FARRER & Co : Briefings archive

In a speech on 4^th December 2007 Mr Charlie McCreevy, the European Commissioner for Internal Market and Services, discussed Sovereign Wealth Funds ("SWFs").

In broad terms, SWFs are investment funds created and owned by governments to invest in foreign assets (such as property, shares, bonds or other financial instruments) for the purpose of generating long-term investment returns. SWFs encompass a wide range of funds and a variety of investment strategies and management, but share common characteristics.

International Financial Services London, which promotes the UK's financial services, has estimated that SWFs grew by 18 per cent in 2007 and that SWFs now manage assets of US$3,300 billion (£1,700 billion).

In this article Martin Day examines SWFs and some of the challenges they present regulators, in more detail.

In his speech, Commissioner McCreevy noted the growth in SWFs largely as a result of rising energy prices and large national trade surpluses and described them as "important sources of liquidity". However, he recognised as legitimate concerns certain aspects of SWFs, such as ownership, control and investment strategy, and identified a need to engage with SWFs on transparency and governance issues basing the approach on openness to investment and avoiding protectionism. He proposed taking the debate on SWFs forward by:

· considering whether it would be helpful for EU Member States to have guidelines at the EU level on investments in sensitive sectors; and

· encouraging SWFs to be transparent in their operations, preferably on the basis of an international code of best practice.

Subsequently, the European Commission published a Communication 'A Common European Approach to Sovereign Wealth Funds' (Brussels, COM (2008) 115 provisional). We return to the recommendations in the Commission's Communication later in this article.

In fact SWFs have been around since the 1950s. To some, the rise of SWFs represents the greatest paradigm shift in the global markets in the last thirty years, whereas to others, SWFs amount to a form of 'state capitalism' and pose a threat to global markets. Inevitably, their growing influence has led to calls for their regulation from various sources, including the Commission and the International Monetary Fund ("IMF").

A SWF is merely a generic term used to define state-owned investment vehicles, agencies and funds with specific responsibility for investing excess foreign exchange reserves allocated to them by their governments. These large cash reserves have generally resulted from increasing trade surpluses due to, for example, the general strength of exports (China) or the recent rise in the price of oil (the Gulf States and Russia).

While SWFs appear to share several common features, each is a distinct product of its country's legal and political environment. Some operate as government departments, others as state agencies, and others on a more arm's length basis via formal mandates from governments or central banks to manage certain foreign exchange reserves. Several countries already have more than one SWF (e.g. Singapore and Dubai). The following table summarises the 2007 picture on acquisition deals activity by SWFs.

China's announcement in September 2007 of the creation of its state investment agency China Investment Corporation ("CIC"), and its initial capitalisation of $200billion, revived much of the interest in SWFs. At the same time, other SWFs (notably Dubai) were raising their profiles. Instead of simply continuing to buy US treasuries or other low yielding government debt, they decided to become active investors.

This raised the question of whether SWFs would use their investments to support or further national political aims and foreign policy strategies rather than for purely economic goals. In turn, this has caused commentators to assess their financial strength and to conclude that SWFs had around $2.5 trillion in assets (more than the hedge fund and private equity industries combined) a figure estimated to be likely to rise to $12 trillion by 2015.[1]

Market conditions have also contributed to the new profile for SWFs. The recent turmoil in the global credit markets has resulted in a number of key casualties. Banks, absorbing sub-prime losses amongst other things, are conserving their capital and not funding acquisitions on the same scale as in 2007 or 2006. Many private equity funds and hedge funds remain becalmed because they need leverage in the form of committed bank debt and cannot access the credit markets. The only market participants with a seemingly limitless core capital are the SWFs. In theory at least, SWFs need no bank credit and can execute deals rapidly.

It may also be noteworthy that union leaders in the United States have won the backing of Californian legislators recently to promote a Bill which seeks to restrict certain Californian public sector pension funds from investing in private equity funds with links to Middle Eastern SWFs, based on concerns raised by the unions on the human rights records of the countries concerned. It has been reported that the legislation, if enacted, would bar investment in private equity firms with links to countries that have failed to sign five of the six United Nations treaties dealing with human rights. Remarkably, the USA itself has only signed three of the treaties concerned. The Sunday Telegraph of 6^th April 2008 reports critics of this Bill as saying that it is thinly disguised protectionism, following on from Dubai Ports World's attempt to buy six US port operations.

In the UK, the most recent high-profile SWF activity was the Qatari-backed Delta Two SWF's attempt to acquire J Sainsbury. Then, in February 2008 one of the Dubai SWFs, Istithmar, formed part of a consortium which acquired the landmark Metropole building in London from the Crown Estate for £130 million. Dubai International Capital has been reported to have held talks to buy Liverpool Football Club.

