1.1 Arbitrage and Avoidance

For most authors, the term regulatory arbitrage has a negative connotation. “A general understanding of regulatory arbitrage implies an avoidance strategy”^[3] with actors “explicitly looking for ways to decrease their regulatory burdens”.^[4] Such avoidance strategies are usually understood as an attempt at crafting a well-tailored transaction with the sole purpose of not qualifying for a specific regulatory regime.^[5] Many have stressed that behavior of this type will, more often than not, only be open to elite players with access to financial advisors and highly sophisticated corporate lawyers.^[6] While a domestic^[7] regulator aims at efficiently supervising regulated entities, so it is suggested, their advisors help them to exploit loopholes and gaps in that regulatory regime.^[8] The underlying assumption is that, in the relevant area, regulatory standards are not crafted well enough. In line with that thought, regulatory arbitrage is defined as “the manipulation of the structure of a deal to take advantage of a gap between the economic substance of a transaction and its regulatory treatment”.^[9]

Authors who address regulatory arbitrage as making use of a gap between the “real” economic substance of a transaction and the “misguided” view the regulator applies – or is forced to apply due to a lack of well-crafted rules – will usually use terms such as structuring, ^[10] avoidance, ^[11] or even manipulation.^[12] The regulator, these authors assume, sets certain rules to which regulated entities must conform.^[13] However, some entities find a way to bypass the rules by making use of something akin to a legal “trick”. Their business logic, what they “actually” do, is the same as everyone else’s. By framing it as something entirely different, not captured by the regulatory regime in place, they avoid certain legal consequences.

1.2 Arbitrage and Competition

Linking regulatory arbitrage to avoidance strategies is not the only way to describe the phenomenon. Instead, regulatory arbitrage has been portrayed as an economically efficient process which eventually results in the regulatory costs of a certain transaction to converge at the lowest level. To use a market-based metaphor: “Regulatory requirements should be viewed as the price of conducting certain business activities in a particular jurisdiction”.^[14]

This view is maybe best illustrated analogizing it to the model of financial arbitrage.^[15] Financial arbitrage can be modeled as a risk-free trade, executed whenever two goods are priced differently, depending on where they are sold. Financial arbitrageurs will exploit such price differences by buying cheaply in one place and selling at the higher price in the other place. Economic theory predicts that, because sellers compete, financial arbitrage will eventually lead to prices converging at the lower level. It eliminates a price difference for two identical goods. In this way, financial arbitrage is described as helping to overcome market inefficiencies.^[16]

Drawing an analogy to this understanding of financial arbitrage, it seems natural to propose that regulatory arbitrage may also contribute to more efficient markets. Whereas financial arbitrageurs are expected to eventually lower the price of a good, regulatory arbitrageurs are assumed to drive the regulatory costs associated with a specific transaction down.^[17] Such effects may be best illustrated if we picture the arbitrageur as facing a choice between different jurisdictions for his endeavor. The competition-view of regulatory arbitrage presupposes that regulators, located in different jurisdictions, compete for relevant transactions or corporations. In order to attract more business and to win the competition they will wish to adjust regulatory prices. Actors are modelled as ready to leave their domestic regulator’s world if another jurisdiction offers them a more attractive environment for an identical transaction.^[18]

The analogy to financial arbitrage is particularly compelling if the arbitrageur chooses between competing “legal markets” offered by different national jurisdictions. The arbitrageur then weighs pros and cons of these jurisdictions and settles for something he conceives as the “best offer”. But regulatory arbitrage does not always involve moving places. Authors who stress the element of avoidance when describing regulatory arbitrage^[19] are usually concerned with instances of reformatting a transaction under one national regulator’s regime. To capture this form of “repackaging-arbitrage” under the competition approach, the focus will be on different regulatory sectors available in one jurisdiction. “Regulatory arbitrage” so it is suggested, “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”.^[20] The “legal markets” on offer are not different national jurisdictions, but differently regulated sectors of one jurisdiction. Modelling these sectors as engaged on a competitive “market for regulation”, a possible prediction could be that a move from one sector to another will lead to regulatory adjustments which better reflect the needs of business and/or consumers.

