Hong Kong is competitive not only as an attractive place to do business but, in its distinct way, also an attractive place to live.

Larry E. Ribstein exposes the wider motivations behind current international pressure to alter Hong Kong’s tax law

From sanctions to blacklists, there is international pressure to significantly depart from Hong Kong’s current practice and start collecting information in relation to the tax affairs of other jurisdictions.

In May 2009 I traveled to Singapore and Hong Kong to get some background information on these leading examples of global legal centers. It connects with my broader work on jurisdictional competition discussed in my recent book (with Erin O’Hara), The Law Market (Oxford University Press, 2009).

Under the general theory articulated in this book, firms seek to escape from regulatory and tax burdens imposed by their home country by “unbundling” law to some extent from that territory. Unbundled law becomes like a commodity traded in a market.

“Offshore” jurisdictions are key global suppliers of this type of law. While interest groups in “onshore” jurisdictions seek to grab benefits from firms’ connections with their countries, interest groups in offshore jurisdictions reduce their tax and regulatory price in exchange for reaping benefits of firms’ moving some of their activities and legal work to their jurisdictions.

Although it might seem that this competition imposes the costs of deregulation to the firms’ home countries, in fact, onshore jurisdictions can respond simply by applying their own law to local firms. At the same time, onshores are constrained by the fact that firms can completely sever their local connections and withdraw fully – or “exit” – not only to offshore jurisdictions, but to other onshores that are willing to recognize offshore law and tax.

This type of exit would leave behind in the onshore jurisdictions what O’Hara and I refer to in our book as “exit-affected” interest groups – those who gain economically from the escaping firms’ physical presence, including workers, lawyers and other professionals, and all those who depended on the local headquarters of a big firm. These interest groups can join with other anti-regulatory groups to oppose attempts to inefficiently tax and regulate firms. Consider what happened after the U.S. passed the Sarbanes-Oxley Act (SOX), when New York saw firms pull out and go to other markets, such as London. Although academics continue to debate exactly what happened and why, the fact of the pullout, and the reaction by former lead SOX supporter Senator Charles Schumer, among others, to seek to limit or delay SOX, are clear enough.

Offshore jurisdictions cannot win the competition just by negating onshore tax and regulation. To begin with, they have to offer reliable law in the sense of establishing a reputation that they will stick to their tax and regulatory bargains. Firms also seek sophistication, expertise, and predictability from the offshores’ adjudicators.

And given that onshores have the last word in deciding whether to recognize offshore law, offshore jurisdictions must take account of how their laws affect onshore jurisdictions. To take a recently prominent example, onshores are worried offshores will compromise their whole ability to tax or regulate by offering Swiss-type privacy or, more generally, a safe haven for wrongdoing. An offshore may be able to generate a global consensus to enforce its regulation by demonstrating that it will not compromise important offshore regulatory and tax norms. It may be difficult for an onshore to defect from this consensus because firms can find plenty of other onshore homes.

Now let’s consider where Singapore and Hong Kong fit in all this. These jurisdictions offer unique advantages. First, they both have fairly substantial reputations as reliable and sophisticated providers of reasonable tax and regulatory rules. Both have histories as strong regional offshores, Singapore attracting wealth from Malaysia, Indonesia and India, and Hong Kong, of course, from China.

Second, both have common law English-based legal systems. Even if one does not assume that this is generally a developmental advantage, it is a clear advantage for a global legal center because it combines flexibility and ability to evolve in a rapidly changing world with the stability brought by the established traditions of legal certainty and property rights embodied in the common law.

Partly because of their similarities, Hong Kong and Singapore compete for increasingly global rather than regional legal business. On my visit, I didn’t get a strong sense of each jurisdiction’s competitive strategy. That may be partly due the fastmoving nature of the global legal environment and the uncertainty of the roles to be played by various types of offshores. Moreover, the main players in each jurisdiction lack the control over their legal system that Delaware lawyers, for example, exercise. Singapore has long been dominated by Lee Kwan Yew, and is still basically operating under his vision. Hong Kong has China to contend with, subject mainly to China’s self interest and the loose constraints of Hong Kong’s SAR status and the Basic Law.

