Over recent months there has been a perceptible shift of power in the world’s financial markets. As volatility sweeps these markets and the flow of investment capital from traditional sources slows from a torrent to a trickle, the highly leveraged dealmakers that have shaped global capitalism over the last decade are being overshadowed by an emerging set of capital rich investors.
These players, known as Sovereign Wealth Funds (“SWFs”), are relatively unique as they have access to a near unlimited supply of investable funds with apparent limited accountability. In addition, while their general investment activities are acknowledged their business rationales are not. Critics argue that such opaque and powerful funds represent threats to both economic stability and national security. Pragmatists, meanwhile, see SWFs as a positive force bringing much needed capital and stability to the U.S. financial services markets while the U.S. economy teeters on the brink of recession.
What are Sovereign Wealth Funds?
SWFs are creatures of their countries’ central governmental authorities, structured along the lines of private equity corporations and designed to realize better returns when investing their countries’ excess foreign exchange reserves. Since January 2001, U.S. Government debt issued to the public has risen by $1.7 trillion, with $1.3 trillion being purchased by foreigners of which $327 billion was purchased by China (Source: The New York Times, December 22, 2007).
It is important to note that although sharing similar characteristics, SWFs are individualized, differing in size, focus and investment experience. The oldest SWF, Kuwait Investment Authority, has been around since 1953. A number have been in place for more than 30 years (Temasek Holdings (Singapore), Abu Dhabi Investment Authority, and Alaska Permanent Reserve Fund Corporation). These funds and others have significant experience of investing responsibly in a broad array of U.S. corporations. (See Table 1 for a listing of the principal SWFs and their year of creation. Some countries have multiple SWFs.) In recent years, the significant increase in the price of oil, the outsourcing of the manufacture of many basic products (such as to China and other low-cost production countries in Southeast Asia) and increased commodity prices have resulted in vast and growing trade and foreign exchange surpluses for many countries in the developing regions. As a consequence, the SWFs are quickly accumulating huge pools of investable funds.
It is not just the size of the funds that are growing but also their number. China has recently launched a new fund; on February 1, 2008, Russia launched a new $32 billion fund (National Welfare Fund); Saudi Arabia is planning to launch the world’s largest fund; while India is exploring possibilities in this area
The total of investable funds held by SWFs is more than $3.4 trillion. Based on a Gross Domestic Product (“GDP”) measurement and using 2006 IMF data, SWFs comprise the fourth largest economy in the world, after the European Union, the United States and Japan. Projections suggest that the pool of investable funds held by SWFs will grow to more than $13.5 trillion (based on a Deutsche Bank analysis), which is larger than the 2006 GDP for the United States.
The timing for SWFs to make investments in the financial services sector in the United States couldn’t be better. With the fallout from the subprime and mortgage problems in the United States, banking organizations (whether commercial banks or investment banks) and other major financial services providers are in need of significant capital injections in order to offset the very large write-downs they have taken and will likely have to take in the future. The write-downs to date aggregate about $150 billion and Table 2 below provides a selected sample of the write-downs suffered by the largest financial services organizations. Foreign investors in the United States are also significantly advantaged by the weak U.S. dollar and the volatile share movements within the financial services sector.
To offset these losses, a number of financial institutions have had SWFs provide large capital injections in exchange for a non-controlling ownership interest at a discounted price. A selection of recent deals is highlighted in Table 3.
With the Fourth Quarter announced results (and anticipated First Quarter 2008 results), it is very likely there will be further investments via capital injections from SWFs into U.S. financial services companies.
Positives, Negatives and Calls for a Code of Conduct
SWFs bring a number of positives to the table: Their investment horizons are generally long-term and without leverage meaning they are not prone to flight risk or capital calls; they have large amounts of capital that can be galvanized in very short order and invested very quickly; have a high tolerance for risk, and are generally not publicly listed or required to make public disclosures.
Opponents often cite a number of negatives associated with SWFs including threats to economic stability due to their significant purchasing power. In the United States, there is significant concern with the absence of reciprocity or the lack of a level playing field by a number of the SWF countries’ policies on investment by foreign investors. That is a particular concern with the newly developed and emerging economies with significant SWFs, such as in the Middle East, Russia and China, where there are limits restricting overseas investment, while the United States is much more “open for business.”
It is also asserted that the motives for SWFs investing in overseas institutions may not be solely commercial. It is feared by some that investment motives may be political, including making investments in politically strategic industries, or to acquire access to special technology or skills, or to further the unknown objectives of the governments SWFs represent. The perceived lack of transparency of such institutions tends to exacerbate suspicion and feelings of insecurity as to the investment motivations.
History suggests there is little evidence to show that political motives drive such transactions. Recent high profile investments in U.S. financial institutions would indicate that SWFs now have a strong vested interest in a thriving U.S. economy. That such investments are made by sovereign states which could, for example, seriously damage Western economies more efficiently and quickly by restricting the production of oil appears to have been lost on many who would argue for protectionism against such investors.
hen investments have touched a raw nerve with U.S. authorities, action has been taken quickly to mitigate such concerns. The proposed Dubai Ports World acquisition of the London-based ports operator, Peninsular & Oriental Steam Navigation Company (“P&O”), including its port facilities in New York, New Jersey, and four other U.S. port cities led to a negative political reaction as these were deemed to be key areas of infrastructure, possible terrorist targets, and a potential means for easy undetected entry into the United States. Threats to block the deal on the grounds of national security were made resulting in DP World selling P&O’s U.S. assets to AIG in December 2006. Another manifestation of U.S. political concern arose when the 70 percent Chinese state-owned energy firm, CNOOC, tried to buy Unocal in 2005. The proposal was met with such strong U.S. political opposition that the offer was withdrawn, forcing Unocal to accept ChevronTexaco’s lower bid.
