Treasure Islands: Dirty Money, Tax Havens and the Men Who Stole Your Cash
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The BIS report calls Cayman “offshore” and Delaware “onshore.”40 It is exactly this misunderstanding—confusing physical geography with political geography—that has led to widespread claims that the secrecy jurisdictions had nothing to do with this gigantic mess. The Bank for International Settlements, along with every other major international financial institution, needs to understand what offshore is and how it works.
Among the only academic experts to have seriously examined offshore’s role in the financial crisis is Jim Stewart, senior lecturer in finance at Trinity College, Dublin.
In reports in July 2008 Stewart investigated the Dublin International Financial Services Centre (IFSC), a secrecy jurisdiction set up in 1987 under the corrupt Irish politician Charles Haughey with help primarily from City of London interests.41 A showcase for high-risk, Wild West financial capitalism, the Dublin IFSC emerged the year after London’s giant deregulatory Big Bang and now hosts over half the world’s top 50 financial institutions. It became a big player in the shadow banking system and now hosts eight thousand funds with $1.5 trillion in assets. Perhaps most alluring of all Dublin’s lures, Stewart said, is its “light touch regulation.”42
In June 2007 two Bear Stearns hedge funds incorporated in the Cayman Islands announced huge losses, presaging its collapse. Bear Stearns had two investment funds and six debt securities listed on the Irish Stock Exchange and operated three subsidiaries in the Dublin IFSC through a holding company, Bear Stearns Ireland Ltd., for which every dollar of equity financed $119 of gross assets—an exceedingly high and dangerous ratio.
The accounts of Bear Stearns Ireland Ltd. state that it was regulated by the Irish Financial Services Regulatory Authority, and EU directives state that the host country—Ireland, in this case—is responsible for regulation. Yet in an interview, the Irish regulator said he considered his remit to extend to “Irish banks”: It was effectively regulated nowhere. The Irish regulator did not feature in any media analysis of Bear Stearns’s insolvency; Stewart cited nineteen funds in difficulties in the crisis and added that “almost always, the IFSC link is not discussed.”
Several German banks that got into trouble also had funds quoted in Dublin. These included IKB, which got €7.8 billion in German state aid; and Sachsen, which got €17.8 billion of emergency funding and €2.8 billion in state aid. “And yet none of the accounts or prospectus for any of the years examined mentioned regulation or the Irish regulator,” Stewart reported. “Within Ireland the Financial Regulator has been quoted as saying that they have no responsibility for entities whose main business is raising and investing in funds based on subprime lending.” The Financial Times analysis of the episode laid the blame almost entirely on the structure of the German banking system.
In Ireland, Stewart noted, if the relevant documents are provided to the regulator by 3 P.M., the fund will be authorized the next day. Yet a prospectus for a quoted instrument is a complex legal and financial document; a debt instrument issued by Sachsen Bank ran to 245 pages. The regulator could not have assessed it in the two hours between 3 P.M. and the normal close of business. In Luxembourg, Stewart noted, a new law stated that a fund can enjoy preauthorization approval if the fund manager “notifies” the regulator within a month of launch. It is the captured state, over again.
In April 2010 the U.S. Securities and Exchange Commission (SEC) opened a fraud probe into Goldman Sachs, alleging that it misled investors by misrepresenting the role of a CDO in a deal known as Abacus 2007-AC1. In July 2010 Goldman agreed to pay $550 million to settle the charge without admitting or denying the SEC’s allegation. The deal’s structure is notable43:
Issuer: ABACUS 2007-AC1, Ltd., Incorporated with limited liability in the Cayman Islands.
Co-Issuer: ABACUS 2007-AC1, Inc., a corporation organized under the laws of the state of Delaware.
