How regulation led to disruptive innovation in retail banking

Since the outset of the global financial crisis, the banking industry has been subject to dramatic regulatory policy change designed to restore stability and remove volatility and systemic risk from the financial sector. This new regulation has addressed capital adequacy, liquidity, organizational structure and corporate governance. In response, traditional banks have implemented changes in their structure, strategy and business models, made significant investments in technologies and systems and fundamentally changed their governance, compliance and risk management frameworks.

It is therefore plain to see that traditional banks have been on the defensive to satisfy risk-averse regulators and have committed an enormous amount of additional resources to managing this regulatory paradigm change whilst at the same time furtively trying to optimize their balance sheets and maximize returns. And at some level it must be accepted that this new regulation has impeded innovation and growth in traditional financial services.

Clayton Christensen, a Harvard Business School professor, coined the term “disruptive innovation” in his 1997 book, The Innovator’s Dilemma, to describe innovation that disrupts an established market and displaces established market leaders. Instances of market disruption are evident in a number of industries around the globe and particularly in industries in which the incumbents are complacent and inefficient and operate using outdated processes and technologies. Netflix, Airbnb and Uber are all examples of market disrupters.

The banking industry in its present state exhibits all the hallmarks of an industry susceptible to disruption yet has been one of the business sectors most resistant to it. This is because banks remain uniquely and systematically important to the economy; they are highly regulated institutions; they largely hold a monopoly on credit issuance; they are the major repository for deposits; and they continue to control the largest payment systems. In many ways, PayPal is the exception that proves the rule: it is difficult to disrupt banks.

However, with traditional banks squarely, and some may say solely, focused on regulatory compliance, opportunities for disruption have become rife and the status quo has finally changed. In recent years a vast number of financial technology companies have started bringing much needed innovation to the market. In a letter to shareholders, JPMorgan Chase CEO Jamie Dimon has previously said, “Silicon Valley is coming. There are hundreds of start-ups with a lot of brains and money working on various alternatives to traditional banking.” Globally, more than US$25 billion of venture capital has been invested in financial technology companies over the last 5 years alone.

A new alternative to retail banking

In particular, the nascent peer-to-peer lending industry and its myriad of start-ups are now starting to disrupt the traditional consumer credit sector at its very core. This year, global peer-to-peer lending is expected to exceed US$60 billion, of which US$35 billion will take place in the United States and US$10 billion will take place in the United Kingdom. PwC has predicted global peer-to-peer lending will exceed US$1 trillion by 2025. All at the expense of traditional retail banks.

Peer-to-peer lending (sometimes referred to as “P2P” lending) is a form of unsecured consumer credit provided by unrelated individuals, or “peers,” without going through a traditional financial intermediary such as a bank or other established financial institution because borrowers are matched directly with lenders. This lending takes places online, on a P2P platform provided by a third party.

Importantly, the P2P provider doesn’t lend its own funds but it does perform valuable services to both borrowers and lenders. It sets the minimum standards that borrowers must satisfy to qualify for a loan, assesses the credit risk and sets the interest rate payable by the borrower. It then provides this information to investors (without disclosing the identity of the borrower) so that they can evaluate the risks and returns of a loan. The P2P provider also administers the loan. Revenue is generated from arranging or servicing fees but not from the spread between lending and deposit rates in a classic intermediation scenario. Those who champion P2P lending compare it to Airbnb and Uber as examples of the new “sharing economy” or “peer-to-peer marketplaces” where the intermediary is displaced and two parties deal with each other directly – in the case of P2P lending, those who want to borrow money and those who want to lend money.

The use of online platforms reduces costs by eliminating many operational expenses associated with traditional consumer bank loans, such as the cost of maintaining and staffing physical branches. These cost savings are passed along to borrowers through lower interest rates than those offered by traditional banks. Furthermore, in the current low interest rate environment, P2P lending provides investors with an alternative investment opportunity where investment returns may be significantly higher than would otherwise be available from traditional fixed income asset classes.

A key marker of success for these P2P platforms has been the innovative use of big data and advanced data analytics in credit modelling and the assessment of credit risk. This kind of data-driven lending, incorporating a wide range of behavioral data, transactional data and educational and employment information to supplement traditional credit scores has demonstrated its superiority over credit assessments based solely on credit scores and has facilitated the extension of smartly priced credit to a broader spectrum of customer than would otherwise be provided credit by traditional retail banks. Furthermore, the delivery of a customized service through a simple interface and a streamlined customer experience has won the hearts and minds of a millennial customer base whose mindset around money, banks and technology differs greatly from the previous generation.

Those championing the democratization of finance have been disappointed by one notable development in the P2P lending space: institutionalization. As much as 75 percent of the money no longer comes from the general public, but from institutional investors such as hedge funds and pension funds, particularly on the larger platforms in the United States – like Lending Club and Prosper. In response, many peer-to-peer lenders have now started to describe themselves as marketplace lenders instead and many of the original P2P investors – individuals – have found themselves marginalized. Lending Club and Prosper have each stated they are trying to balance their lender mix among individuals, institutions and fund managers. However, the P2P business model relies on scale and the fastest, and some say only way for the P2P platforms to significantly increase scale is to turn to institutions for support.

Indeed, some marketplace lenders have already partnered with banks and institutional investors to fund the loans they offer – the Santander Group now has an agreement to fund up to 25 per cent of Lending Club’s loans and JPMorgan Chase has a similar arrangement with smaller rival OnDeck. Proponents of this institutional shift argue that it is good for the industry because it means more capital for borrowers than would otherwise be available solely from individual lenders. Although this argument has some merit, opponents argue that by eliminating peer lenders the disruptive force of the platforms may only be partially realized.

p2pThe future of retail banking

As the peer-to-peer industry continues to experience strong growth and the likes of Lending Club, Prosper and the multitude of imitators that have launched in their wake continue to steal market share from the traditional retail banks, it becomes inevitable that the banks will shift from a collaborative approach to a competitive one and either build or buy their own P2P platform. Indeed, Goldman Sachs has announced plans to launch its own P2P platform sometime in 2016. If one considers the consumer credit market is worth approximately US$3 trillion in the United States alone, the competition can be expected to be fierce.

If traditional retail banks can create P2P platforms that possess the same core capabilities as the existing P2P platforms and at the same time leverage their existing expertise in loan origination, credit underwriting and loan servicing, they may be able to slow the loss of revenue and market share – albeit at lower margins.

Traditional retail banks may also have an unexpected ally in this fight: regulators. There is currently no comprehensive regulatory framework in place governing the P2P industry in either the United States or the United Kingdom where P2P lending is most concentrated. As the industry continues to experience growth, it is inevitable that there will be greater regulation from the likes of the Securities and Exchange Commission and the Financial Services Authority.

The future regulation of P2P will likely, at a minimum, require a substantially more robust compliance and risk management framework and additional compliance processes and infrastructure to be implemented by all P2P platforms. The additional operational costs driven by this regulatory change can be expected to be significant. But for traditional retail banks, this expense will be significantly less because they can once again leverage their existing expertise in regulatory compliance and draw upon their vast regulatory compliance infrastructure already in place. This may see a further erosion of the cost and competitive advantages currently enjoyed by the existing P2P platforms.

The real challenge for regulators will be to impose the appropriate controls without impeding the spectacular innovation and growth that the marketplace lending industry is experiencing. This may prove to be no easy task but if it can be achieved, consumers will ultimately benefit from more competition, more innovation, more choice of products and services, lower costs and improved customer service, and the retail banking industry will have profoundly changed.

The struggles of Baha Mar

A crude translation of Baha Mar might be “Low Sea,” and indeed the unfinished mega hotel/casino project on Nassau’s Cable Beach is aground in shallow waters.

Baha Mar is now in the hands of receivers for its major creditor, a Chinese government bank; its originator and equity owner Sarkis Izmirlian has been forced out; and the Bahamas government sees the country’s major potential foreign-exchange earner lying empty and decaying, while Prime Minister Perry Christie’s many optimistic forecasts are simply blowing in the wind.

The semi-circle of towers, the highest is 25 stories, bearing logos of Hyatt and other brand-name hotels, together with casino, 18-hole golf course and ridge-top club house, dominates the purpose-built landscaped highway system that leads from the airport to downtown Nassau and Paradise Island, home of Baha Mar’s long successful competitor Atlantis.

Every airline arrival passenger sees this looming complex of off-white buildings, said to be 97 percent structurally complete, and may wonder why such an eye-catching enterprise now lies vacant except for wandering maintenance staff.

The attached convention center is booked in April to host the annual meeting of the Inter-American Development Bank, but at the surrounding hotels, doors will stay shut except at the years-old Meliá.

Its history tells the tale. Until 2005, the narrow Cable Beach tourist strip consisted of half a dozen hotels of various sizes and styles scattered along the ocean side of West Bay Street, including a grim Radisson (now Meliá) and the bizarrely ugly Windham casino complex.

Then the Izmirlian family, recent arrivals from Switzerland of Armenian descent, entered the local scene, with no hotel experience, but with a vast fortune earned in the tough business of commodities trading. Father Dikran, now aged 89, famed for controlling the world market for peanuts grown in West Africa, and son Sarkis, a U.S. business school graduate now aged 42, first proposed to the Bahamas authorities a plan simply to acquire and improve the existing properties.

Soon they conceived a more grandiose scheme, with the active encouragement of the Bahamas government, ruled by the Progressive Liberal Party led by the then and future Prime Minister Perry Christie. Under the newly coined name Baha Mar, the resort would stretch from the beach deep inland, re-routing West Bay Street and demolishing and relocating several office buildings and a police station, with government kicking in substantial tracts of Crown Land.

Although the Izmirlians committed equity of $800-$900 million, a major partner was needed to provide funding and management expertise for the planned state-of-the art casino and 2,300 hotel rooms stretching over 1,000 acres. The renowned Harrah’s group, owners of Las Vegas Caesar’s Palace, signed a joint venture agreement. Unfortunately, on the eve of closing in July 2008, Harrah’s pulled out, leaving the Izmirlians with nothing but an unsuccessful breach of contract lawsuit in the New York Courts.

Baha-Mar-hotel-and-casino-DBIt looked like early finito for Baha Mar. But Sarkis began negotiating with Chinese state financial interests, rich with new dollars from the booming economy and eager to invest abroad. Suddenly in 2010, Sarkis appeared in Miami shaking hands with the Chinese Export-Import Bank (CEXIMB), agreeing to a term loan of $2.5 billion, and with the state construction company (CSCEC), which would make an equity investment of $150 million and commit its U.S. subsidiary, known as CCA, to serve as the prime contractor. After tense negotiations over Chinese insistence that CCA be allowed to import some 4,000 Chinese construction workers, the deal was signed, and ground-breaking soon began. Government was happy with the forecast of 5,000 Bahamian employees and about 5 percent contribution to GDP.

We in Nassau watched as new roads were carved out of the bush, barracks for the Chinese were built, and cranes raised hotel towers to the ebullient topping-out ceremony in February 2013. Optimism prevailed, despite critics who grouched that the environmental impact will blight the surroundings, that airlift to Nassau will never fill both Baha Mar and the equally sized Atlantis, and that the complex should have been planned in several phases, as was Atlantis. When the first scheduled opening date of Dec. 8, 2014, was postponed, rumblings were heard but were regarded as typical delays for a large project. In February 2015, the prime minister and Sarkis Izmirlian issued a joint statement stifling any doubts by assuring that construction would be completed to allow opening on March 27. International publicity continued, extolling Baha Mar as the largest single phase hospitality project ever undertaken in the Western Hemisphere and conducting a successful sales campaign for million-dollar condos integrated in the complex.

Thus it came as a rude shock when Baha Mar management with two weeks’ notice abruptly canceled the opening, publicly laying the blame directly on the Chinese prime contractor CCA for shoddy work and quitting on the job. No future opening date was forecast, and Baha Mar had to reimburse hundreds of potential guests who had committed both room reservations and airfares, leaving a bitter taste with international travel agents.

CCA promptly riposted that they had not been fully paid for work done and were overwhelmed by change orders issued by the owner. Despite a Dispute Resolution Committee, the conflicting claims were never resolved. This author has been told by an American civil engineer retained to supervise the project that after two years he resigned in frustration, finding the Chinese firm incompetent to handle such a large and complex venture, and unwilling to change their ways. Earning no revenues, but paying operating expenses plus salaries of 2,000 initial Bahamian employees, including many senior staff, management had to plan for the unavoidable financial crunch, and on the last day of June the Baha Mar board of directors decided to file a petition in Delaware U.S. Federal Court for reorganization and protection from creditors under Chapter 11 of the U.S. bankruptcy code, the rational step for any enterprise with vanishing liquidity but solid assets.

Prime Minister Christie expressed dismay at this predictable strategy and, claiming he had been blindsided, initiated a campaign of vituperation against Izmirlian, even expressing doubts about his mental condition. This personal vendetta was continued by two of his cabinet ministers and the chairman of the PLP, who hinted that Izmirlian should be deported because he displayed “contempt for The Bahamas,” and the Attorney-General Allyson Maynard was instructed to put legal obstacles in his way. To become effective locally, the U.S. Chapter 11 proceedings had to be ratified by the Bahamas Supreme Court. When the judicial hearing was held, the two Chinese parties, the bank and the construction company, opposed the motion and were supported by the attorney general, rhetorically claiming that the Chapter 11 process would violate Bahamian “sovereignty.”

Our Supreme Court Justice Ian Winder had no choice but to rule against the Izmirlian motion, despite his offer to provide $80 million of new capital until reorganization could be completed. Two trips to Beijing by the attorney general and her expensive entourage for “high level” negotiations with the Chinese proved predictably fruitless.

After several false starts, government appointed “provisional liquidators” to initiate involuntary winding up under Bahamian law, which the prime minister insisted would speedily permit prompt resumption of work and opening of the resort. In fact, there was no chance of this, since Bahamian bankruptcy, unlike Chapter11, leaves no room for reorganization but permits only the extreme solution of liquidation and prompt seizure of assets by creditors – a solution that destroys Baha Mar as a going concern. The liquidators now have no funds or authority to pursue claims like the $192 million lawsuit by Baha Mar against CCA for construction failure, or the claims of Bahamian creditors, while Deloitte is financed by CEXIMB to protect strictly its own interests.

From that day to the present, CEXIMB became the dominant party without taking any positive steps towards opening. The 2,000 Bahamian employees specially trained by Baha Mar, were released and then paid for three months by government before that controversial largesse came to an end. A skeleton staff was retained for essential electric power and maintenance at a monthly rate of several million dollars, which CEXIMB had to finance with a $50 million advance from another compliant state-owned entity. Bahamian sub-contractors, owed about $74 million, have gone unpaid as have other local creditors. The unique collection of Bahamian art, borrowed from local collectors to display native creativity, has had to be returned to its owners and its curator dismissed. Sarkis Izmirlian and his president, Disney-trained Tom Dunlap, both now replaced by the receiver, have offered their unique expertise to restart the venture, but have been spurned by government and CEXIMB.

Prime Minister Christie has attempted to retain credibility with the Bahamian public by trumpeting his formal demands to CEXIMB to proceed or sell out, but these have fallen on deaf ears. The latest of his many predictions that a sale was “imminent” was bluntly shot down this February when CEXIMB stated that no specific transaction was under consideration and no timeline could be set for completion. Shortly before preparing this article in early March, new revelations surfaced that question his judgment in siding with the Chinese in every dispute.

First, the Bahamas press discovered a memo from contractor CCA in Nassau to its parent CSCEC in Beijing warning of a “crucial dash” to meet the completion deadline, risking “unmeasurable damages to reputation” and a fine of $250,000 per day past March 27 unless drastic action were taken to dispatch 450 additional Chinese workers – a step never accomplished. This internal document was dated Jan. 20, 2015, just three weeks before the prime minister and Izmirlian gave their “assurances” about on-time opening. Its inexcusable non-disclosure misled the parties into incurring millions of expenses and liabilities. Worse, the project’s quantity surveyors reported that CCA over-billed Baha Mar by $200 million-plus for work done before walking off the job in March 2015, without objection from CEXIMB.

Meanwhile, Andrew Farkas, principal of major U.S. real estate developer Island Capital Group, revealed that he and Sir Sol Kerzner, creator and former owner of Atlantis, had approached CEXIMB to help the bank out of its $2.5 million predicament, making several trips to Beijing only to be rebuffed. They were not given a shred of information needed to present a meaningful bid for ownership, joint venture, or management; any proposals were simply answered “no – buy the mortgage at par or pay it off.” Even the vigorous intercession by the prime minister has not led EXIMB to budge from its hard line.

The present stand-off should lead any Caribbean nation and its foreign investors to consider the following lessons:

  • First, U.S. Chapter 11 provides far better ways to handle a large bankruptcy than the archaic liquidation proceedings inherited from English common law and never modernized in The Bahamas.
  • Second, don’t retain a prime contractor who is in bed with your bank lender through having the same owner, an oriental state 8,000 miles away.

Ironically, The Bahamas and the Chinese seem locked into a new but similar business embrace. Two years ago a Chinese state property company bought Nassau’s iconic downtown Hilton-managed British Colonial Hotel and several acres of adjacent prime waterfront property. An eight-story parking garage is already under construction, to be followed by a glitzy hotel/commercial/marina complex being marketed as The Pointe (sic). It is being built by many of same CCA executives and workers who simply moved down the road from the abandoned Baha Mar. Citizen reaction to the Christie-approved behemoth is doubtful at best, shocked by the 500 work permits granted for Chinese construction laborers.

The site lies across the street from the American embassy, a modest structure compared to the gleaming new edifice where H.E Yuan Guisen, Ambassador of The People’s Republic, presides.  His country’s links with The Bahamas may cause him more headaches as allegations are surfacing in the local press about fraud, corruption and over billing at the highest levels of CEXIMB and CCA.

Meanwhile, Baha Mar towers over Cable Beach, stark and unoccupied, with no predicted date for opening. No guarantee of future profitability was ever given, but that prospect cannot even be tested while the hotels’ doors remain shut.1


  1. In March, Deloitte, the receiver acting for Chinese lender CEXIMB, formally listed the property for sale through Toronto-based international real estate firm Colliers International. It is estimated it will cost any buyer about $600 million to complete construction. Colliers is just beginning to show Baha Mar to potential buyers.

No wrongdoing – the first casualty of the Panama Papers

The Eleventh Commandment, and the First Law of Politics, is: Thou Shalt Not Get Caught. Icelandic Prime Minister Sigmundur David Gunnlaugsson certainly broke this Law in a television documentary, broadcast Sunday, April 3, 2016 in Iceland and several European countries. Obtaining the interview on the false pretense that they wanted to discuss Iceland’s recovery from the 2008 bank collapse, two journalists suddenly began asking him what he knew about the offshore company Wintris. Stunned, Gunnlaugsson grasped for words, brusquely ending the interview and striding out. The reporters told the viewers that the Prime Minister had owned Wintris jointly with his wife and sold his 50 per cent share to her for one US dollar at the end of 2009 after starting his political career. In the documentary and subsequently in the international press Gunnlaugsson was portrayed as a key player in an international exposé of Panama law firm Mossack Fonseca which helps wealthy people setting up offshore companies.

Even if Gunnlaugsson’s wife had informed the public some weeks earlier that she owned a company in the British Virgin Islands, after the broadcast a storm broke out in Iceland. Many felt that Gunnlaugsson had not been telling the full truth about his wife’s offshore company. The Icelanders were also unhappy about seeing their prime minister put in the company of certain unsavory characters in other countries. While support for Gunnlaugsson in his own rural-based Progressive Party waned, the leader of the other party in the coalition government, the center-right Independence Party, cautiously expressed concern about the case. When Gunnlaugsson then, to gain leverage, threatened to dissolve parliament and hold new elections, Iceland’s president refused to grant him permission to do so, stating at a press conference that he would not be party to a power struggle. Now cornered, on April 6, Gunnlaugsson was forced to resign, becoming the first political casualty of the Panama documents. The government parties however decided to continue in a coalition, with the deputy leader of the Progressive Party taking over as prime minister.

The Swedish journalist Sven Bergman who interviewed Prime Minister Gunnlaugsson has since triumphantly described how he laid the trap with which the hapless Icelandic politician was caught. He had not given Gunnlaugsson any opportunity to prepare for the question about the offshore company. Instead, in the midst of the interview, he abruptly started asking about it, while an Icelandic journalist working with him suddenly entered the room and also started asking about the company, creating a carefully prepared scene. Flustered, Gunnlaugsson pointed out before he walked out that the company belonged to his wife and that the couple had always declared it on their tax returns. He added that he had not registered the company with the Icelandic Parliament because it belonged to his wife and not to him.

On April 6, Gunnlaugsson was forced to resign, becoming the first political casualty of the Panama Papers.
On April 6, Gunnlaugsson was forced to resign, becoming the first political casualty of the Panama Papers.

The facts of the matter are undisputed. Gunnlaugsson’s wife, Anna Sigurlaug Palsdottir, is daughter of the former Toyota dealer in Iceland. When her father sold his company, she received a sizeable share of the proceeds of about $10 million. She was then living with Gunnlaugsson in England, and they had not decided whether they would settle there or in Iceland. On the advice of their asset managers, they decided to form a company in the British Virgin Islands, each of them nominally holding one half of the company. After the banking collapse in the autumn of 2008, Gunnlaugsson decided to abandon his studies in England, return to Iceland and enter politics. Within a few months he was elected leader of the Progressive Party. He and his partner formally married, and at the end of 2009, he transferred his nominal share in the offshore company to his wife. Nothing illegal or abnormal had taken place, as the Guardian which reported on the issue observed: “The Guardian has seen no evidence to suggest tax avoidance, evasion or any dishonest financial gain on the part of Gunnlaugsson, Pálsdóttir or Wintris.”

While it is also uncontested that members of the Icelandic Parliament do not have to declare assets of their partners, many felt that Gunnlaugsson should have provided fuller information about his wife’s ownership of the offshore company, especially since it held some bonds in the failed Icelandic banks and could therefore technically be regarded as one of the banks’ creditors. It was indeed the main task of Gunnlaugsson as prime minister to reach an agreement with the banks’ creditors on how to resolve the debt in foreign currency left from the collapse without too much peril for the domestic currency, the krona. As Gunnlaugsson however said in his own defense, he was widely seen as having been very firm in the negotiations with foreign creditors, much more so than the 2009–13 leftwing government. Thus, according to him, he had sacrificed the interests of his wife’s company to the national interest.

Gunnlaugsson had also made many enemies within and outside Iceland with his tough stance in the ‘Icesave’ dispute between Iceland on the one hand and the United Kingdom and the Netherlands on the other hand. This dispute was caused by the British and Dutch governments unilaterally compensating depositors in one of the failed Icelandic banks, and then presenting the bill to the Icelandic government instead of waiting for proceeds from the sale of the bank’s assets to go towards paying off its debts. While the previous leftwing government had implicitly accepted the demands of the British and Dutch governments by making two deals with them, both eventually rejected by Icelandic voters, Gunnlaugsson had strongly opposed the deals. He was vindicated when the EFTA Court finally in early 2013 decided that the Icelandic government was under no obligation to reimburse the British and the Dutch governments for their outlays. This decision contributed much to the resounding victory of Gunnlaugsson’s party in the 2013 parliamentary elections.

