U.S. anti-inversion regulations badly miss target

Medtronic joined a parade of prominent U.S. companies that have set up operations overseas to lower their tax bills. Medtronic shifted its official headquarters to Ireland after acquiring Dublin-based rival Covidien for $50 billion in January 2015. - Photo: Bloomberg

According to the simple Civics 101 view of American government, laws are passed by the legislative branch, interpreted by the judicial branch, and enforced by the executive branch. In reality, both the president and his executive agencies exercise broad rule-making authority, either because Congress has delegated it to them or, more commonly, because they grabbed it for themselves. This is particularly true in the area of tax, where unelected bureaucrats create and amend rules at tremendous cost to private firms and the economy. Examples include the so-called debt equity regulations proposed under Section 385 of the U.S. tax code and related anti-inversion rules.

Medtronic joined a parade of prominent U.S. companies that have set  up operations overseas to lower their tax bills. Medtronic shifted its official headquarters to Ireland after acquiring Dublin-based rival  Covidien for $50 billion in January 2015. - Photo: Bloomberg
Medtronic joined a parade of prominent U.S. companies that have set up operations overseas to lower their tax bills. Medtronic shifted its official headquarters to Ireland after acquiring Dublin-based rival Covidien for $50 billion in January 2015. – Photo: Bloomberg

Targeting inversions

The White House and Democrats in Congress have made corporate inversions a political campaign issue. They have demonized companies moving offshore as “unpatriotic” because they refuse to pay their “fair share.” Rather than reform the problems with the tax code that are driving companies away – high rates, a world-wide system – they think it’s possible to tweak the rules and limit corporate mobility.

Trying to stop companies from moving to jurisdictions with more favorable tax and regulatory systems is a fool’s errand, but it is nevertheless what Treasury Department regulators are seeking to do.

In April they proposed sweeping new regulations that had the immediate effect of scuttling a planned merger between Pfizer and Allergen. In order to make inversions less attractive, the rules require that certain kinds of debt common in inverted and other multinational corporations be treated instead as equity, which is taxed at a higher rate. But the rules are so broadly constructed that they will hinder ordinary business and financial transactions not typically associated with inversions or tax avoidance, like shareholder loans, securitization transactions, and cash pooling. And in addition to the debt equity rules are changes to how multistep acquisitions are considered for tax purposes under Section 7874.

 

Questionable authority and process

Section 385 was established in 1969 as part of the Tax Reform Act of 1969. Seeking to address a growing body of inconsistent case law, Congress gave Treasury authority to establish guidelines and factors to consider for courts distinguishing between debt and equity. Congress intended for regulators to inform the judiciary by clarifying the law, not for them to take on the role of the courts and make those determinations of fact for themselves.

In a prior and equally foolhardy attempt in 2004 to limit reincorporation abroad, Congress enacted Section 7874. It established that a foreign corporation must own over 20 percent of the U.S. corporation in order for the inversion to be valid. The new rules would make it harder to reach that threshold by discounting other acquisitions within the last three years even if they are not directly related. Although Congress set clear guideposts, Treasury is doing everything in its power to undermine or disregard them altogether.

Their procedures are also questionable. In a recent letter, Senate Finance Committee Chairman Orrin Hatch observed, “the Treasury Department is moving at an unprecedented pace and is attempting to regulate a very complex area on a very short timeline.” He faulted regulators for providing, “no advanced notice of the proposed regulations … prior to the early April promulgation.” Further, “Only the standard 90 days was given for written comments to be submitted – despite their tremendous complexity, and despite numerous calls from the business community and tax-writing members of Congress to extend the comment period.”

The U.S. Chamber of Commerce filed a lawsuit in August, arguing that the multiple acquisition rules are not a good faith interpretation of the law and were tailored specifically to impact the Pfizer-Allergen deal. They cite the fact that, once finalized, the rules will be retroactive to the date they were first proposed and thus capable of thwarting current deals despite not going through the full regulatory process. Courts have struck down other overreaching agency interpretations in the past.

 

Congressional opposition

Distraught businesses have found generally receptive ears in Congress. Republicans on the Senate Finance Committee noted in an Aug. 24 letter to Treasury Secretary Lew noted that they “have repeatedly raised concerns … in regards to the range of negative, unintended consequences of these proposed rules, if finalized without substantial reforms.” In his separate letter, Committee Chairman Hatch asked for the rules to be re-proposed in light of the questionable nature of their original introduction and the rushed procedures.

Even Democrats have raised concerns. Although supportive of the rule’s intentions, their members on the House Ways and Means Committee noted in their own letter to Treasury that there are “broader concerns related to various internal cash management practices such as cash pooling,” and asked for consideration of exceptions or transitional rules. Their Republican colleagues were more direct: “The proposed regulations in present form will have a profound and detrimental impact on business operations nationwide.”

 

Offshore and economic impact

Perversely, the debt equity regulations aimed at preventing inversions will likely lead to more corporations leaving U.S. shores. Only instead of inverting, they will simply be acquired by foreign firms. That’s because complexity and costly regulatory burdens put American companies at a global disadvantage. Ernst & Young already estimated a loss of $769 billion to the U.S. over the last decade from such mergers and acquisitions, but that figure would surely increase under the new rules.

Much of the added burden is thanks to the added information reporting required to enforce the regulations. Businesses will have to supply loads of documentation just to make a transaction between two subsidiaries of the same business. The IRS estimates the reporting costs at $15 million annually, though business groups argue they severely underestimate the impact. Business Roundtable suggests the costs of compliance could reach into the millions just for each company.

Ernst & Young’s James Tobin rebuts the Treasury claim that the rules address the problem of inconsistent analysis by different courts, arguing, “the Proposed Regulations merely add costs and the administrative burden of threshold documents for all intercompany debts but with no added certainty.” And the fact that U.S. companies operating overseas must not only comply with the regulations in the country they are operating in, but also with the new reporting burdens from the debt equity regulations, further adds insult to injury. The rules provide yet another reason for new businesses to choose to headquarter anywhere but the United States.

Compounding the damage to the economy is the fact that the rules are backdated to an effective date of April 4, 2016. So even though the rules may not be finalized until later this year or even next year, they are impacting the behavior of companies right now. Businesses are operating under significant and unnecessary uncertainty as the regulations proceed through the rule-making process, a price which Treasury consciously calculated was worth paying in order to torpedo the Pfizer-Allergen deal for political reasons.

The proposed regulations are having an impact now. They will do even more damage if Treasury follows through on its original intention to rush the regulations out the door before the end of the current administration. Given historical precedent, however, we can expect even more aggressive attempts to follow closely behind, as no amount of bureaucratic rule-making will render the hostile U.S. corporate tax code attractive. Only Congress has that power.

Correspondent banking: The ‘de-risking’ phenomenon

In the face of the constant changes and challenges caused by the imposition of global regulations and anti-tax competition initiatives, Caribbean IFCs continue to stand the test of time, thereby validating the role they play in furthering business and investments in the major global economies. The Caribbean IFCs, amid the clamor for greater transparency and censorship on legitimate tax planning practices, demonstrate that they are a durable and valuable part of the modern global economies and very integral to wealth management and wealth structures for high net worth clientele.

That being said, Caribbean IFCs remain under global scrutiny and pressure with the latest round of challenges remaining in play, i.e. – Base Erosion and Profit Shifting (BEPs), outcry for public beneficial ownership registries, the U.S. Foreign Account Tax Compliance Act (FATCA), the OECD’s Standard for Automatic Exchange of Financial Account Information in Tax Matters (aka the Common Reporting Standard (CRS), and the withdrawal of correspondent banking in the region.

Caribbean IFCs, rising to the challenge and refusing to be knocked out, continue to work even harder to address these matters; the outcome thus far giving rise to better governed and transparent financial sectors throughout the region in comparison to onshore jurisdictions.

Better governed and transparent financial sectors may, however, prove insufficient to overcome the challenges faced, given the curtailment of and in some cases withdrawal of correspondent banking relations in the Caribbean region. This issue on its own, continues to be a growing multifaceted problem for regional financial institutions, and with it an overarching threat to erode the ability to do business whatsoever in the region should correspondent banking cease entirely. It shall have a direct impact on each jurisdiction’s legal, regulatory and administrative frameworks for tax transparency, bank supervision, financial services and anti-money laundering (AML) and counter-terrorist financing (CFT).

 

Drivers for ‘de-risking’ may go beyond anti-money laundering/terrorist financing

The main correspondent banking relationship providers in the Caribbean are located in the United States, Canada, and to a lesser extent Europe and elsewhere in the Caribbean.

By any measure, the primary driver for the withdrawal of correspondent banking in the Caribbean region is said to be AML and CFT. Notwithstanding, and in the face of better governed and transparent financial sectors in the region to combat the said AML and CFT, it appears that this may not be the primary driver, given that de-risking continues to occur and pose an impact.

The potential drivers of de-risking, as identified in preliminary information gathered by FATF, with input from the private sector, highlights that there is a continued need to improve the evidence base in order to determine the causes, scale and impact of de-risking.  The FATF approach to de-risking is based on its recommendations, which require financial institutions to identify, assess and understand their money laundering and terrorist financing risks, and implement AML/CFT measures that are commensurate with the risks identified.   The FATF is undertaking work to further clarify the interplay between the FATF standards on customer due diligence, correspondent banking and other intermediated relationships, and wire transfers.

While awaiting findings of such work, I would make an educated guess, and conclude that the age-old taint of tax havens and the undying debate of tax evasion vs. tax avoidance, is at the heart of and the basis for the conclusion and treatment of the Caribbean region collectively as high risk, and of which the region is dealt with in a likeminded manner – de-risking and sanctions for all! This categorization and unwarranted fears fuel the unfair, prejudicial and punitive “do or die” treatment of the Caribbean IFCs in this de-risking phenomenon.

At no point in time is it apparent that Caribbean IFCs have been allowed a fair opportunity to address the ill-conceived fears. Upon a proper identification and assessment of any risk and issues that arise, it would become apparent that the necessary measures have been and/or are being put in place to combat and set such fears aside. Instead, unilateral actions are taken by countries and international financial banking institutions in the U.S. and Europe, to stymie business in the region, for what only can be viewed to have one main purpose – seeking to destroy the sector so as to maximize/ preserve their own revenue streams; to their benefit and to our detriment – all of which is based on a flawed cost benefit analysis.

De-risking makes no commercial sense; correspondent banking being an important component of global public policy and because of the valuable role in plays to facilitate inter alia international trade and foster economic wellbeing. It is the strategies of, and analysis done by such countries and the financial banking institutions of the U.S. and Europe that should be reviewed.

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By any means necessary:  The offensive and defensive plays

This de-risking phenomenon has not stopped the jurisdictions from fighting head on. The region as a whole is addressing and prepared to stay in the game with support from the Caribbean Secretariat and the International Monetary Fund (IMF) urging the Caribbean region to put in place a plan of action to address the withdrawal of correspondent banking.

Thus far, and as evidence of the continued efforts of the varying Caribbean jurisdictions, the respective financial sectors (and its participants) have implemented and/or embarked upon the implementation of the following, in an attempt to be even more transparent, meet international standards, and most importantly, reduce the risk of losing correspondent banking relations: –

  • Greater tax transparency – e.g., meeting the OECD/G20 established “objective criteria”
  • Greater AML/ CFT monitoring
  • Implementation of Basel II to meet international standards
  • Joining the SWIFT/ KYC Registry so as to improve inter alia, the respective institutions risk rating, i.e., reputation, profile, compliance within the correspondent banking arena. The Caribbean Association of Banks has endorsed this Registry.
  • Financial sector participants entering into negotiations with service providers or other institutions in order to provide alternate methods of service that benefit everyone involved.
  • Legislative initiatives to enact legislation and policies to the benefit of the financial sector and its participants (financial institutions, service providers and customers alike)
  • Governmental lobby initiatives (heads of government) to address stakeholders of the international financial institutions, affiliated governments and international bodies relating to same
  • Integration and cooperation.

 

What if?

According to the IMF, as of May 2016, at least 16 banks in the region in five countries have lost all or some of their correspondent banking relationships .

In that regard the region has seen the termination of correspondent banking relations from Belize, Montserrat, Barbados, the Bahamas, the Eastern Caribbean, Guyana, Haiti, Jamaica and Trinidad and Tobago with the shroud of curtailment and/or withdrawal of relations in other jurisdictions, and possibly the entire region. Banking fees to conduct business are now higher and appear in most cases to be punitive.

Should the day ever arise where there is wholesale termination of correspondent banking relations within the region, chaos would ensue within the respective financial sectors, as correspondent banking relations are crucial to the conduct of any business transactions in this day and age (i.e., electronic wire transfers/remittances), and thereafter the negative spill-over into other sectors. Worse yet, the drive of legitimate business underground and the realm of the black market.

That day, however, has not and will not come if the region continues to deal with its challenges head on. In that regard, the ECCB/ OECS Monetary Council has given consideration to the region opening a correspondent Caribbean bank (non-deposit) in the U.S. The proposed plan to establish is in theory good, but there must be a strategic assessment of it, and thereafter proper execution, since without such components it will not work.

 

Conclusion

Under no circumstances can it be acceptable to de-risk an entire sector and region.

The Caribbean region is by far more transparent and compliant with international standards, and in continuing to address as set out above, the region shall weather the storm.

The region must do all it can to address this threat relentlessly so as to combat any notion of loss of correspondent banking relations, and by extension, loss of access to the global financial markets.

Brexit, May and Cayman

The U.K.’s political landscape has completely changed since I wrote my last article for the Cayman Financial Review in early June.

Three weeks after that came the Brexit referendum, the delightful surprise of the vote for the U.K. to leave the European Union, closely followed by David Cameron’s resignation.

After a brief turmoil when no one seemed to know how to operate the Conservative Party’s internal rule book for leadership elections, Theresa May emerged as the new prime minister, not by election but by default as all the other candidates dropped out. George Osborne was removed as chancellor (“brutally sacked,” according to some press reports) and Philip Hammond appointed in his place.

So where does this leave the offshore world? What impact will Brexit, the new U.K. government, and the new government’s response to Brexit have on the global finance industry?

 

Inward or outward?

The big question is which response to Brexit the U.K. will adopt.

As we leave the EU, will we retreat inward to wallow in an insular “little Englander” mentality? Or will we return to the global expansiveness that once saw a small trading nation establish itself across the world? Or will we lose our nerve and end up with Brexit-lite, creeping shamefacedly back to Brussels to do a deal to keep things as much as possible as they were before?

Some signs are worrying, including the prominence of protectionist rhetoric in the campaign and the immediate post-referendum rush to analyze various forms of EU associate membership.

But other things are more positive. Twenty-seven countries, representing two-thirds of global GDP, announced almost immediately after the referendum that they wanted early trade agreements with the U.K., including not just the U.S. and Commonwealth giants such as Australia and India, but also quickly growing unrelated economies such as Brazil and China.

 

Role of offshore centers

Assuming the U.K. does opt for a global, expansionist economy, its historical and constitutional links with many of the world’s leading offshore finance centers could be a very valuable asset in recreating that international outlook.

Cayman and some of the other offshore finance centers play key roles in international investment and the global economy, and closer partnership with them could provide alternative channels for the U.K. into worldwide business once it loses some of its EU connections.

One of the main roles of offshore centers is to act as financial conduits, collecting capital and investing it around the world; the U.K. will want access to that stream of investment capital to offset any losses from Brexit.

But those relationships have, in some cases, been strained in recent years, particularly by the U.K. Treasury’s desperate desire to squeeze more tax out of its people. So the way the U.K. treats its associated jurisdictions will be important; will their attitude be one of openness or of inward-looking tax protectionism?

It is clear that the referendum was just the start of the process and the U.K. has major choices to make; the next few months will shape the direction of how it will use its newfound freedom of action.

 

Brexit and tax stability

Leaving the EU will have wide-ranging implications, including several important ones for international tax.

But it is important to avoid over-reacting. The U.K. has double tax agreements with every member of the European Union; these are all bilateral treaties, independent of the EU, and so will continue to operate in just the same way after Brexit is finalized.

Once it leaves the EU, the U.K. will lose the benefit of the Parent – Subsidiary Directive and the Interest & Royalties Directive, which allow payments of dividends, interest and royalties to and from companies in other EU members to be paid without withholding tax.

But the U.K.’s double tax treaties with the other EU member states already reduce those withholding taxes, in many crucial cases to zero; the U.K.’s tax treaties with Ireland, the Netherlands, France and Germany will still ensure that interest and royalties can be paid without withholding tax after Brexit.

There are a few gaps however; for example, the U.K.-Luxembourg treaty allows a 5 percent withholding tax on royalties and the ones with Estonia and Malta allow 10 percent withholding on both interest and royalties. Under some, such as Belgium or Italy, whether there is withholding tax can depend on the status of the loan or IP licence. These may require some adjustment of group structures to ensure that payments can continue to flow up the corporate chain without withholding taxes.

VAT is also deeply bound up in EU membership, but although the U.K. only adopted VAT as part of the process of joining, there is no talk of abolishing it or even of significantly changing the system. As time goes on, the U.K. and EU VAT systems will, no doubt, diverge slightly, but for now there will be little change.

 

Brexit and tax change

But although many tax matters will stay the same, there will undoubtedly be changes, and opportunities.

One welcome change will be that the U.K. will no longer be subject to the restrictions of the Code of Conduct on Business Tax. That will leave us more free to design competitive tax regimes, although only to the extent allowed by the OECD.

Presumably the U.K.’s associated jurisdictions, including the Cayman Islands, will also be able to escape the Code of Conduct; they were pressured to comply because of their connection with the U.K., so when the U.K. ceases to be a member of the EU, their reason for doing so will end. But that is one of the constitutional complications of Brexit that will have to be settled over the next couple of years.

In fact, the Code of Conduct had very little effect on the Cayman Islands, since it applies only to direct taxes, which Cayman has sensibly avoided imposing. Leaving it will be much more relevant to jurisdictions such as Jersey, where their tax systems used to impose income taxes on “local” companies but not on “international” ones, a regime that had to be changed when compliance with the Code of Conduct was imposed on them.

The U.K. will also be free of the EU’s State Aid rules; these were initially designed to prevent EU member governments from giving grants to failing businesses or industrial sectors, but recently they have increasingly been used to interfere in tax policy, with the EU Commission claiming that various tax exemptions amounted to a disguised subsidy and therefore were classed as illegal State Aid.

This is what the European Union recently used to strike down Ireland’s arrangement with Apple, levying a record-breaking retrospective 13 billion euro tax bill on the company that is causing a diplomatic row between the EU, Ireland and the U.S. Although I would not want to see the U.K. return to the days of subsidizing lame-duck businesses, the State Aid rules have been stretched too far; escaping them will avoid a lot of complications in setting future tax policy.

