Anthony Travers of Cayman Finance provides a forthright commentary on what he describes as the ‘misconceived’ regulatory response to the financial crisis by the US and EU.
The criticism to which the offshore centre is routinely subjected has now reached a crescendo in the wake of the regulatory response to the financial crisis and the hunt by domestic Treasuries for tax revenues to meet the burgeoning deficits of many G20 countries. This then, is a trying time, but do the criticisms amplified by the formidable public relations machines of the EU and US governments withstand scrutiny or are they simply a transparent exercise in blame deflection? Even the briefest analysis does not suggest a level playing field.
Surely if protection and a desire to prevent a repetition were the real objectives, the US regulatory response to the financial crisis would have established some passing reference to two of its fundamental causes. Yet the framers of the Dodd/Frank Act did not see fit to restrict Fannie Mae and Freddie Mac's ability to guarantee mortgages to un-creditworthy borrowers, nor to restrict the rating agencies in granting AAA ratings to the repackaged toxic waste that resulted. In the political world therefore, it follows that the cause of the crisis must have been elsewhere.
Michel Barnier, Europe’s Single Market Commissioner, in converting plans for regulating Europe’s financial markets, proposes Brussels is given new powers to end “abusive speculation” and “impose order” on Europe, including the City of London. “We want to know”, he states with imperious disregard for the regulatory time lag, “who is doing what”. Very possibly he has in mind placing an EU regulator at the screen of every trader. The EU authorities are going to “look at every product”. [They] “can restrict leverage, or in exceptional circumstances even ban a product temporarily”, Barnier told the Daily Telegraph in early September. But, if we apply the Euro-regulatory double-speak translator, what Mr Barnier no doubt said was: “We cannot possibly prop up a totally bankrupt European fiscal Union if hedge funds are allowed to trade in the market place and price European sovereign debt at its true market value rather than the value we attribute”.
Thus we see hedge funds, and indirectly offshore jurisdictions like Cayman and the BVI, which are the domiciles of the majority of them, now targeted in Europe and subject apparently in the UK to a regulatory response that will restrict leverage and require UK-based fund managers to receive 50 per cent of their remuneration after a deferred three year period, as if hedge funds or their bonuses had been instrumental in the European financial meltdown. Even the FSA has concluded that hedge funds were not responsible for crisis. So is the real threat here that which hedge funds pose to the political aspirations of those driving a totalitarian federalist agenda?
Mr Barnier speaks also of the creation of yet another EU regulatory regime – a triad system covering markets, banks and insurance. And, due to the questionable strategy of the recent UK government in pandering to EU regulatory aspiration over and above its obligations to the City, the UK will have no veto power over this body’s regulatory determinations for whatever reason they are arrived at, despite the fact that the City is the only globally recognised financial services centre in the EU. The UK will as a result, carry the same weighted vote in these matters as Latvia.
In the face of this regulatory tsunami, many industry commentators have been forecasting the demise of any offshore jurisdiction which does not fall immediately into line with the new world regulatory order. But in determining the course for the offshore jurisdictions, we need to be somewhat more analytical. So let us start with two undeniable truths. First, what is proposed is not, in the main, global, and second, no financial institution failed in Cayman during the financial crisis. An appropriate regulatory regime in Cayman worked exactly as it was supposed to. It is hard to see in these circumstances why there should be a rush to apply the regulatory notions of jurisdictions with less than enviable records and whose regulatory responses avoid recognition of the real causes of the financial crisis.
But, the whole truth is a good deal more troubling than that. In his book Engineering the Perfect Storm, Jeffrey Friedman points out that ill-considered onshore regulation fuelled the financial crisis. The risk weightings applied under the Basel Convention encouraged heavy investment in the mortgage backed securities market because in 2001 US banking regulators (the very same bastions of public protection) assigned US$2000 of capital for every US$1m of MBS as against US$10,000 for every US$1m of commercial loans. The result was that banks owned 45 per cent of all subprime backed mortgages by 2005, secure in the knowledge that 95 per cent of these were AAA rated and accepted as such by the banking regulators. Thus does ill-considered regulation distort the marketplace and in the current example assumed a direct causal relationship with the catastrophe that followed.
