References in the essay are to end notes that follow the text of the essay below.
The essay raises important issues whose resolution is far from certain. The most important is the value of Sovereign Wealth Funds within markets for investments. Mr. Buhi intimates that there ought to be some skepticism about state engaged in investment activity. But is it clear that SWF's are necessarily bad for markets, or that state capitalism is distortive.
I have taken a different approach. See Larry Catá Backer, The Private Law of Public Law: Public Authorities as Shareholders, Golden Shares, Sovereign Wealth Funds, and the Public Law Element in Private Choice of Law, Tulane Law Review, Vol. 82, No. 1, 2008. I have been concerned about the elaboration of investor standards--the issue at the heart of much of what passes for regulatory efforts. Everyone seems to like SWF money; people just prefer that states would not be doing the investing. They presume that states are special sorts of investors, and on that basis would limit the scope of investment objectives. The EU has been moving toward a reasonable investor standard. I have argued against that. See Larry Catá Backer, Sovereign Wealth Funds And Hungry States: Adjusting the Borders of Public and Sovereign Activity Across Borders, Law at the End of the Day, June 6, 2008. It might be plausible to argue that which ever way you go, the method used to make investment decisions may be a more useful way of regulating SWFs than the regulation of the AMOUNT of shares they own. This is so especially when combined with no sovereign immunity and a right to proceed directly against the fund at their place of action or their home jurisdiction.
Negocio de China: Building Upon the Santiago Principles to Form an International Regime for Sovereign Wealth Fund Regulation
The International Working Group of Sovereign Wealth Funds (IWG) was established at Washington, D.C. in the midst of the subprime financial meltdown. Even as Western politicians were scrambling to construct bailout packages for their battered economies, a series of meetings were held to devise a code of best practices for sovereign wealth funds (SWFs). The document that emerged, the “Santiago Principles” or “Generally Accepted Principles and Practices” (GAPP), recognizes SWFs as “well-established institutional investors and important participants in the international monetary and financial system.”1 There can be no doubt as to the accuracy of that description. What is surprising is utter ineffectiveness of the GAPP regime. The Principles accomplish nothing but a reiteration of the status quo. It seems that the representatives of the Western free markets, in various states of dependency and desperation, were forced to suspend their reservations about the creeping resurgence of state capitalism. That protectionist reflex, however, remains tightly coiled under the surface. It will only take one politically sensitive investment attempt by an SWF to trigger embarrassing political confrontation and financial turmoil.
An omen appeared in 2007 with the birth of the China Investment Corporation (CIC), 2 whose inception stoked fears about SWF proliferation. The CIC’s rise is symbolic in two ways: first, it heralds that global economic power has shifted from West to East and, second, it forecasts that after a decades long trend of privatization, governments are poised to return as a major market player. The reasons the CIC provides a model case for examination of Western fears is also two-fold. First, it is intimately connected to the Chinese government, and thus the Chinese Communist Party. Second, the sheer purchasing power of China’s vast foreign exchange reserves could easily destabilize international financial markets and fundamentally alter the governance of Western corporations if unchecked. Indeed, the IWG was hastily established as a response to the rise of the CIC.
Thus far the Chinese have been model actors, constraining their activities with stricter codes of conduct than that requested of them in the Santiago Principles. In addition to the suggested GAPP guidelines, the Chinese often accept limiting themselves to non-voting shares of stock and rarely purchase more than a ten-percent stake in target companies. These guidelines, as well as stricter transparency requirements, should be included in whatever regime replaces the Santiago Principles.
In the end, the Santiago Principles amount to nothing more than an aspirational statement. The regulation of SWF investments will continue to take place on a bilateral, ad hoc basis. That is unfortunate. If the relationship between any two nations is treated as a purely bilateral one, all disputes become matters of power, prestige and face. Between the United States and China, economic tension could destroy the working relationship on which the world will depend in the 21st century. Thus, largely using the CIC as an example, this paper will define and describe sovereign wealth funds, explore the numerous advantages and dangers associated with their rise, and propose three elements that must underlie a truly comprehensive code of regulation that allows SWFs to maximize their positive attributes while safeguarding the apolitical integrity of the marketplace.
II. THE RISE OF SOVEREIGN WEALTH FUNDS
Some nations are accumulating wealth faster than they can channel it into domestic infrastructure. It is not politically desirable to sit on such large surpluses, in part because of the perceived opportunity cost of not investing the money.3 Diversified investing is tempting because it can earn higher returns than traditional foreign exchange reserves while hedging against fluctuations in their value.
Between 1945 and 2001, the world’s preferred investment instruments were United States Treasury Bonds. Underwritten by the then overwhelming strength of the American economy and liquid enough to be sold in time to prevent a currency crisis, these bonds were rightly considered a safe investment vehicle. Most central banks were content to settle for their security and liquidity.4 The exceptions were a few Middle Eastern emirates with more petrodollars than they knew what to do with. Realizing that oil wealth is not eternal and unsatisfied with the relatively low rate of return on bonds, these nations began innovating new investment vehicles and formed the first major SWFs. The desire for diversification spread in the early years of the 21st century with an increasingly negative prognosis of the American economy. The exponential multiplication of American debt and rapid depreciation of the dollar during the George W. Bush administration convinced many foreign governments to reevaluate their investment portfolios.5
Seeking less exposure to the U.S. Treasury as well as higher yields, these governments are establishing and authorizing SWFs to buy foreign assets including private-sector equity securities.
