Regulatory Arbitrage and High Growth

Arbitrage is a pretty standard term in business, particularly in finance and investments. However, arbitrage is also a fairly standard strategy when addressing regulatory oversight. Despite past success, this method of obtaining approval may be inconsistent and provide a negative connotation depending on the circumstances.

What is Regulatory Arbitrage?

In general terms, regulatory arbitrage consists of organizing discussions with multiple regulatory agencies, aligning their focus to a single or small subset of issues, and addressing all of those issues simultaneously to expedite the process of approval. Rather than spending time and resources on addressing concerns of, for example, the Securities Exchange Commission (SEC), then spending more time and money addressing different concerns of the Federal Trade Commission (FTC), regulatory arbitrage attempts to align all interests and resolve issues simultaneously.

More officially, Black’s Law Dictionary offers the following definition: “Using internal and external differences in business activity. It is done to reduce costs and expand profits. Refer to regulatory consolidation and regulatory harmonization.” Investopedia provides a negative depiction of the strategy, providing “regulatory arbitrage is used by firms to capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulations.” (Emphasis added). The inclusion of the term “loopholes”, I believe, is not necessarily appropriate in this definition and highlights one negative perception of this strategy.

Regulatory Arbitrage Applied

There are a few different scenarios where this strategy may be applied. Really, any situation where multiple regulators have an interest in a transaction or operation, regulatory arbitrage may be attempted. However, the two main scenarios I want to highlight are high growth (Uber) and takeovers/large transactions (Mittal Steel).

Uber — incorporating regulatory arbitrage into the business model

Uber is a great example of regulatory arbitrage, or at least a model to conceptualize how this strategy plays out both within the US and amongst multiple international regulatory agencies. This Business Insider article makes my case for me, but Uber’s model of initially operating in a legal gray area relies on the ability to persuade various regulators to lift the red tape. In part, Uber relied on public support to change local politician’s’ perspective.

Uber had troubles entering Miami, FL, until public support pushed them over the finish line as found in the Miami Herald.

“We had a major sea-change on our approach here in Broward, probably because of the public outcry of support for Uber and Lyft,” said Broward County Commissioner Chip LaMarca.

The ridesharing company was able to leverage support to pressure local politicians — either accept companies like Uber and Lyft, or get voted out of office.

This began one portion of Uber’s expansion strategy: (1) enter a city or market; (2) build public support; (3) regulators threaten fines or removal from the city; (4) fight back with public support and possibility of voting politicians out.

Regulatory arbitrage comes into play, because Uber was able to follow this same model in various markets. They built support and essentially said: “see what happened in Miami? Accept us or the same will happen here and you will be voted out.” Uber was able to focus conversations with various regulators on this topic. This aligned the discussion allowing Uber to fight the same fight (and win) in multiple markets.

Mittal Steel — aligning securities regulators in multiple countries to take-over competitor Arcelor

Mittal Steel also used regulatory arbitrage to expand; however, the context is much different than the Uber example. Rather than expanding into hundreds of small markets and dealing with local regulators (e.g. Uber), Mittal needed to align five countries’ regulators governing securities and corporate law.

Leading up to the acquisition of Arcelor, Mittal was the largest steel manufacturer in the world. The second largest steel manufacturer, Arcelor, was obviously a major competitor threatening Mittal’s growth in various international markets. The answer? Execute a hostile takeover of Arcelor. The next problem? Regulators.

Mittal needed clearance for the takeover in five jurisdictions: Luxembourg, France, Belgium, Spain, and the United States. The first challenge was the European Union Takeover Directive including Luxembourg, France, Belgium, and Spain. Each of the regulators asserted jurisdiction because the takeover impacted business and investors in their respective countries. However, they deferred to Luxembourg which enjoyed exclusive jurisdiction on corporate and market matters. This made Mittal’s life easier — they had to deal with one regulator rather than four. The decision of Luxembourg’s regulators would be utilized by the other three countries.

Next, Mittal elected to extend its offer for the takeover into the US to avoid future litigation. Having clearance in Luxembourg, France, Belgium, and Spain, Mittal perfectly executed regulatory arbitrage by having US regulators consider the same issues previously addressed. Rather than starting from the beginning, Mittal was able to push through discussions with US regulators using a previously approved proposal.

Prior to closing the transaction, Areclor also relied on regulatory arbitrage for the same reasons. When the acquisition was complete, Arcelor and Mittal’s separate stock became one, thus requiring both companies receive approvals from the countries and regulatory bodies mentioned above. Had either Arcelor or Mittal not succeeded, the transaction would have fallen apart.

The success of regulatory arbitrage is apparent considering the success of the takeover. Additional factors such as the sale of steel manufacturer Dofasco being required to eliminate conflicts threatening the transaction. However, the core issue of obtaining regulatory approvals was achieved by employing regulatory arbitrage.

Is this Strategy Worth the Risk?

Implementing this strategy is context dependent and may apply to various circumstances. Uber, for example, effectively applied the strategy in many scenarios, but using this strategy for growth into hundreds of small and several large (national) markets took substantial time, resources, and efforts. They still must rely on the strategy as they continue to grow. Mittal Steel, on the other hand, executed the strategy in a one-time acquisition requiring approval of five countries. This was not an ongoing strategy for growth like the Uber example.

I believe regulatory arbitrage is better built for one-time acts such as Mittal’s takeover of Arcelor. No one can deny Uber’s success given the ~$54B market cap. However, applying regulator arbitrage to Uber’s model is much more complex than in Mittal’s scenario.

Would you implement or recommend regulatory arbitrage?