Regulating Offshore Finance

The Cayman Islands, Bermuda, and the British Virgin Islands are famous as “tax havens” that facilitate the evasion or avoidance of domestic tax. They and a growing number of other offshore jurisdictions in the Caribbean and elsewhere are emerging hubs of modern financial transactions. While offshore jurisdictions tend to attract foreign capital with low tax rates, they may be doing much more than shortchanging the Internal Revenue Service.

In my article, “Regulating Offshore Finance,” I explore how offshore incorporation can enable commercial entities to evade federal regulatory statutes. The applicability of federal statutes and where a commercial entity chooses to incorporate seem like separate issues, with incorporation essentially a private decision on what rules will govern a company’s internal affairs and regulatory statutes a matter of public policy beyond private control.

Yet the legal residence of commercial entities can determine whether federal statutes apply. Under the recent U.S. Supreme Court decisions in Morrison v. National Australia Bank and RJR Nabisco, Inc. v. European Community, financial transactions completed through offshore commercial entities are often, though not always, extraterritorial transactions beyond the reach of federal statutes. Thus, for instance, in Cascade Fund, LLP v. Absolute Capital Mgmt. Holdings Ltd., an investment fund registered in the Cayman Islands was able to avoid federal securities fraud claims on grounds that the transaction took place extraterritorially, even though the fund solicited American investors within the United States. This jurisprudential trend makes it increasingly difficult for private litigants to bring statutory claims designed to protect the market, even in cases that are connected predominantly to the United States.

Regulatory evasion of this kind is particularly problematic, because the mandatory nature of certain statutes—for instance, parties cannot contractually stipulate to waive compliance with the anti-fraud provision of the 1934 Securities and Exchange Act—indicates that there are costs associated with certain private misconduct that are not being fully internalized by the private parties. Moreover, regulatory statutes can advance certain social policies that may conflict with private preferences.

My paper critiques the Supreme Court’s recent extraterritoriality jurisprudence as producing absurd results: the dismissal of cases where factual connections to the United States are overwhelming and there is no risk of conflict with foreign law. Consider the case of In re: Irving H. Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, currently pending before the U.S. Court of Appeals for the Second Circuit and one of dozens of high-stakes lawsuits stemming from the infamous Madoff Ponzi scheme. Readers of this blog are already familiar with Madoff’s $50 billion Ponzi scheme that he ran through his fund, Bernard L. Madoff Investment Securities (BLMIS). Madoff famously did not actually engage in any investments on behalf of his customers but sent them bogus statements showing fictitious profits. Domestic and foreign investors put money into Madoff’s fund through feeder funds formed in the British Virgin Islands and the Cayman Islands. Prior to the collapse of Madoff’s fund, the feeder funds withdrew proceeds from BLMIS’ commingled bank account and distributed them to their investors. The question before the Second Circuit—teed up by split decisions below—is whether fraudulent transfer laws, codified in the U.S. Bankruptcy Code, apply to subsequent transfers made by the feeder funds.

The Second Circuit should decline to find that offshore feeder funds between the debtor (Madoff fund) and the ultimate foreign beneficiaries render the transfers beyond the reach of the Bankruptcy Code. To conclude otherwise would make the domicile of feeder funds—essentially a fiction of paperwork—the determinative factor in the geographic reach of fraudulent transfer laws. That reality is that the chain of transfers originated in New York and many of the feeder funds were controlled and operated from the funds’ related entities located in the United States. Perhaps more important, that line of jurisprudence would create a loophole allowing private regulatory evasion, since a transfer from a domestic debtor to a foreign beneficiary could be immunized from recovery if made through a foreign entity.

More broadly, litigators working on cases involving offshore commercial entities ought to pay close attention to whether any conduct or decisions occur offshore. For instance, a very high percentage of corporate entities registered in offshore financial havens are “exempted” or “excepted” entities under the laws of those jurisdictions, formed for the express purpose of doing business outside of those jurisdictions. The status of these entities is important, because an array of financial dealings involving offshore entities do not involve conduct or decisions in offshore jurisdictions. That ought to matter when judges decide whether a transaction should be governed by domestic law.

Offshore financial transactions should force legal scholars to rethink conceptions of the law that presuppose a link between contact with a territory and its lawmaking authority. Today, territorial contact with a jurisdiction does not necessarily determine whether that jurisdiction has an interest in applying its law to a dispute related to that contact. Forming a feeder fund in the Cayman Islands, for instance, typically entails maintaining a P.O. Box shared there with hundreds if not thousands of other entities. This form of territorial contact with the Cayman Islands does not necessarily trigger the sovereign interest of the Cayman Islands to regulate conduct involving the feeder fund. Fixating on the location of a particular transaction, moreover, where the transaction takes place either in multiple places or electronically, results in arbitrary and inconsistent decisions. At worst, it creates loopholes for private actors to opt out of mandatory laws of the United States that are in part designed to safeguard the public interest.

Offshore jurisdictions should be taken seriously as financial havens that private entities can use to duck domestic regulatory statutes. It’s worth carefully watching to see whether federal extraterritoriality jurisprudence will continue to enable this trend.

This post comes to us from Will Moon, an acting assistant professor at NYU School of Law. It is based on his recent article, “Regulating Offshore Finance,” available here.

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