Here's the simple explanation: The two firms essentially perform a "stock swap." The investment bank buys stock from a hedge fund. While holding the stock, the bank makes payments to the hedge fund equivalent to the dividends earned and appreciation in the stock's value. In return, the hedge fund makes payments to the bank in the form of a benchmark interest rate.
The hedge fund is now earning tax free dividends on the stock because it technically no longer owns it. Meanwhile, the investment bank that does own the stock, and therefore must pay tax on the dividends, offsets the tax payments by expensing the very swap payments it made to the hedge fund. This swap has helped hedge funds avoid payment of $1 billion in taxes. According to the article:
- The government's question: Are the trades executed for any purpose other than to sidestep the dividend tax?
This question sounds eerily similar to the questions being asked of telecom carriers in 2001 during the bursting of the bubble. You may recall that carriers would perform similar "swaps" when Carrier A and Carrier B would sell each other a similar amount of capacity on their networks. The move would have no economic impact on their business but would boost revenues. The SEC asked the same question then: Were the swaps performed for legitimate business reasons or were they for the sole purpose of reporting misleading revenues?
Swaps were OK as long as they were reported separately from the company's regular balance sheet. But this was not always practiced. Joe Nacchio, the former CEO of Qwest Communications International Inc. (NYSE: Q), reported swaps like this in 2001 while his company's inflated stock was in a free fall.
That was 2001's bubble. Today's housing and financial services bubble now seems to have similar ingredients to the one this industry is all too familiar with.
— Raymond McConville, Reporter, Light Reading