EBA Report on the Cum-Ex dividend arbitrage controversy

Banks, brokers and private wealth managers (and their Compliance Officers and PCFs) should take note of the report recently published by the European Banking Authority (EBA) following its inquiry into dividend arbitrage trading schemes.

The accompanying 10 point action plan to enhance the regulatory framework also merits examination. The Report and action plan are relevant to Financial Service Providers, even if they have not participated in dividend arbitrage trading, as regulatory issues could still arise, for example, if any of their current executives were involved in such practices in their former employment.

Background

The EBA report responds to the "Cum-Ex" trading controversy. This involved investors participating in various dividend arbitrage trading schemes. Significant share transactions would typically take place around dates set for dividend payments. In summary, Cum-Ex transactions would produce two refunds of withholding tax paid by the issuer in respect of a single dividend payment to shareholders. Participants appear to have considered that the transactions were not illegal due to careful tax planning.

Germany is generally understood to have been the country most affected, with a reported cost of over $30bn in tax revenues. German federal authorities have argued that the transactions were so obviously illegal that they should not have needed specific legislation to prohibit them. A German criminal prosecution recently concluded with the imposition of suspended sentences and significant fines with hundreds of other investigations continuing. Other countries are investigating whether tax and other laws have been broken in their jurisdictions.

Financial services regulatory responses

Although the Cum-Ex investigation focuses on alleged tax fraud and tax evasion, financial services regulatory issues arise because of the alleged involvement of banks, brokers and private wealth managers in the structuring and execution of the transactions. For example:

  • Anti-money laundering issues are raised if the transactions constituted tax fraud or tax evasion
  • If courts determine that those structuring and executing the transactions were criminally responsible, issues arise regarding the fitness and probity of the individuals concerned. Financial services providers who have never participated in such practices may also be affected if they have staff members recruited from other institutions who had been involved in the practice
  • Equally, if the transactions are illegal, issues are raised concerning whether market conduct requirements were breached
  • The adequacy of the risk management framework that allowed the transactions to take place may also be called in to question
  • Given the size of potential fines and any related potential restitution, prudential issues could be raised for institutions that are subject to criminal and civil action

Although there have been varying responses from national regulators to the emerging issues, the EBA report constitutes the first EU-level coordinated response and may provide further impetus to national regulators' efforts.

The EBA report shows that there is no harmonised understanding of dividend arbitrage trading schemes, or relevant transactions in the EU, due to differences in Member States' tax laws. It concludes that facilitating or handling proceeds from tax crimes undermines the integrity of the EU financial system and sets out expectations of credit institutions and national competent authorities (NCA).

The EBA's 10 point action plan focuses on amendments to the existing regulatory framework to implement stronger controls and prevent illegal dividend arbitrage practices. The aim is to provide NCAs with common tools to assess the impact on institutions' governance arrangements, ensure sound risk management in supervised institutions and take appropriate supervisory measures where weaknesses are identified.

The 10 proposed action points are:

  1. Amend Guidelines on Internal Governance
  2. Amend Guidelines on the Assessment of the Suitability of Members of the Management Body and Key Function Holders
  3. Amend Guidelines on Supervisory Review and Evaluation Process
  4. Monitor prudential colleges, with report on convergence
  5. Assess Guidelines on AML risk factors
  6. Amend Guidelines on Risk-Based Supervision
  7. Amend Opinion on ML/TF Risks
  8. Continue to assess AML competent authorities' handling of ML/TF risks associated with tax crimes, with report on findings
  9. Monitor discussion in AML/CFT colleges and report
  10. Carry out an inquiry

What this could mean for Irish-regulated firms

Whilst acknowledging that Ireland may appear far from the centre of the controversy, Irish regulated institutions might now expect more Central Bank engagement on dividend arbitrage related matters. In addition, Mutual Legal Assistance Treaty requests from foreign jurisdictions may trigger Irish authority investigations of Irish-regulated firms and potentially the full use of the investigative powers at their disposal.

The EBA expects the Central Bank, as Ireland's NCA, to assess whether dividend arbitrage trading schemes constitute tax crimes in Ireland. Following that, NCAs are expected to pursue targeted inspections and consider supervisory activities where there are concerns about the adequacy of regulated firms' internal control and governance arrangements and AML systems and controls.

Irish-regulated firms may be required to identify the degree of any involvement in such transactions on the part of themselves, any branches and their staff members who are subject to the Central Bank's Fitness and Probity regime.

Irish-regulated firms who were involved or associated with such transactions may face challenge on the adequacy of AML compliance and general risk management frameworks and on whether the fitness and probity of any affected PCFs or CFs needs re-assessment.

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