While Gunnlaugsson was not guilty of any wrongdoing in a legal sense, he certainly broke the First Law of Politics: He was caught. He fell into two traps, first in the television interview, then in his meeting with the Icelandic president who denied him permission to dissolve parliament and thus deprived him of any possible leverage. He did not have the cunning of the fox which, according to Machiavelli, a skillful politician has to combine with the courage of the lion. It is however ironic that apparently the only violation of law in this case was committed by those who stole the original Panama Papers and by those who then used those stolen goods to their own personal and financial advantage. It also seems immoral to obtain an interview under false pretenses, as the two journalists did, instead of giving the prime minister opportunity to explain his case – or rather that of his wife – under reasonable circumstances.

In the heated discussion in Iceland after the debacle people tend to overlook that a law firm like Mossack Fonseca can hardly be held responsible for possible misbehavior by its clients. Offshore companies and accounts are perfectly legal. An Icelandic wit once said that alcohol should not be blamed for the drunkard. Similarly, those who take measures to avoid paying more taxes than they are obliged to do should not be blamed for tax cheaters, mafia types, drug lords or corrupt politicians from rogue countries. In all the clamor, “tax havens” have been generally condemned in the Icelandic – and, indeed, the international – press. But sometimes offshore accounts serve as provisions for unpopular minority groups like the Jews in Nazi Germany or by beleaguered opposition politicians in countries controlled by populist bullies, such as Venezuela and, until recently, Argentina.

It has to be stressed that tax competition is not a zero sum game, whereby tax collectors in Western countries lose revenue simply because wealthy people move assets to low-tax countries. Firstly, the interests of tax collectors and taxpayers do not always coincide; they may sometimes clash. Secondly, tax competition can act as a necessary constraint on the otherwise uncontrollable growth of government. Thirdly, if capital is moved from a less to a more efficient use, then everybody gains in the long run. But certainly the Icelandic prime minister was guilty of one sin, unforgiveable in the eyes of many: He had married a rich woman.

Operation Choke Point

American officials have been watching the financial sector around the world in an effort to detect and stop a number of bad activities.  These bad things include hiding and moving the proceeds of crime (so called money laundering), hiding income from tax authorities (tax evasion), moving income to lower tax jurisdictions (tax avoidance), and financing terrorism.  Our Big Brother to the North has been building costly systems for tracking to the extent possible every use of the U.S. dollar anywhere in the world. Thus banks are required to know their customers (KYC) and track every payment and to provide such information to the authorities on demand. Anti-money laundering rules allow governments to block and confiscate money that is suspected of being the proceeds of crime even when no crime has been or can be proven.

Big Brother hates cash because its use leaves no audit trail and thus a hole in the government’s increasingly complete records over every payment made. American law enforcement officials have taken to confiscating significant amounts of cash when they see it (asset forfeiture) and requiring those from whom they took it to prove that it was “honest” money being used for legal purposes.  AML/CFT and asset forfeiture laws turn our traditional legal system (innocent until proven guilty) on its head. In addition, payment systems are being used as part of political sanctions to block payments to or from specific individuals (and their families, and relatives, and friends?) and companies.

In addition to detecting crime with AML and Foreign Corrupt Practices Act (FCPA) type measures, the U.S. is also pursuing payment information in connection with tax evasion with the Foreign Account Tax Compliance Act (FATCA) and other measures being forced on the rest of the world in a futile effort to compensate for bad tax laws in the U.S. These initiatives have nothing to do with prudential regulations, i.e. those designed to limit bank risk taking. Their purpose is to detect and prevent uses of money that Big Brother disapproves of. There is no evidence that they have succeeded in doing so. A study for the International Monetary Fund in 2014 reported that: “Benefits of the FATF AML/CFT system have not been demonstrated….”1

The costs of the system, on the other hand, have been staggering. The compliance costs for banks alone in 2013 were $10 billion.2 While these fall equally on all banks and are easily absorbed by large banks, they impose a significant burden on smaller, community banks. Partially as a result, banks have become more concentrated in the U.S. with the largest banks significantly increasing their share of total bank assets and the number of smaller banks shrinking. Between 1985 and 2010 the number of banks in the U.S. with assets greater than $10 billion increased from 36 to 107 while the number with assets less than $100 million declined from 13,631 to 2,625. Conducting the IMF’s assessments of its member countries’ compliance with AML/CFT requirements (but not of its effectiveness) cost $300,000 each in 2013.3

The most damaging costs of the AML/CFT requirements, however, fall on the poor, who are often excluded from the formal financial sector all together. “This study has learned of no significant effort by any of the standard-setting or assessor bodies to undertake a cost-benefit analysis….  The Fund staff itself has raised questions about whether its substantial investment… has yielded adequate returns.…There needs to be more open acknowledgement of actual and potential financial costs of AML/CFT controls, their potential misuse by authoritarian rulers, and possible adverse effects on populations that rely on remittances and the informal economy, as well as potential negative impacts on NGOs and parts of civil society.”4

“Money laundering and counter-terrorism measures can reduce the volume of overseas remittances to the most vulnerable populations in the poorest countries….  A report by the UN Food and Agricultural Organization reported that: ‘every year, Somali migrants around the world send approximately $1.3 billion to friends and family at home, dwarfing humanitarian aid to Somalia… Banks in the West are closing down the accounts of money transfer operators, thereby threatening to cut the lifeline to hundreds of thousands of Somali families.’”5

Why would banks shut out some of their customers? Foreign banks have been closing the accounts of American customers right and left rather than face the compliance costs and uncertainties (and intimidation) of FATCA. But closing out millions of the world’s poor for fear of AML violations seems a particularly low blow. Apparently not for the American bureaucrats implementing Operation Choke Point.

Todd Zywicki reported that: “The Justice Department’s “Operation Choke Point” initiative has been shrouded in secrecy….  The general outline is the DOJ and bank regulators are putting the screws to banks and other third-party payment processors to refuse banking services to companies and industries that are deemed to pose a “reputation risk” to the bank.6 AML rules require banks to know their customers (KYC), but when their customer is Western Union or its competitors, they need to know the customers of their customer. This can be a tall and stifling order. In many parts of the world the poor who are the usual beneficiaries of remittances, have no birth certificates or other documentary proof of their identities. In Afghanistan, for example, a person’s identity is traditionally verified by the village chief.

Moreover, the collection of such information opens the risk of abuse and it did not take Big Brother long to abuse it. Jonah Bennett reported that: “A Justice Department fraud prevention program came under fire Thursday for allegedly morphing into actively pressuring banks to deny financial services to businesses for political reasons.”7 The IMF sponsored report notes the risk of autocratic regimes misusing such information. Now we must add misuse by the U.S. government.

Cayman has just lived through the consequences of this program (see extensive reports in the Cayman Compass). The Cayman Islands Monetary Authority (CIMA) reported that in 2014 people in Cayman sent $180 million U.S. dollars to family and friends abroad in 682,000 separate payments (averaging $264 per transaction). Over 60 percent of these were sent to Jamaica, largely reflecting the remittance of earnings of Jamaican workers in Cayman.

A Jamaican worker in Cayman, for example, sends money home to his family by taking his Cayman dollar (CI dollar) wages to a money service provider who exchanges them for U.S. dollars at its local bank for onward transfer to Jamaica through the international banking system. The Cayman bank redeems the CI dollar bank notes with CIMA for a U.S. dollar deposit at its correspondent bank in New York, which transfers the funds to Western Union’s bank in the country of the intended recipients. The operation relies on money service providers being able to exchange CI cash for USD deposits abroad so that they can be moved around the world through the international banking network.

On Friday, July 17 of last year Western Union’s local bank, Fidelity, closed Western Union’s accounts thus preventing it from exchanging CI dollars for U.S. dollars and depositing them in New York.  Western Union promptly closed its operations throughout Cayman. Western Union is one of four money transfer services in Cayman. Cayman’s other three money service providers soon received the same treatment from their banks.

Charles Duncan reported in the Cayman Compass that: “hundreds of workers from overseas, mainly from Jamaica, packed into the town hall in George Town on Tuesday night, looking for solutions to the problem of sending cash home.  Standing in the midst of a packed room, one man said, ‘People are waiting.  People are hungry.’  Some in the crowd told of families back home waiting on money for school tuition and other financial support.”8 Without their banks to exchange Cayman dollars for U.S. dollar bank notes, several Cayman money service providers responded by accepting U.S. dollars only and flying them to Jamaica or to a New York bank that would accept them for onward electronic transfer. This required Jamaican workers to exchange their CI dollars for US dollars before visiting the local money service provider. Few of these guest workers have bank accounts and were either charged a higher exchange fee or limited in the amount they could exchange at the banks. The banks in term were quickly drained of the USD cash in their vaults and had to fly in additional bank notes from Miami, as CIMA does not provide USD banknotes. So banks were flying cash in while money remitters were flying it out on a much grander scale than were the alleged money launderers with suitcases.

What brought this situation about? Fidelity explained that profit margins were being squeezed while AML compliance costs and the risk of fines for violations threatened by Operation Choke Point led to their decision to stop these services.  Under Operation Choke Point pressure, Cayman’s retail banks were also being threatened with the loss of their correspondent accounts in New York if they did not give up banking the remittance business. The existing remittance business is relatively expensive.  Western Union charges $12.00 to send $100 dollars to Jamaica from the U.S. Much cheaper services have been and are being developed but are not yet available in Cayman. In the mean time Western Union has sufficient clout to have prevailed on their correspondent banks to back off, at least for the time being, and they and the other money service providers have reopened full services.

All of this is largely the result of Big Brother’s demand that everyone providing payment services know their customers – a requirement that no one has been able to document provides any benefit (i.e. reduction of crime). In fact, Cayman’s money remittance companies comply with KYC requirements established by CIMA, but American pressure has raised the regulatory costs and risks sufficiently that their banks would generally rather not take such business. New payment technologies are likely to by-pass the existing correspondent banking network for transferring funds at much lower costs. But if Big Brother insists on fingerprinting or iris scanning every one using them, they will be largely denied to the poor forcing them suffer unnecessarily for a problematic law that has not made any measurable contribution toward reducing crime.


  1. Terence C. Halliday, Michael Levi, and Peter Reuter  “Global Surveillance Of Dirty Money: Assessing Assessments Of Regimes To Control Money-Laundering And Combat The Financing Of Terrorism”  Center on Law and Globalization, 30 January 2014, p. 47
  2. “Global Anti-Money Laundering Survey 2014”, KPMG, January 2014.
  3. Before retiring from the IMF in 2003, I led 5 such assessments.
  4. IMF Report: Op. cit. p. 7.
  5. Op. cit.  p. 51.
  6. Washington Post, May 24, 2014.
  7. Daily Caller July 18, 2014.
  8. October 1, 2015.

Challenges for the captive industry in 2016

There are three, at least, major threats/opportunities for captives as we enter a new year. These immediate three are 1) changing state regulations, 2) changing U.S. Federal regulations and 3) technology.

In order to fully understand the regulatory situation it is necessary to provide some background. Insurance companies, including captives, are regulated in the U.S. by the 50 individual states and five territories. They regulate insurance companies licensed to headquarter their businesses in their states/territories, and any and all insurers choosing to set up operations in their state, though that state may not be their state of full licensure. If licensed or admitted, forms and rates are approved by the regulators and taxes are lower than for non-admitted insurers, for which there is a separate tax.

The underlying law for this, versus Federal regulation, is the South Eastern Underwriters Association Supreme Court case of 1944. This ruling found that the Sherman Act gave regulatory authority to the individual states for insurance.

Each individual regulator, in his/her territory, reigns supreme, under the legislation and government of that territory. One cannot compel another to do things their way. Only their individual state legislators, by passing laws, can tell the insurance regulators what to do. And they must do only what they are told to do by their legislators.

The reality is, many insurance regulators are appointed by their friends in government, or elected on pro-personal lines issues, and don’t really know much about insurance or regulation. To do their jobs they must turn to others. The others to whom they turn, in addition to their own staff, are other regulators who may be seen to have some knowledge, and to the staff of their trade group, the National Association of Insurance Commissioners (NAIC).

There are trade-offs for using the knowledge of others. The other regulators will want to trade votes on issues important to them, in return for imparting knowledge to the asking party. Some of those issues are inimical to captives.

Staff may know nothing of captives. The NAIC staff, most of whom are very knowledgeable and competent, have their own agendas for giving help. These “returns” may also be inimical to captives, as NAIC is mostly opposed to captives. Why? Captives don’t pay them any money for taxes or data service.

In addition to the NAIC, there exists a group, the National Coalition for Insurance Legislation, (NCOIL). This group is comprised of state legislators, those who actually make the laws, who are focused on insurance. They don’t usually regard the NAIC highly, and often work counter to them. However, they are not as well staffed so don’t get much publicity or notoriety. But they do make the laws, not the NAIC. The NAIC develops and promotes model laws, written to support their views, often quite helpful, which each individual regulator must persuade its legislative bodies to pass. Some do, some don’t.

So, the situation is one where a very competent staff at the NAIC is working with a few knowledgeable regulators to promote their individual agendas in the face of a Federal government which has its own agenda, and the Europeans and their agendas, neither of which give consideration to the NAIC. A battle by highly paid, knowledgeable people for their jobs, against less well paid, in the Federal government anyway, and not as knowledgeable people who have the bigger sticks.

Not good for the consumer. Why is this important to captives? The Federal Insurance Office Executive Director, a former NAIC member, has said openly that captives represent the best place for the regulators to stand their ground together. Why? There is no one of size and strength to speak for captives. There is no one in the Federal government who knows or cares about captives. So, have at it. Will NCOIL not intervene? Not likely. While they understand the issue they have no staff or time to take this on.

So, there is, at this time, very, very little Federal regulation in force. The issue began to boil when the European insurance groups decided that they would not/could not deal with 55 regulators. So, with whom could they transact?

The Feds have pushed their toes into the arena through the Department of the Treasury and the Federal Insurance Office, most notably. They have even signed agreements with some European regulatory groups, even though the Feds have no regulatory authority. They have made the conscious decision to ignore the NAIC.

This has caused the NAIC to invigorate themselves. The most common way to do so is to introduce more studies, committees and model laws. Again, captives are conveniently at the center of much of this activity.

Many successful captive domiciles have knowledgeable, active regulators who work hard within the NAIC to educate their peers and to advance captives while resisting anti-captive regulations. They need to be identified and supported.

Finding a way by which the NAIC and its members can interact with foreign governments is going to be challenging. Much of those types of actions are forbidden under the U.S. Constitution.

Beyond NAIC issues there is the issue of state taxes. While captives are generally at a tax advantage, some U.S. states levy a tax on insurance purchased out of state by in-state businesses. This so-called non-resident tax is usually 4 percent of premiums, which can be a large amount. Some captive domiciliary states have apparently, to some observers, threatened this levy to get captive owners to become licensed at home, regardless of the other reasons for selecting a domicile.

This tax can be compounded in some jurisdictions by a surplus lines tax, applied to business written outside of the traditional admitted lines of coverage. This can also be in the 3-5 percent range. Not all states charge these taxes but the economic challenges faced by all U.S. states have driven the review and application of these existing taxes, which may not have been considered in the past.

Federal regulation is growing through the Treasury Department’s interest in pursuing new taxes. It sees that some insurance goes outside the U.S., while being owned by U.S. taxpayers. Maybe they are not paying their fair share. Information must be captured and taxes imposed.

At this time about the only Federal regulation of insurance is on terrorism and flood, some on agricultural crop. Not much tax income on those. So, many within the Federal government are seeking new ways to regulate, i.e., tax.

This approach is a bit easier than quarreling with the NAIC since the offshore jurisdictions have no presence or say inside the U.S. But since these jurisdictions have all kinds of treaties in effect, the Feds can force them to submit information about the U.S. citizens with money there. Witness FATCA.

The main protagonist is of course, the U.S. Internal Revenue Service. They bring their own position to the table. They regulate. They do not legislate. They administer the laws on the books. They often choose which ones to regulate, and to what extent.

The IRS, like many functions of the U.S. Federal government, suffers from under staffing and under funding. There are only so many projects that they can take on. So, they have developed lists of those areas in which they will concentrate. When published, it became known to all as the Dirty Dozen. Captives, under the 831(b) exemption, made the list. This means that, all other issues aside, staff and funding will be devoted to this area.

The well-known 831(b) exemption is just that: an exemption to the Federal tax. It has nothing to do with state regulations. One must apply for this exemption, to the Secretary of the Treasury. Once granted, it cannot be withdrawn, except with permission of the Secretary. One must qualify annually. Most are familiar with its qualifications, and the fact that they were “expanded” this year, for companies with annual premiums up to $2.4 million.

Not always known is that this exemption was put in place to help small, farmer oriented mutual insurance companies located in rural areas throughout, mostly, the upper Midwest of the U.S. Their association, the National Association of Mutual Insurance Companies (NAMIC), is the promoter and “keeper” of the exemption. NAMIC knows nothing of captives. This situation causes a real disconnect, into which the IRS is pleased to jump.

insurance-riskMost captive users of the exemption have no idea from which it comes, who promotes it, who keeps it alive and well, and why it exists. Not knowing who provides this exemption, and why, can put the captive user at a disadvantage, if their purpose is to follow the law and its intent. This is what puts the IRS at an advantage. They know the purpose and intent, and they know the legislators who sponsor the laws.

All of these Federal areas of insurance interest, the IRS, Treasury and others, cause challenges because a) they have no regulatory authority, and b) those with regulatory authority are at the individual state and territory level, so that there are 55 of them. Getting 55 entities to agree on anything is impossible. This is the point that frustrates the Europeans. They want to deal with the “one” person in charge. In the U.S., there isn’t one.

There is no clear end to the Federal regulatory conundrum, especially in a major U.S. election year. No substantive action will be taken by Congress, and the next action will be driven by the new president, whoever that may be.

The technology impact will be felt in many ways, not the least of which is the reduction of jobs required to complete tasks. An estimate by a noted consulting firm has predicted that up to 25 percent of administrative jobs will soon be made unnecessary by advancing technology. That is both bad news and good news.

Certainly losing one’s job is terrible, but most of us are aware of the overall shortness of supply of qualified people in our industry. Who better to add to your staff than someone that you have already employed? Just move them around.

Yes, it will require in some cases considerable re-training, but not in the essentials of your business, like who your company is, what it does, how it works etc.

How do captives get affected by all of this consternation? Captives for decades have enjoyed a widespread lack of knowledge about their affairs, and worked to keep that ignorance going. With a U.S. push for new tax revenues those days are rapidly going away. The initial response is to tax captives first, then try to understand them.


The internet has done many things to change the insurance world, but those changes will be deemed minor compared to what is coming. In the past, insurance has been a significant laggard in regard to advancing electronic technology. Computers took a while to replace typewriters. Computers took a while to replace paper files, and still have not everywhere. Much mobile activity remains telephone usage, not substantive data exchange and handling.

One way to look at these coming developments is to put them into two categories: cyber risk and data banks. Much has been written on both of these subjects, but little on how they will affect captives.

The main impact is to cover cyber risk in one’s captive. This is often seen as a handy and appropriate coverage, as such coverage that is available in the traditional marketplace can be highly priced and full of coverage holes. There is a reason for that. Actuaries cannot define the risk, therefor they cannot price the risk. That applies to captives, also.

If your actuary cannot price the coverage to be written in your captive that should tell you that trouble is on the horizon. At a minimum that situation means that you may well not have enough cash on hand to pay claims. Or even enough capital to pay claims and satisfy regulators.

Beyond funds you may not have available to your captive the claims expertise necessary to adjust the loss. These claims are new, as we’ve said. The claims expertise may not be available anywhere.

But the scary looming exposure is not just cyber liability per se, but its immediate cousin and working partner, data banks. The risk is not just about the cost to cover a hacker infiltrating a client’s data base. How about your own?

Extending the warning to data banks, it is becoming clear that many, many captives, by their very nature, hold vast amounts of information about their parents, and their parents’ partners. They often hold far more information than the traditional marketplace may hold about their policy holders. This is a monumental, company breaking exposure. All of the information required for traditional underwriting, sitting in piles of paper and stuffed into file drawers in endless rows of cabinets, has suddenly been recognized as holding vital, important, even crucial information. It may not have seemed so when gathered, but to the enterprising hacker it is a gold mine.

Because the captive is often a completely separate entity, with outside management, audit and accounting, it can be overlooked by one’s in-house IT staff. And yet it holds tons of vital information. It must be contained and secured, and all in management must see and recognize the exposure. Today, many do not.

dr-pigAs carriers, and others, convert these piles of paper into electronic files, they can be accessed from the internet, not always legally. The mere conversion to the internet has caused some carriers to overlook the actual information contained in their files. The conversion itself is a monumental task. Reading the stuff while doing it is out of the question. But hackers do so read it.

The value of these data banks is growing exponentially. The protection is not.

New structures such as bank-chains will cause the rapid advancement of captives into the world of higher technology. As companies set up their financing, and even captives set up bank-chains, the exposure is not measurable. “You can’t manage what you can’t measure.” These, and other structures like bank-chains, are not new ideas; they are concepts in place and working now. Again, since many captives are “isolated” by outside management and service providers, they may not see the interconnectedness of their information and not install good barriers.

A signal fact of captives is their innovation. This innovation has led to new coverage, new administrative techniques, new claims procedures and new financing structures. This newness has sometimes blown past the captive basics. Even today, in many captive owning companies, not all know what a captive is, and how it is done. They don’t know how much information is stored in the captive’s vaults and how much in tax can be levied by your favorite domicile. But captives are getting more attention, and so more practitioners must recognize this and address it.

The threats are real, but so is the innovative skill of the captive profession. With some heightened attention to detail captives will meet these threats and move to a higher plane.

Law Talk

A recent decision of the Grand Court of the Cayman Islands in Re China Shanshui Cement Group Limited looked at the ability of Cayman Islands directors to present a winding up petition on behalf of a Cayman Islands company.

In Re China Shanshui Cement Group Limited (23 November 2015) Mangatal J, sitting in the Financial Services Division of the Grand Court of the Cayman Islands, has declined to follow the decision of Jones J in Re China Milk Products Group Ltd.1, and has struck out a winding up petition submitted by the directors of the company for lack of standing to file the petition.

Since it was handed down in 2011, the decision in Re China Milk has been subject to some criticism by Cayman Islands’ practitioners and the recent decision in Re China Shanshui (effectively turning Re China Milk on its head) probably confirms a long-held belief shared by many of them as to the correct interpretation of section 94(2) of the Cayman Islands’ Companies Law.

The question at issue was whether or not directors of a Cayman Islands company had the authority to present a winding up petition on behalf of the company in the absence of either (a) a shareholders resolution or (b) an express provision in the articles of association authorizing such action to be taken by the directors.

Mangatal J held that as a matter of Cayman Islands’ law they did not have such authority. She held that the law was correctly stated by Smellie J (as he then was) in Banco Economico SA v Allied Leasing and Finance Corporation2, applying the well-known English decision in Re Emmadart Ltd.3 which was reversed by statute in England4, but had not been reversed by statute in the Cayman Islands. There had been debate as to this very point in the discussions leading to the 2007 amendments to the Companies Law, but Mangatal J concluded that a deliberate decision had been taken not to reverse Re Emmadart by statute in the Cayman Islands.

In short, she held that section 94(2) of the Companies Law which provides that “where expressly provided for in the articles of association of a company the directors of the company incorporated after the commencement of this Law have authority to present a winding up petition on its behalf without the sanction of a resolution passed at a general meeting” applied to both solvent and insolvent companies (and not just to solvent companies as Jones J had decided in Re China Milk). It merely provided statutory confirmation of the position which had been previously held to be the case in Re Emmadart. There was nothing in section 94(1)(a) allowing “the company” to present a petition which could be construed as allowing “the directors” to do so.

