How To Operate Your Own Merchant Bank
STARTING AN INTERNATIONAL BANK
When a notorious bank robber was asked why he robbed banks, he reportedly replied, - "Because that's where the money is!". International investors have discovered for themselves that owning a bank can be even more lucrative than a career in bank robbery. Because running one's own bank dramatically demonstrates the benefits of offshore financial operations, it is the first case study of what can be accomplished once the investor breads free of domestic confines. Banking is not as exotic as it might seem at first glance. A bank is merely a company organised much like other companies. It is built upon trust and it flourishes, as all companies do, by keeping promises. The following material is of equal importance to the user as well as the organiser of any international business organisation.
History of Banking
Banks were originally warehouses that stored the gold and other valuable property of customers. These warehouses often were operated by goldsmiths who had to safeguard their own stock anyway and issued receipts for the stored valuables. If a buyer wanted to make a payment to a seller, the buyer might sign his warehouse receipt over to the seller or write an order (draft) to the goldsmith telling him to pay some of the buyer's gold to the seller. This was easier and safer than taking his gold out of the warehouse and personally delivering it to the seller. A short time after gold warehousing began, warehouse owners figured out that, gold being gold, they could lend out some of the gold and earn interest, keeping enough on hand to take care of day-to-day withdrawals. Thus fractional reserve banking was born.
Whether or not fractional reserve banking was begun with the knowledge of the depositors, it soon became the way most banks did business. Banks came to pay interest on deposits instead of charging storage fees. Today, depositors lend money to a bank and that bank in turn lends most of it to borrowers, acting as a loan broker.
Banks are more than that, though. In a real sense, banks make money. Their debts, their promises to pay, are money. A bank account balance, which is nothing more than a debt owed by a bank to a depositor, is treated as money by the depositor himself, by those people he makes payments to, and by the government that counts those bank balances in the monetary statistics. Money has become paper, and banks are able to create money in the course of their day-to-day operations. For example, let's say a deposit of US$1,000 is placed in Bank A. Assuming that banks are bound by a 20 percent reserve requirement, (which is higher that that percent normally required by regulators), then Bank A can loan out 80 percent of that money. Bank A thus loans US$800 to Mr. Butcher, who deposits the money in Bank B. Bank B lends US$640 of Mr. Butcher's money to Mr. Baker, who deposits it in Bank C. Bank C lends US$512 of Mr. Baker's money to Ms. Stickmaker, who deposits it in Bank D, and so on. Notice what has happened. The bank accounts of all of the parties still reflect the full balances that they have deposited, even though most of the money was lent out. As the original US$1,000 works its way through the system, it has multiplied to almost US$5,000. All of this new money was created by the banks involved.
Because banks have this unique power to create money, the right to start a bank frequently has been sought by financiers to benefit from their operations and jealously guarded by the entrenched financial establishment. It is more difficult to start a bank than to start perhaps any other business. Brains and money are not enough; political muscle is necessary to overcome the opposition of the established banks who enjoy their monopoly position and fight to preserve it. The bank regulators have established a close relationship with existing banks. Each side benefits from the status quo and no one wants to wee new competition shake things up. The banks will take money and loan it out but they resist letting their clients get into the game. The following pages explain how to start an offshore bank and gain the benefits of banking.
Although it is difficult to start a bank in most of the large bureaucratic countries, there are many nations whose laws are not as strict. In fact, there are jurisdictions where people have been able to start banks just by incorporating a company with the word bank in its name. This has allowed a number of casual to damage the reputation of other banks. When this happens, the local government often restricts the issuance of new licenses and tries to clear the deadwood out from among the old licensed firms. Other jurisdictions, such as the Cayman Islands, have had reasonable bank regulations for some time and so have prospered as financial centres.
When just starting out in banking at a low level of capitalisation, the best strategy is to incorporate the bank in as good a banking environment as one can afford, then to build up enough of a reputation for keeping commitments to start doing business in a better location. Most of today's large banks started with one person or a small group of people who offered nothing but their promises and reputations.
Bank formation is a very political activity everywhere, so it's impossible to know what jurisdiction will be best by the time this introduction is printed. Once a site is selected, a local professional will help obtain the bank license. The local assistance of a registered agent will be needed, in any case, and a well - known local professional can open many doors during the organisation process. A travelling to selected locale to find one. The formation process itself can teach a great deal about how things are accomplished in the chosen haven and in the offshore world in general.
A short aside about preparation is in order here. It is important to learn as much as possible about investing before moving into the international investment community. Someone uncomfortable doing business with his local bank or broker will not enjoy overseas dealings. It is essential to put in the preparation time required by complex ventures, otherwise one may be better off accepting the services of an established international organisation.
One shortcut is to buy a bank that is already in existence. This saves a good deal of time and should end up costing about the same as doing it from scratch. There are companies that make their living by establishing banks and then selling them to interested buyers. These companies range from clean to shady and the normal rules apply about knowing what one is buying before paying. It is a good idea to contact the regulatory authorities in the country where the bank is located to check on the company's reputation. In addition, contact an independent local professional in the area to get an opinion on the legitimacy of the proposed sale.
Organizing the Bank
Bank organisation will be different for each jurisdiction entered. Many banks are incorporated in two tax havens to facilitate business continuity in case the laws (or the government) change in the primary county. The following decisions are common to most banks and are followed by a typical application process.
Capital requirements vary from virtually zero to several hundred thousand US dollars. The lower end applies to countries with no banking laws. The potential banker merely organises a regular corporation and calls it a bank. The more sophisticated tax havens, such as Cayman, The Bahamas, and St. Vincent, have reasonably high capital requirements. This capital need not be cash. Marketable securities, real estate, bonds, and even personal property may be used, provided their value can be proven to the authorities. When carefully structured, most of the money can be borrowed. The borrower must be able to honour the note, however.
