Canadian companies that hold Canadian company stocks for more than a year to get tax-free dividends for a year from the companies.

CFTC Enforcement Director David Meister wouldn't say whether related suits could be filed against individuals in the future or if the alleged misconduct by Royal Bank of Canada also occurred at other banks.

In after hours trading in New York Royal shares (NYSE:RY) fell two per cent or US$1.27 to $57.92.

— With files from the Associated Press

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