Thus, SWFs are a government-managed public fund authorized to invest a portion of a country’s national savings.6 The IWG defines them as “special purpose investment funds or arrangements, owned by the general government,” which need be “created by the general government for macroeconomic purposes,” to “hold, manage, or administer assets to achieve financial objectives,” and “employ a set of investment strategies that include investing in foreign financial assets.”7 Whereas the primary function of a nation’s central bank is to provide monetary stability,8 and short-term liquidity management,9 SWFs have a more aggressive mandate. Their purpose is to maximize long-term returns for various domestic purposes. Specific policy reasons used to establish SWFs have included retaining a portion of the profits from depleting petroleum reserves for the enjoyment of future generations,10 building wealth for retiring pensioners,11 curbing short-term discretionary government spending, 12 currency stabilization,13 subsidizing public education, 14 providing for a war chest during crises 15 and protecting the supervising jurisdiction’s status as an international financial center. 16 Whatever the policy necessitating their invention, they all claim to share a common purpose: wealth creation and money management for the better future of their citizens. 17 As such, SWFs present the opportunity for unprecedented public wealth and prosperity, and they should be allowed to pursue this particular goal ad infinitum.
Unfortunately, SWFs are intimately tied to governments, meaning that they are not above politics and could be commandeered to pursue strategic nationalistic objectives. Most nations sponsoring large SWFs have entrenched ideological predispositions against Western-style democracy and capitalism,18 and so future money flows may easily become conditionally tied to policy adjustments. The largest hoarders of wealth are the governments of export-based economies built upon oil revenue (i.e., Russia and the Middle Eastern states) or manufacturing exports and foreign reserves (i.e., China and Japan). The IMF estimated in 2007 that the assets held by sovereigns totaled USD $5.6 trillion of traditional reserves, of which between $1.9-2.9 trillion were allocated to SWFs.19 These countries are projected to continue accumulating assets at a rate of $800-900 billion USD annually.20 As the world's entire supply of equity shares was estimated at $55 trillion,21 it is possible that unchecked SWFs could one day become the primary stakeholder in global equity markets. They could easily overpower the markets of many developing nations today. Furthermore, massive shifts of capital could – intentionally or unintentionally – easily destabilize even the largest multinational corporations or national economies.
III. THE CHINESE INVESTMENT CORPORATION (CIC)
The CIC characterizes all of the fears that Western markets have regarding SWFs: it is bloated, with one-half trillion U.S. dollars at its command and potential access to a trillion more; 22 it has an aggressive mandate; and, it is directly accountable to the Chinese Communist Party.23
The CIC claims it will operate in a completely commercial way despite its governmental backup, explaining that "it will deal with its forex investment business independently by persisting in the principle of separating government functions from company management." 24 Nonetheless, the CIC enjoys premium cabinet-level positioning within the Chinese government. It is, by its charter, a wholly state-owned enterprise (SOE).25 Most Chinese SOEs report to a state-owned Assets Committee subordinated to the State Council, but the CIC reports directly to the State Council itself – the highest organ of Chinese executive power and administration. 26 The director of the CIC, Lou Jiwei, reports directly to the Premier of China, Wen Jiabao. 27 Furthermore, there is a Communist Party committee seated within the new CIC, including a director and several tiers of deputy directors.28 There can be no doubt that the CIC is inherently political.
The nineteenth Santiago Principle states that SWF investment decisions, “should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds.” Subprinciple 19.1 stipulates that, “[i]f investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed.” Certainly, “maximizing risk-adjusted financial returns” is the highest goal of an SWF. This is in keeping with the American understanding, which accepts that the “elemental purpose” of U.S. corporate law is the facilitation of wealth production.29 American corporate law assumes, therefore, that shareholders are a rational group of capitalists concerned solely with wealth creation. The true intent of foreign governments, especially authoritarian states,30 calls that premise into question. Li Yang of the CIC assures markets that "the [CIC]'s principal purpose is to make profits.”31 He elaborated that, “the company will work to ease the pressure of rising foreign exchange reserves and absorb market liquidity.”32 To further engender trust, the CIC revealed its overall investment strategy in 2007. CIC Director Lou Jiwei stated that it will be their investment strategy to, “pursue reasonable, long-term investments under acceptable risk conditions.”33 Accordingly, the CIC claims it will a) invest in liquid securities, not infrastructure, b) prefer international financial products to the RMB, and c) pursue reasonable returns while maintaining and bolstering the CIC’s ability to provide liquidity should a crisis occur.34
While these are all above-board goals, they hardly exhaust the list of reasons that the Chinese government – or any other – may intend to use its SWF for. Other reasons include mitigating the exposure of foreign reserves to the U.S. Treasury, knowledge acquisition, establishing foreign influence or gaining access to strategic natural resources.
a. Protection Against Volatile Shifts in the Value of the U.S. Dollar
The United States government believes that China is artificially suppressing the exchange rate of its currency, thus making its exports cheaper and easier to sell abroad. Although the Chinese government decoupled the direct link between the RMB and USD in 2005, the subsequent strengthening of the RMB has not appeased Washington. It is no secret that the Bush Administration has sought to recalibrate the dollar downwards to compete with the undervalued Chinese yuan.35 This policy serves a double purpose. First, it closes the foreign exchange rate gap which has agitated Washington for so long. Second, it sharply reduces the purchasing power of foreign exchange reserves held in U.S. dollars. For both of the preceding reasons, China wishes to diversify away from U.S. treasury bonds. Indeed, Lou stated that other reasons for establishing the CIC include, “strengthening the foreign reserve and broadening foreign investment channels.”36 The diversification strategy will accomplish these goals in two ways. First, buying equity shares could yield higher returns and reduce their exposure to dollar fluctuations and interest rate changes.37 Second, as China reduces its habit of buying U.S. Treasury bonds, their yields should rise. 38 Thus, China’s diversification strategy could counter the effect of America’s dollar depreciation by simultaneously increasing the value of all of China’s foreign assets, both equity and debt.