Leaving the EU would also have meant that the U.K. would no longer be subject to the Savings Directive (essentially the EU’s equivalent of the U.S.’s FATCA, a demand for automatic reporting or withholding taxes on interest payments to EU residents). Cayman and various other jurisdictions were pressured into signing up to that Directive because of their connections to the U.K., but technically they did so not via the U.K. but by a direct agreement with the EU. Perversely, the associated territories might have found it more difficult than the U.K. to escape the clutches of the Directive.

However, the Savings Directive is being wound down over the course of 2016 and 2017, to be replaced by compulsory reporting under the OECD’s Common Reporting Standard. By the time Brexit is complete, the Savings Directive should be generally irrelevant.

One issue that will need to be resolved, not to do with tax but important to offshore finance, is the U.K.’s access to EU financial markets under the MiFID passport. It would be a travesty if the U.K. was not able to obtain some sort of equivalence status, but depending on the precise deal obtained, there may need to be some reorganization of fund management groups that include the U.K., which will need careful tax planning.

 

The way forward

The main result of Brexit on tax policy is therefore that it gives the U.K. – and, to some extent, its associated territories – more freedom to set and develop its own tax structures.

That is why the future is so open; if the U.K. uses that freedom to return to nationalist protectionism, imposing more taxes on cross-border business, then it will be a disaster. The globalization of business and finance has been one of the great engines of growth over the last few decades, and if the U.K. uses its tax system to restrict that, it will make us all poorer.

Global finance is already struggling with the compliance burden of FATCA and the CRS; it does not need more restrictions from the U.K.

But alternatively the U.K. could embrace globalization and open its economy, becoming itself a trading and investment hub between Europe and the rest of the world.

 

Forthcoming opportunities

One test of whether the U.K. will become more open or more protectionist will be its attitude to the Base Erosion and Profit Shifting (BEPS) project of the OECD (Organisation for Economic Co-operation and Development).

BEPS is a huge change to the international tax system, but there are increasing concerns that it has been rushed and that it fails to create a coherent new structure. Some areas are particularly worrying, in particular its treatment of intellectual property.

The EU is an enthusiastic supporter of the BEPS objectives and is implementing its own version, but once the U.K. leaves the EU it will be able to make its own decisions.

It is highly likely that the U.S. Congress will refuse to implement BEPS. Will the U.K. continue to follow the EU’s protectionist stance and impose the BEPS restrictions, or will it join with the U.S. in supporting a more open global economy?

The other test will be taxpayer confidentiality. The EU has been pushing various schemes for public disclosure of private information, including (for individuals) beneficial ownership of trusts and shares and (for companies) country-by-country reporting.

None of this is necessary to prevent tax evasion; the tax authorities have other, and generally more effective, ways of getting the information that they need. Even without the Common Reporting Standard, information exchange on request is now well-established and is generally functioning smoothly.

Instead, as we saw in the Panama Papers leak, this information will mostly be used by prurient journalists to gossip about any figures in the public eye whose personal financial information will now become public knowledge.

These disclosures make the U.K. look hostile to international investment, and by adding another layer of administrative costs they discourage global finance. If the U.K. continues to impose these requirements once it leaves the EU, it will be a bad sign that it is still stuck in protectionism rather than embracing an international outlook.

 

The new U.K. government

So which stance will the new U.K. government adopt? Will it adopt a protectionist attitude, more fearful that international investment will risk tax revenues, or will it look outward and embrace the opportunities that Brexit offers to reshape its tax system to make its economy more internationalist, and seek the advantages, the increased jobs and wealth that come from global engagement?

It is difficult to know which way Theresa May will move. She was Home Secretary for all the time that the Conservatives were in office, since 2010 (one of the longest holders of that difficult office). And before that, when her party was in opposition, she was variously spokesman on transport, employment, education and media, as well as doing a stint as party chairman.

She has therefore said very little about tax or economic matters, or even about international affairs, although her recent comments as prime minister have been encouraging:
“This country has always been one of the greatest trading nations, and as we leave the European Union we will have the opportunity to embrace new markets and opportunities as we export British innovation and expertise to the world. I am determined to make the most of the opportunities Brexit presents.”

Although May was in the “remain” camp in the EU debate, she has accepted the referendum result and has appointed a strong team of “leave” supporters to manage the Brexit process, in particular David Davis as “Brexit Minister” (formally Secretary of State for Exiting the European Union) and Liam Fox heading a newly created Department for International Trade.

Both of them are expected to be enthusiastic embracers of the opportunities Brexit offers for a more open and international economy.

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The new chancellor

As the prime minister seems to have little involvement in finance or economics, those of us interested in tax are closely watching the new chancellor, Philip Hammond.

Although initial impressions are encouraging, he is something of an unknown quantity; one profile said that he “has long sought to guard his privacy by appearing to be less interesting than he really is” – a rare quality in a politician.

One very positive aspect is that he has much more experience in business than his predecessors. He didn’t become an MP until he was 42, which gave him time for a first career founding and running various businesses, including property, manufacturing, healthcare and oil, plus stints as a World Bank consultant. In contrast to his predecessor, who inherited money and had little experience outside politics, Hammond probably has more business experience than any chancellor since Neville Chamberlain in the 1930s.

Hammond was also a eurosceptic for most of his time in politics, although he supported Cameron’s “renegotiation” and campaigned for “remain” in the referendum, to some surprise. Had he publicly supported the “leave” camp, he might now have been prime minister, being less controversial than Johnson or Gove, the main leadership challengers from the “leave” side.

On fiscal policy, Hammond appears to be as “dry” as his image; he was George Osborne’s number two when the Conservatives were in opposition and so was one of the architects of the “austerity” manifesto, the commitment to eradicate the government’s deficit mainly by cutting government spending.

However, he was not given a Treasury post after the 2010 election because the Conservatives failed to win an outright majority and such an important post had to go to a Liberal Democrat under the coalition agreement. Instead, Hammond ran first Transport and then Defence, subsequently being made Foreign Secretary. This meant that he was not part of Osborne’s abandonment of austerity and subsequent over-spending, so the seemingly ever-increasing government debt cannot be blamed on him.

As foreign secretary he was involved with some of the offshore centers, and went on the record earlier this year to “reassure him [The Hon. Alden McLaughlin] of the U.K. support for the Overseas Territories,” and one of his early comments as chancellor was that the U.K. would continue to be “outward-looking,” “building on our productive, open and competitive business environment” to “attract companies to invest and grow in the U.K.” and ensure that we make a success of Brexit.

That is all encouraging, and Hammond appears to have genuinely sound pro-business instincts and to believe in balancing the budget; he has said he “strongly believes…the first responsibility of government is to promote economic stability, sound money and prudent public finances.”

That’s a good start for a chancellor, but unfortunately there are signs that he has fallen into the Treasury trap of believing that the way to “prudent public finances” is not to control spending but to squeeze ever more money out of the taxpayer.

His voting record as an MP is mixed, voting to cut taxes in some cases (increasing the income tax threshold; cutting corporation tax) but to increase them in others (primarily “green” and “sin” taxes); encouragingly, he voted against country-by-country reporting. But in general his voting record reflects his party’s position; it is probably going too far to read any personal beliefs into it.

But if his background is encouraging, his early actions as chancellor are less so; in the last few weeks the Treasury has announced that penalties for offshore tax evasion are to increase from 200 percent to 300 percent (not very important, as offshore tax evasion is very rare, but a worrying sign that the Treasury is still obsessed with headline-catching initiatives) and an alarming proposal to fine advisers over their tax advice, which could make it more difficult for companies to get proper professional assistance.

 

Uncertainty, but optimism

The way forward, and the stance of the new government and chancellor, is so far unclear, but the government seems keen to make Brexit happen and make it work, and the chancellor appears to have sound financial and business instincts.

The question is whether the government has the will to make the radical changes, of attitude as well as law, which are needed to take advantage of Brexit.

The U.K.’s associated offshore finance centers could be valuable partners in re-forging international ties for the U.K., if the Treasury can see the bigger picture and work with them.

Prosecuting money laundering offenses in the Cayman Islands: A balancing act

All thieves tend to spend the proceeds of their [crime] if they can before being apprehended. […] Alleging that they are also money launderers because they manage to spend some or all of the proceeds of their predicate crime generally adds nothing to the gravity of their conduct. […] I see no necessary public purpose in proceeding with the counts of money laundering on the facts of this case.”

These were the words of the trial judge in a sentence ruling dated Aug. 1, 2016, in a case before the Grand Court of the Cayman Islands. The defendant pleaded guilty to six of 14 counts of a criminal indictment, nine of which related to money laundering offenses under the Proceeds of Crime Law (2014). Among the guilty pleas were two for money laundering offenses.

Many in the financial sector in the Cayman Islands may be familiar with this case. However, few may have given much thought to the potential impact of the judge’s actual approach.

The Cayman Islands has worked hard to establish its reputation as a leading international offshore jurisdiction. It has, with great effort, emerged from the shadows of being considered a non-compliant, secretive jurisdiction, and a haven for financial evil-doers. In this regard, it is well documented that during the third round of mutual evaluations based on Financial Action Task Force standards, the jurisdiction achieved a high degree of compliance when compared with several advanced economies.

The jurisdiction has, over the years, also put in place a framework to protect against the threats of money laundering and terrorist financing to the broader economy and financial system, with the goal to put the Cayman Islands in a position to maintain reputational integrity and security in the financial sector and the economy as whole, and to comply with international standards set by the FATF.1

In 2017, the Cayman Islands will be undergoing a fourth round of mutual evaluation based on FATF standards. In the fourth round, jurisdictions will be assessed not only for technical compliance with the FATF 40 Recommendations, but also on the effectiveness of 11 Immediate Outcomes.

Of particular relevance to the present discussion is how the Cayman Islands will fare on the assessment of the 7th Immediate Outcome that will seek to measure whether: “Money Laundering offenses and activities are investigated and offenders are prosecuted and [made] subject to effective, proportionate and dissuasive sanctions.”

In addition to the 10 other Immediate Outcomes, what the assessors will be primarily focused on is how well the component parts of this 7th Immediate Outcome operate to mitigate the money laundering risks in the Cayman Islands. They will therefore be assessing effectiveness of the jurisdiction’s AML/CFT enforcement mechanisms.

The incidence of prosecutions for all types of money laundering, including self-laundering (i.e. where the person is involved in the predicate offense) will also be reviewed, and an important component will be the extent to which offenses are investigated, prosecuted and offenders convicted of money laundering and sanctioned appropriately.

The relevance of the judge’s comments should now be immediately apparent. While one should always be respectful of the judiciary’s freedoms and cognizant that precedent and sentencing rules may have played in a part in the outcome of this particular case, context must not be overlooked in the consideration of matters such as these.

To this end, the following are particularly relevant: (i) the crime occurred in or originated from the Cayman Islands; (ii) the reputation of the jurisdiction is of utmost importance to our standing in the international offshore financial sector; and (iii) the jurisdiction has a major role to play in, and international commitments relative to, deterring money laundering and countering the financing of terrorism.

Because of these and other factors, prosecuting the money laundering offenses under the Proceeds of Crime Law (2014), (and moving away from the practice of having the charges “lie on the file”) is supremely important, and may well be even more important in the Cayman context.

The judge in our local case referred, inter alia, to judicial guidance offered in R v. GH2, a recent case heard in the Supreme Court of England and Wales, which effectively dissuaded the prosecution of the money laundering offenses in circumstances where guilt is established in the predicate offenses. It would be a national dilemma indeed if the Cayman Islands followed precedent, but were to fail the assessment of the 7th Immediate Outcome as a consequence.

Perhaps the answer lies in a consideration of a broader “public purpose” in the context of the Cayman Islands, since we are but three small islands trying to maintain a large international reputation for compliance, not only with anti-money laundering measures, but also for tax information transparency and international cooperation.

The Cayman Islands should seek to better balance the impact on the gravity of a criminal’s conduct with a clear understanding of the jurisdiction’s reputational risk in the context of compliance with anti-money laundering standards than may have been reflected in the judge’s remarks, to ensure that every aspect of our national framework to deter money laundering and counter terrorist financing should be seen as working cohesively in order to demonstrate effectiveness.

 

ENDNOTES
  1. Although the recent national risk assessment identified a few areas where further strengthening is required, it is notable that steps are being taken to address these and to enhance the legislative framework accordingly.
  2. [2015] UKSC 24.

OECD Watch

oecd-logoThe Organization for Economic Cooperation and Development (OECD), operating at the behest of its high-tax member nations, has gradually carved for itself a central role in global tax matters over the last two decades. Today, its many initiatives impact and undermine global economic activity in a variety of ways. OECD Watch summarizes and analyzes the organization’s recent activities relating to international finance and tax matters.

 

Base erosion and profit shifting

The BEPS project continues to steam ahead. The OECD has recently released guidance and solicited feedback on several of the action items, including implementation of country-by-country reporting (Action 13), additional guidance on the attribution of profits to permanent establishments (Action 7), revised guidance on profit splits (Actions 8-10), and discussions of interest in the banking and insurance sectors (Action 4) and branch mismatch structures (Action 2).

Representatives from more than 80 countries met June 30-July 1 in Kyoto, Japan in a new “inclusive framework” on BEPS implementation. The “inclusive” part of the approach seeks to placate low-tax and non-OECD jurisdictions that might object to the effort as an attack on their fiscal sovereignty by making it seem as if their input matters. At the meeting, attendees began a process for “establishing terms of reference and methodologies for the peer review of the 4 BEPS minimum standards by their next plenary meeting in January, so that the review of progress on implementation can begin as quickly as possible.”

The OECD further reported progress in drafting the text for the BEPS Multilateral Instrument (MLI), with the expectation that it be ready for signatures before the end of the year. According to the OECD, “The MLI will allow countries to meet the BEPS minimum standard aiming to put an end to treaty shopping (Action 6),” and “address the issue of hybrid mismatches, the updated definition of the ‘permanent establishment’ concept, other forms of treaty abuses with specific treaty rules, as well as improving dispute resolution processes.”

 

Identifying non-cooperative jurisdictions

According to the July OECD Secretary-General Report to G20 Finance Ministers, the OECD has agreed on criteria by which it will be determined whether a jurisdiction is “cooperative with respect to international tax transparency.” Initially, it includes requirements for implementation of the Exchange of Information on Request standard, the Automatic Exchange of Information standard, and the joining of the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.

Benchmarks for at least two of the three criteria would need to be met for a jurisdiction to be considered cooperative. Though it should be noted that extra language was included that is clearly designed to ensure that the United States (almost certainly now the world’s biggest tax haven) remains technically compliant. Specifically, the requirement to participate in the Multilateral Convention can be satisfied with another “sufficiently broad exchange network permitting both EOIR and AEOI,” for which FATCA – and likely FATCA alone – qualifies.

A multi-phase process is promised, which indicates that the goal-posts are sure to be moved in a manner similar to past OECD demands. In fact, the report admits that, “benchmarks would be adjusted over time according to an agreed plan as implementation of the standards progresses.”

And further harking back to the darkest days of blacklists and open intimidation of low-tax jurisdictions, the OECD offered that, “a list based on this approach could be established for the G20 Summit in July 2017.” The G20 replied, in a rather transparent euphemism for political and economic strong-arming of low-tax jurisdictions, that “defensive measures will be considered against listed jurisdictions.”

 

Still grading the on-request standard

Although the OECD quickly moved on to the more invasive automatic exchange standard, jurisdictions are still jumping through the hoops of the peer review process to meet requirements for the exchange of information on request. Ten new peer review reports were released in July, including Phase 2 ratings of “Largely Compliant” for six jurisdictions: Switzerland, Albania, Cameroon, Gabon, Pakistan and Senegal. The United Arab Emirates was rated “Partially Compliant.” Ukraine’s Phase 1 report found sufficient legal and regulatory framework to advance to Phase 2, while Liberia’s supplementary Phase 1 report determined it ready to move on to the next round as well. The supplementary Phase 2 report for Saint Lucia upgraded its rating from “Partially Compliant” to “Largely Compliant.”

To meet the exchange of information on request benchmark as one of the three criteria to avoid being labeled non-cooperative, a “Largely Compliant” rating is required. As of July, that leaves 12 “Partially Compliant” jurisdictions (Andorra, Anguilla, Antigua and Barbuda, Barbados, Costa Rica Curaçao, Indonesia, Israel, Samoa, Sint Maarten, Turkey, United Arab Emirates) and seven others currently blocked from proceeding to Phase 2 reviews (Federated States of Micronesia, Guatemala, Kazakhstan, Lebanon, Nauru, Trinidad and Tobago, Vanuatu), under the microscope. Several of these are undergoing supplementary review, but jurisdictions on these two lists are the most likely candidates to find themselves placed on a new blacklist as things currently stand.

 

Ideological advocacy

The OECD is staking out an even more explicitly political stance on tax than it has before. In July it published a working paper called “Tax Design for Inclusive Economic Growth.” The authors assert that tax policy recommendations should not simply be based on “the impact of taxes on economic growth from an efficiency perspective,” but on what they describe as “inclusive growth” – specifically, the “equity outcomes” of tax policy, and the degree to which domestic tax rules “go hand in hand with the implementation of international tax rules and mechanisms that prevent tax evasion and tax avoidance.”

The paper was also the focus of a July G20 tax symposium in China. According to the OECD, it focused on four broad tax policy design options, two of which included emphasis on “redistributive goals” and “enhancing progressivity of tax systems.” Cementing the organization’s role as a more left-leaning and ideologically driven body, OECD Secretary-General Angel Gurría said he hopes that this “inclusive growth” focus will “become part of a new tax policy contribution to the G20 agenda moving forward.”

 

Future expectations

Exchanges under the new automatic exchange of information are expected to begin in 2017. So now that BEPS, the Common Reporting Standard, and other efforts to rig global tax rules in favor of high-tax jurisdictions have been established, the OECD is placing additional emphasis on convincing nations, through any means possible, to adopt as many of the self-destructive policies as they can. We see this both in the effort to cajole non-OECD member states into the “inclusive framework,” and the establishment of new criteria for judging compliance with OECD dictates.

With a European bloc dominant among OECD membership, we can further look to the European Union’s increasingly hard-line stance on international tax as indication that the OECD will be under tremendous pressure to deliver results. Don’t be surprised if discussions over mechanisms for punishment begin before the ink is even dry on the forthcoming list of non-compliant jurisdictions.

Submerged dangers in the safe harbor for securities settlement payments

For those still wondering if the outcome of a court case can depend entirely on the specific court adjudicating that case, a recent ruling from the Chicago-based U.S. Court of Appeals for the Seventh Circuit  should dispel all doubt. Those advising defendants sued by U.S. bankruptcy trustees  for recovery of securities settlement payments, and those evaluating the implications of such a suit, should take special note of the Seventh Circuit’s announced disagreement with virtually every other Circuit to address the issue.

