Wednesday, January 28, 2009

State Owned Enterprises and Sovereign Investment in Foreign Economic Entities

Much attention has recently been devoted to the rise of sovereign wealth funds. These entities present great difficulties in the application of current legal frameworks because they straddle the traditional divide between public and private law, between states as market regulators and market participants. Those who oppose their growth tend to privilege their public aspects--principally that they are owned by states--adopting a formalist approach to their analysis. Others tend to privilege their private aspects--that they operate like and are subject to regulation outside their home jurisdictions by public regulators--adopting a functionalist approach to regulation. 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.

The usual definitions of such funds reflect the conservative inertia of this conceptual framework. The Americans have sought to define these entities by emphasizing their public nature of these investment instruments. An SWF has been understood to include "a government investment vehicle which is funded by foreign exchange assets, and which manages those assets separately from official reserves." U.S. Department of the Treasury, Press Room, Remarks by Acting Under Secretary for International Affairs Clay Lowery on Sovereign Wealth Funds and the International Financial System, (hp-471, June 21, 2007). The IMF also focuses on the public character of the ultimate owner of the fund. Thus IMF studies would define sovereign wealth funds to include "government-owned investment funds, set up for a variety of macroeconomic purposes. They are commonly funded by the transfer of foreign exchange assets that are invested long term, overseas." International Monetary Fund, Sovereign Wealth Funds--A Work Agenda (February 29, 2008 (prepared by the Monetary and Capital Markets and Policy Development and Review Departments and approved by Mark Allen and Jaime Caruana), at 4. Annex II to this document provides short definitions provided by other stakeholders in the financial system, from Deutsche Bank ("financial vehicles owned by states which hold, manage, or administer public funds and invest them in a wide range of assets") to Morgan Stanley ("An SWF needs to have five ingredients: sovereign; high foreign currency exposure; no explicit liabilities; high-risk tolerance; and long-term investment horizon"). Id., at Annex II, pp. 37-38.

It is that public ownership that serves as the gateway through which further analysis is grounded. Thus, for example, the IMF would distinguish among these funds on the basis of their objectives:
Five types of SWFs can be distinguished based on their main objective: (i) stabilization funds, where the primary objective is to insulate the budget and the economy against commodity (usually oil) price swings; (ii) savings funds for future generations, which aim to convert nonrenewable assets into a more diversified portfolio of assets and mitigate the effects of Dutch disease; (iii) reserve investment corporations, whose assets are often still counted as reserve assets, and are established to increase the return on reserves; (iv) development funds, which typically helpfund socio-economic projects or promote industrial policies that might raise a country’s potential output growth; and (v) contingent pension reserve funds, which provide (from sources other than individual pension contributions) for contingent unspecified pension liabilities on the government’s balance sheet.
IMF, Sovereign Wealth Funds, supra, at 5. This is a framework used in other studies as well. See, e.g., Edward F. Greene & Brian A. Yeager, Sovereign Wealth Funds--A Measured Assessment, 3(3) Capital Markets Law Journal 247-274 (Advance Access publication 10 June 2008) (distinguishing among central banks, stabilization funds, public pension funds, government investment companies and state owned enterprises). American officials have distinguished between two large categories of SWFs, commodity and non-commodity funds. U.S. Department of the Treasury, Press Room, Remarks by Acting Under Secretary for International Affairs Clay Lowery on Sovereign Wealth Funds and the International Financial System, (hp-471, June 21, 2007).

As a consequence, much effort has been expended on measures to control the investment strategies of sovereign wealth funds (understood as another arm of national policy and a possible source of indirect protections of national power abroad), without affecting the level of such inbound investment to states desperately hungry for the funds. See, e.g., 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. The result has been a drift to something like a "reasonable investor policy." This approach has been criticized for its over and under inclusion of restraint and its stubborn ignorance of the nature and scope of investment. See, e.g., 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. See, e.g., Larry Catá Backer, Brazil Builds a Sovereign Wealth Fund and Norway Flexes Its Muscles: Private Participation in the Market or Regulation by Other Means, Law at the End of the Day, May 24, 2008; Larry Catá Backer, Extraterritoriality and Corporate Social Responsibility: Governing Corporations, Governing Developing States, Law at the End of the Day, March 27, 2008.

Much of this control has been accomplished informally and on a state to state basis. The recent joint statement among the United States, Singapore and Abu Dhabi provides a recent case in point.

We support the processes underway in the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) to develop voluntary best practices for SWFs and inward investment regimes for government-controlled investment in recipient countries, respectively. International agreement on a set of voluntary best practices will create a strong incentive among SWFs and investment-recipient countries to hold themselves to high standards. We hope that the IMF and OECD's work can build upon these basic principles:

Policy Principles for Sovereign Wealth Funds (SWFs)

1. SWF investment decisions should be based solely on commercial grounds, rather than to advance, directly or indirectly, the geopolitical goals of the controlling government. SWFs should make this statement formally as part of their basic investment management policies.

