International Financial Centres (IFCs) enable solutions to one of law’s most important problems: how to make credible commitments over time. Credible commitments are needed whenever two or more people or firms are planning interactions that stretch across time.
A family creating a structure to govern multiple generations of wealth management, firms planning a joint venture, and investors making a commitment to fund a business all face the problem of creating commitments that the parties to the arrangement find credible. Without a credible commitment that the trustee will make reasonable investment decisions (let alone not abscond with the assets); that the managers will make reasonable strategic decisions about a firm’s assets; that an insurer will have assets if a claim is made in the future; or any of the countless other instances in which performance by one or more of those involved in a trust, investment, or contract will take place in the future, many of these activities would not occur. Indeed, the essence of such long-term relationships – whether among business partners or family members – is that they will require future actions whose contours cannot be specified today.
An important feature of IFCs is that they specialise in areas of the law that serve their clients. IFCs do so through statutory development and use of case law to address comprehensively the nuances of trust and business entities law. This added value allows the IFC to export the rule of law through its legal services and products—a necessity for locations with populations under 100,000 to expand their local markets. Attracting consumers of legal services to use an IFC trust or business entity requires offering a better product. What makes for “better” law? In part, better law is predictable and widely accepted law. A family putting its assets into a trust or investors organising a business want to know their goals are compatible with the legal rules of the jurisdiction where they are operating. IFCs do not have a monopoly on such rules and draw on well-developed English trust and company laws to enhance their own. IFC courts look to English (and other) cases to fill gaps in their own jurisprudence.
How do IFC laws add value? First, the law can be better organised, clearer, and easier for lawyers to comprehend. Jersey’s creation of its statutory framework for trust law in 1984 is a good example which multiple IFCs followed as a source for their own trust statutes. The Jersey statute distilled (through a collaborative process involving the legal community, the financial industry, and the government) trust law principles to make them clear and easy for trust professionals to use. Jersey regularly updates its trust law – seven times since its initial passage – using the same collaborative process. Second, IFC judges generally put significant weight on the intent of the parties. Third, the law may address a perceived gap. The Bahamas, Bermuda, the British Virgin Islands, the Cayman Islands, Dubai and Jersey all enacted statutory “Hastings-Bass” rules (often including a clarifying statutory framework for mistake issues) in response to the UK Supreme Court’s abandonment of the Hastings-Bass rule in Pitt v Holt and Futter v Futter.[i]
IFCs are legal innovators. The Cayman shipping registry created a security interest in vessels under construction that simplified financing; Guernsey created the protected cell company to make organising captive insurance companies easier (leading to its use for investment funds as well), and was copied by over twenty other jurisdictions; BVI pioneered the international business company, cutting the transaction costs of organising an entity for international investing; Liberia and St Kitts and Nevis imported the civil law foundation into the common law with over twenty other common law jurisdictions following their lead. IFCs are ideal laboratories for creating legal innovations, a capacity generated by their specialisation and focus on maintaining a competitive advantage.[ii] IFC innovations may not be appropriate for every transaction, but the ability to test such innovation in a systematic and observable way strengthens the overall development of law in these areas.
The Shadow Of The Future
Another feature of IFCs is the impact of the ‘shadow of the future,’ a game theory concept identified by Robert Axelrod in The Evolution of Cooperation (1984). Axelrod found that when people expect to interact with each other multiple times, future gains from collaboration can outweigh seeking short-term payoffs from reneging on cooperation. Using a “prisoner’s dilemma” game, he found that where the games repeated indefinitely, cooperation was the superior strategy. In essence, you are less likely to be cheated by a long-term partner than you are by someone engaged in a one-off transaction.
The shadow of the future heavily influences IFCs. Because their economies rely on continuing to attract business, everyone involved understands the importance of ensuring that their legal systems deliver what they promise. At the most basic level, this is a commitment to not depart from the rules of the game. The best-known example of such a defection was the US state of New Jersey’s amendment of its corporations statute in 1913 restricting the use of business trusts. This resulted in the neighboring state of Delaware surpassing New Jersey in corporate charters. That the best example of defection is over 100 years old shows the strong influence of the shadow of the future. More recently, the Cayman Islands’ 2012 abandonment of the idea of a payroll tax on expatriates shows how quickly IFCs will drop ideas that suggest they might renege on their commitments.