In most cases, capitalisation must pass through at least one other bank in the tax haven to prove that it does exist. A country that requires the assets to remain there will not remain on anyone's list of desirable tax havens. A country such as Anguilla couldn't begin to absorb that much capital.
Naming the Bank
The selection of a good name is paramount to a bank's success. One's good reputation and financial strength will be associated with the bank's name, which will be difficult to change once business has commenced, both legally and in the minds of clients and correspondents. The bank can create money only if others accept its paper as money. this trust is dependent, in part, on the institution's name.
The name should be clean and distinctive. Avoid long, wordy, difficult to spell names. Consider selecting a name in another language to reflect transnational business dealings: Banco de Carib, Banco National de Columbia, or Bankhaus Caveat.
Other names create the impression that the bank is substantial, such as: Swiss International Bank Limited, European Pacific Bank Limited, and The First Bank of North America. European Overseas Bank was derived from European American Bank and California Overseas Bank, both multimillion dollar banks.
Still other bank names are directly associated with the owner. Some examples are: Kennedy International Bank and Trust Company, Alexander Bankcorp Limited, and Banque Peterson. The bank name may also describe the types of activities it conducts, such as EP International Trade Bank, Financial Guarantee Bank, and Caribbean Savings Bank.
The international trademarks of other firms must be avoided. Some corporations will sue anyone with names vaguely similar to theirs. Recently, City Bank, a multibillion dollar New-York-based bank, filed suit against 4 million dollar City Bank of San Francisco for having a similar name. While the small bank could win the suit, it might not be able to afford the legal fees. In addition, this type of harassment can affect acceptance of advertising by international periodicals.
Bankers want to deal with other members of their club. There are thousands of banks in the world, so even major ones may not be familiar to everyone. Two recognised international bank publications looked to for information on the size and legitimacy of banks are the International Bankers Directory, (better known as the Banker's Blue Book), and the World Bank Directory, published by Thomsom Financial Publishing (P.O. Box 71690, Chicago, IL 60694-1690, USA, Price: US$330).
Entry in one or both of these listings is highly advisable if a bank wants to do business with organisations that aren't familiar with it or its associates. These publications are serious about maintaining the quality of their listings. At minimum, banks have to submit proof of incorporation. A new bank's incorporator can probably handle the listings.
The bank's directors are elected by the shareholders to direct company policy and appoint the officers of the bank. They are normally the largest shareholders or their close associates. In some cases, outside directors may be elected to advise on areas of expertise not available through the owners or management. Large customers or potential customers may be included both to add knowledge and cement business relationships. A bank directorship is a prestigious and profitable position. The directors know that there is at least one bank where they can get preferred treatment and they also receive a small annual fee.
The stockholders of a bank sometimes prefer to keep their investment confidential. For various reasons, they may not wish to appear to be associated with either the ownership or management of the operation. In most tax havens, the use of nominee directors will ensure this. These are appointed agents into whose names the bank stock is transferred by agreement. They are the owners of record but, per agreement, vote according to the instructions of the true owners. A nominee will generally charge about US$500 per year for this service.
Resident Representative or Office?
All tax havens have local accountants, attorneys, bankers, or quasi - governmental officers who act as local agents for banks or other businesses. These agents forward mail, answer inquiries, represent the bank to regulatory agencies, and perform any other necessary services. They normally charge a minimum fee for a basic package, plus additional time and expenses for extra services. The bank is expected to pay the direct cost of telephones, telexes, and postage. Annual costs for the agent's services vary greatly according to transaction and communication volumes. The representative is bound by the local bank secrecy and responsibility laws.
The establishment of an office offers many advantages over using a representative. For one, the staff is fully dedicated to the bank's needs. A trusted associate who already knows how the organisation operates can handle transactions on site. This reduces crucial communication time lags and lowers the legal exposure of conducting bank business in another jurisdiction.
The drawback is expense. The bank has to rent an office and hire staff. Office equipment, supplies, and furniture are surprisingly expensive in less developed tax havens. An expatriate manager has to be paid wages that are about equal to the home salary. As most tax havens do not encourage outsiders to enter their job market, expect difficulty in getting the necessary entry and work permits for a manager.
Lastly, remember that business in less developed countries runs more slowly and more inefficiently than in the industrialised world. Whether dealing through an agent or one's own office, patience an tolerance are necessary to successfully manage the bank.
It is possible for the owner to travel to a particular tax haven and follow through on the major items of bank incorporation. It's much the same as trying to act as one's own general contractor. Any money saved will probably not compensate for the time and aggravation expended. It is advisable to retain a well - connected professional experienced in dealing with the particular government and bank licensing. Bureaucracies like to deal with friends. Most tax havens have local attorneys or advisors who specialise in chartering offshore banks and corporations.
The incorporator advises the owner on the information required and the form of the documentation necessary, submits the application to the proper authorities, and follows is through the maze of local bureaucracy. Nominee directors are hired by him if necessary. The incorporator helps the owner decide whether to use a registered representative or to open an office. He also helps implement decisions. The incorporator can assist in defining the structure of the organisation, supply information about local conditions, provide marketing ideas, and contribute many more useful services to aid the profitable birth of the bank.
HOW TO PROFIT
As a profession, bankers enjoy high status and the trust of the business community, with a reputation for being conservative. However, the reader who has had many dealings with banks has probably been frustrated by their lack of imagination or, possibly, by incompetence. The fact that bankers consistently make money is an indication of how easy it is to be a banker. The innovative services that major banks cannot or will not offer. The remainder of this introduction covers various services that have been successfully offered by major international banks as will as tax haven banks.
The key to conventional banking profitability is for the bank to borrow money at a low rate and lend it out at a higher rate. The least expensive source of money is deposits: non-interest demand, interest - paying savings, and time deposits. The broader the deposit base, the more stable the bank's money costs will be. The longer the terms of the deposits, the lower liquid reserves need be.
