PD8 - Research Paper. Rozen-Bakher, Z. Legal Distance in FDI - The Differences in the Legal Location Factors between the Home country, Host country, and International Law: Risk Analysis

March 23, 2022 Dr. Ziva Rozen-Bakher

Rozen-Bakher, Z. Legal Distance in FDI - The Differences in the Legal Location Factors between the Home country, Host country, and International Law: Risk Analysis. Research Paper, PD8. https://www.rozen-bakher.com/research-papers/pd8

Rozen-Bakher, Z

Legal Distance in FDI - The Differences in the Legal Location Factors between the Home country, Host country, and International Law: Risk Analysis

Abstract

This study brings to light a new concept of Legal Distance in Foreign Direct Investment (FDI) that refers to the differences in the legal location factors between the home country, the host country, and the international law, with the aim of revealing how the legal distance impact the risk for FDI. At the theory level, the study is based on the International Business Discipline in general, and on the OLI Paradigm of Dunning, in particular. The study examines three legal location factors that determine the legal distance: the legal system, the judicial system, and vital laws for MNEs’ activities, still, the study explores three riskier laws for MNEs namely, the Tax Law (Category I: between MNEs and formal authorities), the Property Rights Law (Category II: between MNEs and other firms), and the Consumer Protection Law (Category III: between MNEs and their customers). The study suggests that a larger legal distance could significantly increase the risk for FDI and even affect the survival of MNEs’ activities in the host country. The study highlights the need for future empirical studies that will investigate the impact of legal distance on the scope of FDI.

Keywords: Legal Location Factors, Foreign Direct Investment (FDI), Legal Distance, Risks, Legal System, Judicial System, International Law, Home Country, Host Country

1. Introduction

Multinational Enterprises (MNEs) operate in an extremely complex legal arena alongside the potential for legal business complications because of the need to work in parallel under three structures of law: the home country law, the host country law, and the international law (Awokuse & Yin, 2010; Bellak & Leibrecht, 2009; Bénassy-Quéré et al., 2007; Buettner & Ruf, 2007; Coulson, 2017; Dixon, 2013; Hoffman, 2016; Holmes, 2009; Kengelbach et al., 2010; Klemm & Van Parys, 2012; Merryman & Pérez-Perdomo, 2007; Thirlway, 2010; Ushijima, 2013; Von Glahn & Taulbee, 2017; Watkin, 2017; White et al., 2015; Yeung, 2014). In other words, exists inherent stress between the home country law, the host country law, and the international law, which are affected the activities of MNEs, either when they conduct Foreign Direct Investment (FDI) or International Trade. Still, the risk for complication from the legal distance is much higher in FDI over international trade, because MNEs are located and operate in the host country when they carry out FDI Inward (Dunning & Lundan, 2008). However, in international trade, MNEs are located and operate from the home country, either online or through local entities in host countries, which reduces the risks due to legal distance. Considering that, the activities of MNEs in host countries are affected by three main legal location factors: the legal system, the judicial system, and vital laws that affect MNEs’ activities in host countries, such as the tax laws (Bellak & Leibrecht, 2009; Buettner & Ruf, 2007; Haufler et al., 2018; Klemm & Van Parys, 2012), property rights laws (Awokuse & Yin, 2010; Li & Resnick, 2003; Ushijima, 2013), labour market regulations (Cooke & Noble, 1998; Gross & Ryan, 2008; Lawson & Bierhanzl, 2004), consumer protection laws (Petrevska & Petrevska, 2015), and antitrust laws (Hoffman, 2016).

In the light of the above, the objective of the study is to reveal how the legal distance impacts the risk for FDI by examining the three main legal location factors namely: the legal system, the judicial system, and the vital laws for MNEs’ activities. Although, there are many laws that could impact MNEs’ activities in host countries, still, there are prominent laws that are critical for MNEs’ activities, so the study explores three essential laws for MNEs namely, the Tax Law, the Property Rights Law, and the Consumer Protection Law.

