Friday, June 06, 2008

Sovereign Wealth Funds And Hungry States: Adjusting the Borders of Public and Sovereign Activity Across Borders

It is always refreshing to see what hunger, or the fear of hunger, does. Not only to people--the effect is well enough explained in thousands of years of literature; much more interesting is the consequences of a fear of recession within the company of rich, bloated developed states. Christopher Rugaber reports that after pilgrimage to the investor sovereigns Middle East, influential Congress members will encourage a regulatory climate that does not restruct the investment of activities of sovereign wealth funds.

Rep. Jim Moran, D-Va., along with other members of the task force, will speak at a Capitol Hill briefing sponsored by the National Council on U.S.-Arab Relations. Moran and Rep. Tom Davis, R-Va., visited several Middle Eastern countries last week, including the United Arab Emirates, which hosts the largest sovereign fund.

"They need to know that this is a positive climate for investment," Moran said in an interview. Some Middle Eastern investors are concerned about a political backlash, he added, but one of the goals of the task force is to avoid "any unforeseen political reactions to their investments."

Christopher Rugaber, Ahead of the Bell: Congress and Foreign Government Funds,, June 5, 2008. The American administration's spokesman was equally effusive in the search for funds to feed home state investment appetites. "Meanwhile, U.S. Treasury Secretary Henry Paulson emphasized U.S. openness to foreign investment and sovereign wealth funds during a visit to the UAE Monday." Id.

In response to earlier criticism that such funds would not operate in the same way as private investor, but rather use their wealth for "political" rather than "financial" gain (though in either case the investors would be seeking to maximize their own wealth and thus be acting rationally) the Congress members offered only what is likely to become the global slogan of SWF governance (as well as the proxy for an approach in developed states): sovereigns may invest in the economies of other sovereigns as long as their funds and activities are transparent. "Moran said he urged government officials in the region to be more transparent about the funds' operations, which some analysts have said could help alleviate such concerns." Id.

Transparency is a good thing, of course. Disclosure is a foundation of the securities laws of many states. Markets work best with reduced information costs and states work well when they seek to reduce the costs of transactions. Yet, it is hard to understand why there ought to be greater requirements for disclosure by one class of shareholders than others. I am as interested in the investment activities of a large private investor who may be taking positions in a host of entities for purposes that may affect me as an investor, citizen, or member of another community, as I would be if that activity was being carried out by a political state acting in its non-sovereign capacity. Perhaps all large investment funds ought to be subject to greater disclosure. On the other hand, efforts at transparency for private funds suggest some of the deficiencies that carry over to issues of sovereign wealth fund transparency. Perhaps a unified approach would be useful since the problem may be the control or regulatory effects of large funds rather then the character of the specific fund investing. For a useful effort, see the work of the Sovereign Wealth Fund Institute.

In addition, some have also urged limits of investment in sensitive industries. The later point, of course makes no sense. If such sensitive industries are open to investment by foreign individuals and entities, then it is hard to understand why they would not engage in the same "politically motivated" conduct (when it is to their benefit as they see it) to which states might be tempted. Or that such conduct, which is controlled and disciplined by a state when the act of a private investor, is somehow beyond regulatory control when the investor is a state. My suggestion, of course, goes to the increasingly understood notion that wealth maximization may be more complex than a narrow vision of short term monetary wealth maximization, and that states are somehow special when they participate in markets they cannot directly control. Thus, Senator Jim Webb (D-VA) expressed in all seriousness his fears:

Other fears could be raised, he writes, if SWFs begin flexing the power they would wield as shareholders in foreign corporations—for instance, what if Middle Eastern or East Asian SWFs banded together to oust the CEO of a U.S. corporation? In corporate governance terms, this would be seen as positive shareholder activism, but when governments are involved, experts are left to guess at whether such clout would be used for financial gain or for political purposes. “The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares,” writes Summers. “It is far from obvious that this will over time be the only motivation of governments as shareholders.”

Council on Foreign Relations, Sovereign Wealth Funds, Jan. 18, 2008. Yet it is far from obvious why this constitutes a special fear. Senator Webb would have little problem, were he a shareholder, to use his shareholder power to oust a CEO merely because he was detested, or liked labor unions, as long as it could be properly clothed in the appropriate language of commerce--that the ousted CEO's relationships with shareholders was detrimental to the long term growth of the company. Yet a sovereign shareholder might also have strong feelings about the value of a particular CEO, or of labor unions and other corporate activities, and seek to act on them.

