Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Nasdaq, LSE, Cadbury Schweppes and extra-territoriality

The UK has in the last week been involved in two tussles about extra
territoriality but has been on opposite sides in the two tussles. In
the case of the possible acquisition of the London Stock Exchange
(LSE) by Nasdaq, the UK has been eager to ensure that the
extra-territorial jurisdiction of US law (particularly Sarbanes Oxley)
does not affect companies listed at LSE. In the case of Cadbury
Schweppes, it is the UK that has been told to stop exerting
territorial jurisdiction to impose a tax on the UK company’s
Dublin subsidiary which is subject to low taxes there.

The fear of extra-territorial jurisdiction of US laws over a US
owned LSE is quite well grounded. Way back in 1979, in the wake of the US
hostage crisis, President Carter issued Executive
Order 12710
under the International Emergency Economic Powers Act
stating: “I hereby order blocked all property and interests in
property of the Government of Iran, its instrumentalities and
controlled entities and the Central Bank of Iran which are or become
subject to the jurisdiction of the United States or which are in or
come within the possession or control of persons subject to the
jurisdiction of the United States.” Nearly half of the blocked
money was in deposits outside the US (principally in London). While
the Iranians did sue in London to release these funds, the courts and
governments were slow in resisting the extra-territorial demands of
the US order and since the entire hostage crisis lasted only 14
months, the legality of the US freeze was not adequately tested. A
good account of this episode is provided by Robert Carswell’s
article “Economic sanctions and the Iran experience”,
in Foreign Affairs, Winter 1981/1982.

In later sanctions against other countries, the US was less
successful. For example, “a U.S. bank in the United Kingdom was
ordered by a British court to release a Libyan bank’s assets
blocked under U.S. unilateral sanctions in 1986. The United States
subsequently authorized the release of the assets.” (GAO-04-1006
“Foreign Regimes’ Assets: The United States Faces
Challenges in Recovering Assets, but Has Mechanisms That Could Guide
Future Efforts”, Government Accountability Office, 2004)

Extra-territorial reach over UK listed companies through a change
in exchange regulations would be less vulnerable to judicial
challenge. The UK government therefore wishes to have a statutory
weapon against it. In a speech on September 13, 2006, Economic Secretary to the Treasury,
Ed Balls stated “ the UK Government will now legislate to
protect our regulatory approach. This legislation will confer a new
and specific power on the FSA to veto rule changes proposed by
exchanges that would be disproportionate in their impact on the
pivotal economic role that exchanges play in the UK and EU economies.
It will outlaw the imposition of any rules that might endanger the
light touch, risk based regulatory regime that underpins London’s

The Financial Services Authority has made its view clear in
February 2005 and again in June 2006.

[W]e will be indifferent to the nationality of the owners or the
managers of any future combined operation, and will be concerned to
ensure that the future operation meets our regulatory standards. If
the LSE remains a UK exchange under a new parent it will continue to
be subject to FSA regulation as a Recognised Investment Exchange

The LSE, as a UK RIE, plays a key role as a focal point for the wider
regulatory framework, including capital raising and corporate
governance. The attractiveness of the UK financial markets, and
ultimately the competitiveness of EU capital markets, depends, in
part, on a system of corporate governance and of regulation which is
of a high standard, but is proportionate and adaptable and attuned to
the requirements of users. (“Potential longer term implications of a
change of ownership of the London Stock exchange”,
4 February 2005)

However, we believe that there could be circumstances where a more
complex regulatory position might arise. Theoretically, in the longer
term, a new entity might seek to achieve further benefits from
rationalisation of its regulatory structure. This could at the extreme
involve the LSE no longer being subject to UK regulation as an
RIE. Its services might be provided from outside the UK, either from
the US, another EU member state or an alternative location, through
the provision of trading screens in the UK and with securities
admitted to trading on the market operated from elsewhere. Such a
move, were it to occur, would potentially have significant
implications for various aspects of the wider regulatory regime as
indicated in our February 2005 statement. If such a market were to be
operated from the US it would require member firms and issuers to be
registered with the SEC and subject to its
oversight. (“Implications of ownership of a UK Recognised
Investment Exchange by a US entity”, FSA/PN/055/2006
12th June 2006).

It is ironic therefore that the UK had to be reminded this week
about the extra-territoriality of its own tax laws by the European
Court of Justice. Though the tax rate in Dublin’s International
Financial Services Centre is only 10%, the UK claimed an additional
20% tax on the Dublin subsidiaries of Cadbury Schweppes on the ground
that these were “controlled foreign companies”. The
European Court ruled that if the foreign subsidiary has offices, staff
and operations in the foreign country, then the fact that it was set
up with an intention to obtain tax relief does not make it a wholly
artificial arrangement that justifies levying UK tax rates. Ireland is
a country that has built up a vibrant financial services industry on
the strength of a sound regulatory and tax regime. The court ruling
will hopefully allow this to survive.

In general, I like regulatory competition. I think of a regulator
as being in the business of manufacturing and providing regulatory
products and services. Consumers of these products and services
(investors, issuers and others) benefit if this
industry is competitive. Similarly, healthy competition in tax rates
also helps put a bound on the rapacity of the nation
state. A vigorous defence of the competitive structure of the
market for regulatory services is therefore very much welcome.


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