b. Knowledge Acquisition
China lacks experienced professionals in financial investment and wealth management. The CIC acknowledges this weakness and has committed itself to “trust foreign fund management and investment advice before switching to self-management.” 39 China’s initial investments were strategically designed to remedy this weakness. Before it was even incorporated, the CIC committed US$3 billion dollars to buy a 9.9% stake in The Blackstone Group, a leading U.S. provider of global asset management and financial advisory services. Protectionist pressures may increase as SWFs invest in Western banks and high-technology companies to acquire skills, brands and technology that they would not be able to develop expeditiously on their own.40
c. Acquiring Soft-Power Influence and Access to Strategic Natural Resources
Where China is deficient in critical natural resources it is spending billions of dollars to secure access to foreign deposits. For example, the CIC has had a role in the proposed merger between Rio Tinto and BHP. This union would create the world’s largest mining company, commanding 40% of global market share. China is the world’s largest consumer of raw iron ore, and the CIC purchased about 1% of Rio Tinto’s shares. Expect to see China build a significant minority stake in Rio Tinto in order to secure iron ore supply.
To its credit – with the striking exception of the Sudan, a pariah government whom the Chinese are trading with for oil despite U.N. condemnation41 – most of China’s economic diplomacy in Africa is highly relevant, humanistic and refreshingly transparent. As Deborah Brautigam of the Council on Foreign Relations points out:
Loans from China don’t get deposited into a dictator’s bank account and promptly sent to Swiss bank accounts. In Angola, for example, China’s recent $2 billion and $2.4 billion Eximbank credit lines were tied to infrastructure investments. Teams of Chinese are already in the country building roads, rehabilitating railways, and building schools and a huge neighborhood of low-cost housing...Compare this with the completely non-transparent $2.35 billion loan extended to Angola by Britain’s Standard Chartered Bank, Barclays, and the Royal Bank of Scotland.42
What leverage the Chinese will build with these governments or what access to natural resource reserves they will gain is a political question open to speculation, but Beijing believes that its so-called “socialism with Chinese characteristics” provides an ideological model for developing economies to follow. Capital flows from a more altruistic China could soon echo the "conditional aid" packages with which Western countries have long tied their support to developing countries with policy conditions.
For these fears among others, concerned nations hastily demanded that the International Monetary Fund do something to address the proliferation of SWFs.
IV. THE SANTIAGO PRINCIPLES
In October 2007, shortly after the establishment of the CIC, the IMF's governing body – the International Monetary and Finance Committee (IMFC) – asked the IMF to “analyze issues for investors and recipients of such flows, including a dialogue of identifying best practices.” 43 Soon thereafter, in May 2008, the International Working Group of Sovereign Wealth Funds was established (IWG). The IWG participants agreed to conduct a dialogue identifying SWF best practices under the auspices of the International Monetary Fund (IMF).44
The result – the Santiago Principles – was published in October 2008. This set of “generally accepted principles and practices” (GAPP) claims to reflect the current investment practices, appropriate governance and accountability arrangements, and policy objectives of SWF wielding nations.45 The GAPP is composed of 24 main principles divisible into three key subject areas: i.e., (i) legal framework, objectives, and coordination with macroeconomic policies (Principles 1-5); (ii) institutional framework and governance structure (Principles 6-17); and (iii) investment and risk management framework (Principles 18-24). 46
However, these principles are merely a voluntary code lacking any binding force. 47 Even if fully implemented, its provisions would be subject to the idiosyncrasies of domestic law.48 This renders them little more than aspirational, but SWF sponsoring nations would be wise to go beyond their requirements in order to engender trust and avoid protectionist clashes.
More than anything else, the Santiago Principles fail to provide a basis for designing an international framework for the regulation of SWFs. As such, regulation remains in the realm of bilateral negotiations between national ministries. The U.S., Germany and EU are taking separate approaches to limit the scope of SWF access, but none will be successful alone. That is why the Western nations scrambled to convene at the IMF in the first place.49 Few could make a more eloquent appeal for an international regulatory regime than this articulated by Martin Wolf:
A resolution will be achieved only by first reaching a mutual understanding of the challenge. Discussions of exchange rate policy require an intellectual honest broker. That is what the International Monetary Fund exists to be. By providing a credible and authoritative analysis of the global position, it can turn what would otherwise be a conflict between powers into a discussion of mutual interests. This is why reform of the IMF…is no arcane or minor matter. The brilliant vision of U.S. leadership during and after the second world war was that institutionalized co-operation could be the basis for a novel global order. This vision is as relevant to the era of a rising China. In deciding how to reform the multilateral institutions it established, the U.S. can also help determine how China itself sees its new role.50Indeed, this shows the limitations of a solely bilateral regime. It is accepted that nations have a right to invest their reserves to maximize returns. However, national SWFs must not be allowed to act opaquely and/or brazenly, violate national security, harm international relations by exercising political leverage, and/or destabilize other governments and financial markets. No bilateral approach could achieve these ambitious objectives.
To give teeth to the Santiago Principles, any IMF regime should be based upon three cardinal principles: transparency, non-voting stock and/or a ten-percent stake ceiling by an SWF investment in any target company. The CIC has accepted these terms on several occasions. Indeed, so far the CIC has done everything within its power to ease the tension surrounding its existence. That level of care far transcends the aspirational statements contained within the Santiago Principles.