2. Why Legal Distance in FDI?: The Differences in the Legal Location Factors between the Home country, Host country, and International Law

MNEs operate in a complex reality at the legal level because their activities are affected in parallel by three different law structures: the law in a home country, the law in a host country law and the international law (Awokuse & Yin, 2010; Bellak & Leibrecht, 2009; Bénassy-Quéré et al., 2007; Brooks & Jeon‐Slaughter, 2001; Buettner & Ruf, 2007; Clarke, 1996; Coulson, 2017; Daniels & Radebauge, 2002; Dixon, 2013; Hoffman, 2016; Holmes, 2009; Kengelbach et al., 2010; Klemm & Van Parys, 2012; Merryman & Pérez-Perdomo, 2007; Thirlway, 2010; Ushijima, 2013; Von Glahn & Taulbee, 2017; Watkin, 2017; White et al., 2015; Yeung, 2014), as follow:

Home Country Law. MNEs are subject, foremost, to the law system, judiciary, and regulations of the home country. The location of the MNE's headquarters defines the home country. The law system in a home country has a significant role with regards to the implementation of MNEs' agreements, as well as in conflict situations. That's because many MNEs define in advance in the agreements that the home country will be the location for filing lawsuits and litigation in cases of dispute between parties. This applies particularly in agreements of licensing and franchising, but also in cases of M&As, especially when the acquirer has a dominant role in the due diligence process alongside the power to determine the conditions of the agreement.

Host Country Law. MNEs are also subject to the legal arena in host countries. However, there is a significant difference between international trade and FDI in relation to the legal arena in a host country. In international trade, the MNE locates in a home country, rather than in a host country because the MNEs export their products and services to the host country through local importers, licensees and franchisees. Consequently, MNEs who operate as exporters from the home country are less affected by the laws in the host country, except the laws of the host country that deal directly with the rules of import and customer protection laws. In contrast, in FDI, the MNEs are located in a host country due to the establishment of a wholly-owned site or due to buying a domestic company. That requires the MNEs to operate under the laws of a host country, even if the laws of the host country differ or contradict the laws of the home country. This reality even becomes more complicated and sometimes impossible when an MNE operates in many host countries. Under this complicated reality, the MNEs are required to act accordingly to the laws of each host country where they operate, even if the laws differ among the host countries. This situation disruptive the MNEs ability to create global firm standardisation, especially regarding the firm policy. That's because MNEs can determine a firm policy that is aligned with the laws of one host country, while in another host country, it may violate the law. Hence, differences in laws of host countries where MNE operates prevents the creation of standardisation and uniform firm policy worldwide.

International Law. The international law arena refers to international laws (Dixon, 2013; Von Glahn & Taulbee, 2017) that are determined by international organisations and come into force by the approval of international courts. International courts also serve as arbitrators in order to solve disputes. Moreover, the international legal arena is also determined by international agreements and conventions, which are based on the ratifications and obligations of the countries (Thirlway, 2010). However, on the one hand, a country can choose if to ratify international agreements and conventions, but on the other, a country and its organisations must obey any international law that is enacted, even if the law was accepted or not by the country or by its organisations. Hence, international law is above the law of a particular sovereign country. Nevertheless, there are sovereign countries that have national laws that are in force in the sovereign territory of the country, despite that the national laws contradict the international laws. Therefore, if exists a contradiction or a conflict between the law of a particular sovereign country and the international law, then international law is more powerful compared to the law at the national level. Considering that, in cases of disputes and conflicts between countries, or between countries and companies or individuals, or between MNEs, then international courts adjudicate the cases based on international law. Notwithstanding, in many cases, MNEs are forced to operate under national laws that are contradicted to international laws. In spite of that, if a dispute arises, then MNEs have the right to give an appeal to an international court against the host country that acts contrary to international laws.