The shadow of the future incentivises IFCs to make a credible commitment to preserve their overall legal framework for trusts, companies and other entities, and transactions. The settlor of a trust, founders of an entity, or parties to a transaction care that the jurisdiction will not change the legal principles it has announced. This confidence enables parties to craft solutions to anticipated problems. This is not the case in many onshore jurisdictions. For example, US bankruptcy law gives federal bankruptcy judges broad equitable powers (such as re-characterising transactions the parties understood as debt into equity and vice versa), putting careful structuring of debt at risk. Most IFCs’ insolvency laws provide greater certainty with fewer such broad grants of power.
More difficult are the problems the parties did not anticipate. Here they must rely on the jurisdiction’s commitment to a general framework. For example, the settlor of a trust in Jersey can reasonably rely on everyone who will be involved to resolve any unanticipated problem (which, by definition, is not resolvable by resort to the settlor’s intent) by applying well-tested, clear principles of trust law. Should the matter reach a Jersey court, it will be handled by an experienced judge familiar with complex trust matters and resolve areas of disagreement in an objective way by resorting to those principles. The jurisdiction’s commitment to its trust law framework and to having a judiciary with the required legal skills and commitment to upholding the integrity of Jersey trust law provides the confidence on which Jersey’s trust business relies.
The same is not true of onshore jurisdictions. While onshore judges may or may not be the equals of IFC judges in their understanding of sophisticated issues (English judges are likely to know a great deal of trust law but judges from civilian jurisdictions are unlikely to do so), even where they do, their commitment to the overall enterprise may be much weaker. For example, the UK Supreme Court’s abandonment of the rule in Hastings-Bass was preceded by multiple judges’ public attacks on the rule, including by the author of the Supreme Court’s judgment.[iii] Whatever the merits of the rule in question, these judges’ expressions of hostility to it – primarily on the grounds that they did not approve of the results in the cases where it was applied – seem inconsistent with a commitment to maintaining the legal framework on which past settlors relied in creating their trusts.
Small Is Beautiful
IFCs’ small size is the final building block in enabling credible commitments. As noted earlier, successful IFCs regularly update their legislation. This is simply not possible in onshore jurisdictions. For example, the English Companies Act is amended relatively infrequently, not because English practitioners lack suggestions on how to improve the law but because the UK Parliament lacks the time to continually legislate in any one area. By contrast, IFC legislatures regularly revisit their financial sector laws, giving them priority in consideration and setting aside even intense personal conflicts to ensure they maintain their competitive advantage.[iv]
More important than their frequency is the process by which IFC legislation is drafted. In virtually every successful IFC we have examined, amendments to financial sector legislation are the result of careful consultations between the financial industry, the regulator and the government. For example, in drafting Jersey’s trust law amendment to create a statutory Hastings-Bass rule, a committee organised with the assistance of Jersey Finance included representatives from leading law firms and trust service providers who crafted a proposal for the government, which was turned into legislation that received the Royal Assent all in less than three months. A similar consultative process would have taken much longer in a larger jurisdiction and would have lacked the trust necessary for such a close collaboration between the independent regulator, the industry and the government.[v]
Change in the law is not an end in itself. A legal framework’s stability is also an important part of the IFCs’ appeal. What is needed is appropriate change, which enhances the value of the jurisdiction’s legal system to those making use of it. Because IFCs regularly update their statutes through a collaborative process, IFCs both strengthen their statutes and avoid mistakes that would harm those who relied on the existing law. By contrast, without such consultative drafting processes, large jurisdictions may give far greater power to special interests seeking advantages as the US and UK tax codes demonstrate.
IFCs play a number of important roles in the global economy. They provide a neutral jurisdiction for multi-jurisdictional investors. They innovate in legal entities. They drive innovations in regulation that make regulators more efficient and more effective, while lowering transaction costs. All of these roles enable firms and individuals to accomplish their goals and to create and preserve wealth. One critical role that IFCs play is to solve the problem of making credible commitments to one another for transactions and entities which will endure for extended periods. IFCs are particularly well-suited to this role because they specialise in the relevant areas of law. The shadow of the future hangs over them and incentivises them to commit only to the value-adding changes that their small size can generate through deep consultation and ongoing internal collaboration.