The three-step scenario in the case is one familiar to hedge fund investors and about which this column has reported in the past.  In step one, a leveraged buyer purchases the shares of a target company, paying a substantial amount of money to the target’s shareholders, but after a short time (four years or less), the buyer finds that it cannot support the burden of the leverage taken on and thus declares bankruptcy.  In step two, a trustee or other control party invokes the bankruptcy law’s provisions on fraudulent conveyances to demand that a former target shareholder return the buyout money to the buyer’s estate for redistribution to creditors.  This shareholder, the trustee’s argument goes, received property from a soon-to-be-insolvent entity and did not offer equivalent value in return, as evidenced by the buyer’s collapse after the leveraged buyout (the argument is more powerful in a true LBO, in which the target company itself is the buyer, and it receives nothing of meaningful value in exchange for buying its own shares from its own former shareholders).

Step three is the crucial and disputed one. The former shareholder-cum-defendant invokes a “safe harbor” provision in section 546(e) of the Bankruptcy Code.  In specified cases, this provision shuts down any attempt to use any of the Code’s claw-back provisions to recover fraudulent conveyances or preferential transfers.   In cases not involving actual fraud, the safe harbor provision prevents the recovery of any “settlement payment” or any other payment “in connection with a securities contract” made either “by or to” a “financial institution” or a series of enumerated financial industry actors.  This provision was designed to avoid a domino chain of failures by other financial market intermediaries if any one financial market intermediary were to fail and a trustee starts selectively recovering value from the recipients of the interconnected web of payments made to settle that intermediary’s securities transactions.

If the debtor-leveraged buyer and the former shareholder were the only parties involved in the buyout transaction, the safe harbor provision would generally not apply.  While the buyout payment is clearly connected to a securities contract, in most cases, neither buyer nor seller is a protected financial markets participant, i.e., a commodity broker, forward contract merchant, stockbroker, securities clearing agency, or financial institution.  But clever lawyers for former shareholder-sellers have seized on the contorted language of the law, noting that the safe harbor protects any securities-related payment “by or to” a financial institution.  In the ordinary course, the trade is cleared not by a hand-to-hand transfer of millions of dollars in cash, but by a payment to a bank-intermediary, a financial institution!  Thus, in all but the most extraordinary securities deals, the debtor-buyer will have  made the challenged payment to a financial institution, and the former shareholder-seller will have received the challenged payment made by a financial institution.  The payment transfer is thus insulated in multiple directions.

This expansive interpretation of the safe harbor has prevailed before the appeals courts in the two most prominent U.S. bankruptcy jurisdictions, the Second Circuit in New York and the Third Circuit in Delaware, as well as the appeals courts in the more provincial Sixth, Eighth, and Tenth Circuits.  While this is good news for former shareholders, it is less positive for the creditors of failed leveraged buyers.

So where would these creditors prefer to see lawsuits filed against their debtors’ securities sellers?  The Seventh Circuit, with jurisdiction over Illinois, Indiana, and Wisconsin, including the major commercial center of Chicago.   In its ruling at the end of July 2016, the Seventh Circuit concluded that the language of the safe harbor provision is facially ambiguous, so it must be interpreted in light of its purpose and history.  It applies, the court held, only where the economic substance of the transaction directly involves a financial industry participant; that is, when the financial intermediary is a counterparty to the securities contract, not a mere payment conduit.

In so ruling, the Seventh Circuit did not reveal any fundamental flaw in the reasoning of the phalanx of prominent appeals courts who construed the safe harbor broadly.  The Seventh Circuit simply disagreed with its sister courts, perhaps for policy-driven reasons even more so than for jurisprudential differences as to proper statutory interpretation.

Note that it is difficult to impossible to manipulate the location of the governing forum in cases like this.  The proper venue for claw-back recovery cases is generally the location of the defendant (the former shareholder, in the case discussed here).  While the debtor or perhaps its creditors can control where the bankruptcy case is filed, they have precious little influence over where potential settlement payment recipients are located throughout the country.  Indeed, the bankruptcy case discussed here was filed in Delaware. The Seventh Circuit became involved only because the former shareholder was located in Chicago and was therefore sued by the trustee there.  In any event, the case demonstrates that in law, as in real estate, the most important value factor is often location, location, location.

Law Talk – Rights of redeeming investors in fund liquidations

In this edition of Law Talk we consider a recent decision of the Cayman Islands’ Court of Appeal in Michael Pearson (as Additional Liquidator of Herald Fund SPC (In Official Liquidation) v Primeo Fund (In Official Liquidation) that has provided further clarity regarding the rights of redeeming investors of Cayman Islands’ funds in liquidation. We also consider an important new law, the Cayman Islands’ Confidential Information Disclosure Law, 2016 which repeals the Confidential Relationships (Preservation) Law (Revised) and effectively de-criminalizes and facilitates the disclosure of confidential information in certain defined circumstances.

 

IN THE COURTS

 

Michael Pearson (Herald Fund) v Primeo Fund (In Official Liquidation)
(Court of Appeal, Unreported 19 July 2016)

Primeo is the latest in a line of decisions in the Cayman Islands courts since the 2008 global financial crisis, considering the issue of the status of redeemed investors in the liquidation of a Cayman Islands fund.  In Primeo the Cayman Islands’ Court of Appeal has shed some light on the difficult questions of law arising in relation to section 37(7)(a) of the Cayman Islands Companies Law (Revised).  In particular, it seeks to clarify the ranking of redeemed investors vis-à-vis other creditors and unredeemed investors in the waterfall of payments in a winding up.

 

Background

Herald Fund SPC (“Herald”) was established as an exempted segregated portfolio company in the Cayman Islands in 2004 and registered as a mutual fund.  Investors in the fund, including Primeo Fund (“Primeo”), also a Cayman Islands investment fund, received non-voting, redeemable, participating shares in exchange for their investments.  Herald was a Madoff feeder fund and invested in Bernard L Madoff Investment Securities LLC (“BLMIS”) which was a limited liability company incorporated in New York.

In late 2008, Herald received redemption requests from a number of shareholders, including Primeo (the “December Redeemers”), for a Dec. 1, 2008 redemption date and, in accordance with the terms of Herald’s Articles of Association, the names of those redeeming shareholders were removed from Herald’s register of members on that date.

On Dec. 11, 2008, Mr. Madoff confessed that BLMIS was a fraudulent ‘ponzi’ or pyramid scheme. Subsequently, the directors of Herald suspended all redemptions and the calculation of Net Asset Value on Dec. 12, 2008 (the “Suspension”) and as a result, the redemption payments to be made to the December Redeemers, including Primeo, were not paid.

On Jan. 23, 2009, Primeo was voluntarily wound up and on April 8, 2009, Primeo was put into official liquidation under the supervision of the Court (the joint official liquidators were later changed on May 11, 2012).  Herald was also put into receivership under the supervision of the Court on July 16, 2013.

The December Redeemers claimed they were entitled to receive their redemption payments as creditors, that they should be treated pari passu with all other unsecured creditors of Herald and that they should rank ahead of those shareholders who had not submitted redemption requests prior to the Suspension.

Conversely, the liquidators of Herald argued that the December Redeemers were caught by section 37(7)(a) of the Companies Law (Revised), that they therefore remained shareholders and had no entitlement to present claims as creditors in relation to the redemption proceeds.

 

The Companies Law

Section 37(7)(a) of the Companies Law (Revised) states:
(a) Where a company is being wound up and, at the commencement of the winding up, any of its shares which are or are liable to be redeemed have not been redeemed or which the company has agreed to purchase have not been purchased, the terms of redemption or purchase may be enforced against the company, and when shares are redeemed or purchased under this subsection they shall be treated as cancelled:
Provided that this paragraph shall not apply if-
(i)    the terms of redemption or purchase provided for the redemption or purchase to take place at a date later than the date of commencement of the winding up; or
(ii)    during the period beginning with the date on which the redemption or purchase was to have taken place and ending with the commencement of the winding up the company could not, at any time, have lawfully made a distribution equal in value to the price at which the shares were to have been redeemed or purchased.

The correct interpretation of the underlined phrase was the subject of this appeal.

 

Grand Court Decision

At first instance, Jones J ruled that section 37(7)(a) did not apply to the December Redeemers (and that they fell outside the scope of that section) on the basis of the reasoning of the Privy Council in Culross Global SPC Limited v Strategic Turnaround Partnership Limited [2010 (2) CILR 364]. Jones J differentiated between the scenario in the instant case and what he considered to be the intended effect of section 37(7)(a).  The primary distinction Jones J made was that he considered that section 37(7)(a) would apply in situations where an investor had submitted a redemption request but had not completed some other requisite procedure or formality in order to validly redeem their shares. In the instant case, the December Redeemers had validly redeemed their shares but had simply not received payment prior to the Suspension. The redemption date had passed prior to the commencement of the winding up and following the reasoning in Culross the debt had crystallized and the December Redeemers had become creditors, fully redeemed even though they were awaiting payment. Jones J’s judgment left open the question as to whether the December Redeemers, including Primeo, would rank pari passu with other unsecured creditors.

 

Judgment of the Court of Appeal

The Court of Appeal upheld the prior decision of the Grand Court and stated that Jones J was correct in holding that section 37(7)(a) did not apply to the December Redeemers. The Court of Appeal found that section 37(7)(a) does not apply in scenarios where, at the commencement of the winding up, the redeemable shares in question have been redeemed in accordance with the Articles of Association, notwithstanding that the redemption proceeds are yet to be received. Field JA stated that section 37(7)(a) applies in situations where at the commencement of the company’s winding up, a shareholder with redeemable shares has a right of redemption under the relevant Articles of Association but there has been no redemption because the steps required by the Articles for this to occur have not been completed.

Notably, the Court of Appeal clarified that redeemed but unpaid investors would not rank pari passu with other unsecured creditors.  The basis of this reasoning was that the redemption proceeds claimed by the investors were founded in the statutory contract between the investors and Herald and therefore would be classified as claims due “in his character of a member” under section 49(g) of the Companies Law (and were therefore subordinated to claims of ordinary third party creditors).  Accordingly, the December Redeemers had provable contingent claims in Herald’s liquidation, although those claims would rank behind Herald’s other unsecured creditors but ahead of other Herald shareholders.

The Court of Appeal’s decision provides helpful clarification as to the status and ranking of claims for unpaid redemption proceeds. It remains to be seen whether the decision will be appealed to the Privy Council by Herald (with respect to the application of section 37(7)(a)) or by Primeo (with respect to the ranking of its claim).

 

New confidential information disclosure law, 2016

A new confidentiality regime was introduced in the Cayman Islands on July 22, 2016, in the form of the Confidential Information Disclosure Law, 2016 (the “CIDL”), replacing the (now repealed) Confidential Relationships (Preservation) Law (Revised) (the “CRPL”) which was often unfairly described as a “secrecy” law.  The CIDL has been enacted to reflect the continuing commitment of the Cayman Islands’ government to global tax information exchange and cooperation between law enforcement authorities.

The CRPL was first enacted back in 1976, when the development of the Cayman Islands as a global financial center was in its early stages, and made it a criminal offense for any person in the Cayman Islands to disclose confidential information obtained during the course of business without consent, subject to a number of limited exceptions .

The CIDL removes the criminal sanctions that attached to disclosure of confidential information under the CRPL and sets out clear pathways through which confidential information  can now be disclosed, without the prior consent of the person to whom it relates.

When a duty of confidentiality arises during the course of business, the CIDL makes it clear that the disclosure of information in the following circumstances, among others, will not constitute a breach of the duty and shall not be actionable:
1.    In the normal course of business (as defined in the CIDL) or with the express or implied consent of the principal;
2.    Pursuant to or in accordance with any right or duty created by other laws and regulations in the Cayman Islands;
3.    In response to requests by Cayman tax, law enforcement and financial regulatory authorities, including the police, the Cayman Islands Monetary Authority and the Financial Reporting Authority; and
4.    Upon direction of the Grand Court pursuant to an application under the CIDL.

A breach of the common law duty of confidentiality will still give rise to a right of remedy (including damages or injunction), so that the question of liability for breach of confidence will now be dealt with under the auspices of the common law and the rules of equity.

Section 3(2) of the CIDL also provides a “whistle-blowing” defense to an action for beach of a duty of confidence to a person who discloses confidential information on wrongdoing, or in relation to a serious threat to the life, health, safety of a person or to the environment. The defense will apply as long as the person acted in good faith and in the reasonable belief that the information was substantially true and disclosed evidence of the wrongdoing or serious threat.

Importantly, as the CRPL did before it, section 4 of the CIDL provides an avenue by which a person may be permitted by the Cayman Islands’ Courts to give confidential information in evidence before any court, tribunal or other authority, whether in the Cayman Islands or elsewhere. Giving of evidence includes making a statement, producing a document by way of discovery, answering interrogatories or testifying during or for the purposes of any proceeding. A person who intends to or is required to give evidence and the evidence consists of or contains confidential information is required to apply to the Cayman Court for directions unless the principal to whom the duty is owed has consented expressly.

The provisions of the CIDL are a further demonstration that the Cayman Islands does not support “secrecy” laws and that this jurisdiction is committed to working with international tax and law enforcement authorities and governments globally to improve corporate and tax transparency, while maintaining necessary respect for the privacy of individuals and corporate entities.

The Cayman Islands government is undertaking significant and exciting Intellectual Property Law reforms

During the last few months, we have seen significant steps taken by the Cayman Islands Government to reform Cayman’s Intellectual Property (IP) Laws. These steps are the result of many months of investment, both time and financial, by government.

The main purpose of these reforms is to build on, and cement, the Cayman Islands as a growing hub for the development and commercial exploitation of IP.

 

What is intellectual property?

The World Intellectual Property Organization (WIPO) defines IP as follows: “Intellectual property refers to creations of the mind: inventions; literary and artistic works; and symbols, names and images used in commerce.”

Intellectual property rights are like any other property right. They allow creators, or owners, of patents, trademarks, design rights or copyrighted works to benefit from their own work or investment in a creation.

WIPO has said that: “An efficient and equitable intellectual property system can help all countries to realize intellectual property’s potential as a catalyst for economic development and social and cultural well-being. The intellectual property system helps strike a balance between the interests of innovators and the public interest, providing an environment in which creativity and invention can flourish, for the benefit of all.”

To consider the use and importance of IP rights globally, it is worth looking at some published statistics:

  • According to WIPO, in 2014, there were approximately 33 million trade marks in force globally, and
  • According to statistics portal, Statista, in 2013, the revenue from the licensing of IP rights in the U.S. alone amounted to approximately US$37 billion.
  • According to the U.S. Patent and Trademark Office, “On April 11, 2012, the U.S. Commerce Department released a comprehensive report, entitled “Intellectual Property and the US Economy: Industries in Focus,” which found that intellectual property (IP)-intensive industries support at least 40 million jobs and contribute more than US$5 trillion dollars to, or 34.8 percent of, U.S. gross domestic product. The report went on to identify 75 industries (from among 313, total) as IP intensive.”

 

Why is reform important?

Cayman is developing and changing as a jurisdiction at a local level. More and more businesses are being established in Cayman in areas such as medicine, music, innovation and technology.

Cayman has traditionally focused on tourism and finance as pillars of the economy. In order to allow new industries to properly flourish and to increase more and more investment in these areas, a robust IP regime is needed to be able to support the intangible rights that flow from such industries. Consider copyright and brand (trade mark) protection in the context of creating and selling music, or patents in the creation of new medicines or medical methods.
It is only with a robust IP regime that creators of IP, be they brands or music or literary work or inventions, can seek protection of their rights, and then go on to exploit their rights through, for example, licensing.

Consider Cayman Enterprise City which boasts more than 180 tech and knowledge-based companies. Fundamentally, all of these companies will draw from an IP regime in order to be able to exploit their innovations. Consider also the U.S. Commerce Department’s report above which identifies 75 industries as IP intensive out of 313 industries looked at. Cayman opens itself up to all of these industries with a proper IP system.

A robust IP regime is also important in the process of attracting foreign investment and businesses. Cayman is an attractive place to house your business, and live, for lifestyle and tax neutrality, just to name two advantages. However a fundamental requirement for IP-intensive businesses and innovators abroad, that are looking to do business in Cayman, is to know that there is a robust IP system in place.

 

What are the reforms that are taking place?

The reforms cover all areas of IP in a stage by stage process.

In July, we saw an overhaul of the copyright laws in Cayman. This was by virtue of the Copyright (Cayman Islands) Order 2015 and the Copyright (Cayman Islands) (Amendment) Order, 2016 (collectively, the New Orders) which essentially, with some modifications and exceptions, extended the entire body of U.K. copyright law into Cayman and therefore fully modernized a copyright law that was vintage and insufficient in a technology driven world.

In October, lawmakers approved a series of new draft laws, namely:

  1. The Patents and Trade Marks (Amendment) Bill, 2016
  2. The Trade Marks Bill, 2016
  3. The Design Rights Registration Bill, 2016

In summary, the key changes for each of these rights are (1) for patents, the draft law proposes provisions to prevent the activities of patent trolls (patent assertion entities); (2) for trademarks, the drafts law proposes a new Cayman trademark system that stands on its own feet, and that is not reliant on first owning a U.K. or EU trade mark and then extending into Cayman (otherwise called, an extension system), and (3) a new design right in the Cayman Islands (which will initially operate as an extension system).

Each of these developments is an important step forward in the creation of a desirable hub for the development and commercial exploitation of IP.

The patent trolling provisions prevent the abusive use of patents.

The new stand-alone trade mark system is a significant and important development for Cayman because it will mean that businesses (both local and foreign) whose interests are more centered in the Americas and the Caribbean will be able to protect their brands without having to first consider registration in the U.K. or EU.

Finally, design rights are a new form of IP in Cayman although much used around the world, and accordingly an important addition to the IP regime overall. In terms of design right, WIPO says: “In a legal sense, an industrial design constitutes the ornamental or aesthetic aspect of an article. An industrial design may consist of three dimensional features, such as the shape of an article, or two dimensional features, such as patterns, lines or color.”

On the practical and processing side, the government has established the Cayman lslands Intellectual Property Office with its own dedicated website, filing system, personnel and technology. Separately, we have seen the launch of the Intellectual Property law gazette to stand alongside the normal Cayman gazette.

In conclusion then, as Cayman continues to grow, develop and evolve in an ever more advanced, diversified and technological world, the introduction of a robust IP system to support growth is welcomed and great news for the Island. This system is in keeping with Cayman’s place as a leader in robust regulatory and legal systems.

Ireland: The latest victim of the EU’s global taxation agenda

Apple, the iconic producer of iPhones and iPads, has been front and center of recent headlines resulting from the European Commission’s investigation of Ireland for providing the company with tax breaks that allegedly should be considered anti-trust violations. Like any other major multinational, Apple has received its fair share of criticism for its tax planning strategies. In this instance, it is being accused of using countries such as Ireland for attaining tax treatment that is more favorable than what’s available to other firms. According to the EU, Ireland was allegedly providing “state aid” to Apple through these low tax deals, and now the EU is demanding Apple pay Ireland up to 13 billion euros (roughly $14.6 billion) in back taxes, interest included.