Still, the difference is also painfully obvious. Senator Webb, as an individual investor, cannot act other than as a private shareholder; all Senator Webb can do is control himself. A sovereign shareholder, on the other hand, can legislate. But sovereign shareholders do not legislate effectively outside the territory under their control. Likewise sovereign shareholders directly in their role as shareholders. Their actions, though can be viewed as regulatory in a sense. They mean to translate the political will of the state through its activist activities as a shareholder (either by the way in chooses to buy and sell shares or the way it seeks to actively participate in the governance of the company. Yet, in that role, sovereign shareholders are in the same position as Senator Webb the individual. In these roles both would seek to act through rather than on the entity. The former requires investment, the latter requires sovereign power.

Of course, Senator Webb would arrive at his value maximizing policy determinations by debating with himself; the sovereign shareholder, like the corporate shareholder, would arrive at its value maximizing decision by application of either fiduciary duty (corporate shareholder) or democratic accountability or its functional equivalent (sovereign shareholders). To hold sovereign wealth funds to some form of commercial folio investment rules would hard wire those standards and move control of the meaning of such terms from investors to the state (and for what purposes in addition to the regulation of sovereign funds). This is the sort of market intervention that is almost designed to create rather than to minimize negative consequences on its functioning.

But to get to this point Senator Webb would have to embrace a fundamental assumption--that states can act as private market participants. For that assumption to work, of course, the sovereign investors would have to be treated like a private investor as well--no sovereign immunity, for example. But would they also have to forego their own wealth maximizing behavior in favor of some mythological construct--the reasonable private investor? For that purpose, commentators have sought ways to force sovereigns to benchmark sovereign conduct--and to that extent severely limit what is essentially ungovernable--their motivations or investing and for shareholder activism. See, e.g., Edwin B. Truman, Sovereign Wealth Funds: The Need for Greater Transparency and Accountability, Peterson Institute for International Economics, Policy Brief No. PB07-6 (August 2007) 7-8. The problem with these proposals is that they are at war with themselves. They tend to hunger for the investment, but wish to treat the investor differently from others. Prior consultations with affected states (whatever that means in a private market for shares of publicly traded companies), severe control of investment strategies and trade volume and the like all suggest that the sovereign is not a private investor.

But all the same, such a sovereign would be treated as private with respect to the funds invested and public with respect to the investment decision. But that tends to distort markets, and impede the very investment that has been made necessary by the aggregate wealth transfers at the heart of the current global financial imbalances. Still, sovereigns do wear two hats. But as long as all shareholders are required, under national legal systems, to avoid activity that breaches their duties--for example to loot the company or to defraud the company--and as long as national legal systems liberally permit shareholders and others to sue the sovereign like any other private party, then everyone should be content. If not, then it seems that more than the character of sovereign wealth funds are at issue. And we should be talking about reforming shareholder rights and obligations vis a vis the corporation for all security holders (but principally equity holders).

Indeed, the United States has long treated investment on an equal footing, whatever the character of the investor. See Scott G. Alvarez (General Counsel Board of Governors Federal Reserve System), Sovereign Wealth Funds, Testimony Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, April 24, 2008 ("As a general matter, the same statutory and regulatory thresholds for review by the federal banking agencies apply to investments by sovereign wealth funds as apply to investments by other domestic and foreign investors in U.S. banks and bank holding companies."). But, mirroring the formula for foreign sovereign immunity, the American statutory structure distinguishes between states and the corporations through which states may operate. With respect to the Bank Holding Company Act (BHC) for example, Alvarez noted:
The BHC Act specifically excludes from its coverage a corporation controlled by the United States or by a state government. Thus, investment companies controlled by the states of Alaska and New Jersey, for example, are specifically excluded from the requirements of the BHC Act. The exclusion does not, on its face, apply to companies controlled by foreign governments and, as I will discuss in more detail below, the Board has not extended this exclusion to companies controlled by foreign governments that make investments in U.S. banks and bank holding companies. Foreign governments to date have primarily invested through sovereign wealth funds that are companies controlled by the foreign government. The effect of the Board's long-standing interpretation is that a sovereign wealth fund that seeks to make an investment in a U.S. bank or bank holding company that exceeds the thresholds in the BHC Act would be required to obtain Board approval prior to making the investment and would become subject to the other provisions of the BHC Act, but its parent foreign government would not.
Id. This clearly is something that ought to be reviewed. Here is a suggestion: If sovereigns are to be treated as participants in the market (and not regulators) when they invest in companies on an equal footing with individuals, then it seems that whether or not they operate directly or indirectly (through a corporation or other entity), they ought ot be treated, not as a public sovereign entity, but as a private sovereign entity. For that purpose, the law should make no distinction between private sovereign entities and other juridical persons. The distinction between public and private sovereign entities would not be hard to figure out--the guidelines are already fairly well established in the Foreign Sovereign Immunities Act and the jurisprudence it has generated. The Federal Reserve Board has essentially taken this position, though in a more roundabout and formalist way: "The Board has long taken the position that while foreign governments themselves are not companies subject to the BHC Act, foreign government-owned corporations such as sovereign wealth funds are companies. Thus any proposed controlling investment in a U.S. bank or bank holding company by a sovereign wealth fund would be subject to Federal Reserve approval." Id.

