Andreas Engert on Transnational Hedge Fund Regulation

Andreas Engert, Professor of Business and Tax Law at the University of Mannheim, Germany, has just published an article well worth reading.  Andreas Engert, "Transnational Hedge Fund Regulation," European Business Organization Law Review 11:329-378 (2010).

Here is the Abstract:  

After the global financial crisis, systemic risk regulation has taken centre stage. Many consider hedge funds a potential threat to financial stability. Regulating hedge funds, however, is necessarily a transnational challenge because no national government alone can effectively control the systemic risks affecting its economy. This article takes the example of hedge funds for a case study of emerging transnational regulation. After an introduction to hedge funds and the reasons for regulating them, it considers the possible elements of a transnational regulatory regime for hedge funds: transnational industry self-regulation, including such induced by the government, regulatory competition between government regulators, and harmonisation of government regulation. The main conclusions are: self-regulation cannot substitute fully for government regulation in controlling systemic risks caused by hedge funds. Equally, regulatory competition tends to undercut systemic risk regulation. Effective transnational regulation can only be accomplished through harmonisation of government regulation. Such harmonisation is likely to arise if regulation is needed to control systemic risk in global financial markets.

Engert distinguishes between transnational law, which is viewed somewhat more narrowly as tied to the structures and ideologies of the modern law-state, and transnational regulation.  Unlike transnational law, transnational regulation, which Engert suggests that transnational regulation "starts out from cross border activities and effects as the object of regulation" but liberates the response from the confines of law ("legal rules imposed and enforced by national governments") to embrace other forms of regulation.  (Id. at 330).  He highlights two forms of regulation that have been hard to incorporate into any system of transnational "law" discourse in Europe; the first are "non-binding or less binding rules ('soft law')."  The second includes "self-imposed or self-enforced rules ('private ordering')."  (Id., 331).  When applied to transnational activities, transnational regulation can suggest cooperation among states and ultimately international rules.  (Id.).  These systemic constructs are applied powerfully to the issue of the regulation of hedge funds.  

Engert's great insight is in the identification of power of polycentricity at the heart of transnational regulation.  The hedge fund case study suggests how in a world of governance fragmentation, of governance regimes that are grounded in the self regulatory power of functionally differentiated communities that overlap in dynamic ways, the state has lost its monopoly on governance. More importantly, law has lost its monopoly as the highest and singular form of legitimate governance, even within political systems.  The law-state has become a factor in the production of governance, like the corporation, the investor community, and international civil society, to name a few.  Engert illustrates how it is now better to speak of regulatory regimes rather than governance systems operating autonomously.  See, Larry Catá Backer,  Private Actors and Public Governance Beyond the State: The Multinational Corporation, the Financial Stability Board and the Global Governance Order (August 13, 2010).

Engert concludes: "Transnational regulation is different. What distinguishes it from regulation in a purely national setting is, primarily, the mismatch between the single regulator’s authority and the scope of the market failure." (Id., 377). He recognizes the importance of governance sources beyond the state, and governance forms outside of law.  Yet, 

[g]overnments thus remain indispensable for regulating hedge funds (if such regulation is considered desirable). Therefore, the specific constraints of multiple government regulators in dealing with transnational hedge fund activities gain importance. Analogously to the limits of self-regulation, regulatory competition among national jurisdictions cannot be trusted to provide for adequate regulation; it implies a slant towards laissez-faire even where stricter systemic risk regulation is called for. . .  .[G]overnments have to coordinate their policies to reassert their power to regulate. (Id.).

But there is a necessary space for non-governmental regulation.  Still, that may also require the guidance of the state, or groups of states, or organizations that are derived fro states.  He explains: " as regards the specific aim of controlling systemic risk from hedge funds, the analysis has led to the somewhat sobering conclusion that industry self- regulation depends critically on support from the government." (Id.,  377).  And Engert is right. Government is indispensable to the regulation of capital--both its flows and its constitution.  But which?  And how much? Engert offers one plausible variation on an answer.  But more importantly, he points to the contours of every answer to the question--that while government is indispensable, it is only one of several components to the solution.  We have entered an era of governance regimes in which the law-state has been diminished but not extinguished, where survival depends on coordination and amalgamation, and in which social-norm communities have become political factors in activities that do not recognize the power of territory.            

Complicity in Human Rights Violations and Sovereign Wealth Funds--The Norwegian Sovereign Wealth Fund and Myanmar Investments

Complicity is becoming an important weapon in the "soft law" arsenal, even as its utility as "hard law" is increasing both as applied within the domestic legal orders of states against private entities, and against states themselves (either as sovereigns or market participants) under domestic or international law systems.  It was only a matter of time before states, even as market participants, would find that their commercial activities would be subject to scrutiny for human rights abuses under a broadened notion of complicity as both hard and soft law, even second order abuses, through the application of social-norm complicity standards as well as "hard law" standards.