Internationally, the SWFs of Dubai, Abu Dhabi and Singapore have been involved in the recapitalisations of Merrill Lynch, Morgan Stanley, Citigroup and UBS. SWFs have also invested large amounts in private equity groups (e.g. China's $3 billion investment in Blackstone Group and Singapore's well-publicised discussions with Texas Pacific Group).

In response to growing pressure, the G7 group of leading industrialised nations has asked the International Monetary Fund ("IMF") to produce a draft code of conduct for SWFs comprising principles of best practice for disclosure and corporate governance and related matters. Already, some SWFs (e.g. Singapore's Government Investment Corporation) have indicated a willingness to adopt such a code, while others have expressed dismay at being targeted in this way. It has been reported that the SWFs of Norway, Singapore and Abu Dhabi have already been working with the IMF to establish disclosure benchmarks.

However, the universal adoption of such a code is likely to be problematic since SWFs lack a representative trade body or association or any other suitable forum in which to debate these issues and as a result of the distinct political backgrounds, outlooks and ambitions of the countries concerned, there is little appetite to establish these. Further, unlike most other market participants, SWFs are only accountable to their governments and not to shareholders, creditors, regulators or to the media. However, as we have recently seen in the UK with the Walker Report and guidelines for disclosure and transparency in private equity[2] and the Hedge Fund Working Group's report and final best practice standards for hedge fund managers[3], it can be difficult for major participants in the financial markets to ignore calls for self-regulation.

At an EU level, national economic protectionism remains pervasive. Germany has announced that it will introduce legislation to counter problems with SWFs. France has also suggested that it will be hostile to any attacks on its national industries and institutions from SWFs. A variety of measures have been suggested across the EU. However, some of these appear to fall foul of EC rules on the free movement of capital (Article 56, EC Treaty)[4].

A common feature of all SWFs is that they are state entities dedicated to portfolio investment. However, a whole range of state-owned entities already operate in the global markets as banks, insurance companies, shipbuilders, airlines, energy suppliers, oil companies etc. Is it intended that regulation for SWFs will apply to all state-owned entities? If not, sovereign states could simply "park" investments in other state-owned entities to avoid scrutiny or compliance with any SWF code of conduct, in which event, effective and even-handed regulation may become an overly ambitious aim.

Similarly, the monitoring of large investments held by private equity or hedge funds presents considerable difficulties, as SWF influence can be significant but may be masked by the involvement of intermediary entities subject to their own self-regulatory rules.

· permitted use by EU national governments of golden share arrangements in respect of strategic industry sectors;

· reciprocity (i.e. EU companies must be able to acquire similar stakes in the home jurisdiction of the relevant SWF); and

The European Commission's Communication mentioned earlier in this article puts forward a number of principles of good governance relevant for SWFs that undertake cross-border investments, including:

· the clear allocation and separation of responsibilities in the internal governance structure of an SWF;

· the development and issue of an investment policy that defines the overall objectives of the SWF's investments;

· the existence of operational autonomy for the entity to achieve its defined objectives;

· public disclosure of the general principles governing a SWF's relationship with governmental authority;

· disclosure of the general principles of internal governance that provide assurances of integrity; and

The Commission's Communication also emphasises that transparency provides a disciplinary effect on the management of sovereign assets, as relevant stakeholders can exercise some degree of oversight on the activities of investors, and monitor whether or not funds deviate from their stated objectives. As such, transparency promotes accountability. In the case of SWFs, transparency not only serves to foster market discipline, but also reduces the incentives for any government intervention. It is therefore a critical factor in offering the confidence that underlies an open investment environment.

Transparency practices that should, in the Commission's view, be considered, include:

· annual disclosure of investment positions and asset allocation, in particular for investments for which there is majority ownership;

The Spring European Council offered Member States the opportunity to endorse a coherent approach to SWF investments in response to emerging concerns. In line with its Treaty principles and the renewed Lisbon Strategy, the EU needs to remain committed to its tradition of openness to capital investments as they are a vital source of strength for the European economies in a globalised world. At the same time, the case for openness needs to be sustained by engaging SWFs in a cooperative effort to enhance their governance standards and the quality of information they provide to markets. This is not only to the benefit of the EU, but is in the mutual interest of all recipient countries as well as of sponsor countries.

The EU's common approach should serve as a contribution to the IMF efforts to set up a code of conduct for SWFs and for their owners, and to OECD work to define principles to be applied by recipient countries when dealing with SWFs. It should help to reach an agreement, preferably by the end of 2008, on a set of guidelines that will build the necessary confidence in the fair and transparent operation of SWFs.