1.3 Guiding Assumption: Arbitrage is Sometimes Unwanted

The preceding descriptions of regulatory arbitrage as avoidance as opposed to competition mark the ends of a spectrum. Even scholars who generally view arbitrage as avoiding a legal regime will agree that widespread avoidance could sometimes be a sign of a flawed regulation.^[21] Conversely, scholars who model arbitrage as an efficient market mechanism are still busy to point out instances of market failure. This surfaces not only in the extensive discussion on whether regulatory arbitrage will lead to a “race to the top”^[22] or to a “race to the bottom”.^[23] Others doubt that national regulators, let alone different sectors of one jurisdiction are competing for the largest “market share of regulation”. After all, it has been pointed out, some entities engaged in regulatory arbitrage might not bring attractive business, but rather come across as “lemons”,^[24] triggering enforcement costs and negative reputational effects.^[25]

It is beyond the scope of this paper to assess whether the avoidance or the competition approach to regulatory arbitrage paints a more realistic picture of the phenomenon. Quite probably, both approaches capture important elements: “arbitrage creates both inefficiency and unfairness”.^[26] For the endeavor pursued here, it is sufficient to assume that regulatory arbitrage is sometimes unwanted from the legislator’s and the regulator’s point of view. This assumption is warranted under both approaches. The competition approach accepts market failures, the avoidance approach suggests as a general rule to suppress arbitrage.

2.1 Background: What is a Cash-Settled Derivative?

A derivative is a financial instrument characterized by its link to an underlying asset.^[30] In the case of equity derivatives, the underlying asset is a share. Often, equity derivatives are used to hedge the risk of price movements of a specific stock or to speculate on such movements. A “put option” insures against a downturn in share prices, because it grants the right to sell shares at a specified “strike price” agreed upon in the option contract. When prices fall, but the strike price has been locked in at the previous (higher) level, the party holding the option does not need to worry about falling prices. Conversely, a “call option” hedges against a rise in share prices, because it allows to buy shares for the strike price, which will stay fixed, hence is in comparison low when prices rise.

An option contract requires payment of a “premium”. This insures against uncertain future price movements. Additionally, derivatives can serve as a speculative tool. Consider a trader betting on share price movements, for example in a short sale. A derivative will be attractive for him, because the trader pays the premium, but does not need to buy the actual shares. He needs to invest less capital for the anticipated gain, in this manner potentially levering his deal many times over.

“Cash settlement” refers to what happens when the option is being exercised by the purchaser of the derivative. One possibility is to physically deliver the shares which are the object of the contract. If derivatives are used to hedge against price movements, this will often be the contract of choice. However, instead of choosing this structure, the parties may agree on settling only the resulting cash position (the difference between the strike price and the price at which the shares trade when the option is exercised) without a transfer of actual shares. Unless the actual shares are needed, cash settlement is a good option, due to its lower transaction costs.

What does all of this have to do with ownership or the position of a shareholder? If an option contract grants the right to physical settlement, the option holder is not (yet) the owner of the shares. Hence, he would not fall under a rule which tied reporting requirements (or other duties) to actual ownership – a potential opportunity for regulatory arbitrage. For illustration, imagine a take-over situation involving a listed company. If only actual ownership qualified, a hedge fund could build a position in call options and, once he has enough options to reach the intended stake, demand physical settlement. Neither management nor shareholders or future investors would have noticed. The rise in stock prices, which we see once the market becomes aware of a take-over plan, a practice called “creeping in”, would not happen. Naturally, most regulators have become aware of this structure.^[31] This is why today’s securities laws are usually worded more broadly. They are not restricted to actual share ownership, but catch a contractual structure which grants a right to an eventual transfer of shares as well.

The case of cash-settled derivatives is controversial since this form of option contract does not provide for physical delivery. Under a contract of this type, ownership is never transferred. Could we say that this situation, a “synthetic long position”, presents an opportunity for arbitrage? After all, arbitrage is a situation in which the economic benefits are preserved. This seems doubtful, to the extent that cash-settled call options do not confer the right to ask for physical settlement by way of actual delivery of shares.

But now market conventions come into play. Even though the seller of the option (the “short” party) is not contractually required to physically settle, business practice for him is to still buy the shares when concluding the contract. Not doing this will ceteris paribus expose him to significant price fluctuations, a risk he will wish to minimize.^[32] Upon expiry or unwinding of the derivative, this “short” party will typically^[33] want to get rid of the shares. The business expectation, more often than not, is that the buyer of the hedge (who is “long”) is in a position to ask for transfer of those shares. While this is not a contractual right, and therefore doesn’t trigger reporting requirements, it still seems to be common practice,^[34] even expected from the short party. A bank unwilling to do so, it is claimed, will take a reputational hit in the business community.^[35]

Against this background, the opportunity for regulatory arbitrage is clearly visible. The hedge fund, which, in our example, is interested in concealing the stake it has been building up, knows, that the counter-party to its hedge will eventually sell the shares. The hedge fund’s management also knows when this will be the case, and might even have the right to unwind the derivative at a point in time they choose.

Summing up, a hedge fund – or any other investor – who might wish to avoid reporting that it has been building up a stake in a corporation’s shares will often be tempted to buy cash-settled derivatives. The combination of the wording of relevant regulatory rules and business practices allows this form of avoiding the regime which is in place for shares. Given the business practice of the short party handing over shares despite a lack of an underlying contractual duty to that end, we can say that the economic substance of the transaction is being preserved, but reporting requirements are not triggered.

Both, the U.S. and the EU have endeavored to close this loophole, yet in different ways. The EU has adapted the legislative wording of its transparency regime. The U.S. has relied on a more general rule capturing schemes of avoidance. A proposed bill, aimed at changing the wording, has so far not been passed.

2.2 The EU Response to Cash-Settled Derivatives

The EU Transparency Directive regulates instances which trigger reporting requirements. Its 2004 version tied disclosure to the acquisition or disposal of

“shares […] to which voting rights are attached”^[36] or “financial instruments that result in an entitlement to acquire, on such holder’s own initiative alone, under a formal agreement, shares to which voting rights are attached”.^[37]

With the rise of more complex derivatives, the EU legislator observed that:

“Financial innovation has led to the creation of new types of financial instruments that give investors economic exposure to companies, the disclosure of which has not been provided for in Directive 2004/109/EC. Those instruments could be used to secretly acquire stocks in companies, which could result in market abuse and give a false and misleading picture of economic ownership of publicly listed companies”.^[38]

Along those lines, the second Transparency Directive of 2013 saw the formerly narrow wording broadened:^[39]

“In order to ensure that issuers and investors have full knowledge of the structure of corporate ownership, the definition of financial instruments in that Directive should cover all instruments with similar economic effect to holding shares and entitlements to acquire shares”.^[40]

Previously, the rule required ownership of shares, to which voting rights are attached, or an entitlement to acquire such shares. Today, the rule applies to financial instruments which are

“referenced to shares […] and with an economic effect similar to that of [options] […] , whether or not they confer a right to a physical settlement”.^[41]

The gap between economic substance and regulatory treatment has been narrowed down, by introducing a broad instead of a narrow term. Any financial instrument with an effect which is “similar” to that of an option qualifies under reporting requirements.

2.3 The U.S. Response to Cash-Settled Derivatives

While the EU makes regulatory arbitrage more difficult by extending the wording of the relevant rule to cover a “similar economic effect”, the U.S. has, so far, opted for a different approach. The ground rule for reporting is formulated in Schedule 13D SEA:

“any person, who […] is directly or indirectly the beneficial owner of more than five percent […] shall, within 10 days after the acquisition, file with the Commission, a statement […]”.^[42]

Under this rule, a hedge fund which has acquired a cash-settled derivative qualifies, if it is considered a “beneficial owner”. This is determined on the basis of § 240.13d-3 para. (a) SEA:

“For the purposes of sections 13d and 13g of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement or understanding, relationship or otherwise has or shares:

1. Voting power, which includes the power to vote, or to direct the voting of, such security and/or

2. Investment power, which includes the power to dispose, or to direct the disposition of, such security”.

Generally, a cash-settled derivative confers neither voting power nor investment power and, accordingly, no beneficial ownership.^[43] However, the rule goes on to state that “any person who […] creates or uses a trust, power of attorney, pooling arrangement, or any other contract, arrangement, or device with the purpose or effect of divesting such person of beneficial ownership […] or preventing the vesting of beneficial ownership as part of a plan or scheme to evade the reporting requirements […] shall be deemed to be beneficial owner […]”.^[44] Under this latter rule, the Court of Appeals of the Second Circuit held that a hedge fund using cash-settled derivatives had violated Section 13D, because it made use of a “scheme to evade the reporting requirements”.^[45]

While the decision turned on a number of specifics of that case, it shows an important difference between the strategies chosen by EU and by U.S. law. The former’s legislative bodies passed a new rule to specifically catch one form of unwanted arbitrage. It clearly signals the type of transaction which is targeted, but does not necessitate proof of any form of intent on the side of the arbitrageur. The latter relies on a general evasion rule. It is broad enough to catch many situations of regulatory arbitrage, but turns on the arbitrageur having set up a “scheme” to evade the reporting requirements.

Interestingly, the U.S. debate on how to treat cash-settled derivatives has not yet come to an end. Instances of takeovers of corporations often raise political awareness of gaps and loopholes in regulation. After a century-old paper mill in Brokaw, Wisconsin, went bankrupt and activist hedge funds were blamed,^[46] Senator Baldwin introduced a bill appropriately named the “Brokaw Act”.^[47] Similar to the EU broadening its definition, under the Brokaw Act beneficial ownership would include derivatives which grant “a pecuniary or indirect pecuniary interest”.^[48] Reporting requirements would be triggered “whether or not the right or instrument shall be subjected to settlement in the underlying equity security”.^[49] A plan or scheme to evade regulation would no longer be required. Critics of the Bill argue that the “creative” use of cash-settled derivatives can be accepted as market practice. Performing the existing checks for evasion, hence insisting on a mens rea element, so it is claimed, will be sufficient.^[50]

3.1 Legislative Drafting-1: Narrow Wording

The question how we “craft legal rules” does indeed lie at the very heart of regulatory arbitrage. Legal rules, the basis for regulatory action, are language-based. For any transaction to qualify for regulatory enforcement, it has to display the features which appear in the relevant legal text – for example the characteristics of “shares” or of “voting rights”. Whenever a legislator chooses a legal term, this involves a certain “willingness to abstract” on his part.^[52] Out of the variety of situations, actors, contractual structures and more, legislators distill a typical, paradigmatic set-up. In that way, the legislator’s decision on how to handle a situation, treat the actors or the contractual structures can be made operational.^[53] When drafting the fitting term for this generalizing exercise, the legislator must make a choice between broader and narrower legal terms.

A narrow wording offers legal security for both, the regulated, who know what to expect, and the regulator, whose sphere of competence is framed in precise words.^[54] At the same time, very precise wording will often lead to restrictions in regulatory enforcement. Coming back to the example of cash-settled derivatives, we see that reporting requirements were (pre-2013 under EU law and still today under U.S. law) narrowly framed and tied to ownership of shares and to voting rights. A financial derivative which does not come with a right to acquire shares fell clearly outside that narrow wording.

While offering legal security of this type helps to create an attractive marketplace for investors, it also implies accepting a certain degree of under-enforcement on the side of the regulator when faced with a situation outside the precise wording. Hence, the narrower the legal terms, the more significant the leeway for arbitrage: the chance to structure a transaction (or any other relevant issue) in a way which does not change its economic substance, but falls outside the legal term’s narrow verbal boundaries.^[55]

3.2 Legislative Drafting-2: Broad Wording, the Spirit of the Rule and the Critique of Legal Formalism

If a legislator is unwilling to accept the under-enforcement linked to a narrowly framed rule, he will opt for the opposite direction. Broad, general terms grant considerable discretion to the regulator, allowing for more efficient enforcement. Consider once again the EU reaction to cash-settled derivatives outlined above.^[56] If any financial instrument with a “similar economic effect” to a share qualifies for reporting obligations, as the EU regime assumes, this form of arbitrage becomes very difficult. The “gap to take advantage of”^[57] has disappeared because the broad, general rule invites the regulator to “see through” the chosen structure of a transaction. Similarly, interpreting a rule in light of its purpose, goal or spirit enhances the regulator’s options enforce and sanction behavior which seems similar to the one the legislator had intended to capture.

With this in mind, why can we not simply rule out arbitrage in this way? Pragmatic counter-arguments immediately spring to mind: What about “normal” investors who, with a perfectly legitimate business interest in mind, hold a simple put option, drag along and tag along rights or irrevocable undertakings? What about a lien on a share or an agreement which gives acquisition rights to a third party?^[58] How can we know if the regulator will consider these as having “similar economic effect”?

More substantive concerns point in the same direction. Any modern state following the rule of law and relying on due process will take pride in the notion of predictability of state action vis-à-vis citizens based on legal norms. What does not fall under the wording of a legal rule is typically nicht verboten (not prohibited). Where the rule in question is broad or open-textured, there are institutions such as regulators and courts to determine their meaning. The degree to which foreseeability is granted and legitimate trust on the side of citizens is honored depends on the type of state action in question. Sending a citizen to prison can only be done if an unambiguous legal provision allows for it. By contrast, settling a dispute between two private citizens via a state court may be more open to courts interpreting legal rules and principles – after all, one private party’s loss due to a court’s liberal interpretation will be the other private party’s gain.

Insisting that conduct can violate the spirit of a rule but still be “perfectly legal” puts an emphasis on legal security, foreseeability and on the words of a legal text. For some, this has the unpleasant ring of legal formalism. It has been suggested that “one source of regulatory arbitrage is associated with ‘legal formalism’ […] a relatively dominant approach in legal thinking and jurisprudence […]. The emphasis on literal interpretation […] constitutes a platform from which many of the intra-jurisdictional regulatory arbitrage opportunities can potentially be launched”.^[59] With its “emphasis on literal interpretation […] even if it ill serves the purpose of the rule”^[60] formalism has been described as carrying a conservative bias,^[61] a “tyranny of the past”^[62] or even a “spirit of rightwing Hegelianism”^[63]. Sticking to the words of a legal text makes arbitrage possible, so the argument runs, because it allows selling a transaction which is identical from an economic point of view as legally distinguishable. An obvious remedy, so it has been claimed, is to turn to broad wording or to a more creative, purposive interpretation.

Of course, the effects of broad wording or of an interpretation in light of the spirit of a rule vary greatly, depending on the area of the law we consider. In constitutional law, it is especially apparent that insisting on the wording of a provision, which does not adequately reflect current culture and values endorsed by most, narrows the protection offered to a citizen against state action. Put differently: a broad reading of the constitution will usually grant citizens more rights, not less. By contrast, interpreting criminal law rules in a broad and goal-oriented fashion curbs civil rights of those who have invested trust in how the law was framed.

Against this background, it is not surprising that we often witness regulatory arbitrage in areas of the law where a premium is placed on legal security. Securities law provides an example, being usually backed up by fines for perpetrators, at times even by the threat of imprisonment. Tax law, to name another example, orders us to pay money to the state. When breaking it we face fines as well as, potentially, imprisonment. The more intrusive the state action under the relevant rule, the more important are clear verbal boundaries.^[64] This is evident where the violation of a rule leads to imprisonment – an idea embodied by the principle of nulla poena sine lege.^[65] Monetary fines or loss of shareholder voting rights hurt less than prison but, obviously, are still enormously significant sanctions attached to “crossing the lines”.

What does this entail for regulatory arbitrage? At first glance, a promising venue to combat regulatory arbitrage could be to adjust the interpretation of the relevant rule in light of its spirit. A closer look has revealed, however, that a more nuanced assessment is in order. What could come across as formalist insistence on a rule’s wording is a key element of legal protection against intrusive state action.

Hence, the “gap between economic substance and regulatory treatment”,^[66] often, is the result of a balancing task faced by the regulator. Legislators and regulators wish to grant legal security for market participants, but at the same time to allow for efficient enforcement. They will generally be unhappy when becoming aware of avoidance strategies built around their rules and enforcement practices. However, for legal rules to serve as reliable guidelines for future behavior, they are also very attentive to providing a clear line between what type of conduct falls under the rule and what does not. Individuals will rely on its wording, corporations will shape their compliance programs accordingly,^[67] investors will take decisions on that basis and regulators will tailor their enforcement strategy to match.

3.3 Anti-Evasion Rules and Avoidance

Moving beyond legislative drafting via broad rules and interpretation, another obvious candidate for a closer look at the economic substance of a transaction are anti-evasion rules such as § 240.13d-3 para. (b) SEA:^[68]

“Any person who […] creates or uses a trust, power of attorney, pooling arrangement, or any other contract, arrangement, or device with the purpose or effect of divesting such person of beneficial ownership […] or preventing the vesting of beneficial ownership as part of a plan or scheme to evade the reporting requirements […] shall be deemed to be beneficial owner […]”.