Traditionally, complicity arose out of criminal law and required both a material and a mental element. See Anna Triponel, "Comparative Corporate Responsibility in the United States and France for Human Rights Violations Abroad," Global Labor and Employment Law for the Practicing Lawyer, Proceedings of the New York University 61st Annual Conference on Labor 59-158 (Andrew P. Morriss and Samuel Estreicher, eds., Austin: Wolters Kluwer, 2010). In another study, it was noted that "a corporation will be directly complicit in human rights abuses where it decides to participate through assistance in the commission of human rights abuses and that assistance contributes to the commission of the human rights abuses by another. The primary perpetrator does not necessarily have to have been found responsible in order for the corporate accomplice to be found liable for having contributed to those same human rights abuses. Nor need the corporation actually wish the results, it is enough if the corporation or its agents knew of the likely effects of their assistance." Andrew Clapham and Scott Jerbi, Categories of Corporate Complicity in Human Rights Abuses, Based on a background paper for the Global Compact dialogue on The role of the private sector in zones of conflict (New York, 21-22 March 2001). Still, as a matter of hard law, the precise standard varies depending on the domestic legal order within which complicity is charged under either the civil or criminal law.  Triponell, supra., at 126-139 (focusing on France and the United States). Another excellent study of complicity by economic enterprises in human rights violations and judicial recourse was prepared in three volumes by the International Commission of jurists (Commission Internationale de Jurists), an organization dedicated to the primacy, coherence and implementation of international law and principles that advance human rights. See, International Commission of Jurists, Report of the ICJ Expert Legal Panel on Corporate Complicity in International Crimes (2008). (3 volumes in English, French or Spanish).

One of the Report's more important insights concerned the broadening of the meaning of complicity.  Complicity has acquired a double set of meanings.  One is grounded in the governance framework of the law-state.  The other is tied to the social-norm systems of non-state governance regimes--the market, the consumer society, multinational corporations and other governance communities beyond the state. "Just as the concept of impunity in the sphere of human rights has taken on a meaning so much more multi-faceted, sophisticated and colorful than the strict historical legal meaning of impunity, in the context of business and human rights, the concept of complicity is now used in a much richer, deeper and broader fashion than before." (Report of the ICJ Expert Legal Panel on Corporate Complicity in International Crimes, supra, Vol. 1:3).

 IWAMURA, Masahiko, Soft Law and the State-Market Relationship,  The University of Tokyo Global COE (“Soft law” refers to norms that are not formal laws provided by the state. State enforcement of these norms is not guaranteed, yet people are somehow bound by them in socio-economic society. These norms vary in their form; some are provided by the state (e.g., regulatory guidelines by ministries etc.), some by businesses or the markets themselves (e.g., self-regulation by industry associations or general standards of business ethics and etiquette etc.), and some are established by the international community (e.g., model laws, resolutions or guidelines of international organizations etc.). Contemporary business laws contain many elusively defined soft laws which play an important role, and which have a significant impact on business activities.

This development parallels changes in the understanding of transnational governance regimes--and their essential polycentric character--reflected in current efforts to structure and harmonize the governance framework for business and human rights among public and private actors.  These seek to connect the public, law based, duties of states, with the social norm based responsibilities of private actors.  See, Business and human rights: Towards operationalizing the “protect, respect and remedy” framework Report of the Special Representative of the Secretary-General on the issue of human rights and transnational corporations and other business enterprises, A/HRC/11/13 (22 April 2009).

Civil society has been especially important in developing the notion that business has a responsibility to avoid becoming complicit in the human rights violations of other companies in which they invest or in the violations of states in which they do business, and that states have a similar obligation in whatever form they act.  Larry Catá Backer, Avoiding Corporate Complicity in the Human Rights Violations of States--Microsoft and Software Licensing, Law at the End of the Day, Nov. 14, 2010; Larry Catá Backer, Michael Komesaroff on China in Africa--State Duty, Corporate Responsibility and the Changing Face of Economic Globalization, Law at the End of the Day, Dec. 13, 2010.  See also Larry Catá Backer,States, Labor as a Market Commodity, and Human Rights Frameworks--Cuba's Grannacional Programs at the Intersection of Business and Human Rights, Law at the End of the Day, July 17, 2010.  Indeed, civil society tends to make no distinction among market participants, irrespective of the ultimate ownership of these economic actors. 