Many commentators agree that SWFs should be reasonably free to invest in foreign markets as long as they meet adequate transparency standards, but few seem to define these criteria. 51 There is consensus that Norway's SWF provides desirable transparency. It lists all investments and their returns on its website as well as its debt/equity mix and identifications of all outside managers.52 Revealing the size and composition of assets under its management gives markets faith in the investment operations of this SWF. However, neither this disclosure, nor public disclosure of audited financial statements, are required under the Santiago Principles.53
To its credit, the CIC is advertising the names and resumes of its membership, a level of transparency atypical of Chinese SOE’s. "The appointments will favor a good outcome as most of the incumbent executives are experienced investment professionals and policy makers,” claims Li Yang, director of the finance research institute of the Chinese Academy of Social Sciences. 54 Yet, as of the date of this article, the CIC has not publicly disclosed all of its holdings on its official website.55 No law or principle would stop the CIC from following the example of the Abu Dhabi Investment Authority which reveals little about its massive investments. 56 It seems unlikely that the CIC would care to do otherwise because, by collaborating with a private-equity firm like Blackstone, a Chinese government that values its privacy will have a financial teacher adept at keeping its innovative operations private.57
To counter these concerns, China and the other IWG nations should agree upon mandatory disclosure requirements for SWF market participants. The Santiago Principles do commit nations to publicly disclose investment policies and the general approach of their risk management frameworks.58 Additional disclosures are required to protect the integrity of the market, and should be required upon every major acquisition. These could resemble, perhaps, the consensus reached in the IOSCO International Disclosure Standards for listing cross-border securities.59 That regime compels market participants selling cross-border securities to fill out a prospectus including: the identity of directors, senior management and advisors; statistics and expected timetables; operating and financial review and prospects, etc. Although unprecedented, it would be prudent to hold security purchasing SWFs to the same standards when crossing borders because of the size of the assets at their command. In the meantime, the emergence of SWFs should compel national regulators to reevaluate the murkiness of hedge funds, likewise establishing greater disclosure criteria. Otherwise, governments could easily channel their investments through these opaque intermediaries to bypass direct regulation, dangerously muddying global financial markets.60
B. Non-voting Stock
Modern company law seeks to emphasize the rights of shareholders in corporate governance, but a perceived threat from SWFs could trigger a political reconsideration of this priority. There is consensus among the Western-capitalist world regarding the fundamental rights of the ideal shareholder. They are enumerated in Principle 1 of The Principles of Corporate Governance promulgated by the Organization for Economic Co-operation and Development (OECD). This states that all shareholders should be able to, among other things, participate and vote in general shareholder meetings, elect members of the board, participate in fundamental corporate changes and share in the profits.61 GAPP Principle number 21 confirms:
SWFs view shareholder ownership rights as a fundamental element of their equity investments’ value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.The explanation attached to this principle states that some SWFs consider voting rights vital, “for their capacity to hold assets and preserve value rather than becoming a forced seller and, by definition, a shorter-term investor,” in addition to, “a mechanism for keeping the management of a company accountable to the shareholders, and thus contributing to good corporate governance and a sound allocation of resources.” 62
Under American corporate law, the shareholders owe no fiduciary duties and are allowed to vote their own interests selfishly.63 Those shareholders vote for directors who in turn vote for officers. Those directors and officers owe extensive duties to both the shareholders and the corporation.64 Much of the fear being generated in the West surrounds the “voice” China will acquire in Western corporations. The fact that the CIC owes a clear fiduciary duty to the CCP concerns the West.
Interestingly, it is worth remembering that American funds have been the most active voices for changing foreign corporate governance norms. 65 It would be hypocritical to bar the CIC from equity investments on these fears given the considerable shareholder activism of U.S. state pension funds, notably CalPERS. Commentators like Jacoby accuse CALpers of successfully altering fundamental practices of Japanese corporate governance:
CalPERS was an aggressive advocate of change. During its first phase of activism, it acted on its own: conscientiously voting its proxies, regularly meeting with executives of Japanese firms, and using the media and other public relations tactics to promulgate its principles. The second phase came when CalPERS leveraged its stake by teaming with other foreign investors and with domestic groups seeking to change Japanese corporate governance. CalPERS had prominence, even notoriety, in the Japanese business community because of its activities in the United States. 66The tenets of “socialism with Chinese characteristics” may be no more compatible with or appropriate for the Western corporate governance. China has so far refrained from corporate activism, but Western institutions are becoming increasingly dependent upon Chinese funding. In the near future, China’s preferences may change.
To illustrate how this may play out, take the following true example. Partly in response to a global controversy over the environmental destruction caused by China’s Three Gorges Dam, ABN Amro and Barclays helped to found the Equator Principles of 2003. This provided a code of conduct for lenders partaking in infrastructure projects in developing countries. Years later, in its determination to win a takeover battle for ABN, Barclays invited the CIC to become its largest shareholder.67 If the CIC becomes a leading stakeholder in a founding member of the Equator Principles, China could neutralize that code and silence, from within, a previous source of antagonism. The temptation to do so will grow as China accumulates more economic leverage.
To address this, the GAPP elaboration suggests that SWFs should disclose ex ante (and could disclose ex post) whether and how they exercise their voting rights by issuing public statements regarding their investment interests and their general approach to board representation. 68 These are hardly adequate. In order to suppress fears in foreign target economies that the aforementioned bad practices will become widespread, some SWFs are going one of two routes. First, they may retain their penchant for activism, as Norway’s SWF has done, but claim only small stakes in each target company. Far from feeling threatened, target companies often welcome such investment with the blessing of their governments. 69 The advantages of this approach will be elaborated in the next section. The second and best solution, one that the Chinese have thus far voluntarily agreed to abide by, is to refrain from buying shares of stock with voting rights or otherwise refrain from exercising voting rights at all. For example, in 2007 the CIC purchased a 9.9% equity stake in Morgan Stanley for US$5 billion while agreeing to be a passive investor with no management role; it took its stake in the Blackstone Group under the same conditions and has not sought voting rights vis-avis Barclays. 70 No political resistance came thanks to this condition and contemporaneous news that Morgan Stanley had suffered a staggering fourth-quarter loss of almost USD$13 billion between net losses and write-downs.
