Changing the rules of the game

Because goods, services, capital and people can move across borders, states must compete for these resources. That competition limits the ability of states to move toward the interventionist end of the spectrum and so frustrates proponents of greater regulation of financial markets. 

Part of the competition for economic activity involves provision of law and competition among states helps shape the law they provide. This competition takes place within a framework of international law including treaties, customary public and private law and conflict of law rules.
Like any competitor with power to affect the rules of the game, however, states seek to alter this framework to provide themselves with advantages against their competitors. The global financial crisis provided a powerful group of states, including the United States, the United Kingdom, France and Germany, with an opportunity to change the rules of international regulatory competition to disadvantage offshore financial centres in their competition with these onshore governments over financial services. Interest groups favouring additional regulation in these onshore jurisdictions have sought to use the financial crisis to seek changes in the rules of the game for international financial competition that reduce OFCs’ comparative advantages.
Changing the rules
Soon after the current financial crisis began, public officials in onshore economies began to blame offshore financial centres for contributing to the crisis and to call for regulatory measures to limit OFCs’ abilities to compete in the global financial market.
New York City District Attorney Robert Morgenthau complained that “vast sums of money … lie outside the jurisdiction of US regulators and other supervisory authorities.”
UK Prime Minister Gordon Brown called on “the whole of the world to take action. That will mean action against regulatory and tax havens in parts of the world, which have escaped the regulatory attention they need.”
French President Nicolas Sarkozy denounced “the excesses of financial capitalism, which has experienced serious abuses: concealment of risks, uncontrolled sophistication of financial instruments, gaps in regulation and persistence of tax havens capturing a part of global savings that would be more justly employed financing investment and growth.”
It shouldn’t be a surprise that at the same time they are demanding ‘standards’ and ‘level playing fields’, many countries are acting inconsistently with well-established international legal principles. In the United States, the Obama Administration endorsed the Stop Tax Haven Abuse Act, legislation proposed by Sen Carl Levin aimed squarely at OFCs that did not cooperate with the US Treasury in enforcing American tax laws. The Levin proposal requires that OFCs assist in stopping not only criminal tax evasion but also legal tax avoidance, ignoring well-established international law principles that jurisdictions are not required to assist each other in collection of tax revenue. In a second departure from normal state-to-state conduct, Germany and other European governments have paid millions of Euros to a thief for account data stolen from a Liechtenstein bank and Germany created a new identity for the thief through a witness protection program.
Despite Liechtenstein’s attempt to arrest the thief for violation of its banking laws, Germany’s government displayed a dramatic unwillingness to abide by the usual norms of comity toward a fellow member of the European single market.
In a third major departure from established international legal principles, Britain invoked anti-terrorism laws against a bank in NATO ally country Iceland to seize assets after the bank’s Internet subsidiary collapsed, putting the bank on the same terrorism list as al-Qaeda.
All these measures are expressions of the desire of interest groups within large, developed economies’ to rewrite the rules to limit regulatory and tax competition by small jurisdictions. If successful, these efforts will damage the world economy by removing an important set of competitors from the scene.
The losers will include not just the residents of OFCs but the residents of the developed economies, since OFCs play an important role in encouraging transaction cost and minimising regulatory and financial innovations.
Competition helps everyone, because when one jurisdiction discovers a new efficiency-enhancing innovation, it can lure economic activities to it. Other jurisdictions then must adopt similar innovations if they are to compete effectively.
The spread of the LLC in the United States following its initial adoption by Wyoming and the development of segregated portfolio companies by offshore jurisdictions with several domestic US jurisdictions following the OFCs’ lead and adopting their own laws allowing versions of these entities, are examples. Of course, competition can’t prevent every bad outcome.
Antigua’s relationship to Sir Allen Stanford and Stanford International Bank, which appears to have been little more than a sizeable Ponzi scheme, is a recent example. While the legal literature contains many claims of such competition producing a ‘race to the bottom’, including with respect to Delaware’s role in corporate governance, these claims are often contested. The challenge for onshore and offshore alike is to distinguish legitimate efforts to prevent fraud, money laundering and other criminal activity from efforts to weaken competitors under the guise of tackling such problems.
There are a number of reasons to think regulatory competition is likely to be beneficial. In The Law Market, reviewed in CFR in April, profs Erin O’Hara and Larry Ribstein offered a theory of regulatory competition based on domestic interest groups lobbying for laws that will attract outsiders to do business in a jurisdiction, with the additional business benefiting the domestic interest groups, (e.g. the Delaware corporate bar benefits from the use of Delaware by out-of-state corporations as the state of incorporation).