Mangatal J’s decision would appear to be correct as a matter of strict statutory construction. However, Jones J’s approach in China Milk does hold some practical commercial appeal, in that it allows directors to take steps to protect the interests of all stakeholders where a company is insolvent (or soon will be).

scalesThe appointment of one or more provisional liquidators in connection with a winding up petition can be a useful tool in a restructuring due to the resulting moratorium on other proceedings. Where a company is facing actual or potential insolvency, the power to petition for a winding-up can be of significant comfort to directors and can facilitate the preservation of assets and value through an expedited restructuring. Denying the directors the power to petition to wind up the company absent express authority either in the articles or in a resolution of shareholders may therefore be considered commercially undesirable, although standard and accepted in some structured finance special purpose vehicles.

Those who are considering taking appointment as directors of a Cayman Islands company are encouraged to check whether the directors are given the power in the articles to petition for a winding up. Depending on the financial position of the company, shareholders may have little or no continuing economic interest in the company and, given the time that it can take to convene a general meeting, a requirement for shareholder consent in support of a petition for winding-up could operate to the detriment of creditors and/or the company.

The restriction on directors confirmed by the Emmadart case has been criticised (and, as discussed, reversed by statute in England) and has not been followed in some Commonwealth countries5. It does however represent current law in the Cayman Islands. Whether the Cayman Islands Legislature sees fit to legislate to restore the position taken in China Milk remains to be seen.


Introduction of LLCs

The much anticipated Limited Liability Companies Bill, 2015 has been published this quarter6 and is expected to be enacted into law in early 2016. Once enacted, it will add another key facet to the Cayman Islands’ entity formation toolbox. It allows for the incorporation of a new Cayman Islands’ vehicle, the limited liability company.

This important legal development has been sought by attorneys and clients in the United States for some time (particularly in the investment funds industry) and is based, in part, on the Delaware form of limited liability company.

Whilst there are various types of limited liability companies presently available in the Cayman Islands, the Cayman LLC will be a distinct entity. The LLC Bill has been modelled using both local legislation (notably the Cayman Islands company and partnership laws) as well as the limited liability legislation of Delaware. As such, the Cayman LLC will have certain features of Cayman companies and partnerships (for example, member liability not being limited by shares nor by guarantee but rather by reference to members’ capital accounts and capital contributions) and also features of a Delaware LLC (for example, allowing for freedom of contract amongst the members as to determining the internal operations of the company).

Some key features of the Cayman LLC will include:

  • The Cayman LLC will be a body corporate with separate legal personality (unlike partnerships in Cayman) and members will have limited liability;
  • At least one member is required and the Cayman LLC may be managed by a “managing member” or a non-member;
  • Members are given considerable flexibility to agree the internal workings and management of the Cayman LLC in their LLC agreement;
  • No share capital – members may have capital accounts and make capital contributions with profits and losses allocated amongst them in accordance with the LLC agreement;
  • Registration is effected by filing a simple registration statement with the Cayman Islands’ Registrar of Limited Liability Companies. The LLC agreement need not be filed; and
  • Existing Cayman Islands exempted companies and certain foreign companies continuing into the Cayman Islands may convert or merge into a Cayman LLC.

The Cayman Islands is the leading jurisdiction globally for fund formation. Given the obvious benefits of using a Cayman LLC (including, simplified fund administration, similar corporate features to a Delaware LLC and the general flexible nature of such an entity) together with the longstanding industry demand for this type of vehicle in the Cayman Islands, once the LLC Bill is enacted into law, we expect that the Cayman LLC will hit the ground running. The flexible nature of this vehicle means it will also be well suited to a broad range of general corporate and commercial applications such as joint venture companies, general partner entities and holding vehicles.

The Cayman LLC is an exciting development for the Cayman Islands and is expected to become available in the early part of 2016. The development of the LLC legislation into law is likely to feature in greater detail in the next Law Talk.

Common Reporting Standard

In the last edition of Law Talk we advised that the OECD’s Common Reporting Standards had been implemented in the Cayman Islands via The Tax Information Authority (International Tax Compliance) (Common Reporting Standard) Regulations, 2015.

The Cayman Islands Tax Information Authority has now published new entity and individual self-certification forms which address disclosure requirements under each of Common Reporting Standards, US FATCA7 and UK FATCA8. The forms are not obligatory (so extracts of them or modified versions may be used) but they are designed to collect all information required.

Cayman Islands reporting financial institutions are required to obtain data on new account holders with effect from 1 January 2016. The Tax Information Authority has published a list of 96 “Participating Jurisdictions”9 for the purposes of Common Reporting Standards and affected Cayman Islands’ entities are required to conduct due diligence on pre-existing and new accounts to determine their reporting requirements in respect of each of the Participating Jurisdictions.

Further Common Reporting Standards-related legislation dealing with penalties and enforcement powers of the Tax Information Authority are anticipated to be issued in the first quarter of 2016, along with guidance notes. The guidance notes are likely to be limited to practical matters specific to the Cayman Islands as the Tax Information Authority has advised that Common Reporting Standards issues should primarily be addressed by information contained on the OECD’s automatic exchange portal.

The Cayman Islands is well placed to deal with the regulatory and reporting issues thrown up by US FATCA, UK FATCA and Common Reporting Standards. Having passed much of the required legislation and guidance and established practical procedures for the submission of information by Cayman Islands’ entities, the Cayman Islands appears to be organized, well informed and on top of these challenging new requirements.


  1. [2011] 2 CILR 61
  2. [1998] CILR 102
  3. [1979] 1 Ch.540
  4. Section 124(1) Insolvency Act 1986
  5. In particular, in a line of Australian cases and, in Bermuda, in Re First Virginia Reinsurance Ltd [2003] 66 WIR 133.
  6. On 18 December 2015.
  7. We have discussed US FATCA in detail in earlier editions of Law Talk. In summary, it refers to the foreign account tax compliance provisions of the Hiring Incentives to Restore Employment Act, 2010 of the United States of America.
  8. We have also discussed UK FATCA in detail in earlier editions of Law Talk. In brief, it refers to the United Kingdom’s equivalent of US FATCA. UK FATCA will likely be phased out by the end of 2017 as the UK will be a Participating Jurisdiction (defined herein) under CRS.
  9. Notably this does not include the United States so the US FATCA legislative framework in the Cayman Islands will continue unaffected.

Quarterly Review


Offshore banking continues to decline

The number of banks in the Cayman Islands dropped by 7 percent in 2015, compared to 2014.

The 12-month decline from 198 to 184 registered banks mostly concerned Class B banks, which are licensed by the Cayman Islands Monetary Authority but only allowed to offer services to customers outside of Cayman.

The number of locally operating Class A banks fell from 13 to 12 and includes six retail and six non-retail banks, the latest CIMA statistics show.
The banking industry has been diminishing constantly since the 1990s, when there were more than 500 banks registered in Cayman. The reasons for the decline range from consolidation in the industry to new regulations that have made operating offshore banks less cost effective. Most recently, the so-called “de-risking” by U.S. correspondent banks provided a new threat to the business model of offshore banks.

Paul Byles
Paul Byles

“The decline generally over the years is due to global consolidation of banks, which has resulted in their branches and subsidiaries merging across various jurisdictions,” said Paul Byles, managing director of First Regents Bank & Trust. “But more recently it has also become more challenging to operate in the offshore banking arena.

“Class B banks in particular are finding it very difficult to maintain correspondent bank accounts in the U.S. and elsewhere. As a result, I believe we will see a further decline in the number of licenses as shareholders question the point of having a Class B license.”

Cayman Class B banks often offer depository services to international clients and maintain access to the U.S. dollar clearing system by establishing correspondent banking services with local Class A banks in Cayman, which in turn have correspondent relationships with U.S. banks.

Local banks are under pressure by their U.S. correspondent banks which, under international regulations governing anti-money laundering, take a risk-based approach on a client-by-client basis.

While the guidelines defined by the Financial Action Task Force would require financial institutions to terminate client relationships only when money laundering or terrorism financing cannot be mitigated, banks have taken an increasingly risk-adverse view when evaluating their client relationships, including their business relations with Cayman banks.

During the past 18 months, many retail banks in Cayman started to inform their Class B bank clients that they can no longer offer correspondent banking services if they relate to funds of the bank’s clients.

This development is threatening the business model of those offshore banks that are not branches or subsidiaries of U.S. banks.

“The new policy of not allowing Class B banks to have correspondent banking accounts has the potential to wipe out an entire industry offering,” Byles said.

The issue echoes the recent problems of money service providers in Cayman to access correspondent banking services that are needed to process remittance payments. Most services were terminated by the banks, which cited “de-risking” and costs as the primary reasons. While the demand for private banking, once a staple service of offshore banks, is still growing globally, there is a danger that Cayman’s reputation for banking services is eroding in line with the fall in the number of banks, Byles said.

“Cayman’s reputation as a leading international banking sector continues to be one of the main features of the jurisdiction. But it’s hard to see how it can remain so if there is a dramatic reduction in the number of banks operating from the jurisdiction,” he said. “A jurisdiction that no longer accommodates smaller private banks runs the risk of losing this service offering entirely.”

Not all banks are affected equally. Cayman continues to be the sixth-largest financial banking center on the basis of its cross-border assets of US$1.37 trillion. International assets and liabilities of Cayman banks of US$1.39 trillion and US$1.44 trillion, respectively, were unchanged between June 2014 and June 2015, the latest available statistics show. According to CIMA, more than 80 percent of more than the US$1.3 trillion on deposit and booked through the Cayman Islands, represents inter-bank bookings between onshore banks and their Cayman Islands branches or subsidiaries.

“These institutions present a very low risk profile for money laundering,” CIMA says on its website.

Cayman companies plead guilty to tax evasion conspiracy

Cayman National Corporation’s affiliated trust and securities management businesses conspired with American taxpayers to hide US$137 million in assets managed by those companies from the U.S. Internal Revenue Service, according to a guilty plea to tax evasion conspiracy allegations recorded in March in Manhattan.

Cayman National Trust Co. Ltd. and Cayman National Securities Ltd. have agreed to forfeit US$6 million as part of the deal. In addition, the companies agreed to turn over account information on the alleged tax evaders whose accounts they managed.

The pleas made in March represented the U.S. Department of Justice’s first criminal conviction of non-Swiss financial entities for tax evasion conspiracy.

Federal prosecutors said Cayman National Trust and Cayman National Securities helped U.S. taxpayers evade income tax bills during a period of “at least” 10 years between 2001 and 2011.

In their guilty plea, Cayman National Trust and Cayman National Securities admitted to encouraging U.S. taxpayer clients to open accounts in the name of sham trusts and sham companies in the Cayman Islands to conceal their beneficial ownership of these accounts.

The sham trusts were nominally directed by Cayman National trust officers, but were controlled by the U.S. clients. The managed companies, for which the trust company provided management services, were shell companies with the sole purpose of holding the assets of U.S. clients, the Department of Justice said.

At its peak in 2009, Cayman National Securities and Cayman National Trust had approximately $137 million in assets under management relating to undeclared accounts held by U.S. clients.

“At least half of those assets … were undeclared,” according to the plea agreement.

The total amount of assets held by Cayman National Corp. companies during the period totaled between US$700 million and US$900 million, according to the U.S. plea agreement.

Between 2001 and 2011, prosecutors said, the two Cayman companies earned US$3.4 million in “gross revenues” from the undeclared U.S. accounts they managed.

Financial services

Company terminations outweigh new registrations

The Cayman Islands Company Registry saw an 8-percent increase in new companies in 2015, but the number of active companies on the registry failed to breach the 100,000-company mark as terminations exceeded new registrations.

New registrations have grown for three consecutive years, and last year’s increase followed 17 percent growth in 2014.

But despite 11,864 new companies registered in the Cayman Islands last year, the number of active companies declined by 1 percent, from 99,459 to 98,838.

Company terminations jumped 66 percent, from 7,321 in 2014 to 12,206 in 2015. Both active resident and non-resident companies on the register experienced a 12 percent decline, whereas exempt companies, the most common company type, continued to increase by 1 percent.

Meanwhile, partnership registrations set a new record with 3,370 new partnerships registered in 2015, compared with the previous high of 2,893 new partnerships in 2014.

Active partnerships registered in Cayman climbed 16 percent to an all-time high of 18,041 last year.

New trust registrations fell to 104 during the period from 140 new trust registrations a year earlier. However, terminations of trusts also dropped from 142 in 2014 to 108 in 2015.

As a result, the number of active trusts registered in Cayman remained virtually unchanged at 1,789, compared to 1,804 in 2014.

Cayman mergers and acquisitions activity highest in five years

The Cayman Islands reached a five-year high in the number of local mergers and acquisitions in 2015.

Deals involving entities registered in Cayman accounted for about a third of the overall deal volume and more than a quarter of the transaction value in major offshore financial centers analyzed by offshore law firm Appleby.

“For four years now, we have seen the Cayman Islands ranked as the most popular destination for investors seeking to acquire offshore assets,” said Simon Raftopoulos, a Cayman-based partner and member of the firm’s Corporate Finance and Private Equity teams. “With nearly 1,000 deals recorded in 2015, Cayman had another standout year and was a significant contributor to a robust year for transactional activity in the offshore markets by all key metrics – deal value, deal volume and average deal size.”

Cayman attracted 974 deals in 2015 worth a cumulative US$125 billion, a 14 percent increase in deal value over 2014. Both the number of deals and the average deal size of US$129 million were 7 percent higher than in the previous year, the Appleby’s Offshore-i report found.

Two of the 10 largest transactions of 2015 involved Cayman-incorporated companies as targets. In one notable institutional buyout, Qihoo 360 Technology, a software publishing business incorporated in Cayman, was sold to True Thrive, a consortium of investors also incorporated in Cayman, for $9.3 billion.

The total cumulative value of offshore M&A deals across all offshore jurisdictions measured in the report in 2015 increased 56 percent over the previous year, with average deal value topping highs not seen since 2007.

Three of the largest quarterly periods of the last decade occurred in 2015 and contributed to a cumulative deal value of US$442 billion across offshore jurisdictions. The year also saw nine megadeals worth in excess of US$5 billion each and more than US$150 billion when combined.

Moreover, there were 75 deals each worth more than $1 billion last year, compared with 52 recorded in 2014.

“The offshore markets are thriving and enjoying some of the best deal activity ever witnessed,” said Frances Woo, managing partner of Appleby’s Hong Kong office. “Offshore saw more value than the Middle East, Africa, Eastern Europe, South and Central America combined. Although 2016 remains fraught with uncertainty and challenges at the macroeconomic level could slow global deal activity, we are quietly optimistic that such good news will continue in 2016.”

The majority of M&A deals, about 30 percent, involved insurance and financial service companies (883 deals), followed by manufacturing with 610 deals; IT and telecoms (287); construction (233); and mining and quarrying (192).

The Cayman Islands also led offshore financial centers in the number of initial public offerings involving offshore-incorporated companies, despite an overall drop in the number of offshore IPOs in 2015.

Cayman-incorporated entities accounted for 45 out of a total 82 IPOs of offshore companies last year.


Cayman’s economic growth slows

The Cayman economy grew an estimated 1.6 percent in the first three quarters of 2015, down from 2.4 percent for the same period in 2014, according to the Economics and Statistics Office.

The ESO projected a gross domestic product growth of 1.7 percent for the year.

Finance and insurance services led economic growth with a 3.6 percent increase. Real estate and renting, electricity and water supply, and agriculture and fishing also grew in the first nine months of last year.

Some sectors did see declines, including a 2.3 percent drop in wholesale and retail trade and about a 1 percent drop in producers of government services. Mining and quarrying, construction, and hotels and restaurants all recorded small drops of less than a third of one percent.

Marco Archer
Marco Archer

“Since the beginning of 2013, the local economy averaged 1.5 percent real GDP growth, that is, 10 of the last 11 quarters recorded positive economic growth,” Finance and Economic Development Minister Marco Archer said in a statement.

While the economy continued to grow, the Cayman Islands recorded a 2.3 percent rate of deflation for the first three quarters of last year. The ESO noted the drop in inflation “resulted mainly from lower price indices for housing and utilities (6.4 percent), transport (4.3 percent), restaurants and hotels (3.0 percent), and miscellaneous goods and services (1.6 percent).”

Government surplus grows to nearly $105 million

Government revenue dropped by 2.4 percent in the first three quarters of 2015, to about $520 million, but the government surplus continued to increase, to almost $105 million.

The Framework for Fiscal Responsibility, signed in 2011 by then-Premier McKeeva Bush, requires the Cayman government to get approval for its budget from the Foreign and Commonwealth Office.

The framework prevents Cayman from taking out additional long-term loans and restrains government spending.

Government’s outstanding debt declined in the first three quarters of 2015, down by almost 5 percent to $518 million as government continues to pay off long-term loans. Government has paid off more than $50 million in outstanding debt since September 2013.

Government spending dropped in almost every category, led by a $5 million drop in personnel costs and a $10 million cut to supplies and consumables, according to the ESO report. The drop in personnel costs, the ESO notes, was “mainly due to lower payment towards the employer portion of pension liability and other personnel cost.”

Subsidies to statutory authorities, including Cayman Airways and the Health Services Authority, dropped by almost $1.5 million in the first three quarters of the year to less than $95 million.

Moody’s maintains Cayman’s credit rating and outlook

International credit rating agency Moody’s has maintained an Aa3 rating for bonds issued by the Cayman Islands government in a foreign currency, and an Aa2 rating for long-term foreign currency ceiling bonds and notes.

In its credit opinion, Moody’s noted government’s “fiscal and debt positions are comparatively robust given fiscal surpluses, low levels of debt, and high debt affordability.”

The rating agency expects budget surpluses of 2 percent to 3 percent of gross domestic product both this year and next, which will result a falling government debt burden.

“The debt-to-GDP ratio is slated to decline to approximately 18.5 percent of GDP in 2015 compared to a peak of 24.4 percent in 2011. We forecast that debt-to-GDP will continue to trend down, declining to around 17.5 percent of GDP in 2016,” Moody’s said.

Despite comparatively lower economic growth rates than equally rated peers, Cayman’s per capita GDP is higher than the median for Aa-rated sovereigns and a key support factor of its high credit rating.

Of the 16 sovereigns rated Aa by Moody’s, only four have a higher per-capita GDP than Cayman and two of them are Middle Eastern oil-producing countries.

“Cayman’s high GDP per capita supports its resiliency in the face of economic and natural disaster shocks, of particular importance given the country’s vulnerability to hurricanes,” the rating agency said.

The rating outlook is stable. Moody’s noted a positive outlook could be considered in the event of a significant reduction of government debt levels coupled with a policy framework that makes it unlikely debt will increase significantly again.

One potential economic risk noted by Moody’s is the shrinking of the financial services sector as a result of tighter regulations from G-20/OECD initiatives involving offshore financial centers.

This would lead to lower economic growth and negatively impact fiscal revenues, but it is a risk that would play out over a longer term of five to seven years.

Meanwhile, the likelihood of a major shock remains low, Moody’s stated.

Beneficial ownership

Beneficial ownership agreement with UK finalized

In April, the Cayman Islands government and the United Kingdom announced a new agreement to provide foreign law enforcement and tax authorities with faster access to beneficial ownership information maintained by local service providers.

The deal does not include a public registry, nor does it create a central government-maintained registry, as previously demanded by the U.K.
Instead the new system will give Cayman officials centralized access to databases held by the financial services companies.

Premier McLaughlin
Premier McLaughlin

Under the new regime, foreign law enforcement and tax agencies will be able to ask Cayman authorities to gather the information from the system. Companies will not know when law enforcement agencies request a search of the databases or what they are searching for.

“The U.K. has recognized that our system of enhancements meets their criteria for the sharing of information; meets global standards; and is best for this jurisdiction,” Premier McLaughlin said.

Mauritius and the ‘color of money’

The largest bail amount in history is of the order of $1.5 billion for the release of Subrata Roy, “managing worker” at Sahara India, a financial organization which once claimed to be India’s second largest employer.

Unable to deposit the amount, Roy has been in Delhi’s Tihar jail since 2014. Among his company’s assets are iconic London and New York hotels, Grosvenor House, and The Plaza, which Sahara said it would sell to spring the boss. For several months, prison authorities gave him access to a conference room with video facilities to facilitate transactions that would enable him to raise the bail. Given the value of the properties on the block, it seems strange that no deals were forthcoming. The 67 year-old Roy no longer makes the headlines.

In 2012, an intriguing headline featured on the pages of Times of India, India’s largest English daily: “Mauritius offers India two islands in effort to preserve tax treaty.”

According to the paper, “Mauritius has offered a couple of sun-drenched islands to India as part of a trade and investment deal. While the offer has been talked about for a while, Mauritius has revived it – at a time when it’s very keen on persevering with the 1983 double-taxation avoidance treaty with India.” Those islands were never ceded to India, and the Times of India retracted the news, but the very fact that the item was published underlined the importance to Mauritius of its financial relationship with India.

The hotels that didn’t get sold and the islands that were never ceded are linked through the more shadowy realms of India’s financial flows.

Let’s look at the Sahara case first: Subrata Roy was the flamboyant head of a “residuary non-banking company” or RNBC, which accepts deposits of tiny amounts. Over time, Sahara came to build townships, and own cricket teams, a newspaper, even an airline. When Roy’s two sons were married in 2004, 10,500 guests attended the joint celebrations in his 170 acre-estate in the north Indian city of Lucknow. A Russian gymnast showered flower petals on guests from a hot-air balloon, flamenco dancers entertained them, and they were joined by the prime minister, political leaders from every major party, and the A-listers of Bollywood, India’s cinema fraternity.

Roy’s political connections were well known, and rumors of whose money he was managing changed with every major election. The facts that landed him jail were that he had failed to obtain requisite clearance for the issue of several bond schemes of two Sahara companies, with a total face value of Rs. 20,000 crore, roughly $3 billion. The Securities and Exchange Board of India (SEBI) ruled the issues to be illegal, and asked Sahara to refund the amounts to its 30 million depositors. This mammoth number allowed Sahara to claim that all individual deposits were of a cash value of below Rs. 10,000, the threshold above which transactions need to be made by check or other banking channels.

Confronted by the regulator and the courts, Sahara said the bulk of these deposits had been repaid; further, that no complaints of non-payment had been received. It was unable to satisfy the courts of the former claim, though the latter seemed to be true. When the courts asked for documents pertaining to the deposits, they arrived by the truckload. The courts sent officials out to track depositors selected at random: not one could be located. No depositors, ergo no complaints!

Fed up, the courts ruled that Sahara should deposit Rs. 20,000 crore with SEBI. Roy was thrown into jail, and the price of his “Get Out of Jail” card was set at half this sum, Rs. 10,000 crore. The fact that this sum is not forthcoming leads many to believe that the Sahara assets are not Roy’s to control, and that beneficiaries other than the company determine their disposal.

India’s intelligence agency, the Central Bureau of Investigation, or CBI, estimated in 2012 that US$500 billion of illegal money of Indian origin was stashed abroad. Against that number, the sums involved in the Sahara transaction barely cause the needle to budge.

But unlike in the Sahara case, much of that money does come back. Gains from unrecorded transactions, many related to real estate clearances and transactions, find their way to traditional bolt-holes overseas, and are held there until required in India.

When this money is ready to return to India, it seeks anonymity. This has been provided by the convenient device of participatory notes, or PNs, which allow Foreign Institutional Investors (FIIs) to buy Indian equities without revealing the ultimate beneficiary to our regulators. Since 2000, the largest point of origin of such investments has been Mauritius; in the first decade of this century, nine of the 10 largest investors in India were based in Mauritius.

