Managing Regulatory Arbitrage: A conflict of laws approach

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Last week I presented a new paper at a Private International Law conference held at Duke Law School.  My paper proposed a conflict of laws approach to managing regulatory arbitrage.   The advantage of this approach  is that it provides a more nuanced, sophisticated,  and nevertheless manageable approach  to answering questions like, “when should so-called host regulators of a global systemically important financial institution differ to so-called home regulators, and vice versa?” A further advantage is that it requires no new legislation, no new agreements to be hammered out at global conferences of regulators, nothing but the more forceful and creative application of laws that are already part of the legal systems of all of the nations in which major financial centers are found. Hence is it it is almost hard to believe that these legal tools have not yet been deployed. The explanation is a story of silo thinking: specialists in the conflict of laws know very little about financial regulation, and on the whole confined themselves to examples such as inheritance, marriage, land disputes, and the like. For their part, financial regulation experts know next to nothing about the conflict of laws, if they are even aware of the doctrines existence.

Here is the basic argument in a nutshell:

The 2008 financial crisis began with traders within the UK subsidiary of American international group (AIG) engaging in trading activity that was largely beyond the reach of US regulators, despite the fact that the US parent institution, and hence the US economy, was on the hook for actions in that subsidiary.  Since the 2008 crisis, regulators have worked hard through the G20, to address the differences in regulation that made AIG’s traders’ actions possible in the first place. How have the markets responded? The new rules hammered out at the G20 apply to banks.  So financiers has simply found ways of booking their transactions through institutions that are not banks, and hence are not subject to the G 20s rules.  In both cases – – the regulatory challenge of AIG, and the regulatory challenge of shadow banking – – we have conduct that is somehow beyond the reach of regulators, conduct that threatens the sovereignty of nationstates, and threatens the well-being of national economies.  This is the problem of so-called regulatory arbitrage: in both examples, the regulatory challenge is part of the business model. The very purpose of booking the transaction offshore, or through a kind of entity that is not subject to particular kind of regulation, is to circumvent regulatory authority.

For financial economists, arbitrage is not inherently a bad thing. On the contrary, we often hear financiers themselves make arguments for the economic importance of their activity by claiming that it is arbitrage, not speculation (see, e.g., Bernstein 1993; P. Harrison 1997). And indeed, the reasoning that enables arbitrage is one of the great singular achievements of economic thought. In arbitrage, we see similarities across what looks at first glance like differences: a basket of stocks and an index, golf course memberships and yacht club memberships, the rules of one legal system and those of another. And indeed, the investment strategy behind regulatory arbitrage is exactly the same as a strategy in other kinds of arbitrage. An investment opportunity is created by a discrepancy in the price of the investment – – perhaps the investment is outright prohibited in one jurisdiction, and hence its price is infinite, or perhaps the penalties, or the odds of getting caught or prosecuted, differ from one jurisdiction to another.

So what is the problem with regulatory arbitrage? Simply put, investment activity that has profound effects in one state or market is beyond that states regulatory reach. Commentators have surmised that this can create a race to the bottom effect as investors choose the most favorable rules simply by choosing to frame their transactions in terms of one locality or one legal form or another. Often, moreover, the most favorable rules are not even the rules of any particular nationstate. They are rules created by market participants themselves, the private market associations such as the international swaps and derivatives Association, and enshrined in contracts which are then deemed enforceable by nationstates even though the rules created by market participants are not socially optimal for any of the nationstates that enforce the contracts.

Why have nation-states proven so incapable of addressing regulatory arbitrage? We might say that the law has been perennially one step behind financial arbitrage in its ability to grasp  functional similarities across national differences, and coordinate among legal differences. In the cat and mouse game between regulators and financiers, it often seems that finance is the more creative partner, always one step ahead. Yet remarkably, the laws most sophisticated tool for thinking about how to coordinate among regulatory differences has yet to be deployed at all in discussions of global financial regulation. That tool is the technical, arcane, genius of a field known  in the civil law world as private international law or, in the  common-law world as the Conflict of Laws.  The conflict of laws is the body of law that determines what law should apply  in situations  in which more than one sovereign can arguably lay claim to a problem. What law governs a contract between a bank in London and another bank in the Cayman Islands concerning assets in Singapore, and executed over the Internet? The answer is found in the conflict of laws. In other words, “Conflicts” is a body of law that addresses a question that has been largely ignored in global financial regulatory debates–the question of the question of the allocation of authority across regulatory regimes and hence of the scope of national, international, and non-state regulation: how far does each regulatory extend, and what should be done when these overlap?

