FFoorrddhhaamm JJoouurrnnaall ooff CCoorrppoorraattee && FFiinnaanncciiaall LLaaww Volume 22 Issue 4 Article 2 2017 RReegguullaattoorryy AArrbbiittrraaggee aanndd HHeeddggee FFuunndd RReegguullaattiioonn:: TThhee NNeeeedd ffoorr aa TTrraannssnnaattiioonnaall RReessppoonnssee Hossein Nabilou Faculty of Law, Economics and Finance, University of Luxembourg, [email protected] Follow this and additional works at: https://ir.lawnet.fordham.edu/jcfl Part of the Finance and Financial Management Commons, and the Law Commons RReeccoommmmeennddeedd CCiittaattiioonn Hossein Nabilou, Regulatory Arbitrage and Hedge Fund Regulation: The Need for a Transnational Response, 22 Fordham J. Corp. & Fin. L. 557 (2017). Available at: https://ir.lawnet.fordham.edu/jcfl/vol22/iss4/2 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Journal of Corporate & Financial Law by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. RReegguullaattoorryy AArrbbiittrraaggee aanndd HHeeddggee FFuunndd RReegguullaattiioonn:: TThhee NNeeeedd ffoorr aa TTrraannssnnaattiioonnaall RReessppoonnssee CCoovveerr PPaaggee FFoooottnnoottee Faculty of Law, Economics and Finance, University of Luxembourg; LL.M., University of Pennsylvania Law School; E-mail: [email protected]. The author is grateful to Alessio M. Pacces for his comments on earlier drafts of this Article and the members of the editorial board of the Fordham Journal of Corporate & Financial Law for their seamless and painstaking editorial diligence and their insightful comments on this Article. All errors are my own. This article is available in Fordham Journal of Corporate & Financial Law: https://ir.lawnet.fordham.edu/jcfl/vol22/ iss4/2 REGULATORY ARBITRAGE AND HEDGE FUND REGULATION: THE NEED FOR A TRANSNATIONAL RESPONSE Hossein Nabilou* Regulatory arbitrage is an indispensable element of regulatory competition as it provides regulatory substitutes for firms, and allows those firms to optimally benefit from such competition. This also increases the elasticity of demand for regulators and engenders accountability among them. Hedge funds, as paragons of exploiting regulatory discrepancies, are heavily criticized for thwarting efforts to address systemic risk. This Article investigates the arbitrage-seeking behavior of hedge funds in a globally-fragmented financial regulatory framework. Despite its benefits, regulatory arbitrage involves certain costs. Although market discipline can constrain these negative externalities, due to certain idiosyncratic features of the hedge fund industry, such as the sophistication of investor base, operational mobility, higher attrition rate, and lack of transparency, market discipline by itself cannot fully limit the potential externalities of regulatory arbitrage by hedge funds. These features weaken market signals and reduce the reputational benefits of being subject to greater regulatory oversight. The lower reputational costs and broad private investor exemptions in turn reduce the overall costs of regulatory arbitrage for hedge funds in comparison to other financial services providers and mainstream financial institutions, and make it more likely for hedge funds to engage in regulatory arbitrage. In a departure from mainstream research, which recommends regulatory coordination, cooperation, harmonization, and consolidation as legal remedies to address problems originating from regulatory arbitrage by hedge funds, this Article argues that such proposals are at best misguided and at worst systemic risk amplifiers. * Faculty of Law, Economics and Finance, University of Luxembourg; LL.M., University of Pennsylvania Law School; E-mail: [email protected]. The author is grateful to Alessio M. Pacces for his comments on earlier drafts of this Article and the members of the editorial board of the Fordham Journal of Corporate & Financial Law for their seamless and painstaking editorial diligence and their insightful comments on this Article. All errors are my own. 557 558 FORDHAM JOURNAL [Vol. XXII OF CORPORATE & FINANCIAL LAW Instead, this Article suggests that to reduce the likelihood of regulatory arbitrage, instead of regulating hedge funds directly, the strategies for regulation should focus on indirect regulation of the funds through their counterparties, creditors, and investors for whom reputational costs of regulatory arbitrage tend to be significantly high. TABLE OF CONTENTS  INTRODUCTION ............................................................................ 558  I. REGULATORY ARBITRAGE: CONCEPT AND DYNAMICS ........... 562  II. CAUSES OF REGULATORY ARBITRAGE .................................. 