Mauritius2Aside from its convenient location (and those lovely islands in the sun), Mauritius has become a financial gateway to India thanks to a double tax avoidance treaty (DTAC) with India. Capital gains in India get taxed at the Mauritius rate of 3 percent, and much of this, I am informed, can be eliminated by local tax avoidance measures. India has a similar treaty with Singapore, which has a much deeper and stronger financial market, but the Limitation of Benefits (LoB)1 provisions in Singapore make it less attractive to those in a hurry to move money into India.

What kind of investors would seek the cover of participatory notes? Some investors desire anonymity for strategic reasons, not wanting to reveal the extent or timing of their bets on specific assets; others, who are round-tripping illicit funds, get the benefit of the same cover. Some money, it is believed, has both colors at once – and belongs to Indian businessmen who control listed companies, and use the PN route to manipulate the prices of their own stock.

Concerns about the color of PN money have existed for almost two decades now, and were formally tabled in 2001 by a Joint Parliamentary Committee on securities scams. Since then, regulators have passed the buck to politicians, who have passed it to each other. In October 2007, in a bullish market flush with liquidity, the regulator banned PNs, and Indian equities crashed. Within the week, the matter was ‘clarified’ stating the stricture would only apply to fresh exposures. The markets duly recovered.

Since then, there has been much bureaucratic business with disclosure norms and quantitative ceilings on FIIs and the number of sub-accounts they run. But PNs still ply the Indian Ocean: try analyzing any form of foreign investment into India – portfolio or direct – and you end up concluding that Mauritius is the largest source of global finance.

Though there is periodic concern about how tax avoidance agreements will affect the Mauritius routing, there is also little incentive to rock this cozy arrangement. At the broader level, FIIs, and the PNs they hold, have become critical to the health of Indian equity markets. Over 20 percent of the floating stock in listed Indian companies is held by FIIs, and no government wants to rock the boat of our stock markets by triggering an exit, even a temporary one.

In his first year in office, Prime Minister Modi made a two-day visit to the tiny nation, signaling its place in the Indian world-view. Speaking to the Mauritius parliament in March 2015, Prime Minister Modi told its leaders that, while there were concerns about the treaty giving shelter to tax evaders, and it need to be reviewed in that light, “I also assure you that we will do nothing to harm this vibrant sector of one of our closest strategic partners.”

For the time being, at least, Mauritius seems to have been granted status quo – without ceding its islands. A pity about Mr. Roy, though.


  1. To qualify for the capital gains exemption, the Singapore entity must have incurred an annual expenditure of 200,000 Singapore dollars on operations in Singapore in the 24 months prior to the date the capital gains arise.

Mistreated? Tax treaties and ActionAid

ActionAid, a NGO that works on development issues, has just issued Mistreated, a report condemning tax treaties’ impact on developing countries’ tax collection efforts. The report makes two critical errors in condemning tax treaties. It ignores the value of legal systems and it ignores accounting and economic reality. These mistakes are made over and over again by critics of offshore centers. However, we should praise the group for creating a database of tax treaties and for being transparent about its classification system. Too often, those asserting that there are billions of untaxed dollars, euros, pounds, RMB, and other currencies hidden around the world simply make undocumented claims. ActionAid properly shows its work and put its database of treaties on an Excel spreadsheet available on its website.1

Are tax treaties a problem or a solution?

mistreatedActionAid claims tax treaties facilitate tax avoidance by multinationals and thereby deny governments tax revenue that could be spent on schools, infrastructure, and other public investments. The group claims that treaty provisions which “set the rules about how established a foreign multinational has to be before it pays tax on its profits,” prohibitions on “withholding taxes” (i.e. taxes applied to payments leaving a jurisdiction), and restrictions on capital gains taxation all critically undermine efforts by developing countries to tax multinationals.

The value of legal systems

Like most of OFC critics, ActionAid doesn’t think investors need to make use of alternative jurisdictions when making investments into a developing country. For example, it criticizes Uganda’s treaty with the Netherlands for reducing the taxes Uganda can levy on investment coming into the country via the Netherlands. This raises the question of why Uganda has a tax treaty with the Netherlands. Was the Ugandan government simply hoodwinked by clever international investors into making a bad deal? This appears to be ActionAid’s position.

However, this ignores the role the Netherlands plays in the world economy. The Dutch have long been successful in creating a tax treaty network and a centerpiece of Dutch tax policy for decades has been avoidance of withholding taxes and taxation of dividends, royalties, and interest both generally and within groups of related entities. Why? The Dutch benefit by making the Netherlands an attractive location for holding companies. And more generally, the Netherlands is an attractive base for businesses to find customers because of its low corruption levels and its friendliness to international trade. The Netherlands ranked 5 out of 168 in the 2015 Corruptions Perception Index and in the 98th percentile for the 2010 Control of Corruption Index. Transparency International ranked it 5 out of 142 in the Global Competiveness Index (2012-13).

If we compare Uganda’s scores on these measures, we see why structuring a business in the Netherlands might be attractive to an investor. Transparency International ranked Uganda 139th out of 168 countries in the 2015 Corruptions Perception Index and in just the 21st percentile in the 2010 Control of Corruption Index. Similarly, Uganda ranked just 123rd out 142 countries in the Global Competitiveness Index (2012-13).

Moreover, the Netherlands has long had a policy of positioning itself as a platform for multinational business. The Dutch willingness to adopt a position of (mostly) tax neutrality for international businesses brings those businesses to the Netherlands, whose government then benefits from taxing the economic activity they generate by paying employees, buying goods and services, etc. Uganda benefits because investors who would either not be willing to invest at all or who would demand a higher return to compensate for the increased risk, are now willing to invest in Uganda.

ActionAid argues that tax treaties are not needed to promote investment, noting that there is US$112 billion of U.S. investment into Brazil in 2014 despite the lack of a U.S.-Brazilian treaty. This anecdote neglects to consider both the attractiveness of Brazil as a market and the dynamics of U.S.-Brazilian investment flows. The correct question is how much would investment change if there were a treaty, not whether there is any investment in the absence of a treaty. Moreover, the reason for the absence of a treaty appears to be due to significant policy differences over a range of issues including intellectual property rights and agricultural trade.

Ignoring accounting and economic reality

The reason there are double tax treaties is that it is often hard to reconcile tax obligations across borders. Indeed, the League of Nations abandoned its first efforts in 1927 on the grounds that “[i]n matters of double taxation in particular, the fiscal systems of various countries are so fundamentally different that it seems at present practically impossible to draft a collective convention, unless it was worded in such general terms as to be of no practical value.”2 Finding such solutions is hard, something that is rarely recognized by critics of international financial transactions.

Indeed, I would have expected ActionAid to be at least somewhat sympathetic to the difficulties in translating economic and accounting realities into formal systems given its own experience. In its Charity Navigator rating based on fiscal 2012 data, it earned a low rating for spending a large amount on administration (23 percent of money raised) and fundraising (23.8 percent). But when an International Business Times report was critical of ActionAid based on that, the agency responded that the percentages were high because it used accrual rather than cash accounting and so multiyear donations were booked when made.3 As a result, some years looked good, and some not so good even if expenditures were similar. Indeed, the current Charity Navigator report shows ActionAid doing much better: just 9.9 percent on administrative expenses and 11.9 percent on fundraising.4 The even more complex accounting issues involved in a multinational business are as easily misrepresented by the type of indicators on which ActionAid relies as this relatively simply impact of the choice of accounting method had on ActionAid.

If we dig in a bit and look at tax treaties’ restrictions on withholding taxes, we can see that ending withholding taxes is not the terrible move for a developing country that ActionAid believes it is. First, it is not a surprise that treaties eliminate or significantly limit withholding taxes. These taxes are often imposed as motivation to persuade other jurisdictions to enter into a treaty. Second, the economic impact of a withholding tax is not as ActionAid seems to believe. If, say, Uganda levied a 30 percent withholding tax on dividend payments to Dutch entities, the result would most likely be that the Dutch entities would either insist on a higher return on their Ugandan investment or forego the investment entirely. The rate of return on capital is the result of market forces evaluating the riskiness of the investment. Imposing a withholding tax on those investments would only cause investors to insist that the recipients of the investment pay more by providing a higher return on their investments.

This is not a theoretical point. When the United States cancelled the tax treaty covering the Netherlands Antilles in the 1980s, it initially did not take this into account and induced panic in bond markets.5 The U.S. had to quickly backtrack on the application of the withholding tax that the treaty cancellation restored to existing bonds. The dynamic impact of a withholding tax on foreign dividend payments from Uganda would thus be to make capital more expensive in Uganda, reducing investment into the country and slowing economic growth.


What the world needs are ways to reduce the cost of investment in developing economies to provide more opportunities for people there to build businesses, not ways to increase that cost. We need more investment in places like Uganda, as well as more competition with governments like Uganda’s, to induce them to serve their people’s needs. Unfortunately, ActionAid’s recommendations would move the world in just the opposite direction.


  1. The spreadsheet is available at
  2. League of Nations, Double Taxation and Tax Evasion 8 (1927).
  3. Connor Adams Sheets, Ebola Relief Charities: 5 Aid Groups to Avoid Donating To, International Business Times (Oct. 10, 2014) available at
  4. Charity Navigator,
  5. Craig Boise and I discuss this in Change, Dependency, and Regime Plasticity in Offshore Financial Intermediation: The Saga of the Netherlands Antilles, Texas International Law Journal 45:377 (2009) available at

Innovation in payment systems

The past decade has seen a veritable revolution in retail payment systems, with the development of online and mobile payments, and new peer-to-peer systems. More is to come; potentially much more. The speed of this process and the outcome will depend in part on the way such systems are regulated.
Since the first promissory notes were issued by bankers in 14th century Italy, payment systems have sought to balance parties’ desire for convenience and speed with the need to ensure that payments are valid and secure. Over the ensuing centuries, various innovations, including bills of exchange and checks, were developed that offered alternative means of effecting payment.

Among the most significant innovations in the 20th century was the development of payment cards. This began in 1914 when Western Union first offered charge cards to some customers. In the 1920s, many larger U.S. stores followed suit – several using a system called “Charge Plate.” These simple, “two-party” charge cards were a formal way for merchants to offer short-term credit to regular customers, which would typically be paid off in full at a specified date.

While some merchants no doubt accepted cards from other stores early on, Diners’ Club established the first full-fledged payment network in 1951, followed by American Express in 1958. These “three party” cards enable consumers to acquire goods in multiple stores, with payment being made by the card issuer, to be repaid by the card owner at a later date.

In the 1960s, two groups of banks established their own payment networks, which eventually became MasterCard and Visa. These “four party” systems (and other similar networks) work as follows: (1) the consumer obtains goods or services from (2) the merchant, (3) the merchant’s “acquirer” (usually a bank) then acquires funds from (4) the card issuer (i.e. the company who issued the card to the consumer and to whom the consumer will owe payment). Meanwhile, the entire process occurs over a platform operated by one of the payment networks.

Payment cards enable consumers to make purchases they otherwise wouldn’t make for lack of cash in their pockets. Credit cards also enable consumers to make purchases for which they don’t have funds in their bank accounts. As a result, consumers are better able to time purchases to coincide with their felt needs. Payments using cards also tend to be quicker than those using cash and they reduce the opportunity for till operators to steal money. This increase in convenience and security benefits both consumers and merchants.

In the past few years, several new payment systems have been developed. Among the most successful is M-Pesa, which enables one party to send a payment by encrypted text message to another party from their cell phone. M-Pesa, which began in Kenya and Tanzania, and is now operating in Afghanistan, India, South Africa, and parts of Eastern Europe, is particularly valued by people who do not have formal bank accounts, since it enables them securely to hold funds on deposit and transfer them at low cost to other M-Pesa users. In Kenya, transfers of between 10 KSh (about $0.1) and 49 KSh between registered users currently cost 1 Ksh ($0.01), while the cost of sending between 501 and 1,000 KSh is 15Ksh. These are much lower than the costs of using a conventional (three or four-party) payment network, especially for smaller transactions.1

In the U.S. and Europe, several companies have established their own mobile payment networks that, like M-Pesa, enable users to transfer funds via a common intermediary to other users. Among the most popular is VenMo, which was started in 2009 and bought by PayPal in 2013. While these systems are commonly referred to as “peer-to-peer”, they are actually peer-repository-peer, or PRP, systems, since the funds are not moved directly from one individual to another but are moved from one users’ account to another users’ account held by the same repository.

One reason PRP transactions can be offered at lower cost is that payments are generally not guaranteed by the network operator (whereas conventional credit card networks typically guarantee payment to a merchant even if they are unable to collect funds from the card holder). That significantly reduces the risk faced by the network and reduces the need to expend resources combatting fraud and theft.

However, as some users have found to their cost, the lack of protection against some types of fraud opens PRP payments systems to abuse. One common scam is for a purchaser to offer to pay for an item, such as concert tickets, in two tranches from two different accounts, initiate payment for both tranches and then, once the tickets have been transferred from vendor to purchaser, reverse the payment for the other tranche before the money has been received by the vendor.2

PayPal itself operates a multifaceted ecosystem of online payments, enabling low-cost transactions between owners of PayPal accounts as well as acting as an acquirer of credit card payments for merchants (acquiring funds from the card issuer). Another recent entrant, Square, also acts as an acquirer, offering processing with lower monthly fees than most other acquirers.

When acting as acquirers, PayPal, Square, et al. effectively operate as a layer on top of existing payment networks. But they offer certain advantages over older payment interfaces, including convenience and security. PayPal stores payment information securely on its servers and facilitates online transactions without requiring users to re-enter their credit card data, thereby reducing the potential for so-called “man-in-the-middle” attacks (basically, theft of information by other people with access to the network) when undertaking transactions on open networks. Meanwhile, Square transmits data securely and inexpensively, reducing opportunities for credit card information to be captured and stolen by merchants or hackers. In light of the problems experienced by Target and other stores in which the card details and other personal information of millions of shoppers was stolen, these are significant advantages.

The new generation of near-field communication (NFC) mobile payments being rolled out by Apple and Google store credit card information online – not in the phones – and so are able to transmit payment information (in the form of tokens) securely without substantial risk of man-in-the-middle attacks. Samsung’s system uses a different mechanism that relies on localized encryption of credit card information, which is also very secure. These mobile payments systems operate as a layer on top of existing payment networks (and charge a fee for the so doing). But as they become more popular, the incidence of fraud and theft should decline, which will in turn reduce the costs to payment networks, enabling them to reduce their fees.
In addition, Chase and some other banks have begun to offer their own payments solutions. These appear to be very similar to three-party schemes developed by Diners Club and American Express. But while those older three-party schemes tend to be more expensive than the four-party schemes, ChasePay claims to be much less expensive.3 One crucial difference is that ChasePay is only available to JPMorganChase customers – and is only available through the use of smartphones, which likely have lower risk of fraud and theft than conventional cards.

The cost advantages of mobile payments come in part from the enhanced security inherent in many modern smartphones. However, if the U.S. government were to succeed in compelling phone manufacturers such as Apple to develop a hack that would give them a back door into the phones, that advantage would potentially be significantly reduced. There are ways around this – for example by requiring the use of multiple tiers of security codes but these would make the use of phones for transactions more cumbersome and likely undermine their use for the majority of purposes.

While mobile payments in principle offer security and cost advantages, implementation entails up-front capital expenditure. To incentivize a shift to mobile payments, networks may choose to subsidize the installment of devices capable of receiving such payments. However, to do so they will need to be able to recoup their investment. Traditionally, card payment networks have done this through the interchange fee. However, increasingly governments are imposing caps on these fees: in the US, as part of the Dodd Frank Act, such fee caps were imposed on debit card transactions for cards issued by banks with assets of more than $10 billion; in Europe, much lower fee caps have now been imposed on all four-party cards (debit and credit). These fee caps will act as a direct disincentive to roll out mobile payments.

Another payments innovation that is receiving considerable attention is Bitcoin, which in addition to being a means of payment in its own right (and a pure peer-to-peer one, at that), can also be used as a transitional medium of exchange. In principle, Bitcoin and similar private digital currencies offer cost advantages compared with transacting in fiat money but so far uptake by merchants has been slow, making them less convenient. Part of the problem may be that most digital currencies, including Bitcoin, are open source, so there is no “owner” who could profit from subsidizing merchant interfaces and thereby expanding the network.

In addition to digital currencies, the blockchain – the encrypted distributed ledger that underpins bitcoin – is seen by many as having the potential to enhance the security of payments and lower their cost. Several banks and payment networks are involved in projects seeking to realize this goal.
In summary, retail payments are undergoing a phase of rapid change, with new technologies providing higher levels of convenience and security, with attendant lower costs. These changes will benefit both merchants and consumers. However, the rate of change will depend very much on the regulatory environment: attempts to interfere with security and pricing of services will hinder development and rollout of new technologies.

If governments force mobile phone companies to create “back doors” into smart phones, as the U.S. government has been seeking with Apple, they will effectively hand the keys to those phones to criminals. And if criminals are able to break into smart phones, then the ostensible security advantages of those phones will be drastically reduced – potentially undermining their use for payments.

In Europe, the caps on interchange fees have likely contributed to the slow roll-out of Apple Pay there. In the U.S., Apple charges 15 basis points per transaction. In the EU, credit card interchange fees are capped at 30 basis points and debit card fees at 20 basis points. Clearly the US fee model is unlikely to be viable in the EU, so Apple will have little incentive to support the adoption of Apple Pay there. The same presumably applies to other mobile payment systems.


  1. Warren Coats wrote at greater length about M-PESA here:
  2. See e.g.:

Anguilla’s indigenous banking crisis: An in-depth analysis and lessons for the region

On Aug. 12, 2013, the Eastern Caribbean Central Bank took control of Anguilla’s two indigenous banks, the National Bank of Anguilla Limited (NBA) and Caribbean Commercial Bank (Anguilla) Limited (CCB) under the powers granted to it under the Eastern Caribbean Central Bank Agreement Act which established the central bank within the laws of Anguilla.1

The central bank took the action after consultations with the Monetary Council and followed its directions.

Then-Governor of the ECCB, Sir K Dwight Venner noted that the Central Bank was empowered under the Act to assume control of and carry on the affairs of a financial institution and if necessary to take over the property and undertaking of a financial institution if the interests of the financial institution’s depositors or creditors are threatened; the financial institution is likely to become unable to meet its obligations; or the financial system of a member territory is in danger of disruption.

Venner stated that in the opinion of the Monetary Council and the Central Bank, all three circumstances were present in the case of both NBA and CCB, and he announced that the central bank would take control and possession of the banks’ funds and assets and manage their operations.

He noted the central bank would also investigate the affairs of the banks and their affiliates, provide financial assistance and restructure the businesses if required and take all necessary steps to protect depositors, creditors and the stability of the financial system.

The decision by the Monetary Council to take control of the banks had the support of the government of Anguilla and the British government. Since then, the banks have been under the conservatorship of the ECCB with technical support being provided by the International Monetary Fund, World Bank and regional banking experts.2

The background

The history of the two Banks is a storied one and despite the current situation, speaks to the vision and achievement of the Anguillian people over the past nearly 40 years. By the 1970s, while still relatively poor, and in the wake of political and socio-economic changes regionally and internationally, there began a move to gain greater economic control over the island’s economic affairs. Up to that point, banking was dominated by foreign institutions from Canada, the U.K. and to a lesser extent, the U.S.

Local people were not able to gain access to capital easily as these institutions had strict lending policies which were not only linked – many suspected – to the financial ability to repay but quite frankly also to race and class. The fact was that if you were not someone of a certain racial make-up or skin hue and from a certain class, with a few exceptions, gaining a bank loan was not possible in many parts of the region.

Anguillians established CCB as Anguilla’s first locally owned,  controlled and managed bank in 1976.
Anguillians established CCB as Anguilla’s first locally owned,
controlled and managed bank in 1976.

Thus, in 1976, with local and regional capital, Anguillians established CCB as Anguilla’s first locally owned, controlled and managed bank which serviced the needs of local people.   Immediately, Anguillians en masse, who hitherto were unable to get a loan from Barclays Bank and Bank of America, the only two banks on the island at that time, were able to secure financing to buy land, construct homes, purchase household goods, cover expenses and advance themselves.

In 1984, after Bank of America decided to close its branch in Anguilla and locals purchased its assets with government’s assistance, NBA was born and commenced operations in early 1985.  Together, the banks transformed the local banking sector and contributed immensely to the development of the island. So successful were these banks that at the time of the ECCB action, together they accounted for 76.7 percent of the assets of the banking sector in the jurisdiction.  To insert an Americanism here, these banks were too big to fail since the consequences would be dire for Anguilla.

NBA commenced operations in early 1985.

Why did the banks fail? The official line

Chief Minister, Victor F. Banks, who is also chairman of the Monetary Council of the ECCB, released the findings of the first proper report dealing with an analysis of the lending practices of the banks during the five-year period prior to the conservatorship conducted by Grant Thornton from the BVI. In a Nov. 3, 2015 press release the government noted:
“The current balance sheet deficiency at NBA and CCB is due primarily to the quantum of non-performing loans and increasing provisions being made against such loans as a result of falling property prices in Anguilla. This problem was in part contributed to by the overreliance on the valuation of the security being advanced as collateral in the loan approval process, as opposed to analyzing cash-flows and the ability of the applicant to repay the loans in changing economic conditions. Given the limited issues identified surrounding related party loans it does not appear as though these were a major factor in causing the banks’ current situation.”

The bank resolution

In late 2015, GOA presented a bank resolution strategy to the British government for approval.  The plan was drafted by the Ministry of Finance, the ECCB, with assistance from the IMF, World Bank and other officials, including those from the U.K.

In his Budget Address in December 2015, Chief Minister Banks finally told the jurisdiction that the government of Anguilla would in effect bail-out the banks to the tune of EC$302 million (approximately US$112.3 million) in borrowing to be amortized over 25 years. To put that figure into context, the expected revenue raised by government for 2016 to run all of its operations is projected at EC$225.3 million.

To fund this bail-out, all indirect taxes like license fees in various areas and property taxes were increased as of Jan. 1, 2016. It is expected that more increases shall come over the years to finance the resolution strategy.

Subsequent to the passage of the budget and the legislation, shareholders of one of the banks launched legal action against the ECCB on a matter being heard in Chambers.

In addition, on the Feb. 22, 2016, the Financial Services Commission announced that on an application by it, the High Court had appointed William Tacon, a chartered accountant with FTI Consulting from the BVI as administrator of the two offshore banks.

Observations and lessons to be learnt

Despite the analysis by Grant Thornton and its reference to loans to related parties and the reason for the non-performing loans, along with politically correct statements by government officials, the fact is that the failure of the indigenous banks is due to mismanagement on behalf of their leadership both at board and senior management levels.

The argument about loans to related parties not being a major contributor to the banks’ current situation is nonsense, to say the least, since in a small community like Anguilla, every person can qualify on an expanded definition as a related party due to family and social links. To keen observers of both banks, it was known that there was too much incestuous lending, too much lending based not on sound business/risk principles but based on personal, familial, social and political connections. I don’t fault Grant Thornton for not picking up or writing about this but as an Anguillian, I can speak bluntly about the situation.

The fact is that the banks were managed as personal fiefdoms by a social clique of friends who were major shareholders and who all seemed to think the same way. There was no vision, no outside influence, no one to call them out and the leadership all suffered from group think reflective of a common outlook and political affiliations with the political party in office at the time between 2000 and 2010.