Another critical reason to avoid voting stakes is to avoid a future conflict between the principles of sovereign immunity and “piercing the corporate veil.” Piercing allows creditors to reach beyond the limited liability shield of incorporation when a debt ought to be directly attributed to the shareholders.71 Stakeholding SWFs should not immune from engaging in the sorts of market activities that would usually merit piercing. Nonetheless, nationalistic perceptions of an entitlement to sovereign immunity as well as conflicting spending priorities will doubtlessly make foreign sovereigns hesitant to abide by court decisions. Combine this with the expectation that sovereigns will compensate SWFs for loses and SWF managers may be encouraged to engage in morally hazardous behavior themselves or convince their directors on the boards of held corporations to do the same.
C. The Benefits of a Ten-Percent Ownership Ceiling
Even if the non-voting stock rule defies international consensus, the IWG or its successor should codify the ten-percent investment ceiling precedent that has emerged. SWFs have been active in helping financial firms raise capital during the current crisis, but none have exceeded this limitation. Abu Dhabi's SWF paid USD$7.5 billion for a 4.9% stake in Citigroup and Singapore's invested USD$9.72 billion for a 9% stake in UBS. China’s investment in Barclays could be viewed as reciprocal treatment for RBS’s investment in the Bank of China, just as the CIC’s investment in Blackstone can be seen as reciprocating Goldman Sachs and American Express acquiring 10% of the Industrial and Commercial Bank of China. The CIC also acquired a 9.9% stake of Morgan Stanley worth US$5 billion on December 19, 2007. These examples go back to 1988, when the British government forced the Kuwaitis to reduce their 20% stake in BP to 9.9% of equity. Since that time a precedent has emerged where most SWF purchases do not exceed 10% of the target company’s outstanding stock. If this practice were codified, it would have several beneficial effects for SWF investing.
First, it will create clear guidelines for investment. Reciprocity alone will never be a complete solution. A bilateral, ad hoc situation will inevitably lead to more conflict. Both the U.S. Committee on Foreign Investment and Britain’s Chancellor of the Exchequer note that reciprocal market access is key to the ad hoc vetting process. The continental Europeans are leading the international backlash. German Chancellor Angela Merkel wants the European Union to establish an agency similar to the U.S. Committee on Foreign Investment (and its Exon-Florio law72) to scrutinize foreign takeovers. EU Trade Commissioner Peter Mandelson advanced the alternative approach that the EU might allow governments to hold “golden shares” to block acquisitions of sensitive industries.73 Brussels has opposed the deployment of golden shares in the past, but Mr. Mandelson believes that any system should be regulated at a pan-European level to avoid distorting the European single market.74 These different approaches underscore the need for a global response. Bilateral regimes will destabilize international financial markets and encourage retaliation and protectionism.
Second, the ten-percent limitation would help protect national security interests. Defining what industries fall under the umbrella of “national security” is sensitive and often unpredictable due to idiosyncratic local conditions.75 This can be especially challenging in the Sino-American context. For example, the U.S. Congress engaged in a politically-charged battle to divest Dubai Ports World of control of five major U.S. ports in 2006, while that company successfully runs the major port in Hong Kong.76 National Security concerns also become tricky to manage due to the diversified operations of major multinational companies: what seems innocuous today could become a matter of concern tomorrow. It is difficult, embarrassing and invites reprisal to divest SWFs of rightfully purchased assets based upon vacillating national security concerns. Thus, allowing SWFs to acquire ten-percent of non-managerial stock in any company seems to be a decent compromise. The cross-pollination of defense spending may even, if well orchestrated, contribute to international peace and security.
Third, a ten-percent ceiling would mitigate fears that large capital flows from SWFs will be used to destabilize markets or governments. Never has the potential for so much capital to enter the market at one time existed before the rise of SWFs. If an SWF made a bad investment and had to unwind it fast, it could destroy firms and/or destabilize entire sectors of the global economy. The IMF warned that, “a single institution could make sudden portfolio adjustments that could have significant price effects on certain asset classes. Market rumours of such adjustments may lead to volatility as previous announcements by central banks have shown,” in its global financial stability report. 77 This sentiment is echoed by Willem Buiter, Professor of European Political Economy at the London School of Economics:
[I]f and to the extent that these SWFs are large enough to be systemically important, a failure by one or more of them – or even a significant loss suffered by one or more of them - could drag a significant number of counterparties into the abyss and thus endanger financial stability worldwide.78There is also an example proving that SWFs can be used to destabilize foreign governments. Some attribute the political turmoil in Thailand in part to Singapore’s Temasek SWF acquiring a local telecommunications company. A senior Temasek official warned that similar problems may be brewing in China, where the group bought stakes in two state banks. 79 Obviously, a SWF should avoid destabilizing governments and markets by risky speculation, abusing privileged information or engaging in crony capitalism. A ten percent ceiling would prevent the appearance of hostile takeovers of national firms. It would also prevent a foreign government from being able to sway domestic policy using national industries. Lawrence Summers challenges us to imagine a foreign government using its SWF to apply political leverage on a host government, “when a country joins some ‘coalition of the willing’ and asks the US president to support a tax break for a company in which it has invested? Or when a decision has to be made about whether to bail out a company, much of whose debt is held by an ally’s central bank?” 80 Dr. Summers proposes that funneling SWF funds through financial intermediaries would reduce these concerns.81 Unfortunately, this remedy is insufficient. That make SWF holdings more transparent under the current non-disclosure regime and compel SWFs to commandeer intermediaries to do their lobbying for them.
Thus, the most viable and least hypocritical option available to all parties given present realities is to limit the assets available for sale to foreign interests. Both East and West already do this, and a benchmark 10% level of access has developed. This number provides a common ground for the IMF to build a SWF investment regime upon, and should have been included in the Santiago Principles. This scheme is the only way to eliminate the need to insult foreign governments and thereby invite retaliation through individual, ad hoc rejection notices.