McClatchy’s, the only mainstream media organization to investigate the deal’s offshore nature, found 148 such deals by Goldman Sachs in the Cayman Islands over a seven-year period.44 In fact, every big Wall Street player used the Caymans for this business. These deals “became key links in a chain of exotic insurance-like bets called credit-default swaps that worsened the global economic collapse by enabling major financial institutions to take bigger and bigger risks without counting them on their balance sheets . . . sheltered by the Caymans’ opaque regulatory apparatus.”
It was not so much the Caymans’ opacity that attracted these large players—though that helped—as its “flexibility.” When tax haven supporters say they promote “efficiency” in global markets, this is the kind of thing they are talking about. At the heart of this efficiency is these jurisdictions’ flexibility, which, as we have seen, is really about their political capture by financial capital. Whatever the banks want, they get. And from this flows power.
Rudolf Elmer, a senior accountant in a Swiss bank’s Caymans office until 2003, takes the story further.45
Supervision in the Caymans was especially lax, he said. “Even if you have the right regulatory framework,” he said, “you need the brainpower to audit the banks and companies. There is a general lack of this in the offshore world. You get a lot of high-risk issues running through the islands, being covered by junior auditors in CIMA [the Cayman Islands Monetary Authority].”
One of his office’s functions was to take out cheap short-term loans and invest the proceeds in longer-term assets with higher rates of return. This is an easy way to make tax-free money—but it is dangerous too: You must “roll over” short-term loans every few days, replacing one loan with another. This is easy in the good times, but when lending dries up, as it did in 2007, you must still repay the short-term loans fast—but suddenly nobody will provide new loans to replace them. You can fall into default very quickly. This is exactly what brought down the British bank Northern Rock in 2007. Yet the Caymans regulator, Elmer said, took an extremist laissez-faire approach to these so-called maturity mismatches. “This is a short-term and long-term problem,” said Elmer. “From a regulatory point of view we couldn’t have done that in the UK or Switzerland. The Cayman Islands Monetary Authority (CIMA) should have picked that up.”
Elmer was involved in two CIMA audits. In the first one, he and his local CEO talked for an hour or so with a CIMA official. “The CIMA person said, ‘Is it the same as it used to be?’ The CEO said, ‘Yes, it is the same.’ The CIMA guy said, ‘No problem.’ The Cayman regulator knew our CEO well, and he knew he would tell him the truth. Personal relationships were key.” A subsequent, later audit was more extensive and lasted about a week. “You have to be very experienced in that sort of thing,” said Elmer. “Two junior auditors came in and made a lengthy report, which had little content. I went through those audits, and from a regulatory point of view, they were not sufficient at all.” No further action was taken.
“It was quite crucial for [our] group to use Cayman and BVI vehicles,” he said. “It boils down to three things: tax, regulatory, and legal advantages. You have a lot of freedom.”
This extreme freedom, turning the secrecy jurisdictions into hothouses for risky new banking products, contributed massively to the crisis of the world’s major economies.
The rise of debt in our economies has yet more offshore fathers. There is only space here briefly to sketch a few important ones.
In 2009 the IMF published a detailed report explaining how tax havens, combined with distortions in onshore tax systems, cranked up the global debt engine by encouraging firms to borrow rather than finance themselves out of equity.46 These effects, it said, “are pervasive, often large—and hard to justify given the potential impact on financial stability.” Amid all the noise from G20 leaders about tax havens in 2008 and 2009, the IMF concluded, this dangerous offshore aspect went entirely unnoticed.
The core principles the IMF outlined are simple. A corporation borrows money from offshore, then pays interest on that loan back to the offshore financing company. It then uses the old transfer pricing t
rick: the profits are offshore, where they avoid tax, and the costs (the interest payments) are onshore, where they are deducted against tax.
This simple trick is central to the business model of private equity companies. They will buy a company that someone has sweated for years to create, then load it up with debt, cutting the tax bill and magnifying the returns.