2. Greater information disclosure by SWFs, in areas such as purpose, investment objectives, institutional arrangements, and financial information – particularly asset allocation, benchmarks, and rates of return over appropriate historical periods – can help reduce uncertainty in financial markets and build trust in recipient countries.

3. SWFs should have in place strong governance structures, internal controls, and operational and risk management systems.

4. SWFs and the private sector should compete fairly.

5. SWFs should respect host-country rules by complying with all applicable regulatory and disclosure requirements of the countries in which they invest.

Policy Principles for Countries Receiving SWF Investment

1. Countries receiving SWF investment should not erect protectionist barriers to portfolio or foreign direct investment.

2. Recipient countries should ensure predictable investment frameworks. Inward investment rules should be publicly available, clearly articulated, predictable, and supported by strong and consistent rule of law.

3. Recipient countries should not discriminate among investors. Inward investment policies should treat like-situated investors equally.

4. Recipient countries should respect investor decisions by being as unintrusive as possible, rather than seeking to direct SWF investment. Any restrictions imposed on investments for national security reasons should be proportional to genuine national security risks raised by the transaction.

U.S. Department of the Treasury, Press Room, Treasury Reaches Agreement on Principles for Sovereign Wealth Fund Investment with Singapore and Abu Dhabi 30 (hp-881, March 20, 2008). And, indeed, the recently embraced so-called "Santiago Principles" embrace this notion of some kind of reasonable investor model for judging the activities of SWF abroad.

My principal interest in this essay, however, is not to explore the principal vehicles through which states are now seeking to invest in the economic activities of others. Rather, I will focus on a potentially confounding vehicle for both economic activity in its own right and activities abroad that might broadly include investment activities usually associated with sovereign wealth funds--state owned enterprises operating as separate legal persons. Greene and Yeager, supra, suggest that these vehicles "may be the most problematic from an investee-country's perspective, particularly when the acquirer and the target are infrastructure companies, because the investments may be seen as a means for gaining political leverage." Id., at 253. For examples, they point to the investment activities of Dubai Ports World and the China National Offshore Oil Company. Id., at 253-254. See, Larry Catá Backer, Missing the Point of the Ports Problem—Getting Foreign Governments Out of U.S. Security Related Business, Law at the End of the Day, March 26, 2006.

But let us consider the problem more closely. The issue of the investment consequences of state owned enterprises whose business is not investment presents issues similar to those of the typical SWF, but with significant differences. From a functional perspective, centered on the state as ultimate owner, there may be little difference between a state owned hotel corporation purchasing a large hotel corporation with principle offices in Chicago and incorporated in Delaware, and a SWF purchasing a controlling interest in the same firm. In both cases the target company is controlled by an enterprise whose ultimate owner is a state. In both cases, the state, as ultimate shareholder, can assert a power of control over the entity that may or may not reflect the sort of values a private shareholder might be expected to assert. Thus, states might be tempted to use their ownership for political purposes--that is to maximize their national interests through their ownership of foreign entities--even if those entities suffer financially as a result. Thus, of example, if the state owned hotel corporation of State A wanted to ruin the competing hotel business of State B, it might cause State A Hotel Corp to purchase State B Hotel Corp for the purpose of either shutting it down or causing State B to make concessions that would preserve the business of the hotels in State A. But this scenario is not necessarily logical, realistic, or peculiar to public entities. First, unless the target entity is wholly owned, the public shareholder would be subject to suit for breaches of duty or abuse of power by the minority shareholders in many jurisdictions (but not all to be sure). Second, all shareholders seek to maximize their personal interest in their investments. It stands to reason that a public shareholder would measure its interests (and its maximization) on a scale distinct from that of an individual or legal person that is not a state. Third, the sort of predatory behavior suggested by the example is usually actionable under the domestic law of the state where it occurs. The evil or disruptive potential of such behavior is only troublesome to the extent that states, as owners of entities that invest in foreign jurisdictions, may evade local law or may avoid treatment as a shareholder like any other.

Yet, under the current system of global economic ordering, a functional analysis does raise some of those concerns. Principal among them is that a large corporation may effectively order its operations so that it effectively regulates itself. See Larry Catá Backer, The Autonomous Global Enterprise: On the Role of Organizational Law Beyond Asset Partitioning and Legal Personality, Tulsa Law Journal, Vol 41, 2006.

We have seen how the territorial principle and the principle of regulatory hierarchy can open the possibility of enterprise self-regulation. Any enterprise that can disperse its assets among a large enough number of regulatory units will transform the relationship between regulator and enterprise. For the traditional relationship that is both singular and hierarchical, globalization permits the enterprise to treat regulation as another factor in the production of wealth. The enterprise, now in a position to shop for regulatory regimes, or even bargain for domestication within the territory of a regulatory territory, can take advantage of the limitations of the territorial principle to minimize the effects of regulation to inhibit enterprise activity. The principle of regulatory hierarchy can then be turned on its head. The ability to commodify regulation makes it at least theoretically possible to construct an economic entity which, through careful planning can take advantage of asset partitioning, cross holdings, and global dispersion of assets to avoid effective regulation by any one political community.
Id. It is in this context that a state owned enterprise, one bent on aggressive investment in other entities abroad, might pose a regulatory danger. It is not just that such entities are owned and perhaps managed in the ultimate interests of a state, but it is that such enterprises, is managed well enough, might also be able to evade local control.

