Treasure Islands: Dirty Money, Tax Havens and the Men Who Stole Your Cash

by Nicholas Shaxson

  On November 4, 1980, du Pont was reelected as governor of Delaware, and the draft legislation was unveiled in public two months later, on January 14. Du Pont’s administration gave the state general assembly the deadline the banks demanded: pass the bill by February 4 or the deal was off.10

  The bill sailed through on February 3, and du Pont signed the Delaware Financial Center Development Act two weeks later.

  Delaware was to remove interest rate ceilings on credit cards, personal loans, car loans, and more. Banks would have powers to foreclose on people’s homes if they defaulted on credit card debts; they could establish places of business overseas or offshore, and they got a regressive state tax structure to boot. And crucially, because Delaware law could now be “exported” to other states, this was to be rolled out across America.

  Two hundred years of legislation capping interest rates in the United States had now lost all force.11

  Despite the timing—the bill was passed less than a week before Ronald Reagan took office as U.S. president—all interviewees stressed that this came purely from Delaware and the New York bankers, not from Washington. “Lawmakers quickly realized,” wrote du Pont’s biographer, “that the Financial Center Development Act was favored by almost everybody in the state’s power structure—and by the powers most likely to contribute significantly to their future election campaigns.”12

  Out-of-state banks flooded into Delaware, and the credit card industry took off. Within months the credit card giant MBNA had opened its first office in a vacant supermarket; within a decade it had over $80 billion in outstanding credit card debt. “Every night helicopters took off from here carrying receipts and paperwork from all the credit card business,” said du Pont. “It gave us 25 years of growth and revenues growing every year.” Before 1980, Delaware’s revenue just from the bank franchise tax had trickled in at just $3 million–odd per year. By 2007 it was taking $175 million.13

  Just as Ronald Reagan prepared his assault on America’s unions, American workers began to trade their union cards for credit cards.

  Two months after the bill’s passage, the New York Times summed up.14 “To bankers and their supporters the law is modern and comprehensive, drafted in a thoughtful manner. To some state officials, legislators and consumer advocates, both in Delaware and elsewhere, the bill was stampeded through the Delaware Legislature, is one-sided and, as one critic put it, a banker’s ‘dream.’”

  “Bankers say the possibility that the Delaware plan could be enacted in other states is a sign of healthy competition among the states and a reflection of the current emphasis on states’ rights,” continued the article. “Their critics say it illustrates the ability of powerful private interests to pass laws with national ramifications by singling out and exploiting the weakest and most malleable states.”

  The same Times article noticed something else. “Many legislators say they did not read the 61-page bill before agreeing to sponsor it and did not understand the complicated measure before voting on it.” Harris B. McDowell, the majority whip for the Democrat-controlled Senate, said he was told at the last minute. “I confess I have no expertise in the banking area,” he said. “I am mystified by the bill.” He voted for it on a promise that it would create jobs. Others said the only hearing for the bill, which lasted just three hours, was handled and timed in ways that prevented many legislators from attending and inhibited rebuttal. Delaware’s Consumer Affairs Department never saw the bill before its passage, a deliberate exclusion that Kenton defended by saying that he and du Pont shared the “bias” that “banks should charge what they want in fees.”

  “I didn’t see any sense in running that fundamental principle by anybody who doesn’t agree with it,” he added.

  This pattern will be familiar to offshore legislators worldwide. In Delaware, bankers had found a small and malleable legislature, used special legislative tricks to stymie bothersome objectors from other stakeholders, worked hard to keep objectors in the dark, reassured bamboozled legislators that all would be well, and created “ring-fences” giving special exemptions to outsiders that were not available to locals.