One of the more significant emerging group of economic actors are states that have invested their wealth in corporate securities.  Larry Catá Backer, Sovereign Investing in Times of Crisis: Global Regulation of Sovereign Wealth Funds, State Owned Enterprises and the Chinese Experience. Transnational Law & Contemporary Problems, Vol. 19, No. 1, 2009. Operating through sovereign wealth funds and state owned enterprises, usually though not always organized as separate juridical persons, states can participate in markets beyond their national borders.

 "The Crown Estate has reached a deal with Norway's sovereign wealth fund to sell a stake in Regent Street, one of the world's most famous shopping sites, for £448m."  The Telegraph (4 Nov. 2010).

As shareholders, of course, states have sought to rely on the traditional legal distinction between shareholders and the entities in which they  invest.   What they may be discovering is that the simultaneously application set of social-norm governance standards may affect even the ability of states to avoid determinations of violation of human rights norms.  These determinations may not be founded on the law systems of states, but they may produce reaction strong enough to affect behavior, ven if not compelled through traditional processes and structures of law.

 In a recently released report, Broken Ethics: The Norwegian Government's Investment in Oil and Gas Companies Operating in Burma (Myanmar) (December 2010), the civil society organization EarthRights International has now taken another step in that direction, arguing that sovereign wealth funds also have the obligation of avoiding becoming complicit in the human rights violations of the corporations in which they invest or the states in which these corporations operate.

This report finds the Norwegian government complicit in human rights abuses in Burma through investments held by the Norwegian Pension Fund-Global (Fund), including USD $4.7 billion invested in 15 oil and gas companies from eight countries operating in Burma. The report documents human rights conditions associated with these 15 company's projects, finding on-going abuses including forced labor, killings, and land confiscation, and the high likelihood that other projects will result in additional abuses in the coming years. These continued investments put Norway in violation of its own Ethical Guidelines for responsible investment. (EarthRights International, Broken Ethics.)

 But EarthRights is doing more than seeking to impose soft law standards on the Norwegian SWF.  Rather, it appears ot suggest that because the state is the owner of the investment vehicle, the hard law obligations that bind Norway, also bind its actions as a shareholder of companies, and as the owner of an investment business.  In this case, then, the character of the shareholder affects the character of the rules that are binding on it.  As a state actor, even in private form, the Kingdom of Norway might find that soft law is quite hard.  In Norway's case, moreover, EarthRights appears to suggest that the internal operating rules of the SWF, articulated through the remedial structures of the Ethics Council, have binding effect, not merely as soft law, but as a legal basis binding as the domestic law of Norway. 

"Engineers work on the Yadana pipeline in the 1990’s. EarthRights International (ERI) has documented that many of the access roads and helicopter landing pads for the pipeline were built with forced labour on land confiscated without compensation. An ERI report released on Wednesday accuses the Norwegian government of complicity in such abuses by the Burmese regime by way of a Norway sovereign wealth fund stake in 15 firms in Burma’s energy sector, including Chevron and Total, who operate the pipeline. Photo: ERI" Thomas Maung Shwe, Report condemns Norway fund’s Burma investments, Mizzima (Dec. 17, 2010). 

In a recent article, I suggested the framework within which the Norwegian Ethics Council operates. Larry Catá Backer, "Sovereign Wealth Funds as Regulatory Chameleons: The Norwegian Sovereign Wealth Funds and Public Global Governance Through Private Global Investment," Georgetown Journal of International Law, Vol. 41(2):425-500 (2010), at 456-63 The most important and controversial aspects of the application of the Global Funds’ investment principles are bound up in ethical guidelines for investment. (Styrer, Rad Og Utvalg, Ethical Guidelines, Norwegian Government Pension Fund—Global). The Guidelines are based on two premises. The first is that the Fund must be managed to protect the wealth generated by the exploitation of Norway’s extractive industries, mostly petroleum, and to extract a “sound return in the long term.” (Id., at Clause 1). The second is that the first objective is contingent on a number of policy factors, including “sustainable development in the economic, environmental and social sense.” (Id.). . . .The Fund is to be used not merely to protect and increase the value of the Fund itself, but to influence behaviors among the pool of potential targets of investment. First, the Fund is to have a proactive policy charge. . . . And second, the Fund is to withhold investment to avoid investment in companies it deems might “contribute to unethical acts or omissions, such as violations of fundamental humanitarian principles, serious violations of human rights, gross corruption or severe environmental damages.” (Id., at Clause 2). To meet its objectives, the Ethical Guidelines provides recommendations on the Fund’s implementation. (Id.). It is grounded on three principal activities—exercise of ownership rights, negative screening of companies, and exclusion of companies from the investment pool. (Id.).