Leveraged buyouts—always involving offshore leverage—accelerated fast ahead of the crisis: The amount raised by private equity funds rose more than sixfold from 2003 to over $300 billion in 2007, by which time their share of all U.S. merger and acquisition activity had risen to 30 percent.47 Reports praise private equity companies for excellent “value creation.” Sometimes private equity companies do create real value. But this core feature of their business model is not value creation but value skimming. A big tax bill is slashed, the company’s shares or value rise, managers’ remunerations become engorged, and wealth is shifted away from taxpayers to wealthy managers and stockholders. Nowhere in any of this did anyone produce a better or cheaper widget. And in the process, extra debt is injected into the financial system. Plenty of good firms have gone bust as a result of this offshore debt-loading, which the New York Times in 2009 described as “a Wall Street version of ‘Flip This House.’”48 More than half of the companies that defaulted on their debt that year were either previously or currently owned by private equity firms.
A lot of innovation that corporations do—I’m talking about useful innovations to make better and cheaper goods and services, not the financial innovations that simply shift wealth upward and risks downward along the social scale—happen in small and medium enterprises. But the offshore system works directly against this.
First, it subsidizes multinationals by helping them cut their taxes and grow faster, making it harder for the innovative minnows to compete. And when small innovative firms do emerge they becomes targets for predators who seek to “unlock value” from “synergies” created by bringing the small firm into the bigger, more diversified one. Some synergies may be useful—economies of scale, for instance—but too often the predator can “unlock value” simply by being better at squeezing out these abusive, unproductive offshore tax privileges. Some make their best profits by seeking out and harvesting those small, genuinely innovative companies that haven’t yet been abusive enough on offshore tax avoidance to “unlock” those abuses for themselves.
This harvesting then removes nimble, competitive, and innovative firms from the marketplace and relocates them inside large corporate bureaucracies, curbing competition and potentially raising prices. Debt rises, and ordinary people pay more tax, or see their schools and hospitals fall into disrepair. And if the predators leave their earnings offshore they can “defer” tax on them indefinitely. Deferred taxation is, as the accountant Richard Murphy puts it, “an interest-free loan from the government, with no repayment date.” In other words, more debt.
Consider what happens when this multinational corporation is a bank. Like multinationals on steroids, banks have been particularly adept at going offshore to grow fast: by using it to escape tax, to dodge reserves requirements and other financial regulation, and to gear up their borrowings.
Banks achieved a staggering 16 percent annual return on equity between 1986 and 2006, according to Bank of England data,49 and this offshore-enhanced growth means the banks are now big enough to hold us all ransom. Unless taxpayers give them what they want, financial calamity ensues. This is the “too big to fail” problem—courtesy of offshore.
But even that is still not all.
This one takes a little bit of explanation. Many blame the latest crisis not just on deregulation but also on global macroeconomic imbalances, as funds have flowed from countries with export surpluses, like China, India, Russia, and Saudi Arabia, and into deficit countries like the United States and Britain. This has led to overconsumption and borrowing in the deficit countries.
Now look at Global Financial Integrity’s estimate that illicit financial flows out of developing countries has been running at up to a trillion dollars each year. Most has flowed out of large developing countries like China and Russia and Saudi Arabia and into large OECD countries like Britain and the United States. Illicit flows in the other direction are much smaller, so the net result is a flow worth hundreds of billions of dollars each year into rich economies and secrecy jurisdictions.50 The illicit flows, which are unrecorded and hardly noticed, add to those recorded imbalances.
Let’s look quickly at what happens on the ground. Imagine a Mexican company orders construction equipment from the United States and agrees to a price of $10 million. But the Mexican company asks for the commercial invoice to be drawn to read $12 million. The buyer does this because when he pays his $12 million, $2 million of that is secretly deposited into his Miami bank account. The missing $2 million is invisible to the numbers crunchers who compile the trade statistics—though it represents a very real illicit financial flow from Mexico to the United States—and it has tangible effects: It will push up U.S. house prices, distort the U.S. housing market, and boosts bank profits from their mortgage operations. First-time buyers find it harder to get on the property ladder, a housing bubble inflates further, and debt builds up in the economy.
