Offshore Regulation: A Game Plan for the Cayman Islands?
Published in IFC Review December 2011
With the network of Tax Information Exchange Agreements in the Cayman Islands well above the minimum OECD requirement and with that jurisdiction setting the example of proactive reporting under the European Union Savings Directive, Mr Pascal Saint-Amans, the head of the OECD, declares he is now satisfied at the tax compliance shown by the offshore jurisdictions and is finally prepared to tell "the true story". President Sarkozy, on cue, announces that the expression ‘tax havens’ should be reserved for jurisdictions that fail to meet the transparency test, including Liechtenstein, Panama and Switzerland (but not, interestingly, Monaco).
It should therefore be evident to even to the most rabid supporter of the Tax Justice Network that they will need new definitions; tax transparency in that bastion of offshore financial centres, the Cayman Islands, other Overseas Territories and the Crown Dependencies has been established to a standard that far exceeds that demonstrated in a number of G20 jurisdictions. But is this then a time for quiet reflection whilst the G-20 political machine focuses on more relevant issues? I doubt it. No doubt the cross hairs remain firmly targeted on the offshore world, all the more so due to the enhanced regulatory initiatives which are now in effect and planned for the United States and Europe.
But whereas there existed some framework in securing tax transparency, that is to say a largely international accord to the effect that tax evasion should be eradicated, there exists no similar consensus on the question of what constitutes effective offshore regulation.
The debate such as it is in relation to the offshore jurisdictions is characterised by references to "dark pools of unregulated capital", monies that are "stashed" in offshore jurisdictions and the "systemic risk" that necessarily follows from jurisdictions like the Cayman Islands providing the domicile to some 9,750 of the world's hedge funds.
We find therefore the same misconceptions, misunderstandings and outright misrepresentations in the area of offshore regulation as characterised in the commentary from the OECD, the FATF and even the IMF on the issue of tax transparency. It is cold comfort that much of this comment in the tax transparency debate is now shown to have been ill considered; the battle rages on. The international bodies do not indicate any intention of retreating, they simply seek to advance in a different direction.
But this ill founded criticism of offshore regulation needs to be looked at critically if the offshore jurisdiction is to establish a meaningful legislative and regulatory response. A start point is that no financial institutions failed in the Cayman Islands during the financial crisis. Secondly, before embarking on any additional regulation, some analysis should be undertaken on the possible adverse effects of increased regulation in the context of the circumstances affecting offshore financial services industries. That analysis should precede any determination as to what may be appropriate by way of increased regulation and should seek to arrive at a balanced conclusion by evaluating the positives, if any, and the negatives of such proposals. Comments typified by the suggestions that ‘greater transparency’ is required and that any regulatory proposal is thereby justified are inadequate without some evaluation. Given the full regulator to regulator disclosure that exists in Cayman under the IOSCO rules, the questions are greater transparency in relation to what and in favour of whom?
Inappropriate regulation reduces the attraction of a financial services centre. As with taxation, it increases cost and delay and disincentivises users, particularly when faced with more attractive competitor jurisdictions.
Indeed, it may be said that since the advent of tax transparency, the twin cornerstones, the absence of taxation and the absence of inappropriate regulation, are the two fundamental drivers of the Cayman Islands financial services industry. Accordingly, if it is accepted that inappropriate regulation has a negative effect on public and private sector revenues, it necessarily follows that very careful consideration must be given to what constitutes appropriate regulation.
By way of comparison, it is now becoming widely recognised that the imposition of the Dodd-Frank legislation in the United States together with the impending FATCA legislation has had a highly negative effect on the United States financial services industry to the point where there are now wide spread suggestions that the entire Dodd-Frank regulatory initiative may be repealed and significant exemption be given under Sarbannes Oxley. Mistakes of this magnitude and effect are not ones that the Cayman Islands financial services industry can afford in the current environment.
There is a further preliminary but fundamental point that requires a higher level of focus than has been demonstrated in the discussion to date. Offshore finance vehicles do not trade in the offshore jurisdiction, they trade in the jurisdictions where the markets operate and in those jurisdictions there is or should be pre-existing regulation to which the assets in question are already subject. Accordingly, it is meaningless, but potentially dangerous, to simply adopt or make reference to onshore regulation as being of application in the context of an offshore jurisdiction. It follows that offshore legislation and regulation must be specific to the requirements of the offshore jurisdiction's financial service industry and must take into account onshore regulation, which has already been applied to the assets in question. For this reason alone, the reference to Cayman Islands funds causing ‘systemic risk’ is flawed; the assets in question, to take a specific example, invested through a UK resident fund manager will already have been subject to FSA regulation.
Accordingly, it is simply not possible to apply onshore regulation in the context of an offshore financial services industry without first demonstrating some greater understanding of the manner in which the offshore vehicle functions in practice. Certainly, a higher level of understanding is currently demonstrated by the comments of various international bodies. If that point is not well understood, potentially duplicative regulation will be the inevitable and highly damaging outcome.