It was then that the Banks expanded their balance sheets rapidly as Anguilla experienced a property boom and great economic development especially between 2004 and 2008. That is the real reason why loans were granted to persons for projects, whether mortgage or commercial, which elsewhere or in other institutions, would never have been made.

The genius of the banks and their storied history of closeness to the local population, the desire to help the small man get ahead to build a home, educate his children and advance in life, was also their great weakness. Hindsight is 20/20 but some of us, in quiet conversations, raised alarms about the quality of senior management and directors of both institutions, many of whom held positions based not on any great academic qualifications or known business acumen but because of who they were, their political connections and their shareholding in the banks.

Some like me voted with our feet and sold our shares when we decided that there was nothing that we could do to influence the direction of the banks. As an aside, I once held shares in NBA but decided in 2003 to sell them for a small profit after I concluded that the management both at board and senior management levels left much to be desired. Someone who is a large shareholder in a bank does not necessarily make a great director of the institution but it was clear that the large shareholders demanded a say in the running of the banks to both protect and advance their interests and it is now clear, that this was done at the cost of other shareholders, depositors and the general population of Anguilla.

Thus, what the fall in property prices, caused by the downturn in the global economy and which also affected Anguilla’s immensely in around 2008/2009 did was to expose weaknesses in the banks’ leadership and decision-making and shed light on the many wrong business decisions that were made.

To take Grant Thornton’s analysis further, had proper risk analyses been done on the borrowers and the projects, whether personal or commercial which were being funded, then once there was evidence of the ability to repay the loan which was sound, the fall in price of the underlying asset would have had less of an impact.

Blaming falling property prices for causing the high level of non-performing loans is like the captain of the Titanic blaming the presence of the iceberg in the North Atlantic Ocean for the sinking of the ship. The iceberg was supposed to be or was likely to have been in that area of the ocean at that time of the year. The task of the captain, knowing this, was to navigate his ship safely around the iceberg and through the North Atlantic Ocean. The task of the management of the banks was to lead them through changing economic circumstances and not blame said circumstances for their failures and the liquidity issues that the banks now face. After all, that is what they were being paid for.

The first lesson to be drawn from Anguilla’s problem is that, especially where indigenous banks are concerned, because of their peculiar nature of being small, localized, patriotic in a sense, sound leadership needs to be put in place both at board and senior management levels. Business decisions must be made on sound principles with proper risk analysis being done and not clouded by emotional, nationalistic, personal or political preferences and prejudices. It is clear that in the case of these two banks, this was a major failing. In fact, at one point, Anguilla’s Chief Minister Osbourne Fleming was also chairman of CCB. When this was brought to the attention of the ECCB, nothing was done. Fleming was once Anguilla’s representative on the Monetary Council. It is safe to say that this was a most unusual situation.

The second reason why, in my opinion, the banks failed was lax regulation by the ECCB. The Central Bank cannot pretend to be an innocent party in this saga. Had the ECCB done its job and intervened earlier when there were clear warning signs, then perhaps the problem would not have become as bad as it did. There was evidence, as admitted by senior bank officials in private conversations, that from as far back as 2008/2009, the ECCB had concerns about the viability of the banks as the property market in Anguilla which, as those of us on the ground were well aware, was inflated, and in the midst of an artificial and unsustainable bubble, was beginning to collapse. Instead of removing the leadership of the banks, the ECCB did nothing. Some have argued that perhaps this was because Anguilla’s then minister of finance, who is now chief minister and again minister of finance, and its representative on the Monetary Council was related to and had close relationships with the senior management of both institutions. It is this type and level of conflicts of interest that are unique and peculiar to very small places like Anguilla that makes it even more important that proper regulation and standards are put in place especially where indigenous banks are concerned.

This extends to the Financial Services Council which should have done more to ensure that the management of the two subsidiaries which were under its licensing and supervision were up to the task and that all was well. That regulatory body also failed in its statutory duty to ensure the viability of these two licensees and must also shoulder some of the blame. The FSC, unlike the ECCB, had and has the power to approve directors before they are appointed to the board of an offshore bank and thus, it could have done more to ensure that the subsidiaries were properly managed.

Thus, the second lesson that needs to be drawn from this is that there is no excuse or room for weak or lax regulation no matter the circumstances. Unlike international banks which are subject to supervision by large international regulatory bodies and have resources to put in place extensive systems of control, risk management, Chinese walls and manage conflicts better, indigenous banks are small, insular and often present in only one jurisdiction and thus only subject to local regulation. It therefore makes it even more axiomatic that the regulator is on the ball at all times.

The third lesson that should be drawn from this is that where indigenous banks are concerned, especially where share ownership is not widespread, board and senior management appointments should be subject to regulatory approval. It is ironic that for the two offshore banks, the FSC had to approve the directors but for the two parent companies, whomever the shareholders decided to appoint as directors, no matter their qualifications, got to sit on the boards.

It was a running joke amongst a few of us in the offshore sector about the poor quality of the boards of both banks and even at the level of the two offshore banks. In many cases, it was risible to see who got to be directors of these institutions and as a result the entire jurisdiction is paying a high price in increased taxation on the population, massive reputational damage and banking inconvenience.

The broader picture

Anguilla’s indigenous banking crisis could not have come at a worse time granted that U.S. and European banks, under pressure from their regulators, are considering ending correspondent banking relationships with regional indigenous and offshore banks as part of their de-risking exercises.
In fact, in the case of Belize, this has happened to some of its banks. The risk to the region of being destroyed by losing correspondent banking relationships is so great that CARICOM (the Caribbean Community) has established a Ministerial Committee to look at the issue. It is chaired by Antigua and Barbuda’s Prime Minister and Minister of Finance, Gaston Browne, to lead the response to this issue.

Prime Minister Browne has described the threat in the following terms: “If there were any scheme designed to destroy the economies of several countries without a military war, then this is such a scheme. It is erroneous; it is pernicious; and it is vicious.” It remains to be seen how effective the work of this committee is but the risk to the region cannot be overstated.


Anguilla and Anguillians should be very proud of the banks. These institutions were created at a time when access to capital was limited and restricted and they have contributed immensely to the island’s development. However, those who started them, weren’t ideally suited to continue managing their operations in an increasingly changing world after a certain point when the banks reached a certain size and stage of their developmental cycle. It is indeed human nature never to realize when one has reached one’s level of incompetence and despite protestations to the contrary, the fact is that the management of these banks was not suited to continue to be in charge of them after a certain stage of their development especially as the global economic situation moved beyond their own understanding.

However, not only did the management fail but so did the shareholders by continuing to repose trust in persons who were clearly out of their depth. In addition, both the ECCB and the FSC failed to take the necessary steps needed to rein the management in and to put the institutions on a sound footing. This was due to cowardice, political considerations, social restraints and a lack of vision. Now, as a result of failures by all these actors, the entire jurisdiction and population will pay the price.

The lessons to be learnt from Anguilla’s mistakes with its indigenous banks are clear. Proper management is required irrespective of ownership; the banks should be run on sound business principles without political interference or overly nationalistic and social considerations within reason of course since that is indeed a difficult balancing act to achieve; there needs to be proper and sound regulation, again without political interference and regulators should have the legal and regulatory tools to ensure this is done; and finally, directors and senior management should be subjected to regulatory approval. Despite owning shares, there is no God-given right for any shareholder to be appointed a director of a financial institution which has fiduciary obligations to depositors and is part of a regional and global financial system.

Hopefully, other indigenous banks will not suffer the fate of those here in Anguilla and will take heed before it is too late.  Only time will tell.


  1. For background information on the ECCB and how it functions, refer to a previous article I wrote at:–The-road-ahead/).
  2. It is worth noting that in addition to the two Banks, each of them had a subsidiary which was licensed not by the ECCB but by the Financial Services Commission (FSC), the island’s regulator of the offshore or international financial services industry. These two institutions, wholly owned subsidiaries of the aforementioned Banks, being the National Bank of Anguilla (Private Banking & Trust) Ltd (NBAPBT) and the Caribbean Commercial Investment Bank Ltd (CCIB) were also taken over by the ECCB at the same time.

Security vs. security: The trade-offs in financial surveillance

For decades, a number of regulatory programs aimed at the financial services sector have been recognized as threats to financial privacy. Taxation and financial surveillance schemes undercut people’s ability to control information about themselves, and these schemes have continued to grow, increasingly menacing law-abiding people’s privacy in service of the search for law-breakers. But as government and corporate information systems have gone digital and networked, the threats to privacy have expanded even more quickly and significantly than the growth of surveillance.

No longer is just privacy at stake, but individuals’ security. Data breaches from information systems, made more likely by digitization and networking, create not just concerns about controlling financial information; they afford a new criminal class of hackers and other malefactors opportunities to harm individuals and their families financially and, in the worst cases, bodily. The trade-offs in financial surveillance are no longer between privacy and security, but between individual security and state security.

Privacy and financial information

Many people are familiar with the threats to financial privacy that exist, but often only in passing. An acute understanding of privacy is essential, and it is equally important to recognize that our financial activities and relationships are deeply revealing of our values, our relationships, and our day-to-day activities. These things are our own business. Our finances and property are a bulwark of independence from others. With wealth, we are independent actors. Without it, we are supplicants to whoever offers us bread – or permits us control of the bread we thought was ours. Protecting our privacy and property are both important elements of modern liberty.

The word “privacy” is sometimes vexing because it is used to describe a number of important interests that people have, including seclusion, fair treatment, autonomy and security. But the best sense of privacy is control of personal information about oneself. A person has privacy when he or she has the power to control personal information and has used that power consistent with his or her interests and values.

Privacy is easy to protect in many circumstances – even second nature. We put on clothes in the morning to protect privacy in the appearance of our bodies, and most of us reach days’ end, day after day and year over year, with our bodily privacy intact. It is difficult to protect privacy online, on the other hand, because many people do not know how their computers and devices work, much less how they share information with a variety of actors online. People often fail to use the control they have when they surf the World Wide Web or use other Internet protocols.

It seemed for many years that people’s online privacy troubles would be remedied as they learned better how to control information about themselves. People would also learn that being a part of the information economy offers them many benefits, such as zero-priced online content and services. The plan was to develop online habits like we have offline, gathering privacy and security around our online activities.

But the Snowden revelations of June 2013 showed that we are often actually disabled from protecting privacy as we wish when we communicate online. The contractual promises that telecommunications providers have made to Americans for years, and the privacy protection obligations pressed on them in regulation, have given way in secret government proceedings to a systematic regime of information sharing with national security agencies. The U.S. government actively works to undercut encryption systems that would allow us to cloak our communications the way we do our bodies. What we learned from Snowden was probably only the tip of a very large, globe-spanning iceberg.

Communications privacy, we now know, is in the same poor state as financial privacy. It is not just a matter of wanting to control personal information and figuring out how to do so. The law makes it impossible to enter into private relations with nearly any financial services provider. Such businesses labor under requirements to collect prescribed information about their clients – “know your customer” rules – and they have continuing and growing obligations to turn over data about customers that might be interesting to tax authorities. In parallel, they have been more and more obligated in recent decades to act as arms of law enforcement and the national security bureaucracy. “Know your customer” and “suspicious activity reporting” are staples of the global financial surveillance regime pushed by the Paris-based Financial Action Task Force, which seeks harmonized surveillance at high levels the same way the Organization for Economic Cooperation and Development seeks harmonized high tax levels worldwide.

The result is that financial privacy is very hard to maintain beyond quotidian cash transactions. It is nearly impossible for people of significant wealth to protect their financial privacy. Today, a person who has committed no crime or fraud is subject to the same generalized surveillance system – and barred from having private financial transactions – as a fraudster or thief.

In the Western tradition, people are presumed innocent until proven guilty, and they are entitled to protect privacy as they wish, for any reason or no reason. The ability to control our own property and information about ourselves is a part of the bedrock of freedom and autonomy that people have been wresting from the powerful since Magna Carta. Privacy and property are that important. But the international legal system today seeks to allow us a decreasing share of both.

Obviously, some trade-offs between privacy and security are necessary. There is no legitimate privacy claim that shelters one from valid investigations of crimes such as theft, fraud and violence. Nobody wants a system so private that criminal networks or terrorist groups can operate with impunity. But the costs of financial surveillance have risen in recent years. The efficiencies of digitization make exposure of private financial information more threatening than it was only a few years ago.

Analog data and digital data

Digitization is at the heart of the data revolution, and it has had vast benefits, to be sure. But those benefits come with costs that are inextricably linked. One of the costs is increased risks to data security. While we get the benefits of the data revolution (and governments get its surveillance benefits), the risks from collecting data in digital form have grown. Our privacy and data security is more threatened now by taxation and financial surveillance than it was when these policies and programs began.

Language and writing were not the final advance in human record-keeping and communications. The ability to translate words, sounds and images into digital codes has enabled people and organizations to transmit information of all kinds around the world at the speed of light, to store it cheaply, to copy it an infinite number of times, and to process it into new and valuable combinations. The Internet we know, our easy access to communications and entertainment, and many, many economic advances are products of that digitization.

The same benefits have accrued to governments in at least some degree as they seek to amass and use data about our tax obligations and the people among us who may be criminals or terrorists. It is easier to transmit, store, copy, and process data about people and their finances.

In corporations and governments alike, files about us no longer reside on paper in a single file cabinet, our privacy protected by the practical obscurity of this kind of record. Our files are digitized and made available across networks to a variety of actors.

lockBy policy, of course, the people and organizations to which our information is available should have a legitimate purpose for accessing it, and they should not use the data for unauthorized purposes. But wrongful access to data is easier on digital networks, which are accessible remotely, controlled only by highly fallible passcode and other “authentication” systems. It’s a simple fact of modern life that data breaches happen more often and expose larger quantities of data. Data security risks are higher.

Governments aren’t the only organizations to allow breaches of personal and private data about their employees and subjects, but examples of this happening are legion. Examples include recent reports that the U.S. Department of Homeland Security and Federal Bureau of Investigation saw 200 gigabytes of sensitive information absconded with, including personal details about 30,000 of their employees. In June 2015, the United States government’s Office of Personnel Management announced that it had exposed the records of as many as four million people, a number later revised upward to 18 million.

And, of course, hackers are going where the money is. Recent reports from the U.K. and the U.S. state of Oregon show that exposure of sensitive personal details is allowing hackers to file false tax returns to collect funds properly owing to legitimate taxpayers.

It may be that, on average, government databases pose greater risks to security because government agencies and their employees do not suffer losses if the data they control is breached. There is no argument that corporate systems are perfect, but when a corporate system is breached, the company faces substantial liability and public relations costs that will impact the income of potentially every employee, and especially top management. Government organizations enjoy continued funding streams even in the face of failures. Indeed, some agencies are rewarded with larger budgets to clean up after, or compensate for, their lapses.

Digitization means more data about more people and things is more widely available. This includes our personal financial data. When a government agency – or Google or Facebook – collects digital data about us, there is a greater risk than there was before that this data will be exposed to a wrongdoer. And once data about us is “in the wild,” there is no telling where it may end up. Data has no necessary physical form, but it is like a volatile gas: Once it is out of the bottle, there’s no putting it back.

The security vs. security trade-off

In the past, it was fairly well recognized that record-keeping and reporting for tax purposes produced a trade-off between individual privacy and the funding needs of the state. Financial surveillance for crime control and terrorism was likewise a privacy cost exchanged for a national security benefit.

But this framework isn’t necessarily the right one any more. It is not just privacy put at risk by wrongful exposure under tax and financial surveillance policies, but individual security. The millions of individual data records breached in recent years don’t just threaten embarrassing or concerning disclosure, but the risk of identity frauds or phishing attacks that abscond with substantial amounts of individuals’ assets. It is not privacy at risk, but the keys to our financial wealth.

In the worst cases, of course, revelation of financial information can position wrongdoers not just to steal, but to select targets for robbery, kidnapping and even murder. In 1989, the murder of actress Rebecca Schaeffer spurred new privacy protections for driver license records because the California Department of Motor Vehicles had given out her home address to a stalker simply for the asking. It is not privacy at risk any more. It is personal security – mostly the security of our assets, but also, in rare cases, of our homes and families.

That does not mean there should be zero monitoring of financial transactions and financial flows. But it does mean that financial surveillance systems should be reassessed with their full costs in mind. The surveillance regime pushed by the Financial Action Task Force produces billions of dollars in compliance costs annually around the world, and it also puts individuals’ financial information at risk. If these policies are to be validated, they must be shown to produce more in national security than they cost in dollars and personal security. Taxation schemes, likewise, must be shown to produce more in revenues for needed government functions than they produce in economic dislocation, disincentives to investment, privacy and security risk, and other costs.

The challenge of making these kinds of calculation is not easy – it’s somewhat like comparing the weight of a rock to the length of a line. And many people operate simply on gut feelings: “the government needs this money” or “terrorism is really bad,” so financial surveillance is “good.” But it is essential to consider articulately whether financial surveillance actually produces net benefits. The FATF has endorsed financial institutions using risk management in their compliance programs for years. The FATF’s own principles should be subjected to the rigor of risk assessment to see whether they provide net security gains.

The modern trade-off in digitized financial surveillance is not between privacy and security, but personal security vs. national and state security. Given the presumption that states exist to protect individuals, these are trade-offs between equally important values. The privacy and security risks from financial surveillance should be more carefully considered in assessments of taxation and financial surveillance schemes.

New regulatory changes make funding for startups easier

On May 16, Americans will get a new way to both raise and invest capital. The long-awaited investment crowdfunding law will be live, more than four years after Congress and the White House gave it the green light. Although the subject of much enthusiasm in some corners of the Internet, the final product may be too clunky to be an effective engine of small business growth. The idea behind the new law – that the Internet can and should be leveraged to facilitate capital formation – however, remains a good one and other recent changes in U.S. law may provide better avenues for attracting investment.

Crowdfunding as it is commonly understood dates from the mid 2000s, when sites such as ArtistShare followed by Sellaband, Indiegogo and Kickstarter emerged. These sites enable the general public to provide funding to projects that interest them via web-based platforms. The underlying concept – raising funds from the public through a large number of small donations – is, however, much older than the Internet. In the 19th century, it was known as “taking subscriptions” and was done door-to-door.  The Statue of Liberty stands in New York Harbor thanks to just such a subscription campaign. What is new is the Internet’s ability to minimize transaction costs and extend the reach of a campaign to thousands or even millions of people.

Although online crowdfunding is now entering its second decade, its usefulness has been limited by the fact that using crowdfunding as a way of selling securities has not been legal in the U.S. Specifically, while a company has been able to use crowdfunding to raise capital, it has not been able to offer a return on investment. Instead, companies have offered rewards such as hand-written thank-you notes from the CEO, t-shirts, or priority on a wait-list for a coveted product. Glamorous ventures, such as music or film productions, have been able to offer perks such as the donors’ names written in a CD’s liner notes, or included in a film’s credits. Obviously not every venture will have the ability to offer such attractive incentives. Additionally, while many donors may enjoy seeing their names in lights, others may simply prefer the chance to make money.

Unfortunately, until now, the structure of American securities laws has made such investment nearly impossible to offer legally. With only a few exceptions, investment by the general public (the so-called retail investors) has been limited to public companies. There was no option suitable for very small companies to access the public capital markets to obtain seed money to start a business, or a small amount of capital for a modest expansion. The guiding assumption under U.S. federal securities law is that a transparent and fair market requires certain mandated disclosures from the issuer. These requirements can be waived when it is clear that the investors can “fend for themselves” without the assistance of government. Private placements, for example, may be done without mandated disclosure because the pool of investors is limited to those believed to be either financial sophisticated or able to withstand a financial loss (or both). A registered public offering, however, carries too heavy a regulatory burden to be feasible for raising a very small amount of money; certainly it would not be feasible for a company looking to raise only $1 million or even less.

The new law allows investment crowdfunding, and allows retail investors to participate, but strictly constrains both issuers and investors alike. Starting May 16, most privately-held U.S. companies will be allowed to raise up to $1 million per year in capital using special online platforms or traditional brokers.  There are no wealth-based restrictions on who may invest, as there are with private placements, although there is a cap on how much an individual may invest, based on net worth and income: Investors with income or net worth less than $100,000 may invest the greater  of $2,000 or 5 percent of whichever is lesser, annual income or net worth, in any given year, and investors with income or net worth greater than $100,000 may invest 10 percent of whichever is greater, net worth or income, up to a cap of $100,000 annually.

There are additional restrictions and requirements, the full weight (and cost) of which may make investment crowdfunding ultimately unworkable. For example, issuers, although permitted to sell to the general public, are severely limited in their ability to advertise the offering. For the most part, they may only direct investors to the online platform listing the offering. The reason for the limitation is most likely to ensure that potential investors have the full complement of information required to be included on the platform. But not only does the restriction make it difficult for issuers to promote the offering, it may unwittingly expose them to liability. A company looking to raise less than $1 million in capital is a small company with limited funds for legal advice. The more complicated the rules for crowdfunding, and the more nuanced their application, the more likely that companies will get into trouble. It is not unreasonable to expect that a start-up, especially one that has not been able to afford a lawyer, might run afoul of this rule while using social media or other sources to advertise the offering.

Other parts of the new law make investment crowdfunding equally unattractive. Issuers must use accrual-based instead of cash-based accounting even though few small businesses use accrual-based accounting. Issuers must also make a number of disclosures to the SEC at the time of the offering, and must continue to make annual disclosures. And missing even one follow-on disclosure puts the company at substantial risk: If a company fails to make its disclosures, it loses an important regulatory exemption and could be forced either to go public – an expensive and unfeasible option for very small companies – or be found in violation of the securities laws.

While this particular law may not prove workable, there are other new laws that have been phased in in the U.S. in the last few years that offer companies the ability to raise capital online. While not part of the legal provision titled “crowdfunding,” they operate in a similar way and may ultimately be more useful for small companies looking to raise cash.

Until recently, private placements in the U.S. were subject to strict rules regarding how they could be advertised. Whether the offerings were promoted to a narrow audience was a key factor in determining whether they were truly “private” and therefore exempt from several regulatory requirements. In 2013, the law changed. Now issuers may advertise as widely as they wish, so long as they sell only to certain investors, called “accredited investors,” who are, generally speaking, institutions and wealthy individuals. While this type of offering is not “crowdfunding” in the sense that it is not an offering to the general public, since retail investors are excluded, it does share with crowdfunding its use of the Internet as a means to reach a wide audience. Additionally, several online platforms have sprung up that allow accredited investors to browse offerings and select companies for investment. As with most private placements in the U.S., there is no cap on the amount an issuer can raise using this type of offering.

Another change in the law, which became effective in 2015, allows issuers to raise up to $50 million in capital through sales to the general public. This type of offering has been dubbed the “mini-IPO” because, like an IPO, it allows the company to sell securities to the general public, and allows the securities sold through the offering to be freely traded in the secondary market. Securities sold through private placements are typically “restricted” and secondary trading is limited. This type of offering has existed almost as long as the U.S. securities laws have, but until the recent changes it was hamstrung both by a low cap on the amount that could be raised – $5 milllion – and by the requirement that the offerings comply with state laws. Because the U.S. has a federal system, and each state has its own laws, all securities offerings must comply with local state laws unless the federal government has claimed exclusive jurisdiction. The federal Securities and Exchange Commission has long had exclusive jurisdiction over public offerings and most private placements. But until last year, the mini-IPO, also known as a Regulation A offering, was still subject to state registration. This made Regulation A offerings so cumbersome that in recent years there was sometimes only a single offering of this type in an entire year. The new law exempts some offerings under Regulation A from state registration if the issuer provides certain ongoing disclosures to the SEC, and increases the amount that can be raised from $5 million to $50 million. Both the reduced regulatory burden and the increased cap will likely make this type of offering more attractive to issuers. The fact that Regulation A offerings can include retail investors makes the Internet a viable option for soliciting investment.

