In 2020 the world experienced the greatest economic slowdown since the Great Depression. Yet globalization is expected to roar forward. The hunt for yield and long-term value will direct more investment to emerging markets who are transforming into consumption-led economies. The reignition of trade wars will drive companies to spread out production around the world to make supply chains more resilient. The drive to widen profit margins will bring operations to lower wage countries. These trends entice firms to consider investing in emerging economies.
Their task, however, is made difficult by a troubling feature of developing democracies. In these jurisdictions, commerce is often regulated not by rule of law but rather through rule by law. This means political elites determine the fate of businesses through their appointed bureaucrats who enforce political control by determining the rules and regulations, and then apply these selectively. Favorable treatment by courts is predicated on a company’s standing in the eyes of the political bosses. By Western standards, this amounts to political corruption.
In much of the emerging world, the norm of a culture of nepotism based on family, identity and locality predates the idea of a democratic nation state by centuries. Because business agreements in the U.S. and Europe are protected by highly evolved democratic institutions, including the courts, companies do not have to rely on personal relationships to conduct their business. Still, even these democratic institutions sometimes fall under the siege of “tribal” forces intent on giving the upper hand to one group over another.
No amount of contractual lawyering or insurance coverage can insulate a foreign company from unknown contingencies the absence of a reliable legal system creates. Standard risk mitigation measures are not always enough. To get more control over the fate of their business interests, companies can devise alternative solutions to abate risks. We call this “leveraging outside the rule of law”.
Leverage, in this context, falls into two categories: Hard and soft. “Hard leverage” is the force of a governing authority to impose penalties or give relief. Legitimate governments apply hard leverage when administering rule of law. Criminal organizations also apply their own hard leverage through violence, blackmail, and bribes. “Soft leverage” includes all other means to inspire local actors, including officials and community leaders, to act in support of an enterprise’s progress, without offering these individuals any item of significant value. Soft leverage by this definition complies with foreign corrupt practice requirements.
Foreign investors in weak rule of law jurisdictions can better mitigate risk by developing local soft leverage strategies to get control over their organization’s future instead of putting all of their trust in the hard leverage system of legal institutions. Four types, or levels, of soft leverage are explained below.
Lever 1: Long-term benefits to host communities
Executives tasked with negotiating foreign direct investment (FDI) incentives know well the appeal of their enterprise to a prospective host country. By offering commercial benefits to the local population, such as jobs, supply contracts and transfer of know-how, they are indeed applying soft leverage.
Once an investment is made, the firm has a sunk cost. Without a reliable and strong rule of law system in place, the balance of leverage shifts to local partners and officials who become de facto custodians of the enterprise. Firms may not recognize their vulnerability until they face a challenge and see the hard leverage of judicial and other regulatory mechanisms they had relied upon evaporate.
Unless they had already invested in soft leverage, foreign firms may be ill-equipped to handle unpredictable obstacles imposed by a hostile bureaucracy. The local government may be supportive at the time of the firm’s entry into the market, but a different, less accommodating government may arise later.
Building soft leverage at the local level involves marrying a community’s welfare with the enterprise’s long-term success. This may involve openly making the scaling up of an enterprise (further investment, local jobs and contracts) conditional upon its local success. A company can also create soft leverage by committing to a community’s social sustainability through education, environment, and countless other Corporate Social Responsibility (CSR) initiatives.
CSRs should be created with the purpose of building a shared future with the local communities by aligning a company’s social and environmental activities with its business purpose. In doing so, CSR activities mitigate risks, enhance reputation, and contribute to positive results.
Let’s take an example. Azerbaijan-based NEQSOL Holding saw its 2019 investment in Caucasus Online, an internet service provider, stonewalled and expropriated by Georgia in 2020. Foreign ownership of strategic assets, including internet communications, can bring political costs to the leaders that allow them. So, in this case, NEQSOL was up against a steady current from the start. Once it became misaligned with government officials, there was no backstop of soft leverage to block the expropriation. NEQSOL had not made a significant investment in Georgia’s local communities through CSR, nor did it create major employment opportunities for the local workforce. Eventually, Georgia’s political leadership said the transaction did not have their necessary consent. NEQSOL claimed that its transaction was wrongfully targeted. The subjectivity surrounding the decision suggests that NEQSOL was entirely relying on the hard leverage of the government and may have been ill prepared for such a harsh judgement.
Lever 2: Public opinion as an ally
Even in authoritarian regimes, leaders want to keep domestic public opinion on their side. When locals feel they have a vested interest in the success of an enterprise, we can say the firm has soft leverage. Local communities can become antibodies against unfair treatment by urging decision makers to protect an enterprise that they support – either because they think it brings them benefits or sometimes simply for ideological reasons (for instance, because they see it being unjustly attacked by a domestic corrupt regime that they, too, despise).
International public opinion also matters. For one, FDI flows remain the most important external source of finance in many emerging markets where the leadership prioritizes it to drive economic growth. They understand that a successful track record of foreign investments can become a signpost for future endeavors, and their desire to keep investors happy may result in officials leveraging their own power over the state apparatus to support international enterprises.
In addition to direct economic (FDI) impacts of keeping international public opinion appeased, the instant and widespread flow of global information can also shape an emerging country’s standing on the international stage on other issues – such as tourism and security – in the eyes of Western governments and non-governmental institutions, who still maintain influence over the country.