  Most important was this typically offshore feature that made all these things possible. “It’s small, you can get the leadership together because of that,” Biondi said. “The leadership was accessible at the governor’s office but also in the legislature and in the business community.” Du Pont made exactly the same point. “I used to say to them, if you’ve got a problem, you come on in and around this one table, we can put together all the people we need to solve your problem, whatever it may turn out to be. And we’ll talk about it. We’re small enough. We can move fast. We can get things done.”15 Swayze agreed and added a detail. “There were significant forces in the New York legislature opposed to this,” he said. “Delaware took advantage of the fact that New York couldn’t turn the dreadnought around in the harbor. We’re small, we take advantage of opportunities, and we can fill that void.”16

  In other words, we can give the bankers what they need, faster than anyone else. Delaware is a legislature for hire.

  Once Delaware fell, the banks then wielded it as a crowbar against other states. Thomas Shriver of the Pennsylvania Bankers Association warned that Delaware is “a very viable option if the Pennsylvania Legislature doesn’t enact a bill we have proposed.” Robert Erwin, head of Maryland’s consumer protection division, warned that if other states gave in to the “pressure” from Delaware, “then it becomes a game of Russian roulette among the 50 states, trying to outdo themselves.”

  With interest rates caps removed, the credit card industry took off, and Americans splurged on debt. By mid-2007, as the global financial crisis emerged, U.S. consumers owed nearly $1 trillion on their credit cards17—and that is not to mention loans people took out against their homes to pay the credit card bills. Not a single one of those interviewed for this book who were involved in the passage of the Financial Center Development Act showed any signs of doubt that it was a very good thing.

  The respected liberal lawyer Thomas Geoghegan points to the significance of this episode.18 “Some people still think our financial collapse was the result of a technical glitch—a failure, say, to regulate derivatives or hedge funds,” he wrote. “No, the deregulation that led to our Time of Troubles was of a deeper, darker kind. The problem was not that we ‘deregulated the New Deal’ but that we deregulated a much older, even ancient, set of laws . . . the laws against usury, which had existed in some form in every civilization from the time of the Babylonian Empire to the end of Jimmy Carter’s term, and which had been so taken for granted that no one ever even mentioned it to us in law school. That’s when we found out what happens when an advanced industrial economy tries to function with no cap at all on interest rates.”

  This probably overstates the case: There is no single explanation for the latest crisis. Still, Geoghegan has identified an important contributing factor. The elimination of usury caps spilled out into a wide variety of financial fields.

  Credit card debt, money market funds, and numerous other instruments that fueled the borrowing binge and the crisis—the removal of interest rate caps—had effects that are incalculable.

  Having helped deregulate and boost the supply of debt, Delaware also set about getting a share of the demand side. It did this by setting itself up as a major player in the securitization industry—the business of parceling up mortgages and other loans, including on credit cards, and repackaging the debt and selling it on. Once again, Delaware did this simply by establishing the exact legal framework that corporations demanded.

  The Delaware Financial Center Development Act of 1981 itself contained a section eliminating “affiliated finance companies” from all state taxes. These act like banks but aren’t formally banks, so they fall outside banking regulations. Along with structured investment vehicles and their like, these are a core part of the global “shadow banking system”19 that dragged the world into economic crisis from 2007. T
hese companies were especially prominent in the United States, notably in Delaware. In 1983 a new International Banking Development Act got Delaware into the new offshore game of international banking facilities. When that was enacted, Chase and several other banks promptly moved foreign offshore activities to Delaware.

  Biondi outlines several other statutes that followed and his role in them. “I wrote those bills with my boys here,” he said. The 1986 Foreign Act Development built on the 1983 legislation designed to let foreign banks take advantage of Delaware’s regressive bank franchise taxes. New tax legislation in 1987 enticed banks that wanted to get into dealing securities. “My staff and I wrote it,” Biondi explained. “We represented Morgan, Chase, Citicorp, Bank of New York, and Bankers Trust.” Biondi’s team also wrote the Bank and Trust Company Insurance Powers Act of 1989, authorizing banks to sell and underwrite insurance.20 The Delaware Statutory Trust Act of 1988, giving huge flexibility to people setting up such trusts, and “the protection of trust assets from creditors,” made Delaware the top jurisdiction for setting up so-called Balance Sheet CDOs, which allowed banks to offload their assets onto other investors and were another important contributor to the crisis.21 A new act in January 2000 allowed Limited Liability Partnerships: a major contributor to the degradation of corporate governance, which I will soon explore in detail. There was also the Asset-Backed Securities Facilitation Act of 2002, which further opened the securitization spigots.

