Regulatory Arbitrage

What Is Regulatory Arbitrage?

Regulatory arbitrage is a practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulations. Arbitrage opportunities may be accomplished by a variety of tactics, including restructuring transactions, financial engineering and geographic relocation to amenable jurisdictions.

Regulatory arbitrage is difficult to prevent entirely, but its prevalence can be limited by closing the most obvious loopholes and thus increasing the costs associated with circumventing the regulation.

How Regulatory Arbitrage Works

Businesses might apply regulatory arbitrage strategies to take advantage of tax havens and other forms of regulatory breaks. This can be accomplished by incorporating the company or establishing subsidiaries in jurisdictions that offer regulatory advantages.

For instance, the Cayman Islands are frequently chosen as the relocation destination for companies applying regulatory arbitrage. The government of the Cayman Islands allows businesses to form there and not pay taxes on revenue earned outside of the territory. Rather than pay taxes, companies located their pay a licensing fee to the local government. Similarly, in the United States, many companies choose to incorporate in the state of Delaware due its more favorable taxation and regulatory environment.

While regulatory arbitrage is often legal, it may not be entirely ethical as the practice can undermine the spirit of a law or regulation that can lead to potentially harmful consequences. For instance, if a country has lax regulations on money laundering, a corporate unit located in that country could exploit that to conduct malfeasance.

Enticing Regulatory Arbitrage

Reduced regulatory burdens and increased privacy on executive income have made such havens attractive to banks in particular. Economic crises in the United States triggered the introduction of legislation to bolster regulation of the financial industry. The heightened burden faced by these banks led to regularly arbitrage efforts.

For example, banks might look to cross-border acquisition deals in order to create an avenue to essentially escape the regulatory systems they are under. By acquiring an institution in a more favorable regulatory environment, the bank might be able to remove itself from oversight deemed burdensome.

There are locations within the United States that offer certain tax breaks. There is no state sales tax for example in Delaware. State corporate income tax on goods have also been eliminated in that state. Businesses incorporated in Delaware do not need to have their operating headquarters located there to benefit from the tax breaks or other advantages. For example, a company could establish a subsidiary office in the state to meet the criteria need to benefit from the regulatory breaks the state offers.

Companies can also structure transactions to their advantage. An example of regulatory arbitrage came from Blackstone's 2007 IPO. In an unusual move, Blackstone went public as a master limited partnership in an effort to avoid the higher tax rates imposed on corporations. In order to retain these tax advantages, Blackstone also had to avoid classification as an investment company. Through carefully negotiating the tax regulations, Blackstone sought to exploit a "regulatory arbitrage" between the tax code's legal definitions and economic substance.