This is part of a broader anti-tax avoidance crusade spearheaded by supranational entities with corporations serving as the perfect scapegoats. On the surface, these moves by the European Commission might be standard corporation-bashing grandstanding, but there is a much larger endgame at play – global taxation rules. The immediate victim in this discussion is Ireland and its sovereignty in matters of taxation. But the implications go much farther. This Apple case is the perfect storm for the European Commission, which is hoping it can ignite anti-corporate sentiments, while at the same time advancing its global taxation agenda.

For a better understanding of the context of the Apple controversy, this article will seek to analyze the following:

  1. The business practices of Apple and tax laws of Ireland that were deemed irregular by the European Commission
  2. The international players involved in this case
  3. The real agenda pursued by the EU
  4. Potential solutions to this controversy

 

Apple’s tax practices

Apple and many other multinational firms have expanded their operations across the globe through the establishment of subsidiary companies outside of their country of domicile. Such moves are economically logical in an increasingly globalized world that requires more localized knowledge in running global operations. Additionally, such incentives to establish subsidiaries abroad have been propelled by tax policies that make it uneconomical for companies to maintain the bulk of their operations in their country of origin.

From a practical perspective, this means that companies often engage in substantial transactions between the parent company and foreign subsidiaries, as well as between those subsidiaries. Pricing these intra-company transactions (a.k.a., transfer pricing) is a very important issue in the field of global tax policy since governments are paranoid that firms understandably will attempt to minimize profits in high-tax nations and maximize their earnings in low-tax jurisdictions.

The practice of transfer pricing has earned many corporations, especially Apple, great criticism from self-styled tax justice advocates and international authorities alike. Essentially, transfer pricing involves the exchange of goods or services between two or more divisions of the same company. Large firms with subsidiary divisions that are treated as separate entities are closely watched by national tax authorities as they use transfer pricing to conduct internal transactions.

Transfer pricing and similar tax planning strategies are nothing new in the realm of international business. It is the logical response to increasingly complex tax regimes that make it harder for businesses to maintain their operations in their country of origin.

Companies have a fiduciary obligation to their workers and shareholders, so opting for a low-tax environment is an optimal and understandable strategy for promoting the welfare of the aforementioned parties.

This nuance is overlooked by activist bureaucrats and political figures, both of whom are constantly looking for ways to collect as much tax revenue as possible to finance their extravagant welfare states. As already noted, the popular perception is that multinationals are under-stating profits in high-tax nations and booking profits in lower-tax nations. While the desire for tax transparency is laudable, the complex situations that both businesses and nations find themselves in are largely the fault of misguided fiscal policy.

 

Globalizing a domestic problem

Globalization has brought unprecedented degrees of economic prosperity to individuals worldwide through the voluntary exchange of goods, services and ideas. Sadly, onerous tax policy has effectively become internationalized, as entities such as the EU and OECD are working to take the complex tax policies of some of their member countries and turn them into international standards (a.k.a., so-called “best practices”) for all nations to follow.

The latest Apple probe is not just confined to the EU; it has also drawn the U.S. into the mix. At first glance, the U.S. Treasury correctly points out that the EU is targeting American companies like Apple in a way that could undermine global tax policy in the future. However, close analysis past actions of the U.S. in matters of international taxation paint another picture – one that is based on national self-interest as opposed to genuine tax reform.
The U.S. sees the EU’s action as more of a move to take away the American government’s ability to collect tax revenue. Even though the U.S. may have reasonable fiscal policies in certain areas when compared to the EU, it is not exempt from the desire to get their hands on as much tax revenue as possible, be it through its high levels of corporate taxation, its aggressive system of worldwide taxation, or its enthusiastic quest to establish a global tax collecting apparatus through laws such as the Foreign Account Tax Compliance Act (FATCA).

 

What is really at stake

The logic behind the EU’s classification of Ireland’s tax policy as a “subsidy” is rather strange when one contemplates the meaning of the word. Generally speaking, subsidies are a form of financial payment or special favor given to individuals or industries at the expense of taxpayers and/or consumers. These money transfers are generally for the sole benefit of a narrow sector of society – politically connected industries in these instances – in the name of the public good. And there are plenty of unambiguous examples of government subsidies for companies, including the Export-Import Bank in the United States.

What Ireland offered Apple and countless other corporations, however, are by no means subsidies. Competitive policies of low taxation and wholesale reductions of government involvement in the economy are the complete opposite of subsidies. Subsidies involve the government literally aiding industries through taxpayer-funded transfers, but that’s not the case with Ireland and Apple. Ireland has built a solid reputation for its low corporate tax policies, most notably a corporate tax rate of 12.5 percent (and even lower when Irish-based subsidiaries have non-Irish-source income), that have allowed it to become an attractive hub for multinational corporations.

Unfortunately, in the eyes of Brussels, Ireland’s low corporate taxes are viewed as unfair competitive advantages. When Ireland provides tax rates below the EU bureaucrat’s desired targets, it is immediately branded as country that is providing unfair state aid, and thus must be punished.

Beyond questions of the appropriate rate of taxation, EU bureaucrats ultimately want control over their member countries’ fiscal decision-making. Such a supranational vision of how tax policy is conducted has the potential of undermining the sovereignty of EU member states while also threatening to create a system that will facilitate ever-rising tax burdens.

The EU Commission’s proposal involves a retroactive replacement of present Irish tax law with a vision of what the original law should have been its eyes. If the EU has its way, retroactive rulings of this kind will generate increased degrees of legal uncertainty for corporations. This could potentially compel corporate prospects to look elsewhere in search of more institutionally sound environments. Consumers and everyday people ultimately end up losing out from the loss of valuable services provided by corporations – cheap goods, investment, and jobs – once these businesses have no choice but to take their operations elsewhere.

 

Resolving the tax conundrum

It would behoove Western governments to reconsider their current approach to taxation. In his letter to European Apple customers, current Apple CEO Tim Cook offered the more rational suggestion of taxing company profits where economic value is actually created. The best approach to handling tax disputes is to effectively “de-globalize” the situation and pursue more territorial means of taxation. Once fiscal issues become globalized, international bureaucracies will only magnify the degree of red-tape and bureaucracy that is involved, consequently leading to polices that not only are bad for shareholders, but also consumers and workers.

Tax policy is already complicated at the domestic level, and internationalizing the issue with global bureaucracy in the mix will add more problems. If EU countries are concerned with transfer pricing policies, they already have mechanisms in place that can make transfer pricing policies conform with arms-length standards. There is no need for top-down decrees that deprive countries of their ability to set their own fiscal policies.

What the Apple case is indicative of is the need for countries – U.S. and EU countries alike – to simplify their tax codes and lower their tax rates. Supranational organizations such as the EU and the OECD have a knack for turning simple matters into bureaucratic boondoggles.

The overarching trend of tax competition between jurisdictions has been a fixture of the world economy for the past few decades, and with very positive results. Tax rates have become more reasonable, and competition has allowed corporations to freely move their operations to locations where they face less burdensome taxation and regulations. In turn, countless citizens benefit from the increased investment and productive activity that these businesses provide.

While it may be troubling that corporations that would otherwise keep their operations domestically end up going abroad, policymakers would be wise to not pursue punitive measures against these corporations. This would only create a vicious cycle of interventions that may actually aggravate current economic problems, instead of actually striking at the very root of the problem – the flawed system of taxation. Hopefully, cooler heads will prevail and more territorial-based alternatives to taxation are put forward by policymakers in the near future.

In the meantime, perhaps Ireland should respond to the current tax attack in the same way it reacted to an EU-instigated attack on its tax system almost 20 years ago. Back in the 1990s, Ireland had a 30 percent tax rate for some companies, but a 10 percent tax rate for manufacturers and financial companies. The EU asserted this was unfair, obviously hoping to force Ireland to impose a 30 percent rate on all firms. Ireland turned lemons into lemonade, however, by instead adopting its iconic 12.5 percent rate.

Today, the EU has ruled that Ireland’s tax system is unfair because Irish companies (or, in this case, the Irish subsidiaries of foreign companies) sometimes pay lower tax rates on income earned outside of Ireland than they pay on their Irish-source income. Why that’s an antitrust violation is a mystery, but Ireland should once again snatch victory from the jaws of defeat by adopting a tax rate – perhaps 5 percent – that is universally applicable.

One suspects the EU bureaucrats will rue the day they launched another fiscal attack on Ireland.

Basel III: The key to perennial deficits?

In the aftermath of the 2008 global economic crisis, governments around the world have adopted new capitalization requirements for financial institutions. Known as Basel III, these regulations have been sold as a way to strengthen shock absorption in the banking industry, to improve its risk management and enhance transparency.

However, as is the case with most government regulations, Basel III comes with unintended, and potentially harmful, consequences. At the heart of the problem is the new structure of capitalization requirements that give strong preferential treatment to government debt – to some extent without adequate appreciation of the quality of its credit rating.

The core of the problem is that financial institutions do not need to set aside the same amount of capital in purchasing bonds from governments as they do for buying private equity. The lower capitalization rates apply to government bonds generally with at least AA- rating.

The big can of worms is opened by the proviso saying that banks can buy domestic-government debt at any credit rating, with less own capital than if they buy prime-credit private equity.

On the face of it, this does not seem to be a problem. Historically, government bonds have been a very safe low-risk anchor for any investment strategy; if the Basel III requirements had been introduced in, say, the 1990s, they would not have been cause for concern.

However, given the experience from the crisis that broke out in 2008, they put these regulations in a new light.

Starting in 2009, banks experienced dwindling loan demand from non-financial businesses. Default risks increased (as is always the case during a recession), growing the need for low-risk government bonds. However, Europe’s treasury bond market offered a narrowing window of low-risk opportunities. A growing share was drifting into high-risk waters, with numerous credit downgrades across Europe. Financial institutions increased their ownership of downgraded government debt by 55 percent in a four-year period, 2009-2013.

  • In April 2009, Moody’s put the Irish government on downgrade watch, executing the first of a total of five downgrades three months later. That same year, the Irish government added 24.6 billion euros to its debt, and financial institutions bought 78 percent of that new debt.
  • In 2010, when Fitch added two Irish downgrades to those by Moody’s, the Dublin government borrowed 39.5 billion euros. Financial institutions purchased 59 percent of it.
  • By 2011, when Standard & Poor’s put Ireland on yet another downgrade watch, financial institutions stabilized their ownership of Irish debt. However, the pattern from Ireland was repeated in Spain. In June 2010, Moody’s put Spain on downgrade watch. In the following two years they downgraded the Spanish government’s credit rating five times. During that time the Spanish government borrowed 323 billion euros, of which financial institutions picked up 71 percent.
  • This amount, 230 billion euros, was more than three times as much as financial institutions had invested in Spanish debt over the seven years preceding 2009.
  • Portugal went on Moody’s downgrade watch in May 2010, followed by a downgrade in July that year. Another four downgrades took place in the following 18 months. Despite its declining credit rating, in 2010-2012 the government in Lisbon was able to borrow another 64 billion euros. Financial institutions bought 55 percent of the new debt.
  • Italy was put on downgrade watch in June 2011. In the following 12 months the country was hit by three downgrades; while Italy’s credit went into a tailspin, financial institutions purchased 203.5 billion euros worth of Italian government debt – 66 billion euros more than what the government needed to borrow.

In four of the five most credit-challenged countries in Europe, financial institutions bought massive amounts of Treasury bonds right as the crisis escalated. It is important to note, though, that this level of data is not available for Greece, the most troubled government in Europe. What is well known, though, is the Greek debt write-off in 2012, when investors lost one quarter of their money with the stroke of a pen.

Purchases of weak-credit government debt were not limited to Ireland, Portugal, Spain, Italy and Greece. France lost its AAA rating with Standard & Poor’s in January 2012. In November that year, Moody’s downgraded France, followed by Fitch in July of 2013 and yet another downgrade by S&P in November 2013. In 2010-2012, the French government borrowed 341 billion euros, of which financial institutions bought 44 percent, or 150 billion euros.

But not only that: The financial-institution share of the debt purchases actually accelerated as France came closer to a downgrade. They bought:

  • 16.3 percent of new French debt in 2010,
  • 45.6 percent in 2011, and
  • 66.5 percent in 2012.

Other countries downgraded by Standard & Poor’s at that time were Austria, Cyprus, Malta, Slovakia and Slovenia.

The investments in downgraded government debt reviewed here took place before the Basel III requirements went into effect. It is relevant to ask how much more debt from these governments that banks would have bought had Basel III been in place in 2008.

This is not just a hypothetical question. A new economic crisis will come, and it will lead to major expansions in government debt. Among the governments that will increase borrowing are the ones mentioned here, most of which have not recovered their credit rating. This means that Treasury bonds with AA- or higher credit are more scarce now, relatively speaking, than before 2008. Therefore, in response to the capitalization bias in Basel III, financial institutions will prioritize domestic government debt, even if its credit is rated far below AAA.

The obvious question is what will happen to banks with major investments in low-credit domestic government debt. While government defaults are rare, the Greek debt write-down has opened possible future losses to bank portfolios that were unthinkable only 10-15 years ago.

Two factors exacerbate the problem. The first one is the “flip side” of the domestic debt incentive. While constructed to motivate banks to buy domestic public debt, it also reinforces the incentive to governments to use deficits as a permanent method for funding spending.

Since they know that their domestic banks are skewed – by government regulations – to buy up their debt regardless of credit status, they are much less inclined to restrain spending. At least in theory, this could lead to a situation where governments calculate on deficits as a permanent source of funding spending.

Secondly, the Basel III capitalization regulations could lead to the perpetuation of risky monetary policy. During the economic crisis, European monetary policy became focused on quantity management, supplying low-cost loans to financial institutions in return for investments in downgraded government debt. This led financial institutions to abandon risk aversion for risk neutrality. Over a longer period of time, lax monetary policy over-supplies the economy with liquidity, perpetuates low-to-negative interest rates and, in addition to neutralizing government-debt risk, leads to excessive liquidity supply to financial and real estate markets.

In conclusion, the effects of Basel III regulations of bond investments could be a destabilization of the very financial system the regulations are created to stabilize. Consistent with Austrian economic theory, over-supply of liquidity leads to asset-price spirals and investment patterns that are inconsistent with real economic activity and underlying consumer preferences. If we add to this the neutralization of risk assessment of government spending, there is a strong case for a destabilization of multiple national economies in Europe, not limited to the financial system. With governments being able to spend on borrowed money, impervious to their credit rating, the negative macroeconomic effects of government spending will add to a destabilized financial system.

Much of this reasoning remains theoretical as the combined effects of Basel III have never been tried before in a real-life economy. However, evidence from the latest economic crisis, economic theory and prevailing negative experience of long-term growth in government spending all, in isolation, suggest that the combination of the three presents the industrialized world with a potentially catastrophic scenario for the next economic crisis.

The optimum size of governmental units

Is Cayman too small to be a successful independent country? What is the optimal size of government units? How much of the economy should government own or control? Mankind has made amazing technological and economic progress in the last 300 years, but very little progress in improving governmental systems in the last 3,000 years. Since the Athenian experiments with democracy 2,500 years ago, there have been hardly any advances in finding answers to basic questions about how much or how little democracy is best.

The Scottish Enlightenment of the 17th and 18th centuries largely set the terms of political debate for the Anglosphere, beginning with the basic proposition that some government is necessary to protect person and property, and ensure liberty. During the 20th century, virtually every form and size of government that could be imagined was tried in practice, most often with disastrous results. But the good news is that there is substantial empirical evidence of what works and what doesn’t.

According to the IMF, World Bank, and CIA – Qatar, Luxembourg, Brunei, Kuwait, Norway, UAE, Liechtenstein, Macau, Bermuda, Isle of Man, Monaco, Saint Maarten, San Marino and Jersey – all have higher per capita incomes than the U.S. But they are either petro-states or micro-states (with populations of less than a million) who prosper by largely engaging in tax and regulatory arbitrage. There are three political jurisdictions – Switzerland, Hong Kong and Singapore – with multimillion populations and highly diversified economies that are not resource rich but have real per capita incomes (on purchasing power parity basis) greater than the U.S. What can we learn from these successes? The enclosed table details some of their characteristics. Cayman has been added as an example of a successful micro-state, which succeeds in part by having a portion of its economy engaged in legal tax and regulatory arbitrage opportunities resulting from American and European inefficiencies.

It is apparent that it is not necessary for a country to have a large population to be prosperous. The U.S. is the only country in the world with a population of more than 100 million that enjoys a high per capita income. It is also apparent that countries do not need a large government sector to have high per capita incomes. This observation reinforces the findings of many studies that as government spending begins to exceed roughly a quarter of GDP, economic growth rates tend to slow. Most countries are well over that level, with the EU countries having government sectors exceeding 40 percent of GDP (France is 55 percent), which may explain the income stagnation. Maximum individual tax rates of more than 20 percent and corporate tax rates of more than 15 percent are not necessary for fiscal soundness and are a drag on economic growth. Cayman and some other jurisdictions show that consumption taxes can make income taxation unnecessary.

jurisdictions

rahn-curveBack in the 1980s, when I was the chief economist for the United States Chamber of Commerce, we were in the midst of preparing some testimony on the relative economic performance of countries. Looking at the data, it appeared to me that there might be an inverse relationship with the size of government as a percentage of GDP and economic growth. That is, as the government sector in any economy grew larger, economic growth slowed and at some point became negative. I asked two of the economists on our staff, Cesar Conda and William Orzechowski, to take a closer look at the data – which was very limited at the time – and we concluded that there was a negative relationship once government exceeded roughly a quarter of GDP. A couple years later, Gerald Scully of the University of Texas, Robert Barro of Harvard University, independently using much more data and a more sophisticated analysis, found the same negative relationship between government growth as a share of GDP and economic growth. In 1993, Harrison Fox and I did a more detailed study, which again supported the finding of the earlier studies – that when government spending exceeded 25 percent of GDP, measurable reductions in the rate of growth begin to appear. (Peter Brimelow wrote an extensive article “Why the Deficit is the Wrong Number” in the March 15, 1993 issue of Forbes magazine, reporting on our study with the enclosed curve).

In the years since, many other studies by researchers around the world have looked at the same relationship. Critics of the concept claim that a number of the studies show that the negative relationship between spending and growth may not be particularly robust, and there are major definitional and quality problems with data from many countries.

In 2009, two economists, Dimitar Chobanov and Adriana Mladenova from the Institute of Market economics in Bulgaria, concluded in their extensive study of the issue: “The evidence indicates that the optimum size of government, e.g. the share of overall government spending that maximizes economic growth, is no greater than 25% of GDP (at a 95% confidence level) based on data from OECD countries. In addition, the evidence indicates that the optimum level of government consumption on final goods and services as a share of GDP is 10.4% based on panel data of 81 countries. However, due to model and data limitations, it is probable that the results are biased upwards, and the true ‘optimum’ government level is even smaller than the existing empirical study indicates.”