The emergence of large SWFs was, perhaps, inevitable. It was at least predictable. SWFs have a positive role to play in human progress. They present outstanding prospects for peace as the world becomes more and more economically symbiotic. They represent opportunities for Western corporations to access previously closed markets and integrate those emerging economies into the global financial mainstream. They provide an opportunity for unprecedented public wealth creation which can be channeled into health care, education, infrastructure and other human needs.82 Furthermore, China in particular has earned all of the money it is investing, not through the lottery of natural resource allocation, but through the unbelievable work ethic of its people. If the Chinese government is successful in producing more wealth to pull more of its citizens out of poverty, it will be a model example for the world.
Unfortunately, the potential for mischief means that all SWFs must be addressed seriously with an international regulatory regime worthy of the challenge. Because they are intimately tied to politics and national interests, SWFs could be abused for nationalist aims. Several nations sponsoring large SWFs have entrenched predispositions against democracy and free-market capitalism. Fears regarding their true intentions, reasonable or not, will trigger protectionist responses unless compartmentalized.
The massive public bailouts of private sector investment banks have created a ripe atmosphere for increased financial regulation across the West, and those nations would be wise to use this opportunity to demand just that. As global markets become more addicted to SWF liquidity, it will become harder to achieve favorable points of compromise at the negotiating table. Given the present situation and the need for long-term investors with ample liquidity, it is in the interest of all parties to make the Santiago Principles a success by installing safety provisions and making them binding.
The solution must be serious, binding and international. If unregulated or merely regulated at an ad hoc, bilateral level, SWFs will cause disruptions in ways both foreseen and unforeseen. As such, the Santiago Principles are a positive first step insofar as they indicate the issue is being seriously addressed, but they provide no binding regulations to govern the activities of SWFs. The IMF must forge an agreement which welcomes reasonable amounts of state-owned capital into the financial markets for the good of humanity but denies states the ability to use their SWFs for strategic objectives. The best way is to ensure that SWFs are impotent in the political arena through a binding, three-prong regime:
1. Much stricter transparency standards are needed regarding each SWF in general, and its individual investments as they arise
2. SWFs should only be allowed to invest in non-voting equity shares, and
3. SWFs should be barred from owning more than a set limit, say a ten-percent equity interest, in any private foreign corporation.
To ensure the safety and apolitical orientation of the free markets, the GAPP should be expanded to include these important principles.
1. International Working Group on Sovereign Wealth Funds, Generally Accepted Principles and Practices, “Santiago Principles,” Introduction, p. 1, available at http://www.iwg-swf.org/pubs/gapplist.htm.
2. In Chinese, 中国投资有限责任公司.
3. “Jennifer Johnson-Calari, director of Sovereign Investments Partnerships at the World Bank, says there is a huge opportunity cost to ‘uninvested’ capital tied up in reserves. ‘This is financial capital that is unexploited, very much like agricultural land lays fallow, unploughed,’ she says.” Tony Tassel, et al., How Sovereign Wealth Funds are Muscling in on Global Markets, Fin. Times, May 24, 2007.
4. The Bank of England states that, “[t]here is a widespread agreement on the ‘classic trilogy of objectives’ for official reserves management: Security, Liquidity and Return. And there is also agreement that of these, Return is in most cases the third most important of the three. One rendition of the trilogy of objectives into a combined statement of official reserves management is ‘The objective of official reserves management should be to maximize return, subject to the maintenance of sufficient security of the assets and adequate liquidity for meeting the calls on the reserves.’ John Nugee, Foreign Exchange Reserves Management, Handbooks for Central Banking No. 19, Center for Central Banking Studies, Bank of England, 14.
5. Modern SWFs date back to the 1950’s, but they have proliferated in the early 21st century. Since the year 2000, the Taiwan National Stabilisation Fund (2000), Kazahkstan National Fund (2000), Qatar Investment Authority (2000), Stabilisation Fund of the Russian Federation (2003), Central Huijin Investment Corporation (2003), Australian Government Future Fune (2004), Korea Investment Corporation (2006) and China Investment Corporation (2007) have come online. Indian and Japanese SWFs are in the planning stages.
6. The term “sovereign wealth fund” seems to have originated in a 2005 publication: Andrew Rosenov, Who Holds the Wealth of Nations, Central Banking, 2005, 15(4), 52-57.
The Santiago Principles define Sovereign wealth funds as, “special purpose investment funds or arrangements that are owned by the general government. Created by the general government for macroeconomic purposes, SWFs hold, manage, or administer assets to achieve financial objectives, and employ a set of investment strategies that include investing in foreign financial assets.
7. Santiago Principles, supra note 2, at 27 (Appendices and References).
8. See R. Lastra, Legal Foundations of International Monetary Stability, Oxford University Press, 2006, at 35. Lastra defines monetary stability as:
The maintenance of the internal value of money (i.e., price stability) as well as the external value of the currency (i.e., the stability of the currency vis-à-vis other currencies, which is, in turn, influenced by the choice of exchange rate regime).9. See Douglas Arner, Financial Stability, Economic Growth and the Role of Law, Cambridge University Press, 2007, 126-127. Arner identifies the various roles of central banks including currency issuance, monetary policy, banking supervision and regulation, financial stability and lender of last resort services, etc.
10. The Alaska Permanent Fund, Abu Dhabi Investment Authority and the Government Pension Fund of Norway.
11. The Government Pension Fund of Norway. This SWF has two jobs: to act as a buffer against volatility in the price of oil and as a long-term savings vehicle. It is becoming more risk-seeking, announcing in April 2007 that it would increase the share of equities in its portfolio from 40% to 60%. See China takes the bank: How Sovereign Investors Plan to Operate, The Economist, July 26, 2007.
