In the first of a two-part series first published in SLT 255 (June), Market FinReg's Seb Malik takes a deep-dive into the murky world of cum-ex dividend schemes that have brought the reputation of securities lending programmes into disrepute
Cum-ex dividend schemes are the greatest alleged tax fraud of a generation costing European countries an estimated €55 billion.
Securities lending sits at the heart of this alleged fraud.
Litigation reached the English High Court last year. Depending on how litigation plays out, the industry’s master agreement template, the Global Master Securities Lending Agreement (GMSLA) may find a key element of its structure under intense scrutiny by English courts.
To the extent possible in a short memo, I wish to share my views concerning the key issues and how they should be disposed of ahead of litigation in English courts.
At its core lies the claiming of two tax rebates from, say, the German government for withholding tax paid on dividends, when only one is ever paid.
The profits are split between the participating (colluding?) parties. The key chain is when the day before a dividend entitlement date, an entity (S) short sells the shares with (“cum”) dividends to a buyer (B) for T+2 settlement. After the dividend entitlement date, S buys the shares without (“ex”) dividends from entity O and delivers it to B for immediate settlement, thereby allowing S to settle his initial trade with B.
Since S’s initial short trade was cum dividend, S pays dividend compensation to the effect that B receives the share with the dividends payment. O was the holder on record on the record date and so legitimately claims its own tax rebate.
Following B’s receipt of the shares and dividends compensation, B’s custodian bank issues a tax certificate which allows B to claim withholding tax.
Thus both B and O have claimed a withholding tax rebate while only O has actually paid. This is where the profit comes from. The full scheme together with a schematic has been set out in [2019] EWHC 705 (Ch) at [30-32] (available on www.bailii.org).
Law firms have written lengthy articles discussing the relationship between ‘economic ownership’ and ‘beneficial ownership’ and whether in a short sale beneficial ownership is transferred to the borrower or just economic ownership. I am not persuaded by this approach.
The key point is this: on the dividend entitlement date, who had, at the very least, economic ownership of the shares? Clearly O did, so his withholding tax rebate is lawful, ignoring extrinsic considerations. But was B’s tax rebate lawful? I submit not. This is at best an unlawful claim, at worst, depending on B’s state of mind, a case of fraud.
The GMSLA is a master agreement that stipulates all borrowing and lending trades constitute a ‘single agreement’. This allows for netting in the event of default and assets not becoming generally available on a ‘pari passu’ basis for creditors. Under point 4.2, there is an execution date – the date when the paperwork and legal contract for the individual securities lending is executed.
Then there is a settlement date, typically T+2 or T+3 when the securities and collateral are simultaneously delivered to each other. At this point “all rights and title and interest” are passed from one party to the other. The lender also warrants that it is “entitled to pass full legal and beneficial ownership”. I will return to the beneficial ownership shortly.
It is thus clear, on the date of execution of the lend, the borrower does not own legal title to the securities. This they only obtain on settlement date. So, in our cum-ex scenario, S did not legally own the securities before the dividend entitlement date and hence their claim for a dividend
tax refund is baseless.
To me, this ought to dispose of the matter. But, if matters progress, I do not consider a GMSLA borrower to hold beneficial ownership, only legal title. The manufactured payment returning the dividend to the lender, coupled with a short timescale are strong indicators that the beneficial owner remains the same.
The industrial-scale pilfering of tax-payers’ money in illegal, immoral and economically meaningless transactions is shameful. It is precisely the reason why the EU has opted for a highly-prescriptive regulatory regime.
The next time you hear complaints of over-regulation, consider cum-ex and how many hospitals, schools or nurseries €55 billion could fund.
Part two: the Bonn ruling, a case study
