Asialaw - Clarity for Corporate Counsel

There is nothing new about sovereign wealth funds (state-owned entities that manage the savings of a country for the purpose of investment): the oldest was established in 1953, and most of the biggest were set up before the year 2000. Five of the seven largest funds, which all have assets of over US$100 billion each, are owned by Asian or Middle Eastern states (see box: Fund facts).

Why all the fuss about sovereign wealth?
Sovereign wealth funds (SWFs) from Asia and the Middle East have invested roughly US$69 billion into struggling US financial institutions since June 2007 (see box: Sovereign wealth gets the world's attention), and fears surrounding their political intentions have led politicians to react quickly against them. French Premier Nicolas Sarkozy labelled them "aggressive" and the German Chancellor made a statement promising to protect her own country's industries.

Under President George W Bush, the US government last year began to push for the adoption of a formalized code of conduct for sovereign wealth funds. This need for a set of rules seems to be supported by major banks. Standard Chartered Bank's chief economist and group head of global research, Gerald Lyons, said in a report that "appropriate regulation of all aspects of the financial sector is needed, and sovereign funds should not be immune, particularly as their importance grows." He went on to say that SWFs needed to adopt the best practices of "the open funds such as Norway."

At this January's annual meeting of the World Economic Forum in Davos, former US Treasury Secretary Larry Summers once again brought the issue of fund regulation to the fore. During a speech at the sovereign wealth funds panel meeting, Summers said he was "baffled" as to why SWFs couldn't agree "on some piece of paper that says: We're under no circumstances going to speculate in currencies; we're always going to be a long-term investor; we're never going to use our SWF to pursue any political objective."

Not everyone agrees on the need for more external controls. Tom Karol, president of the Sovereign Investment Council (a newly-created US-based organization designed to serve the interests of sovereign funds) says that "fear and suspicion" are the reasons behind the growing calls for regulations. "There are no proven cases of abuse, not a single serious allegation of misconduct and no evidence has been submitted of any legal or ethical violations by sovereign investment funds," he says. "The urgency [of the need for a code of conduct] comes not from the conduct of sovereign funds, but from the growing risk of a backlash of xenophobia and financial protectionism."

Who should make the sovereign wealth rules?
Karol - along with many others with connections to SWFs - thinks that any level of greater disclosure should be self-regulated. "Self-regulation has proven to be the most effective regulation of conduct in most market situations," he says. SWFs are making it clear that they do not like interference from external authorities who might not fully understand the implications of any imposed regulations. "It's the funds that actually understand the operations best," Karol explains, "and they are the best ones to say 'if you want this information, here's the best way to get it, with the least imposition on the funds,' and basically control themselves."

Others argue that it is the job of regulatory regimes such as the International Monetary Fund (IMF), the World Bank or even the BIS (Bank for International Settlements) to oversee discussions. In his report for Standard Chartered, Lyons says that imposing rules at the country or regional levels would be a "second-best outcome" and that it would be better for "a credible global body to seek to establish some ground rules, providing the views of emerging countries were fully reflected."

It was the IMF that originally helped design SWFs, with the goal of modernizing developing countries, particularly those which relied on oil prices for economic stability. In October 2007, the International Monetary and Financial Committee at the IMF asked staff to explore the development of a code of conduct, noting the growing significance of SWFs in international financial markets. Although the committee said it recognized the funds' positive role in the market, it went on to say that it welcomed "a dialogue on identifying best practices" and stressed "the importance of resisting protectionism and maintaining an open global financial system."

A roundtable discussion was held at the IMF in November 2007, and was attended by delegates representing central banks, ministries of finance and sovereign wealth funds from 28 countries. A report on the outcome of the IMF's work is expected in mid-April.

It is not an easy job to get agreement from a diverse group of participants on a controversial set of rules, and not everyone is confident that the IMF is the best body to do the job. Writing in the Wall Street Journal, US Senator Evan Bayh said that it would be a mistake for the IMF to be responsible for oversight as it "lacks enforcement power and has proven ineffective in discharging many of its current responsibilities." He calls for the US to strengthen its own rules on sovereign investors. A review by the Committee on Foreign Investment in the United States (CFIUS) is only required when an investment exceeds 10% of total ownership; this level was not reached in recent high-profile deals.
The speed of progress within large bodies might also be a problem: it has been reported that IMF talks are stalled, with participants unable to agree on a definition of "transparency". For those who say the need for a Code is urgent, perhaps relying on large institutions is not the answer.

