U.S. regulator accuses Royal Bank of 'wash trade' scheme

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Royal Bank of Canada has been accused by U.S. regulators of breaking the rules in order to orchestrate a complex trading scheme to gain a tax advantage in Canada.

The Commodity Futures Trading Commission, which regulates derivatives trading in the U.S., said in court documents Monday that senior officials at RBC created "a wash trading scheme of massive proportion" that enabled it to earn Canadian tax credits.

The scheme is the largest that the CFTC has ever brought forward based on the value of the securities traded, which it said were in the "hundreds of millions of dollars." But the bank issued a statement strongly denying the charges, saying it sought clearance from the CFTC as far back as 2005 to make the trades in question. A bank spokeswoman said the impact of the case was "not a financially material event."

While it is unclear what financial sanctions RBC would have to pay if found in violation of the law, the case has raised eyebrows on both sides of the border, and is expected to draw scrutiny from tax authorities in Canada. And it is based on transactions involving a number of RBC divisions.

The CFTC alleges that the scheme involved the bank purchasing dividend-paying stocks in the U.S. and Canada in order to gain lucrative tax credits.

RBC subsidiaries then exchanged shares and futures contracts between themselves – and by doing so, effectively influenced prices and nullified the risks posed by owning those shares.

The CFTC has deemed this strategy to be a "wash trade." A wash trade is a trade that involves the purchase and sale of a security either simultaneously or within a short period of time, sometimes to manipulate price or to create the false appearance of market activity, and is illegal under the U.S. Commodity Exchange Act. Under this legislation, market participants can't use multiple futures contracts that offset each other to hedge positions.

In the case of U.S. stocks, RBC believed that under Canadian tax rules, it could use the taxes it paid on U.S. dividends to help offset its Canadian taxes. For that reason, the bank is alleged to have bought large quantities of U.S. stocks near their dividend dates through its Caribbean subsidiaries.

On top of conducting wash trades, the CFTC also alleges that RBC set prices for the futures internally, which means the contracts weren't subject to competitive market pricing. By doing so, the regulator believes the bank intended "to negate risk and price competition."

The CFTC also alleges that RBC misrepresented what it had done in discussions with regulators.

But the bank said Monday that regulators raised no problems with this strategy when it ran the idea past the CFTC in 2005.

"Before we made a single trade, we proactively contacted the exchange to seek its guidance. These trades were fully documented, transparent, and reviewed by both the CFTC and the exchanges, and for the next several years were monitored by them," the bank said in a statement. "RBC's trading was permissible in 2005, and it is permissible today under the CFTC's published guidance."

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

However, the CFTC argues that it was led to believe that the trading prices were set by arm's length parties. Rather, the regulator alleges: "RBC traded almost exclusively with its subsidiaries at prices that were not determined by competitive market forces."

RBC said in a statement the trades did not distort the price in the market of the stocks and were above board.

The CFTC is seeking a jury trial in New York to settle the matter. The regulator can seek greater of three times the amount RBC gained from the trades, or about $135,000 (U.S.) per violation. The number of violations has yet to be determined.

Neither the CFTC nor RBC gave any indication of the value of the tax credits the bank was able to access via the strategy.