There are many myths and misconceptions about the role that international finance centers, such as the British Virgin Islands and the Cayman Islands, play in international finance.
Sadly, many common narratives about IFCs do nothing to dispel these myths.
However, it appears that the conversation concerning the role of IFCs may now be changing. This can be seen in the publication of a number of recent academic works which highlight some of the real, practical and beneficial virtues of international financial centers.
Relevant examples of such work include Sutherland, Voss and Buckley’s article Chinese Incorporation for Institutional Arbitrage and Access to Finance in the IFC Review, which examines how IFCs allow Chinese companies to access capital and institutions that would otherwise be unavailable domestically.
A further key development can be seen in Gordon and Morriss’ paper Moving Money: International Financial Flows, Taxes & Money Laundering in the Hastings International and Comparative Law Review, which addresses some of the many misconceptions about IFCs and provides a considered view as to the important role that IFCs play in international finance.
Following on from these works, a further paper was recently published in the Tsinghua China Law Review. This paper, Seeking Truth From Fact: Rationale and Use of Offshore Jurisdictions in the PRC, looks at international finance centers in terms of the role they have played in the People’s Republic of China (PRC).
The following article will provide a condensed summary of some of the key arguments and observations raised in the Tsinghua China Law Review, which should be of relevance to anyone whose work or interests relate to the Asian markets.
The role of IFCs in Chinese FDI
IFCs have played a leading role in structuring foreign direct investment (FDI) into and out of the PRC. For instance, the BVI is the fourth largest recipient of global FDI inflows (receiving US$92 billion in 2013) and the second largest investor in the PRC (providing US$10.4 billion or 9.1 percent of inward FDI into the PRC in 2010).
The three largest sources of FDI into the PRC come from the BVI, Cayman and Hong Kong. Given the large fund flows that pass between the BVI, Cayman and the PRC, it is frequently asked why such small Caribbean islands should be both significant recipients of global FDI and leading contributors of FDI into the PRC.
A common response to this question is to claim that IFCs are used in order to avoid taxes and to enable the round-tripping of funds. Round-tripping is a process whereby funds are routed offshore in order to return to the PRC as “foreign” capital and therefore allow PRC companies to utilize certain tax and legal advantages that are given to foreign investors.
Many observers work under the assumption that the use of IFCs represents round-tripping behavior. However, this approach is problematic as it fails to consider the practical and commercial rationale behind the use of IFCs in structuring international finance transactions. In addition, the round-tripping assumption is based on flawed analysis, particularly as the argument is based on an outdated academic paper which is irrelevant to any discussion of IFCs, given that recent Chinese legal developments have restricted the ability of Chinese enterprises to round-trip funds. However, despite the implementation of these restrictions on round-trip investments, the use of IFCs in PRC investment has continued to grow. This suggests that there are other more important drivers behind the popularity of IFCs.
The legal, economic and political context
In order to understand what has given rise to the popularity of IFCs in the PRC, it is important to look at the legal, economic and political context which led to the use of these jurisdictions. The key point to consider is that the PRC has been in a continual state of development, given that the PRC was opening up to the world and moving towards a more market-oriented system.
This led to the PRC experimenting with different legal and economic regimes, such as the special economic zones and the special administrative regions of Hong Kong and Macau, which operated with different tax and regulatory regimes to the rest of the PRC. Moving offshore was simply an extension of the same concept.
Similarly, with the move to a more market-based system, the PRC was left with inadequate corporate laws that were not well suited to modern international commerce. Given the difficulties with implementing new market-based laws in the PRC, a preferable solution was to adopt the laws of a third jurisdiction by locating transactions offshore.
As a result, IFCs, such as the BVI and Cayman, were frequently used by PRC enterprises as a means to overcome legal and regulatory deficiencies in the Chinese legal system. The BVI and Cayman were an obvious choice for Chinese investors, given that they are common law jurisdictions, with modern commercial courts, whose ultimate court of appeal is the Privy Council in London. As a result, these IFCs offered the advantages of legal stability, commercial flexibility and modern corporate law.
Inward FDI: Access to finance and legal solutions
The need for legal stability and commercial solutions was essential for Chinese enterprise, as there were certain features of Chinese law and the PRC economy that inhibited the growth of PRC companies. As a result, IFCs were used as a platform in order to access international capital, and to rely upon the legal rights and remedies offered by mature and modern common law jurisdictions.
In terms of finance, lending in the PRC was traditionally the sole preserve of state-owned banks. This resulted in preferential treatment for state-owned enterprise, whereas private enterprise found it difficult to access funds. By relocating to IFCs, entrepreneurs were able to access the international capital markets, as lenders and investors were more familiar with BVI and Cayman companies and comfortable with the common law concepts underpinning the jurisdiction.
