Sovereign wealth funds and corporate governance: a minimalist response to the new mercantilism.

• Author: Gilson, Ronald J.

INTRODUCTION I. THE SOVEREIGN WEALTH FUND PHENOMENON II. Two FACES OF SWF EQUITY INVESTMENTS III. A MINIMALIST SOLUTION: VOTE SUSPENSION IV. THE LIMITS OF VOTE SUSPENSION A. The Problem of Underinclusion B. The Problem of Overinclusion CONCLUSION INTRODUCTION

Keynes taught years ago that international cash flows are always political. (1) Western response to the enormous increase in the number and the assets of sovereign wealth funds (SWFs), and other government-directed investment vehicles that often get lumped together under the SWF label, proves Keynes right. To their most severe critics, SWFs are a threat to the sovereignty of the nations in whose corporations they invest. The heat of the metaphors matches the volume of the complaints. The nations whose corporations are targets of investments are said to be threatened with becoming "sharecropper" states if ownership of industry moves to foreign-government absentee holders. (2) More tempered critics fear that SWFs will make decisions for political, not economic reasons. (3) Calls for both domestic and international regulation of sovereign wealth funds' investments are now a daily occurrence. (4) In this Article we frame a minimalist response to concerns over SWFs.

The high profile controversy over the rise of SWFs is one--but only one--of the frictions that result from the interaction of two very different conceptions of the role of government in a capitalist economy--"state capitalism as opposed to market capitalism." (5) In the form of market capitalism that has developed in the advanced economies, to be sure with fits and starts, the individual company is the unit whose value is maximized. Prohibitions against government subsidies and preferences reflected in WTO and European Union rules are designed to prevent governments from shifting the level of profit maximization from the company to the state. In contrast, some major developing countries (China foremost among them) increasingly reflect a form of state capitalism--what we call the new mercantilism. In this form, the country is the unit whose value is to be maximized, with a corresponding increase in the role of the national government as a direct participant in and coordinator of the effort. For the developed economies, the belief that free trade and competition amongst companies increases GDP at the national level is an article of faith: the market polices the tautology. For developing economies, particularly those whose enterprises must compete with companies from more advanced economies, the state, acting through SWFs, through direct ownership of operating companies, and through regulation, seeks to level the playing field. For the new mercantile capitalism, the government attempts to ensure that company-level behavior results in country-level maximization of economic, social, and political benefits.

Although SWFs constitute only one mechanism of state involvement in the economy, they have attracted great attention because for some commentators they are the current face of this tension between competing forms of capitalism. Lawrence Summers has pointed out that the cross-border activities of SWFs and other sovereign investment vehicles have reversed the trend toward privatization that swept over the globe in the past quarter century. (6) Governments are now accumulating stakes in what were purely private entities. As one commentator argues,

these trends [in the growth of SWFs and their investment activities] involve a dramatic increase in the role of governments in the ownership and management of national assets. This characteristic is unnerving and disquieting. It calls into question our most basic assumptions about the structure and functioning of our economies and the international financial system. (7) Looking behind the rhetoric, SWFs' investments have attracted attention as a result of two factors, one economic, the other tied to national regulation. On the economic side are the large accumulations of government wealth SWFs represent, together with changes in how this wealth is invested. The great success of Asian exporting nations, especially China, and the rapid rise in oil prices have dramatically increased the foreign currency reserves of nations with trade- and commodity-based economies. China's foreign currency reserve of $1.4 trillion is mentioned almost daily in the U.S. media. (8) Private analysts estimate that with oil prices at the now-modest level of $70 per barrel, $2 billion of new petrodollars enter world financial markets every day. (9)