Dan Mitchell of the Cato Institute has argued for a number of years that the “growth-maximizing size of government is probably far lower than 25 percent of economic output.” He argues, based on his extensive review of many studies and substantial empirical evidence, that: “Spending on core public goods (rule of law, courts, etc.) generally are associated with better economic performance; Spending on physical and human capital (infrastructure and education) can be productive, though governments often do a poor job based on a money-to-outcomes basis: Most government spending, though, is for transfers and consumption, and these are areas where the economic effects are overwhelmingly negative.”

Economic freedom and protection of basic civil liberties is highly correlated with real per capita income and with life expectancy. Full democracy is also unnecessary to have high per capita incomes. The degree of democracy in Hong Kong is very limited, but civil liberties are for the most part still protected, as part of the 50-year (two systems) agreement with the U.K. Cayman has a very high degree of democracy in all matters except for defense, foreign policy and the final appellant court.

Switzerland has arguably the best overall economic and political governance system in the world. Each member of the National Council, the lower House of the Federal Assembly of Switzerland, represents approximately 40,000 people, not much larger than the 33,000 people represented by each member of the U.S. Congress in 1792. Each U.S. House of Representatives member now represents almost a three quarters of a million people. Virginia now has roughly the same population as Switzerland, but each member of the Virginia House of Delegates (the oldest continuous legislative body in the new world) now represents about 100,000 people. Each member of the British Parliament also represents about 100,000 people, while in its overseas territory of Cayman, each local member of the Assembly represents only about 4,000 people. In Singapore, there are about 55,000 citizens for each representative in the Legislative Assembly. Does democracy tend to break down if there are too many citizens per representative? Is the European Union too centralized to function well? Will Britain be better off economically and will civil liberties of its citizens be better protected because of Brexit?

grand-caymanOther than defense, are there any advantages to living in a large state over a small one? And if we went to a world with many more small states, how could they defend themselves?
Large centralized states with large government sectors get mired down in many layers of bureaucracy for which democracy is no cure, but part of the problem. The U.S. and Switzerland are both constitutional federal republics, where considerable power is delegated to the subunits of government – in the U.S. states and localities, and in Switzerland cantons and communes.

The Swiss have done a better job than the U.S. at devolving government to the lowest possible level and thus ensuring considerable competition between government units. Most traditional functions of government, such as police, fire, schools, local roads, land use, etc., can be carried out perfectly well at the local level, as the Swiss have shown. The Swiss communes (towns) raise most of their own taxes, which stay in the commune – thus avoiding the bureaucratic toll charge that occurs when tax money is sent to a larger unit of government and the locals have to plead to get some of it back. The national government in Bern has far fewer direct functions than most national governments, and constraints on its growth are provided by both spending and debt limitation provisions, and the double veto provisions of the Swiss direct democracy provisions. Major issues must be settled by a referendum, on such matters as immigration policy and whether to have a national minimum wage, etc. A major act must not only be approved by a direct vote by a majority of the people, but also by a majority of the cantons. Referendums must be limited to single issues, and those that involve significant expense must also define where the revenue to pay for the measure is to come from.

The Swiss system was designed to be cumbersome, because the founders wanted to make sure that the time required for a major change would be greater than the passions of the moment. As a Swiss friend once said to me, “By the time we Swiss can get around to taking an action, other countries have already proved it to be a bad idea, so we don’t bother.” The Swiss also benefit from considerable tax and regulatory competition between the cantons. After 800 years of trial and error and the occasional civil war, the Swiss have figured out how to have a government that protects civil liberties but allows for considerable experimentation and choice on economic and social issues at the local level. They do not have access to the sea nor much in the way of natural resources, yet they have a very high level of prosperity and happiness, and a very stable government – despite considerable language and religious differences. The secret is local control where the people do feel they have some influence on the government unit that most affects them.

One of the ironies is that the writers of the U.S. Constitution incorporated lessons from the Swiss experience. Then in 1848, the Swiss created a new constitution to a large extent based on the U.S. Constitution. Over the years, the Swiss have amended their constitution many more times than has the U.S., but they stuck much more faithfully to what was actually written, rather than allow the courts to water down the document through “judicial review” as has been done in the U.S.

Can features of the Swiss governmental system be adopted by other countries, including very large countries like the U.S? My argument is, yes. There is nothing inherently unique about the Swiss people. For many years, they have had large numbers of immigrants, but the Swiss have been successful in getting most of them to adopt Swiss values.

In the U.S., people are increasingly dissatisfied with the federal government in Washington, but tend to be more satisfied with their state and particularly local governments. The U.S. Constitution gives very few powers to the Federal government – and as the 10th Amendment to the Constitution reads: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” So there is not only no prohibition of a massive devolution of power to the states and localities, it would be very much in line with the thinking of the American Founders.
The U.S. and other countries could also adopt the direct democracy provisions, including the double majority – again a direct vote of all of the people and then a vote by the state legislatures with the requirement that a majority of the states concur. The Swiss-style single issue and its attendant funding should be made part of any reform package.

As in the U.S., people throughout the world are becoming increasingly hostile to big bureaucratic governments that stifle liberty and economic potential. The Swiss and even smaller states with smaller government sectors have proved that big states and big government have no inherent advantage, and, if anything, quite the opposite. Those larger countries that are not federal republics, such as the U.K and France, could devolve powers to regional and local jurisdictions so that the people would again feel more like they are masters of their own destinies. Legislative districts ought to be small enough so the people might actually know and meet their representatives (and who ought to be part of the most important level of government).

Small states could enter into alliances with larger states for national defense; but this would need to be a two-way street, whereby members of the alliance all agree, as part of the condition of being a member of the alliance, to contribute the same share of GDP and pro-rata manpower to the effort. Treaties and other international agreements should be made part of the referendum process so that organizations like the OECD would not be able to impose minimum global tax rates without the consent of the people in each jurisdiction.

The problem of political governance, including the optimum size of governmental units, is not hopeless; in fact, it is just the opposite. The Swiss and other nations have shown what works. There is no reason why all cannot enjoy a high degree of personal liberty, economic freedom, and live in a community that provides whatever level of government benefits, under the control of that community, its citizens desire.

Membership of OECD forums

Over the years, the OECD, a 34 member intergovernmental network that includes the U.S., the U.K., Europe, Australia, Canada, Japan, South Korea,  has designed various forums for multilateral engagement on international tax policy. Working with the G-20, which comprises ten OECD  members, nine non-OECD members, and one representative of the European Union, the OECD initially sought collaboration and peer review of country practices beyond its membership in 2002 when it created the Global Forum in connection with its Harmful Tax Practices Initiative. Now in connection with the Base Erosion and Profit Shifting (BEPS) Initiative and separately as part of its expansion of information exchange under the common reporting standard, the OECD is expanding its horizons, building new forums that will bring together OECD and non-OECD countries for purposes of monitoring national implementation of the BEPS action items as well as gathering new sources of data on national practices through peer review. A brief summary of the main OECD forums follows, together with visuals of the membership of each.

OECD Forum on Tax Administration – created in 2002 with OECD and G20 members plus 5 nonOECD members. The mandate of the FTA is to “improve taxpayer services and tax compliance by helping tax administrations.”

Global Forum – created in 2002 with OECD and non-OECD members to peer monitor national practices arising from the Harmful Tax Practices Initiative.

MAATM – Formed in 1987, the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, a framework agreement that lays out principles for information exchange and assistance in collection among nations. The MAATM, also referred to as the MAC, is not self-executing but requires signatory nations to implement terms via bilateral or multilateral agreements.

MAATM 2010 Protocol – updating the MAATM to allow for automatic exchange of information among other matters.

MCAA-CRS – a multilateral competent authority agreement among parties to the MAATM. The MCAA-CRS sets out the terms for automatic exchange of information and assistance in collection with regard to the common reporting standard (CRS). The CRS is the global version of FATCA designed by the OECD for adoption by member and non-member states. The MCAA-CRS is not a treaty; rather, it is a competent authority agreement entered into by designated Finance or Treasury officials in each country to implement treaty terms.

MCAA-CBC – a multilateral competent authority agreement among parties to the MAATM. The MCAA-CBC sets out the terms for automatic exchange of country-by-country reports in connection with the BEPS minimum standard.  The MCAA-CBC is also a competent authority agreement entered into by designated Finance or Treasury officials in each country.

OECD Inclusive Framework – announced in 2016, the Inclusive Framework is the new umbrella group formed to draw together OECD members with non-OECD members that agree to implement the standards of the BEPS initiative (“BEPS Associates”). The role of the Inclusive Framework will be to coordinate peer review and monitoring among OECD members and BEPS Associates of the BEPS minimum standards, in addition to specified national practices (such as interest deductibility and controlled foreign corporation rules.

 


COUNTRY
OECD Forum on
Tax Admin
(as at August 2016)
OECD Incl. Frmwk (Associates)
(as at August 2016)
MCAA-CRS
(as at August 2016)
MCAA-CBC
(as at August 2016)
MAATM 1987
MAC MAATM 2010 Protocol
(as at August 2016)
Global Forum
(as at August 2016)
SUM FOR COUNTRY
Australia
1
1
1
1
1
1
1
7
Canada
1
1
1
1
1
1
1
7
France
1
1
1
1
1
1
1
7
Germany
1
1
1
1
1
1
1
7
Italy
1
1
1
1
1
1
1
7
Japan
1
1
1
1
1
1
1
7
Korea, Republic of (S.K.)
1
1
1
1
1
1
1
7
Mexico
1
1
1
1
1
1
1
7
United Kingdom
1
1
1
1
1
1
1
7
Argentina
1
1
1
1
1
1
1
7
Austria
1
1
1
1
1
1
1
7
Belgium
1
1
1
1
1
1
1
7
Chile
1
1
1
1
1
1
1
7
China
1
1
1
1
1
1
1
7
Czech Republic
1
1
1
1
1
1
1
7
Denmark
1
1
1
1
1
1
1
7
Estonia
1
1
1
1
1
1
1
7
Finland
1
1
1
1
1
1
1
7
Greece
1
1
1
1
1
1
1
7
Iceland
1
1
1
1
1
1
1
7
India
1
1
1
1
1
1
1
7
Ireland
1
1
1
1
1
1
1
7
Israel
1
1
1
1
1
1
1
7
Luxembourg
1
1
1
1
1
1
1
7
Netherlands
1
1
1
1
1
1
1
7
New Zealand
1
1
1
1
1
1
1
7
Norway
1
1
1
1
1
1
1
7
Portugal
1
1
1
1
1
1
1
7
Slovakia (Slovak Republic)
1
1
1
1
1
1
1
7
Slovenia
1
1
1
1
1
1
1
7
South Africa
1
1
1
1
1
1
1
7
Spain
1
1
1
1
1
1
1
7
Sweden
1
1
1
1
1
1
1
7
Switzerland
1
1
1
1
1
1
1
7
Costa Rica
1
1
1
1
1
1
1
7
Hungary
1
1
1
1
1
1
6
Indonesia
1
1
1
1
1
1
6
Poland
1
1
1
1
1
1
6
Russian Federation
1
1
1
1
1
1
6
Colombia
1
1
1
1
1
1
6
Curaçao
1
1
1
1
1
1
6
Liechtenstein
1
1
1
1
1
1
6
Turkey
1
1
1
1
1
5
United States
1
1
1
1
1
5
Brazil
1
1
1
1
1
5
Aruba
1
1
1
1
1
5
Bermuda
1
1
1
1
1
5
Bulgaria
1
1
1
1
1
5
Croatia
1
1
1
1
1
5
Georgia
1
1
1
1
1
5
Guernsey
1
1
1
1
1
5
Isle of Man
1
1
1
1
1
5
Jersey
1
1
1
1
1
5
Latvia
1
1
1
1
1
5
Lithuania
1
1
1
1
1
5
Malaysia
1
1
1
1
1
5
Malta
1
1
1
1
1
5
Monaco
1
1
1
1
1
5
Nigeria
1
1
1
1
1
5
Romania
1
1
1
1
1
5
San Marino
1
1
1
1
1
5
Senegal
1
1
1
1
1
5
Seychelles
1
1
1
1
1
5
Singapore
1
1
1
1
1
5
Uruguay
1
1
1
1
1
5
Saudi Arabia
1
1
1
1
4
Albania
1
1
1
1
4
Andorra
1
1
1
1
4
Anguilla
1
1
1
1
4
Barbados
1
1
1
1
4
Belize
1
1
1
1
4
Cameroon
1
1
1
1
4
Cayman Islands
1
1
1
1
4
Cyprus
1
1
1
1
4
Gabon
1
1
1
1
4
Ghana
1
1
1
1
4
Gibraltar
1
1
1
1
4
Jamaica
1
1
1
1
4
Kenya
1
1
1
1
4
Montserrat
1
1
1
1
4
Nauru
1
1
1
1
4
Niue
1
1
1
1
4
Sint Maarteen
1
1
1
1
4
Turks and Caicos Islands
1
1
1
1
4
Virgin Islands (British)
1
1
1
1
4
Faroe Islands
1
1
1
3
Greenland
1
1
1
3
Mauritius
1
1
1
3
Azerbaijan
1
1
1
3
Burkina Faso
1
1
1
3
Dominican Republic
1
1
1
3
El Salvador
1
1
1
3
Guatemala
1
1
1
3
Hong Kong
1
1
1
3
Kazakhstan
1
1
1
3
Morocco
1
1
1
3
Philippines
1
1
1
3
Saint Kitts and Nevis
1
1
1
3
St. Vincent & the Grenadines
1
1
1
3
Samoa
1
1
1
3
Tunisia
1
1
1
3
Uganda
1
1
1
3
Ukraine
1
1
1
3
Angola
1
1
2
Moldova, Republic of
1
1
2
Antigua and Barbuda
1
1
2
Brunei Darussalam
1
1
2
Cook Islands
1
1
2
Egypt
1
1
2
Grenada
1
1
2
Kuwait
1
1
2
Liberia
1
1
2
Marshall Islands
1
1
2
Pakistan
1
1
2
Papua New Guinea
1
1
2
Paraguay
1
1
2
Saint Lucia
1
1
2
Bangladesh
1
1
Benin
1
1
Congo, Republic of (Brazzaville)
1
1
Democratic Republic of the Congo (Kinshasa)
1
1
Eritrea
1
1
Haiti
1
1
Sierra Leone
1
1
Sri Lanka
1
1
Armenia
1
1
Bahamas
1
1
Bahrain
1
1
Botswana
1
1
Chad
1
1
Dominica
1
1
Guyana
1
1
Ivory Coast
1
1
Lebanon
1
1
Lesotho
1
1
Macau
1
1
Macedonia, Rep. of
1
1
Mauritania
1
1
Niger
1
1
Panama
1
1
Peru
1
1
Qatar
1
1
Tanzania; officially the United Republic of Tanzania
1
1
Trinidad and Tobago
1
1
United Arab Emirates
1
1
Vanuatu
1
1
TOTAL
23
62
61
21
75
80
110

Out of line – Hanjin Shipping’s filing for receivership raises more concerns for the maritime industry

In late August, Hanjin Shipping, a South Korea-based containership liner company, filed for receivership in bankruptcy court in Seoul, a few days after its primary creditors announced their disapproval of the company’s restructuring plan.

It has been an open secret that the shipping industry is in terrible shape since defaults have been happening with almost metronomic accuracy. However, Hanjin is the seventh biggest containership liner company in the world, with almost 140 vessels under ownership and management, the premier shipping company of the export-oriented South Korean economy and it was bankrolled by several of the country’s state-run banks. In short, Hanjin was considered “too big to fail,” reminiscent of the banking crisis days in 2008.

One could say, that Hanjin’s filing caught many people by surprise; so much so that, at the time of the filing, $14.5 billion worth of merchandise was stuck in containers onboard Hanjin-controlled vessels.

The Hanjin bankruptcy petition is unique in several respects. First, despite the weakness of the shipping industry in the last few years, the next largest containership liner bankruptcy after Hanjin happened exactly 30 years ago (United States Lines in 1986), indicating that liner companies are better positioned than dry bulk and tanker companies to sustain the rogue waves of bad markets.

It really takes an exceptionally bad market to rock containership liner companies and now the industry is in the midst of one.

Filings of containership liner companies are inexecrable logistical nightmares where cargo from thousands of shippers gets derailed simultaneously in different legal jurisdictions and several ports worldwide, where port operators demand advance payment in order to dock and unload the vessels. Technically speaking, each of the containers onboard even on the same ship can constitute a distinct legal claim, with potentially thousands of claims just deriving from one of today’s monster behemoths.

The fact that containership liner companies operate in so-called alliances – in the CKYHE Alliance in the case of Hanjin Shipping – and that many of their vessels are chartered-in from other shipowners can only amplify the impact of the default, and potentially trigger a domino effect of more defaults by other companies.

In the case of Hanjin, Danaos, a publicly listed shipowner who charters out its vessels on long-term contracts (tonnage provider in maritime lingo), has approximately $560 million of outstanding contractual revenue now in jeopardy. This shortfall may force many of Danaos’ own lenders to take another look at the company and possibly demand more assurances in the form of equity, etc.

It will take some time for the Hanjin situation to settle, and given the circumstances of the company, liquidation is the probable outcome. Hanjin will be forced to sell its vessels to satisfy creditor demands. And with the company name severely undermined to command any customer loyalty, the company will soon be relayed to maritime history business books or feature only on the smokestacks of small vessels as a marginal, regional shipowner.

There will be litigation for the next couple of years with counterparties trying to salvage as much as they can from their unfortunate exposure to Hanjin. It is a sad outcome and an inglorious conclusion to an otherwise respectful effort to be a shipowner with global reach.

But, what has gone so awry?

For starters, the crisis in the shipping industry has been the worst of the last 30 years. Demand for shipping has been slowing down because of decelerating world economies, at a time when the world’s fleet is relatively new. Lots of today’s ships were financed and built when the shipping banks were expanding their balance sheets in the last decade. And this modern fleet keeps growing even today, due to the time lapse between placing a newbuilding order and the physical delivery of a vessel. Today’s ships were ordered two years ago.

There is a structural imbalance between tonnage supply and demand that will take time to tend to equilibrium. To understand just how oversupplied the market is, one has to consider that between February and August 2016, the Baltic Dry Index, proxy for the dry overall dry bulk market, more than doubled but dry bulk vessels today still do not earn enough freight revenue to cover their operating expenses.

The market is so oversupplied that it costs a shipper now on average $600 to have a container shipped from China to North America, but a containership liner company like Hanjin has to charge more than $1,500 for the same container in order to break even. It’s a bad market no doubt, with no easy solutions for a recovery, and with victims along the way.