The American approach might find its mirror reverse image in the European Union, that other great shopping centre for sovereign funds in search of investment vehicles. The Europeans are much more suspicious of governments investing outside their home territories and less likely to accept that states can ever act in non sovereign capacities.
Joaquin Almunia, the EU's economic commissioner, said Brussels would soon submit proposals to EU governments and Euro-MPs, a use of wording that hints at a legally-binding directive. Germany has led the campaign to clamp down on state-funds wielding $3 trillion, afraid that "giant locusts" may buy stakes in strategic industries to gain technology secrets. German Chancellor Angela Merkel stopped Russia's Mischkonzerns Sistema from taking a bite of Deutsche Telekom last year, and put her foot down when Russia's VTB bank began nibbling at EADS, the Airbus and defence group. Berlin is now drafting a law enabling it to vet non-EU takeovers, and to create a superfund to defend German crown jewels. Both Austria and Hungary have erected barriers.
EC to Rule on Sovereign Wealth Funds, Telegraph, Nov. 29, 2007. The Commission rightly would be leery of permitting EU Member States much of a margin of appreciation on the regulation of sovereign investors. After the golden share cases (see Larry Catá Backer,The End of Golden Shares in the EU: The EU Commission Takes a Step in its Abolition, It Ought to Harmonize the Rules of Sovereign Investments Instead Law at the End of the Day, March 9, 2008), it is clear that the regulation of state investment, even as private parties, implicates the internal market (and particularly the free movement of capital Art. 56 EC) as well as competition regulation (and particularly state aids under Article 87 EC). On the latter see Larry Catá Backer,State Subsidies and the Character of the Market Transactions of Sovereigns: The Case of EADS, Law at the End of the Day, May 29, 2008. At the time, "EU sources say Brussels is examining options stretching from an IMF-style code to a full directive giving Brussels the power to dictate policy." EC to Rule on Sovereign Wealth Funds, Telegraph, supra. This is a particulary sensitive topic for Britain. "London is a clearing house for the mammoth funds rapidly changing the investment universe." Id.

By February, it was reported that "The European Commission will consider a code of conduct asking sovereign wealth funds run by countries to stress commercial goals rather than strategic considerations when making investments, an EU official said." EU To Consider Sovereign Wealth Voluntary Code, Reuters, Feb, 23, 2008. These were to mirror the code being prepared by the International Monetary Fund. Id. "Mr. McCreey added that the EU had no plans to limit investment by such funds, only that all business 'should follow some common principles on transparency and governance.'" EU in Sovereign Wealth Fund Call, BBCNews On Line, Feb,. 27, 2008.

A common policy is likely coming. And that makes sense. Yet, the outline of the common policy has been outlined by the Commission evidences the confusion still evident at the European level. Or better put, the continued failure to resilve the fundamental issue--can states be treated as wholly private entities when they invest or are they always special and require a special public-private rule? One has a sense of the contradiction by looking at the foundations of the common policy.
•Commitment to an open investment environment: in line with the Lisbon Strategy for growth and jobs, the EU should reaffirm its commitment to open markets for foreign capital and to an investor-friendly investment climate. Any protectionist move or any move perceived as such may inspire third countries to follow suit and trigger a negative spiral of protectionism. The EU prospers from its openness to the rest of the world – and from its investments abroad – and hence would be among the first to suffer from a trend towards protectionism. At the same time, the EU should endeavour to open SWFs owners' countries to EU investors and secure a fair and equitable treatment for them, notably through FTA negotiations.
• Support of multilateral work: the EU should actively drive forward work carried out by international organisations, in particular the IMF and the OECD. The EU welcomes an open dialogue with SWFs owners and recognises the benefits of a global approach to a common framework for SWF investment.
• Use of existing instruments: the EU and the Member States already have specific instruments that enable them to formulate appropriate responses to risks or challenges raised by cross-border investments, including investments by SWFs, for reasons of public policy and public security.
• Respect of EC Treaty obligations and international commitments: the EU and its Member States will continue to act in a way fully compatible with the principles laid down in the Treaty establishing the EC and with international obligations of the EU.
• Proportionality and transparency: measures taken for public interest reasons on investment should not go beyond what is necessary to achieve the justified goal, in line with the principle of proportionality, and the legal framework should be predictable and transparent.

