Canadian regulators play catch-up on U.S. RBC charges

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As Royal Bank of Canada prepares to defend itself against an explosive lawsuit launched by a U.S. regulator over alleged improper stock trading, authorities in Canada are scrambling to get up to speed on the case.

Canadian authorities, including the Office of the Superintendant of Financial Institutions and the Canada Revenue Agency, are now probing the allegations launched against RBC. But sources say U.S. authorities took the unusual step of giving their Canadian counterparts minimal warning – in some cases only hours – that a lawsuit was coming.

The Commodity Futures Trading Commission in Washington, D.C. is suing RBC over allegations that Canada's largest bank orchestrated hundreds of millions of dollars of improper "wash trades," where various arms of the bank traded large blocks of shares and futures between themselves, possibly distorting the market.

RBC has called the allegations "absurd." On Tuesday, RBC chief executive officer Gord Nixon said the bank intends to vigorously defend its reputation. "We certainly reject the allegations as unwarranted," Mr. Nixon said.

But as Canadian authorities began to sift through the complex series of allegations against the bank, new details emerged Tuesday that the CFTC had been in contact with RBC prior to announcing the suit, and is believed to have offered RBC a chance to settle. The bank is said to have passed on the chance to pay a cash penalty, believing it did nothing wrong.

The CFTC, which regulates derivatives trading in the U.S., has alleged that RBC was trading large blocks of shares and futures between its various subsidiaries as a way to take advantage of Canadian tax credits on dividend-paying stocks. RBC wanted to hold the shares for a year to gain a Canadian tax credit, but sold derivatives on those shares to mitigate the risk of stock prices fluctuating in that time.

According to the court documents, another arm of RBC purchased those derivatives in large block trades that were later reported to the OneChicago exchange in Illinois. The regulator alleges the RBC deals were executed without respect to market prices and without sufficient clarity to the market, and therefore violated U.S. trading rules.

The lawyer representing RBC said Tuesday that the bank informed the exchange and the regulator as far back as 2005 that it was making such large block trades between its various subsidiaries and asked if there were any concerns. Arthur Hahn, a partner at Katten Muchin Rosenman LLP in Chicago, said the bank was never told there was a problem, nor was it told to stop.

Mr. Hahn said the bank was contacted at one point by the CFTC looking for more information on the trades, but was not told to stop. The trades are considered wash trades, since the bank mitigates its risk by balancing a long position with a short position.

"We believe we fully and accurately reported [the trades]to them at the initial time," Mr. Hahn said. "And we believe that there simply is no question that the trading fit within their guidance."

Sources close the situation say Canadian regulators were surprised they weren't contacted by the U.S. regulator weeks or months ahead of the civil case being filed in a New York court on Monday, given that it potentially involves the Canadian Revenue Agency.

The CRA wouldn't comment Tuesday. However, the federal bank regulator OSFI acknowledged it is now looking into the matter on behalf of Canadian authorities to gauge the situation. "We have had meetings with the bank," said OSFI spokesman Rod Giles. "We're obviously aware of the situation... and we're monitoring things. But it wouldn't be appropriate to comment until the court has heard the evidence and the arguments from the various parties and issues a judgment."

A spokesperson with the CFTC would not comment further on the case Tuesday.

The case rests on how much information RBC disclosed to the CFTC. While the bank said it cleared its strategy with the regulator, the CFTC alleges that RBC didn't disclose that it would be both a buyer and a seller for these trades, and that it would set the prices internally without an independent, or arm's length, middleman.

"If you're going into the market and trading with yourself, you're sending a distorted signal," said lawyer Daniel Waldman, former general counsel at the CFTC and now a partner at Arnold & Porter LLP in Washington. To outside observers the trades appear legitimate, "when in fact you don't really care about the price because you're just buying and selling with yourself."

RBC's lawyer said the bank intends to show in court that the trades executed between the various subsidiaries of RBC were done at levels that closely tracked market prices, and were not done to distort the market or inflate profits.