Generally

Offshore Financial Centers and Financial Havens require an appreciation of the transactional risks accompanying their benefits. Even the simplest transactions give rise to complex legal relationships and draw upon a number of legal disciplines.

It is essential in dealing with this aspect of using Offshore Financial Centers to develop a method identifying the various relationships created and the underlying risk associated with each part of the financial transaction. To accomplish this, a technique can be used in evaluating transactions to determine the means that can be employed to reduce or eliminate each risk. The identification of risks can be crucial because it also serves to broaden appreciation of the risk and reward relationship, thereby improving decision ability. The ability to minimize or eliminate risk is dependent upon the degree and types of risks involved. (1)

Analysts in the process of evaluating risks often divide them into three basic categories: legal risk, market risk, and credit risk. Legal risk can be explained as the risk that the legal or structural expectations of the parties to a transaction will not be fulfilled. An example of this risk would be the critical problems that can flow from the governing foreign law inherent in transactions involving parties of different countries. Political and sovereign risks can also contribute to such unexpected results by virtue of Sovereign Immunity concepts, the Act of State Doctrine, and exchange controls. These legal risks may occur ancillary to those doctrines or independently. Remedies may be weak, unreliable, or non-existent under foreign laws.

Market risk, on the other hand, comprises dangers of price fluctuation including currency or exchange rate risk. (2) This is unavoidable in many foreign investment or trade activities. A third category of risk used in this technique of isolating the particular risk is credit risk. It is of special significance in the complexities that international transactions occasion. Credit risk includes the risk that a counter-party will not perform to contract as a result of unanticipated business or financial circumstances. Generally counter-parties are those related to the transaction and who experience the credit risk stemming from their performance, financial condition, correspondent banks, and depositories such as clearing systems. These counter-parties and the attendant credit risk involve a range of risks. It can comprise a combination of legal relationships and credit risks. Liquidity risk can also be combined with legal and credit risks, producing a hybrid effect.

Legal Risk Overview

Legal risks are the risks associated with legal expectations of the parties. Each party to a transaction desires the transaction be performed according to their initial perceptions. The risks are managed by legal agreements and contractual instruments attempting to anticipate risks, thereby reducing or eliminating perceived exposures. The important key is the ability to recognize the various possibilities. It requires some individual thought because each can be unique.

International transactions pose particularly difficult legal risks because the international legal system is basically in its infancy. Offshore Financial Centers by virtue of their very nature are an exploitation of relaxed regulation and taxation anomalies among various countries. They can be wrought with major legal concerns. The nature of international transactions has its risk management embedded and dependent upon the ability to limit these exposures in a contractual agreement and corporate planning. It is appropriate, therefore, to address the basic elements of contractual and corporate considerations peculiar to international transactions. This involves a discussion of jurisdiction concepts, the governing law to be applied to a particular transaction, and the recognition and enforcement of legal judgments obtained. Additionally, the doctrine of Sovereign Immunity and the Act of State Doctrine are at the heart of these considerations. This writing has as its purpose to document in general the liability risk that comes with the use of International Financial Centers.

Legal Risk of Liability

The legal risk associated with jurisdictional issues involves interrelated corporate structures. This is basically an issue of how susceptible a corporate structure is to accountability of its deep pocket affiliate and the exposure of its parent or subsidiary units to theories of courts’ jurisdictional notions. The objective is to reach a particular affiliate of a corporate structure by gaining jurisdiction through its subsidiary or parent. The purpose may not necessarily be to reach the deep pocket but rather secure judicial jurisdiction in the sought forum.

Corporations are generally regarded as fictitious legal persons with separate identities. A claim against a parent corporation or subsidiary company is thought to be the responsibility of the particular corporate entity. This is the separate entity theory. That judicial jurisdiction is obtained over a subsidiary corporation does not itself provide judicial jurisdiction over a parent corporation, even in circumstances in which the subsidiary is a wholly owned entity of the parent. (3)

A theory contrasted with the separate entity theory is the enterprise theory. The enterprise theory promotes the notion that each entity is viewed separately and artificial. The theory prefers to view corporate structures in totality, viewing the entire structure as an enterprise, an integrated enterprise. These two theories are used in trying to pierce a corporate structure designed to insulate the liability of a subsidiary’s activities from its parent or affiliated subsidiaries. Offshore planning seeks to conform to these theories to produce liability insulation between affiliated entities. The enterprise theory seeks to pierce the corporate veil of a related corporate entity to gain access to its affiliates in order to obtain jurisdiction as well as for other purposes.

Several other theories are asserted in the seeking of judicial jurisdiction over an affiliate through its subsidiary or parent. One contention is based on the concept the subsidiary or parent is an alter ego of an affiliate entity. (4) An alter ego theory would likely be asserted when one corporate entity has consistently disregarded the separate existence and corporate formalities of a subsidiary. It can exist where a parent exercises a high degree of control over subsidiary activity. (5) Essential factors in this analysis are corporate formalities, the subsidiary operating with its own decision-making process, as well as independent and substantial capitalization. It must exhibit independence and autonomy. (6)

Agency relationship is another concept used under the enterprise theory to pierce the corporate veil for jurisdictional purposes. There is a general acceptance each entity is separate and independent, but the activity of one entity on behalf of the other can be to such a degree that it lends itself to piercing of the veil. The systematic and continuous conduct of business through the agency of a corporate affiliate can enable a court to obtain general judicial jurisdiction over a related entity. (7) Specific in personam jurisdiction can be obtained by an adjudicating court if specific activities are carried on by an agent-subsidiary. (8) Appropriate attention to these factors can enable corporate structures to avoid unnecessary exposure to the jurisdictional reach of foreign tribunals.

In summary, the classic utility of financial offshore planning is to avail the taxpayer of the benefits of the deregulation environment to avoid those costs and the lower tax incentives accorded foreign participants. In this process, conduit corporate structures that are wrought with intra-company pricing perils are policed by the intricate provisions of Section 482. (9) In gaining the international planning advantages the focus is often concentrated upon those complexities governing intra related entities and often times overlook these risks in developing advantageous structures and thereby subjecting the structure to avoidable risk exposure.

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Footnotes

 

1. See generally, Recent Innovations in International Banking, Bank for International Settlements, Chapter 10, The Impact of Innovation of Financial Stability, prepared by a study group established by the Central Banks of the Groups of Ten Countries (April 1986).

2. See Perspective: Managing Foreign Exchange Exposure, Harry Taylor, Managing Foreign Exchange Risk, Essays Commissioned in Honor of the Centenary of the Wharton School, University of Pennsylvania, Edited by Richard J. Herrins, Cambridge University Press, 1983.

3. Restatement (Second) of Conflict of Laws Section 52 (1971).

4. See Cannon Mfg. Co. v. Cudahay Packing Co., 267 U. S. 333 (1925).

5. See Miles v. American Tel. & Tel. Co., 703 F.2d 193 (5th Cir. 1983) and Fish v. East, 114 F2d 177 (10th Cir. 1940).

6. Born and Westin, 2/Judicial Jurisdiction, International Civil Litigation In United States Courts, page 105, Kluwer Law and Taxation Publishers, Deventer, The Netherlands.

7. Hargrave v. Fibreboard Corp., 710 F. 2d 1154 (5th Cir. 1983).

8. Frummer v. Hilton Hotels International, 281 N. Y. S. 2d 41 (1967).

9. IRC Section 482 (1986).

In accordance with Circular 230 Disclosure