In a forthcoming book I am editing for the American Enterprise Institute, Professor Jonathan Macey and Anna Dionne argue that competition between offshore and onshore jurisdictions produces efficiency-increasing competition to offer regulatory measures and innovations in both onshore and offshore jurisdictions as a result of competition to offer ‘optimal laxity’.
In the same volume, Prof Rose-Marie Antoine shows that offshore jurisdictions are more innovative than onshore jurisdictions in developing governance mechanisms for trusts as a result of their competition for trust business, while I argue that OFCs have produced beneficial innovations in hedge fund and captive insurance law.
However, as noted earlier, the financial crisis has prompted a wide range of policy proposals from onshore governments aimed at restricting the ability of OFCs to compete with the onshore governments. Implicit in these proposals is the argument that competition between OFCs and onshore governments reduces onshore jurisdictions’ ability to regulate in beneficial ways. Other critics of OFCs have argued that offshore jurisdictions promote fraud and theft, particularly in countries with poor governance and proposed regulatory measures limiting competition from OFCs.
These proposals rest on claims that onshore governments’ regulatory efforts in financial services are undercut by competition from OFCs and that restricting competition from OFCs will enhance onshore regulatory efforts. Both of these statements are controversial, although the policymakers making these arguments have generally treated them as self-evident and not requiring an effort to provide proof.
Do OFCs undercut onshore regulation of financial services?
The claim that onshore regulatory efforts are undercut by the regulatory competition provided by OFCs can be divided into three parts.
First, onshore regulators claim that offshore jurisdictions regulate too little. Second, onshore regulators argue that offshore confidentiality laws allow onshore taxpayers to illegally evade taxes they owe onshore governments. Third, onshore governments argue that the lower tax rates in offshore jurisdictions reduce onshore governments’ abilities to tax their citizens by enabling onshore taxpayers to structure transactions to reduce their taxes.
Regulatory laxity
There are three reasons to believe OFCs are not competing through laxity. First, there is no agreed objective measure of regulatory stringency by which we can compare regulators in different jurisdictions. While onshore politicians sometimes suggest that OFCs are unregulated, regulators in major OFCs often have broader powers than onshore regulators and are less constrained by formal restrictions imposed by administrative law. Comparing regulatory frameworks thus requires both evaluating formal rules and powers and the actual practice of regulation across jurisdictions. Leading OFCs like Bermuda, the Cayman Islands, the Channel Islands, Dubai and Singapore offer a combination of laws, regulations, regulators and regulatory culture that makes the effective degree of regulation at least equal to that in onshore jurisdiction, although sometimes with different goals.
Second, offshore jurisdictions have large investments in their reputations, since any offshore jurisdiction that allowed significant fraudulent or criminal behaviour would quickly lose its ability to attract business and so deprive its population of the benefit of the offshore financial sector. These revenues are significant: the Cayman Islands derives approximately half of its government revenues from offshore-financial industry fees and a significant portion of tourism is finance-industry-related as well. As a result, the major OFCs have invested heavily in their regulatory infrastructure. For example, the Cayman Islands Monetary Authority board consists of financial professionals drawn from both the islands and internationally and whose credentials compare favourably to those of regulators in the United States. The Cayman Islands Stock Exchange is an affiliate member of the International Organisation of Securities Commissions, a member of the Inter-market Surveillance Group and recognised by the UK Revenue and Customs Board, signalling that it meets international standards and allowing listed securities to be sold in major markets. Major OFCs are regularly reviewed by the International Monetary Fund, an organisation controlled by onshore governments and generally received favourable reviews when compared against best practices standards that onshore governments sometimes do not themselves meet.
British OFCs are also reviewed by the British Treasury and most have received favourable reviews. Thus by most objective measures, the major OFCs, if not the less developed ones like Antigua, have been successful at providing adequate regulation, at times even exceeding the regulatory stringency of onshore governments. There is some indirect evidence to support this contention. The most dramatic frauds in recent years have occurred not in OFCs but in onshore jurisdictions: Enron, Parmalat, and Madoff are scandals with onshore roots.
Third, even among regulators in major onshore financial centres, there are differences in how regulatory agencies are structured, the regulatory philosophy and the regulations imposed on financial services firms. The United States and the United Kingdom take dramatically different approaches to financial services regulation in both the structure of their regulators and type of regulation. The competition between New York City and London over financial services business is at least as intense as the competition between those financial centres and OFCs. Thus, aside from jurisdictions that have no serious regulatory oversight or corruption problems, the largest OFCs provide what is best described as a different form of regulation rather than an absence of regulation. This is not surprising; as Macey and Dionne note, jurisdictions compete in many regulatory dimensions and zero is rarely the desired level of regulation by financial services firms themselves.