While waiting for a swift and strong recovery, one has to ponder how companies like Hanjin came down so badly? How can a company with a strong contract base in its native Korean export industry and other manufacturers worldwide that is so well integrated into the world’s liner shipping network manage to fold so badly?

Poor strategy and financial mismanagement cannot be excluded, as of the 140 vessels operated by the company, only 40 were self-owned and the remaining 100 were chartered-in; effectively a form of off-balance financing where other shipowners’ ships were chartered at higher rates when market expectations were more optimistic.

This top-heavy house-of-cards has been burning $2 million per day between its contractual obligations to other owners’ vessels and what Hanjin was able to earn in the present market.

At current market rates, it would have cost $700 million for Hanjin to buy a year’s time for market recovery, $1.4 billion for two years’ runway. Bad markets can be bad for all shipowners, but they are unforgiving for those who are over-levered or least prepared.

And, this bad market is causing problems for many entities in shipping. It is not about problems in a vacuum any more, but cascading problems that have to be faced on a comparative and timely basis. As big and crucial as Hanjin has been as a shipping interest, and as solid and strong as their primary creditors have been, including the state-owned Korean Development Bank (KDB), there have been bigger considerations.

KDB had to bail out Korean shipbuilders and notably Daewoo Shipbuilding and Marine Engineering (DSME) earlier in 2016 at a price of close to $2 billion, given that the weak freight market has been causing defaults on shipbuilders as well, and not just shipowners.

In the summer of 2016, KDB also had to bail out a smaller domestic shipping company, Hyundai Merchant Marine, that was also affected by weak freight rates. Having spent lots of dry powder on DSME and HMM – and taking lots of heat domestically for using taxpayer funding to support preferred members of the chaebol nexus – when Hanjin decided finally to seek help, there was little political will left for support.

All players in shipping have problems these days, and there is increasing risk of a cascading effect. Extracting a solution requires one to be first to the altar while there is still some enthusiasm and dry powder and while a solution to one’s problems can be lined up within a greater platform solution.

There is still plenty of risk for contagion from charterers, shipowners, shipping banks, and shipbuilders, and being proactive is better than being reactive to a crisis.

Hanjin’s case is only one example of the shipping industry adapting to an oversupplied market, as many of the variables create headwinds for the industry, at least in the short term. From slowing economies to shipping banks leaving the shipping industry – a topic covered previously in these pages, shipping companies are facing a new reality and business model. Some will have to fail, but the survivors will have to have a bigger balance sheet, through consolidation and M&A, and a more efficient and lenient structure.

Without direct taxes, how does the Cayman Islands generate its revenue?

ci-ocean-front-view

The Cayman Islands is often portrayed as a tax haven. And indeed Cayman does not have any corporation tax, income tax, inheritance tax and similar kinds of revenue.

ci-flag-circleYet, residents are acutely aware that they are subjected to taxes as government needs to raise revenue to pay for infrastructure, health, education and the day-to-day operations of the public sector.

Rather than rely on direct taxation, Cayman’s economic model is based on indirect taxes, fees and duties.

 

Coercive revenue

The bulk of government revenue for the next 18 months, for example, comes from $852 million in what’s called “coercive revenue,” meaning mandatory fees and duties, including import duty, work permit fees and company registration fees.

 

Imports

The biggest revenue generator for the country is categorized as “other import duty,” forecast to bring in more than $152 million. This is import duty for most goods brought into the Cayman Islands, except for alcohol, tobacco and gasoline, which are separate categories. Most consumer products are subject to a 22-percent import duty, but in some case higher or lower rates can apply.

 

Drinking, smoking, driving tax

Together, importing alcohol, tobacco and gasoline account for about $52.7 million in government revenue over the next six months. Alcohol has the biggest share of that, contributing more than $27 million, with gasoline adding more than $13.5 million and tobacco adding more than $11.5 million.

 

Immigration fees

Fees for work permits, collected by the Immigration Department, government forecast will add almost $100 million in revenue. Annual work permit fees for people with permanent residence are expected to add more than $20 million to government coffers. The budget forecasts almost $12 million from other immigration fees, including non-refundable repatriation fees (meant to repatriate someone if they are forced to leave or pass away while working on island) and fees for applying for Caymanian status and permanent residency.

 

Company fees

Fees for company registration add more than $125 million to government revenue. The bulk of that income, $110 million, comes from exempt companies registered in Cayman. Bank and trust licenses add another $31 million to the budget. Mutual fund administrators are expected to pay more than $47.5 million to government and partnership fees are forecast to bring in more than $52 million.

 

Property

Government expects to make $55 million from stamp duty on land transfers in the new budget. Public revenue includes another $31 million for property-related fees, including land registry fees and building permits.

 

Tourism

Fees related to tourism, primarily charges for cruise ship departures and tourist accommodations, add more than $46 million to government’s budget.

 

Other revenue

Government expects to bring in more than $381.6 million from what’s considered “non-coercive” sources, including facility rentals, government sales and a separate set of fees.

 

Fees

Non-coercive fees, not be confused with the numerous fees considered coercive, are expected to contribute $158 million to government coffers.

These fees include trade certificates, marriage licenses, a number of immigration fees not included in coercive immigration permit fees, passport fees and dozens of other small fees from core government, statutory authorities and government companies.

Government expects to bring in more than $2.5 million in garbage fees, more than $2 million for vehicle inspections, $11 million for aircraft inspection and licensing, and more than $18 million in cargo handling fees.

 

Sales

Sales account for more than $157 million in government income for the next 18 months, including authorities and government-owned companies.

Sales include $39 million from the Water Authority, $64 million for Cayman Airways passenger tickets, and $15 million for vehicle licensing fees. Police clearances are expected to generate more than $1.3 million in revenue.

The budget forecasts income of more than $2.4 million from postage stamps, not including the $30,000 expected for “philatelic sales” to stamp collectors.

 

Rentals

Rentals of post office boxes, government facilities like craft market stalls and town halls, contribute almost $5.5 million to the government budget in the coming fiscal cycle.

P.O. Box rental fees are expected to generate more than $1.5 million for the new budget. The budget forecasts government housing rentals will bring in $38,000.

In defense of the British Empire

Would the world have been better off if there had never been a British Empire?  Would North America have been better off if it was never colonized by the British?

The common belief is that the British colonial period was a stain on human history, and some from former British colonies still blame their lack of progress on British colonialism (despite having been free for at least a half of century).  Enclosed is a table that lists most of the areas of the globe that the British at one time ruled.  (Some non-listed places are tiny islands or have been incorporated into states that were never ruled by Britain or by some other country.)

in-defenseSome of my ancestors were involved in the American Revolutionary War against the British – and I am pleased that they won.  But that being said, if the present-day U.S. had been successfully colonized by the Spanish, French, or even the Russians (all of whom at one time or another did control much of the present territory of the U.S.), would those who now live on those lands enjoy as much freedom and prosperity?  I think not.  If Spain (and Portugal) had controlled Canada and the U.S. in the way they did Latin America, with their feudal law system, it is arguable that the U.S. would be much poorer.

The British brought the concept of the rule of law with the “common law,” along with a strong commitment to the protection of private property and individual liberties most everywhere they went, unlike other colonial powers..  The idea of the “divine right of kings” was thrown out by the British during the Glorious Revolution of 1688 when the Parliament gained clear supremacy.  The English had limited the king’s power from the time of the Magna Carta in 1215.  The British had also benefited from the Scottish Enlightenment, which firmly established the concept that the individual had rights that could not be taken away by the state.  The American Declaration of Liberty and the Constitution are reflections of this change of thinking.

Implicit in my argument is that if the British had not become the colonial power in all of the areas it took over, some other country would have, given the advances in ship design and construction.  It could be argued that the world would have been better off if there had been no foreign colonization.  Because of unique circumstances, i.e. weak monarchies, resulting in the development of the protections of private property and commercial law, the industrial revolution began in England and the Netherlands.  This led for the first time in history to a sustained rise in innovation and real incomes.  There is little reason to believe if the English (and the Dutch) had left the rest of the world alone, other places would have developed any faster or have more freedom than they have now.

The table clearly shows that there are great benefits to living in a British dependency or territory.  In almost all cases, the people enjoy a very high standard of living, substantially exceeding that in the British homeland and in many cases in the U.S., while enjoying all or more of the liberties of Englishmen.  Caymanians clearly made a wise decision by opting to be a British Overseas Territory, rather than being part of Jamaica.  Those former colonies whose populations ended up having a substantial percentage of people of British Isles heritage – the U.S., Canada, Australia, New Zealand – have done very well by any standard because they brought along the ideas of rule of law and private property rights.

Other than Hong Kong and Singapore, the British were not successful in transferring most of their ideas of economic freedom, the rule of law, and individual liberties to their colonies, despite considerable efforts to do so.  These days we refer to the effort as nation building, which for the most part has also been unsuccessful by the U.S. and others in the Middle East and Africa.

Those who blame their lack of development on British colonialism should explain how their country would have done better without being a colony.  Would they have adopted the rule of law, private property protections, free markets, free trade, etc. on their own?  What is preventing them from doing so now?  Singapore and Hong Kong are examples of British colonies that not only adopted British institutions and its legal system, but established even more economic freedom and have become very rich since the end of the colonial period, without having natural resources.  The table clearly shows that, other than the oil-rich states, there is a very high relationship between economic freedom and per capita income.  The British, like all, have faults, but they are not to blame for economic misery in former colonies, which for better or worse are now masters of their own destinies.

Fighting populism by tempering bureaucratic centralization

Blaming outsiders for economic maladies appeals to base human instincts evolved over millennia to engender beliefs that the economy is zero-sum: one person’s gain is another’s loss. In the violent, resource-constrained world of our Paleolithic ancestors, such beliefs may have been rational. But in the modern world, in which we each specialize according to our abilities and trade for mutual gains, it is highly irrational. Competition, be it with your neighbor or a foreign company, drives innovation, as each party is motivated to develop better, less expensive products to meet felt needs.

The constitutions of the EU and U.S. both contain provisions intended to constrain the ability of states to impose restrictions on trade. Over time, however, these provisions (especially the Commerce Clause in the U.S. and Articles 34-36 in the EU) have increasingly been used to pass legislation intended to harmonize regulations, which in turn has empowered bureaucracies that are incentivized continuously to expand their role. The result has been a massive increase in the regulatory burden, hindering innovation and thereby slowing economic growth.

Over the course of the past century, states have increasingly taken on responsibility for redistributing resources from those with greater wealth to the less wealthy. This has increased the burden on taxpayers and created enormous unfunded liabilities. In the U.S., total unfunded liabilities of federal, state and local governments were recently estimated at $200 trillion – more than 10 times current annual GDP.

As the potential for direct resource transfers has become more politically difficult, some governments have sought to use regulation as an indirect mechanism for such transfers. But these often have the opposite effect to that intended. In the U.S., state and now federal health insurance mandates are intended to ensure coverage for certain conditions but in so doing they increase the cost of insurance. In the EU, regulations imposing price controls on interchange fees seek to reduce the cost to consumers but result in higher bank fees, harming especially the poorest in society. Meanwhile, minimum wage regulations incentivize manufacturers and retailers to introduce labor-saving technologies, which reduce employment, especially among the youth.

Perhaps the most egregious intervention by governments has been attempts to manage the money supply. For decades, governments have sought to manipulate interest rates, and more generally access to credit, as a means of engineering growth to coincide with elections. As a result, business cycles have been exacerbated, with higher rates of malinvestment during booms followed by longer recessions and overall slower rates of growth.

The coalescence of growth-stifling regulations, increased spending and perverse monetary interventions has resulted in increasingly distorted economies. While most of those who have become wealthy have likely done so through perfectly legitimate means, benefitting everyone in the process, some have had their wealth enhanced by regulations and transfers that have come at the expense of the majority of productive workers.

The dramatic increases in wealth of a relatively small number of super-rich, some unjustly so, combined with stagnating incomes of many, and large numbers of people effectively priced out of work have led to widespread feelings of disenfranchisement. Add to this both real and perceived threats from migrants, some of whom are violently opposed to liberty.

In combination, these conditions are highly conducive for populist politicians who claim that they will make nations great again. Ironically, however, populist policies that arbitrarily limit transactions, whether through restrictions on trade or migration, reduce innovation and growth and have the potential to result in a vicious cycle of stagnation and further disenfranchisement. Think: Argentina, Venezuela, Bolivia, and Greece.

While Britain’s vote to leave the EU owes something to fear of migrants, it was not entirely motivated by populism. Many voters and most of the intellectual leaders of the leave campaign were mainly concerned about the harm done by EU regulations and the direct net cost to taxpayers. As such, Brexit has the potential either to reinforce or to temper populist sentiments. If upon exiting the EU, Britain maintains essentially free trade in goods, capital and services with the EU, while removing barriers to trade with non-EU countries and establishes better rules on migration, then it will likely increase innovation and growth domestically, improving the lot of those who currently feel disenfranchised, thereby tempering populism.

Some EU officials have signaled that they want to “punish” Britain for exiting the EU. But such punishment would be more masochism than sadism and while sado-masochism is not unheard of in Brussels, it seems an unwise choice in this case. It is also unlikely. Britain imports more goods from the EU than it exports to the EU and the leaders of companies who export goods to Britain – especially large companies such as VW, Peugeot-Renault, LVMH, Bayer, and Danone – will lobby their governments to maintain open trade in goods. Meanwhile, financial firms such as Deutsche Bank and Santander that have a significant presence in the U.K. will want the U.K. to maintain its passporting rights.

If people in other EU countries see conditions improving in Britain as a result of Brexit, there will be pressure for realignment in the EU. One possibility is that Britain remains part of the European Free Trade Area (EFTA) and other countries – Denmark? Holland? – join, creating a new, powerful region of free trade that offers a competing model to the EU. In turn, the remaining members of the EU might push for reforms tempering the tendency towards bureaucratic centralization and thereby in turn mitigating the power of the populists.

Britain’s Brexit vote opens way for a regulatory rethink

In June, as the world well knows now, the people of Britain voted to leave the European Union. At least some of the popular animus toward the vote was a revulsion of regulatory harmonization. People were fed up with the European Commission’s one-size-fits-all approach toward matters as diverse as weights and measures, bank capital asset requirements, and even the curvature of bananas. Thus, Britain leaving the EU provides not just a chance to rethink the country’s relationship with Europe and the rest of the world, but also how we approach global regulation.

Global regulation isn’t going away. As World Trade Organization (WTO) Director Pascal Lamy recently told Institutional Investor regarding two big multilateral trades deals that are currently foundering, “[The Trans-Pacific Partnership] was the last of the classical agreements addressing protectionism, whereas [the Transatlantic Trade and Investment Partnership] would be the first trade agreement addressing the problems not of protection but of ‘precaution’ – the standards on safety, quality, traceability and the environment.” In other words, future trade deals won’t be about breaking down tariffs – they’ll be about “harmonizing” regulations.

Trade agreements have been going this way for some time. The North American Free Trade Agreement (NAFTA), agreed in the early 1990s, contains provisions on labor and environmental standards. American trade agreements since then have followed this model, imposed more and stricter regulatory standards on partner nations. Indeed, some recent U.S. agreements, such as the one with Panama that came into force in 2012, have been called “Trade Promotion Agreements” rather than “Free Trade Agreements” in recognition of this change in emphasis.

The Trans-Pacific Partnership goes further, even dropping the word “trade” from its title. The U.S. Trade Representative describes the draft agreement thusly: “[T]he Trans-Pacific Partnership reflects the United States’ economic priorities and values. The TPP not only seeks to provide new and meaningful market access for American goods and services exports, but also set high-standard rules for trade, and address vital 21st-century issues within the global economy.” [Emphases added]

The trend is clearly toward global harmonization of rules and standards. In a sense, this is understandable. Tariff barriers around the world have been falling ever since the General Agreement on Tariffs and Trade, the predecessor to the WTO, was signed in 1948. Today’s main obstacle to increasing trade lies in the form of non-tariff barriers, mostly national-level regulations designed to protect local industries.

These can range from food “safety” standards grounded in cultural bias to customs border inspections designed to slow imports. A famous example was France’s response to affordable video cassette recorders from Japan. The French government required that all VCR imports had to pass through one customs house in Bayeux that was so small it had but one inspector who worked less than five hours a day. The Japanese had little grounds for complaint, as Japan has its own onerous inspection rules — such as one that requires customs inspectors to draw a picture of the imported object.

Regulatory harmonization reduces some of this problem. If all goods are produced according to the same standards, there is no need for burdensome customs inspections. This was the guiding principle behind the abolition of border trade controls within the European Union’s customs union. A VCR constructed in Budapest is treated the same as one produced in Bayonne.

Extending the principle to be included in trade agreements might make some sense upon first look. But such harmonization is often bad news for people in the developing world, as it can result in protectionism by other means.

Poorer countries have a comparative advantage in trade, based on their lower costs of production. If those costs are increased as a result of stricter regulation demanded by their developed country trading partners, their advantage will be reduced and they will export less.
This is why American trade unions lobby for strict labor regulations in trade agreements. They view lower labor costs in developing countries as “unfair” competition for the companies where their members work. Jobs will be lost at home without these standards, they claim. They are right, up to a point.

The principle of comparative advantage – first developed by English economist David Ricardo in 1817 – suggests that countries should give up on industries, even where they are better at them than their competitors, if they have an even bigger advantage in other areas. For example, Courtney Walsh may have been an excellent car mechanic, but it made more sense for him to concentrate on cricket and pay someone to fix his vehicle. Regulatory harmonization erodes comparative advantages by imposing uniform rules on countries facing different circumstances, and leads to a misallocation of resources.

It’s also potentially very bad news for people in the developed world. Not only do they not gain the advantage from trade they could get in terms of more affordable imports, but harmonization itself magnifies risks that already exist. A good example is the move toward harmonization of financial services regulation following the financial crisis.

An agreement among global rulemakers to regulate financial services the same way means that if the regulations are faulty, the world could face a global crisis. We saw this at play during the euro crisis. The Basel II capital standards assigned very low risk to sovereign debt, which provided an incentive for banks to hold national debt as a way to meet their capital reserve requirements. As it turned out, debt from countries like Greece and Spain proved to be very risky, leading to a loss in confidence in European banks and the need for continent-wide bailouts. While the Basel Accords have been updated recently, banking regulators are often still “fighting the last war,” and their rules may become hostage to fortune.

Last but not least, there’s a risk of regulatory cartelization. You have to be in the harmonized club or you don’t get access to the club’s markets. That is what happened with the European Union. Former Czech President Vaclav Klaus lamented that his country spent so much time liberalizing after the fall of the Berlin Wall only to have to reimpose so many of the same restrictions on business when it joined the European Union. Moreover, being in such a club results in an ever-increasing cycle of more regulation as national governments do not have to worry about other member nations developing better policy. Again, this is what happened with the European Union.

This is why Brexit could prove so important. The British people’s implicit rejection of harmonization as a prime objective of trade policy could lead to a new focus on regulatory competition.