3. How to Measure Legal Distance in FDI?: Legal System, Judicial System and Vital Laws for MNEs’ Activities

3.1 Types of Legal System

There are three main types of legal systems in the world - Common Law, Civil Law and Theocratic Law, which may affect the MNEs’ activities in various legal issues (Coulson, 2017; Daniels & Radebauge, 2002; Elon, 1993; Holmes, 2009; Merryman & Pérez-Perdomo, 2007; Watkin, 2017), as follow:

Common Law. Common law (Holmes, 2009) refers to a legal system in a country that is based on tradition, customs and legal precedents, which guide the courts in the interpretation of the events of the cases in order to give a verdict that relies on the tradition and legal precedents in the country. For example, in the UK, in which its legal system is based on Common law, the Speaker of the House of Commons, Mr Bercow, ruled out the third meaningful vote of May's Brexit deal, based on the longstanding convention that dating back to the year of 1604 (Elgot, 2019). Common law exists in countries such as, the USA, Canada, and the UK, as well as in countries that were formerly British colonies under the British Empire, such as Australia and India. In common law, the agreements are usually long, very formulated and are written in full detail.

Civil Law. Civil law (Merryman & Pérez-Perdomo, 2007; Watkin, 2017) refers to a legal system that is based on an organized set of laws that guide the judicial system in the country in order to give a verdict that relies on facts. In civil law, the verdict relies on strict laws, while in common law, the verdict relies on judge-made law (Rubin, 2000). More importantly, in civil law, there is less room for interpretations compared to common law. Civil law exists in around 70 countries worldwide, such as Germany and France in Europe, as well as in many countries in South America (Merryman & Pérez-Perdomo, 2007). In civil law, the agreements are usually short and are written in a concise way.

Theocratic Law. Theocratic law refers to a rigid and conservative legal system that is based on scripture and religious beliefs (Coulson, 2017). Theocratic law has not changed over time, despite the advanced developments in the world. For example, Islamic law relies on the Sharia law, which is derived from the religious precepts of Islam and the sages writing (Coulson, 2017), particularly the Quran and the Hadith. There are Islamic countries where the legal system is based mainly on theocratic law, such as Iran, Sudan, Pakistan and Saudi Arabia. However, there are Muslim countries where the legal system is a combination of Islamic law and civil law. Jewish law is an additional example of Theocratic law, which is based on the Bible, Mishnah, and Talmud (Elon, 1993), yet in some cases, it contradicts the Israeli law that is based mostly on the common law, still, it is used in Israel mainly in family matters or among religious Jews law (Ben Bezalel Bezeq, 2014).

3.2 Judicial System

The judicial system in a country affects MNEs' activities, particularly in relation to the independence and efficiency of the judicial system (Globerman & Shapiro, 2002). That particularly applies in cases of business legal disputes, either between MNEs and the country authorities or between at least two firms, which are brought up for litigating in courts.

The judicial system in a country is derived from four main characteristics: structure, hierarchy, independence, and efficiency (Bénassy-Quéré et al., 2007; Bitzenis, 2006; Brooks & Jeon‐Slaughter, 2001; Clarke, 1996; Daniels & Radebauge, 2002; Lewin et al., 1982; Yeung, 2014), as follow:

Structure. The structure of the judicial system in a country refers to the division of courts based on the issues that are brought up in courts. Accordingly, each court has jurisdiction over certain matters, such as labour courts. From the perspective of MNEs, understanding the structure of the court system in a host country contributes to the MNEs efficiency in legal matters, especially when a company carries out FDI inward in a host country.

Hierarchy. The hierarchical structure of the courts in a country is based on the level of authority of the courts, such as regional, provincial, national, federal, and supreme court. The hierarchical structure is more complicated in big countries, especially in federal countries, such as the USA. Lack of knowledge regarding the hierarchy of the court system in a host country may influence negatively MNEs' activities because the hierarchy of the court system can influence the outcome of the verdict. For example, in the USA, there are significant differences between the states within the USA in relation to laws (Ihlresearch.org, 2008), so litigation in one state may lead to a different verdict compared to other states. Hence, in some cases in the USA, MNEs may prefer to litigate in one state over another state. Given that, MNEs will try to choose the preferable level of court's authority in the host country, based on the MNE's interests.