Norway Oil Fund Expels Two Companies,  Reuters, Jan. 30, 2009.

Negative screening and exclusion provide the heart of the operationalization of the Ethics Guidelines, for which an institutional framework and procedures are established, and lines of authority delineated. (Id., Caluse 4). The Ethics Guidelines are overseen by a Council of Ethics, established by Royal decree in 2004 and revised in 2005. (Id.). The Ethics Council consists of five members, and is entitled to some support in the form of a modest secretariat. The Ethics Council is constituted as an independent advisory body, the principle of objective of which is to assess whether particular companies ought to be excluded from investment by the Government Pension Fund—Global, and to submit its recommendations with respect thereto, to the Minister of Finance. . . . . The Ethics Council is required to make a recommendation of exclusion after the conduct of a negative screening investigation where the Council concludes that the companies at issue either “produce weapons that through their normal use violate fundamental humanitarian principles; or sell weapons or military materiel to states.” (Styrer, Rad Og Utvalg, Ethical Guidelines, Norwegian Government Pension Fund—Global, Clause 4.4 and Clause 3.2 supplementary guidelines). The recommendation in turn is based on two conclusions. The first is that there is a connection between the company under investigation and the ethical violation described in the Ethics Guidelines. The second is that the connection between company and violation in turn represents an unacceptable risk for the company (and the Fund) to contribute to future violations. (Council on Ethics Gov’t Pension Fund—Global, Annual Report 2007, 7 (2007),

Council on Ethics, Norwegian Government Pension Fund - Global. The members of the Council are:Programme Manager Anne Lill Gade; Associate Professor Dr. juris Gro Nystuen (Chair of the Council); Managing Director Ylva Lindberg; Professor Ph.D. Andreas Føllesdal; Professor dr. juris Ola Mestad.

Using the Ethics Council's own determinations as a starting pointy, EarthRights International determined " that the Norwegian people, through their government’s sovereign wealth fund, have USD $4.7 billion invested in 15 companies – hailing from eight countries – involved in the oil and gas sector in Burma." EarthRights International, Broken Ethics: The Norwegian Government's Investment in Oil and Gas Companies Operating in Burma (Myanmar), supra, at 6:

This report analyzes whether the Fund’s investments in 15 companies involved in Burma’s oil and gas sector are in line with the Ethical Guidelines and the Council’s standards for investment, and whether the companies should be subjected to the Council’s recommendation for observation or exclusion from the Fund.
This report provides evidence linking the oil companies Total S.A. (France), Chevron Corporation (U.S.), PTT Exploration and Production Company (PTTEP) (Thailand), the Petroleum Authority of Thailand (PTT), and JX Holdings, Inc. (formerly Nippon Oil Corp.) (Japan) with serious, ongoing human rights abuses in connection with the operation and maintenance of the Yadana and Yetagun natural gas pipelines in Burma. The Fund has a cumulative USD $3.7 billion invested in these companies.
This report also reveals that the Norwegian Fund has a cumulative USD $457 million invested in companies participating in the controversial Shwe gas and oil transport pipeline projects that extend from Burma to the China border, including Daewoo International (South Korea), POSCO (South Korea), Korea Gas Corp. (South Korea), GAIL of India, Ltd. (GAIL) (India), Hyundai Heavy Industries (South Korea), PetroChina (China), and Kunlun Energy Co. Ltd. (formerly CNPC Hong Kong Ltd.)(China). This report links these companies to current human rights abuses and an unreasonably high likelihood of future abuses associated with the projects. Documented abuses to date include violations of property rights through uncompensated land confiscation, and violations of civil and political rights through the military regime’s persecution of local people suspected of opposing the projects. As this report shows, the Burmese Army (Tatmadaw) has committed these abuses on behalf of the companies’ interests and investments. (Id., at 5-6).

There is a suggestion of political motivation for the Ethics Council's reticence. “'Norway is particularly afraid to single out Total, one of Europe’s biggest companies, a multibillion-dollar giant known to have the backing of the French government in everything it does. If Norway acknowledged the truth about Total, they would then have to examine many other European firms they’ve invested in. Companies like BP, Shell and BAE that have all engaged in extremely unethical behaviour both at home and abroad,' Morgan said." Thomas Maung Shwe, Report condemns Norway fund’s Burma investments, Mizzima (Dec. 17, 2010). (quoting Matthew Morgan, a doctoral candidate at Canada’s York University who has studied Western foreign policy towards Burma). But EarthRights International is seeking to hold the Ethics Council to its own rules, to its own prior determinations and the norms that have been created thereby. In effect, EarthRights International is suggesting that the Ethics Council is impermissibly acting like a political institution when its obligation is to act like a judicial one. 