12. The Alaska Permanent Fund.
13. The Stabilization Fund of the Russian Federation.
14. The Texas state Permanent University Fund (PUF).
15. The Kuwait Investment Authority.
16. The Government of Singapore Investment Corporation; The Hong Kong Monetary Authority.
17. The classic example cited is that of the Gilbert Islands in Micronesia. In the early 1950’s the British colonial government imposed a levy on the export of bird manure. Though this natural resource was depleted (much the way petroleum reserves someday will be), this gradual savings developed into the Kiribati Revenue Equalisation Reserve Fund, an investment portfolio now worth several times the local GDP.
18. The Preamble of the Constitution of the People’s Republic of China still states that, “We must persevere in the struggle of the proletariat against the bourgeoisie and in the struggle for the socialist road against the capitalist road. We must oppose revisionism and prevent the restoration of capitalism.”
19. Id. These amount to about 10 times less than the assets under management of mature market institutional investors ($53 trillion) and modestly higher than those managed by hedge funds ($1 trillion to $1.5 trillion).
21. The World’s Most Expensive Club, The Economist, May 24, 2007.
22. CIA World Factbook, Rank Order – Reserves of Foreign Exchange and Gold, available at https://www.cia.gov/library/publications/the-world-factbook/rankorder/ 2188rank.html, last visited 12/2/2007.
“[The amount of cash held by the CIC] represents the single largest pool of cash that any government has thrown at anything, ever. Adjusted for inflation, the US’s largest effort, the Marshall Plan, comes in at just over $100bn,’ says Statfor, a US security consulting intelligence agency.” Tony Tassel, et al., How Sovereign Wealth Funds are Muscling in on Global Markets, Fin. Times, May 24, 2007. This statement captures the alarmed moo in Washington.23. “China will struggle to copy state investment agencies such as those of Dubai and Singapore by taking large stakes abroad. Nobody is scared of those nations; of China they are afraid...China’s trade surplus and exchange rate policy are bad enough, but if it is seen to be buying up the world economy with the proceeds, it can only end in hearings before Congress, public demands for protectionism, and ever louder demands for a higher renminbi.” Editorial Comment, China Should Beware a Backlash, Fin. Times, July 24, 2007.
25. Zhong guo tou zi gong si cheng li, xin lang cai jing, Chinese financial report available at http://finance.sina.com.cn/focus/whtzgs/.
27. Id. The Premier of China is also known by the title of “Premier of the State Council of China.” He is the highest ranking administrator within the Chinese civil bureaucracy.
28. China’s Trillion-Dollar Kitty is Ready, Asia Times Online, available at http://www.atimes.com/atimes/China_Business/ IJ02Cb01.html, October 2, 2007, last visited December 12, 2007.
29. William T. Allen, “Ambiguity in Corporation Law,” 22 Del.J.Corp.L., 894-897 (1997).
30. “What has received less attention are the particular risks associated with ownership by government-controlled entities...The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.” Lawrence Summers, Funds That Shake Capitalist Logic, Fin. Times, July 29, 2007.
31. Asia Times, supra note 29.
33. Chinese financial report, supra note 26.
34. Chinese financial report, supra note 26. (translation by Li Ying, Ph.D. Candidate, The University of Hong Kong).
Interestingly, “[a] country’s tolerance for greater exchange rate flexibility should reduce its demand for reserves, because its central bank would not need a large reserve stockpile to manage a fixed exchange rate; therefore, reserve holdings are likely to be lower the more variable the country’s exchange rate is.” Foreign Exchange Reserves in East Asia: Why the High Demand?, FRBSF Economic Letter, No. 2003-11, April 25, 2003.
35. French President Nicholas Sarkozy used his largely conciliatory first speech to the U.S. Congress to accuse the administration of depreciating the dollar. Nicholas Sarkozy, President of France, Renewing the French-American Alliance, Address to Joint Session of Congress, November 7, 2007. China’s currency suppression is fueling the rapid growth of its currency reserves by making its exports cheaper and easier to sell abroad.
36. Chinese financial report, supra note 26.
37. Editorial Comment, China Should Beware a Backlash, Fin. Times, July 24, 2007.
38. Morgan Stanley estimates that if buying eases, bond yields could rise by as much as 30-40 basis points over the next 10 years. See John Willman, Big Spenders Stir Protectionism, Fin. Times, July 29, 2007.
39. Chinese financial report, supra note 26.
40. See Gapper, Learn to Love State-Owned Investors, Fin. Times, July 27, 2007.
41. Andrew Heavens, Darfur Rebels Reject Chinese Peacekeepers, Reuters, November 24, 2007.
42. Deborah Brautigam, et al., Is Chinese Investment Good for Africa?, Council on Foreign Relations, last visited November 2008.
43. Santiago Principles, supra note 2, at p 1.
44. Id. The IWG is composed of twenty-six IMF member nations with SWF interests, met three times (once in Washington, D.C., Singapore, and Santiago, respectively). The member countries are Australia, Azerbaijan, Bahrain, Botswana, Canada, Chile, China, Equatorial Guinea, Islamic Republic of Iran, Ireland, Korea, Kuwait, Libya, Mexico, New Zealand, Norway, Qatar, Russia, Singapore, Timor-Leste, Trinidad and Tobago, the United Arab Emirates, and the United States. Permanent observers of the IWG are Oman, Saudi Arabia, Vietnam, the OECD, and the World Bank.
45. See generally Santiago Principles, supra note 2, Part 1, page 7.
47. “The GAPP is a voluntary set of principles and practices that the members of the IWG support and either have implemented or aspire to implement,” Id. at p. 5.
48. “In furtherance of the ‘Objective and Purpose,’ the IWG members either have implemented or intend to implement the following principles and practices, on a voluntary basis, each of which is subject to home country laws, regulations, requirements and obligations,” Id. at 7.
49. Western dominated institutions like the G-7 and IMF have traditionally overseen global finance, but are no longer considered fair arbiters of the international financial architecture. The G-7 includes financial lightweights like Italy while shutting out China. Meanwhile, the United States is a blocking minority shareholder on all IMF decisions. As the Eastern nations now have massive economic leverage, a potential agreement to regulate SWFs could be closely linked to negotiations about an overhaul of financial institutions.