One St. Vincent bank was opened by a large US manufacturing company just to take advantage of the US - St. Vincent float. The firm estimates that opening a bank just to pay suppliers added US$500,000 to its profits. However, some debtors are hesitant to accept foreign checks and will not authorise credit until they clear. Since governments almost always accept these checks, they are an excellent means of paying tax liabilities.
Another selling tool is the numbered checking account where no signature is required, only the account number, although the secrecy regulations of most tax havens do not require banks to even respond to inquiries about depositors. Since each account has a number for accounting purposes anyway, this service requires no extra effort. This offers clients the ultimate in confidentiality but entails a heavy responsibility on the bank's part of protecting the identity of the account holder. The account holder can have all checks and statements retained at the bank or sent wherever requested. A post office box is recommended for all confidential correspondence.
Savings accounts are an offshore bank's most attractive deposit service. A tax haven bank is not required to report information on individual accounts to any governmental agency. If the bank's client chooses to evade taxes in his home country and deposit certain assets in his tax haven bank, he can considerably increase the investment yield on his savings account. This is the simplest use of a tax haven bank. It is a use over which the bank has no control.
This tax advantage means that the interest rate paid does not have to be much higher than major bank rates. For example, the authors know of offshore banks that paid 9 to 13 percent on US dollars while the Eurodollar rate was 10 to 11 percent. Interest rates vary with the amount and time period of the deposit.
As the offshore bank doesn't have a household name and isn't located in a major money centre, it does have to pay slightly higher interest than major banks and provide better, more innovative service. The offshore bank needs impressive documentation, professional advertising, and an articulate staff. It must present a substantial appearance so that people will trust it with their money.
Deposits are developed through business associates, family, friends and the public. When advertising, the bank must consider the banking law of each country in which it advertises. International publications with a multinational and sophisticated readership, such as the Economist and the International Herald Tribune, are good vehicles for attracting clients. These ads should not be too pointed, so as not to attract regulatory attention. Each inquiry is promptly followed up with brochure, rate sheets, and a signature card.
A mailing list is established with these names, for sending updated brochures and announcements of new services every few months. Potential customers are reassured by this proof of continuity. Actual deposits can arrive months or even years after the first contract.
The bank can accept deposits in any major currency. In these inflationary times, many people seek to protect their assets by investing their savings in a hard currency, such as Swiss francs or German marks. These countries have established a reputation for upholding the value of their currency and for avoiding depreciation by inflation. The bank converts the deposits into the bank's prime currency, figures interest on the original amount, and converts back when the account is drawn upon. The cost of this transaction increases if the currency deposited becomes more valuable than the prime currency, so the bank may cover a larger deposit with a currency futures contract. However, this complicates bookkeeping as a new account must be set up to record currency valuation losses or profits.
A classic banking strategy for increasing deposits is to require compensating balances for loans. A 12 percent loan with a 25 percent compensating balances requirement produces an effective interest rate of 16 percent. A 12 percent loan of US$100,000 for example, accrues US$12,000 annual interest. If the borrower only gets the use of US$75,000, the actual rate is US$12,000/US$75,000 or 16 percent. (Loan packages requiring a 100 percent compensating balance are discussed under lending.)
Imaginative packaging of services helps increase deposits. Trust administration requires that some money be kept in current accounts to pay for current obligations and new investments. When providing management services for other banks, insurance companies, or trading companies, the offshore bank enjoys, in turn, the deposits and clearing services of these organisations, as well as its management fees. Real estate administration and margin accounts also provide cash flow through the bank.
After the offshore bank has successfully attracted deposits, something must be done with them. Lending money at a higher rate than interest paid on it insures a profit, but only if the loan is repaid. Successful lending depends on good business sense, the ability to read people and balance sheets, knowledge of collateral, and negotiating ability. Spread the risk wide enough that one or two bad loans won't cripple the bank.
Most tax havens do not have usury laws, so the offshore bank can charge higher interest rates than are allowed in most countries. The bank can accept a percentage of ownership in a customer's organisation as part of the fee for a loan. When doing so, it tries to negotiate as high a compensating balance as it can to take advantage of a bank's right of offset. This means that if the bank is owed a past - due debt by the organisation, the bank can use any of the borrowing assets it controls to offset the debt. Therefore, any compensating balance is money that will not be lost, serving to lower risks and increase profits.
Some loans can be structured with 100 percent compensating balances. The loan is immediately transferred to a savings account in the bank. These back-to-back loans have a spread of 1 to 3 percent, the difference between the loan rate and the savings account rate. There are several reasons these loans can be useful.
A corporation may need to show a higher capitalisation on its books than it actually has at a particular point in time to enable it to get a loan form another lender or better terms from its suppliers. A principal in the company can borrow a sum from an offshore bank and use it to purchase a time deposit from the same bank. He then uses this certified deposit to purchase more stock in the company. As a result, the company's balance sheet shows increased paid - in capital and increased current assets. The principal's personal balance sheet reflects a higher level of debt and a higher asset value of investment in the company. The interest paid on the personal loan can be deducted, while the company pays taxes on interest received. Since the personal tax rate is normally higher than the corporate rate, the tax reduction can cover the bank's free.
An entity producing foreign income can do even better. It can set up a foreign trading company, for instance, to be managed by the bank. The trading company buys a product at production cost and sells it at a normal profit margin. The profit is then invested in a time deposit account. The amount of the deposit can be lent back to the parent company at a 1 to 3 percent spread over the Certificate of Deposit (CD) rate. Since the trading company is based in a tax haven, it pays no taxes on either the profit or the interest received. The parent company gets use of the profit and receives a tax deduction on the interest paid by the bank.