Crowdfunding and closely related concepts will likely play an increasingly important role in capital formation both in the U.S. and abroad. By one estimate, crowdfunding platforms raised more than $16 billion worldwide in 2014. Although the basic premise is an old one, the methods, including the ease of reaching millions of people almost instantly via the Internet, are still very new. Regulators have wrestled with how to maintain existing frameworks while welcoming innovation. They have not always gotten it right. But the diversity of capital access now available to smaller businesses may help to smooth over some of the roughest edges in existing regulation, while also pointing the way toward improvements down the road.

Argentina’s revival?

When Mauricio Macri took over as the president of Argentina, he vowed to revive an economy that after 12 years of populist-left rule was stagnating with double-digit inflation and widening current and fiscal deficits.

His goal is to achieve sustainable economic growth and public finances, including by working with the opposition.

“For us to make the changes that we have promised, we must put together diverse teams, bring on visions that are different from our reality,” Macri said in his Dec. 10 inaugural speech after winning the election for Cambiemos (Let’s Change), a coalition of center-right parties. “We must be united in a country of diversity.”

The 57-year-old civil engineer’s strategy is an about-face to his predecessors Cristina Fernandez de Kirchner and her late husband Nestor Kirchner. Their style divided society, such as with the phrase often used by the party: “You’re either with us or against us.” And their interventionism drove away investment. Currency controls, price caps and protectionist trade policies slimmed profit potential and made it harder to do business.

The Kirchners had early success to build a following. They rebuilt the economy after it shrank 11 percent in 2002, when unemployment surged to 25 percent and the poverty rate to 54 percent.

The recovery came thanks in part to a policy of keeping a lid on utility rates to promote consumer spending. But it was surging international commodity demand and prices during the 2000s that really fueled the rebound. Nestor Kirchner sustained a weak exchange rate to increase exports of beef, corn and soybeans, the latter becoming the country’s biggest export. This fattened foreign reserves and turned the fiscal and trade accounts to surpluses. The economy averaged 8 percent annual growth between 2003 and 2011, and the central bank’s dollar reserves expanded to a record $53 billion in 2011.

The Kirchners, however, failed to fully settle a $100 billion default from 2001. In 2005 and 2010 restructurings of the defaulted bonds, they got a total of 93 percent acceptance for offers of 30 cents on the dollar. But the rest of the creditors sought to collect in full, including by seizing Argentine assets abroad. A group of hedge funds, among them NML Capital, a unit of U.S. billionaire Paul Singer’s Elliott Management, went on to win a lawsuit in U.S. courts for a settlement at full face value plus past-due interest. The 7 percent of these so-called holdout creditors stand to collect a total of more than $10 billion in claims.

Without a full settlement, Argentina couldn’t borrow abroad at a time of globally low interest rates from the early 2000s. This left the Kirchners with few options to finance rising utility subsidies and social welfare programs, and to pay the national debt.

Indeed, after a failure to get congressional approval in 2008 to hike taxes on agriculture exports, the government renationalized the private pension funds, securing nearly $30 billion. It went on to change the central bank charter so it would become a primary lender for growth, development and paying the national debt, not to defend the value of the currency, as was its historical mandate.

Tax pressure was increased to a high of 36.6 percent in 2015, according to the Argentine Institute of Fiscal Analysis, a think-tank. Access to dollars was restricted, including via a ban on companies sending profits abroad. It became harder to import goods. The government hoarded dollars for essential imports, in particular energy supplies to make up for dwindling domestic energy supplies. The low natural gas a power pricing – as well as on diesel and gasoline – discouraged investment to sustain energy production and infrastructure capacity. In 2004, the country lost the energy self-sufficiency it had gained in the late 1990s, causing imports to surge and the fiscal and trade accounts to fall into deficit. Dollar reserves shrank to a nine-year low of $24 billion at the end of 2015.

With dollars tight, the Kirchners ramped up the printing of pesos, and inflation accelerated to a peak of 40 percent in 2014 before receding to 26 percent in 2015. Infrastructure sagged and energy shortages hit. This year, the economy is poised to contract by 1 percent and is not on track to recover until 2017, according to the International Monetary Fund.

The challenge

argentina-flagMacri faces the challenge of turning this around, and to do so he is focusing on cutting inflation, narrowing the fiscal deficit and reeling back foreign investment.

In his first three months in office, the son of a multi-millionaire has made a quick start in setting up the economy for sustainable growth.

Days after swearing in, his finance minister, Alfonso Prat-Gay, eliminated the 15 percent to 23 percent export taxes on beef, corn and wheat, and cut them to 30 percent from 35 percent for soybeans. The former central bank chief and JPMorgan Chase banker subsequently lifted currency controls in place since 2011, and allowed the peso to float freely. The peso immediately depreciated 40 percent to 13.76 per dollar from 9.83, and has since weakened by more than 50 percent since then to nearly 16 per dollar.

The tax cut and devaluation has helped to bring in what’s needed most: dollars.

Farmers stepped up exports to repatriate $5.3 billion in the two months after the Dec. 16 devaluation, according to the Argentine Oilseed Industry Chamber and the Cereals Exporters Center, industry groups. That’s about a quarter of the $20 billion in their repatriations during all of 2015.

The inflow helped to refill foreign currency reserves to nearly $30 billion at the end of February.

Macri’s targets are to steadily boost dollar reserves and financing to slash inflation to between 3.5 percent and 6.5 percent in 2019 from 30 percent this year, and to cut the fiscal deficit to 0.3 percent of GDP in 2019 from 7.5 percent in 2015.

“We cannot continue living with inflation if we want to grow,” Macri said in February. “We’ve had inflation for years, and it is going to take us a while to reduce it.”

The main driver of this high inflation was an expansionary monetary policy pursued by Cristina Fernandez de Kirchner to fuel economic growth and fund swelling expenditures, including on a renationalized state airline, popular television rights for football and a bulging public payroll.

To contain monetary expansion, Macri is trimming the public payroll and subsidies for electricity and other utilities, as well as raising interest rates.

Macri’s production minister, Francisco Cabrera, estimates that the cuts in utility subsidies alone will reduce public spending by about 80 billion pesos ($5.1 billion). Transport and utility subsidies reached 4.1 percent of GDP in 2014, up from 0.4 percent in 2004, according to the Argentine Association of Budget and Public Financial Management, an NGO.

At the same time, the central bank has jacked up interest rates to encourage savings in pesos to reduce the amount of circulating cash and stem a chronic flight to dollars. After the devaluation, the benchmark interest rate for 35-day central bank notes was increased to 38 percent, and then gradually cut it to 30 percent in mid-February. The bank then increased the rate again to 30.5 percent as inflation remained stubbornly high. This was designed to provide more incentive to save in pesos, helping to ease pressure on the exchange rate to depreciate.

Cabrera said he expects these measures to start slowing inflation in the second half of 2016.

There is optimism that this may happen.

“We are celebrating because we’re not in a crisis,” said Martin Polo, an economist at Analytica Consultora, a consulting firm in Buenos Aires. “If the currency controls had continued, then Argentina would be heading toward in a balance of payments crisis.”

Reserves fell by $10 billion in the second half of 2015.

With an overvalued exchange rate, exports were in decline, a situation worsened by falling global commodity prices since mid-2014 as well as a surge in energy imports. The current account deficit reached 3 percent of GDP in 2015, as the value of imports exceeded the value of exports. Argentina couldn’t borrow abroad to reduce monetary expansion, and foreign investment wasn’t coming because of the currency controls, high borrowing rates and interventionism. This left the previous government with little room to depreciate the peso.

“The only alternative to avoid a devaluation was to burn through foreign reserves,” Polo said.

But as the reserves dwindled, “the Macri government had to let the exchange rate go,” he added.

Wage demands

argentina1By keeping the exchange rate stable with higher interest rates and a reduction in monetary expansion, this will help with the next challenge of containing wage demands and the impact on inflation, said Federico MacDougall, an economist at the University of Belgrano in Buenos Aires.

Most of the unions have come out to ask for more than 30 percent salary hikes this year to keep pace with inflation.

But to contain inflation, MacDougall said the government must moderate wage increases to 26 percent, as anything much higher would reduce exports by hurting industrial competitiveness. Keeping a lid on wage hikes, in turn, would help the central bank to cut interest rates to a more attractive 12 percent to 14 percent for companies to ramp up investment to help prevent a prolonged economic contraction.

“In the short term, if interest rates continue at this level, the economy is unviable,” MacDougall said. “Salaries must be cut in dollar terms so that the country is competitive and so that companies are more profitable and can grow and sustain employment.”

Borrowing abroad

The next big challenge is to regain access again to global financial markets, something that is on track after three months of negotiations with holders of bonds from the 2001 default.

The first agreement came in early February, when a group of 50,000 Italians holding $900 million in defaulted bonds agreed to a $1.35 billion cash settlement with past-due interest. Argentina subsequently offered to pay the rest of the holdouts $6.5 billion for about $9 billion in claims, or an average of 75 cents on the dollar.

After reaching a preliminary settlement deal on February 28 with NML Capital and three other hedge funds, Prat-Gay said the country is poised to emerge from default after 15 years.

“This puts us at the starting line for growth,” he said.

The resolution of the holdout issue will allow the country to borrow again, so too companies, said Eduardo Levy Yeyati, an economist at Elypsis, an economic consulting firm in Buenos Aires. “This will pave the way for much needed foreign direct investment.”

Even so, he warned that perhaps a larger challenge is “to rekindle growth and preserve employment after four years of stagnation and against global headwinds.” The world economy is sluggish and commodities prices are in decline, which likely will slow Argentina’s recovery.

But, Levy Yeyati said, it won’t tip the country into a fiscal or balance of payments crisis.

“I see no meaningful risk of a crisis, unless it is a global one,” he said. “Argentina is solvent and does not face currency mismatches or a severe current account deficit. The fiscal adjustment, though, should take longer, particularly if the government prioritizes economic activity and employment in the short run. I think fiscal balance at the end of its four-year period is a feasible but not necessarily optimal goal.”

After so many years as a pariah in the global financial markets, Argentina could stand out as a new attraction at a time when China, Brazil and other emerging markets are now struggling.

Argentina captured a third of the foreign direct investment it could have between 2003 and 2015, whereas it was the No. 2 destination in Latin America in the 1990s. “Now we are the seventh,” noted Polo. “Argentina has huge potential to capture FDI and this will help with infrastructure projects.”

If the investment comes, this will put the country on track to containing inflation and mending public finances.

“The strategy this year is to gain time via the capital markets to resolve the current and fiscal deficits that Macri inherited from the previous government,” said Esteban Fernandez Medrano, an economist at MacroVision Consulting in Buenos Aires.

With improved economic policies and a downturn in other emerging markets, Argentina could attract foreign investors looking for higher returns. Fernandez Medrano estimates that this would put the economy on track to grow at a sustainable 4 percent over the long term, not the unsustainable 8 percent per year of the first eight years of Kirchnerism.

“The market is taking Macri’s first measures positively,” Medrano said. “But there is still a lot to do.”

Indian pharma: Treasure at the bottom of the pyramid

India is perceived as the boiler room of the world’s technology engine. This perception has reached its pinnacle as a stereotype in the form of the “Indian techie.” Almost all the technology companies, whether global champions or contenders, have significant operations in India which continue to grow even while there are cut-backs elsewhere. What is perhaps not so widely known is that India is also the world’s pharmacy. The common man in the West would probably not realize that most of the medication that he is taking has been made in India. The Indian pharmaceutical industry, while being much older than its tech cousin made a significant impact on the world at the same time as its more visible cousin, in the early part of this century. As an example, more than 95 percent of drugs to treat HIV/AIDS are manufactured by Indian companies just as there is Indian code in virtually every computer program anywhere in the world.

All this progress was visible only in this century and it is now hard to imagine India in the last century fumbling through a Soviet-style planned economy with deep and extensive government control. With liberalization of the economy, many of the government monopolies no longer exist. There is however one monopoly that all governments, irrespective of their economic leanings, confer on private parties – patents. A patent is an exclusive right to produce goods or exclusive use of a process to produce goods. While patent legislation has always been national, i.e., countries have their own procedures, the World Trade Organization’s Agreement on Trade Related Intellectual Property Rights (TRIPS) set a global minimum standard. Many countries, including India, had to amend their IPR (Intellectual Property Rights) laws to comply with their TRIPS obligations despite opposition from civil rights groups who believed that the developing world was opening itself up to dominance by the developed world, which would use IPR as a weapon to monopolize knowledge and deny it to the developing word.

One of the major risks of a free market economy advocated by the World Trade Organization (WTO) is abuse of dominance and market power. Every country has reserved to itself the power to reign in entities that abuse their dominance to undermine market efficiency. We in India, and the Europeans, refer to this as competition law, the Americans as anti-trust law but the underlying objectives and principles are universal, based on sound economic theory that transcends national borders. India’s Competition Act is quite recent and took a very long time to be implemented. As a result, competition law jurisprudence is still at a very nascent stage of evolution in India. However, thanks to TRIPS, the protection against abuse of the monopolies granted by IPR exists in each of the IPR legislation themselves and relief from abuse of IPR monopolies is therefore not entirely dependent on competition law.

How unhappy some multinational corporations are about India’s IPR regime is frequently in the news, usually, in the form of reports by “industry groups,” funded primarily by multinational pharma companies, that have been very critical of India’s IPR law. The time taken in examining patent applications and the lack of efficient online search for patents granted and patent applications are issues that India, like any developing country with history, legacy and poor infrastructure confronts and this affects both Indian and international entities seeking protection for IPR in a non-discriminatory manner.

pillsThe decision of the Indian Supreme Court refusing to allow Novartis to extend the life of a patent for Imatinib1 by “evergreening” an old patent and the compulsory license for Sorofenib, are two instances that are frequently quoted to support the position that India’s IPR regime does not conform to global norms. To be fair, there are others like Boeing and Raytheon who have been supportive of India’s IPR regime and the technology giants who have not been able to patent all their software in India2 don’t seem to be complaining. There have been murmurs that issuing compulsory licenses amounts to illegal expropriation of property which is prohibited by international law. This seems more posturing and sabre rattling than a real threat since no country has raised a dispute at the WTO regarding any violation by India of its TRIPS obligations or sued under any of the investment protection treaties. In fact, there are several instances of the United States of America issuing compulsory licenses and for products like memory chips, automobile transmission systems and software programs, all less important than life saving drugs.

The first case of compulsory licensing3 that hit the headlines was Nexavar. Sorofenib, a cancer drug available in India since 2009 under the brand name Nexavar was imported and sold by Bayer for 280,000 rupees (approx. US$ 4,300) per patient per month, many years after the patent was granted. It is estimated that less than 1 percent of the cancer patients who needed the drug could get it in India. Natco, an Indian generic manufacturer, sought a license from Bayer so that it could make the drug widely available in India for an affordable price4. Bayer refused to grant Natco a license and as a result, Natco applied for a compulsory license which was granted by the Controller of Patents. The Intellectual Property Appellate Board, the Bombay High Court and finally, the Supreme Court confirmed the compulsory license allowing Natco to manufacture and sell orofenib at 8,800 rupees (approx. US$130) per patient making it affordable and more accessible to patients.

One easily forgets, since it is rarely mentioned, that the objective of granting patents was for society to benefit from the knowledge of the patent holder. A patent is therefore a method of transfer of knowledge to society by an inventor with the incentive of the limited monopoly granted by the patent. There has been universal acknowledgement, at least since the time of Adam Smith5, that monopolies distort the market price of goods. It is for this reason that whenever monopolies are granted, there are regulations protecting market price – airport charges, electricity tariffs and telecom interconnection and termination charges are good examples of regulatory checks on monopolies.

The Indian Patent Act has provisions requiring the patent holder to ensure that (i) the patented product is widely available at a reasonable price, (ii) government can have the patented product manufactured for non-commercial use and (iii) the patent can be revoked in public interest. Until the instances of Novartis and Nexavar, these provisions have rarely been enforced in India and as a result, patent holders had no fear of punishment for any abuse of monopoly.

Since these two decisions, patent holders seem to have realized not only that legislation will be enforced but there is also the opportunity to enjoy the economic benefits of selling to the bottom of the pyramid, which in the case of India is greater than the population of several European countries. Take the case of Nexavar which has had increasing sales despite little investment in the Indian market once Natco and Cipla launched “competing” products at a fraction of the price. In addition to the profits from the increased sales of Nexavar, Bayer also earns royalties from Natco, under the compulsory license, without expending any additional effort or cost – good money for old rope. Despite there being significantly cheaper alternatives, the prices of neither Nexavar nor Gleevec have been reduced but sales, on the other hand, have increased. The only conclusion one can draw is that with widespread availability of the drugs, thanks to Indian manufacturers, the overall markets for the two drugs have been growing significantly and there has been a segmentation of the market by price. The myth in circulation that introduction of competition will cause a drastic reduction in price of the protected monopoly as alleged by patent holders has been busted by the sales data for both Nexavar and Gleevec.

This realization of the risk of punishment for abuse of monopoly and the opportunity to make profits without any additional expense is perhaps the basis for a number of licensing deals concluded recently by patent holders. In addition to the HIV/AIDS drugs freely available for non-exclusive license through the Medicines Patent Pool, the announcement last year by Gilead to license Sofosbuvir, the “$1,000 pill” to seven Indian generic manufacturers is a significant acknowledgement that the government will implement the law to come down heavily on monopolies but also that there is an opportunity to make profits for no additional effort or cost by segmenting the market by price. As a result of this licensing model, Sofosbuvir is available in India for US$14 a pill, and its combination with Ledipasvir (sold by Gilead as Harvoni in the U.S.), is also available in India at a fraction of the international price. In January 2016, Bristol Myers announced that it was contributing Daclatasvir to the Medicines Patent Pool for non-exclusive licensing. The combination of Daclatasvir and Sofosbuvir is widely believed to be the standard treatment for Hepatitis C. This is an excellent example of multinational drug companies realising that there is a lot of money to be made “at the bottom of the pyramid “but that it requires a different business model – of cooperation with Indian generic manufacturers who are able to produce high quality drugs at the lowest price and also have the distribution network to get it to various parts of India and the rest of the developing world that the multinational pharma companies cannot hope to reach.

With a billion mobile phone users and a rapidly growing market for mobile phones, it is not difficult to see how well technology companies have exploited the opportunity to offer a variety of phones at prices that range from as low as $15 to exclusive phones that cost thousands of U.S. dollars.

While the tech and pharma sectors find themselves on opposite sides in the patent battles in the U.S., both industries seem to be developing in a similar way – a segmentation of various stages of discovery/innovation by start-ups or specialist smaller players, commercialization by the multinationals, with localized sales and manufacturing. Like the technology sector, large pharma companies are realising that their own R&D efforts are inefficient and new drugs that are being brought to market were really discovered in niche labs6, much like the innovation that we have seen in the technology industry.

We could argue about whether the compulsory licensing of Nexavar and the decision of the Indian Supreme Court in the Gleevec case caused Gilead to adopt the business model that it did to mitigate against the risk of losing the market for the only cure for Hepatitis C or if Gilead did it in the interest of poor patients in the developing world. But it would be hard to ignore the new business model that Gilead, with an insignificant presence in India, may have pioneered for multinational pharma companies in developing markets. While India has a long way to go in fixing its bureaucracy and one hears that the U.S. IPR system is in desperate need of reform, implementing the law to direct economic activity for social good has to be a desirable objective of the Indian government and an example for others to follow. While this may seem like a return to India’s socialist past, there will be few complaints when there is a lot of money to be made not just for the most modern drugs but also for old rope7.


  1. A drug to treat cancer which costs about US$90,000 in the United States but sold in India for Rupees 108,000 (US$1635). As a result of the decision of the Supreme Court of India, Indian equivalents are available for Rupees 8000 (US$120).
  2. India offers very limited patent protection for software.
  3. The government forcing a patent holder to license the patented drug and thereby forfeit the monopoly granted by a patent.
  4. Affordability is an issue in India since the vast majority of Indians (estimated to be about 82%) do not have health insurance and health insurance policies only pay for “in-patient” costs, not the cost of drugs.
  5. Wealth of Nations (1776).
  6. Sofosbuvir was not invented by Gilead but was a key asset in the US$ 11 billion acquisition of Pharmasset, a US based drug discovery company.
  7. For a report on the failure of the regulatory mechanism to prevent pharma companies from increasing prices for old drugs significantly in the United States, see,

The increasing ‘publicness’ of private funds: Where do we go from here?

Although the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was passed over five years ago, regulators are still untangling the myriad of financial reforms mandated under this law. Shortly after the passage of the Dodd-Frank Act Congress passed the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), which then loosened many of the restrictions that historically applied to public companies. These laws made extensive reforms related to enhancing investor protection, mitigating systemic risk, and promoting capital formation. Given these sweeping changes, academics across disciplines have undertaken the arduous task of investigating the theoretical and empirical impacts that these reforms have had on various market participants. Scholars have taken a particular interest in examining the eroding distinction between public and private entities in light of these seismic shifts in our securities law framework. They have mostly focused on the incoherent treatment of “publicness” under both the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).

Even still, academics have focused minimal attention on how the concept of publicness has recently transformed within the investment fund industry, which is subject to intricate layers of regulation that extend beyond the Securities and Exchange Acts. This analysis deserves heightened attention since investment funds collectively manage over $18 trillion for over 90 million households in the United States. Moreover, the Dodd-Frank Act has seemingly muddled the distinction between public and private investment funds through its haphazard regulation of hedge funds and other private funds. While Congress largely designed this legislation to mitigate systemic risk, it has seemingly complicated the intricate patchwork of regulation that currently applies to these entities. With this increase in regulatory complexity, unique investor protection concerns have likely arisen for fund investors. These concerns, which are further discussed below, relate to the possible over-inclusive and under-inclusive indicators of publicness that are now embedded in this elaborate web of legislation.

As background, investment funds, such as mutual funds and money-market funds are considered “public” entities given their extensive registration requirements (“Registered Funds”). Although the term “public” has not been specifically defined under the federal securities laws, Registered Funds are subject to multiple layers of legislation because they are available for investment by the public at large. Such investors are generally referred to as retail investors and they are automatically guaranteed various investor protection mechanisms provided under these laws. Registered Funds must therefore register under the Investment Company Act of 1940 (“1940 Act”), which is the primary legislation that is tailored to the industry. It includes detailed disclosure mandates, restrictions on riskier investments and strategies, governance requirements, and several other directives that extend beyond the “truth in securities” framework under the inaugural Securities and Exchange Acts.

Registered Funds must still register under a number of ancillary laws, which includes both the Securities and Exchange Acts. If a Registered Fund is engaged in the trading of futures or other derivatives, then it could be subject to additional regulation under the Commodity Exchange Act of 1936 (“Commodity Exchange Act”), unless there is an available exemption. The advisers of Registered Funds must also register under the Investment Advisers Act of 1940 (“Advisers Act”), which triggers heightened fiduciary duties for such advisers to act in the best interest of their clients. Registered advisers must also disclose material information relating to their business practices, fees, disciplinary history, certain conflicts of interest, and other material information related to their advisory business.