Michael Maduell, founder of the Sovereign Wealth Fund Institute, a non-partisan organization dedicated to studying SWFs, thinks that the involvement of the IMF makes things tricky. "Many countries argue that the IMF is just an extension of the US government; with countries like Russia and China, I don't think they'd be open [to the IMF's oversight]. But, they're investing in the US so they're kind of at the whim of the US as well." Maduell also points out that before agreeing to any rules or regulations, sovereign investors will want to know what is in it for them. "If you put up some sort of rules, people aren't going to obey them unless there's any consequence to them. If there was some kind of incentive behind the rules, then I believe you could get most of the parties to comply."

What should a code for sovereign wealth contain?
"Some transparency as to general strategy of investments, background of the management and supervisory board, statutory authority and articles of association and portfolio would help to remove the mystery from some funds," says Stephen Harder, a China-based partner with Clifford Chance. "However, it is unclear whether this transparency will be acceptable in countries which otherwise are less than transparent about government actions generally," he adds.

According to Nicholas Kwan, regional head of research for Asia at Standard Chartered Bank, the central issues for a set of guidelines on the operation of SWFs relate to transparency, governance structure and disclosure. Kwan thinks it is important to be able to monitor the motives for the activities of sovereign funds. "The basic principle is still to what extent [SWFs'] economic activities are more confined or based on economic grounds rather than on non-economic grounds like politics and strategic considerations," he told Asialaw.

It might seem that a transparent, well-behaved SWF could be used as a model when drawing up a code of conduct. Candidates could include Norway's fund - rated as "very transparent" by Standard Chartered Bank, and highly diversified with regular disclosure - or Singapore's Temasek, which takes a different approach and seems to go to great lengths to separate itself from the typical image of an SWF. "In essence, the only factor that makes Temasek seem like a SWF is the technical fact that we are owned by the Singapore government," a spokesman said. "While we are state-owned, we are not state-run or state-directed. Our investment decisions are made by our management and independent board - the Singapore government is not involved at all."

But, as Karol explains, sovereign funds are all quite different from each other in size, structure, operations, and purpose. "Some of the older funds have evolved comprehensive internal regulations that have operated effectively in the global markets for decades," he says. "Many of the newer funds have looked at many good models, such as US university endowments, for guidance in their operations. We must be very careful in looking to a 'one size fits all' approach to such diverse and complex operations."

In his report, Lyons echoes this sentiment, expressing doubts about getting sovereign wealth fund players to agree on regulations. "Whether it is possible to have a code of conduct for SWFs remains to be seen, the likelihood being that many countries will view it as their money, and they may not view it as relevant what Norway, or indeed other countries do," he says.

Christopher Clarke, Hong Kong office managing partner and head of regulatory, Asia, at DLA Piper, says that a code should be allowed to evolve, starting from a simple, voluntary framework. "As a first step, I don't think any code can be anything other than voluntary. Then, as time goes on, more SWFs will realise that having a Code is beneficial and more and more SWFs will participate."

What good, or harm, could a sovereign wealth code do?
As well as comforting leaders of countries whose institutions are receiving money from sovereign funds, the introduction of a code of conduct would allow concerned citizens to see where their own country's money was being spent. Some think that a clearer set of guidelines would also make it easier for the funds themselves. "If there's no code, there may be little difference [for law firms], but there may be implications with the investee countries' own regulators bringing in tighter controls," says Clarke. "Having a Code might actually make it easier for sovereign wealth funds to invest. It would be a lot simpler if there was a list of requirements and they could effectively 'tick the boxes' in order to avoid detailed scrutiny and delay."

Harder's view is similar. "Some countries may adopt streamlined procedures to approve investments by SWFs that comply by a Code, and this may act as an incentive for some SWFs," he says.

However, many are worried about over-regulation and protectionism. Although supporters of SWFs acknowledge that the size and lack of disclosure of some funds might trouble policy makers, they warn against going too far. "It would be too easy for some agencies to create rules which impose significant costs and limitations on the funds, while providing mountains of information which is of little or no substantive use," says Karol.