566  A. DIFFERENTIAL REGULATORY TREATMENT OF HOMOGENOUS FINANCIAL ACTIVITIES .................................................... 566  B. FINANCIAL MARKET COMPARTMENTALIZATION ............... 567  C. REGULATORY COMPETITION ............................................. 573  D. PARTIAL INDUSTRY REGULATION ..................................... 578  E. DEFINITIONAL PROBLEMS: LEGAL INTERPRETATION AND REGULATORY ARBITRAGE .............................................. 580  III. ADDRESSING REGULATORY ARBITRAGE: MARKET LIMITS VS. PUBLIC POLICY RESPONSES ................................................ 583  A. DO MARKETS LIMIT REGULATORY ARBITRAGE? .............. 584  B. SHORTCOMINGS OF MARKET FORCES IN ADDRESSING REGULATORY ARBITRAGE BY HEDGE FUNDS .................. 586  1. Legal Placebo Effects and Hedge Fund Reputational Concerns .................................................................. 587  2. Attrition Rate in the Hedge Fund Industry and Reputational Concerns ............................................ 588  3. Transparency and Reputational Concerns in the Hedge Fund Industry ........................................................... 591  IV. PUBLIC POLICY RESPONSES TO REGULATORY ARBITRAGE BY HEDGE FUNDS ...................................................................... 595  CONCLUSION ................................................................................ 602  INTRODUCTION In regulation of economic activities, the alternatives are no longer between the two polar extremes of laissez-faire capitalism and government-central planning.1 The complexity of the modern financial 1. SANFORD IKEDA, DYNAMICS OF THE MIXED ECONOMY: TOWARD A THEORY OF INTERVENTIONISM (2003). 2017] REGULATORY ARBITRAGE AND 559 HEDGE FUND REGULATION system offers no viable solution other than a mixed economy within which private enterprises and the government must cooperate in order to shape economic incentives meaningfully. One of the challenging problems arising from having a mixed economy in place is determining where to draw the line between regulated markets and unregulated markets, and between lightly-regulated and heavily-regulated markets.2 The discussion around hedge funds cannot be separated from their traditional development as private investment companies that have been granted special exemptions by regulatory systems due to their private status and high tolerance for risk. In addition, the globalization of financial markets poses serious challenges to regulatory regimes and their responses to address potential systemic effects of investment funds. Hedge funds are one of the global players of the investment world. However, their regulatory framework remains local. The cross-border reach of the modern trading infrastructure and the existing patchwork of financial regulatory regimes enables circumvention of the specific mandates of individual regimes in a globally-fragmented financial regulatory system. The regulatory arbitrage opportunities arising in this fragmented regulatory framework coupled with economic firms’ desire to maximize their profits by reducing their regulatory costs incentivize exploitation of discrepancies. Hence, fragmented regulatory systems not only lead to the comingling of regulated economic activities with unregulated ones,3 but also result in regulatory arbitrage. Regulatory arbitrage has as long a history as regulation itself and is as ubiquitous as economic regulation. The first instances of regulatory 2. See generally Charles Goodhart, The Boundary Problem in Financial Regulation, 206 NAT’L INST. ECON. REV. 48 (2008). 3. James W. McKie, Regulation and the Free Market: The Problem of Boundaries, 1 BELL J. ECON. & MGMT. SCI. 66 (1970). 560 FORDHAM JOURNAL [Vol. XXII OF CORPORATE & FINANCIAL LAW arbitrage are documented in the context of medical ethics4 and taxation.5 In financial markets, the well-known example of religious prohibitions on interest sparked huge regulatory arbitrage activities. The advent of instruments such as murabaha transactions and ijara wa iqtina (leasing and promise to gift) in Islamic finance,6 and of mechanisms such as dry exchanges (cambio secco) and discretionary deposits7 was to circumvent the ban on riba8 in Islamic finance and interest in Christianity.9 Regulatory 4. Durant reports about the widespread presence of tax evasion in ancient Greece. WILL DURANT, THE LIFE OF GREECE: THE STORY OF CIVILIZATION, VOL. 2 (2011). The great lawgiver of ancient Athens, Solon, was criticized on the account that the strong and the clever could escape his laws by twisting those laws to their advantage. Id. It is also well-documented that the Hippocratic code of medical ethics regarding abortion was systematically circumvented by physicians outsourcing the practice to midwives. Id. The modern equivalence of midwives in finance are the special purpose vehicles (SPVs) designed to enjoy the exceptions from certain bankruptcy requirements (bankruptcy- proof financing). 