In contrast, private investment funds, which include hedge funds, and private equity funds, are generally exempt from the complex web of regulation applicable to Registered Funds (“Private Funds”).  Private Funds evade regulation by restricting investors to institutional investors and high net-worth individuals. Such investors are deemed to have the resources to adequately protect themselves without the need for federal safeguards. In exchange for restricting investors in this manner, Private Funds have more flexibility to incur leverage and pursue innovative strategies, which can incorporate derivatives, illiquid instruments, and other unique financial instruments. They are also exempt from the detailed disclosure and governance requirements intrinsic in these laws. Private Fund industries have grown exponentially in recent decades since institutional investors such as pension plans, insurance companies, and endowments are increasingly relying on these vehicles to manage risk and earn returns. Some estimates have found that hedge funds manage over $3 trillion in the United States, with private equity funds managing over $1 trillion in assets under management.

While Private Funds have historically evaded significant regulation, they were beholden to the requirements embedded in the intricate web of exemptions provided under the laws enumerated above. These requirements can be referred to as “indicators of publicness” since they effectively serve as bright-line dividing lines between public and private funds. A prevalent indicator of publicness includes the status of investors since investment funds that restrict offerings to elite investors are considered private and are thus exempt from federal regulation.  An additional indicator includes advertising, where investment companies that broadly solicit investments from the general public, such as mutual funds and money-market funds, are required to register under the federal securities laws.  This particular indicator of publicness was drastically altered under the JOBS Act as Private Funds can now advertise without triggering the registration requirements under the Securities Act. Additional indicators include size of the pool, and number of investors/clients. Under the Exchange Act for example, Private Funds that have over $10 million in total assets avoid registration by restricting ownership to less than 2,000 persons (after the passage of the JOBS Act), or less than 500 persons who are unaccredited investors.

However, evolving “notions of publicness” started to emerge within the investment fund industry that were not easily captured by the existing securities law framework. Regulators grew primarily concerned that the innovative financial products and strategies utilized by Private Funds could adversely affect the general public by increasing and transmitting systemic risk. The near failure of Long-Term Capital Management (“LTCM”) in 1998 catapulted Private Funds into this emerging debate.  LTCM’s leverage was so exceedingly high, that it was set to default on over $1 trillion in debt to a number of investment banks.  The default of these obligations would have likely crippled the global economy, which prompted the Federal Reserve to orchestrate a private deal amongst LTCM’s counterparties.

Additional concerns expressed by Congressional and SEC reports include the participation of Private Funds in the shadow banking industry and the retailization of Private Funds. With respect to shadow banking, Private Funds were arguably engaged in the creation and distribution of credit through their trading of certain derivative instruments. This led to an opaque market that seemingly increased leverage in the broader financial markets while escaping regulation by banking regulators. With respect to retailization, retail investors are often indirectly exposed to Private Funds through their pension plan investments. Since pension plans qualify as institutional investors that can sufficiently protect themselves, they are not guaranteed the investor protection measures mandated under federal securities laws. As pension plans started to expand investments into Private Funds to earn returns and manage risk, regulators queried whether underlying retail investors were sufficiently protected.

Congress finally responded to these evolving notions of publicness with the passage of the Dodd-Frank Act. This legislation created new registration requirements under ancillary legislation such as the Advisers Act and Commodity Exchange Act, as opposed to focusing on the 1940 Act, which is the primary legislation that governs the industry. In summary, many Private Fund advisers must now register under the Advisers Act, which is often viewed as being the least restrictive amongst the federal securities laws. It includes additional fiduciary obligations and disclosure information for registered advisers, but does not restrict leverage, require standardized valuations, or mandate many of the other investor protection mechanisms provided under the 1940 Act. The Dodd-Frank Act did amend the Advisers Act to require that Private Fund advisers provide additional proprietary information to the SEC, which is supposed to remain confidential.  The SEC can however disclose this information to the newly created Financial Stability Oversight Council (“FSOC”). This entity is broadly charged with regulating entities that pose a systemic threat to the economy. In terms of increased regulation under the Commodity Exchange Act, many OTC derivatives, which are frequently traded by Private Funds, must now be traded through registered clearinghouses. Under authority granted under the Dodd-Frank Act, the CFTC also retooled many exemptions to make it more difficult for Private Funds to avoid regulation under the Commodity Exchange Act.

By and large, since these evolving notions of publicness have been integrated into ancillary laws, or addressed through additional layers of regulation, Congress has effectively expanded and complicated the patchwork of regulation that applies to these entities. The extent to which this increase in regulatory complexity will protect the general public is also questionable. FSOC has yet to identify a Private Fund as being systemically harmful as the council has been embroiled in battles with the industry over appropriate measures of systemic risk. In the meantime, the SEC still collects such confidential information from Private Funds in an incoherent and inconsistent manner. Mandating registration under the Advisers Act could enhance investor protection to a degree, but such investor protection mechanisms are minimal in relation to the 1940 Act. Enhancements under the Commodity Exchange Act could also boost transparency with respect to various OTC derivatives, but many scholars have argued that these new reforms can serve to concentrate systemic risk amongst these newly authorized central clearinghouses.

In fact, Congress’s avoidance of the 1940 Act could harm investors as this primary legislation still relies on historical indicators of publicness, such as status of investors for example, in delineating private and public investment funds. Since these historical indicators do not appropriately reflect the emerging notions of publicness discussed herein, they are likely under-inclusive and over-inclusive from an investor protection standpoint. In terms of such indicators being under-inclusive, a systemically harmful Private Fund could still evade regulation under the 1940 Act. Retail investors could thus be exposed, albeit indirectly, to systemically harmful funds that evade significant regulation. For instance, the Texas County & District Retirement System has recently allocated 25 percent of its assets into Private Fund investments. If this pension inadvertently invests with a hedge fund that is later deemed systemically harmful, while FSOC is engaged in the opaque and unpredictable process of analyzing this same fund, the retirement accounts of its thousands of underlying retail investors could be compromised.

These historical indicators of publicness can also be over-inclusive as they prevent regulators from distinguishing amongst the heterogeneous strategies of Private Funds. Contrary to popular belief, many of these strategies do not pose a systemic threat to the economy. Since regulators have not looked behind the status of investors in determining the publicness of investment funds, they have not made these nuanced distinctions. This leaves retail investors with limited options in terms of maximizing returns and managing risk. Mutual funds, which form a major component of 401(k) retirement accounts for retail investors across the country, are automatically subject to the stringent capital restrictions under the 1940 Act. They are therefore limited in the innovative strategies that they can pursue given the restrictions on derivatives, illiquid instruments, distressed securities, and other exotic instruments. These limitations become more problematic during economic downturns when Private Funds have more freedoms to engage in short-selling and other tactics to help investors earn absolute returns irrespective of market conditions.

To better protect investors in these constantly evolving markets, Congress should redirect its attention to the 1940 Act.  With this constant focus on ancillary legislation, there is a lack of clarity as to the distinction between public and private funds. Making this distinction is now a convoluted task that involves an analysis of several ancillary exemptions, and attempting to predict the circumstances under which FSOC may deem a Private Fund systemically harmful. Congress can achieve this ambitious goal by first directing regulators to agree on appropriate levels of systemic risk indicators, such as leverage, interconnectedness, substitutability, complexity, and/or global activities. Once these indicators have been agreed upon, regulators can then integrate these indicators into existing 1940 Act exemptions. A basic example related to interconnectedness could read as follows (with x being the agreed upon indicator): “Private Funds relying on section 3(c)(7), shall have a ratio of collateral posted relative to its NAV that does not exceed x percent.” Thus, Private Funds that are excessively interconnected with other financial institutions would be forced to register under the 1940 Act.

Any such amendments would then require a wholesale review of the 1940 Act as many of its restrictions may unduly affect capital formation for newly registered entities. The existing restrictions on leverage and derivatives would likely need retooling to accommodate a larger range of innovative strategies that are currently utilized by Private Funds. Updating these capital restrictions would also create more opportunities for retail investors to directly access strategies that would better protect their investments in declining markets. However, updating these provisions (among others) would be an arduous task as the 1940 Act is widely known as being the most complex and cumbersome legislation within the securities law realm. Dedicating resources to this endeavor may fail to engender political support, which may have played a role in Congress’ decision to avoid the 1940 Act in the new regulation of Private Funds. Nevertheless, revamping the 1940 Act is long overdue and can be delegated to a number of regulatory agencies. This onerous task will likely become a necessity with the endless stream of innovations that will inevitably pervade the industry. By continuing to focus on ancillary legislation to accommodate these changes, the industry’s regulatory patchwork will continue to grow in complexity, leading to a possible increase in investor protection harms.


Audit committees for alternative investment funds: All stakeholders win

Corporate governance is vitally important to both public company shareholders and mutual fund investors alike. The audit process is a cornerstone to that governance process and the comfort added by audit committees is valued by all stakeholders; investors, management, administrators, regulators and auditors. Perhaps the time has come for alternative investment funds to embrace the concept of audit committees?

Could this be an opportunity for alternative investment managers to differentiate themselves with potential institutional investors? An audit committee could provide CFOs with an effective resource to ensure audit efficiency. For auditors it provides an independent party to ensure commitments and deadlines are met, not just by the audit firm but also by the client and thus reducing the likelihood of significant unbillable cost overruns. If independent audit committees had been in place for investment management frauds such as Madoff, Weavering and Bayou, investors would have benefitted from a very different outcome. In short, all stakeholders would benefit from this evolutionary change in the alternative investment industry and what makes it such a no-brainer is that the marginal cost to those stakeholders is negligible and in some cases negative. It’s a classic win-win.

The continuing evolution of fund governance

Fund governance has been an evolving element of the global alternative investment management industry. The importance of fund governance increased dramatically after Madoff and other investment management scandals.

In the U.K., corporate governance is engrained into the business culture, including alternative investment funds. Investors are demanding of engaged and experienced governance professionals adding value and representing the best interests of investors. In the U.S. it is our observation that the acceptance of enhanced governance is increasing dramatically as institutional investors now make up the majority of capital. These necessarily demanding investors see independent governance as a priority. Independent fund governance, whether in a partnership or corporate structure, is now best practice in the eyes of these large allocators.

In the U.S. mutual fund industry there has been a clearer evolution. Today mutual fund boards and trustees have clear mandates from which regulators and investors take great value. Not long ago mutual fund boards were composed of largely non-independent members. Between 1996 and 2012, the number of complexes reporting that independent directors hold 75 percent or more of board seats rose from 46 percent to 85 percent. Today the vast majority of these governance bodies are independent and with an independent chairman. Investors and regulators take great interest in board compositions.

Mutual fund audit committees

auditIn the mutual fund and public company worlds, audit committees represent an important and valued function for investors and other stakeholders. Expectations of these audit committees and their importance is increasing. Audit committees are under increasing scrutiny and the quality of financial reports is seen to be at stake. Uniquely in investment funds, the fund determines the price at which investors buy and sell their mutual fund shares, the net asset value or NAV. Mistakes, deliberate or inadvertent, cause some investors to lose money and opens the gates to expensive lawsuits and substantial damages.

We ask, “If audit committees are seen to add comfort to investors as to the above concerns, why is the concept not relevant to alternative investment fund investors?” More specifically, “Why doesn’t that concept resonate with institutional investors who insist on effective independent oversight and governance in their stock and mutual fund holdings?”

Numerous mutual fund regulatory and professional bodies are vitally interested in mutual fund audit committee structure and procedures. The SEC, the Investment Companies Institute, the New York, American and NASD Stock Exchanges all constantly emphasize the responsibility of audit committees and have numerous requirements which continue to evolve. “Best practices” have been established for audit committees which include having a written charter to spell out its duties and powers and a recommendation that the committee be made up of individuals who are “financially literate.”

The SEC has a very strong preference that at least one member of the audit committee should be a financial expert. A financial expert is defined as a person who has the following attributes: (i) an understanding of generally accepted accounting principles and financial statements; (ii) the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves; (iii) experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements, or experience actively supervising one or more persons engaged in such activities; (iv) an understanding of internal controls and procedures for financial reporting; and (v) an understanding of audit committee functions.

The responsibilities of audit committees to mutual funds range from overseeing the integrity of the financial statements to assessing the quality of the audits performed. In perhaps typical fashion, there are ongoing attempts underway in the U.S. to develop detailed guidance and checklists to provide audit committees with a fail-safe roadmap upon which to fulfil their responsibilities and form their conclusions. Some fear that professional judgement, the most valued skills these individuals have to offer, is getting lost in the process.

Audit committees for alternative investment funds

Any application of the audit committee to the alternative investment space must not, in the opinion of the authors, become checklist driven. A mandate should be established by the board in consultation with the investment manager to ensure the audit committee function will meet investor needs and expectations.

Key responsibilities of an alternative investment fund audit committee would be driven by the mandate developed. If drafted effectively, the audit committee mandate will aid CFO’s and auditors and provide value to regulators. There is considerable flexibility as the detail of the audit committee mandate but we would expect to see the responsibilities include:

  • Overseeing the audit – the committee would review the audit planning process and key deadlines to ensure completion meets investor and regulatory deadlines.
  • Overseeing financial reporting and monitoring controls around financial reporting – the committee would work with auditors to ensure proper controls are in place and working effectively.
  • Maintaining integrity of a fund’s financial statements – this is a broad responsibility but it would be a key conclusion of the audit committee to the board as a whole and to investors.
  • Provide compliance and risk management oversight, which would include ensuring that auditors have fulfilled their obligations under applicable laws and regulations.
    Managing the interaction of the investment manager and independent auditor – the committee would ensure the audits are running efficiently and that agreed-upon timelines and commitments are being met by both auditors and the management. This could save the CFO and/or COO precious time around year end, save the fund audit fees for extra charges and, for audit firms, eliminate large cost overruns which are rarely passed onto their client in full.
  • Understanding overall valuation work and oversee valuation of Level 3 assets.
    Oversee accounting for, and disclosure of, side letter agreements.
  • Assess correspondence from the auditors, including the audit engagement Communications to Those Charges with Governance. Any concerns or issues communicated by the auditors would be addressed.
  • Where applicable, ensure the Cayman auditor signoff process is well planned with agreed-upon deadlines being met.
  • Assessing auditor independence – this would include a review of other services provided to the fund and the investment manager by the audit firm to ensure independence is not tainted. This is not currently being done in the alternative space and would provide considerable value to investors as it does in the mutual fund space.
  • As in the mutual fund world, the audit committee could make objective decisions, or assist with decisions, on auditor selection, retention and compensation. If done correctly and with the right committee members, management would benefit from the experience of the committee. Investors would gain assurance that the auditor selection process has been done objectively and with oversight by an independent party and that the selection is based on more than the cheapest fee quote as that is not always in the best interest of investors.

The audit committee mandates can be very flexible but the overall objective is to protect investor interests without introducing unnecessary bureaucracy. An effective mandate will ensure that the very critical audit process is independent and that a quality audit is conducted. For investment managers with audit committees, they can stress the value to investors this provides when meeting with potential investors and operational due diligence teams – a differentiating factor from competitors.

Audit committee composition and leadership

For larger boards and/or boards that govern a large group of many smaller entities, we believe the creation of an audit committee would be a relatively easy addition. Larger boards typically have individuals with diverse skill sets and the creation of an audit committee of two or three independent individuals with knowledge of financial reporting would be most likely possible. For this committee to be effective in the eyes of investors it must be comprised of only independent directors. Clearly best practice is to have at least one financial expert on the committee.

The most obvious option is to simply add one board member to an existing board who has the required financial expert experience. Assuming investors and the investment advisor are satisfied with the existing board members, adding an individual with the right audit committee leadership skills achieves an effective audit oversight function for the fund with little disruption.

The concept of the audit committee or audit oversight is not, however, only applicable to large funds and complex groups. The concept can be applied to smaller boards and for standalone funds who typically have a board of two independent directors and one representative from the investment manager. These growing smaller funds are trying to appeal to institutional investors who will find the audit committee/oversight concept appealing. These smaller boards do not need a radical overhaul to reap the benefits of audit oversight. They could simply add one new board member who has “financial expert” skills. That individual would take on the audit oversight function and report back to the board.


As previously discussed, there is a concern among stakeholders in the mutual fund world that the audit committee is moving towards a checklist mentality and a lack of professional judgement. If you have the right professionals on the audit committee, you need to benefit from their insights and judgement. Given the flexibility of the alternative investment world, the risk is low that the function degenerates into a painful exercise for CFOs and the auditors and, worst of all, adds no value for investors. The committee must to be allowed to have the flexibility to use their accumulated experience to maximize audit committee effectiveness.

As this concept gains acceptance in the alternative investment industry, there may be a challenge finding enough individuals to fulfil the critical “financial expert” role. That person must chair the committee, or take on the function solely, and report to the main board. There are few professionals in the existing database of offshore directors that would possess these skills, although there are new entrants entering the marketplace constantly. Without the proper leadership, the audit committee concept will lose credibility.

Finally, there is an additional cost to be incurred to gain the benefits of audit oversight. The responsibilities of the audit committee are significant and investor expectations are rightly high. If working correctly, this committee is a winner for all stakeholders. An effective audit committee will, among other benefits, give investors additional comfort that is currently absent, satisfy regulators, aid CFO’s during the audit process and in evaluating auditor performance. It will also potentially save audit overrun charges. Investment managers will achieve a level of governance that exceeds current best practices, which will appeal to potential large allocators. If the committee is effective, the benefits will far outweigh the costs.


Audit committees are a prominent and important component of corporate governance in both the public company and the mutual fund world. The benefits are recognized and valued by all parties including investors, auditors, regulators and management. Shouldn’t alternative investment fund investors and other stakeholders gain the same benefits and comfort?

In the alternative investment fund industry, effective fund governance is an increasingly important topic. Its importance has become very prominent with institutional investors whom now make up the majority of invested capital in the industry. Best practices for fund governance now includes:

  • Independent professionals comprising the majority of the board;
  • Diverse and complimentary skills sets among directors;
  • Experienced and active professionals filling governance positions;
  • Split boards with professionals from different governance services companies; and
  • Recognition that the cheapest director is not necessarily the best choice for investors and the fund.

In a publication from the operational due diligence firm Castle Hall Alternative’s titled “Redefining Corporate Governance; Towards a New Framework for Hedge Fund Directors,” they comment – “Finally, once a ‘best practice’ board has been created, the bigger question is what happens next — what should the directors actually do? There is clearly little point adding more experience and capability to a board, if all key decisions impacting the structure and operation of the fund remain wholly vested with the manager.” The material goes on to examine some of the areas where boards could and should become more active, including negotiating the PPM and mandating that administrators and other service providers perform more robust procedures.

Recognizing that the audit process is a cornerstone of fund governance, we propose that a logical extension of board responsibility and one which will undoubtedly provide more effective governance; the creation of an audit committee.

To compete for institutional investor allocations, investment managers need, at the very least, to meet governance best practices. Meeting these best practices is mandatory just to be considered by these necessarily demanding investors. Could an investment manager create a competitive advantage by exceeding these best practices through the early adoption of the audit committee? It would certainly provide potential investors with additional comfort, and put a manager ahead of the curve in satisfying tough questions from these highly valued investors.

An economy for the 99 percent

Why does anti-poverty work so often end up as an anti-wealth campaign?

Oxfam, the billion-dollar British-based global charity conglomerate, founded to relieve poverty in Greece (does nothing change?), has issued a report entitled “An economy for the 1%: How privilege and power in the economy drive extreme inequality and how this can be stopped” (2016).

Not surprisingly, given the title and its source, the report finds that inequality is bad, is getting worse, and a lot of the blame for this lies with “tax havens” such as the Cayman Islands which, Oxfam claims, “enables the richest individuals to hide $7.6 trillion.”

At the pinnacle of this inequality, apparently 62 individuals have the same wealth as the poorest 50 percent of the world combined; a group that, they point out, could fit in a bus, if billionaires ever travelled by bus.

But is this right? Are Oxfam’s figures correct, are their claims valid and do we have a problem with the global economy?

Well no, not really. There are several flaws with Oxfam’s calculations, some even bigger problems with their conceptual approach and some huge errors in their proposed solutions.

Unrealistic comparisons

The first problem is that when Oxfam is comparing wealth between people in different countries, it uses market exchange rates, rather than the “purchasing power parity” exchange rates that are normally used in such comparisons.

Purchasing power parity (PPP) is basically a more formal version of the Big Mac index; what matters is not how many U.S. dollars the bank will give you for your money, but what you can buy with it in the place where you are living.

So the average household income in India is around 375,000 rupees per year.  If that was taken into a bank and converted into U.S. dollars, it would get somewhere around $5,500; but since that isn’t what is going happen to it, that isn’t much use. What we want to know is what standard of living it will buy in India, and doing that analysis finds that it is equivalent to an income in the United States of over $28,000. Not riches by Western standards, but far from the poverty that $5,500 suggests.

The Oxfam report even uses fluctuations in foreign exchange markets to claim that the poor are getting poorer. They claim that the income of the bottom 50 percent has actually dropped in the last five years, whereas all that has actually happened is that the dollar has become stronger, so while in 2008 it would take less than 40 Indian rupees to buy a U.S. dollar, it now needs nearly 70.

On Oxfam’s figures, an Indian family with the same income would now look over 40 percent poorer than they were in 2008, simply because of a shift in foreign exchange markets that will have almost no effect on a low-income family.

In fact, when we use PPP exchange rates to compare what people can actually buy with their money, the income of the poorest in the world has risen by more than that of the richest; since 2008 the income of the poorest tenth has doubled (+99 percent) and overall the income of the poorest half of the world is well over two and a half times what it was then (+166 percent). In contrast although the income of the richest tenth has increased, it has done so much more slowly, only rising by three quarters (75 percent).

That looks like a result that poverty campaigners should be celebrating, not complaining about.

Treatment of debt

The second problem with the Oxfam report is that it uses net assets rather than gross to work out which wealth band people are in – in other words it adds together your assets and deducts your liabilities.

While that may sound sensible, it produces figures that are useless for making international comparisons.

Think about two people; one is an African subsistence farmer, who very rarely even sees cash; the other an American youngster, recently graduated from Yale with student debt, who has just started work for Merrill Lynch and has bought a house on a 95 percent mortgage.

Who is the wealthier? Well, if we follow the logic of the Oxfam report, the African farmer is richer than the Yale graduate.

How do they get such an absurd – even offensive – result?

What they do is add together the American’s assets and deduct his liabilities.  If the house is worth $500,000, add a bit of money in his bank account to take that up to $501,000. But then they deduct his 95 percent mortgage, which on $500,000 will be $475,000, and $50,000 of student debt and a credit card bill of $1,500, and those debts together are higher than the value of the assets.  That gives a negative wealth of $25,500.

The African subsistence farmer, on the other hand, has a couple of dollars that he made selling a bit of excess produce at market last week, but no debt (no-one is likely to lend him any money, because he has no cash income to make the repayments).

But that couple of dollars the African farmer has makes his wealth greater, at least mathematically, than the Yale graduate’s net debt. Absurd (and rather insulting to tell the genuinely impoverished African that he is wealthier than a Yale graduate working for Merrill Lynch), but that is how Oxfam thinks.

Yes, Oxfam say that 62 billionaires are, together, richer than the poorest half of the world’s population, which is an astonishing figure. But the way Oxfam do their calculations, a street busker with a couple of dimes in his collecting tin is “wealthier” than the combined wealth of the poorest third of the world’s population, because he at least has positive wealth but they, overall, have more debt than measured assets.

Impoverished West?