Most people agree that competition is a good thing. Even President Obama sings its praises, having signed an executive order last April directing his administration to take steps to increase competition. In markets, competition imposes discipline that can deliver great rewards for innovation, quality, customer service and value for money—and punish those who fail to deliver those things. The world beats a path to your door when you design a better mousetrap, while those who cling to the old way get left behind. Even a great company like Eastman-Kodak, once a proud member of the Dow Jones Industrial Index, can disappear as a result of misjudging competitive forces.

In the world of international regulation, competition works like this: Two countries recognize each other’s regulatory regimes as equivalent in aims and objectives, and allow goods and services regulated in one country to be marketed in the other. This process can quickly reveal deficiencies in one country’s rules, point to better regulatory practices, and create pressure for reform.

Regulatory competition is inherent in the United States’ federal system of government. Different state regulators demand different rules for goods and services produced in their states, but for the most part these pose no obstacle to interstate commerce. Such “competitive federalism” allows states to serve as laboratories, conducting experiments to see which regulatory systems work best. For example, in some states, labor unions may collect dues from non-members, while in other states “right to work” laws bar collection of forced dues. More states recently have adopted “right to work,” as it provides significant economic benefits.

Similarly, as anyone familiar with the U.S. banking system knows, some small local banks call themselves incongruously “national banks.” That is because they are chartered by the federal government rather than their state under rules from the 1860s, revived in the 1990s, that allow for the formation of banks under national, rather than state, rules. These rules are often stricter than state rules – they have higher capital requirements, for example – but provide a way for banks to operate across state lines without having to navigate a patchwork of varying state rules. Yet, as national banks gained a competitive advantage, state banks responded by introducing such innovations as payment by check.

On an international level, regulatory competition already exists in the form of Mutual Recognition Agreements (MRAs). These agreements allow the free flow across borders of goods manufactured according to different regulatory standards. An example is the MRA between Germany and its EU partners that allows the sale in Germany of beer not brewed in accordance with the country’s centuries-old Beer Purity Law, the Reinheitsgebot. As it happens, Germans quite like those laws, so foreign beers have not diluted the market noticeably, but the MRA means German brewers can produce beers for export not subject to the law, allowing them to cater to different consumer tastes across Europe.

Mutual recognition is also at the heart of EU financial regulations for the “passporting” of financial firms into EU markets. Passporting is policed by the European Securities and Markets Authority (ESMA), which can also grant passporting rights to non-EU firms on the basis of “regulatory equivalence” – a recognition that other jurisdictions provide a similar level of quality assurance. In July 2016, ESMA recommended extending passporting rights to firms from the United States, Australia, Canada, Guernsey, Hong Kong, Japan, Jersey, Switzerland, and of course the Cayman Islands. Therefore, it is highly unlikely that passporting will be refused to the U.K.’s financial services industry after the nation leaves the EU.

As the U.K. sets to embark on a hectic round of trade negotiations to offset any problems that may result from its exit from the EU’s customs union, MRAs and regulatory equivalence could prove to be Trade Minister Liam Fox’s secret weapon. They will significantly cut down the time needed to conclude trade deals by circumventing the extensive wrangling over the details of harmonization that takes up most of the time in trade negotiations these days. Prime Minister Theresa May’s government should follow that route.

With the U.K. having similar regulatory aims as most other developed nations, equivalence should be easy to demonstrate. The trade deals the U.K. negotiates over the next few years could demonstrate that whatever happens with the TPP and TTIP, regulatory competition is the way forward for world trade.

A tax cure for Sisyphean American monetarism?

Eight years into unprecedented monetary and fiscal expansions, the U.S. economy remains sick to its core. Worse, the U.S. malaise is neither unique in the global setting, nor is it cyclical (or passing) in nature.

Let’s sum up the key evidence.

For more than six years now, the U.S. recovery (in terms of economic growth) has been anemic, judging by historical records and the rates expected from a natural business cycle bounce back. All despite the unprecedented increases in the U.S. public debt levels and monetary supports. And the downside risks to growth are still present, even as the Fed and the federal government have run out of room for further easing.

And for more than a decade now, labor markets headline data has been at odds with other economic trends. Most worrying here is the broken lineages between labor productivity growth and headline unemployment statistics. The U.S. unemployment rate has been at around 5 percent mark for a year now. The combination of the steady and low trend unemployment should be associated with preceding periods of high capital investment, accelerated labor and total factor productivity growth and healthy corporate balance sheets.

Alas, today, exactly the opposite holds. Yes, the U.S. economy is officially at or near full employment. But labor force participation remains below pre-crisis levels, although it is rising, at last, over the more recent months. Non-farm payrolls are growing. But the quality of new jobs creation is questionable, with the majority of jobs still concentrated in low value-added services sub-sectors.

Meanwhile, in the corporate sector, two simultaneously occurring phenomena have presented a serious challenge to the “normal recovery” hypothesis that postulates that in a cyclical recovery, companies use the improved quality of their balance sheets to invest in accelerated capex programs. The virtuous cycle of such investment uplift leads to improved equity valuations, leading to a decline in debt-to-equity-linked ratios and a boost to the balance sheets.

What we are witnessing today, however, is the opposite of a “healthy cycle” in corporate finance. Based on the latest data from FactSet and S&P Global Ratings, excluding a handful of flagship U.S. corporates, the majority of American businesses are suffering from a new bout of debt overhang. The headline figures look healthy: there is $1.8 trillion in cash currently accumulated in U.S. corporate accounts. However, just 25 companies out of the total group of 2,000 tracked by the S&P hold over 50 percent of that cash. For the other 1,975 companies, debt has been on the rise as cash holdings have been falling. Cash cover of U.S. corporate debt is currently down to 15 percent (or US$15 in cash held per US$100 in debt) – a figure that is lower than at the height of the Global Financial Crisis (GFC). And, as of July 2016, there are more companies in default on their debt obligations than in all of 2015. After setting a post-GFC record in defaults in 2015, corporate America is on the march to set another record this year.

Earlier in August, BAML research showed that to cover repayment of high yield corporate bonds, U.S. companies’ issues of junk debt securities, will require 8.5 years’ worth of their operating earnings. This is double the burden of debt back in 2008. First-half 2016 also shows declines in corporate profits, further increasing the weight of corporate indebtedness.
With roughly US$11 trillion of global debt trading at negative yields, the road to monetary easing is no longer worth traveling.

How do we know this?

You might excuse growth in debt if the funds were used to finance new investment or other expenditure relating to productivity growth. Alas, nothing of the sort is happening. Per the latest data, the U.S. corporate sector has managed to record a third consecutive quarter of declining real business investment. In historical terms, we have to go back to 1986-1987 to find another three-quarters-long stretch of negative investment growth outside a recession.

Growth in business equipment excluding agricultural and mining sectors is also negative now, having posted declining growth rates over the last four quarters. As Credit Suisse research shows, over the last three quarters, business investment was running below the 2010-2015 growth average in 20 out of 24 major Equipment Investment Categories and in 12 out of 18 major Structures Investment Categories.

And while investment is shrinking, labor productivity growth is outright tanking. In fact, as noted in a recent analysis by the Wall Street Journal, “The longest slide in worker productivity since the late 1970s is haunting the U.S. economy’s long-term prospects.”

I covered the plight of the U.S. labor productivity and the structural nature of decline in productivity growth in these pages before, warning that the trend reflects not a cyclical (or temporary) correction, but a long-term dynamic consistent with the twin secular stagnation theses: the prospect of structurally lower growth in the economy besieged by depressed demand and falling returns on investment in non-financial capital. But it is worth reminding readers just how big the problem really is.

Based on BLS data, non-farm business productivity fell 0.4 percent year-on-year in 2Q 2016. In simple terms, U.S. workers worked long hours producing less output per hour than in 1Q 2016. This marked the third consecutive quarter of labor productivity declines, the longest consecutive streak since 1979. As was noted by MarketWatch, “The average annual rate of productivity growth from 2007 to 2015 has sunk to 1.3%, well below the long-term rate of 2.2% per year from 1947 to 2014.”

This is the main malaise that renders both exceptional monetary and traditional fiscal policies powerless: you can prime the debt pump, but you can’t get any serious returns in terms of real economic activity growth without changing labor and total factor productivities.

Stagnation in labor productivity implies, over the longer run, stagnation in real household incomes, decline in demand, investment and fiscal revenues. No amount of monetary easing can address these negative factors. Neither can monetary policy (as evidenced by the last eight years of endless experimentations) shift the investment cycle in the presence of a productivity trap. In other words, slow productivity is simultaneously caused by, and causes in return, low investment.

Access to cheap money can alleviate the debt service costs to the economy, but it cannot break the vicious productivity-investment tightening loop. The further up the hill Sisyphus climbs, the further downhill he will slide.

Interestingly, many economists today recognize the problem. Stephen King of HSBC, Larry Summers of Harvard, Northwestern University’s Robert Gordon (of the original supply-side secular stagnation thesis fame) – all coming from different sides of economic debate and ideological backgrounds – are case in point. Even the Fed is sensing the dangers, as illustrated by Janet Yellen’s comments made just prior to the Jackson Hole meeting in August. But none so far have managed to grasp the solution. Thus, Gordon and Summers tend to support the idea of large-scale public investment to compensate for lagging private investment. The Fed is pushing for fiscal supports (in wages and investment terms) to be thrown behind its monetary efforts. And in a lengthy editorial on the future of Fed’s policies, the Wall Street Journal called for shifting the Fed inflation target to accommodate for more open-ended monetary easing.

In reality, addressing the simultaneous challenges of low productivity growth and shrinking investment by corporate America requires, in the long run, removing barriers to demand growth and in the short run, increasing investable funds available to the U.S. companies. The former can be achieved only via continued de-leveraging of households and a simultaneous increase in real after-tax income available for investment.

Fortunately, the entire agenda can be supported by the reforms of the U.S. tax system. Take for example the estimated cash holding of U.S. corporations amassed outside the U.S. Based on data compiled by Moody’s and S&P at the end of 2015, U.S. multinationals held some USD 1.7-1.8 trillion in funds outside the U.S. Some of these funds are, undoubtedly, held for investment purposes relating to these companies’ global operations. But a good chunk of it relates to legal tax optimization strategies pursued by these companies in order to maximize their returns to shareholders.

Currently, there is a cost for onshoring these funds into the U.S. when it comes to paying dividends. On the upper side, the cost of direct compliance with the literally insane U.S. tax system that levies double taxation of income and, worse, treats all worldwide income as if it was earned within the U.S. On the lower side, the cost is legal tax shifting strategies, such as using debt issuance to pay dividends in the U.S., for example. The latter runs around 2-3 percent of funds involved, and with currency risks as well as other risks can rise to 3-4 percent.

Now, suppose the U.S. authorities offer a tax amnesty for repatriation of funds accumulated above with a one-off tax rate of 5 percent (just above the lower cost margin). Assuming 60 percent of all corporate cash holdings abroad relate to tax optimization strategies, the net revenue earned by the U.S. federal government from this transaction will be around US$51 billion-$54 billion.

Should the U.S. opt to apply the same rate on future cash repatriations, using data from Moody’s over the period of 2007-2015, and assumptions above, direct net annual benefits to the U.S. Treasury from the tax code revision will be around US$3.75 billion-$4 billion.

Indirect benefits (outside the fiscal balance sheet) will see a substantial injection of investable funds into U.S. corporate sector. Over the last eight years, U.S. companies accumulated, on average, US$120-$125 billion of foreign earnings in offshore accounts per annum. Bringing even half of it back into the U.S. will increase corporate investment (net of dividends) by around US$65 billion. Take a usual multiple to this number and see how much more fiscal room the feds will have.

These revenues should be pumped back into real investment, by broadening tax incentives for households and small businesses undertaking real investment and/or funding pensions. These incentives today, in turn, will see reduced demand for federal spending in the future (due to improved private pensions coverage) and increase indirect revenues accruing to the government from new investment and business formation.

Differential taxation on foreign and domestic earnings will help several other areas where the U.S. economy is struggling. One, it will incentivize greater exports from the U.S., not only for larger enterprises, but also for smaller and medium-sized ones. This, in turn, will help reduce non-sustainable current account deficits the U.S. been running. Two, onshoring earnings will help reduce corporate leverage, simultaneously alleviating the problem of debt overhang and improving corporate balance sheets’ resilience to future shocks. Three, it will encourage innovation and, with it, labor productivity growth. Currently, returns to technological innovation in global markets can exceed the returns in the U.S. The reason for it is the profit margins that are being compressed by innovation: in the competitive markets, like the U.S., new technology earns less per dollar of disruption it induces on completion than in less competitive and less developed markets in much of the rest of the world. Encouraging exports, therefore, should not only improve profitability, but also productivity (value added) and innovation.

In time, of course, the U.S. needs to lower the corporate tax rate across the board, to bring it closer in line with international standards. Taking the first step with lower foreign earnings tax will help to create a learning curve for such a move and free some resources to fund the broader rate changes. Also in time (although the sooner the better), the U.S. should end the practice of double taxation of corporate dividends. This will discourage corporates from gaming their dividend policies and improve the quality of American pensions.

Strangely, to the best of my knowledge, no political candidate, nor any notable academic economist, has spotted this opportunity to date.

The emergence of Unconstrained Mutual Funds

Unconstrained Mutual Funds (UMFs) have proliferated in the recent past because of their attractive characteristics in an otherwise challenging investment environment. Record-low interest rates, significant market dislocations, and retail investors’ persistent efforts to boost income and protect capital have significantly increased the demand for UMFs in the last few years. In 2016, Morningstar categorized 448 mutual funds as involving some element of unconstrained or non-traditional characteristics. The popularity of UMFs can partially be traced back to their ability to pursue absolute returns in the fixed-income market without being affected by the constraints of conventional credit mutual fund benchmarks.

Managing UMFs provides investment managers with many benefits. The investment manager of a UMF typically has broad authority regarding the trading and investment of fund capital.

For example, the manager may have broad authority to take significant investment risks using derivatives, including as part of the investment adviser’s directional investment strategy, but also for hedging. Investment managers of UMFs may also be permitted to commit a significant percentage of the fund’s total capital to concentrated positions in one or more U.S. or non-U.S. issuers, or in particular U.S. or non-U.S. industrial sectors or markets; direct the fund to invest heavily in illiquid securities, non-investment grade securities, and potentially non-securities (e.g., bank loans); and shorten and lengthen the duration of the portfolio. Additionally, the manager may not be required to cause the fund to adhere to a performance benchmark or index. Many of these UMF benefits and characteristics are shared with private funds.

UMFs can exacerbate investment risks. For instance, some of the most popular UMF strategies could significantly increase a portfolio’s exposure to risk, especially during a downturn. UMFs are also characterized by high annual portfolio turnover. On average, UMF performance has disappointed over the last three years, with returns lower than the return on the 10-year Treasury; often poor UMF performance has been accompanied by high fees and increased credit risk. While the volatility of UMFs (3.83) was higher than that of intermediate funds (2.95), it was lower than that of long-term funds (5.98). According to some estimates, the average UMF has an annual turnover of around 198 percent; in other words, in the course of a calendar year, by Sept. 30 the average UMF could have turned over the entire securities portfolio it held as of the end of the preceding March. Moreover, the complexity of UMF trading has increased so much that leading analysts struggle to assess UMF portfolios and their performance. Because UMFs are not linked to any specific index and frequently may invest in bonds, interest rates, currencies, and securities, with a reservation of rights by the manager to trade even more types of securities and instruments in diverse markets while also engaging in short selling, some call these vehicles “go anywhere” funds.

1.  Regulatory differences between UMFs and private funds

Unlike private funds, as mutual funds UMFs are subject to the extensive regulatory requirements of the Investment Company Act of 1940, among many other legal requirements. Compliance with the provisions of the Company Act means that UMFs may be marketed and sold to all classes of retail investors, including retail investors who have limited, or even no experience investing in securities. Private funds, in contrast, are not marketed to retail investors. Instead, the opportunity to invest in a private fund is restricted to those who meet particular experiential and net worth investment criteria indicating that they are able to understand the risks associated with investing in the fund, including the risk that their investment could lose all or the greater part of its value. Because private fund investments are restricted to investors deemed to be sophisticated – a category that does not include the majority of retail investors – private funds generally are exempt from the registration and other substantive provisions of the Company Act.

In contrast with mutual funds and UMFs, private funds are generally not required to comply with the substantive requirements of the Company Act. This means, for example, that a private fund need not: register with the SEC; register a class of shares with the SEC; provide periodic financial and individual portfolio holdings information to the SEC or to investors; comply with Rule 12b-1 regarding the use of fund assets to pay fund marketing expenses; comply with the requirement to strike a NAV on a daily basis; pay investor redemption proceeds within seven (7) days; or limit its short selling or borrowing, including through the use of derivative contracts. Moreover, unlike for mutual funds (including UMFs), private funds are not required to have independent directors.

Operating a private fund without the duty to comply with the Company Act obligations that apply to mutual funds provides the private fund manager with significant benefits. For instance, the private fund manager has far greater flexibility to pursue diverse investment strategies, and to structure the terms of the contract between the fund and its investors. In particular, the manager may structure the fund to attain objectives that would be inconsistent with investor protection mandates common to mutual fund advisers. Those objectives may include: investing in sectors outside of the manager’s specialization, using any type of equity or fixed income securities or derivative instruments; investing heavily in illiquid securities; engaging in no hedging of fund positions; taking concentrated positions in the securities of a particular issuer, or the securities of several issuers in a particular sector or geographic market (including in non-U.S. markets); borrowing heavily against the fund’s positions and cash; reporting infrequently to investors regarding fund performance; severely limiting the amount of information provided to investors regarding the fund’s portfolio (including by disclosing no information regarding significant positions which the fund has taken); limiting the number of redemption requests that an investor may submit in a particular period (e.g., for any trailing 12-month period); limiting the amount of capital that an investor may redeem at any one time; suspending redemptions by investors entirely, where it is consistent with the investment manager’s fiduciary duty to do so; and calculating the fund’s NAV according to a methodology selected by the investment manager. Finally, private fund advisers benefit from staying exempt from the Company Act to avoid the significant expenses incurred in registering and operating a mutual fund (including a UMF) subject to the Company Act.