Those seeking to restrict IFCs’ roles in the global economy rarely see beyond their focus on (often speculative) tax revenue losses resulting from tax competition with low and zero-direct tax jurisdictions. This narrow focus obscures the importance to the facilitation of firms and individuals being able to engage in transactions that fulfil the parties’ goals. Such tunnel vision is not surprising because much of what IFCs’ “customers” do falls into the category of what nineteenth-century French economist Frédéric Bastiat called the “not seen”: “In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen….”[vi]
It is easy for onshore politicians to “see” tax revenue losses, even if they are not real, because the notion that an estate would escape taxation or profits would be untaxed is readily comprehensible. What is much harder to see are the results ‘unfolding in succession’ of organising a transaction or business in an IFC – the business that continues to produce goods and services, employ workers, and pay dividends to its owners because of a careful business structure that enabled it to flourish past the death or retirement of its founder; the family whose collective wealth is prudently invested, creating yet more wealth; or the investment fund which pools sufficient resources to enable it to fund new businesses at a scale that generates real impact in lives around the world. None of those things would be possible if the participants could not make credible commitments to one another. IFCs’ ability to themselves credibly commit to a value-enhancing legal system is critical to ensuring that – even if ‘unseen’ – these important activities continue to strengthen law and regulation and make the world a better place.
[i] Briefly, the “rule in Hastings-Bass” enabled courts to, in their discretion, undo transactions by trustees where the trustee had considered something the trustee should not have considered or failed to consider something the trustee should have considered. Often used in cases where trustee errors led to substantial tax liabilities, the rule solved the problem of a trust beneficiary being harmed by a trustee’s action where the trustee’s action (or inaction) was based on incorrect advice from counsel about the consequences of action or inaction, as well as other, analogous situations. Since the beneficiary would have no remedy against the trustee’s counsel, and an action against the trustee would be difficult as the trustee would have sought advice and acted on the advice, such cases left beneficiaries vulnerable.
[ii] See IFC Regulatory Innovation: Vital to the Maintenance of a Healthy Global Financial Ecosystem, IFC REVIEW (2022); IFCs: Pioneers in Transmission of Legal Innovation (with Charlotte Ku), IFC REVIEW (2021); IFCs’ “Secret Sauce”: A Commitment to an Effective Legal Infrastructure, IFC REVIEW (2022); The Evolution of Offshore: From Tax Havens to IFCs, IFC REVIEW (April 2020).
[iii] Sir Gavin Lightman, Guest editorial on Hastings-Bass, 15 TRUSTS & TRUSTEES 184 (2009) (judge in Abacus Trust Co. (Isle of Man) v. Barr calling for a “reconsideration by an appellate court” and for courts to “sweep aside” the Rule); Lord Neuberger of Abbotsbury, Aspects of the Law of Mistake: Re Hastings-Bass, 15(4) TRUSTS & TRUSTEES 189 (2009) (“It appears that Doctor Equity can administer a magical morning-after pill to trustees suffering from post-transaction remorse, but not to anyone else” and rule is “a sort of get-out-of-gaol-free card”); Sir Robert Walker, The Limits of the Principle in Re Hastings-Bass, 13 K.C.L.J. 173 (2002) (arguing that “the unrestrained extension of the Hastings-Bass principle could lead to trustees being treated as a new class of incapacitated persons, like children or feeble-minded adults. No one could ever be sure that they had taken proper advice … or that they meant what they said.”). Such open hostility to a rule that was likely to come before them is unusual in American courts, where judicial neutrality generally requires judges refrain from such public comments.
[iv] Tony Freyer & Andrew P. Morriss, Creating Cayman as an Offshore Financial Center: Structure & Strategy since 1960, 45 ARIZ. ST. L. J. 1297, 1356-57 (2013) (“even during the periods of the greatest personal rancor in the mid-1980s, there were numerous examples of all members voting in favor of measures sought by the financial industry even as they hurled insults like ‘I call that a good communist vote’ at each other.”).
[v] Two US examples highlight this point. The Uniform Law Commission, which proposes statutes to address problems common to states, through a consultative process that involves all interest groups, typically takes years to produce its drafts, and even where it succeeds in gaining their widespread adoption, takes years to do so. Similarly, the American Law Institute, a private organisation of leading lawyers, produces restatements of the law, which serve as persuasive authority. As with the proposed uniform acts, the restatements take years, often decades, to produce.
[vi] Frédéric Bastiat, That Which is Seen, and That Which is Not Seen (1850).
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 a Professor 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.