  All these helped Delaware become, as one expert put it, “The Jurisdiction of Choice in Securitisation.”22

  Even more broadly, Delaware has played a central role in transforming global banking from its traditional fare of funneling savings into productive investments toward more speculative, risky, fee-based banking models. “Delaware recognized the quantum shift in the financial services industry toward fee based activities,” said Swayze, “and it provided the legislative and regulatory framework to accommodate that shift.”23

  Now here is the big point. I do not claim that this story constitutes an explosive new revelation about the ultimate causes of the latest mortgage and financial disasters. This was just one among the many tangled roots of the crisis—though an important one. My point is to show just what a tax haven is: a state captured by financial interests from elsewhere. Mark Twain said that history does not repeat itself—but it rhymes. My next story, from thousands of miles across the Atlantic Ocean in the British tax haven of Jersey, rhymes almost perfectly with this tale from Delaware.

  In June 1995 the director of Jersey’s Financial Services Department met with a partner in Mourant du Feu & Jeune, a member of the so-called “Offshore Magic Circle,” made up of the ten or so law firms most active offshore. They discussed a corporate form known as the Limited Liability Partnership (LLP).

  A letter then began to circulate in Jersey political circles, dated October 9, 1995.

  “My firm has been working with the UK partnership of Price Waterhouse (PW) and English solicitors, Slaughter and May, to find a method of obtaining some limited liability protection for the partners’ personal assets without completely restructuring PW’s business and losing the cultural benefits of a partnership,” the letter said. After surveying several jurisdictions, it continued, Jersey was deemed the most suitable. “We are therefore seeking support of your Committee for the introduction of a Special Limited Partnership Law in Jersey during 1996.”

  In short, the private firms wanted to write a new law for Jersey. In fact, a draft law had already been prepared in London.

  The letter urged Jersey’s powerful Finance and Economics Committee to consider the law by December, then have it debated in the States Assembly the following January or February. “We would also propose that we would prepare any necessary subordinate legislation required in connection with the Special Limited Partnership Law. We appreciate that this is a very short time scale.”

  “It would be very important for PW and I believe, Jersey’s finance industry, that the correct messages are sent to the media,” the letter continued, proposing that Jersey’s PR firm Shandwicks and Price Waterhouse’s media team get straight to work.

  The Big Four accounting firms—PricewaterhouseCoopers (PWC), Ernst & Young, KPMG, and Deloitte Touche—are giants: PWC employed over 146,000 people and generated $28 billion in revenues in 2008, making it the world’s largest professional services firm. Auditors also occupy a very special place in the global economy. Their audits are the main tools by which societies know about, and regulate, the world’s biggest corporations: In a sense, they are the private police forces of capitalism.24 Audit failures lie behind most great corporate scandals: Enron, WorldCom, and most of the collapses related to the latest financial crisis. Because of the extreme dangers bad audits pose to corporate capitalism in general, and to you and me in particular, governments try to regulate this profession with extra care.

  Since the middle of the nineteenth century, limited liability has been part of a grand bargain at the heart of corporate governance. If a limited liability company goes bust, owners and shareholders may lose the money they invested, but their losses (or liabilities) are limited to that: They are not liable for additional debts the corporation has racked up. This concept was controversial when it was first introduced: It was feared that it would erode standards of accountability, but it was justified on the grounds that these investor protections would encourage people to invest and boost economic activity. But there was a caveat: In exchange for the gift of limited liability, corporations must agree to have their accounts properly audited, and have these audits published, to open a true and fair window into what they were up to. It was an early-warning system to keep the risks manageable.