For all that, state owned enterprises are not sovereign wealth funds from a formal perspective. Their functions are quite distinct. State owned enterprises are meant to operate the way their privately owned counterparts do. Their principal objects are consonant with those of private actors. Yet like private actors, they might seek to aggressively insert themselves in the economic life of other states where that has the effect of enhancing their own financial condition, increasing its market share or reducing competitive pressures, among the usual "reasonable actor" objectives. But that very conduct can produce the sorts of interventions that might make states quite nervous where the entity is owned by a state. And indeed, because state owned enterprises are not funds, their investment activities might not fall within the limitations of the Santiago Principles and similar mechanisms.

Thus, the state owned enterprise presents a unique variant on the SWF. Though it is neither a fund, nor was it created for the purpose of investing in other entities, a state owned enterprise might naturally engage in such activities. But it does so in the context of maximizing its own business operations rather than as an end in itself. Yet those business operations, as classically understood, are themselves undertaken to maximize the interests of the entity (and its shareholders). If there is a unity between shareholder and corporate interests (for example where the entity's shares are wholly owned by the state, then it would be logical to assume that the maximization of state value in such enterprises includes the political value of that enterprise's operations. On the other hand, even if that is the case, at least with respect to its global operations, such an entity (and its state owner) would be liable in host jurisdictions, for breaches of duty, abuse of power, looting and the like in its relationships with its foreign owned subsidiaries. Consequently, the similarities in result mask significant differences between state's as owners of SWFs and states as sole shareholders of operating entities that may also inverts in foreign undertakings.

State owned enterprises also presents its own set of unique regulatory problems. As suggested above, the regulatory approaches of the Santiago Principles and other efforts designed to control enterprises in the business of investing have little relevance to enterprises that constitute operating units in other industries but which (like their privately owned counterparts) also engage in investment activities or in the development of a global network of operations grounded in ownership of enterprises in a variety of host states. Indeed, the problem of control is different, and the ability to distinguish between behaviors of state owned enterprises and others much more difficult. The regulatory tools are also cruder--resort to foreign direct investment regimes, and the construction of baroque exemptions for state owned enterprises from free movement provisions available to others. But these probabl do more harm than good. And a state owned enterprise version of the the Santiago Principles--a reasonable private company investment model" would be difficult to articulate and harder to apply with any degree of consistency. Indeed, in the case of state owned enterprises investing abroad, even more so than with SWF, the host states might be tempted to use the difference in ownership for its own purposes. Thus, and perversely, state owned enterprises investing abroad for legitimate purposes , might be subject to regulatory hurdles as a method by host states to manipulate the competitive environment internally in ways that would be irregular if the regulating state had sought to distinguish among privately owned forms.

As a consequence, states as market participants acting outside their territories, especially when operating through wholly owned or controlled state owned enterprises present a unique problem. This presents a class that is formally not SWF but functionally can be as powerful agents of projections of state power abroad as any SWF. The regulatory approaches to such enterprises are unlikely to be found in the control mechanics being developed for SWFs. And indeed, the principles of regulation ought to be based on a different framework. On the one hand, such regulations ought to be strengthened to permit minority shareholders of foreign subsidiaries to protect their interests against actions of state owned enterprises and their owners--including actions against the state owners of the stated owned enterprise, and national laws that ensure that state owned enterprises, acting as shareholders of subsidiaries, must act solely in the interests of the company they control (at least when they act as corporate directors, or when they exercise shareholder power in self dealing transactions). On the other, the host state might take for itself additional power to intervene in the actions of enterprises over which it has regulatory control. Many corporate statutes confer a power on the state to bring an action to dissolve a corporation that exceeds or abuses the authority conferred on it by law. (Revised Model Business Corporation Act, Section 14.30). Moreover, the state is usually granted a right to administratively dissolve a corporation (id., at Section 14.20). Both of those concepts could be used, broadened to fit the context of subsidiaries of foreign state owned corporations, to give a state the power to intervene in such subsidiaries where it might be clear that those who own or control a domestically chartered enterprise are using that enterprise for purposes other than those for which the enterprise was chartered (for example "to engage in any lawful business." Revised ModelBusiness Corporation Act Section 3.01(a)).

But this approach also suggests the smallness of the problem. In a sense the problem of sovereign wealth funds, like that of state owned enterprises engaging in investment activities abroad, can be reduced to issues of abuse. These include the abuse of power, abuse of corporate form, abuse of the corporate franchise, abuse of the market. Much of what is required, then, are rules that ensure that, like their private or individual counterparts, that abuse if controlled and the integrity of markets are preserved., This is both a tall order and a manageable task. But to that end, it requires a reconception of states when they engage in market participatory activities.

No comments: