Arm's Length Market

What Is an Arm's Length Market?

An arm's length market describes a financial market consisting of parties that have no relationship or contact with one another aside from the transaction at hand. In the United States, the majority of exchanges are considered to be arm's length, where buyers and sellers are matched according to only to the details of a transaction. The two parties will often remain anonymous - never knowing they were involved with each other. Arm's length markets go a long way in determining fair market values for assets.

The transactions that take place in arm's length markets are known as arm's length transactions, in which the buyers and sellers act independently and do not have any relationship to each other.

Arm's length may be contrasted with arm-in-arm, where counterparties know each other and may have pre-existing relationships.

The Basics of an Arm's Length Market

An arm's length market is based on the principle that parties should have equal influence in transactions. Furthermore, it removes opportunities for deals derived from personal relationships, which may manipulate the market, as well as taking advantage of personal relationships (either positive or negative) to influence price. Modern stock markets are considered to be the paradigm of arm's length markets since electronic trades do not reveal who the counterparty(ies) are.

The expression is used specifically in contract law to arrange an agreement that will stand up to legal scrutiny, even though the parties may have shared interests (e.g., employer-employee) or are too closely related to be seen as completely independent (e.g., the parties have familial ties).

Tax laws throughout the world are designed to treat the results of a transaction differently when parties are dealing at arm's length and when they are not.

An arm's length relationship is separate from a fiduciary relationship, where the parties are not on an equal footing, but rather, power, control, and information asymmetries exist.

It is also one of the key elements in international taxation as it allows an adequate allocation of profit taxation rights among countries that conclude double tax conventions, through transfer pricing, among each country.

Example of an Arm's Length Market

For example, Samer is attempting to sell his house in the market and move away. His daughter LoLo lives in the same city. He would like to keep the house in the family as it has been for years. Samer has the house appraised, and it is worth $1,750,000.

However, his daughter just finished college. Thus, she cannot afford the house at the fair market value. So, Samer, being a great dad, decides that he will sell the house for $200,000. This is not an arm’s length transaction because the two parties are related. Furthermore, the agreed upon price was discounted well below the fair value. If Samer had sold to a complete stranger for $1,550,000, this would be arm’s length because they are unrelated. Even though the price is slightly below the appraisal, the agreed upon price is the result of negotiations between the two parties.