5. Not so far from Greece, Bartlett illustrates how differential tax treatment of citizens (especially small landowners) and slaves in the Roman Empire induced regulatory arbitrage. Bruce Bartlett, How Excessive Government Killed Ancient Rome, 14 CATO J. 287, 300–01 (1994). Since landowner citizens were heavily taxed and slaves were tax exempt, the citizens used to change their civil status from citizen to slave to avoid excessive taxation. Id. He notes how, despite increases in tax rates, the tax revenues decreased, which in turn contributed to the further decline of the Roman Empire. Id. 6. Michael S. Knoll, The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage, 87 OR. L. REV. 93, 103-04 (2008). It is also argued that most Islamic finance instruments were invented to circumvent the restrictions that Sharia law places on riba (interest) and gharar (excessive uncertainty) in financial contracts. See MAHMOUD A. EL-GAMAL, ISLAMIC FINANCE: LAW, ECONOMICS, AND PRACTICE (2006). 7. See generally TIM PARKS, MEDICI MONEY: BANKING, METAPHYSICS AND ART IN FIFTEENTH-CENTURY FLORENCE (2013). 8. In Islamic finance, it is believed riba is different from interest. See generally ABD AL-RAHMAN AL-JAZIRI, AL-FIQH ‘ALA AL-MADHAHIB AL-ARBA’AH (1986); TIMUR KURAN, THE LONG DIVERGENCE: HOW ISLAMIC LAW HELD BACK THE MIDDLE EAST (2011). 9. Ferguson demonstrates how Jews dominated the financial markets of medieval Europe by interpreting the Bible in a certain way to circumvent its ban on interest. See NIALL FERGUSON, CIVILIZATION: THE WEST AND THE REST (2011). Kuran illustrates how indigenous Christians and Jews of the Middle East dominated the most profitable economic sectors in the region, especially in banking and insurance, through the choice of law. Timur Kuran, Why the Middle East Is Economically Underdeveloped: Historical Mechanisms of Institutional Stagnation, 18 J. ECON. PERSP. 71, 72 (2004). Such a freedom to choose to be subject to their own laws enabled them to escape the restrictions posed by Islamic economic institutions while Muslims themselves lacked such an option. 2017] REGULATORY ARBITRAGE AND 561 HEDGE FUND REGULATION arbitrage reached its zenith in the globalization and information age.10 In modern times, the globalization of trade and finance gave traders more informational advantages. Coupled with the absence of global coordination, such a trend amplified the likelihood, magnitude, and frequency of regulatory arbitrage.11 A hedge fund can be defined as a privately organized investment vehicle “with a specific fee structure not widely available to the public, aimed at generating absolute returns irrespective of market movements (alpha)12 through active trading and other strategies.”13 Hedge funds are Id. Indeed, it was impossible for Muslims to convert (punishable by death sentence) to another religion (restructure the business entity) and take advantage of other regulatory jurisdictions. Id. However, such a reorganization or change in civil status was allowed in the Roman Empire. Id. 10. Indeed, globalization decreased regulators’ power by harnessing more regulatory arbitrage opportunities for firms that did not prefer the regulatory policies of their jurisdiction. Jonathan R. Macey, Regulatory Globalization as a Response to Regulatory Competition, 52 EMORY L.J. 1353, 1357 (2003). 11. More recently, it was argued that regulatory arbitrage was one of the main reasons for the fall of the Glass-Steagall wall in 1999. Viral V. Acharya, Paul Wachtel & Ingo Walter, International Alignment of Financial Sector Regulation, in RESTORING FINANCIAL STABILITY: HOW TO REPAIR A FAILED SYSTEM 368 (Viral V. Acharya & Matthew Richardson eds., 2009). In China, since there have been strict restrictions on lending within the country (China’s benchmark interest rate being 6%, while the same rate in Hong Kong being 0.5%), Chinese companies use trade finance instruments to borrow money offshore at much lower interest rates. See Wei Shen, Competing for Renminbi: Financial Centers in the Context of Renminbi Globalization, in RECONCEPTUALISING GLOBAL FINANCE AND ITS REGULATION 198, 198-99 (Ross P. Buckley, Emilios Avgouleas & Douglas W. Arner eds., 2016). The regulatory arbitrage activities are not limited to the prohibitions or caps on interest rates; it would happen in any other context. For example, the recent tightening and enforcement actions against banking secrecy laws might result in the rise of organizations offering alternative unreported channels for funds. Such restrictions on banking might even create incentives for firms to relocate the deposits to the least compliant bank havens.. See Ruth Plato- Shinar, Cross-Border Banking: Reconceptualising Bank Secrecy, in RECONCEPTUALISING GLOBAL FINANCE AND ITS REGULATION 249 (2014); see also Niels Johannesen & Gabriel Zucman, The End of Bank Secrecy? An Evaluation of the G-20 Tax Haven Crackdown, 6 AM. ECON. J. 65, 65 (2014). 