Independence. The independence of the judiciary system in a country refers to the functioning of the courts without political influences (Clarke, 1996; Daniels & Radebauge, 2002), political prejudice and discrimination based on race (Brooks & Jeon‐Slaughter, 2001), religion, and other discrimination grounds. The degree of balance of powers between the courts, government and parliament in a country indicates the degree of independence of the court system. The ruling of the UK Supreme Court that Boris Johnson’s suspension of Parliament is unlawful due to the trying to achieve a no-deal Brexit by a shutdown of parliament, is a good example for the independence of courts in a democracy (Kentish & Dearden, 2019). From the viewpoint of MNEs, an independent court system that is free from corruption and bribery may protect better the laws of the country. Thereby, the independence of the judiciary system in a country can serve as a safeguard to the rights of MNEs who operate in the country (Bénassy-Quéré et al., 2007; Bitzenis, 2006). This is highly important regarding the MNEs' property rights or in cases of business conflicts between MNEs and local entities.

Efficiency. The efficiency of the court system in a country refers to the operational efficiency of the courts in terms of the duration of the legal process and bureaucratic proceedings (Lewin et al., 1982; Yeung, 2014). MNEs put emphasis on the efficiency of the court system because it may increase the risks in cases of violation of agreements. A long duration of legal proceedings in the host country is the main concern of MNEs because it may hinder the MNE's ability to get in a reasonable time a verdict against local entities who violate the agreements. That's may increase the MNEs' costs, especially in case of a long legal battle. Notably, there are countries where the judicial system is ineffective, and the legal proceedings may take many years until giving a verdict by the court. This situation severely damages the investment and the profits of MNEs whose rights have been violated in the host country. Hence, from the viewpoint of MNEs, the long duration of a judicial process along with the complexity of local bureaucratic proceedings (Bitzenis, 2006), may significantly increase the risk of FDI.

3.3 Vital Laws for MNEs’ Activities

MNEs put a great emphasis on laws that are relevant to international business activity (Kengelbach et al., 2010), yet most of the laws and regulations in a country apply to all companies that operate in the country, even if the companies are local or foreign ones, such as the laws that are related to consumer rights, labour and environment. Nonetheless, some rules and regulations are specifically related to foreign companies, such as the tax laws that distinguish between local and foreign companies.

There are ample laws that could influence MNEs' activities (Bishop, 2009; Fenwick & Wrbka, 2018), yet there are laws that are riskier for MNEs activities, still, it’s possible to sort them by three categories, as follow:

· Category I - MNEs and Formal Authorities. Laws with a high risk for legal disputes between MNEs and formal authorities, such as the tax laws.

· Category II - MNEs and other Firms. Laws with a high risk for legal disputes between MNEs and other firms, either local or foreign, such as the property rights law.

· Category III - MNEs and their Customers. Laws with a high risk for legal disputes between MNEs and their customers, such as the consumer protection rights law.

Hence, this study examines three riskier laws for MNEs’ activities from each category mentions above namely, the tax law, the property rights law and the consumer protection law.