  By contrast, a general partnership is very different from a limited liability company. Investors in a partnership are experienced professionals who should know what they are doing, and they have unlimited liability. When things go wrong they are personally liable for all losses: Creditors can theoretically take even the shirts off the partners’ backs. Since they have given up the right to shift losses onto the rest of society, partners are held to less stringent standards of disclosure. Partners were also subjected to “joint and several” liability, in which a partner is liable not only for his or her own mistakes but also for the mistakes of others in the partnership.25 All this helps focus auditors’ minds on doing their job properly—and to police their colleagues too.

  Konrad Hummler, the managing partner of an unlimited liability company, Wegelin Private Bank, in Switzerland, explains what it is like to operate under such rules.26

  “Partners who have [joint and several] unlimited liability have a solidarity; the dynamic within the group is totally different,” Hummler said. “On so many boards—and I have quite some experience of this—one doesn’t dare to ask the right questions. This [unlimited liability] is the only way of doing business where you dare to ask the really difficult questions—mostly the simplest questions. I will say, ‘Listen, Mr. Chairman, I still don’t understand the case.’ The chairman will say, ‘You obviously haven’t read your papers properly.’ At this point I don’t stop the discussion, but I say again, ‘Mr Chairman I still don’t understand this bloody thing.’ That’s the difference. Because of your unlimited liability, you think twice.”

  Joint and several unlimited liability for partners in audit firms is clearly, given their special role in policing modern capitalism, a very good idea.

  What was being proposed in Jersey, however, was different again: a law allowing limited liability partnerships (or LLPs.) An LLP for accountancy firms is an example of having your cake and eating it: An LLP partner not only gets the benefits of being in a partnership—less disclosure, lower taxes, and weaker regulation—but it gets the limited liability protection too. And if a partner commits wrongdoing or is negligent, other partners who are not involved aren’t accountable for the consequences. This law was the product of what Professor Prem Sikka, of Essex University, calls auditors’ ultimate aim
“to use the state to shield it from the consequences of its own failures.”27 For those involved, it is the best of all worlds. For the rest of society, it is the worst of all worlds.

  The draft Jersey LLP Act was worse still. LLPs would not need to have their own accounts audited or even to say on their invoices or letterheads that they were registered in Jersey. It had no provisions for regulating audit firms or investigating misdemeanors, and it offered other audit stakeholders—that is, the public—almost no rights. To get these astonishingly generous concessions from the public at large, these multibillion-dollar global corporations would have to pay a one-time fee of just ten thousand pounds at first, then five thousand pounds a year afterward.

  As with the liberalization of usury provisions in Delaware, the Jersey proposal was a delayed reaction to the ideological revolution associated with Ronald Reagan and Margaret Thatcher: a shift away from the view that competitive markets need robust regulation to a childlike faith in self-regulation by market actors.

  Big accountancy firms had already gotten LLPs in the United States after first influencing the Texas legislature in 1991; within four years nearly half of U.S. states had it. These limited liability provisions “took away the most powerful incentive for self-policing by the corporate professions of law and accounting,” wrote the tax expert David Cay Johnston, and “help explain the wave of corporate cheating that swept the country.”28 Already there was evidence from the United States that whenever these provisions are introduced, less time is allocated to each audit, and quality suffers. It is nearly impossible to provide a smoking gun in such cases, but these kinds of concessions were undoubtedly important factors in the Enron and WorldCom disasters and in the destruction of Enron’s auditor, Arthur Andersen LLP.

  In Britain, following high-profile audit failures such as BCCI, Polly Peck, and many others, auditors had already squeezed major concessions out of the government, having won the right in 1989 to be limited liability companies29—though few audit companies converted, since many did not want to have to publish their accounts. A British House of Lords decision in 1990 worsened matters, ruling that auditors owe no “duty of care” to any individual stakeholder injured by audit failures.