Unpacking the FIERCE Risks: Enforcement of Contracts
This is part five in a six-part series of how we think about the risks of investing in early-stage companies in emerging markets.
June 27, 2019
The Enforcement of Contracts risk
The World Bank describes enforcement of contracts in the following manner: “Enforcing Contracts measures the time and cost for resolving a commercial dispute through a local first-instance court and the quality of judicial processes index, evaluating whether each economy has adopted a series of good practices that promote quality and efficiency in the court system¹.”
The ability to enforce a contract is central to the proper and effective functioning of any economic ecosystem. This stems from the notion of inviolability or sanctity of contracts — that whatever agreement lawfully and willingly entered into must be mutually upheld and dutifully performed by all parties. It is on this premise that where one party breaches the contract, the injured (non-breaching) party has the right to access legal mechanisms of redress, through a legal or regulatory system that recognizes and applies the appropriate judicial deliberations and resources to address the breach.
Where a jurisdiction has limited or uncertain mechanisms of contract enforcement, the adverse effects become evident. For instance, uncertainty created by challenges posed by corruption, high costs of legal procedures, or slow bureaucratic processes often deter investors from investing in entrepreneurs who have great potential or innovation, but operate in a risky or largely unexplored sector. Even in instances where the business model or product has been tested, investors may still hold back, because they are unsure of the consequences of a breach, and whether or not they will receive any form of relief from the legal or judicial system. These investors could range from individuals to investment funds and banks, who will be hesitant to provide capital to startups, small and growing businesses, and enterprises.
What that means for us
In our particular line of business, investing in emerging markets in Africa, we find ourselves making multiple considerations related to the enforcement of contracts. These include the associated costs, time, stakeholders such as sector regulators, the application of rule of law (as the basis for the enforcement of contracts), and complexity of procedures. We ask ourselves questions such as:
As a minority investor in the business, what provisions need to be included in the investment documents in order to protect our interests and prevent the management team from taking actions that may be detrimental to our investment?
What is the nature of our relationship with the portfolio company’s management team and how will that relationship be tested in the event of a potential breach of contract?
What steps should be taken and what recourse do we have when management is directly responsible for a breach, perhaps by not adhering to their agreement with us or applicable laws or regulations, or if the company fails, or the management team and the investors can no longer work together?
What is the practice or precedence within the country and sector for enforcing contracts?
What clauses do we have in our contracts to facilitate the enforcement of the contract, and will the country where the company is based honor a contractual agreement to use foreign law as the governing law for the agreement between the parties?
Are arbitration, mediation, or other forms of alternative dispute resolution recognizable forms of dispute resolution in the country where the company is based, and will a decision rendered using a form of alternative dispute resolution in another country be enforceable in the country where the company is based.
By agreeing to invest in a holding company based in a foreign jurisdiction with stronger enforcement of contract, can some of the risk be mitigated?
Do our clauses on enforcement of contracts conflict with other clauses that co-investors have with the same portfolio company? How does this affect us?
The contracting environment in any country plays a role in determining what players are confident enough to engage commercially in it. In emerging economies, there are varying levels of enforcement of contracts. The variations are both country to country, and sector to sector. For instance, if the regulatory framework has not evolved to match certain technological advancements, investors may find themselves weighing the potential risk posed by a failed contract in a jurisdiction generally lacking the means to address it, vis a vis the opportunity presented for both financial and impact returns.
Of potentially more weight, however, is the effectiveness and efficiency of the legal institutions². Where the law is comprehensive enough but the institutions are still lacking in capacity and/or are characterized by bureaucracy, corruption or some other incompetency, investors lack confidence in the enforcement of contracts. We therefore find ourselves asking broader questions such as:
What is the history of the enforcement of contracts in the jurisdiction under consideration?
What is the role of legal institutions in enforcing contracts of our nature?
Does the legal regime have a tendency to favor the investor or the investee?
What is the trend in enforcing a contract where the aggrieved party is a foreign investor?
Lastly, and of primary importance, is to consider the validity of the contract in question. As an investor, the responsibility for due diligence falls squarely in our lap:
Is the nature of the business permissible by law?
Has the company been duly incorporated (as per the laws of the land) and registered with the relevant authorities?
