International financial centres (IFCs) around the world have led a creative wave of new and improved business entities over the past few decades.
IFCs’ innovations start with importing business entities from elsewhere and transforming those structures as they adapt them to fit their particular legal systems and business models.[i] Offshore jurisdictions are not alone in generating innovations but especially considering their size and place in the global economy, are consistently at the forefront of innovation and so have mastered the recipe. But IFCs offer more than new or refined statutory frameworks. To draw on a cooking metaphor, what is the IFCs’ “secret sauce”?
The secret sauce that makes IFCs successful is their ability to offer a principled framework for addressing unknown future circumstances. This framework results from the ability of creative private legal and financial sectors to connect with IFC governments, regulators, and judiciaries to bring new ideas to the marketplace. This important IFC contribution to the world economy is often overshadowed by the headline grabbing focus of big jurisdictions’ efforts to limit tax competition.
Why New Business Entities?
Virtually every jurisdiction has a limited liability entity (e.g., the corporation), often with different rules for smaller, private entities and larger, public ones.[ii] The ubiquity of the corporate form in legal systems around the world today makes us forget that it is a relatively recent innovation. The modern corporate form of a limited liability entity established by registration, controlled by a board elected by shareholders, and with professional managers reporting to the board achieved widespread legal recognition in Europe and North America only in the second half of the 19th century.[iii] More recently, we find in many jurisdictions an increasing number of non-corporate business entities which combine pass-through taxation with limited liability, which business entities expert Larry Ribstein termed “uncorporations”.[iv] Since the 1980s, the number and diversity of business entities has increased rapidly in many jurisdictions both on- and off-shore.
The demand for different business entities arises because they are put to different uses. Publicly traded corporations are the entity that most people associate with business entities. But these are only a tiny fraction of the limited liability entities in existence around the world, let alone the broader universe of all business entities. Not only are there non-publicly traded corporations, but there are also companies limited by guarantee, limited partnerships, limited liability companies, segregated portfolio companies (and their many variants), business trusts, anstalts, private foundations/stiftungs, limited liability limited partnerships, and many more. The variety makes it easier for individuals to find an entity which most closely suits their needs in terms of governance, structure, and other attributes.
Having a variety of business entities is economically important because it offers a range of structures to meet the multifaceted needs of clients. While virtually any purpose can at least be approximated by being shoehorned into an existing entity, usually at a significant cost, having available more “off the rack” solutions enhances the ability of individuals and their advisers to meet their needs. As the late, great economist Jane Jacobs noted in a 2001 interview, “development is differentiation – new differentiation of what already existed. Practically every new thing that happens is a differentiation of a previous thing.”[v] Creating the infrastructure to allow for a differentiated universe of business entities is thus a crucial ingredient in a legal system’s recipe for promoting economic activity.
Differentiation provides multiple paths to achieve objectives. However, successful differentiation requires more than just a statute authorising a new entity. Consider the development of entities which enable segregation of assets for securitisation and alternative risk transfer. The key to a successful entity in these cases is confidence that those operating the entity will meet its objectives by following the agreed to terms that created it. Part of generating this confidence requires applicable insolvency law to respect the segregation of the assets involved and not – as many large economies’ laws do -- to empower courts to recharacterise assets or rewrite contracts. Granting bankruptcy courts broad discretion and equitable powers to courts to balance a wide set of interests is important in many situations but allowing it to undo a securitisation or catastrophe bond would be disastrous. The world economy needs places that can ensure that the investors in the transaction get what they were promised.
Offering a differentiated menu of business entities with a range of fiduciary obligations of the participants to one another, insolvency rules, governance norms, etc. is an important function of IFCs. But merely creating a menu of varied entities and an overall legal environment in which investors can have confidence that transactions will proceed as planned is still not the entire recipe. To be successful at innovating these entities, system-wide knowledge to ensure reliable performance and delivery of results are essential, an area in which IFCs have a distinct advantage.
Solving The Entity Governance Problem
No matter what form of business entity is selected, dealing with anticipated situations is relatively straightforward and a variety of means exist for different business entities to have solutions at hand when something anticipated materialises: A trust’s settlor can leave a letter of wishes, a corporation’s or LLC’s ‘constitutional’ documents can provide guidance, and so forth. It is when we come to unanticipated circumstances that something different is needed.