Commission of the European Communities, Communication From the Commission to the European Parliament, the Council, the European Economic and Social Committee, and the Committee of the Regions, A Common European Approach to Sovereign Wealth Funds, Brussels, xxx COM(2008) 115 provisional, at 9. It may be impossible for the EU to get the money they desire and preserve their public law applies approach to the governance to sovereign investment. Indeed, the EU, at its base, continues to view sovereign investing as essentially sovereign--and acceptable only when the sovereign is eliminated from the equation. This requires preventing the sovereign from controlling (effectuvely) the policy of the investment of its funds. "Clarity about the degree of possible political interference in the operation of a SWF is a prerequisite for addressing concerns about the existence of political and other non-commercial considerations in the operation of a fund." Id., at 10. Indeed, the EU makes no bones of the equation of sovereign wealth funds with old socialist state run enterprises. Id., at 10 (Text box). This conforms to the EU Court of Justice Golden Share rules but perhaps less well with the realities of sovereign activities sin markets which they cannot control.

On June 6, 2008, the EU revealed a little more of the direction in which some hope it might be headed. In an article published to the Wall Street Journal, Peter Mandelson declared "A state acting like a business--throwing the resources of government behind a company that competes with others--is a different proposition from a state looking to invest its surplus capital in the most commercially advantageous way. " Peter Mandelson, Sovereign Wealth and Politics, Wall Street Journal, June 6, 2008. For the Europeans, gesture is everything. Mandelson faulted the sovereign wealth funds for "getting the facts right and the politics wrong." Id. And then he raised the usual fear--states cannot resist acting like sovereigns even when they (pretend) to act as private actors in the market. "The possibility that a state might seek to use its investments for political leverage is very slim, but because recipients are not quite sure of the rules of the game, they can’t exclude it entirely." Id.

Well. Mandelson, sounding more like Caesar (addressing his wife) than like Mandelson, suggests the mechanism by which such finds might remain above suspicion. This, mechanism, he offers, provides the formula to enhance the likelihood that the problem will go away before states feel compelled to intervene:
The smart move from the funds would be to confound the suspicions. If sovereign wealth funds want to manage the politics of their dramatic rise, they should study the experience of the hedge-fund and private-equity industries in Britain. When rising public anxiety about their intentions and business models put them on the defensive, hedge funds and private equity moved quickly to reassure with voluntary codes of conduct. Sovereign wealth funds should do the same.
Id. He noted that Norway, Singapore and Abu Dhabi, having read the tea leaves correctly, has all decided to have a hand in the construction of such a transparency code. Id. One expects them to help produce something to their collective liking. And, of course, if the funds play nice, then they will be rewarded--
"The OECD will this week adopt a declaration welcoming SWF investments and recommitting members to principles of openness and nondiscrimination. The funds should see this as a gesture of good faith, and OECD politicians should stand by it. It is the essential quid pro quo that could seal this code and allow governments to turn down the heat under this issue. "

Id. But critically, Mandelson appeared willing to accept the proposition that sovereigns might act like, and be treated as, private investors under certain circumstances (those involving conformity to OECD or IMF transparency rules). "So long as its capital is invested for no other goal than a good commercial return, a sovereign wealth fund is not different from a pension fund, and its investments are likely to be much longer-term. " Id.

But the limitations are clear--the reward will be available only where state investors can establish (perhaps according to a formula or a set of standards of actions) that they are not investing for the purpose of maximizing their own aggregate best interests (a luxury not denied other shareholders). The EU thus appears suspicious but perhaps ready to deal. Yet, for all the happy talk, I am less certain that such a standard can be imposed. On its face it seems inconsistent with a decade long development of a jurisprudence of state participation in companies under Article 56 EC (free movement of goods in the context of golden shares) and Article 87 EC (state aids). If the EU remains true to the implications of that jurisprudence, I am not sure that the "so long as" requirements will be broadly applied. And so what appears to be an open hand may, in the end, be more closed than that of the United States. The Commission, however, continues its work. The realization of that work, though, remains clouded in inconsistency and desire. See A Common European Approach to Sovereign Wealth Funds, supra. It may not be possible to have an open policy in light of the construction of the internal market limitation in EU jurisprudence.

Moreover the Organization for Economic Development and Cooperation (OEDC) has declared its adherence to a policy of transparency as well. OECD Countries Commit to Open Climate for Sovereign Wealth Funds, June 5, 2008 ("The EU has welcomed a joint commitment by OECD Ministers at their annual meeting in Paris on 5 June to an open investment environment for Sovereign Wealth Funds. OECD Ministers adopted a declaration that committed them to a transparent and predicable investment environment that does not discriminate against Sovereign Wealth Fund investors."). See also OECD, Chair's summary of the OECD Council at Ministerial Level, Paris, 4-5 June 2008 - Outreach, Reform and the Economics of Climate Change, June 5, 2008. Transparency is also at the top of the agenda of the IMF. See IMF Intensifies Work on Sovereign Wealth Funds, March 4, 2008. It is not clear that these entities are talking about the same thing, though.

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