Since OFCs specialise in products for sophisticated investors, it is not surprising that OFCs regulate differently from onshore jurisdictions where regulatory concern is focused on retail products. Distinguishing difference from the absence of regulation seems to beyond many onshore politicians but is critical to understanding the role of OFCs. The differences between legitimate OFC and onshore regulators are differences in focus, philosophy and approach, similar to the differences among onshore jurisdictions rather than driven by regulatory laxity. The regulatory competition is thus better described as a competition for the optimal level of regulation.
Onshore governments love to attack OFCs for providing strong financial privacy laws. An attack on confidentiality is central to the proposed Stop Tax Haven Abuse Act in the United States, with the draft legislation including a series of presumptions to disadvantage those jurisdictions that fail to assist the United States in stopping tax avoidance as well as tax evasion.
Does confidentiality undermine onshore efforts at regulation? Certainly the inability of onshore law enforcement or tax authorities to obtain comprehensive information on offshore financial activity means that money laundering and tax evasion are more likely to succeed than if onshore authorities had complete information. But success in law enforcement and tax collection are not the sole metrics by which policies must be evaluated.
As Rose-Marie Antoine argues, however, “that confidentiality can sometimes be abused does not make confidentiality itself an abusive or illegitimate concept. Rather, we have accepted that in every financial endeavour and structure there will be weaknesses and what we need to do is to have checks and balances and avenues for redress.”
Financial privacy is not something of interest only to OFCs or money launderers. Confidentiality in financial matters is a well-established principle in both civil and common law. For example, most common law OFCs trace their confidentiality laws to the landmark 1924 UK decision, Tournier v. National Provincial Bank and confidentiality in commercial matters is the basis for the protection of trade secrets, a position that the United States, among others, has frequently and vigorously asserted.
Civil law jurisdictions have their own long history of respecting financial privacy. Differences over confidentiality between onshore jurisdictions and OFCs thus reflect differences in emphasis, not differences in kind.
Further, financial confidentiality also protects opposition politicians from countries like Venezuela, Russia and Zimbabwe, where governments have attempted to undercut domestic opponents by attacking their financial resources. A significant problem with the attacks on confidentiality by the European Union and United States is that those attacks make it harder for jurisdictions to refuse requests for information from unsavoury regimes.
Confidentiality is thus not an issue on which onshore governments can legitimately claim that other interests must yield to their interests in enforcing their tax laws. Rather, it requires that jurisdictions negotiate accommodations to each others’ interests, with both OFCs and onshore jurisdictions treating each others’ interests as deserving of respect. At the moment, however, the onshore assault is yielding some results, with Switzerland tentatively agreeing to breaches of bank secrecy, which would have been previously unthinkable, as a result of the UBS scandal. And if the Stop Tax Haven Abuse Act becomes law in the United States in anything approximating its summer 2009 form, it will be virtually impossible for any jurisdiction to avoid a high degree of co-operation with the United States tax authorities to avoid the draconian presumptions the act will apply to non-cooperative jurisdictions.
These changes are unlikely to have the effects their sponsors anticipate. Confidentiality was vital to the 1960s and 1970s business models of OFCs seeking individual wealth management business but is irrelevant to the 1990s and later business models built on aircraft financing, captive insurance, asset securitisation and hedge fund domicile.
Tax competition
Tax competition is often misleadingly described as a simple competition between high and low tax jurisdictions over rates applied to a single form of taxation. Rather, as Prof Craig Boise notes in the AEI volume mentioned earlier, different jurisdictions have different tax structures and those differences create opportunities for business structuring to reduce overall tax bills. For example, while the ‘zero tax’ Cayman Islands has no income tax, it has what is effectively a hefty sales tax through import duties. Cayman also has significant property transfer taxes. As a result, Cayman’s tax structure is quite similar to that used by Texas, which also has no income tax and a predominately sales and property tax regime. Not surprisingly, given onshore jurisdictions’ hypocrisy on tax practices, Cayman, but not Texas, is considered to be engaged in ‘unfair tax competition’ and is singled out for pressure over its tax structure.
Differences in tax systems are inevitable because their purposes differ and because of path-dependent choices about definitions and concepts. As a result, businesses have an incentive to structure themselves to minimise the total cost of doing business, including legal and accounting fees plus tax payments. Onshore governments can restrict such competition by erecting barriers that raise the cost of using OFC structures, but they do so at a cost to themselves. For example, Barbados has an extensive network of tax treaties that allow companies from high tax jurisdictions to reduce their tax burden on international operations below the domestic level.