Also, reserve-rich countries have begun to change their investment strategy. Until recently, these surpluses were conservatively invested, heavily in U.S. treasury securities and other national government bonds. Capital was recycled without economic or political disruption. (10) That pattern has changed, but for economic reasons rather than because of changes in international relations or foreign policy. Many governments have recently announced plans to shift investment strategies for sovereign assets from conservative holdings of government bonds to higher-risk/higher-return investments in equities or corporate acquisitions. (11) Even the Norwegian Government Pension Fund, the most conservative of the sovereign wealth funds, has increased its allocation to equity by half--from 40% to 60% of its portfolio. (12) China has also signaled its intent to increase its equity investments, both in its sovereign wealth funds and in the portfolio of the government pension fund. (13) The announced reason for these changes in portfolio strategy is straightforward. Like the Bush administration's plan to shift social security investments into the capital markets, reserve-rich countries say they are seeking the higher returns and greater diversification associated with investing in a broader range of asset classes.

The result has been a boom in high-profile, and highly controversial investments. The Abu Dhabi Investment Authority (ADIA) recently acquired Citibank debt convertible into 4.9% of its common stock, which would make ADIA one of the bank's largest shareholders. (14) A Chinese fund purchased just under 10% of Blackstone's equity in 2007. (15) Chinese and Singaporean entities are discussing the purchase of a significant stake in Barclays. (16) Another Abu Dhabi entity purchased 8.1% of the common stock of Advanced Micro Devices, a U.S. chipmaker with Defense Department contracts. (17) Somewhat less controversially but no less significantly, SWFs have recently made multibillion dollar investments in U.S. investment banks such as Citigroup, Morgan Stanley and Merrill Lynch, whose capital was depleted by the meltdown in the subprime mortgage market. (18) Collectively, sovereign wealth funds have invested approximately $60 billion in Western banks since May 2007. (19)

The regulatory reason for the controversy over SWFs is slightly more nuanced. We must recognize that the tension between state- and market-versions of capitalism is playing itself out in two very different kinds of equity investments. The first is acquisitions of controlling stakes in domestic companies by operating companies owned by or affiliated with foreign-government entities. A prominent example is the failed 2005 bid for Unocal by the China National Offshore Oil Corporation (CNOOC), an energy company controlled by the Chinese government. To finance the bid, CNOOC was to receive low- interest loans from a state-owned bank and its state-owned majority shareholder. (20) Most countries already have regulatory regimes in place to screen out potentially threatening investments of this type. In the United States, for example, inbound foreign investment is governed by the Exon-Florio statute, (21) most recently amended in 2007. (22) Under the Exon-Florio regime, the inter-agency Committee on Foreign Investment in the United States (CFIUS) reviews all notices of pending foreign acquisitions of control over U.S. companies and can recommend to the president that specific transactions be blocked because they pose a threat to national security. (23) The definition of "control" in the CFIUS regulations is quite broad. It is not a bright line majority ownership test; rather, CFIUS looks to the functional abilities of an acquirer to exercise control. (24) The regulations provide that there is no control when voting securities are held "solely for purposes of investment," which is defined in circular fashion to mean that the acquirer "has no intention of determining or directing the basic business decisions of the issuer." (25)

CFIUS is explicitly charged with considering "whether the covered transaction is a foreign government-controlled transaction." (26) Subject to a narrow exception, foreign government-controlled transactions trigger an automatic 45-day investigation and various congressional reporting requirements, and require the president to make and publicly announce the final decision on whether to approve or block the deal. (27) Other U.S. statutes prohibit foreign ownership of controlling stakes in particular industries, such as airlines or nuclear energy. (28) In other industries, such as commercial banking, the acquisition of control--by a domestic or foreign entity--subjects the acquirer to a comprehensive regulatory regime of reporting, activities restrictions, and supervision that is unworkable for all but highly specialized firms. (29) Although the national regulatory mechanics differ, virtually all major countries already have regulatory protections in place to guard against threats to national interests that take the form of acquisitions of control. (30)

The current controversy over SWFs, and our attention here, concerns a second kind of equity investment: the acquisition of significant, but noncontrolling, stakes in domestic companies by portfolio investors affiliated with foreign governments. In other words, our focus is the type of equity investments that are not...