Here's an example: Parent company A manufactures a product for US$800,00, which it sells for US$1 million. The US$200,000 profit is invested in an 8 percent CD and is lent to A at 10 percent. A's tax rate is 48 percent and the offshore tax is zero. The balance sheet shows
Original Cash Flow
US$200,000 profit pre-tax
(US$96,000) tax @ 48%
US$104,000 profit after tax
With an offshore company and back-to-back loan, the figures read as follows:
US$800,000 trading company sales
(US$800,000) cost of goods
0 gross profit
(US$20,000) interest paid @ 10%
(US$10,400) foreign sales loss
(US$16,000) interest @ 8%
US$216,000 Total profit
Parent A's loss US$216,00
US$205,600 net corporate profit
(US$104,000) profit after tax w/o offshore company
US$101,600 increase in net
So, in this example, the after - tax profit on the foreign trade portion of the business increased by 98.9 percent.
Other loans made by the bank are covered by various levels of collateral. Business loans can be backed by stock, inventory, and compensating balances. Real estate or constructions loans, of course, are collateralised by the property. Personal loans also can be made.
An interesting variation is accomplished with a captive insurance company. It works in this way: A US corporation sets up a self - insurance trust to cover employee hospitalisation and worker's compensation claims. This trust reinsures almost all this risk with a foreign insurance company that is owned by a principal or the corporation. The surplus is lent back to the corporation as we have seen previously.
This allows companies to retain profits they would otherwise be giving to insurance companies as well as accumulate cash reserves tax - free and obtain current US tax deductions for most of the costs.
Lending escrow money is slightly more risky. The bank lends someone a sum that is kept in escrow at the bank or a co-operating escrow company. The agreement must be written such that the escrow cannot be closed and the money transferred unless additional financing is obtained. This allows the client to tie up a property until money is found to pay for it. This type of loan should require higher fees than the previously discussed loans. If the escrow should close, the bank must pay the amount agreed upon. Then there is no deposit to offset the bank's up - fronted cash payments if the client cannot pay. Some banks have received 3 to 10 percent loan origination fees and prime rate plus 3 percent as interest on this type of loan. A real estate expert should approve each escrow agreement before the bank makes the loan.
An active securities brokerage profitably increases loan production. The brokers sell the equivalent of a US margin account, allowing the bank's customers to borrow a percentage of the value of their stock or commodity purchase. The bank then lends up to 75 percent of the cost of listed stocks with reasonable safety. A St.Vincent bank, for instance, has a margin account in the US through which it does most of its trading. Through the account, the bank purchases securities for its customers with complete secrecy and lets clients borrow up to 75 percent of the value of the securities purchased at an interest rate of about US prime rate plus 2 percent. The bank borrows 50 percent of the purchase from its clearing broker at slightly less than prime rate. Thus the bank makes about a 2-point spread on half the purchase price. If the bank watches each open position carefully, the only risk is in huge moves or trading suspensions.
Say there is purchase of 1,000 shares of EP Corporation at US$50 a share. The shares are kept for 6 months and sold for US$60 per share. Prime rate and brokerage interest rate is 12 percent. The bank charges 14 percent.
US$50,000 initial cost
US$50,500 total cost
US$37,500 loan @ 14%
US$50,500 total payment
US$60,000 gross proceeds
(US$2,625) interest @ 14% of US$37,500
US$56,875 net proceeds
US$37,500 payment of loan
US$19,375 net to buyer on a cash investment of US$13,000 equals 98% annual return on investment
The bank borrowed US$25,000 from its broker at 12% lending:
US$37,500 to the customer @ 14%
US$2,625 interest received from customer
(US$1,500) interest paid to broker
US$1,125 net interest on US$12,500 net loan 18% annualised return plus US$1,000 commission.
The customer's return is speculative. The bank's return on investment is stable.
Another option for the bank is to purchase debt instruments, such as acceptances, commercial paper, bonds, and promissory notes. Purchasing a loan is much the same as making one, although the buyer may be able to get some sort of guarantee from the seller to reduce exposure. Buying or selling instruments allows the bank to balance its loan portfolio and spread its risks much the same as reinsurance.
Care should be taken to ensure than loans are complementary to the capital structure. If deposits are short-term, the bank should be careful about making many long-term loans. It should not have too much illiquid collateral, for if some large loans are defaulted, it may become difficult to meet short-term obligations. It's a good idea to keep the size of individual loans below 10 percent of the net-asset base. While this seems like a conservative, corner banker's philosophy, it is also sound business judgement for a small company. Not following this practice reduces one's chances of becoming a big company.
A bank must make up for small size with innovation, service, and accommodation. That is how it can surpass the corner banker and avoid the need to speculate or make imprudent loans.
A tax haven bank can make investments for its own portfolio, particularly when the bank's owner wishes to make investments confidentially and to pay no taxes on the gains. It is also possible to arbitrage investments, (that is, by a stock in one's home jurisdiction while simultaneously selling it short offshore). This is done so that the loss is suffered in the country where a tax loss can be used, while the gain is made in a tax-free jurisdiction. This is most easily done with commodity transactions. Although for tax purposes commodity transactions are marked up to market at the end of each year, no such restriction applies to securities transactions.
An Anguilla bank has been able to earn significant profits through commodities brokerage by using some of its particular banking advantages. In one transaction, it was able to purchase sugar in Central America by issuing its own letter of credit to the seller. The L.C. specified that delivery and payment were to be made at a future date. The bank then found a buyer at a higher price. Receiving the buyer's letter or credit, the bank was able to immediately negotiate it at a discount at the buyer's paying bank. Just by exchanging paper, the bank made in excess of US$400,000 in profit with little risk. Anything short of the physical delivery of gold bullion is a paper transaction; the fact that only paper changed hands is what made it a banking transaction rather than an ordinary warehouse transaction.
