Investors can preserve and enhance value – and also enhance fairness – by building considerations of the Rule of Law into their investment approaches. If they act to reinforce the Rule of Law, there’s scope for them to bolster returns. If they don’t, they risk a significant loss of value over time.
Economies work better when the Rule of Law is in place. More commerce happens because businesses can trust each other, with the legal regime as something to fall back on if need be. Business occurs in the formal sector rather than informally, bolstering tax revenues and the overall robustness of the system. Investors can invest more because they have greater certainty that they will be able to retrieve their investments as well as make a fair return upon them.
The Rule of Law is fairness. By requiring that all, even the most powerful, are subject to the legal system, it ensures that governments and officialdom need to act fairly between parties and not in an arbitrary way. It is the basis on which commerce can happen without weaker parties fearing that they will be exploited by stronger ones in an excessively unfair way. It underpins capitalism by allowing us to believe it is worthwhile to agree contracts and to trust that they will be fairly enforced, and to believe that our property rights will be protected. The counterfactual of an absence of the Rule of Law makes for riskier business and riskier investments, and simply fewer investment opportunities because economic activity shrinks without these protections being in place.
Investors thus need to work to reinforce and bolster the Rule of Law so that their investments can prosper and flourish:
“This paper attempts to draw out the interdependence between economic prosperity, long- term investment and ESG, and the Rule of Law. It offers investors insights into the ways in which their ESG activities already interact with Rule of Law concepts and delivery. It seeks to develop ways in which this background issue can be brought more into the foreground of investor and company ESG activities.”
This quote is from my recently-published discussion paper for the excellent Bingham Centre for the Rule of Law. The paper also sets out concrete actions that investors can take to deliver on bolstering the Rule of Law. Among the tools available within the paper are a set of questions that investors might ask as part of these efforts. Reflecting the different roles in the investment chain, these questions come in different sections. Most notable are questions from asset owners to their fund managers, and questions from fund managers to their investee companies and other assets.
Among the questions for asset owners to ask their fund managers are:
- Which countries, if any, would you avoid investing in because of Rule of Law concerns? If none, why not? Why do you believe that you have sufficient protection for your investments in the absence of confidence in the Rule of Law?
- We note your increased exposure over the period to investments in [country XXX]. What due diligence have you done to be confident that the Rule of Law is sufficiently in place in that country for you to be assured of the returns you hope for from those investments?
- How do you integrate Rule of Law considerations into your stewardship activities, either in terms of activities to deliver against Principle 4 of the UK Stewardship Code 2020 or in your dialogues with investee companies?
- What are you doing to help ensure a fair playing field for companies that are seeking to maintain high ESG standards across their activities and supply chains, so that they are not undercut by less scrupulous competitors? How do you avoid investing in those less scrupulous competitors?
The questions that asset managers might ask their investee companies include:
- Which countries, if any, would you avoid investing in or working with suppliers from because of Rule of Law concerns? If none, why not? Why do you believe that you have sufficient protection for your investments and stakeholders in the absence of confidence in the Rule of Law?
- Which countries do you operate in where you are most concerned about your ability to rely on the legal system to enforce your rights?
- Are you confident about your ability to repatriate cash from your operations in [country YYY]?
- Where do you see legal and regulatory frameworks eroding that you believe may be a cause for concern in future years?
- Which countries do you operate in where you are most concerned about the extent to which the law allows others to outcompete on the basis of treating stakeholders less well than you believe is appropriate for your business?
The Rule of Law is fairness. It underpins good business. Smart investors who want to have good businesses and strong economies to invest in therefore have a clear interest in reinforcing the Rule of Law. Asset owners need to include this in their oversight efforts.
See also: The Rule of Law is fairness; Dobbs isn’t
The Rule of Law and investor approaches to ESG: Discussion paper, Paul Lee, Bingham Centre for the Rule of Law, September 2022