Similarly, lenders preferred BVI and Cayman companies as security could be taken over their assets or shares. This was a key issue in certain types of lending, such as acquisition finance, as a PRC target would not generally have the ability to give credit support by way of guarantee or security over its assets to a lender of offshore acquisition debt. Additionally, BVI and Cayman companies were chosen for the purposes of international listings, as it was not feasible to use PRC companies owing to a number of institutional and legal factors in the PRC which impeded the listing of their shares.
In terms of law, IFCs were frequently chosen due to the inherent advantages of its legal system. BVI and Cayman companies operate with minimal regulatory interference and a high level of corporate flexibility. Foreign law contracts are enforceable in these jurisdictions and the law provides shareholders and creditors with certain rights and remedies. Given the advantages of IFCs, they were frequently used as a means to structure transactions where PRC law proved inadequate.
For example, BVI and Cayman companies are frequently involved in M&A deals involving PRC companies. It is preferable to structure the acquisition of a PRC company offshore, through the use of a company incorporated in the BVI or Cayman, as such transactions are generally not subject to PRC jurisdiction and review. In addition, the laws of BVI and Cayman provide for cross-border mergers, which are not recognized under PRC law, so there is more flexibility available when the deal is structured in an IFC.
The BVI and Cayman have also been used in private equity deals in the PRC. Investors have historically been concerned about investing in the PRC due to weak shareholder protections, inadequate corporate legislation, the risk of government intervention and uncertain market conditions. Key issues have included an absence of legal concepts traditionally seen in private equity deals.
For instance, PRC law has not provided for preferred share rights or anti-dilution provisions, which led to investors preferring to structure the deal offshore, where such rights were recognized.
Outward FDI: Holding companies and joint ventures
IFCs also play a significant role in outbound investment by Chinese enterprises. According to an OECD review of PRC outward investment, 80 percent of the PRC’s outward FDI flows headed towards three economies from 2003 to 2006, namely Hong Kong, the BVI and Cayman.
IFCs have been popular tools for outward investment, given legal and policy limitations in the PRC which have inhibited investment. For instance, PRC enterprises had a number of domestic constraints including a cumbersome government approval process, problems with access to finance, a lack of currency convertibility and a lack of experience. In addition to internal constraints, PRC enterprise faced external constraints, such as the problem of negotiating complex foreign regulations, the need to ensure legal certainty in the investment structure, the need to protect investments against risk, and the need for corporate flexibility. All of these are factors which tend towards the use of offshore vehicles.
For example, BVI and Cayman companies are often used in project financing. One advantage is that these IFCs have modern security regimes and allow for security to be taken over a company’s assets with free choice as to the governing law of the underlying security agreement. This assists with the ability of a group to raise finance.
To take another example, BVI and Cayman companies have been used as listing vehicles and holding companies. For example, at the end of 2012, about 1,137 companies (or approximately 75 percent of all listed companies) on the HKSE Main Board and Growth Enterprise Market were incorporated in an IFC.
Furthermore, one study of listed Chinese companies on the HKSE, NYSE and Nasdaq found that of 72 sample firms, 42 had one or more BVI holding companies. It was observed that these holding companies were generally used as a means to control the underlying operating companies and to effect any acquisition or sale of the underlying companies at the offshore level. As a result, corporate transactions could rely upon the flexibility and certainty provided by the laws of Cayman and the BVI in accessing international capital markets and in structuring multi-jurisdictional transactions.
IFCs are also frequently used to structure joint-ventures, as they can be used as a means of sharing legal and financial risk. Taking Africa as an example, BVI and Cayman companies have frequently been used in African FDI as the joint venture, acquisition, holding or investment vehicle. However, PRC investors have encountered risks in investing into Africa due to the unstable local business, political and legal environment. The legal systems in African countries are often undeveloped and unfamiliar to Chinese investors and carry the risk that, in the case of disputes, the dispute may not be settled efficiently or effectively. As a result, BVI and Cayman companies have been used as they permit access to a familiar and stable system of law and ensure that disputes can be settled in a neutral jurisdiction where no party has a home-field advantage.
Contrary to the popular view that IFCs have been used in the PRC for the round-tripping of funds, it is clear that this theory is not only outdated, but fails to account for the complex ways in which IFCs have been used to resolve legal and financial issues resulting from inefficiencies in PRC law. The prominence of IFCs in Chinese foreign investment can mainly be seen as serving a legal need. Legal solutions were required in order to ensure the effective management, ownership and control of investments into and out of the PRC and such solutions were found by utilizing companies incorporated in Cayman and the BVI.
The full paper was originally published in the Tsinghua China Law Review, 6 TSINGHUA CHINA L. REV. (2014) and is available here