IFCs: Providing The Rule of Law

The Needs

The world’s poorest countries desperately need their economies to grow if their populations are to have better lives. For example, Africa has about 17 per cent of the world’s population but only 3 per cent of global GDP. The root causes of African nations’ underdevelopment are complex, but one critical element is that there is too little investment in their economies. The same is true of many economies in Latin America and Asia. Few of the people living in them will prosper without more investment.

Some of that investment can come from internal sources, but most economies require outside investment to grow. Even where domestic savings exist at the levels necessary to make meaningful contributions to growth, most developing countries lack the legal and regulatory infrastructure necessary to support a domestic capital market. Even if robust domestic capital markets can eventually be built in most developing economies, it will take time for them to develop the reputations necessary to attract major foreign investment. And the investment needed will take many forms – laws and regulations cut the transactions costs for investing through equity, debt, joint ventures, subsidiaries, new ventures, and more. Each of those types of investment requires legal infrastructure, regulatory infrastructure, and courts capable of handling issues that may arise in the future.

Moreover, international investments often involve more than money. International investors bring marketing know-how, intellectual property, and a wide range of technical and managerial expertise. Non-financial contributions increase the demands on the legal infrastructure that supports the investment; for example, properly recognising, protecting, and accounting for intellectual property is more complex than a straightforward injection of cash would be.

Institutions For Meeting This Need

An investor contemplating an investment in a foreign jurisdiction must address several different categories of risk. First, the investment is subject to political risk. A change in government (whether by election or by coup d’état) in a developing economy can lead to significant changes in policy that can impact the investment. The government may seize the investment outright, devalue the local currency, impose exchange controls, raise taxes or fees, impose new taxes or fees, change the regulatory environment, or take other action that reduces the value of the investment. Today, outright confiscation is less of a problem than it was in the 1960s and 1970s, both because the dismal record of such seizures persuaded many governments that it was not worth the effort and because a growing body of international obligations generally requires payment to the owners of fair market value.

Regulatory risks remain a major threat, however. Some of these are addressed through the dense network of bilateral investment treaties which generally protect foreign investors by requiring that they be treated no differently from domestic investors. But such a guarantee does not prevent a foolish, misguided, incompetent, or evil government from mistreating both domestic and foreign investors equally. Venezuela provides a contemporary case study of how a kleptocratic government willing to destroy its economy can succeed in doing so in short order. Moreover, an investment treaty network protects only those coming into an economy from a jurisdiction with which the recipient jurisdiction has an investment treaty. (Some countries also assist their investors in making outbound investments by providing political risk insurance and a number of private insurers also offer policies covering at least some political risks.) Being able to opt in to a treaty network by locating a legal entity in a jurisdiction with a treaty with the destination jurisdiction vastly expands the opportunities for making use of these safeguards.

These measures do not address an important third category of risk, however. When multiple investors pool their investments, they need a mechanism to address the governance of their pooled investment. In some cases, the investment may be in a business entity directly, in others it may come from a pooled investment vehicle such as an investment fund. In either case, there is a need for a legal framework to govern the relationship among the investors (both foreign and domestic) and address potential future problems. This requires having up-to-date and well-thought-out statutes, precedents that – even if not binding – provide guidance on how particular situations will be handled, and a judicial system capable of fairly and efficiently resolving unanticipated disputes in the future.

The Role Of IFCs

IFCs help meet the demand for solutions to this third category of risk. By providing legal systems which offer a powerful combination of modern, efficient, well-designed laws and regulations, regulatory agencies staffed with experienced, well-credentialed experts, and court systems capable of quick, fair, and thoughtful decisions, IFCs offer alternative locations for transactions and entities. Because investors’ confidence in the robustness of their transactions and structures is greater due to IFCs’ legal environments, the riskiness of the transaction declines, and the rewards necessary to lure investors into the transaction are reduced. In short, the price of investing in a developing economy is reduced.  And when the price of something falls, the amount demanded increases. That’s good for investors, it’s good for developing countries, and it’s good for the world’s poorest.

IFCs have three crucial advantages over the investors’ home jurisdictions and the developing economy. First, locating an investment entity in a neutral jurisdiction rather than where some of the investors will have a “home court” advantage lowers risk and puts those involved at ease that they will not be disadvantaged by favouritism toward the local party.

Second, IFCs have developed sophisticated bodies of law and regulations to enable investors to custom-build entities and transactions to meet their needs. Not only do jurisdictions like the Bahamas, Bermuda, the Cayman Islands, Guernsey, the Isle of Man, and Jersey have modern statutory frameworks for companies, LLCs, partnerships, and trusts, they are constantly innovating in improving those structures. The segregated portfolio company rapidly spread from Guernsey to other IFCs; Jersey’s trust law inspired multiple imitations; the British Virgin Islands’ International Business Company law inspired multiple refinements and adaptations. The dynamic created by competition among IFCs benefits the global economy by spurring innovation in solving investors’ problems.

Third, IFCs have assembled regulators and judiciaries familiar with the nuances of complex arrangements. They provide not only prompt decisions in contested matters but can bless arrangements through prior approvals. For example, some IFC courts will hear petitions by trustees seeking approval for transactions, and virtually all IFC financial regulators will meet with regulated entities to discuss proposed courses of action to ensure that regulatory concerns can be addressed ex ante rather than ex post. Building international confidence in the robustness of international investment vehicles to ‘unknown unknowns’ is a vital contribution.

Nothing stops any jurisdiction from providing this type of infrastructure, of course. But it is harder to do in large jurisdictions such as the United States or United Kingdom. Regulators in big economies are more likely to be constrained by the demands of consumer-focused regulation and the due process limits that their size and scope require than are the regulatory bodies of small jurisdictions. Every regulator I have spoken to in over a dozen IFCs has stressed the importance of maintaining an open door to the service providers and regulated entities. This doesn’t make them push-overs, of course. IFC regulators themselves often have multi-jurisdictional careers and having a financial scandal on their watch would be the kiss of death to their chances of promotion or a new job offer. Moreover, as collective bodies, IFC regulators know their jurisdictions’ reputations as legitimate business centres are crucial to attracting and retaining the types of clients they want. A key benefit of IFCs is that they harness these incentives to improve the international investment climate.

Developing countries face numerous obstacles in creating the financial and legal infrastructure that will bring investment. Not only can developing countries ill afford the cost of creating sophisticated financial regulators and courts at their current level of development, but they lack the important element of market pressure to keep the courts and regulators honest and focused. Everyone at the Jersey Financial Services Commission knows that a slip up opens the door for Guernsey to lure business away to it, and vice versa; Caymanian regulators know that making a mistake in Cayman gives an opening to Bermuda or the Bahamas, and their counterparts in Bermuda and the Bahamas are equally aware. This competitive pressure has not produced a race to the bottom but instead a race to quality. In the past two decades, the best IFCs have expanded their investment in their regulatory and legal infrastructure, joining and actively participating in international bodies like the International Organisation of Securities Commissions  (IOSCO)  and the Financial Action Task Force (FATF), earning high marks in assessments by the FATF, MoneyVal, and others, and demonstrating an overall commitment to keeping bad actors out of their jurisdictions.

Not Just Businesses

Investments require the rule of law to be successful but they are not the only source of demand for it. Careers take people across borders regularly, making funding and coordination of employee benefits such as health care and pensions more complex. Families share properties, businesses, and assets across borders, complicating estate planning, funding education, medical care, and more, and creating coordination problems with everything from insurance coverage to taxes. Multigenerational family companies and foundations that channel family charitable work span jurisdictions as well. Family offices are one way to meet these needs, but the legal and regulatory systems that permit solving these problems require considerable investment. The success of IFCs in attracting top lawyers, accountants, fund managers, and other professionals who provide such services demonstrates their value.

Conclusion

Improving the lives of the poorest around the world is going to require massive private investment in productive activities. This need cannot be met by government provided aid – its scale and capability are incapable of sparking the transformations necessary. It cannot be met through private charity, which is effective at focusing resources on addressing crises but cannot provide legal infrastructure. Both aid and private charity have important roles to play but they alone cannot transform the lives of the bottom billion. Only economic growth can solve this problem. And growth requires investment – of time, expertise, intellectual property, and money. For that investment to find its way into developing economies requires solving a number of difficult problems. It needs to be easier for investors to help spark that growth. One of the biggest obstacles is the lack of rule of law in the places that need the investment the most. Fortunately, IFCs are helping to meet this need.  

Andrew Morriss
Andrew Morriss is Professor of the Bush School of Government & Public Service and School of Law at Texas A&M University. Prior to this position, he was the Dean of the Texas A&M School of Innovation, the Dean of the Texas A&M School of Law, the D. Paul Jones & Charlene A. Jones Chairholder in Law at the University of Alabama, the Ross & Helen Workman Professor of Law at the University of Illinois, and the Galen J. Roush Chair in Law at Case Western Reserve University.