Cum-Ex Trading: Challenges for Regulators
26 Mar 2020

“This was a collective case of thievery from state coffers”—so declared presiding Judge Roland Zickler of the Bonn criminal court in December 2019 at the trial of Martin Shields and Nicholas Diable, two British traders charged with aggravated tax evasion in Germany’s biggest post-war fraud prosecution. Although this was only a preliminary ruling at the time, it was also an accurate forecast, with both men being convicted in March 2020 in an accelerated judgment ahead of the coronavirus shutdown.

The trial related to the duo’s participation in “Cum-Ex trading”, a system of share-dealing intended to enable reclaims of capital gains tax ostensibly withheld at source on dividends paid by Europe’s largest companies (sometimes known as ”withholding tax”), which operated in Germany until 2012.

The controversial aspect of Cum-Ex is that it involves multiple tax reclaims in respect of the same dividend payment. If all such claims are paid, the national tax authority necessarily disburses far more than it collected via the withholding tax.

Those who contend that Cum-Ex was legitimate (as Shields and Diable unsuccessfully did) argue that their ingenuity enabled them to exploit a loophole. While they denied fraud, they admitted that the national exchequers of the countries whose tax laws enabled Cum-Ex to flourish until they were amended lost a staggering amount of their taxpayers’ money.

For deals involving Shields and Diable, the German prosecutors calculated the loss to their country at 400 million euros ($445 million). For Shields personally, the Bonn court has ordered him to pay 14 million euros in respect of his benefit.

Although this financial penalty may seem commensurate with the scale of the losses, onlookers may be surprised to learn that both men received only suspended prison sentences. This is in part due to the extraordinary level of cooperation they provided to the prosecution by admitting and explaining their conduct in minute technical detail at trial, despite knowing that this would likely result in conviction.

More importantly, it should be understood that Shields and Diable were but two actors in a cast of hundreds in the Cum-Ex production. Every tax reclaim was the end product of a long chain of transactions, each involving a facilitating institution, many of which are household names. As such, it would be mistaken to expect these sentences to reflect the full extent of misconduct related to Cum-Ex trading. The question that follows is what action will result for those other actors.

To work, Cum-Ex trading had to involve a large number of participants playing different and sequential roles. It was not necessary that all participants knew how Cum-Ex operated or that they were facilitating a Cum-Ex transaction. That the facilitators or secondary parties had limited knowledge will become the crucial issue in any subsequent litigation against them.

Of course, while those at the center like Shields and Diable had to know the full picture, it will have to be proven by evidence that the network of supporting players, apart from the fact that they played a role, were similarly or sufficiently informed.

The size of this network and the threats of criminal and/or regulatory sanction, as well as civil litigation which they might eventually face, explains why media reports of the trial describe the public benches of the Bonn courtroom as being packed with representatives from financial institutions.

In some ways, the Bonn verdict itself is of little importance. What matters is what the trial has revealed about how much the secondary parties knew or suspected about their involvement in Cum-Ex, and the surge of criminal, civil and regulatory action which is likely to follow in Germany and other affected countries. 

Criminal Action in the U.K.

A number of wholesale banking institutions whom the media and others have claimed were Cum-Ex secondary parties have significant London operations. Are they exposed to a risk of criminal prosecution?

Firstly, mention should be made here of the corporate “failure to prevent facilitation of tax evasion” offense introduced by the Criminal Finances Act 2017. However, this offense only captures conduct occurring after September 30, 2017, and so even the most recent Cum-Ex activity will fall outside its reach.

Residual criminal risk lies in relation to substantive offenses under the Fraud Act 2006, or money laundering offenses (either facilitation or receiving offenses, or the offense of “failure to report” by a person working in the “regulated sector”). All these offenses can be committed in the U.K., notwithstanding that Cum-Ex occurred in continental Europe.

The challenge for a putative U.K. prosecutor is a need to prove that the individual or corporate suspect had sufficient knowledge or suspicion. In the sprawling web of Cum-Ex, this challenge might be formidable.

The risk seems remote. The U.K. Serious Fraud Office has given no hint that a criminal investigation is under way. The National Crime Agency has confirmed that its Cum-Ex investigation into U.K. parties, following a referral by the Danish tax authorities, has been discontinued. 

Regulatory Action in the U.K.

Conversely, in terms of upstream or potential regulatory risk arising from involvement in Cum-Ex, the risk is substantial. It is clear that the Financial Conduct Authority (FCA) is contemplating significant and wide-ranging enforcement action. London-based wholesale lending and broking traders were a considerable source of support for the Cum-Ex trading which involved companies on the Germany FTSE-100 equivalent DAX exchange. For example, the shares in these companies were often borrowed from the custodian banks based in London.

By David Corker and Nick Barnard, Corker Binning, 26 March 2020

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