In addition, before determining whether proposed regulation is appropriate, some consideration should be given to its source and whether the rationale is technical or political. By way of example, a widely held private sector and government view in the United Kingdom is that certain of the proposed European Union regulatory initiatives, the Financial Services Tax and the European Union Alternative Investment Funds Directive, if enacted in current form, are likely to cause harm to the financial services industry in the City and may result in an exodus of financial services from Europe. In short the initiatives are simply political in nature. Mr Barnier, the EU Commissioner for Internal Markets and Services, it should be remembered, stated to his eternal discredit that he could not care if the EUAIFMD caused unemployment in the City of London. This cause and effect, however, is of considerable interest to us in the Cayman Islands. Analysis should be undertaken of the source and rationale, and regulations driven by pure political aspiration analysed as such.
It is correct that in respect of the Cayman finance services industry, over 90 percent of EU fund managers of Cayman Funds are situate in the City and currently within the EU and therefore subject to the vagaries of the EU regulatory process, but it is also common knowledge in the industry that the well advised UK situate fund manager has in place contingency plans to relocate outside of the EU. That then too becomes a highly relevant factor to be taken into account before automatically considering the application of the EUAIFM Directive.
It follows from the foregoing that there should be some discipline introduced into the consideration of onshore regulatory initiatives that takes into account what is essential and what is not, what may be of benefit and what is not. It is a self evident proposition that regulators believe that the answer to failed regulation is increased regulation.
Furthermore, it falls to discount and distinguish self interested proposals from private sector representatives and industry bodies that seek to increase fee income with proposed regulation that is duplicative or provides no other discernible benefit.
It is submitted that there are three tests that should be applied, one of which must be met before consideration is given to introducing new regulation in the offshore jurisdiction.
The regulation must:
- Be seen to meet a specific and evidenced regulatory failure and not merely a perceived concern;
- Conform to a globally imposed regulatory standard without which the offshore jurisdiction could not provide the relevant financial services product;
- Provide a clear and obtainable benefit in favour of the offshore jurisdiction's financial services industry. ‘Obtainable’ for these purposes means that the proposed regulatory amendment or revision does not contravene any pre-existing globally established applicable regulatory regime.
And in any of the above cases:
- The regulation should not be duplicative of existing law or regulation;
- The regulation should not increase costs to users of the offshore financial services industry unless the additional regulation adds in the minds of those users a recognized and discernable correlative benefit.
In considering new regulation against these tests, we should consider what is meant by a global regulatory standard. There is a very distinct difference with respect to regulatory initiatives emanating from the European Union as against what may be considered appropriate or necessary by way of regulation in the United States, Australasia, or Central and South America.
By way of specific example, we can consider the distinction that existed between the need to deflect an OECD initiative to blacklist for non tax transparency on the one hand and any other regulatory initiative currently emanating from Europe, the OECD or the FATF in respect of which there is no global accord.
It should be remembered that of the four tests laid down in the European Union driven 1998 OECD Report on Harmful Tax Competition, it was only the requirement for tax transparency which found favour with the United States Treasury Department and therefore, the abolition of tax evasion became an internationally accepted standard and one with which the Cayman Islands was obliged to comply. The same could be said for the Basel Banking accords regardless of their lack of effect. Both, by way of example, clearly meet the tests laid down in Point 2 above. However, it is certainly not the case that current regulatory initiatives mentioned above being suggested by European Union bodies will find favour globally.
Applying the above tests, it seems only to be the case that European Union sponsored regulation should be considered for introduction in the Cayman Islands both if it meets a globally accepted standard imposed on a global basis and without which an essential part of the Cayman Islands financial services industry cannot function.
In considering regulation a little should be said about the ‘systematic risk of offshore funds. Apart from the fact that the assets in question will trade through an onshore regulated entity, there is a substantial body of opinion in the private sector that considers that hedge funds do not occasion such risk. Accordingly, the question of whether various EU bodies are sound in seeking to rely on the assumption that funds occasion systemic risk must be evaluated. If they do not, there is no basis for further regulation.
It is not surprising that the various EU bodies do not produce evidence to support the assumption that ‘funds cause systemic risk’. The evidence is that they do not. This is not simply evidence suggested by the Alternative Investment Managers Association but is supported entirely by the findings of the UK regulatory body, the Financial Services Authority (the FSA), in its February report "Assessing Possible Sources of Systemic Risks from Hedge Funds" dated February 2010 which concludes:
- That hedge funds did not prove a potentially destablising credit counterparty risk
- That hedge funds show a 'relatively low level of leverage".
- There was no clear 'evidence' that any hedge fund posed a significant systemic risk.
By way of summary, it is worthy of note that in arriving at these conclusions, the FSA after actual research forms a totally contrary view to the politically motivated comments of EU regulators. It follows by way of conclusion that great care must be attached in analysing the source of regulatory recommendations and measures taken to discount politically motivated commentary dressed in the guise of an accepted regulatory initiative. It is suggested that application of the above tests will serve as an appropriate start point by which to measure any proposed regulatory initiative in the offshore jurisdiction and that additional regulation should not proceed whether by way of legislation or otherwise unless the objective application of the tests suggests a clear imperative.
There is a disingenuity about much of what is claimed in relation to the need for regulation in the offshore financial jurisdictions. Those jurisdictions need to be prepared to accept regulation which is relevant and appropriate and based on a sound understanding of the fundamentals and disregard the rest.