In this rousing treatise on the benefits of compliance as a commercially beneficial force, the managing partner of a strategic advisory firm looks at the measures that governments compel financial firms to take against corruption and the ways in which such compliance actually benefits the bottom line. The problems that corrupt third-party partners in foreign countries pose are not necessarily insurmountable.

In June 1998 the Financial Times wrote: “For hapless foreign investors, the web of Suharto’s patronage held the key to success in Indonesia. Now, just ten days into the post-Suharto era, those links have become a curse.”

Let us imagine for a moment that regulators did not exist. Let us imagine that there is no British Bribery Act 2010, no US Foreign Corrupt Practices Act 1977 and not a single regulation against money laundering. Let us imagine, furthermore, that we are all homines oeconomici, rationally maximising our own selfish wellbeing with little concern for ethics or other people. Would we still bother to do the things we now do to comply with governmental diktats? In particular, would we worry about the behaviour of our affiliates and partners in corrupt and authoritarian countries?

I ask not because regulation and ethics are unimportant, but because good compliance can become difficult to advocate if it is only aimed at the avoidance of bad things and worth doing solely because it is forced upon us. In addition to minimising losses, can it also increase gains?

Is it worthwhile to look for the good in regulations?

The quotation from the Financial Times gives us a clue. The context was the fall of Indonesian President Suharto in May 1998, when he was replaced by a protégé after a period of civil unrest and student demonstrations. As president he had opened up the economy to foreign investors, particularly in infrastructure, and had become famous for awarding contracts to foreign companies that did business with, or benefited, members of his family and other favourites. Many foreign companies actively sought out Indonesian partners with the right governmental connections and this strategy worked for precisely as long as Suharto held power. As soon as he fell, however, many companies found their deals cancelled by the new Government, which did not seem to care that the contracts had been drafted well by expensive lawyers, and instead shared the widespread belief that many of the contracts had been signed corruptly and were therefore detrimental to Indonesian interests. The punishment for some of these foreign investors was an instant drop in share price and their characterisation as 'hapless' on the front page of the Financial Times.

Problems for partners

Problems of this sort are, of course, not unique to Indonesia. The Collaboratory for Research on Global Projects at Stanford University studied 33 power projects in emerging markets during the 1990s and found that only 12 of the 33 contracts in the sample had actually held. Of the remainder, two were cancelled, eight were renegotiated unilaterally and 11 were renegotiated with the consent of both the Government and the private contractors. Ryan Orr from Stanford says that “over the long lifecycle of an infrastructure project, negotiating power slowly shifts from the private investor to the host government.” The Government initially welcomes the investor’s expertise, technology and money and offers a good deal, but once the project is in place, the cement set and the machinery difficult to move, the Government can take advantage of the fact that the investor has no other projects in play to re-negotiate the deal. Although such opportunism is clearly important, he adds that there may also be other factors: “the debt-like nature of many of the investments lead to payments problems [sic] in times of economic crisis, many agreements are with sub-national entities which are less concerned with the overall impact of conflict over contracts than are central governments, allegations of corruption and undue pressure by home governments make the fairness of agreements suspicious, problems of regulation in natural monopolies are difficult to solve, and, perhaps, spreading democracy accelerates conflicts between hosts and investors.”

The short term for all this is 'political risk,' but it is a dangerous shorthand because it implies that political risk is an objective fact about the host country, ideally numbered somewhere between 1 and 10 and unrelated to the way in which the investor behaves and the partnerships he chooses in that country. The author Daniel Litvin puts it as follows: “Companies have tended to focus their attention, and their best brains, on narrow economic issues — such as how best to market their goods or to boost profits from year to year — rather than the social and political environment in which they do business, even though neglecting this, or failing to understand it, has often damaged their interests in the long run. Many multinationals today still think of this non-economic context as merely a ‘public relations’ issue; or instead they categorise any problems as ‘political risk’, suggesting they are simply beyond their control.”

A particularly common mistake is to manage political risk by trying to predict the political future and then by choosing local partners accordingly. Political prediction is an incredibly difficult thing to do, as recent events in the US and UK surely suggest. In Indonesia during Suharto’s heyday, all the experts were absolutely sure (on the basis of apparently good analysis) that Suharto’s eventual successor would have to be a military officer from the island of Java. They were somewhat surprised when his successor, BJ Habibie, turned out to be a civilian from the island of Sulawesi. As the economist John Kenneth Galbraith famously said: “There are two classes of forecasters: those who don't know, and those who don't know they don't know.” He also said that the whole point of economics was to make astrology look respectable.

My friend General Abacha

The sophisticated thing to do in unpredictable environments is not to put all your hopes in one strongman, or to try to identify the strongman’s most likely successor and cultivate him as well. This is too similar to walking into a casino and putting all your chips on Red Seven. Instead, it makes sense to find partners in the host country who command support throughout society and who will be likely to thrive whatever the political future holds. When my firm works for a client-firm it goes through the track records of its potential allies with a fine tooth-comb, often going back over decades, in an effort to understand how potential future Governments, local activists, think tanks, employees, partners and customers perceive them. Is this someone who has made money by exploiting a corrupt relationship or a single contact in an influential family, who may be powerful today but may be thoroughly counter-productive tomorrow? Or is this someone who is actually good at business, someone who benefits his country's economy and who therefore commands support from people all over the political spectrum and at different levels of society? Is this someone whose business success depends on many mutually-beneficial and legitimate relationships and transactions and not on a single corruptly-signed contract?

I like this type of compliance. When I do it I am not just looking for 'red flags' because the regulators have told me to. I am, instead, trying to steer Western financial firms, my clients, away from superficially attractive, currently-powerful business partners, not only because the regulator would object or because they might fall foul of anti-corruption laws (though these are of course important), but also because such people are not going to be good long-term partners. Indeed, they might become liabilities when the Government changes and all that the Western client is left with is a reputation for signing corrupt deals that have not been in the best interests of the host country. At this point, the Western firm becomes an easy target for a new regime that wants to shake things up, be that for the public good or perhaps merely to give its own hangers-on a piece of the action. My aim is always to find people in the host country who have learnt to thrive honestly - even in a difficult, corrupt environment - because they contribute to that economy without having to rely on nepotism and corruption and because they treat their partners well...you included.

* Peter Wilson can be reached on pwilson@herminius.com