Maduell also thinks that bureaucracy might make even the more open funds uncomfortable. "If you're doing something right, then why do you need a code to moderate it?" he asks. "It would just be one more bureaucratic agency to report to."

Angel Gurria, secretary-general of the Organization for Economic Co-operation and Development (OECD), has also warned about putting too much pressure on sovereign funds, saying they can be beneficial and were a step towards addressing global economic imbalances. "SWFs could become sovereign development funds and could improve liquidity," Gurria said at Davos.

Why sovereign funds oppose a code of conduct
According to Clarke, there are three basic, understandable, reasons for SWFs' reluctance to see the imposition of a Code. "There's the issue of sovereignty. Strategically, they may be concerned about the loss of their strategic investment advantage. And there are confidentiality issues, too." Sovereign investors, like all investors, are interested in the best returns, and do not want to announce their strategies to the world.

No one likes to be labelled as a villain or to have their motives questioned, and in recent months funds have spoken out against the prevailing negative view. At Davos, the Russian Deputy Prime Minister Aleksey Kudrin said: "[SWFs] are long term and not speculative. They play a very positive role on the global market. Any concern about the political underlining of these funds is exaggerated." Bader Al Sa'ad, managing director of the Kuwait Investment Authority (KIA), pointed out that his funds had been in operation for 55 years and had "never made a political decision", only looking to the bottom line. In a recent Financial Times article, the Norwegian Finance minister, Kristin Halvorsen, defended his country's fund. "The fund is not an instrument for political posturing," he writes, underlining its high degree of transparency and pursuit of best practices, "based on internationally accepted principles such as the United Nations Global Compact and the OECD guidelines on corporate governance and multinational enterprises."

During their deals with some of the large US banks, and seeing the amount of negative attention that they were getting, sovereign investors took unprecedented steps to appear non-threatening: Temasek even went as far as turning down the right to a seat on the board of Merrill Lynch during investment talks earlier this year. More recently, China Investment Corporation (CIC) and Singapore's GIC have put aside their differences with private equity funds and begun to make large investments in them, in apparent efforts to avoid further public scrutiny.

Sovereign wealth funds remain in control
Bad publicity may lead sovereign funds to alter their style, but it will certainly not stop them investing their huge reserves. "At the moment, with less M&A activity happening, as the SWFs that are the ones with the money at the moment, so they're the ones who will be doing the deals and generating a lot of work," Clarke told Asialaw. "In my experience, if someone needs money quickly and someone has money to invest, then usually it's the investor that has the upper hand." The sovereign funds are in the driving seat and this means recipient countries need to take care not to over-regulate, and turn away potential cash. "I'm aware of companies who just don't bother to look at investment in the US," Clarke said. "The tighter investment regulations there mean that it just takes up much more management time, and so now they look elsewhere instead."

In a possible sign of funds refocusing their attention, Dubai International Capital last month announced plans to invest about US$5 billion in India, China and Japan over the next few years.

As well as turning away sovereign investors, a code of conduct might simply be a waste of time in many sectors, as Harder points out. "Considering the strategic stakes, it is likely that major cross border investments in sensitive sectors will continue to be subject to general national security approvals in most countries, regardless of the compliance of a SWF or foreign state owned enterprise with any code of conduct."

Sovereign funds must be more open
Whatever the intentions of sovereign wealth funds, and whether or not politicians and analysts have over-reacted, perhaps it does not really matter. What does matter is that SWFs have access to vast amounts of cash and will continue to look for places to put it. This means greater opportunities for lawyers. "In terms of the size of the deals they do, [SWFs] are huge potential clients for international law firms," says Clarke. "SWFs will need a wide spectrum of international legal advice relating to investments in many countries around the world," adds Harder.

Although their liquidity ultimately gives them the upper hand, opponents and supporters all agree that SWFs need to do more to communicate their intentions. This would benefit everyone, as increased openness would prevent recipient countries from feeling the need to take steps to impose their own, stricter restrictions (as Australia did recently). "If all these funds weren't so secretive, maybe they wouldn't create such controversy," says Maduell.

In the words of the Sovereign Investment Council, "Shed Some Light Or Take The Heat".