I gathered that Singapore has tended to regulate its financial institutions with a somewhat lighter hand than Hong Kong, though I’m still working on the specifics. Singapore evidently has been competing with Switzerland in offering privacy, though both have bowed recently to global demands for transparency. At the same time, Singapore may be more careful in deciding which financial institutions to admit to their zone of safety.

A recently prominent example, onshores are worried offshores will compromise their whole ability to tax or regulate by offering Swiss-type privacy or, more generally, a safe haven for wrongdoing.

In theory, at least, both jurisdictions might do more in offering innovative legal structures for firms, somewhat along the Delaware model. My most recent book, Rise of the Uncorporation (Oxford University Press, 2009), shows the role played by coherent business organization statutory standard firms. I see little U.S.-style experimentation elsewhere in the world, which suggests a market opportunity for global legal centers. Singapore recently adopted a limited liability partnership act, though it’s not clear precisely what types of firms the act is designed for.

The global financial meltdown poses a challenge for global legal centers. As discussed in my article, Bubble Laws (40 Houst. L. Rev. 77, 2003), financial crashes become boom times for regulation – from the English Bubble Act, through the 1930s securities laws, Sarbanes- Oxley, and now, what? This tendency is especially important in the context of global regulatory competition. Recall that onshores have an incentive to recognize offshore law to avoid costly exit by firms, including to other onshore jurisdictions. Offshores theoretically can be defeated by a strong regulatory cartel of onshores, perhaps effectuated through the Organisation for Economic Co-operation and Development (OECD) or other organizations with global reach. These organizations loosely serve the role of the federal government in the U.S. system. But without a strong constitution binding onshores, the cartel is difficult to maintain.

The difficulty of maintaining a strong onshore cartel diminishes in a global financial crisis. The risk of a complete breakdown in the financial system, made salient and perhaps exaggerated by the media, and the general tendency toward post-bubble regulation, can reinforce the cartel. This environment might let U.S. Congress and the Obama administration significantly increase financial regulation and reduce opportunities for tax and regulatory flight without worrying about a repeat of the post-SOX-type exit of cross-listing firms if the firms have nowhere better to go. However, this bubble mentality has a limited shelf life. Perhaps more importantly, offshores are responding, and even if they do nothing will look more attractive as the U.S. ratchets up the tax and regulation, including increased regulation of hedge funds.

Significantly, Hong Kong and Singapore are not only attractive places to do business but, in their distinct ways, attractive places to live. Hong Kong taxes its residents at a much lower rate than high-income earners currently pay in the U.S., and the U.S. is planning to increase that differential. Hong Kong offers more of a go-go life style and nightlife than Singapore. Based on what I experienced, both places are easier to live in and offer some advantages over cities like New York, London, Chicago or Los Angeles. Among other things, they both have impressive mass transit systems which are clean and efficiently run.

So where is this going? Onshores can get more aggressive in blocking the exits. The U.S. deals with the tax lure by taxing U.S. non-residents on their non-U.S. income. Onshores also can go the other way and lighten up on those who have the greatest ability to expatriate. We saw a bit of this with the post-SOX exemptions by the U.S. Securities and Exchange Commission for foreign firms. The danger with this “price discrimination” strategy is that the less mobile will demand equal treatment. They won’t like being “discriminated” against just because they’re more stuck in (some would say more loyal to) their home country. This exit can lead to general deregulation.

In general, the offshores are beginning to realize how to compete in a global environment. Onshores like the U.S. seem increasingly clueless. Does it really make sense to yield to short-sighted demands for financial regulation if this causes the U.S. to lose its edge as a global leader in finance? Does it make sense to cede access to one of the most exciting business environments in the world to other country’s citizens in order to grab a comparatively little more tax revenue?

In short, Hong Kong and Singapore offer something relatively new, or at least a new stage in an evolutionary process: full-service global legal centers, which use law and legal systems to attract not only legal business and “brass plates,” but also firms themselves and their workers. Hong Kong and Singapore thus transcend other offshores like the Cayman Islands, though this type of “limited-service” offshore center also has an important role to play. Both places have shown that they can use their legal systems to attract considerable wealth. If the U.S. tries to deal with this competition by pinning its hopes on a global cartel or withdrawing into itself, it may end up increasingly on the margins of the global financial community.

© Larry E. Ribstein

Professor Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law at University of Illinois.