This deduction of debt explains why, in Oxfam’s figures, around a quarter of the “poorest” 10 percent of people in the world are allegedly in Europe and the U.S.; this is not genuine poverty in global terms, but merely the ability to borrow money and so have a negative financial worth.


What is fascinating about the way Oxfam calculate wealth is that even if we had a perfectly equal society, they would still be able to complain about massive wealth inequality simply because of demographics – the fact that at any point different people are at different ages, at different points in their life.

Imagine a world where everyone goes to Yale and everyone leaves with student debt, to all get a job with Merrill Lynch (on the same salary) and buy the same type of house on the same sort of mortgage.

Perfect equality, but still the recent graduates will still be in debt and will have negative wealth; those who have been working a few years will have paid off some of their debt but will still be more or less break-even in terms of assets and liabilities; but those who are older will have paid off their debt and mortgage, and will be enjoying a valuable house and well-filled retirement savings plan. Then as they retire, they start to eat into their retirement savings and their wealth starts to drop again.

With that sort of scenario, even with everyone having, over their life, exactly the same incomes, assets and liabilities, the method of taking a snapshot view in one year means that those coming up to retirement will be wealthier than those either younger or older.

Indeed, if you want to put a few figures to the scenario, it is fairly easy to get a situation where the “richest” 5 percent have more wealth than the “poorest” 50 percent combined – within a society of perfect equality.

Inevitable inequality

The fact is that inequality is an inevitable part of the human condition, and all attempts to arrange society in any other way has failed – and have usually ended up with more inequality and poverty rather than less.

The Oxfam report says, of income inequality, that it “is unimaginable that the CEO of a tobacco company in India is as productive as 439 of his employees combined.” But is it really unimaginable that the person who builds the business, who creates the markets for the company’s products, and therefore generates value for those employees’ labor, is legitimately so valuable to the business? The fact that Oxfam cannot imagine a rational explanation does not mean that none exists.

Even Oxfam does not operate on the principle of equality that it espouses.

According to its annual report, Oxfam’s UK staff are paid an average of almost £33,000 per year, but their overseas staff get less than half of that – an average of just £14,500.

And looking at the top of the organization, Oxfam’s chief executive was paid £122,538 last year; that’s nearly four times the average for their U.K. staff and almost ten times the average for their overseas staff.

To borrow Oxfam’s own rhetoric, can we really imagine that their chief executive does more to help the poor than ten members of staff who are actually working in the third world to deliver its programs?

And that is just the income inequality; their wealth inequality is even more extreme because Oxfam also has a £35 million defined benefit pension scheme for some of its staff, including four of its senior employees. Again this demonstrates inequality within the organization, because not all staff are allowed to share in this (the scheme was closed to new members in 2003). But even more shocking is the global inequality it enshrines; that pension scheme alone gives some of Oxfam’s staff more wealth than about the poorest third of the world combined.

The reality

So ignoring Oxfam’s rhetoric, what is really happening?

1percentEven on Oxfam’s own figures, the poor are getting richer – and they are doing so faster than the rich.

Between 2000 and 2015, the wealth of the poorest half of the world’s population increased by 149 percent, leaving them with two and a half times the wealth they started off with. In contrast, the wealth of the wealthiest tenth only increased by 111 percent.

And the same thing is happening to global incomes; between 1988 and 2011 the income of the poorest half rose by 166 percent, but the income of the richest tenth only rose by 75 percent. Every one of the poorer 10 percent bands saw their income rise by a higher percentage than the richest tenth did.

And these are on Oxfam’s own figures; if we used proper methods (purchasing power parity, gross assets rather than net), the improvement for the poorest in the world would be even greater.

The poor are actually catching up on the rich. Yes, very slowly, but if it is equality that Oxfam wants, the capitalist, free market world is actually moving in the right direction.

Damaging tax proposals

Oxfam’s questionable statistics on inequality are bad enough, but its proposals for tax reforms could be truly damaging to the poorest.

The report calls for several of the classic tax errors, tax reforms that may sound good but which are known to be seriously damaging.

So Oxfam calls for “national wealth taxes” even though of the few things that we know with something close to certainty about tax economics is that wealth taxes are one of the most damaging ways to raise money. By taxing investment, they discourage it, which destroys decent job opportunities.

The report also claims “the tax burden is falling on ordinary people, while the richest companies … pay too little.” This is to ignore the strong research about tax incidence; that when taxes on companies are increased, a lot of the economic damage falls not on the shareholders but on workers and those looking for jobs. If companies are taxed more, they will invest less, and if they invest less there will be fewer jobs, or those jobs will be less productive (because of lower investment in machinery or innovation) and therefore be less well paid.

The role of offshore finance

As well as questionable financial analysis, Oxfam’s report also has the standard attacks on “tax havens,” which operates a “global spider’s web … maintained by a highly paid, industrious bevy of professionals” (for those readers in the offshore finance industry, that’s probably the nicest thing they are likely to say about you).

We even see the old canard that low tax countries encourage high tax countries to reduce their taxes in a “race to the bottom.” Have any major economies stopped taxing businesses? No, of course they haven’t. As I have analyzed elsewhere, that “race to the bottom” simply hasn’t happened. Tax competition has probably stopped the high tax countries hiking their tax rates even higher, but it certainly hasn’t turned the world into a tax-free paradise.

And this claim, again from the Oxfam report, is simply ludicrously naïve: “Almost a third (30 percent) of rich Africans’ wealth – a total of $500bn – is held offshore in tax havens. It is estimated that this costs African countries $14bn a year in lost tax revenues. This is enough money to pay for healthcare that could save the lives of 4 million children and employ enough teachers to get every African child into school.”

The reason so much African wealth is held offshore is that so many of the continent’s political systems are mired in corruption, and too many of its governments are spending their money on oppression and civil war. The sad fact is that for many African governments, more tax revenues means more weapons; not more healthcare and education but more torture and killings.

The report is very clear: “Oxfam is calling on world leaders to … end the era of tax havens.” Yet one of the standard mechanisms for investment into developing countries is for that investment to be made through an offshore financial center that Oxfam would probably characterise as a “tax haven.”
Many developing nations are in a low state of development because they have unstable political, legal and financial systems, so investment via a stable, familiar jurisdiction makes an investment more attractive and therefore more likely to happen. Again, the cost of attacking tax avoidance is less involvement by multinationals, and so fewer jobs and fewer opportunities for the less well off, and the loss of exposure to expertise, knowledge, training and international business practices.

True poverty reduction

The huge factor that Oxfam seems to ignore is that the spread of free market capitalism and free trade in the last twenty years has brought about the biggest reduction in poverty that the world has ever seen.

On the World Bank’s calculations, between 1990 and 2010 the growth of international trade and investment lifted almost a billion people around the world out of poverty.

That’s almost a billion people rescued, not from the relative poverty of the Yale graduate with a student loan but from the true grinding poverty of less than $1.25 a day. That’s people scratching a living from subsistence farming on meagre land in Africa, or scavenging from rubbish heaps in South America, moving into productive, paid, reliable employment that provides for their families.

It is this poverty reduction that Oxfam seems to want to halt and even reverse, by criticising the companies who are engaging with the developing world and by proposing tax changes that will reduce investment and therefore reduce these opportunities for the poorest, leaving people in poor countries with no way to escape poverty and dependence on aid.

Testamentary freedom, wills and succession

Testamentary freedom has been in the legal press again recently, this time as a consequence of the introduction of the EU Succession Regulation (No.650/2012) in Europe and the debate as to whether the U.K. would opt in, or opt out, of it.

The regulation binds EU member states that have opted in and in summary, provides that the law applicable to succession to a deceased’s worldwide estate will be that of the deceased’s ‘habitual residence’, which is to be established by reference to all the circumstances of the deceased’s life in the years up to the time of his death. It expressly excludes questions relating to trusts, tax and matrimonial property. The aim is to create a more uniform approach to succession in contrast to the position previously, where some member states would determine the applicable law by reference to the location and nature of the assets of the estate, or by the domicile of the deceased. This gave rise to conflicts of laws issues which would hold up the administration of the estate and increase the costs of doing so. Worthy as that aim is however, it remains open to question the extent to which the regulation will achieve consistency of approach, particularly given that the U.K., Ireland, Switzerland and Denmark have opted out.

Although the regulation does not have direct application in the Cayman Islands, the discussion about it has brought the topics of wills and succession and more particularly, testamentary freedom, domicile, residence and cross-border estates, sharply into focus once again, issues which are of relevance to practitioners here.

The basic principle in English common law jurisdictions, like the Cayman Islands, is that a testator can dispose of his or her estate in whatever way he or she wishes. Like many basic principles, this is subject to a number of caveats and conditions. Testamentary freedom and the rationale underpinning it were described in the English case of Banks v Goodfellow (1869-70) LR 5 QB 549, at 563, in this way: “The law of every civilised people concedes to the owner of property the right of determining by his will, either in whole or in part, to whom the effects which he leaves behind him shall pass … The English law leaves everything to the unfettered discretion of the testator … the common sentiments of mankind may be safely trusted to secure, on the whole, a better disposition of the property of the dead, and one more accurately adjusted to the requirements of each particular case than could be obtained through a distribution prescribed by the stereotyped and inflexible rules of a general law.”

In contrast to testamentary freedom, regimes exist including forced heirship1, elective shares2 or community property3 dictating the disposition of property on death. Within those broad categories lies a varied and complex network of rules, regulations and convention governing property disposition on death in each individual country or state4. In short, each regime operates to limit testamentary freedom by preventing disinheritance, usually of a testator’s surviving spouse and/or children. Those limitations can affect not only individuals and the extent of their inherited wealth, but also the operation and disposition of family businesses when the owner dies.

Other jurisdictions like Guernsey have moved more recently to abolish their forced heirship regimes5, recognizing that testamentary freedom is an attractive concept for wealthy testators who may wish to settle there and adopt Guernsey as their domicile.

The question of a testator’s domicile can be vitally important. Domicile may be key not only to the availability of testamentary freedom but also to the determination of the validity of the will, the liability to estate or inheritance taxes, the entitlement to and proper forum for taking out the grant and to family provision claims6.

Deciding domicile is not as straightforward as simply looking at where the deceased was living at the time he died, even in cases where the deceased may have been living in a particular place for several years. The general rule here in the Cayman Islands is that a child will take the domicile of his father, unless illegitimate in which case he takes the domicile of his mother. As an adult, a person may acquire a domicile of choice which is different to the domicile of his father. This is where disputes often arise in succession claims. It is not easy to acquire a domicile of choice: As I have already mentioned, it is not only defined by where the testator lives, but requires evidence of an unequivocal intention to reside permanently and indefinitely in that country, such that he abandons his domicile of origin7.

Further, in order to avail oneself of freedom of testamentary disposition in English common law jurisdictions, a testator must have capacity to do so, in other words, he must be an adult8 and he must possess a certain level of understanding of what he is doing by making a will. This level of understanding is referred to as ‘testamentary capacity’ and despite close judicial scrutiny over the years, the basic test for testamentary capacity remains, broadly, as set out in Banks v Goodfellow.

As evidenced in several cases in England since Banks, testamentary capacity has repeatedly vexed not only lawyers and the courts, but also experts in the field of psychiatry, medicine and dementia, alcohol and drug dependencies. It has on occasion, led to long drawn out battles lasting several years costing millions of dollars and often involving the most intense scrutiny of the minutiae of family and business relationships, much of which ends up being played out in the press9. The question of whether a testator had crossed “an imprecise divide”10 at the time he executed his will is notoriously difficult to assess after the fact; after all, the testator is no longer around to be subjected to medical testing, although there is often a wealth of anecdotal evidence to be assessed. As Lord Cranworth described it so eloquently, “There is no possibility of mistaking midnight from noon, but at what precise moment twilight becomes darkness is hard to determine.”11

A testator must know and approve of his will’s contents12 but as Chadwick LJ put it in Hoff v Atherton [2005] WTLR 99, “Where there is nothing to excite suspicion, the court may infer (without more) that a testator who signs a document as his will does know its contents. It would be surprising if he did not.” Not surprisingly, a claim that a testator did not know and approve of his will’s contents is often run in conjunction with a claim of mental incapacity.

One example of when suspicion will be aroused is when a beneficiary under the will is instrumental in its preparation13. Another might be when there has been a fundamental and arguably irrational change in the testator’s intentions between prior wills and a final will.14 Practitioners do also have to be alert to undue influence, another claim which is often run in conjunction with a claim of mental incapacity. Clients who are mentally and physically frail may be more vulnerable to bullying from those who wish to take advantage of them. Practitioners are encouraged to meet elderly clients alone and not in the presence of any of the intended beneficiaries of the will and enquiries should always be made about any lifetime gifts that may have been made by the testator. Appeals to a testator’s affection would not be enough, the undue influence has to be sufficient to “overpower the volition”15 so there is an evidential burden to discharge for anyone making such an allegation.

Testators with assets all over the world are often advised to make separate wills in each country where assets are held. These local wills should comply with the relevant local laws. Problems do occasionally arise, usually as a consequence of one of the wills unintentionally revoking an earlier will. Practitioners here who are asked to draft a will to deal with Cayman Islands assets should be provided with copies of all other wills to ensure the Cayman law will is drafted accordingly.

While succession claims only rarely come before the Cayman Islands’ court, cross border issues and conflicts of laws do arise after the death of a client in relation to the administration of assets held here, particularly if there is a question over the client’s capacity, domicile or testamentary freedom. Given that we are involved in an international financial services industry, it is incumbent on us all to be alert to potential issues and to areas of concern and to take advice in the relevant jurisdiction if questions do arise.


  1. Eg Civil law jurisdictions like France or Brazil and Islamic Shari’a law countries
  2. Eg New York and Florida
  3. Eg Switzerland or California
  4. ‘Succession and Forced Heirship Disputes’ by Andrew De La Rosa in ‘ International Trust Disputes’, OUP 2012.
  5. The Inheritance (Guernsey) Law 2011
  6. Eg in England and Wales under the Inheritance (Provision for Family and Dependents) Act 1975 (as amended)
  7. Holliday v Musa [2010] EWCA Civ 335 and Morris v Davies [2011] WTLR 1643
  8. Unless he is a serving member of the armed forces on actual military service or a mariner at sea s7 Wills Law (2004 Revision)
  9. See for example the Jimi Hendrix and Brooke Astor estate disputes in the USA
  10. Sharp v Adam [2006] WTLR 1059
  11. Boyse v Rossborough (1857) 6 HL Cas 2, cited in Sharp v Adam
  12. Wyntle v Nye [1959] 1 All ER 552
  13. Fuller v Strum [2002] 2 All ER 87
  14. Boudh v Bodh [2007] EWCA Civ 1019
  15. From Hall v Hall (1888) IP & D 481, quoted in Carpeto v Good [2002] EWHC 640.

The fight of the EU against tax avoidance – beyond BEPS

With the European Parliament showcasing its commitment to combat tax havens as well as tax avoidance and the European Commission pursuing state aid infringement procedures against Luxembourg and other member states, we have witnessed various harbingers of tougher regulations and increased tax harmonization in Europe throughout 2015 . Judging from the European Commission’s ‘Anti- Tax Avoidance Directive’ from the Jan. 28, 2016 , which is focused on ensuring uniformity in implementing the OECD BEPS outputs across the EU, the new year promises to be no less exciting.

The Anti-Tax Avoidance Directive – implementing anti-BEPS measures

The Anti-Tax Avoidance Directive (ATA Directive) proposed by the Commission comprises six anti-avoidance measures. Three of these measures are specifically designed to ensure uniform implementation of the OECD BEPS measures, namely:

  • interest limitation rule (BEPS Action 4 – Article 4 of ATA Directive)
  • controlled foreign company (CFC) legislation (BEPS Action 3 – Article 8 of ATA Directive)
  • framework to tackle hybrid mismatches (BEPS Action 2 – Article 10 of ATA Directive)

The measures are targeted at counter-acting “some of the most pervasive aggressive tax planning schemes”  and reflect the Leitmotiv of the OECD BEPS project, namely combating artificial tax structures by aligning the creation of economic value added with the allocation of profits and taxation. Combined with the reforms of the transfer pricing regulations (BEPS Actions 8-10) the measures are likely to significantly enhance the feasibility of applying the arm’s length principle as the main paradigm of international taxation. The measures have been discussed at length within the OECD BEPS project and can arguably be regarded as a more or less adequate response to aggressive tax planning. While the benefits of the individual measures are subject to debate, the necessity of reforming the arm’s length principle for coping with 21st century business structures enjoys a comparatively broad international consensus . In view of the comprehensive nature of the reforms it seems more likely than not that the extent of BEPS generating aggressive tax planning will be substantially curbed within three to five years.

taxConsidering that the BEPS project was concluded at breakneck pace, it would have appeared sensible for the EU to adopt a kind of wait-and-see attitude and leave it up to the member states to follow through with the implementation of anti-BEPS measures. A directive, however, is legally binding on all member states and leaves comparatively little leeway to the member states. According to the Commission “the possibility of proposing soft law was also considered as an option but was discarded as inappropriate for securing a coordinated approach” . It is somewhat difficult to understand why exactly soft law was considered to be inappropriate. Appropriate institutions for implementing soft law do exist in the EU. For instance the EUJTPF, which assists and advises the European Commission on transfer pricing tax matters, could have issued general guidance for facilitating a sufficient degree of uniformity in implementing anti-BEPS measures . The main argument advanced by the Commission, namely that leaving implementation to the member states would “only replicate and possibly worsen the existing fragmentation in the internal market and perpetuate the present inefficiencies and distortions in the international patchwork of distinct measures,” is unconvincing. Following this line of reasoning would imply that the Commission seriously believes that member states individually implementing the three Anti-BEPS measures would likely lead to an increase in tax avoidance rather than decrease.

The eagerness of the European Commissions to move beyond BEPS

The approach adopted by the Commission could also be interpreted to imply a general lack of faith in the effectiveness of the OECD anti-BEPS measures. It would appear somewhat premature, however, to judge the effectiveness of the anti-BEPS measures at this point and thus this (benign) interpretation cannot be entirely accurate. The set-up of the ATA Directive makes it rather clear that the ultimate motivation of the Commission is to utilize the BEPS project as a convenient stepping stone towards greater tax harmonization within the EU.

In this context, the following two aspects should be considered:

1.     The Commission intends to implement anti-avoidance measures that go beyond the OECD anti-BEPS measures. The three additional measures contained in the ATA Directive are:

  • Exit taxation (Article 5 of the ATA Directive)
  • Switch-over clause (Article 6 of the ATA Directive)
  • General anti-abuse rule – GAAR (Article 6 of the ATA Directive)

The provision of exit taxation would require all member states to levy an exit tax on realized gains in the event of an MNE transferring assets (or residence) to another (presumably low tax) jurisdiction. Some member states (such as Germany) already have exit tax provisions in place. While most restructurings involving the transfer of assets have valid commercial reasons, the Commission holds the opinion that “such practices distort the market because they erode the tax base of the state of departure and shift future profits to be subject to tax in the low-tax jurisdiction of destination.” Irrespective of whether one would subscribe to the somewhat paranoid opinion of the Commission, it is difficult to see the harm in member states decide on their own whether or not to implement exit taxation in a protectionist effort to secure their tax base. The introduction of an excessively broad GAAR which is intended to close any gaps that could possibly exist in the current anti-abuse rules of member states is also rather intriguing. In effect the GAAR proposed by the Commission would give national tax authorities a blank check to ignore any legal arrangement of taxpayers that are deemed to have been put into place for no valid commercial reasons – a clear definition of these “non-genuine arrangements” or of the procedure to evaluate suspicious arrangement is not provided. Again, irrespective of one’s comfort level in view of legal provisions granting vast discretionary powers to tax authorities, it is unclear why the Commission feels compelled to force the member states to adopt such a provision.

2.    The Commission will relaunch its proposal for a Common Consolidated Corporate Tax Base (CCCTB), which it considers to constitute a holistic solution to creating a fairer and more efficient taxation in Europe. In its press release accompanying the publication of the proposal for the ATA Directive (MEMO-16/160) the Commission made it quite clear that it ultimate regards the CCCTB as the only comprehensive solution for base erosion and profit shifting. It felt, however, that “we should not wait for the CCCTB to be proposed, agreed and implemented before taking action against major areas of tax avoidance.” The ATA Directive is perceived as offering immediate and effective solutions to tax avoidance while work on the CCCTB is underway.

As pointed out before in the Cayman Financial Review, the implications of adopting the CCCTB are rather worrisome . Not only is the CCCTB, and formulary apportionment in general, technically ill-suited to provide a panacea against BEPS, but an implementation of the CCCTB would have even more fundamental ramifications – most notably weakening the position of the arm’s length principle as the leading paradigm of international taxation. It is not feasible and possibly beside the point to argue whether one paradigm would be superior to the other on theoretical grounds. At the end of the day, the question which paradigm is to be applied remains an ideological question. The arm’s length principle simulates a market process in order to identify the economic value of a specific transaction and allocates the tax base accordingly, while formulary apportionment is based on a political value judgment regarding a fair or more equitable distribution of income. The ATA Directive clearly shows that the ideological preference of the Commission in respect to transfer pricing is fundamentally at odds with that of the OECD.

While the arm’s length principle is merely a tool or mechanism that should by no means be regarded as a sort of pseudo-religion, the benefits of having an established international consensus that is based on market processes and somewhat limits the discretionary powers of tax authorities and governmental value judgment about an equitable division of income should be to carefully considered. Business representative tend to profess that they are indifferent in regards to the paradigm of international taxation as long as it is uniformly applied on a global level. While this point of view is somewhat understandable, it is questionable whether it reflects a deliberate evaluation of the practical implications of adopting formulary apportionment – e.g. the water’s edge effect of introducing formulary apportionment on a local/regional level. There is no need to be uncritical of the work performed by the OECD, but it would be prudent to keep things in perspective. Insofar as the reforms proposed by the OECD relate to ‘modernizing’ the arm’s length principle, European transfer pricing professionals should consider adopting a more supportive stance – especially in case they regard the alternative of adopting the CCCTB as rather unappealing.

Issues to keep in mind

While taxpayers may perceive the arm’s length principle vs. formulary apportionment discussion as rather boring, they would be well advised to monitor the further developments closely. A paradigm change would leave no business model unaffected. Think about financial holding structures and any value chain centered on creating and utilizing intellectual property – applying formulary apportionment would have dramatic effect on the allocation of income. Government officials from countries that are hosting a lot of high value added activities based on intangibles as well as a small but highly qualified workforce should also be on the alert – formulary apportionment generally does not recognize or reward the impact of intangibles and a highly qualified workforce.

Coming back to the EU and making some predictions for 2016: In order to get a feeling for the intentions and political commitment of the legislators it is worthwhile to pay close attention to the wording adopted by the Commission. One idiosyncratic phrase utilized by the Commission in justifying the increased harmonization in implementing uniform anti-avoidance measures throughout Europe was the necessity to preserve the “common competitiveness” of the EU. A governmental body resorting to phrases like common competitiveness and introducing blank check GAAR provisions documents its willingness to do pretty much “whatever it takes” to reach its ultimate objective. A forceful push towards further tax harmonization in the EU and the implementation of various additional anti-avoidance measures, such as the External Strategy including a uniform European listing procedure for third countries not complying with the EU taxation code of conduct, are a foregone conclusion. The most intriguing question is arguably whether the re-launch of the CCCTB will generate sufficient political momentum to eventually achieve approval and implementation . Luckily this is not a forgone conclusion and it will all the more intriguing be exciting to watch – so, do not blink.