50. Martin Wolf, U.S. and China Need Strong Institutions, Fin. Times, April 18, 2006.
51. As pointed out in a speech by Dr. Y.V. Reddy, Governor of the Reserve Bank of India, “SWFs may or may not be subjected to such rigorous accountability and transparency tests, internally, by the governments concerned. The main reason for lack of clarity is that global benchmarks for disclosure are yet to evolve.”
52. See The Government Pension Fund of Norway web site, available at http://www.norges-bank.no/Pages/Article____41137.aspx.
53. See generally, Santiago Principles, supra note 2.
54. See Chinese financial report, supra note 26.
55. China Investment Corporation website, Investments, available at http://www.china-inv.cn/cicen/investment/investment_investment.html.
56. Tassel, supra note 23.
57. “It is a marriage made in heaven—a partnership that does not want investors to ask questions with a country whose firms do not want investors to ask questions. I worry about the serious conflicts of interest this generates,’ opines Raghuram Rajan, of the University of Chicago's Graduate School of Business.” The Economist, supra note 12.
58. Santiago Principles, supra note 2, GAPP Principle 4.
59. IOSCO, Report of the Technical Committee, International Disclosure Standards for Cross-Border Offerings and Initial Listings by Foreign Issuers, 1998, 3.
60. Some already do. “Given the size of the funds to be deployed, SWFs also could go on a buying spree of corporate assets. This could inflame nationalistic sentiment if they acquire foreign companies seen locally as having strategic importance. That may be one reason why some SWFs channel their investments through discreet secondary managers.” Tassel, supra note 23.
61. OECD Principles of Corporate Governance, Principle 1.
62. Santiago Principles, supra note 2, Explanation of GAPP Principle 19 at 22.
63. Gamble v. Queens County Water Co. (NY 1890) stated that shareholders represent themselves in all voting circumstances. They do not have to represent the corporation. The only small exception where a court will intervene is if the action is so illogical that the only possible purpose would be to perpetuate an inequity; i.e., must be sub-serving some outside, foreign interest. Normally “waste” fits this description. It will be interesting to see if any government actions could be so opposed to the corporation’s wellbeing to merit similar treatment.
64. Delaware case law and the Delaware code articulate the duties owed by managers and directors to the corporation and shareholders. These four duties are care and loyalty (to the corporation), disclosure (to the shareholders), and good faith (to all) at §8.30, §8.31 and Subchapter (F) §8.60-8.64.
65. Jacoby, Sanford M., Convergence by Design: The Case of CalPERS in Japan, 55 Am. J. Comp. Law 239, Spring 2007.
67. Editorial Comment, China Should Beware a Backlash, Fin. Times, July 24, 2007.
68. Santiago Principles, supra note 2, Explanation of GAPP Principle 21 at 22.
69. David Jonsson, Sovereign Wealth Funds: A Potential Tool of Asymmetric Warfare, August 11, 2007, available at http://www.therant.us/guest/jonsson/ 08112007.htm.
70. John Wilman, Big Spenders Stir Protectionism, Fin. Times, July 29, 2007.
71. “When the conception of corporate entity is employed to defraud creditors, to evade an existing obligation, to circumvent a statute, to achieve or perpetuate a monopoly, or to protect knavery or crime, the courts will draw aside the veil…and will do justice between real persons.” I. Maurice Wormser, Piercing the Veil of Corporate Entity, 12 Colum. L. Rev. 496, 517 (1912).
72. P.L. 100-418, title V, Subtitle A, Part II, or 50 U.S.C. app 2170. In 1988, amid concerns over foreign acquisition of certain types of U.S. firms by Japanese firms, Congress approved the Exon-Florio provision of the Defense Production Act. This grants the President the authority to block proposed or pending foreign acquisitions of “persons engaged in interstate commerce in the United States” that threaten to harm national security. In subsequent legislation, Congress directed that this process be applied “in any instance in which an entity controlled by or acting on behalf of a foreign government seeks to engage in any merger, acquisition, or takeover which could result in control of a person engaged in interstate commerce in the United States that could affect the national security of the United States.”
73. A “golden share” is an advanced control-right equity share able to outvote all other shares in a shareholders meeting under certain specified circumstances.
74. Gapper, Learn to Love State-Owned Investors, Fin. Times, July 27, 2007.
75. Defense and high-technology industry are not the only sectors which potentially fall under the national security umbrella. Others include telecommunications, energy, resources, intellectual property rights and even the media.
76. The U.S. Congress forced Dubai Ports World to sell five port terminals it acquired in 2006. This followed a 2005 rally by Congress to oppose a bid by the Chinese state-controlled oil company, CNOOC, for Unocal. Supporters of Chevron, the domestic rival bidder that won Unocal instead, successfully portrayed CNOOC as a front for Beijing’s strategic energy interests during the controversy.
77. Tassel, supra note 23.
78. Willem Buiter, Taming Sovereign Wealth Funds in Two Steps, Maverecon – Willem Buiter’s Blog, available at http://maverecon.blogspot.com/2007/07 /taming-sovereign-wealth-funds-in-two.html, last visited September 2008.
79. Tassel, supra note 23.
80. Summers, supra note 31. Unfortunately, Summers proposes only that “[a]ll of these risks would be greatly mitigated if SWFs invested through intermediary asset managers, as is the case with most institutional pools of capital such as endowments and pension funds. The experience of many endowments and pension funds suggests that this approach is in most cases likely to produce the best risk-adjusted returns.”
81. Summers, supra note 28.
82. Temasek, the Singaporean SWF which caused the coup d’état in Thailand and faces ongoing questions over its transparency, announced plans to set up a $330 million dollar fund to finance regional development.