2.  Shared characteristics of UMFs and private funds

Analyzing multiple metrics, UMFs share important investment strategy and risk attributes with private funds. UMFs and private funds use similar strategies and investment products; UMFs and private funds use dynamic trading strategies and derivative holdings to avoid parametric normal distributions; and UMFs use a higher proportion of derivatives than the average mutual fund. Because of these shared investment strategy and risk attributes, the average UMF’s risk profile is substantially more complex, and generally involves more risks than that of the average mutual fund, and is closer to the risk profile of a private fund.
UMFs and private funds use similar strategies and investment products. The average private fund is authorized to use dynamic trading strategies, leverage, and derivatives in order to deliver alpha to investors. UMFs use a higher proportion of derivatives than other mutual funds. Moreover, private funds employ a broad range of investment instruments, including the following: 15.3 percent employ strategies involving forward contracts; 21.2 percent employ strategies involving futures contracts; 21.8 percent employ strategies involving options; 17 percent employ strategies involving swap contracts; and 29.1 percent employ one of the prior listed four instruments. While these percentage holdings are generally consistent with the traditional role of a mutual fund in a portfolio (that is, as part of a long-only, buy-and-hold investment strategy based on an allocation to standard asset classes), UMF trading of these instrument types in the aggregate exceeds most of these thresholds. UMFs therefore appear to follow instrument selection and trading strategies comparable to those employed by private funds.

Like private funds, UMFs use dynamic trading strategies and derivative holdings to avoid parametric normal distributions. Because of their use of options, UMFs, like private funds, can generate options-like returns and exhibit non-normal payoffs. However, while private funds’ unique management incentives combined with their flexibility in investment strategy (e.g., the authority to use potentially unlimited leverage and derivatives, and to take highly concentrated positions and engage in potentially unlimited short selling) can help explain their performance advantage over mutual funds, the performance record for UMFs is less clearly distinguished from that of other mutual funds.

UMFs use a higher proportion of derivatives in their portfolio than do other mutual funds. According to some estimates, a total of 71 percent of private funds trade derivative securities, which is more than three times larger than the number of mutual funds trading such securities. UMF derivative transactions greatly exceed the number of derivative transactions engaged in by other mutual funds. This is a core characteristic that UMFs share with private funds, and another important point of contrast with other mutual funds.

UMFs’ greater use of derivatives relative to that of other mutual funds concomitantly increases those funds’ risk profiles above that of the average mutual fund. Mutual funds display no systemic difference in risk or return measures between funds that do and do not use derivatives. UMFs engage in a higher number of derivatives transactions than the average mutual fund. Some evidence suggests that mutual funds that use derivatives engage in less risk-shifting than mutual funds that do not use derivatives, and that there is little influence through derivative use on the fund flow-performance relationship. However, derivative use by UMFs is closer to that of a typical private fund, which may mean that the absence of evidence on risk-shifting by the average mutual fund that engages in derivatives transactions is less relevant.

The average portfolio turnover rate for UMFs suggests a level more consistent with the turnover rate of a private fund. The average turnover rate for a UMF exceeds the portfolio turnover rate for fixed income mutual funds by more than 150 percent. The turnover rate in UMF portfolios relative to that of other mutual fund portfolios suggests that UMFs trade at levels consistent with those of private funds. The higher UMF turnover rate relative to that of other mutual funds can be partially explained by the strategies pursued by UMFs, including the extensive use of derivatives among UMFs.

3.  Retail investor concerns

The growth in the number of UMF launches, in combination with important investment strategy and risk attributes shared by UMFs and private funds, raise several potential retail investor protection concerns. The “go anywhere” features of UMFs may impede a retail investor’s ability to ascertain and understand the UMF’s investments, and the risks associated with those investments. More specifically, the lack of standard benchmarks for UMFs, the recent emergence of UMFs as an investment asset type, and the diversity among and complexity of UMFs’ strategies and risk exposures make it uniquely challenging for retail investors to evaluate the risks of investing in UMF securities.

Retail investors may be led to believe that UMFs, because they are marketed, offered, and regulated as mutual funds, are “safe” products relative to other fixed income mutual funds. This is a risk that is unique to retail investors in UMFs: a private fund investor, who by definition is relatively more sophisticated and wealthier than a retail investor, would have no reason to believe that there is active government regulation of the private fund in a manner conceptually similar to what the SEC requires of mutual funds. Nonetheless, the mutual fund characteristics of a UMF may cause the average retail investor to conclude that the investor’s past experience selecting mutual fund investments for his or her personal portfolio will provide adequate grounding to understand the risks associated with purchasing UMF shares.

Any such conclusion would be mistaken, as retail investors in UMFs face many of the same types of investment strategy and other risks as those faced by relatively more sophisticated and wealthier investors in private funds, a group who the SEC has determined can “fend for themselves.” Accordingly, retail investors’ experience investing in “traditional” mutual funds is likely to be a poor indicator of whether a retail investor will understand the risks associated with investing in a UMF.

Titan International Securities Inc v The Attorney General of Belize: a decision at first instance that should be read across Caribbean International Financial Centres (IFCs)

On Jan. 15, 2016, Justice Courtney Abel of the Supreme Court of Belize handed down a decision which should be read across Caribbean IFCs, especially by regulators and law enforcement agencies from common law jurisdictions. The court found that the manner of the execution of a search warrant on the private offices of a licensed entity was unconstitutional and gave a multimillion-dollar award in damages.

The decision is extremely pertinent to the work of Financial Intelligence/Investigation Units (FIUs) which are present in most if not all IFCs. This article seeks to explain the decision and offer brief comments as to its potential effect on regional jurisprudence. Belize no longer has the Privy Council (PC) as its final court as most Caribbean IFCs do, but instead has the Caribbean Court of Justice (CCJ). However, the fact is that given the similarity in legislation, this decision will impact the wider Caribbean as lawyers and judges look to the region’s other common law legal systems for guidance on statutory interpretation and the application of these laws in practice.

 

Background

On Sept. 8, 2014, a 22-page indictment was unsealed in the U.S. (the Indictment) which charged Titan International Securities Inc. (Titan) and Kelvin Leach (the president of Titan) with being involved in a conspiracy and implicated in a fraudulent scheme with Robert Bandfield and his related companies, along with other persons in the U.S., to evade taxes.

They were also charged with being involved in securities fraud, money laundering, and other offenses. As a consequence, on the same day the U.S. Department of Justice (DOJ) made a Request for Assistance (the Request) under section 18 of the Mutual Legal Assistance and International Cooperation Act No. 18 of 2014 (MLAT) of the Laws of Belize to the Attorney General (AG) of Belize to have Titan’s offices searched “as quickly as possible to prevent the destruction of evidence” and alleged that “a substantial amount of client information is held on hard copy files and on computers” in Titan’s office. The DOJ also asked that the Request be kept confidential.

The Request expressly stated that the documents needed included “any and all documents or other evidence (in copy or original) seized during the execution of search warrants.” The AG agreed and worked through the Belize police to secure the warrant from a local magistrate to effectuate the search. The AG also requested the assistance of the Belize FIU. The magistrate issued the search warrant on the strength of the Request to a superintendent “and to all and every Police Constable and Peace Officers of Belize and to the Officers of the Financial Intelligence Unit of Belize.”

 

Details of the search

To understand the decision by the court, it is important to detail pertinent facts about the execution of the search warrant.

  • The search took place the same day between 1:45/2 p.m. and 9 p.m.
  • A copy of the search warrant was read to Mr. Leach but a copy was not given to or left with him.
  • The police led the search, but a police officer attached or seconded to the FIU was present throughout, along with a Crown counsel in the AG’s Ministry in observance. Another attorney from the FIU joined the search around 6 p.m.
  • Photographs were taken of Titan’s office in the course of the search and a large quantity of items were seized.
  • Titan’s office was effectively gutted and computers were not turned on to determine what was relevant because “it was not feasible at the moment.”
  • Items seized included items that “couldn’t conceivably assist in proving or disproving financial crimes.” These were items belonging to non-U.S. persons for tax purposes and thus could not possibly be part of the remit of the warrant.
  • An inventory of items seized was not left with Mr. Leach and he is unable to account for all of Titan’s items seized.
  • Titan’s attorneys were denied entrance to Titan’s office during the search; it was claimed inadvertently.
  • The seized items were taken away from Titan’s office and housed at the AG’s office and the FIU’s office.
  • Titan’s license was suspended the same day by email, followed up by formal confirmation by letter from the International Financial Services Commission dated Sept. 17, 2014, which prevented Titan from carrying on its “trading in financial and commodity-based derivative instruments and other securities.” At the time of the court action, the suspension had not been lifted.
  • The FIU, by letter dated Oct. 3, 2014, required the AG to produce to them in the following terms “all records seized on September 9th, 2014 pursuant to MLAT of that date.”
  • Items taken during the search and seizure were eventually returned on Jan. 20, 2015.

 

Legal issues

For purposes of this article, the two legal issues I will discuss are:

  1. Whether section 18 of the MLAT and the MLAT itself were constitutional.
  2. Was the search and seizure conducted lawfully?
The constitutionality of the MLAT and section 18 specifically

Many legal scholars have long questioned the constitutionality of many of the pieces of legislation enacted in Caribbean IFCs to fight international crime, tax evasion, and facilitate exchange of information along with the Intergovernmental Agreements to implement U.S. law into domestic statute. The MLATs have also come in for legal scrutiny. Titan argued that section 18 breached sections 9 and 14 of the Belize Constitution. Section 9 deals with the prohibition against unreasonable search of a person or his property or the entry of others on his premises, while section 14 deals with the prohibition against arbitrary or unlawful interference with his privacy, family, home, or correspondence and the prohibition against unlawful attacks on his honor and reputation.

The court started its analysis by noting that section 9(2) of the Constitution contains the traditional savings clause: “Nothing contained in or done under the authority of any law shall be held to be inconsistent with or in contravention of this section to the extent that the law in question makes provision that is required in the interests of defence, public safety, public order, public morality….” This clause is referenced in section 14(2) nearly verbatim. Thus, as the court said at paragraph 50 of its decision that “The right to protection from arbitrary searches, unlawful and/or interference with his privacy is obviously not an absolute right and any law which makes reasonable provision for search and seizure, that satisfies the limitations contained in the provisions of section 9(2)(a) of the Constitution, is obviously protected from being struck down.”

The court then went on to examine section 18(1) and (2) which made it clear that the power to search is predicated on there being criminal proceedings against a person in a foreign state or the person has been arrested in the course of a criminal investigation. Section 18(1) also provides that there needs to be reasonable grounds for suspecting that the evidence is located on premises in Belize, while section 18(2) states that the power to search is only to the extent that it is reasonably required for the purpose of discovering the evidence.

The court held that as a result of the presence of section 18(1) and (2), which introduce limitations and safeguards, any search and seizure carried out under warrant issued under section 18, would be both reasonable and proportionate in a democratic society and provides in the court’s view, adequate legal safeguards to protect and safeguard the public interest from the risk of excessiveness or arbitrariness in any search, as well as against the unlawful invasion of privacy. The court went on to say that all these limitations and reasonable safeguards would preserve the constitutionality of section 18 even without resort to the presumption of constitutionality which exists in relation to any constitutional challenge of provisions in any legislation.

It is hard to argue with this interpretation and legal analysis granted that the test is one of reasonable safeguards and limitations on the right to search and seizure. In his judgment, Justice Abel referenced the Canadian case of Thanh Long Vu v Her Majesty The Queen and AG of Ontario et al [2013] 3 R.C.S. 657 as illustrative of two ways by which the balance between protecting the interests of the individual, the individual’s right against arbitrary search and the interest of the public in law enforcement. Justice Abel quoted that “First, the police must obtain judicial authorization for the search before they conduct it, usually in the form of a search warrant. The prior authorization requirement ensures that, before a search is conducted, a judicial officer is satisfied that the public’s interest in being left alone by government must give way to the government’s interest in intruding on the individual’s privacy in order to advance he goals of law enforcement.”

Justice Abel went on to quote: “Second, an authorized search must be conducted in a reasonable manner. This ensures that the search is no more intrusive than is reasonably necessary to achieve its objective. In short, prior authorization prevents unjustified intrusions while the requirement that the search be conducted reasonably limits potential abuse of the authorization to search.”

It is obvious then that the court found the safeguards and limitations in section 18 satisfactory and in line with the judicial thinking in the aforementioned case to ground its determination that the MLAT is constitutional under the laws of Belize.

The legality of the search and seizure operation

Justice Abel, after reviewing the facts, concluded that the search was executed in an unreasonable and excessive but not necessarily oppressive manner. He ruled that the actual search and subsequent events abused the authorization granted to search the premises and seize items in Titan’s premises in the manner and way in which it was executed and as a consequence was a breach of Titan’s constitutional rights against arbitrary or unlawful interference with its privacy. The court held that the defendants ought to have been more careful about the manner in which it conducted the search and seizure and ought to have:

  • Provided a copy of the search warrant to Mr. Leach which would have eliminated the appearance of high-handedness and given an air of legality and respectfulness to the whole operation and possibly put Titan at ease.
  • The officers ought not to have denied Titan’s lawyer entry into the premises to witness the search and seizure unless there was good reason to deny his entry, and none was provided to the court. Again, this would have been done much to clothe the operations with propriety, transparency and demonstrate a desire not to exceed legal authority.
  • The officers took pictures which were not disclosed, and the court expressed the view that there was no excuse for Titan not to have been provided with copies of photographs as part of the disclosure process in the proceedings before the court.
  • A director of Titan was prevented from witnessing the search and seizure, and the court expressed the view that this would have eliminated the appearance of high-handedness and leant an air of legality.
  • Police and other officers of the AG and FIU ought to have taken measures or at least taken some steps not to remove Titan’s files, records, computers, computer servers and electronically stored information, unrelated to the warrant, rather than the indiscriminate removal of such items.
  • The court found that it was inexcusable that no inventory was prepared of the items seized and no attempt made to obtain from a representative of Titan some form of confirmation of what items were removed. In the absence of such inventory and of any detailed inventory being produced to date, the result is that the defendants have to take full responsibility of the risk, thereby being accused of not returning all items which has now resulted.
  • The court stated that the defendants ought to have taken every possible step to minimize the disruption of Titan’s business, and even if a shutdown were inevitable, to minimize the period of shutdown by reason of the search and seizure, and make a concerted and ostensible effort to ensure that any disruption was not done to persons other than my disruption, which was not done to persons other than those named on the warrant.

As a consequence, the court granted to Titan the declaration it sought that the indiscriminate removal of all files, records, computers of Titan and the effective shutdown of Titan’s office was disproportionate and in excess of any statutory authority to search and seizure evidence in possession of Titan and in aid of foreign court proceedings in the U.S.

 

Damages awarded

Justice Abel did a thorough, though in my opinion an unnecessary, analysis of the law with regards to the awarding of damages for a constitutional breach. His starting point was of course the Constitution, specifically section 20 which speaks of redress in favor of applicants who have alleged a breach of any of the provisions in sections 3 to 19. He then referenced the Privy Council’s decision in Maharaj v The Attorney General of Trinidad and Tobago (No. 2) (1978) 2 All ER 670 which established the principle that damages can be granted as redress for breach of constitutional rights. This principle has been followed in several cases, but for Belize’s purposes it was definitively upheld by the CCJ in the case of The Maya Leaders Alliance et al v The Attorney General of Belize [2015] CCJ 15 (AJ).

The court noted, however, that damages are at its discretion and are not awarded as of right especially where a declaration alone would serve to vindicate the constitutional right that has been infringed. Further, damages had to be proved. Justice Abel added that the purpose of an award is not only to compensate Titan for the wrong suffered, but may also be to reflect public feelings at the state’s violation of such an important right and to vindicate the constitutional right which has been contravened. He explained that the measure of damages should, depending on the circumstance of the case, reflect any additional dimension, gravity or outrage (as the case may be) which breach of a constitutional right adds to any other common-law measure of damage and to deter further breaches. The Justice went on to note that the court must seek and be ready to fashion a remedy to grant an appropriate and effective relief for a contravention of a protected right and if that is by way of a mandatory order for the payment of a money sum by the State, the court is both empowered and in appropriate cases, obliged to do so.

Titan argued that the fundamental object of an award of damages is to award just compensation for loss suffered, and the measure of compensation is to put it in the position as if the constitutional right had not been infringed. It also argued that the court is obliged to conduct the assessment of damages as at the date the cause of action occurred. In making its claim for damages of US$22,273,700, Titan focused on the magnitude of the harm that was done to it, the manifest breach of the terms of the Request and search warrant, the period over which the wrongs persisted, the alleged aggravating conduct accompanying the wrongdoing and the government’s conduct in relation to Titan’s property.

The court held, however, that even if the value of Titan were as claimed above at the date of the search, a large part of the estimate attributable to the future profitability and viability of Titan was greatly compromised because of the indictment and other bad publicity about Titan’s activities in Belize and elsewhere. The court was of the view that Titan would not be able to attract future business. Finally, and most importantly from the court’s perspective, Titan’s trading license was suspended, which affected its status and ability to trade.

Justice Abel thus discounted Titan’s claim by 80 percent and awarded compensatory damages for the constitutional breach in the amount of US$4.460 million. While vindicatory damages were not awarded, legal costs in favor of Titan were.

 

Conclusion

This case was interesting in many ways in that it addressed from a legal perspective many concerns that those of us in the industry have had for years with regard to MLATs and the work of FIUs. In Belize, at least several things have now been settled subject to an appeal which, as of the time of my writing, no evidence had been adduced that one has been so lodged. Firstly, the court held that a FIU cannot participate in a search under a warrant issued to the police under section 18 of the MLAT. Section 18 of the MLAT gives the search power to the police and not the FIU, and the police officer who was assigned to the FIU was ruled by the court to have been there in her capacity as an employee of the FIU and not as a police officer. This made the warrant defective and in excess of the powers that the magistrate has to issue warrants. However, the court severed the bad part and upheld the warrant and thus the lawfulness of the warrant itself. Secondly, the court upheld the constitutionality of the MLAT itself, which is important and clarificatory for Belizeans in general. Thirdly, the court held that the police breached the extent of the search warrant by taking items that were unrelated to U.S. persons and which were outside the ambit of the warrant itself. Fourthly, it held that the indiscriminate removal of all Titan’s files and documents was a breach of Titan’s constitutional protections.

FIUs, the police and regulatory bodies should, in my view, take heed and note that they must exercise caution when conducting searches, especially with such haste under implicit pressure from U.S. authorities. It is worth noting that U.S. agents were present in Belize at the time of the search, although they did not take part in it. The court noted, however, that they took images of all documents which the Belizean authorities took from Titan’s office.

My one major criticism of the decision, however, is the refusal, at least based on my understanding since that section of the judgment was awkwardly worded in my opinion, by the court to grant an injunction to Titan barring the use by U.S. officials of the non-U.S. related client information based on an undertaking between the defendants and a limitation that the defendants were to give to the U.S. along the same lines. I am not sure how effective such an undertaking and limitation would be in practice and question the wisdom of this, but I shall defer to Justice Abel on that point as I must.

Irrespective, the court in Belize has done a good job of defending privacy, property rights, due process, upholding constitutional principles and holding the State to account for rushing to destroy a business based on legal matters in the U.S.

It remains to be seen whether the region as a whole will follow Belize’s lead in ensuring that the rights of the citizens are not trampled upon to satisfy the U.S. in its fight against international crime to which most IFCs, including Belize, are committed.

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