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Tamed Tigers: Sovereign Wealth Funds as Passive Investors

By Patrick Schuette

I. Introduction

The purpose of this article is to analyze the current role of sovereign wealth funds in a corporate governance scheme. Sovereign wealth funds, which have become increasingly important institutional investors in the United States, have found their activities in equities markets in the United States increasingly constrained due to stringent regulations.  While these sovereign wealth funds raise important policy considerations for lawmakers, these regulations hinder sovereign wealth funds in their role as investors.  Despite the power the sovereign wealth funds could hold in American companies, these funds have effectively become ?tamed tigers.? Despite their enormous power, they simply cannot exercise it. Thus, this article will examine whether having sovereign wealth funds in a ?tamed tiger? capacity should continue or whether regulations should encourage more activity from sovereign wealth funds.

II. Sovereign Wealth Funds

The best definition of what sovereign wealth funds are and what they do comes from the Santiago Principles, which is as follows.

Sovereign wealth funds (SWFs) are 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. SWFs have diverse legal, institutional, and governance structures.[1]

This description effectively encompasses the basic structures and objectives underlying sovereign wealth funds. Separating sovereign wealth funds from other institutional investors, such as hedge funds and mutual funds, is the element of state ownership. While most other institutional investors have profit as their sole objective, state ownership of sovereign wealth funds adds a layer of general policy objectives to these sovereign wealth funds. Furthermore, sovereign wealth funds typically have one of three sources of funding: account surpluses from commodity exports (such as oil), excess foreign exchange reserves, and pension reserves.[2]

These sources of funding have allowed sovereign wealth funds to balloon in size. As of the end of 2007, sovereign wealth funds had $3.3 trillion in assets under management.[3] This total dwarfed the $1.9 trillion managed by hedge funds and the $800 billion managed by private equity, but was much smaller than pension funds ($28.5 trillion), mutual funds ($27.3 trillion), and insurance funds ($19.1 trillion).[4] The largest commodity-based sovereign wealth fund is the Abu Dhabi Investment Counsel, based in the UAE, with $875b in assets under management, while the Government Pension Fund of Norway is the largest non-commodity sovereign wealth fund, with $380b in assets under management.[5]

Given the size and policy objectives of these sovereign wealth funds, there have been a number of concerns raised about sovereign wealth funds. In essence, the concerns with these funds focus on sovereign wealth funds taking up large equity positions in American companies and exploiting their control. Securities and Exchange Commission Chairman Christopher Cox encapsulated these concerns when he pondered whether these funds, ?will always direct their affairs in furtherance of investment returns, or rather will use business resources in pursuit of other government interests.?[6]

III. The Response: CFIUS

The United States government has a strong regulatory structure in place to alleviate these concerns. The primary regulator of sovereign wealth funds is the Committee on Foreign Investment in the United States (CFIUS). In the context of sovereign wealth funds, CFIUS reviews any of their acquisitions of U.S. firms that could result in control of those firms where that control could affect the national security of the U.S.[7] This national security inquiry has a broad focus, as the review centers on whether the fund acquires control of the ?critical infrastructure of or within? the United States.[8] Furthermore, under subsequent regulations, ?control? is given a broad definition to encompass the power, direct or indirect, to ?determine, direct, or decide matters affecting an entity.?[9] CFIUS has the power to suspend or prohibit the transaction and can seek divestiture or other relief in order to enforce its powers.[10]

These broad statutory and regulatory mandates allow CFIUS to alleviate concerns of sovereign wealth funds abusing controlling positions in U.S. firms.  CFIUS deters these funds from using their business resources in the U.S. in pursuit of government interests, rather than in pursuit of investment returns. Moreover, rather than outright block these transactions, CFIUS typically places conditions on controlling foreign owners in exchange for their approval. When a subsidiary of French company Matra purchased Fairchild Industries, a space and military firm,[11] CFIUS required Matra to overhaul its export control system in exchange for approval.[12]

Some people want CFIUS to take a more critical eye toward sovereign wealth funds. One of the most outspoken proponents of further regulation constraining sovereign wealth funds is U.S. Senator Evan Bayh of Indiana. In a February 2008 op-ed, Bayh voiced his concerns about the increasing power and influence of sovereign wealth funds, particularly those in Russia and China.[13] While Bayh gave credence to national security concerns posed by these funds, he also cited the potential for intellectual property theft and currency manipulation among the dangers these funds could pose.[14] He also discussed the need for a broader definition of ?control? to encapsulate situations where a dominant foreign minority shareholder.[15] Bayh mentioned Citigroup?s largest individual shareholder, Saudi Prince Alwaleed bin Talal at less than 5%, in passing.[16] Tellingly, at the end of 2007, Prince Alwaleed was instrumental in the ousting of Citigroup CEO Chuck Prince, despite holding a very small percentage of Citigroup?s shares.[17]