The bank's array of financial services is its most important method of gaining customers and deposits, as well as being a source of lucrative fees. An offshore banking license normally allows the licensee to be a broker, agent, insurer, advisor, manager, guarantor, and perhaps, even confessor. Each of these services can be contrived to increase deposit and loan business. In most cases, the fees are competitive with those in a particular market. A few telephone calls can provide the prevailing rates.
The authors have noticed that mere mention of involvement in an offshore bank sometimes elicits the comment. "Oh, dirty-money laundering." Some people imagine that a tax haven banker spends most of his time in the back room counting US$100 bills.
A banker who does that type of business undoubtedly knew his customers long before his offshore banking career began and would never talk about them. The money would be deposited, sent to companies who would lend it to others to disperse it even more. A convoluted trail is necessary to obscure from various regulatory authorities the sources and uses of these funds. Corporations are easily set up in tax havens such as Panama or Hong Kong, where little or no reporting is required. As long as countries try to impose confiscatory taxes on their citizens and interfere with free trade, money laundering will continue.
There is a related service field that is easier to enter: moving money out of blocked-currency countries. Many countries restrict capital outflow. Whatever reasons may cause a country to block currency will also cause its citizens to want to get their money out. Offshore banks can help these people control their own wealth.
There are at least as many ways of circumventing currency laws as there are countries making them. One technique works like this. A manufacturing company wishes to convert blocked currency to US dollars, move the US dollars offshore, then sell the offshore US dollars at a premium. The company arranges for a letter of credit to be issued by an offshore bank in its favour. The credit is payable by a Hong Kong company upon shipment of some high-technology equipment. This credit is taken to a friendly banker who lends the US dollars ostensibly to buy necessary supplies from the US. The funds are transferred to the offshore bank and deposited in savings accounts or certificates of deposit. The company then sells the US dollar funds to nationals at a 25 percent premium over the official exchange rate. After selling, it repays the loan in blocked currency at the official rate. The items are never shipped and the letter of credit expires. The offshore bank gets a fee for the letter of credit as well as new deposits. The original company makes 20 percent on the exchange rate.
The offshore bank also charge excess prices for goods and services to entities in these countries and then deposit the excess in their accounts. Here again, the bank gets fees and deposits. This is known as "over-invoicing'. Over and under invoicing for currency and tax considerations is, today, Hong Kong's largest service industry.
Several offshore banks have been successful in providing letters of accommodation which can aid third parties in obtaining financing for their projects. This is simply a letter from the bank stating that, upon the deposit of a specified amount into a "sinking fund", it will issue a letter of credit guaranteeing the payment of a larger sum in the future. For example, the letter might require a US$485,000 deposit to guarantee a US$1 million payment in 10 years. The US$1 million is simply US$485,000 compounded annually at 7,5 percent for 10 years. The initial sinking fund deposit pays for the letter of credit.
Note that the bank does not commit to obtaining the financing or even the initial deposit. Its letter promises so little that the letter must look very impressive for it to be able to help anyone. This type of letter has been successfully used to establish credibility, tie up a deal, and interest other lenders or investors in the underlying transaction.
The bank can earn further profits from this venture by actually issuing the letter of credit. It not only gets 1 to 2 percent of the future guarantee as a fee but also a 10 year deposit paying a fairly low interest rate. However, if the client could raise the sinking fund payment, he probably wouldn't need the guarantee, so the bank loans the cash to him. It then gets a 2 to 8 percent spread over the savings account rate.
The letter or credit must be written so that it cannot be opened (that is, accepted) unless the underlying deal has a reasonable chance of success. Otherwise, the note will not be paid and the bank will still be obligated to pay someone the face value of the letter of credit at the future date. It cannot offset the savings account because acceptance of the letter of credit moves the bank's obligation to a third party, while the obligation to pay the bank remains with the original party. Therefore, banks that issue many letters of commitment for accommodation or credit are careful about lending money to support the letter of credit.
These documents are most useful for reassuring private investors. A prime bank will only accept the letter of credit when it wants to make a loan but needs more documentation for its loan file.
A stand-by mortgage commitment is another type of guarantee. This assures an interim lender that the client will have long - term financing available to pay off the construction loan. To begin the project before normal long - term financing is obtained, the developer will have to pay the offshore bank several points for a stand-by commitment he hopes he will never use. The interest rate of a stand-by loan is several points above prevailing rates to compensate for the bank's risk in financing an uneconomical project.
The bank charter allows the bank to be a broker/agent for real estate, commodities, securities, or insurance. This can be done for its own account or for clients. Security and commodity transactions can be cleared through established brokers at wholesale rates. The bank offers clients confidentiality and the ability to avoid taxes.
A bonus for securities trading client is the ability to circumvent some countries' restrictions on insider trading or trading in restricted stocks. A client sometimes purchases the stock of a company he owns or represents because he is privy to information not released to the public. He can profit from this information through an offshore bank without various government or exchange investigators hounding him. Care should be taken that the actual mechanics of the purchase and sale do not violate the laws of any country where they are carried out. This can be accomplished in almost every instance with proper structure and transaction planning.
Almost all tax haven bank charters bestow the authority to carry on the business of a trust company, to receive assets into custody on behalf of clients, and to manage, administer, and invest them in accordance with their instructions. Competitive fees are low for this service and the responsibility to the client is great. All jurisdictions are seriously upset by any violation of the fiduciary responsibilities of a trust. Trust laws are complicated and competent legal advice is probably necessary for each situation before a bank gets into this business.
Providing management services for other offshore organisations should be profitable, particularly if the bank has an office in the tax haven. In the case of offshore insurance and trading companies, we have already seen that the tax advantages, particularly when coupled with the back-to-back loans, makes management easy to sell. The bank earns fees both for setting up these companies and for managing them.
This can also be true with bank management. If one want a bank without the added overhead of a walk-in office, anther bank with an office can be the perfect agent. The managing bank knows the business, can answer questions, and act as correspondent. Both banks profit, one from lower overhead and the other from more fee income.