3.3.1 Tax Law: Category I - MNEs and Formal Authorities

Country' tax policy in general and the corporate tax rates, in particular, have a significant effect on the volume of MNEs’ activities (Bartik, 1985; Bellak & Leibrecht, 2009; Buettner & Ruf, 2007; Devereux & Griffith, 1998; Haufler et al., 2018; Klemm & Van Parys, 2012; Loree & Guisinger, 1995) due to its impact on corporate profitability and cash flow (Daniels & Radebaugh, 2002; Haufler et al., 2018). Hence, tax differences between the home country and host countries may motivate MNEs to relocate activities and capital to host countries where the corporate tax rate is lower than in the home country (Cooke, 2001; Devereux & Griffith, 1998; Haufler et al., 2018; Loree & Guisinger, 1995) or compared to other host countries with a higher corporate tax rate. It can be argued, that the MNEs conduct 'tax shopping' by comparing the corporate tax rate among host countries with a potential for FDI inward alongside by comparing it to the corporate tax rate in the home country. Thus, as the tax rate gap is larger, then it increases the worth of the investment from the view of the tax aspect (Dunning & Lundan, 2008). From the perspective of MNEs, low taxation contributes to higher profitability alongside high effectiveness to leverage investments. Consequently, attractive tax policy in a country has a huge effect on the MNEs' decision location when conducting FDI inward in host countries (Bartik, 1985; Buettner & Ruf, 2007; Devereux & Griffith, 1998; Haufler et al., 2018). However, the trying of MNEs to maximise the profit of the firm by trying to minimize the tax payment has the potential for legal complications with the tax authorities. It can be argued, that the ‘tax avoiding’ (Dyreng et al., 2008; Wang et al., 2020) become to ‘Art’ of MNEs, yet it can involve a high risk for legal complications (Ginesti et al., 2020), especially in host countries with the problematic judicial system.

3.3.2 Property Rights Law: Category II - MNEs and other Firms

The level of protection of property rights in a host country has a positive influence on the volume of FDI inward (Awokuse & Yin, 2010; Li & Resnick, 2003; Seyoum,1996; Ushijima, 2013), especially in high-tech industries (Lee & Mansfield, 1996). That's because it's necessary to transfer innovative technological knowledge or intellectual property to host countries in high-tech industries (Lall, 1992; Globerman & Shapiro, 2003). The level of protection of property rights is derived from the laws and regulations in a country regarding the protection of tangible or intangible property against theft or illegal use, such as intellectual property, patents, and technological development. Hence, the level of protection of property rights differs between countries. There are countries with good protection of property rights, especially advanced countries. However, there are countries that suffer from weak protection, especially among developing countries where the copyrights are violated in an illegal way. Nevertheless, the main problem is that some countries give informal legitimacy for local firms to make imitations and copies without the fear of penalties (Gupta & Govindarajan, 2000). Notably, a distinction should be done between existing protection laws and law enforcement by governmental authorities. Hence, there are countries with proper protection of property rights, but the national authorities don't enforce the laws. In light of that, these countries suffer from weak protection of property rights due to a lack of law enforcement, rather than due to a lack of property protection laws.

Considering the outlined above, MNEs put emphasis on the importance of the protection of the property rights in a host country (Awokuse & Yin, 2010; Ushijima, 2013) because weak protection may damage the value of the tangible and intangible intellectual assets of the companies. Therefore, MNEs avoid transferring technological knowledge to host countries where governments ignore inventors' rights or copyrights because of the fear that the informal legitimacy that is granted to local imitations and copies by the host government will damage the MNEs' competitive advantages (Feinberg & Majumdar, 2001; Lall, 1992; Globerman & Shapiro, 2003). Hence, in host countries with weak protection of property rights, MNEs prefer to operate through local distributors rather than through local production (Glass & Saggi, 2002). Nevertheless, in cases that the MNEs are required to conduct FDI inward, despite weak protection of property rights in a host country, then the MNEs prefer to transfer a relative old technological knowledge. More specifically, in these cases, MNEs prefer to establish a wholly-owned subsidiary (Leahy & Naghavi, 2010; Lee & Mansfield, 1996) over a joint venture in order to avoid transferring significant new knowledge to a local company. From the standpoint of MNEs, that's preferable because of the fear that in the future the joint venture will go into liquidation. Under this scenario, the local company may become a competitor with the ability to use the knowledge of MNEs that was learned during the joint venture period. In spite of the above, establishing a wholly-owned subsidiary in a host country where property rights are violated, will not help to preserve the MNEs' patents against imitations (You & Katayama, 2005). The imitations problem (Wong, 2012) has become a critical issue because, sometimes, imitations are getting into the markets at very low prices even before the entry of the original product to the markets. That's lead to damage in the potential sales of the original product, and thereby, it significantly reduces the life cycle of the original product. Given that, reforms in the protection of property rights in a host country encourage FDI inward, particularly in R&D activities and technology industries (Branstetter et al., 2006; Khoury & Peng, 2011). That in return contributes to the creation of new patents in the host country (Branstetter et al., 2006; Khoury & Peng, 2011).