So we are assured that Basel III makes no such similar mistakes. Or are we? Commentators have already pointed out that none of Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch would have failed the increased Basel III capital adequacy ratios, each having regulatory capital ranging from 12.3 per cent to 16.1 per cent. Thus, the much-lauded Basel III would not have saved any of them. It may have assisted the regulators in their deliberations, if before failing to define adequately what constitutes “too big to fail” they had accurately analysed what is meant by “small enough to succeed”.
In all of this we do not take the words of the regulators as gospel. It is becoming increasingly evident that the market has a very distinct voice and so far as EU regulation is concerned is voting with its feet. The excellent and objective KPMG report ‘The Future of Alternative Investments’”[i] investigates the opinions of over 200 investment managers, administrators, institutional investors and service providers on the effect of the suggested increased regulation. It states in categoric terms:
“Anticipated regulation, driven by external forces that continue to blame alternative investments for the meltdown of the global financial system, is not wanted by the majority of investors, managers or service providers. The widely held view is that the industry did not cause or contribute to the credit crisis. Furthermore, investors believe more regulation will not produce any tangible benefits”.
In the offshore centres we conclude that the new regulation will ultimately stifle ingenuity and entrepreneurial opportunities. The survival of only larger operators will impede potential growth at the peril of UK and the US economies, which are regulating themselves out of a productive industry and the capital flows that are essential to the recovery of their failing economies. The report makes clear that the effect of this regulation paradoxically will be to create a marketplace dominated by fewer larger institutions, but none of which, can be “too big to fail”?
But the effect of localised or regional regulation rather than global regulation is equally perverse given the financial marketplace is not static. The exodus of fund managers and banks from London is now occurring as alternative offices are established in Switzerland, (the most unlikely of unintended beneficiaries), Hong Kong and Singapore. The offshore jurisdictions, too, would be an excellent choice to relocate an investment management company. Further we must not lose sight of the fact that a Cayman hedge fund trading with a Swiss, Dubai, Hong Kong, Singaporean or Cayman fund manager does so free of the restrictions of the new Euro-regulatory regime. This means in turn that the Cayman hedge fund, as BlueCrest recently concluded, may continue to trade traditional hedge fund strategies and with traditional rates of return – with which the Euro-based UCITS model will struggle to compete, starved as it will be of the oxygen of leverage, a more liberal risk profile and the best-remunerated talent.
As misguided as the regulatory response may be and as unintended as its outcome, it pales by comparison to the mischaracterisation of the offshore centre suggested by certain US Senators and indeed, the President. In the light of the readily verifiable and standard-setting advances made by the Cayman Islands, Bermuda, the BVI and the Crown Dependencies with respect to all crimes, anti-money laundering and tax transparency, the most recent outburst from Senator Dorgan on the floor of the Senate, erroneously describing the Cayman Islands as a "tax secrecy" jurisdiction, is politically and factually out of touch. Is this then an isolated error explained away by inadequate briefing or is it indicative of something more sinister? Can we connect the dots between this ill-founded outburst and the recent comments of Jeffrey Owens, Head of the OECD Tax Division, who says he fully supports the use of illegally obtained or stolen financial information from financial firms in order to track down tax cheats. "What we don't condone”, says Mr Owens with apparent moral authority, “is tax payers who do not comply with their obligations" but apparently oblivious to the well-established principle of tax law that renders a tax liability in one jurisdiction unenforceable in another and the illegality with which the OECD is tainted when an OECD member country pays a bribe to a bank officer to obtain the disclosure of protected information in violation of an individual’s right to privacy.
But tax evasion was off the table in the Cayman Islands nearly a decade ago and even the Swiss are a mere referendum away from the understanding that tax evasion is wrong. So what now are the ramifications of the new world order suggested by Mr Owens?
