An Update on Cum-Ex: A long-running banking scandal is coming to a head

As the long-running Cum-Ex banking scandal comes to a head in Germany, how should international financial institutions be bracing for impact?

The Cum-Ex dividend trading scandal, which has been rumbling on throughout Europe for a number of years, sparked into life in March with the convictions of two former London-based investment bankers - Martin Shields and Nicholas Diable. These convictions mark the first occasion where Cum-Ex trading has been adjudicated to be criminal tax evasion. Notably, both defendants avoided immediate prison sentences in return for extensive cooperation with the prosecutors and the return of their ill-gotten gains.

However, rather than this being the conclusion of a story, it is in fact just the start of what will likely become the unravelling of another banking scandal to rival or even eclipse the scale of Libor and FX rate manipulation.

Support for this view can be taken from the speech of Mark Steward the UK Financial Conduct Authority's Executive Director of Enforcement and Market Oversight, which was delivered shortly before these convictions took place and signals both what the FCA's first steps will be and the scale of the issue in London:

"the FCA has worked closely with European authorities for some time on...dividend stripping tax avoidance schemes that have operated in Denmark, Germany, France and Italy. The FCA has been investigating substantial and suspected abusive share trading in London's markets that has allegedly supported these schemes. These investigations are now very close to their conclusion and decisions about action are imminent."

What is striking about this statement, although not in the least bit surprising for those who understand the central part that the City of London plays in European financial markets, is the acknowledgment that whilst the tax evasion schemes themselves exploited the dividend withholding tax regimes of other EU countries, much of the structuring, trading, financing and promotion of it took place in the City of London.

Recap on Cum-Ex

In brief, Cum-Ex trading is a form of dividend arbitrage where trading and lending of securities and derivatives are constructed around dividend dates in order to generate multiple withholding tax (WHT) reclaims for the same stock. Cum-Ex trading became industrial in scale and resulted in huge WHT reclaims in Germany, Spain, Italy, France, Denmark and elsewhere. It is thought that at least €55 billion in wrongful WHT reclaims were made before tax regimes reacted to close the 'loopholes'.

Redrawing the Line between Evasion and Avoidance

Dividend arbitrage - placing shares in alternative tax jurisdictions in order minimise tax exposure - has been accepted practice for a very long time and was, at least by the standards of the time, on the right side of the tax avoidance / evasion line. Cum-Ex trading and its close relative Cum-Cum trading were also, according to legal opinions given at the time, thought to be on the lawful side of the dividing line (although sailing pretty close to it). Those opinions have now been blown out of the water and the lawyers who gave them are themselves facing criminal investigations. In this way the line between tax avoidance and evasion in dividend arbitrage has been re-drawn and will continue to be so as more cases follow. Inevitably, as this progressive re-drawing develops, regulators and prosecutors will examine trading patterns, conduct and behaviour, not through the standards of the day, but through the lens of whatever the newly drawn lines are.

Who will be affected?

Financial institutions who have been directly or indirectly involved in activity relating to the borrowing and lending of European equities around dividend dates will be affected. This will include investment bank trading desks, inter-dealer brokers, settlement agents and custodian banks.

What will the Regulators be looking at?

Regulators will be looking at all facets of trade in equities around dividend dates, guided by the exchange of information and intelligence from EU counterparts, going back over many years to establish the extent to which firms were involved. They will be particularly interested in unusual trading patterns, trades with no apparent risk, off-market trades, trades with profitability out of line with the risk involved, the role of firms in promoting dividend arbitrage opportunities to clients, whether firms took care to understand the true nature and purpose of the transactions and whether there was adequate management oversight (such as via the Money Laundering Reporting Officer and whether suspicious activity reports were appropriately submitted).

The exposure to risk will range in severity from criminal investigations and penalties through to regulatory failings or failings in systems and controls. The nature and extent of the risk exposure will depend on the proximity to any instances of evasion or fraud, the degree of knowledge and whether 'red flags' in transactions were identified and managed.

Key risk areas include:

• Criminal law offences
• Compliance with anti-money laundering requirements
• Compliance with market abuse regulations
• Failing to have adequate systems and controls in place to counter the risk of furthering financial crime
• Failing to test the adequacy of systems and controls to identify and manage money laundering risks
• Civil proceedings for the recovery of WHT reclaims

What approach should Financial Institutions be taking?

Understanding the exposure to risk, dealing with the regulators and remediating against this background is complex and challenging.

The timescales and volumes involved in dividend arbitrage trading can only be managed with a forensic data-driven approach led by a deep knowledge of market practice and trading norms.

A successful approach will necessitate both analysing structured trading data and blending this with sources of unstructured data (such as chat, email and voice) to accurately quantify risk exposure and to establish, where appropriate, defensible positions across the firm's book of relevant business.