As if all this were not enough, there is yet more.
Trust is a central ingredient in any economy. Where participants in a market don’t trust each other, expensive litigation substitutes for honest behavior. And there is nothing—nothing—like the offshore system to generate opacity and erode trust and the behavioral constraint. When nobody can find out what a company’s true financial position is until after the money has evaporated, trickery and bamboozlement abound. Financial markets seized up in 2007 because nobody knew, or trusted, what the other players in the market were doing, or what they were worth, or what or where their risks were. It is no coincidence that so many of those involved in great financial trickery, like Enron, or the empire of the fraudster Bernie Madoff, or Sir Allen Stanford’s Stanford Bank, or Long Term Capital Management, or Lehman Brothers, or AIG, were so thoroughly entrenched offshore.
The secrecy jurisdictions specialize in bamboozlement. Along with the secrecy, and a curmudgeonly reluctance to co-operate with foreign jurisdictions, the offshore system provides endless incentives for corporations—especially financial ones—to festoon their affairs across jurisdictions, usually a complex mix of onshore and offshore, to fox the regulators. These giant impenetrable offshore trails, sliced, diced, and trailed around the world, increased the distance between the lenders and their borrowers until bankers no longer knew who their ultimate clients were. It is hardly a surprise that the Royal Bank of Scotland in 2003 offered a gold credit card with a ten-thousand-pound spending limit to a Monty Slater in Manchester, England. Monty Slater was a Shih Tzu dog.51
John Maynard Keynes summed up the problem well. “Remoteness between ownership and operation is an evil in the relations among men, likely or certain in the long run to set up strains and enmities which will bring to nought the financial calculation.”
With this observation, Keynes exposed the flaw in the grand bargain at the heart of the globalization project. In giving freedom to finance, people in democratic nation-states lost their freedom to choose and implement the laws and rules that they wanted. But they handed these freedoms to the world’s financiers in exchange for a promise: that the efficiency gains from those free financial flows will be so great as to make that loss of freedom worthwhile.
The tax havens helped bring this calculation to naught.
CONCLUSION
Reclaiming Our Culture
JOHN MAYNARD KEYNES’S OBSERVATION IN THE AFTERMATH of the Wall Street Crash, which I cited in chapter 3, is as apt today as it was when first articulated: “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.” But the financial system is vastly more dangerous and pervasive now. Changes to d
omestic banking regulations matter but will never suffice. Reform must be based on a thorough grasp of the new, globalized reality—and anyone who wants to understand the modern financial machine must understand what tax havens are and how they work.
We must tackle the offshore system. I will point to ten major areas for change, in no particular order and as briefly as I can. All overlap with each other—and the last ties them all together.
First, we can pursue transparency. Many and varied changes are needed; here are two.
About 60 percent of world trade happens inside multinational corporations, which cut taxes by shuffling money between jurisdictions to create artificial paper trails that shift their profits into zero-tax havens and their costs into high-tax countries. The complexity and cost of this system cause great harm.
But these maneuverings are invisible in corporations’ annual reports. Under current accounting rules corporations can scoop up all their results—profits, borrowings, tax payments, and so on—from several countries and consolidate each into one figure, perhaps broken down by region. So a corporation may publish its profits from, say, Africa, but nobody can unpick those numbers to work out the profits in each country. You can’t find the information anywhere. Trillions of dollars’ worth of cross-border flows simply disappear from view. So a citizen in a country where a multinational operates cannot tell from these reports even whether that corporation operates there, let alone what it does, its level of activity, its profits, its local employment, or its tax payments. As multinationals become ever more complex, this problem just gets worse.
One might think that the main global rule-setter for international accounting standards would be a public international body accountable to democratic governments. It is not. The International Accounting Standards Board (IASB) is a private company financed by the Big Four accountancy firms and global multinationals, headquartered in the City of London, and registered in Delaware.1