The running of an offshore bank quickly builds valuable experience in investment, tax, trust, negotiation, and such areas. The bank can sell this knowledge as a consultant. Since few people in the world have been exposed to the many types of international services available, the bank can almost always show clients where potential savings can be made. A reasonable consulting fee structure helps avoid wasting time with the merely curious. The bank may waive fees if the client does purchase its services.
However, since service is an offshore bank's best selling point, it will offer almost anything to keep its clients happy.
The broad business charter granted by most offshore banking authorities enables banks to participate in profitable related financial activities. Each of these can generate fees as well as new deposit and loan business. Insurance, investment banking, mortgage banking, title and escrow, and fiduciary services can all fit into the business plan.
This introduction has discussed how managing captive insurance companies can generate income. The next logical step is writing one's own insurance policies. The organisation can reinsure those captive insurance companies already under its management, as well as insuring or reinsuring its own (and its associates') risks. The bank keeps the profits and the investment capital. Until its reserves have grown enough to pay large claim, it should reinsure at a comfortable level. Reinsurance companies keep low profiles but are easy to find in the United States, Europe, and most island tax havens.
It is relatively simple to decide what areas to insure. Compare premiums for the last five years with claims paid. Check the most profitable insurance companies to see what lines they sell. Consult an actuary before reinsuring for others; they keep track of statistical probabilities of various claims and losses. Actuaries can be found in the telephone directory of any major city.
An insurance company can also sell annuities, a lump sum payment that guarantees the client a specified stream of income for life. The cost and payout are derived from actuarial tables and suitable interest rates. Deposits derived from annuities are particularly suitable for long-term investments such as real estate. Accordingly, insurance companies can perform much of the same investor services that banks do.
Investment banking, a related business which requires sharp financial, marketing, and negotiation skills, can be quite lucrative. When underwriting a large project, there are fees for packaging and marketing the issue. The underwriter may negotiate a percentage of equity ownership or the project as an added incentive. Deposits are created from the proceeds of the issue and from a normal banking relationship with the client.
The prospectus is the primary document an investment bank uses to raise money from the public. It must show a strong professional business plan and detail a complete description of the venture and its risks. The successful underwriting of a large project will bring the bank prestige as well as profit.
Mortgage banking is a less exciting but still valuable service. The bank can invest in mortgages for itself or be an agent for others. Payment collections, record maintenance, and remittances to the mortgages are an additional source of fees. Entrepreneurs needing mortgage money can be cross sold such services as financial guarantees, escrow loans, and tax reduction services.
A title and escrow company associated with the offshore banking and mortgage banking business provides additional possibilities. The bank lends money to a client who gives it to the escrow company to deposit back in the bank. Thus the money never leaves the bank until the escrow closes. The agreement can be written so that the escrow does not close until the client resells the property or gets paid back without ever losing control of the money. The bank receives escrow fees, loan fees and interest on the loan. The client has tied up a large piece of property with little front money and can make a quick profit on the sale.
This chapter has shown some of the ways that money can be made with an international bank. Most of these techniques also apply to international corporations generally. These techniques have worked for others. How far each person can go with them or add to them will be determined by his or her imagination, determination, intelligence, and salesmanship. The authors make no ethical or legal judgements concerning the application of the techniques to any specific case. Moral and legal standards vary widely among the jurisdictions with which a transnational trader will probably do business. Accordingly, these judgements must be left to the reader and legal counsel.
Tax considerations have been treated rather simplistically due to the differences in local laws. In almost all cases, tax problems can be solved legally. An expert in the area's local law should be consulted.
In mature economies, growing businesses have problems securing expansion capital. This leads to the slow growth and the negative growth trends that have been the most significant features of the American economy over the past 25 years.
Commentators spend a great deal of time wondering why the economy is growing so slowly. The answer is simple: economic growth is slow because there has been precious little capital accumulation. People have not been saving at the rates that they used to because the government siphons off an increasingly larger chunk of people's money. Government polices make it easier and more beneficial to spend and consume rather than to save and invest.
Why should anyone bother to save when he will not be able to enjoy the fruits of his savings because of high tax rates? Remember, consumption is not taxed as much as earnings and leisure is not taxed at all. Instead of saving for retirement, people are trapped in an old-age welfare program that keeps money unavailable for investment in productive enterprises. By transferring wealth from the industrious to bureaucrats and slackers, the government has guaranteed that waste will replace industry.
The government has placed other barriers in the way of raising capital. The rules and regulations of the SEC make it very expensive and time consuming to raise money. A public offering usually takes more than six months to put together and costs anywhere from US$50,000 on up. The SEC leaves a person with two choices when he wants to market his securities: he can place them privately among friends and relatives without active marketing, (this can be effective if one's relatives are named Rockefeller), or he can register his securities with the SEC do a public offering.
Private placements make it difficult to raise substantial sums of money unless one is well connected. The SEC allows a maximum of only 35 friends and family members, so they had better be willing to invest a lot. The seller can also place shares privately with "sophisticated" investors who invest over US$150,000, but they can be hard to find.
Public offering require the seller to file numerous pieces of paper and then wait months for the SEC to approve the proposed sale. A huge company with a staff of lawyers may be able to cope with the piles of paperwork required for a public offering but a person just starting his own business may find it unworkably difficult. This is doubly bad for the economy because employment experts project that the vast majority of new jobs will come from small companies. No one knows how many people remain unemployed because companies could not get money to fund their start-up operations.
Public offerings are so expensive and so slow that they are useless for taking advantage of immediate opportunities. By the time all the paperwork is done, the chance has slipped away. Public offerings also require that companies disclose confidential business information to competitors and whoever else is interested. This information sharing can be particularly damaging to new companies in areas of emerging technologies. Recently, the National Security Agency, (America's eavesdropper to the world), asked that one of its contractors, an electronics company, withdraw its public offering. The NSA feared that the annual filings that the company would have to make would give other nations too much information about the relationship between the agency and the company.