12. The alpha measures the excess return of a fund relative to a benchmark index. Simply put, the alpha shows by how much a hedge fund outperforms the markets, which can serve as a measurement of managerial skill. See William A. Roach Jr., Hedge Fund Regulation: “What Side of the Hedges Are You on?”, 40 U. MEM. L. REV. 165, 166 (2009) (arguing that generation of returns is one of the significant features of hedge funds). 13. For a definition of hedge funds, see Hossein Nabilou, The Conundrum of Hedge Fund Definition, 14 EUR. COMPANY & FIN. L. REV. 149 (2017). 562 FORDHAM JOURNAL [Vol. XXII OF CORPORATE & FINANCIAL LAW historically viewed as paragons of exploiting regulatory discrepancies. Moreover, the recent global financial crisis triggered a debate about their contribution to the event. Thus far, there is plenty of literature on the potential systemic externalities of hedge funds. The debate about hedge funds and their role in the financial crisis easily lent itself to political abuse on both sides of the Atlantic.14 Although different explanations are presented for such an unprecedented regulatory animosity towards hedge funds,15 the post-crisis anti-hedge fund sentiment can partly be understood against a background of hedge funds gaming regulatory regimes by engaging in regulatory arbitrage. This Article proceeds as follows. Part I defines and analyzes the concept and dynamics of regulatory arbitrage. Part II explains regulatory arbitrage in the context of regulatory competition, and discusses its virtues—in terms of delivering the benefits of regulatory competition— and its social costs (or negative externalities). Part III elucidates the role of market discipline and government regulation in reducing the social costs of regulatory arbitrage, and evaluates the reasons for the failure of market mechanisms to address the social costs of regulatory arbitrage by hedge funds. Part IV discusses the role of public policy responses in constraining the negative externalities of regulatory arbitrage and highlights the role of indirect regulation in addressing such problems. Finally, the Article concludes by noting that indirect regulation can better address the potential externalities of regulatory arbitrage by hedge funds. I. REGULATORY ARBITRAGE: CONCEPT AND DYNAMICS Arbitrage is “the exploitation of a price difference between two goods that are essentially the same.”16 Arbitrage often takes place where 14. Politicians demonized hedge funds as being “crazy” and “hellish” which “fall like a plague of locusts over [the] companies, devour everything, then fly on to the next one.” Sebastian Mallaby, Hands off Hedge Funds, 86 FOREIGN AFF. 91, 92 (2007) (quoting Franz Müntefering, Germany’s former deputy chancellor); Lex Column, The Italian Locust, FIN. TIMES (London), Oct. 16, 2008. 15. Romano argues that such a move toward regulating hedge funds is understandable in the traditional wariness toward short-selling activities. See Roberta Romano, Against Financial Regulation Harmonization: A Comment (Yale L. & Econ. Research Paper No. 414, 2010), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=16 97348 [https://perma.cc/SRJ9-7MK6]. 16. Andreas Engert, Transnational Hedge Fund Regulation, 11 EUR. BUS. ORG. L. REV. 329, 357 (2010). 2017] REGULATORY ARBITRAGE AND 563 HEDGE FUND REGULATION the prices of identical goods are different in two markets. In addition to the price differentials stemming from market inefficiencies, some of these differences arise from different regulatory schemes. To understand regulatory arbitrage, regulatory requirements should be viewed as the price of conducting certain business activities in a particular jurisdiction. In this context, differential regulatory treatment of homogenous activities in different jurisdictions imposes differential costs on identical economic activities. Accordingly, the goods and services produced within two different jurisdictions will have different fixed costs. This