A favorable public opinion requires a committed reputation management strategy. This can be achieved through crafting a narrative about the value benefits provided by the firm to the local people as well as by spotlighting a victimized firm’s rightful standing in the face of unfair and biased treatment by the authorities. Social media offers some ideal platforms to reach local populations as they are less likely to be censored.
Lever 3: Positive relationship with regime leaders
In some countries where checks and balances do not work as they do in democratic societies, being afoul with power elites can quickly render any enterprise inoperable. Prior to entering China, Google miscalculated the value the Chinese Communist Party placed on regime preservation. The value their search engine brought to the country’s knowledge economy was eclipsed by a conflict with the government over censorship. Google had to choose between sticking to its principles on free speech and withdrawing its search engine. Ultimately, Google chose to withdraw.
Successful NGOs and corporations have found it helpful to invest in developing relationships with key individuals to provide their organizations with what they often call a “top cover”. While some form of alignment with a local regime is desirable for many companies, they may have a hard time finding methods of doing this within legal bounds. If unprepared local managers find themselves pressured to bribe their way into good favor with officials, they seriously risk subjecting their firm to foreign corrupt practices violations and possibly even severe penalties.
Understanding leverage from the perspective of leaders requires a knowledge of how tribalism works. Regime leadership is backed by a community that supports it and benefits from it. The community is an interconnective web of businesses, organizations and government officials. Bonded by political or ethnic loyalty, they operate as a hive, commandeering control of the state by populating key positions in government as well as in the state apparatus. Regimes, in essence, are tribes.
In a country divided into rivaling communities contesting for control, a lot more than money and influence is at stake if a regime topples. In tribal societies, it is not uncommon for victorious actors to take crippling measures against rivals, including former incumbents of high positions. A leverage comes from working with the tribal forces that can lift actors to power and bring them down.
A tribal-minded leader will assess a foreign investment according to how much it benefits his or her community. The “hard-leverage” of bureaucracy is applied accordingly. Foreign investors can become collateral damage in an inter-tribal contest for supremacy. A well-intentioned foreign investor may believe the investment helps the entire country by bringing jobs and technology transfers. Regime leaders, however, may assess that these commercial benefits empower a local rival. The calculations for where to domicile a factory, who to select as a local partner and employ in senior management, and which communities get CSR, should all take into consideration the sentiments of the ruling regime that has regulatory authority over the enterprise. Directing these benefits to communities at odds with political elites can turn well-meaning actions into liabilities.
Take, for example, one of the largest “investments” in monetary terms in modern history: the Unites States’ efforts to stabilize Iraq. Saddam Hussein ruled Iraq through tribal leaders. US Government upset the tribal balance by attempting to implant a Western style democracy. The abrupt removal of Saddam’s autocratic regime and its replacement with a democratic state has been subject to strong criticism, internationally and from home. It failed because it took control away from the real power brokers of the country, the tribal leaders, who had long ruled via deeply engrained local norms. Violence ensued for five years following the US intervention and was ultimately quelled by General Petraeus’s strategic maneuver to make powerful Iraqi tribal leaders beneficiaries of America’s policies.
Transforming potential problem makers into stakeholders is a key aspect of ensuring leverage. Helping local communities with ties to ruling elites develops grassroots support, reduces legal risks, and puts political wind behind the enterprise.
Firms must stay alert that any such incentives are carried out in full compliance with FCPA regulations. It is advisable to consult a lawyer prior to making any offers or transactions in a foreign territory.
Leverage 4: Intelligence as a weapon
In jurisdictions where contracts are not readily enforceable through law, they become the beginning points of long negotiations with local officials and business partners. The ever-present risk of extreme and unpredictable change further complicates doing business in emerging markets. New regulations, financial instability, and political turmoil can end up altering what the counterparties had initially deemed a fair agreement. Anticipating a return to the negotiation table, firms can strengthen their bargaining position by better understanding what costs and/or benefits its counterparties are able to or likely to use to their advantage.
Leverage also matters when keeping management control over an investment made in a foreign jurisdiction. The presence of a loyal set of eyes watching accounting and inventory movements can alert foreign partners to potential fraud, embezzlement, or other illegal/undesirable activities related to the enterprise.
Conclusion
Tribalism flourishes everywhere in the world, not just in developing countries. When people band together and compete for political influence or commercial gain, they are acting in a tribal fashion. In mature democracies, however, the potential of such tribes attaining an unfair advantage is balanced by real rule of law and the force of impartial state institutions. Where business interests are protected by contractual agreements that are systematically and efficiently enforced by the courts, the need for business owners to establish leverage outside the rule of law is very small.
If tribes can commandeer and exploit the power of the state, the legal system is rendered unreliable and businesses are forced to find other means of protecting their interests. There is not a cookie cutter solution to mitigating political and financial risk in all such circumstances. Every country’s cultural and political dynamics at a given point in time must be taken into consideration when devising a strategy.
The courts are one means of what we would call “hard leverage”. As explained above in detail, by seeking additional means of “soft leverage”, businesses can develop other tools to better protect their investments in foreign jurisdictions.
*Allen Collinsworth is the president of Fara Group. The services that Fara Group provides are fully compliant with the laws of the United States and the local laws of foreign countries where it operates on a project basis. Faragroup will not facilitate any illegal activity.