Regulators or market participants who make a claim about the application of one or another body of law to a given party or transaction are in fact making an implicit claim about private international law. For example, the application of the ring fence contains an implicit invocation of a territorial principle of private international law, in which the territorial location of an asset determines the relevant regulatory authority.

 

The Conflict of Laws Alternative

There is an alternative to harmonizing substantive regulation on the one hand or devolving into regulatory nationalism on the other.  This alternative approach to regulatory coordination at the international level could significantly reduce the possibility of regulatory arbitrage without incurring the risks associated with harmonization. This alternative also has the signal benefit of not requiring changes to national law that in turn provoke domestic  interest group politics of the kind seen recently in the United States and elsewhere.

The conflict of laws approach to international regulatory coordination, developed over centuries since its origination in the context of the need for stable trade relations after the fall of the Roman Empire, rejects at the outset international substantive harmonization as a utopian pipe dream. Rather, it accepts that regulatory nationalism is a fact of life, and therefore sets for itself the more modest goal of coordination among different national regimes. In other words, the approach of this body of law is not to define one set of rules that apply for all, as in the case of public international law, but rather simply to define under what circumstance in particular dispute or problem shall be subject to one state’s law or another. One can think of this as global regulation “in the meantime” prior to our achieving the utopian ideal of pure international integration.

Attention to the rules and processes that should govern the allocation of regulatory authority among overlapping sovereigns is not just a second best approach, however. There are many advantages to this approach.   First, it takes an agnostic view of the very possibility of a singular overarching “right answer” to the question of what the rules of regulation should be. The doctrines of conflict of laws instruct judges always to be aware that their own perspective is a situated one, a partial one, and that a judge elsewhere in another jurisdiction could and most likely would think of the dispute at hand in different terms. This pluralistic orientation, this attention to differences in approaches, speaks directly to a significant weakness in G 20 led efforts at global financial regulatory harmonization.  Although the G 20 has made significant progress in becoming more inclusive, it still remains something of a North Atlantic club, at considerable cost to its own legitimacy.   The conflicts decision, in contrast, does not suffer from this kind of legitimacy gap because it claims to be nothing more than it is one particular possible view of the issue among many.

Another advantage to the conflict approach is that it is case driven, and hence builds coordination from the ground up rather than from the top down. Cases are presented to courts as they develop, and hence immediate problems can be addressed now, rather than waiting for long-term harmonization. This ground-up approach also has the important benefit of allowing for greater participation in the process of generating consensus, since cases are defined and argued by the litigants themselves, through their legal representatives. This address is another major weakness of the G 20 approach, which still assumes that nationstates speak of one voice and hence that national negotiators adequately represent the national interest – – public and private. Market participants have severely critiqued this model for the way it excludes private actors from the negotiating process. Yet beyond this weakness, it also fails to account for the way a state may encompass a number of regulatory authorities, a number of jurisdictions, and hence a number of regulatory philosophies.

A third advantage of a conflict of laws approach is that, in contrast to substantive regulatory standards, they are actually already is considerable agreement on the formal rules of private international law or conflict of laws.  Some difference of philosophy exists between the American approach, on one end of the spectrum, and the civil law approach, on the other. Yet on the whole, a great deal is already shared. For this reason, some legal commentators have suggested that the conflict of laws may serve, in a parallel way, as a tool of unification within the European Union, where substantive unification seems out of reach.

 

Yet what is perhaps most intriguing about conflict of laws is also perhaps what accounts for the fact that it has been ignored as a tool of global financial regulation: it is a highly technical body of law, with an  intricate and fine grained set of doctrines, arguments, and rules evolved over many centuries.  The technical quality of the field surely makes it intimidating to some – – the esteemed judge Weinreb  famously said: “if I want the parties to settle a dispute I say boom there must be a conflict of laws issue in this question.” Yet the very technical quality of conflicts provides a vocabulary or a register for moving beyond overt politics in discussions of difficult international questions.  Conflicts turns political questions into technical ones.