3.3.3 Consumer Protection Law: Category III - MNEs and their Customers

Consumer protection rights are considered as one of the most challenges of MNEs in marketing products and services at a global level. The consumer protection rights refer to the set of laws that related to the rights of consumers when they make transactions for buying products and services, such as companies’ obligation to consumers, rules of sale, cancellation policy, and product liability (Daniels & Radebaugh, 2002; Petrevska & Petrevska, 2015). Hence, the consumer protection rights are related not only to FDI but also to international trade because MNEs as exporters need to sell their products accordingly to the consumer protection rights in a host country, even if the sale performs by local importers. This is especially relevant to topics as cancellation policy, and product liability.

However, consumer protection rights differ between countries, so MNEs need to adapt their policy to the consumer protection rights in each of the host countries where MNE operates (Petrevska & Petrevska, 2015). That complicates MNEs' ability to create global uniformity of consumer protection policy in host countries where the MNE operates worldwide because of the differences between host countries regarding consumer protection law. Moreover, under these circumstances, even an MNE that operates only through international trade (e.g. export) based on the consumer protection law of the home country, has the likelihood for risks of business legal disputes in case of contradiction in the consumer protection laws between the home country and the host countries.

4. Conclusions

This study brings to light a new concept of Legal Distance in FDI that reflect the differences in the legal location factors between the home country, the host country, and the international law, with the aim of reducing the risks for FDI. The study is based on the International Business Discipline in general, and on the OLI Paradigm of Dunning (Dunning & Lundan, 2008), in particular. The study explores three legal location factors that determine the legal distance: the legal system, the judicial system, and vital laws for MNEs’ activities. Firstly, the study distinguishes between three types of a legal system: Common Law, Civil Law, and Theocratic Law (Coulson, 2017; Daniels & Radebauge, 2002; Elon, 1993; Holmes, 2009; Merryman & Pérez-Perdomo, 2007; Watkin, 2017). Secondly, the study suggests that four indicators determine the judicial system in a country: structure, hierarchy, independence, and efficiency (Bénassy-Quéré et al., 2007; Bitzenis, 2006; Brooks & Jeon‐Slaughter, 2001; Clarke, 1996; Daniels & Radebauge, 2002; Lewin et al., 1982; Yeung, 2014). Thirdly, the study distinguishes between three categories of riskier laws for MNEs: Category I) Laws with a high risk for legal disputes between MNEs and formal authorities, such as the tax laws. Category II) Laws with a high risk for legal disputes between MNEs and other firms, either local or foreign, such as the property rights law. Category III) Laws with a high risk for legal disputes between MNEs and their customers, such as the consumer protection rights law. Hence, the study examines three riskier laws for FDI from each category: the tax law, the property rights law and the consumer protection law.

The study suggests that understanding the legal distance between the home country and host country, as well as the legal distance between home country/host country and the international law, may help to reduce the risks for FDI by avoiding legal complications. In other words, understanding the legal distance may help to deal with the complicated global legal structure when MNEs conduct FDI Inward in host countries. Hence, from the MNEs’ perspective, a large legal distance discourages FDI inward before entry to the host country, while increasing the risks for FDI after entry to the host country. A large legal distance could even jeopardize the operations and assets, especially in cases of a problematic legal arena in the host country. Thereby, in cases of a large legal distance, MNEs may prefer an entry mode through international trade, rather than via FDI to lower the operational and managerial risks.

The study concludes that the legal distance between the home country and host country, as well as between the home country/host country and the international law, may significantly impact the risk for FDI in terms of legal complications and legal disputes, which may even impact the survival of the activity in the host country. The study highlights that MNEs should be aware of the legal distance between the home country and host country, as well as between the home country/host country and the international law to reduce the risks for FDI due to the legal location factors. The study emphasises the need for future empirical studies that will investigate the impact of legal distance on the scope of FDI.

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