These problems with public offerings have caused a number of major companies to go private in recent years. They no longer wish to deal with the burden of Securities regulators.
Individuals can use the international financial markets to go private too. This chapter discusses how to legally sell securities in a broader market than that allowed with private placements. The reader will learn how to improve his balance sheet in a remarkably short period of time. He will also find out how to tap into the international investment community, where the wealth of the world feeds from restrictive taxes and regulations seeks new outlets for profit.
A large American institution recently found itself in some financial difficulty. It needed to borrow a great deal of money. This institution had nearly exhausted the resources of domestic lenders, so it turned to the international offer lenders anonymity and tax-free interest to entice them to lend their money.
Thus the US government recently began to market its obligations to foreign nationals. It repealed, (for some types of payments), the 30 percent withholding-tax law that had required withholding taxes from payments made to residents of countries without tax treaties with the US. It also allowed foreign banks to buy securities and hold them for anonymous beneficial owners, as long as the banks certified that the true owners were not residents of the US. These two new regulations also apply to obligations issued by US banks and corporations.
The official explanation for these changes was that they allow large US borrowers to tap the Eurodollar market directly for funds, without having to use the numerous subsidiaries that they have set up in the Caribbean to get around the domestic restrictions. The real motive, however, was that the US government itself wished to enter the market to hold down its cost of borrowing, and to reduce the risk that its massive borrowings would dry up the credit markets and bring on a recession before the 1984 presidential election.
In order to play the informational money game, even the government of the United States had to bow to the rules and give foreign lenders the conditions they demand. It is not as generous with its own citizens. They remain subject to the Bank Secrecy Act, which requires banks to reveal all fact about their customers, and to the standby withholding regulations, which require banks to withhold taxes from the interest payments of all account holders who have failed to supply their correct Taxpayer ID or Social Security number. It might be worth one's while to discover how to follow the example of the federal government and large corporations and raise money overseas cheaply and privately.
BEARER DEPOSITORY RECEIPTS
The Securities and Exchange Commission is limited by restrictions that do not necessarily apply to a private company or individual. The basic restriction on the SEC's regulatory authority is geographical; its authority does not extend beyond the borders of the United States. It is therefore possible to construct a series of domestic and foreign transactions that might not be legal in a single country but that are legal in the country in which each transaction takes place. Such a series of transactions requires careful planning and expert legal and financial advice, but can be a fast and private way to raise money.
Here is an example of how such a financing plan might work. Quantum, Inc. is a small but innovative electronic company that needs money in a hurry for substantial speculative research. An eventual breakthrough in the research project would reap tremendous rewards but no breakthrough can be guaranteed. For these reasons, Quantum would have liked to finance this research by going public. However, because of difficulties and delays imposed upon companies going public in the United States, a normal regulated public offering cannot meet Quantum's needs. Time is of the essence in the highly competitive field of electronics.
Incorporate Hong Kong holding company. The series of transactions necessary to generate capital for Quantum begins with the incorporation of a Hong Kong company named Quantum Holding, Limited. Hong Kong has been chosen for this example but any of 15 other jurisdictions could have been used. Quantum Holding is incorporated and managed by nominees, and its scope of authority is severely limited. The number of its authorised shares and their par value identical to those of Quantum.
Holding company purchases stock from Quantum. Quantum Holding makes an offer to Quantum to purchase 10,000 shares of Quantum stock, the same number Quantum would have issued if made a public offering. In lieu of cash, Quantum Holding pay for the shares with a one-year promissory note. This transaction is permitted under securities regulations because the buyer is foreign and no offer to sell is made domestically.
BDR are sold in London. The nest step is for Quantum Holding to issue 10,000 shares of its stock, placing them with a St.Vincent bank that act as depository. In exchange, the depository bank issues 10,000 bearer depository receipts (BDRs). These BDRs are placed, on best-efforts basis, (in some cases this function is not needed or can be performed elsewhere). Arrangements are also made for the broker-dealer to act as market maker for the BDRs as well. Note that these transactions do not take place domestically and do not involve domestic nationals. Therefore, they are beyond the jurisdiction of domestic securities regulations. In the countries in which the transactions occur, they comply fully wit local laws and regulations.
BDR proceeds are paid to Quantum. When the BDRs have been sold, the funds generated from the sale are remitted to the depository bank in the West Indies. Under prior agreement, the depository bank forwards them directly to Quantum, on behalf of Quantum Holding, to retire the promissory note. As before, this series of payments is fully permissible in the jurisdictions through which they pass.
The only legal caveat that should be made at this point is that securities regulations do not permit such a sale if there is a pre-existing intent to distribute the bearer depository receipts domestically or to distribute them to domestic nationals abroad, except by unsolicited private placements. Although one cannot be held accountable for who ultimately possesses these bearer documents, it would be improper for the distribution to be made with the express intent of putting such BDRs in the hands of fellow citizens on a general offering basis.
Maple Leal Real Estate, Inc.
Another example of how bearer depository receipts work is provided by Maple Leaf Real Estate, Inc. It is a publicly held company. However, large blocks of its stock are held by management and promoters in lettered or restricted form. These shareholders are active in a wide range of capital intensive business dealings, many of which require a high degree of liquidity from their participants. For this reason, the management of Maple Leaf Real Estate would like to accommodate its needs for liquidity through the legal transfer of the lettered shares.
Shares are deposited and BDRs issued. To provide the needed liquidity, an agreement is entered into with an offshore bank to act as a depository for shares of Maple Leaf stock. Under this agreement, the depository bank issues bearer depository receipts in exchange for shares of Maple Leaf stock deposited by both Maple Leaf and other holders. These BDRs can be held by the owners of the deposited stock or by the depository bank itself under a placement agreement.