Although conflict of laws doctrines are normally imagined as in the context of judicial decision-making, in fact there is nothing that limits conflicts thinking to the judicial sphere. Legislatures can and often do make conflicts rules – – as when they write the scope of a law into the text of the law itself. Private parties also make conflicts rules, in the context of private agreements. And whether they recognize it or not, national financial regulators are making conflicts decisions already every day. For example, the much-maligned decision of some national regulators to make use of “ring fences” at times of crisis is in fact an assertion on the part of these regulators that they have legal authority over certain assets  under certain conditions by virtue of the fact that those assets are located physically within their territory (Buxbaum 2009). Of course, territory is only one possible basis for regulatory authority among many in private international law, including, for example, a choice of law made by the parties, the location of a certain parties’ headquarters, or the impact of a given transaction on a particular national market. When the US CFTC  asserts authority to regulate foreign brokers and dealers who enter into transactions with US customers, it is making an implicit conflict of laws argument that regulatory authority should be allocated according to the domicile of the buyer.

From one point of view, of course, the usage of the ring fence is evidence of a failure of global harmonization, as it is a choice not to cooperate internationally. Yet from another point of view, it is also an assertion of a certain theory about the proper allocation of regulatory authority in a global context, and it is a practical choice of an alternative method of global coordination.  From this latter point of view, legal moves such as the ring fence are practical instantiations of an institutional alternative to global harmonization through international conferences.  They become all the more important in the current condition in which, at least in the short-term, there is insufficient substantive agreement about globally harmonized regulatory standards. What is perhaps more troubling is that such assertions are made in ad-hoc, largely unprincipled ways, without recourse to a shared technical set of rules or standards that would determine when such a claim might be legitimate or when it is not. A grammar of argumentation informed by Conflicts principles, in contrast, would provide structure and regularity to such episodes of international regulatory conflict.

The full-length paper demonstrates the utility of the conflicts approach with respect to one particular high-profile case of overlapping regulatory authority, the question of the US SEC’s case against Goldman Sachs trader Fabrice Tourre. Let me simply point out some of the advantages of the Conflicts approach for addressing cases such as this one.

One of the fundamental insights of private international law is that questions of jurisdiction and questions of choice of law are divisible inquiries. What this means is that simply because a given regime has the power to govern a certain issue (just because it has jurisdiction) does not mean that it should do so (choice of law). In certain circumstances, it might be more appropriate for it to defer to another regulatory authority and apply that authority’s rules if, for example, the parties have stipulated among themselves that a different law should apply to their transaction and it is appropriate to defer to the will of the parties, or again if another regulatory authority has a greater interest in the matter.  Hence UK courts routinely apply the laws of other nations pursuant to their own conflicts rules, for example.  A second and equally fundamental starting insight of this discipline is that the answer to such questions turns on very contextually-specific inquiries.  What other regulatory authority is involved? How different are the rules and principles of the two possible authorities? Who are the parties? What is the nature of the transaction? What state and private interests are implicated?

This approach may provide a means of addressing concerns about regulatory arbitrage through means other than imposing uniform regulatory standards on all jurisdictions.  As we saw,  regulatory arbitrage depends on access to market participant-driven conflict of laws rules–it depends on market participants’ confidence that simply by mandating in their contractual agreements that a certain law will apply, or simply by moving assets or even corporate headquarters from one jurisdiction to another, they will be able to avail themselves of that jurisdiction’s rules.

Yet a sophisticated conflict of laws analysis might not guarantee such clear outcomes.  For example, there may be cases in which a court or a regulator would refuse to defer to the parties’ choice of law, or when, notwithstanding that certain assets are located in, say, the Cayman Islands, a regulator elsewhere would determine that it is legally permissible and appropriate to exercise authority over those assets.  Simply introducing such regulatory complexity into the equation makes it much less easy for market participants to play one jurisdiction against another with threats of regulatory arbitrage. Ironically, it might also encourage private sector commitment to the cause of creating harmonized rules, and thus feed into the success of the FSB’s wider project.

Conflicts-style reasoning need not be the province of courts alone.  The principles could equally be deployed, in an analogous way, by regulators seeking to answer for themselves the question of what their policy should be regarding the reach of their regulatory authority and its relationship to other regulatory authorities.  The value of such an approach is that it builds agreement in a highly practical way, from the ground up, beginning from where we are, in the present moment, from diversity of regulatory practice and seeking to define the scope in which diversity can be accommodated, rather than beginning from a rather utopian and top-down search for global uniformity.

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