difference in fixed costs will affect the price of final products and services. A firm, which is free to choose between two jurisdictions with differential regulatory costs will engage in business at lower regulatory costs.17 Therefore, regulatory arbitrage, broadly defined, refers to shifting activities from a heavily regulated financial sector to an unregulated or lightly regulated financial sector with the aim of maximizing profits by taking advantage of regulatory differentials. In essence, “regulatory arbitrage exploits the gap between the economic substance of a transaction and its legal or regulatory treatment.”18 Regulatory arbitrage can also be seen as an unintended consequence of effective regulation. Effective regulation is costly and “is likely to penalize those within the regulated sector, relative to those just outside, causing substitution flows towards the unregulated.”19 Firms engaged in regulatory arbitrage often do so to avoid taxes, strict accounting standards, disclosure requirements, and regulatory burdens.20 Although there are different mechanisms to engage in regulatory arbitrage, the most popular and apparently the least costly mechanism involves restructuring a deal.21 For instance, most financial derivatives were designed to take advantage of arbitrage opportunities.22 Derivatives and strategies exploiting such market discrepancies enable market participants to avoid financial regulations and tax burdens.23 17. Id. 18. Victor Fleischer, Regulatory Arbitrage, 89 TEX. L. REV. 227, 229. 19. Goodhart, supra note 2, at 48. 20. Fleischer, supra note 18, at 229. 21. Id. at 230. 22. Id. 23. Lynn A. Stout, Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets, 21 J. CORP. L. 53, 57 (1995). 564 FORDHAM JOURNAL [Vol. XXII OF CORPORATE & FINANCIAL LAW Opportunities for regulatory arbitrage may arise within one single jurisdiction or between two or more jurisdictions. “Intra-jurisdiction regulatory arbitrage”24 arises where one jurisdiction treats some financial activities differently from other similar activities, thereby subjecting the same financial activities or methods to governance under different rules. In the presence of such differential regulation, if there are two methods of achieving the same outcome within one jurisdiction and one method costs less than the other, ceteris paribus, a profit-maximizing firm will choose the method involving lower costs either by restructuring its legal entity (institutional engineering) or by shifting the business activities towards the lower cost method using legal and financial engineering. The latter form is achieved either by specifically tailoring the features of a financial product or by choosing the markets in which trades will take place. Needless to say, both methods involve legal and financial engineering, which mainly involve the use of derivatives. It is well-acknowledged that one of the driving forces behind financial innovation has been financial regulation.25 Indeed, some financial innovations are “designed to keep regulators in the dark.”26 Financial regulation follows the logic and dynamics of influence and change in the behavior of regulated industries. From this perspective, most financial innovations were strategic responses to regulations. Financial institutions have created an array of innovative derivative instruments to circumvent regulation or decrease the costs of compliance. For example, Gorton and Metrick identify regulatory changes as one of the major factors giving rise to shadow banks, the other being private innovation.27 In their work, the rise of shadow banking is mainly attributed to the regulatory developments within the past four decades that benefited certain categories of financial institutions and instruments to the detriment of their close substitutes. The main beneficiaries of these regulatory changes were money market mutual funds (“MMMFs”) substituting bank deposits, securitization used for off-balance-sheet 24. It seems that what Charles Goodhart dubs a “boundary problem” is the same as intra-jurisdictional regulatory arbitrage. See Goodhart, supra note 2. 25. Merton Miller, Financial Innovation: The Last Twenty Years and the Next, 21 J. FIN. & QUANTITATIVE ANALYSIS 459, 459 (1986); see also Frank Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 J. CORP. L. 211, 227 (1996). 26. Jean Tirole, Lessons from the Crisis, in BALANCING THE BANKS: GLOBAL LESSONS FROM THE FINANCIAL CRISIS 29 (Mathias Dewatripont et al. eds., 2010). 27. Gary B. Gorton & Andrew Metrick, Regulating the Shadow Banking System, BROOKINGS PAPERS ON ECON. ACTIVITY, Fall 2010, at 261, 269.