Opponents of tax competition typically portray this as a loss of tax revenue to the high tax domestic jurisdiction. It is equally possible to consider it as enabling the high tax jurisdiction to price discriminate in its taxation between international and domestic activity, applying a higher rate to domestic income than would be possible otherwise. For example, Canadian natural resource companies, among the world’s leaders in their field, would find it difficult to compete internationally if they had to pay domestic Canadian tax rates on their non-Canadian operations.
Moreover, there are a number of areas where taxation is irrelevant to OFCs’ business models. For example, the Cayman Islands is the domicile of the captive insurance companies of many US non-profit health care providers, a group unconcerned with taxation of earnings. And many offshore captives opt to pay US income taxes as if they were US entities, again making tax issues irrelevant to the decision to locate offshore. Similarly, many investors in offshore hedge funds are non-profit organisations, such as university endowments. For these investors, the tax exemption of an OFC-based hedge fund is not a means of avoiding US income taxes.
Finally, tax-related OFC structures often offer onshore jurisdictions considerable benefits. For example, the use of finance subsidiaries in the Netherlands Antilles in the 1970s and early 1980s saved US corporate borrowers an estimated 2-3 per cent interest because such subsidiaries allowed the US parents to obtain financing in the cheaper Eurodollar market. Tax structuring undoubtedly plays a role in some aspects of modern OFC business models but it is less important than onshore governments appear to believe.
Efforts to limit tax competition are likely to be at least partially counterproductive, since obstructing use of OFCs will deny the benefits of OFC structures to onshore jurisdictions’ economies. To the extent that tax competition from OFCs limits the upper level of tax rates an onshore jurisdiction can charge, an onshore jurisdiction wishing to charge more must simply find other margins on which to compete. New York and France are able to levy high taxes on entities operating within their boundaries despite tax competition from Texas and Ireland because they offer amenities and advantages not available in the latter two. New York and France may not be able to accomplish all of their tax policy objectives, but their tax policies can hardly be said to have been frustrated by tax competition from lower tax jurisdictions.
Will limiting competition by OFCs enhance onshore regulation?
No, OFCs like Bermuda, the Cayman Islands, the Channel Islands, Hong Kong and Singapore play a constructive role in international finance for three reasons. First, they offer onshore jurisdictions important advantages. OFCs provide a means of price-discrimination. Some economic activities sensitive to transactions costs, including tax rates, relocate to OFCs. But the profits from the OFC-located segment ultimately will be re-invested or spent in onshore jurisdictions, creating more economic activity onshore, because investment opportunities within OFCs are too small to absorb the capital created by the offshore sector. As the example of Canadian natural resource companies shows, allowing businesses to opt out of domestic tax regimes for their international businesses can have important benefits for both shareholders and businesses. As the non-profit health care captive example shows, OFCs offer more ways to cut transactions costs than low taxes.
Second, the constraints imposed on well-run onshore economies by OFCs are relatively small and affect large economies like the United States and European Union only on the margin. For example, even assuming the worst case scenario, nominal US corporate tax rates remain among the world’s highest. At most, OFCs offer some American businesses a chance to lower their tax rates in the same fashion as the complexities of the Internal Revenue Code do for others. Confidentiality provisions are largely irrelevant to most business structures and virtually all OFCs already have tax information exchange agreements that permit transfer of information where there is specific evidence of criminal activity.
Even the impact of legal innovations offshore is attenuated by the additional transactions costs of operating in multiple jurisdictions. It seems hard to credit onshore politicians’ claims that there is a significant pool of unregulated and under-taxed funds to be recaptured by new international financial regulations. OFCs are likely to have a larger impact on smaller economies, where the ability to opt out of a corrupt or inefficient legal system is important to creating viable non-state sectors.
Third, setting the ‘rules of the game’ for international finance is properly the subject of multilateral negotiations among all affected jurisdictions. The domestic interests of any one sector, whether concerned with tax collections or securities regulation, cannot be the only concern. In their efforts to resist competition from OFCs, the United States and European Union risk damaging an international financial system that has served the world economy well since World War II. Rather than changing the rules, onshore jurisdictions should strive to compete more effectively on the merits.

A longer version of this article including footnotes will appear in Nexus, Chapman University’s journal of law and policy, as part of a symposium on “Law, Markets and the Role of the State”.


Enron building, Houston Texas