Norway’s Pension Fund to Boost Investments in Asia, ScandAsia.com, July 2, 2010.

There are several important aspects of this report, beyond the substantive charges, that are worth highlighting.

1. There is an assumption that the Ethics Council is a quasi-judicial body, with a jurisprudence to which it is bound. This is probably the most significant insight to be drawn form the EarthRights International Broken Ethics Report, supra. I had previously suggested that the work of the Ethics Council was essentially political--that it was an instrument for the implementation of public law through the mechanics of investment in private markets. What the EarthRights International Report suggests is that civil society elements, and perhaps others, are now beginning to treat the Council's  function as judicial in character.   EarthRights International identifies the Council's standard for complicity in investment  in quasi judicial terms, and speaks of its prior determinations as having some effect of a jurisprudential character. (Id., at 9).   It also speaks of the need for the Ethics Council to "reform and build upon its approach to the ethics of investment in Burma."  EarthRights International, Broken Ethics, supra, at 37.  It describes approving the adoption of a "strict standard of immediate exclusion for companies involved in new onshore pipeline construction in Burma."  Id. See also "Recommendation to the Council on Ethics, id., at 39.  The judcialization of standards for determining complicity are described as well, noting both the reliance on judicial opinions of other jurisdictions and judicial standards for measuring complicity.  (Id., at 11-13). This is a subject I will take up in more detail in February 2011 when I review the decisions of the Ethics Council in an effort to derive a coherent jurisprudence from that body of work. 

2.  Complicity might extend to second level participants in markets, especially if those second level actors are states or their instrumentalities. While it remains almost universally accepted within the domestic legal orders of most states that the separate legal personalities of individually organized corporations, and natural persons, ought to be respected (absent fraud, for example), it is also becoming truer that when individuals contribute to the activities of another (whether natural or juridical) person, that person might become part of those activities and thus directly liable for the consequences.  While generally mere investment has not been accepted as a legally sufficient trigger for such liability, the affirmative act of investment by a state or by a commercial enterprise owned or controlled by a  state, may be an exception to this limitation.  The reason for the exception is grounded in the independent obligation of states--beyond a connection with the object of investment, to comply with international law and legal obligations, including human rights and humanitarian law.  

3.  Sovereign Wealth Funds are especially likely to be bound by human rights obligations, even ones that flow from the secondary consequences of their investment activities, under the Santiago Principles. The Norwegian SWF Ethics Council has suggested an embrace this reading of complicity as a guiding principle for its screening decisions. "The Ethical Guidelines establish that companies shall be excluded from the Government Pension Fund in order to prevent the Fund’s complicity in grave violations. Even if the intention of exclusion is to avoid complicity in violations, the outcome may still be that the company in question, other companies and other stakeholders are affected by the exclusion mechanism." Gro Nystuen, “Consultation Statement from the Council on Ethics Concerning the Evaluation of the Ethical Guidelines for the Government Pension Fund-Global,” Sept. 29, 2008 in Council on Ethics, Annual Report 2008, 115, 118.

4.  The proposed U.N. Protect-Respect-Remedy Principles may support the position of EarthRights International.  Report of the Special Representative of the Secretary General on the issue of human rights and transnational corporations and other business enterprises, John Ruggie, Guiding Principles for the implementation of the United Nations 'Protect, Respect, and Remedy' Framework, DRAFT, November 22, 2010.  Guideline 4 provides:  "States should maintain adequate domestic policy space to meet their international human rights obligations when pursuing business-related policy objectives with other States or business enterprises, particularly when they enter into investment treaties or contracts." Guiding Principles, supra, Principle 4. The Commentary suggests that states be sensitive to these issues in their relations with both foreign public and private entities.  Id.  Where states operate a commercial activity, like a sovereign wealth fund, that find is also subject to the autonomous responsibility to respect human rights.  That responsibility is expressed in some respect by a strong obligation to engage in human rights due diligence.   That human rights due diligence "Should extend beyond a business enterprise’s own activities to include relationships with business partners, suppliers, and other non-State and State entities that are associated with the enterprise’s activities." Guiding Principles, supra, Principle 15.c.  The Commentary notes: "Questions of complicity may arise when a business enterprise contributes to, or is seen as contributing to, adverse human rights impacts caused by third parties. . . . In relation to complicity in international crimes, the weight of international legal opinion indicates that the relevant standard for aiding and abetting such crimes is knowingly providing practical assistance or encouragement that has a substantial effect on the commission of a crime." Id.  It seems clear that the Ethics Council might well breach its obligations in this respect.