Do we, as an investor, have to file a notice with any authority before making the proposed investment?
The idea behind all the questioning is to identify the most effective system of redress, considering cost, time, and expertise. It also seeks to gauge the quality of the judicial process by considering court structure and proceedings, case management, court automation, and alternative dispute resolution.³
The rise of arbitration as the default method of conflict resolution
Arbitration as a dispute resolution mechanism has grown to general acceptance, and in some jurisdictions, such as Kenya, the courts can enforce a decision arrived at by an arbitrator. The benefits of arbitration make it viable and attractive to investors, including the faster process compared to litigation, lower costs, and the possibility of finding expertise with the particular area or sector in which the dispute occurs, as opposed to judges in the formal judicial system, who deal with nearly any kind of any transaction in any sector.
It is important to note that each of the five countries that VestedWorld has invested in — Ghana, Kenya, Nigeria, Rwanda and Uganda — has ratified The New York Arbitration Convention on the Recognition and Enforcement of Foreign Arbitral Awards⁴. This means that each of them not only recognizes the legitimacy of arbitration as a dispute resolution mechanism but also agrees to give effect to private agreements to arbitrate and to enforce arbitral awards made in other jurisdictions.
Bright skies in the contracting horizons
The increased presence of multinational corporations and the rise in foreign direct investment in some emerging economies may be seen as evidence that the business climate is conducive, and this includes to a large extent, the level of contract enforcement and legal redress. Policies have been put in place to both encourage and maintain the flow of capital into the economies in order to spur economic growth and development.
According to the World Bank’s Ease of Doing Business Score (DB), which measures business regulations and their effect on economies, the countries of current investment interest to VestedWorld (Kenya⁵, Rwanda⁶, Uganda⁷, Nigeria⁸, and Ghana⁹) score above 50 in the general ease of doing business index, with Rwanda in the lead at 77.88 (ranked 29th globally) and Kenya following closely at 70.31 (ranked 61 globally).
In particular, the Enforcement of Contracts Score (EC) has seen an improvement in both Rwanda and Nigeria since 2018. This change in both countries has been attributed to reforms made through the introduction of ‘new rules of civil procedure for small claims courts which limit adjournments to unforeseen and exceptional circumstances’. The other countries have remained consistent in their scores, and we consider this to be a positive signal as well.
The principle of self-enforcement
Despite finding its definition in the formal legal context, the enforcement of contracts originates from the principle of self-enforcement. This comes from the understanding that the contract, willingly and lawfully entered into, has benefits to all contracting parties. These benefits serve as incentives for each party to do all within their power and within the bounds of law and the contract, to uphold their end of the deal.
“The limited empirical evidence suggests that private enforcement tools are often more effective than public tools. However, some public enforcement is necessary, and private enforcement mechanisms often require public laws to function. Private initiatives are often also taken under the threat of legislation or regulation, although in some countries bottom-up, private-led initiatives preceded and even shaped public laws¹⁰.”
One of the indicators of self-enforcement that we consider is the quality or standard of corporate governance processes by which the company operates and is controlled. These ought to be structured in a way that ensures transparency, accountability and security both within the organization and in its relationship with all stakeholders: founders, employees, shareholders, financiers etc. We look out for a company that has built a culture of proper record keeping (including contracts with employees, partners, suppliers and even customers where prudent and necessary), can show a history of following due process, and has measures to both mitigate and address breaches. Some level of board governance is also an important indicator. During due diligence, we check the quality of other investors and board members, including their value-add, sector experience, previous conduct, and potential for conflict of interest. Strong board dynamics are often a positive sign of accountability, transparency, and adherence to contracts.
The nature of investing in emerging markets requires a great element of trust and relationship-building between investors, such as VestedWorld, and the founders of the companies we invest in. A proper enforcement of contracts regime is necessary to mitigate the risk allowed by the relationship between investor and founder. In addition to that, investing in jurisdictions that have clear procedures and processes for dispute resolution affords either contracting party confidence that the other party will be held liable for breach, and that this could either deter breach or give relief to the injured party.
A robust enforcement of contracts regime is, therefore, antecedent to economic growth and in some cases facilitates the development of solutions or innovations that are of socioeconomic impact and benefit to communities in emerging markets, not to mention their economic profitability to both founders and investors.