IFCs offer solutions where larger onshore jurisdictions cannot. Take the case of a successful entrepreneur who wants to both provide for her heirs and ensure the continuation of the business to which she devoted so much of her career. Putting the shares of the business into a private foundation or trust would be a common way to accomplish these goals. What happens, however, when unforeseen circumstances arise? If the foundation or trust is located in an IFC, the likelihood of an effective response will be higher because of a collective commitment to find a durable solution. In an IFC, the board or trustees will work out how to respond within the context of generally accepted principles (the jurisdiction’s foundation law or trust law) that are recognised by/subscribed to by the local community of legal practitioners and judges called upon to resolve any conflicts. Crucially, all the lawyers and judges will be committed to the jurisdiction’s success given the economic importance of the financial sector and be motivated to resolve the issue in ways that redounds to the jurisdiction’s credit.[vi] Further, it is linked to a credible commitment that the IFC’s legal system will continue to have the characteristics that drew those forming the entity (the clients, the legal and other professionals) to the jurisdiction in the first place. What makes that promise credible? What ingredients are needed? The answer is that those preparing the “recipe” need to be paying close attention to getting it right.
One reason IFCs outperform onshore jurisdictions in innovation is that IFCs have different governance structures. Most IFCs are relatively small jurisdictions. Bermuda has a population of roughly 64,000; Cayman, 66,000; Jersey, 97,000; Guernsey, 62,000; and the Isle of Man, 85,000. Even larger IFCs are not that large: the Bahamas has a population of just over 393,000. By comparison, even the most innovative US jurisdictions are huge – Delaware (a corporate law leader) has almost a million; Vermont (a major domicile for captives) over 620,000; and even Wyoming (a leader in LLCs) nearly 600,000. The smaller communities in IFCs enable speedier and more responsive methods of governance, including less formal ones. Proposals for new business entities are more likely to get more rapid and focused legislative attention in smaller jurisdictions where the link between meeting customer needs and the jurisdictions’ continued prosperity is clearer. As one example of that clarity, consider that Caymanian legislators regularly invoked the need to not “kill the goose that lays the golden eggs” in their discussions of the fees charged for offshore business entity registration, a subject that rarely is explicitly considered in onshore deliberations of tax rates.[vii] For jurisdictions unable or unwilling to provide such focus and attention, success and prosperity are less sustainable.
Another reason IFCs outperform onshore jurisdictions is that a larger percentage of legislators and members of the executive branch of IFC governments understand the importance of finding new lines of business and offering broad menus of business entities. They further understand the need for regular updates to their statutes to ensure continuous development of their legal infrastructure. For example, the major overhauls of English company law in the UK are spread across decades, in part because the British Parliament simply does not have time to address it more often. By contrast, many IFCs update their business entity statutes every few years or even annually (as does Delaware). Indeed, the most successful IFCs have mechanisms through which the financial industry can collaborate with the government in identifying opportunities for new legislation to make a jurisdiction more attractive for business innovation and growth. As a result, laws provide innovations with solid legal grounding because they are drafted in collaboration with the lawyers and other professionals who understand where the existing system is sub-optimal and where changes are needed to meet their clients’ needs.
The final reason for IFC competitive advantage in legal innovation is that IFC legal and financial communities are creative. Economist Richard Florida, whose work identified the role of the “creative class” in fueling economic growth, argues that communities of practice, which “emphasize exploration and discovery” and are linked by “process and structure” are able to balance practice and process to produce growth. “Practice without process becomes unmanageable, but process without practice damps out the creativity required for innovation; the two sides exist in perpetual tension. Only the most sophisticated and aware organizations are able to balance these countervailing forces in ways that lead to sustained creativity and long-run growth.”[viii]
People may point to larger financial centres like London and New York and wonder how IFCs can beat the combination of the City bar and the Chancery Division of the English courts or the New York bar and the Delaware Chancery Court? Part of the answer is that IFCs don’t “beat” those jurisdictions but instead have a symbiotic relationship that provides something the onshore bar and courts cannot.
Focused And Dedicated Long-Term Commitment To The Recipe
What then is the nature of the relationship? One element is focused and dedicated attention. Not only is it too hard to get Parliament’s (or most legislature’s) attention for regular updates to business entities statutes, it can also be hard to maintain focus on needed change without including unrelated and potentially disruptive provisions in pursuit of other agendas advanced by powerful political figures. It is also difficult to replicate onshore the long-term commitment IFCs can make to maintain their legal infrastructure to include experienced counsel, a thoughtful judiciary, and a body of legal rules and principles that effectively solve problems for business entities clients.