BDRs are sold through London market maker. As in the case of Quantum, arrangements are made to have a London broker-dealer act as a market maker for the BDRs. Once this is done, the market maker may be contacted directly for the buying or selling of BDRs. If preferable, the depository bank places the BDRs with the market maker for sale on behalf or the depositor of the original shares of Maple Leaf stock.
BDR sale proceeds are paid to stock owners. The funds from such sales are remitted to the depositors of the shares, thus providing them with the liquidity they seek.
In addition to the greater flexibility that holders of restricted shares of Maple Leaf Real Estate now have, Maple Leaf itself raises capital from new offerings, just as Quantum did.
Note that in each case there is no restriction on domestic buyers purchasing the BDRs on their own initiative. However, no recommendation may be made to a local client to buy the BDrs through the London market maker. On the other hand, a duty to disclose the existence of a London market for the related BDRs arises when such information is material to a domestic transaction.
Gilt Complex Mining
Gilt Complex Mining is a newly claimed, one-man gold mining operation in Colorado. Although assay reports have been very good, (0.47 to 0.63 ounces per ton), the extent of the ore body has not yet been fully determined. Another uncertainty arises from the fact that the ore is made up of complex gold-telluride compounds that may be very expensive to refine.
In spite of these problems, the owner of Gilt Complex believes that the company's claim can be brought into profitable production if enough money is raised. A number of social and business associates have expressed an interest in investing but the funds they could contribute fall short of what is needed to bring the mines into operation.
Because of the highly variable gold market, the delay inherent in a full-blown SEC registration is considered unacceptable. As the company is in the initial stages of development of its mining properties, its funds are already committed to assessment of the claims, payments on equipment, and salaries. There are no extra moneys available to pay for an offering of BDRs through London as described in previous examples. An analysis of Gilt Complex Mining's situation suggests that a two-stage procedure should be used to raise funds.
Raise seed money. The first step is to raise as much money as possible through domestic private placements. The owner's friends and acquaintances, (numbering no more than the SEC-approved limit of 35), and unlimited numbers of sophisticated investors, (those investing more than US$150,000 in cash), can be approached and persuaded to invest.
Seed money funds BDR London offering. This private-placement seed money is then used to fund a Hong Kong holding company and BDR sales in London as in the example of Quantum, Inc.
These two steps complement one another. The first phase provides money for the second and the second phase gives the domestic private-placement investors an easily ascertainable fair market value for their shares. All that they need do, if they wish to determine what their shares are worth, is to find out what the BDRs are trading for in London.
BUSINESS BALANCE SHEET LOANS
Wouldn't it be wonderful it one's business could create net worth just like a bank? With an accommodating financial institution, it is possible. The case history that follows shows how small businesses can use these methods to get the financial help they need.
William Ballast is the owner of a wholesale distribution company. When one of his suppliers announces a gigantic inventory sale, Ballast is eager to take advantage of it. He knows that if he can increase his inventory with goods at the lower price, his average unit cost will be lower and profits would increase accordingly.
Ballast calls a financial consultant to discuss his problem. Ballast is advised to submit a current balance sheet reflecting higher cash assets to obtain a more favourable line or credit. Although Ballast favours such a move, he also wants to avoid a long-term debt commitment. He fears that the interest payments from such a debt would wipe out any gains made by buying the additional inventory on sale.
Owner borrows moneys from lender. The consultant suggests that a personal loan be made to Ballast. The funds from this loan are to be placed in a savings account in the name of Ballast's company. After the funds are deposited, the company would have a new balance sheet prepared according to accepted accounting practices, which would reflect its increased liquidity. With the stronger financial picture presented, the supplier could be more favourably disposed toward extending the line of credit. Ballast is convinced that this is a sound approach and enters into an agreement to implement the plan whereby the funds would be provided by a lender supplied by his consultant.
Deposit loan proceeds in company account. When the funds are lent to Ballast, he simply endorses the cashier's check to the bank on which it was drawn. At the same time, a passbook for a savings account, containing an identical balance and bearing the name of Ballast's company, is issued and turned over to Ballast.
Increase company assets on balance sheet. Based on the updated balance sheet, the supplier increases the line of credit for Ballast's company. After the new credit line is established, the funds, no longer needed, are returned to the lender. The cost of the program was kept to a minimum and the desired profits realised.
Robert Jensen knows of a valuable parcel of land that he believes could be profitably developed. If he could get an option on the property, he could organise a highly successful joint venture to develop the land. Jensen is afraid that if he doesn't act quickly, someone else will buy the land from under him. He needs time to secure funding for the option and line up partners for his joint venture.
Secure option on land. Jensen convinces the landowner to give him 90 days to raise the total purchase price of US$2million. In order to hold the land for 90 days, Jensen needs to deposit 10 percent in an escrow account as a demonstration of his financial strength.
Borrow money to open escrow account. Working with a consultant, Jensen arranges for a bank to loan him US$200,000 and hold it in an escrow company account on his behalf. After the account is opened, the company provides Jensen with documents showing that the moneys are on deposit. The escrow company then writes a series of letters indicating the steps being taken to assure the successful completion of the transaction. The satisfies the seller and gives Jensen time to put his investment group together.
From joint venture. Potential investors approached by Jensen are excited by the project and are especially impressed by the fact that Jensen has already secured an option on the land. They agree to fund the project with Jensen as equity partner and project manager. Jensen contributes his option.
Substitute new escrow account. The joint venture then opens a new escrow account for US$200,000 and substitutes it for the one originally opened by Jensen. The old account is closed. The funds in the original escrow, having served their purpose, are returned to the lender.
As a result of the above transaction, Jensen now holds substantial equity in a commercial real estate development worth several million dollars. His only costs were a few points for the loan, the escrow account, and the supporting documents that went to the various interested parties.
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