As justified as these concerns and calls for stricter regulation may be, the CFIUS process is open to abuse. One way this process can be abused is in the context of hostile takeovers. British Tire and Rubber (BTR) attempted to purchase Norton Company, an American firm that manufactured ceramic ball bearings used in the space shuttle.[18] Norton garnered political support through claims of national security concerns. Over 100 congressmen urged a CFIUS investigation.[19] Eventually, a white knight in the form of a French buyer made an offer for Norton Company at a higher price.[20] No national security concerns were raised about the French buyer and the deal went through.[21]

While this regulatory structure provides strong protection of national security interests, it has also hamstrung the influence of sovereign wealth funds. This process is open to political abuse. Furthermore, CFIUS placing conditions on acquisitions keep sovereign wealth funds from effectively exercising control. Without this influence, sovereign wealth funds are basically forced to be passive shareholders. If sovereign wealth funds take an active role in a firm where they have control, they could face possible retribution from CFIUS.  They are forced to be tamed tigers.

This creates a set of unusual incentives for sovereign wealth funds and firms in which they invest. Sovereign wealth funds have a much lower incentive to monitor equity investments in U.S. firms. If these U.S. firms have managers who are making poor business decisions, sovereign wealth funds would be hesitant to remove these managers, even if their rationale was for legitimate reasons.  Sovereign wealth funds have the resources and expertise to effectively monitor their equity investments and to bring in top-flight managers to these firms. Sovereign wealth funds that have no political motivation whatsoever will avoid investing in the United States simply because they do not want to deal with these regulatory hurdles. The cost of becoming tamed tigers might become too much for them to stomach.[22]

IV. What to favor?

These potential abuses by sovereign wealth funds and the firms which receive their equity investment raise a basic question for regulators and legislators: How should these concerns be balanced? Any regulation which minimizes the potential for sovereign wealth funds to abuse controlling positions in these firms reduces the ability and incentive these funds have to monitor and control their investments. In contrast, a regulation which encourages sovereign wealth funds to take an active role in the corporate governance of these firms would open the door for sovereign wealth funds to act contrarily to sovereign wealth funds. If legislators and CFIUS instead aimed to strike a balance between these competing interests, a suitable balance might not be found, resulting in more potential for abuse from both sovereign wealth funds and from their equity investments.

A ?time will tell? approach might help create a better understanding of how state ownership affects the investment activities of sovereign wealth funds.  The current credit crisis could help illuminate whether these sovereign wealth funds are acting for investment or political purposes.  For example, Norway?s Government Pension Fund was short-selling the bonds of Iceland?s distressed banks, which resulted in Iceland?s prime minister accusing Norway of attempting to destabilize Iceland?s economy.[23] The recent collapse in the price of oil[24] could also shine a light on how sovereign wealth funds behave, given that a number of them are both strongly dependent on account surpluses from oil exports and are in countries which have based their economies around oil.

There is also something to be said for caution. The analysis above strongly suggests that these sovereign wealth funds have a lot of potential for mischief. National security concerns aside, these sovereign wealth funds are large enough to move markets in significant ways. Corporate governance concerns resulting from the inability of sovereign wealth funds could at least be limited to specific firms. However, creating potential for misbehavior from sovereign wealth funds could have widespread disastrous consequences within and beyond the markets. While a number of existing political, regulatory, and economic factors make equity investment an unlikely avenue for sovereign wealth funds to abuse their power,[25] further regulation might be necessary. If an individual minority shareholder like Prince Alwaleed has enough power to oust a CEO, sovereign wealth funds with even greater resources and political influence could do much more damage in comparable minority shareholder positions.

While this trade-off might be a bitter pill to swallow, it is necessary. Misbehaving managers at various firms would be preferable to the potential troubles these sovereign wealth funds could create. Sovereign wealth fund investment should be encouraged, but regulators must ensure they will remain passive. These tigers have to be tamed.

Full post as published by The Journal of the Business Law Society on November 02, 2008 (boomark / email).