The reason onshore jurisdictions cannot is that they are simply too big. There are too many distractions including pitting social concerns against economic success, too many opportunities for politicians to defect from the bargain, and too little dependence on the financial sector to consistently focus both government and the legal and financial community on maintaining the jurisdiction’s competitiveness. IFCs have fewer viable economic alternatives to success in the financial sector given their limited natural resources and small internal markets. Their size and unique statuses may also impose fewer restrictions. Even Delaware, which otherwise does an excellent job of mimicking IFCs’ advantages, is hampered in making such a credible commitment because Delaware entities remain subject to US federal bankruptcy law, where judges have broad powers to recharacterise transactions and take other actions that disrupt the expectations of the parties in insolvency proceedings, and US federal securities law, which overlays costly regulatory measures which are often irrelevant to the type of businesses forming entities in IFCs.
The Final Dish
Even a casual glance at the statutory innovations in many IFCs over the past few decades shows that these jurisdictions are capable of developing new solutions for their clients. But simply counting statutes would miss the secret sauce in IFCs’ recipe for lowering transactions costs: their ability to credibly commit to the long-term maintenance of a legal infrastructure that businesspeople can trust to address unforeseen future problems in a principled and reasoned manner. Adam Smith remarked in The Wealth of Nations that it was “not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.[ix] So it is with successful IFCs: their promise to maintain the attractive features of their legal systems stems from their long-term interest to maintain the coordinated and symbiotic working relationship that brought them initial success. That is a much stronger basis for the credibility of a commitment to balance process and structure for productive outcomes than exists for any large jurisdiction. The world economy needs IFCs because it needs that commitment.
[i] See Andrew P. Morriss & Charlotte Ku, IFCs: Pioneers in Transmission of Legal Innovation, IFC Review, Jan. 1, 2021, https://www.ifcreview.com/articles/2021/january/ifcs-pioneers-in-transmission-of-legal-innovation/. Note that when we say “business entities” we are including business uses of trusts even though trusts are not entities. To avoid having to say repeatedly “business entities and trusts,” we ask the reader’s indulgence and ask that you mentally append “and trusts” each time we say “business entities” and add a mental asterisk that the authors are not idiots and we do realise that trusts are not entities.
[ii] For a modern analysis of the commonalities among the corporate form in developed economies, see Reinier H. Kraakman, et al., The Anatomy of Corporate Law: A Comparative and Functional Approach (2nd ed.) (Oxford: Oxford University Press, 2009).
[iii] For a detailed sociological history of the legal recognition of corporations in the France, Germany, the United Kingdom, and the United States, see A.B. Levy, Private Corporations and Their Control (London: Routledge 2016 ) and L.C.B. Gower, Gower’s Principles of Modern Company Law (London: Stevens & Sons, 4th ed., 1979), which has a historical section dropped from later editions.
[iv] Larry E. Ribstein, The Rise of the Uncorporation (Oxford: Oxford University Press, 2009).
[v] Bill Steigerwald, Remembering Jane Jacobs, Trib Live (Oct. 22, 2021) https://archive.triblive.com/news/remembering-jane-jacobs-2/.
[vi] See Jonathan R. Macey & Geoffrey P. Miller, Toward an Interest-Group Theory of Delaware Corporate Law, 65 Tex. L. Rev. 469 (1987), explaining the role of a jurisdiction’s bar as an interest group.
[vii] Tony Freyer & Andrew P. Morriss, Creating Cayman as an Offshore Financial Center: Structure & Strategy since 1960, 45 Ariz. St. L. J. 1297, 1348-1349 (2013)
[viii] Richard Florida, The Rise of the Creative Class, Revisited 26-27 (Basic Books, 2012).
[ix] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book 1, Chapter 2 (1776).
Andrew P. Morriss
Andrew Morriss is Professor of the Bush School of Government & Public Service and School of Law at Texas A&M University. Prior to this position, he was the Dean of the Texas A&M School of Innovation, the Dean of the Texas A&M School of Law, the D. Paul Jones & Charlene A. Jones Chairholder in Law at the University of Alabama, the Ross & Helen Workman Professor of Law at the University of Illinois, and the Galen J. Roush Chair in Law at Case Western Reserve University.
Charlotte Ku is Professor and Director of Global Programs at Texas A&M University School of Law. Her specialties include international law and global governance. She has previously served as Professor and Assistant Dean for Graduate and International Legal Studies at University of Illinois College of Law, Acting Director of Lauterpacht Research Centre for International Law at University of Cambridge, and Executive Director and Executive Vice President at American Society of International Law.