To find the truth of this continual criticism of the offshore centre we must look back to the 1998 OECD Report on Harmful Tax Competition. Here is the genesis of belief in the one universal high rate of tax fixed by a globally omnipotent bureaucracy. And so hamstrung is the OECD in the pursuit of that objective with the troublesome distinction between lawful tax avoidance and unlawful tax evasion that it seeks to evade the point altogether by introducing the principle of "escaping taxation". This nebulous concept is apparently of application any time any otherwise lawful arrangement does not meet with the philosophy of the relevant Government with respect to the redistribution of wealth. But the problem with this thinking is that it replaces a code or set of rules with entirely subjective thinking. The essence of legal tax structuring is that the rules are certain and enforced by the courts. This blurring of the rule of law involves an erosion of fundamental rights that should concern law-abiding people not just in the offshore centres, but everywhere.
The OECD notion that tax competition is harmful is itself entirely subjective and is based on the belief that individuals or corporations must pay the highest rate of tax without the right to lawfully mitigate or reduce taxes even though legitimate provisions of domestic law are available. Thus too, decent laws in decent places establish the rules whereby a competitor in the market place can, provided he does not induce a breach of contract, obtain market share at the expense of an existing supplier. But according to the OECD, tax revenues “lost” by mobile capital and labour being attracted to more tax competitive jurisdictions, consequent upon the sovereign right of an independent nation to fix its own tax laws and rates, is a ‘harm’ against which any high tax jurisdiction is entitled to be protected. So the OECD claims "that it is therefore worth exploring the possibility of addressing harmful tax competition using a wide range of ‘non tax’ measures".
Although it has taken some 12 years for the OECD to come out in favour of illegality in the pursuit of that objective, we now have a clear indication that from the outset the OECD regarded the word “measures” as entirely supporting illegal conduct.
And we see the same approach underlying the OECD's suggestion in that report that any jurisdiction which conducts financial activities with a lack of "substantial presence" should be regarded as a “tax haven” and "harmful" regardless of the tax transparency in effect in the jurisdiction and the absence of tax evasion. But this too is no more than a blatant attack on the rule of law. If the structuring of offshore hedge funds, private equity or structured finance vehicles complies with the laws of the various jurisdictions through which they invariably operate then they are necessarily lawfully conducting business. The fact that they do not resemble in form or function, a car manufacturing plant in Detroit with 5,000 people under one roof should not be regarded as an appropriate basis of criticism.
It goes without saying that you cannot structure over US$3 trillion of hedge fund investment from vehicles in the Cayman Islands for the benefit of institutional investors and to their satisfaction on the basis of full transparency, with fully audited accounts and reporting function without the activities from subscription to investment to audit to regulation being substantial. The marketplace considers these vehicles to be real and to justify the fees paid. What we are left with from the OECD and indeed President Obama is the suggestion that the laws and accounting principles which apply to these vehicles should count for nothing, that these financial arrangements amount to a "tax scam" simply because the economic activity does not conform to a highly subjective view of what the OECD and, apparently, the President and Senators Dorgan and Levin think economic activity should look like.
In the light of the evident advances with respect to tax and regulatory transparency, verifiably established by the offshore financial centres and confirmed routinely by the IMF, the FATF and the GAO, the risks for organisations like the OECD and indeed for politicians who continue to mischaracterise the position is that it is they who will be seen as out of touch and irrelevant. Increasingly the offshore financial centres are looking to Asia and the emerging markets generally to cement relationships. The expertise available in jurisdictions like the Cayman Islands is undeniable. It is the continued misperceptions of the EU and US politicians which leads to protectionist legislation and the risk that they cut themselves off from the international capital that flows through the financial centre. The future for the transparent offshore centre seems assured. It is the EU and the US that increasingly, through misconceived regulation, prejudice their own long term financial well-being.
[i] The Future of Alternative Investments, KPMG and International Fund Investment, 201
Anthony Travers OBE
Anthony Travers OBE is the Senior Partner of Travers Thorp Alberga, former Chairman of Cayman Finance and former President of the Cayman Islands Law Society. The former Managing and Senior Partner of Maples and Calder, he has extensive experience in all aspects of Cayman Islands law and has worked closely with the Government and prepared the Cayman Islands legislation for Mutual Funds and Private Equity vehicles, in the Private Trusts area, the Asset Protection Legislation and drafted the Cayman Islands Stock Exchange Law. Anthony was made an Officer of the Most Excellent Order (OBE) for his services to the Government and the Financial sector in August 1998. Anthony has written numerous articles and has spoken regularly at conferences and seminars.