The Council of the European Union ("the Council") has now published the Presidency conclusions from the Brussels European Council of 13^th and 14^th March 2008 (see http://www.consilium.europa.eu/uedocs/cms_Data/ docs/pressdata/en/ec/99410.pdf).

The Council welcomed the Communication on SWFs from the Commission and agreed with the need for a common European approach to SWFs, taking into account national prerogatives. The Council also supported the objective of agreeing on a voluntary code of conduct for SWFs at an international level.

The IMF's Executive Board has also now given the green light for further analysis on the role of SWFs in the global economy and endorsed a proposal for the IMF to work with SWFs and other relevant parties to prepare a set of best practices for such institutions.

At its meeting on 21^st March 2008, the Board discussed a proposal relating to SWFs, which provided an opportunity for the Directors to discuss SWFs and ways to facilitate the development of a set of voluntary best practices by SWFs. This work will be coordinated with the work of the Organisation for Co-operation and Development ("OECD") mentioned below on practices for recipient countries, as appropriate.

On 1^st May 2008 the International Working Group of Sovereign Wealth Funds ("IWG") at the IMF reported that representatives of SWFs had now met at IMF headquarters in Washington, D.C. from 30^th April to 1^st May to exchange views amongst the SWFs, recipient countries and with representatives from the OECD and the European Commission. The participants agreed that SWFs invest on the basis of economic, financial risk and return-related considerations.

The IWG was formally established at the May meeting and now aims to present by October 2008 a set of SWF principles that properly reflect SWFs' investment practices and objectives. It comprises representatives from 25 IMF member countries, and is co-chaired by a senior representative of the Abu Dhabi Investment Authority ("ADIA") and the Director of the IMF's Monetary and Capital Markets Department.

The IMF's set of best practices is likely to cover issues of public governance, transparency, and accountability principles – all of which should help enhance understanding of the operations of SWFs.

"A better understanding of the role and practices of SWFs and the development of a set of best practices could help countries with SWFs benefit from the experience of other countries, strengthen their domestic policy frameworks and institutions, and further their macroeconomic and financial interests," the Director of the IMF's Monetary and Capital Markets Department is reported as saying.

The OECD published its own report on sovereign wealth funds in mid-April this year, and presented its findings at the spring meetings of the IMF and the World Bank. Together with the IMF, the OECD has been working to produce best practice and governance and transparency standards for SWFs, as part of its wider "Freedom of Investment" project.

The OECD countries agreed to base their investment policies towards SWFs on existing investment instruments, including the 1961 Code of Liberalisation of Capital Movements, and the Declaration on International Investment and Multinational Enterprises, which the OECD issued in 1976 and revised in 2000. These instruments commit recipient countries that are OECD members to:

· non-discrimination against foreign investors versus domestic investment "in like situations";

· transparency of information about any restrictions to foreign investment, (which could be achieved in the case of SWFs by means of making evaluation criteria publicly available, by consulting with interested parties about plans to change investment policies, and by notifying them in good time when changes were planned);

· progressive liberalisation, involving the gradual elimination of all restrictions on inward capital movements;

· "unilateral liberalisation" (i.e. not to insist on reciprocity as a condition for liberalisation).

The instruments also involve a process of regular "peer review" to monitor countries' observance of the principles. At the same time, they recognise recipient countries' rights to protect their national security. However, the OECD report states that while national security was a legitimate concern, it should not be a cover for protectionist policies, and countries' security-related safeguards should be made as open as possible.

In a letter to the G7 Finance Ministers accompanying the report, the OECD said that observance by SWFs of high standards of transparency and governance would help recipient countries keep their markets open while safeguarding national security. "The resulting framework will foster mutually beneficial situations where SWFs enjoy fair treatment in recipient country markets and recipient countries can confidently resist pressures for protectionist responses," the letter concludes.

SWFs will remain a feature of the global economy. It is possible that certain SWFs will unilaterally adopt a rather benign and flexible code of conduct based more or less loosely on a non-prescriptive IMF model. Such a voluntary code will then become the de facto market

standard. Those SWFs that do not broadly follow suit will then be judged against this standard accordingly.

[1] Morgan Stanley Global Paper, 3^rd May 2007

[2] See Walker Review: Guidelines for Private equity

[3] See Hedge Funds: Best Practice Standards

[4] See for example, the European Court of Justice decision in the Volkswagen case, Case C-112/05 Commission v Germany, 23^rd October 2007