To avoid similar confrontations we see the current investments being structured as non-controlling, with no officer, director or business interlocks. When recently offered a place on the board of directors of UBS, the chairman of GIC of Singapore refused “...in the light of our intention to clearly not seek any control of UBS...” (The Business Times, January 27, 2008). Furthermore, the public reaction to the investment by Abu Dhabi’s ADIA in Citigroup has been muted. Evidence of that has been the reaction by U.S. Senator Charles Schumer of New York that the investment “allows what is fundamentally a very strong company to weather a difficult time.” The subsequent investments in Citigroup have also been made with a minimum of publicly expressed concern. It is very likely there will continue to be similar investments made in the U.S. financial services sector (See Table 3) and as long as there is such a dire need for capital such deals are likely to be completed with minimal governmental objection.
The SWFs recognize that if the investments in a commercial bank, savings bank, or thrift were to be viewed as tantamount to a “control” position or to entail more than a 9.9 percent equity voting interest, then they would be required to make a Change in Bank Control filing with the U.S. federal bank regulators and, depending on state law, with a state regulator, and go through a bank regulatory process that would require extensive public disclosures.
Recent months have seen a number of governments, international financial organizations and industry commentators calling for guidelines, codes of conduct and in some cases legislation relating to SWFs’ investments.
The IMF and the World Bank have been asked by the G7 to formulate best practices for SWFs while the OECD is to work on guidelines for countries receiving investments from SWFs. While there was hope expressed for a “best practices” standard, there has been significant pushback by the SWFs (The New York Times, February 9, 2008).
Governments around the world are taking different approaches to the impact SWFs are having. In the UK, an open door policy is being maintained; in the United States, the Government Accountability Office is investigating SWFs and Congress has held hearings; Switzerland has stated it will continue to monitor SWF activities; France has indicated a very protectionist sentiment for certain key businesses; while Germany is drafting new legislation to protect “public order and security” along with a provision to block foreign investment if 25 percent or more of a company’s voting rights are purchased.
The success of any code of conduct will require participation and engagement from the SWFs. Some funds such as the Government Pension Fund of Norway already provide a high degree of public transparency. Other well established funds could feel that given their long track records as responsible and passive investors, they are being unfairly targeted due to the political uncertainty generated by less established funds from China and Russia.
Reed Smith partner and former General Counsel of Dubai World, Sahia Ahmad, believes that certain SWFs would welcome a code of conduct: “It’s important to bear in mind that Sovereign Wealth Funds are not homogeneous and will view the issue of transparency in very different ways. The newer Middle Eastern funds such as Dubai’s Istithmar operate in a similar fashion to Private Equity houses and would be more receptive to reporting, if it is was clear what was required and the rules were not overly stringent.”
Sahia believes, however, it would be a much tougher sell to the more established funds. “They are used to setting the rules, not having them imposed upon them. For success a clear, respectful and open dialogue would be essential.”
The challenge is not one of establishing a code of conduct for SWFs to adhere to but gaining buy-in from the majority of SWFs that such a code is a benefit to their long-term strategies. Until this happens governments of the investee countries and the United States in particular will continue to closely monitor and oversee with some degree of concern the activities and investments of Sovereign Wealth Funds.
The U.S. Monitoring Process
So long as an investment in a bank or its parent holding company (whether a bank holding company or financial holding company) is (i) not for more than a 9.9 percent voting interest in a class of securities or (ii) does not also include a director or officer position, or (iii) does not represent a “control” interest, then no prior federal bank regulatory approval is required. However, it is advisable that such a SWF investor contact the investee organization’s primary banking regulator to describe the nature and purpose of the investment. The purpose would be to address in advance any questions that the banking regulators might have and to eliminate the surprise element. They need to also consider the potential political repercussions of such an investment and may need to make additional forewarnings.
One aspect of U.S. laws that a SWF investor should keep in mind, although not generally applicable to investments in U.S. banking organizations, is the Exon-Florio amendment to Section 721 of the Defense Production Act of 1950 (50 U.S.C. app. Section 2170 (2000)). This legislation and its implementing rules, administered by the Executive Office of the President through the Committee on Foreign Investment in the United States (“CFIUS”), comes into play when a foreign investor seeks to acquire control of a U.S. company engaged in interstate commerce in the United States and the acquisition has national security implications. If it is deemed to threaten or to impair the national security of the United States and that threat cannot be mitigated, then the acquisition will likely be denied. The proposed investment is subject to an administrative review by CFIUS, a fourteen-member Committee chaired by the Secretary of the Treasury that reviews the investment and makes a recommendation to the President on whether to approve or deny the investment.
It should be noted that in July 2007, following the furor over the Dubai Ports World proposed investment, the statute was amended to cover investments involving critical infrastructure, the incapacity or destruction of which “would have a debilitating impact on national security” (Foreign Investment and National Security Act of 2007) (50 U.S.C. Section 2170 (a)(6)). While this is intended to cover cross-border transactions in the areas of energy, technology, shipping and transportation, where a major U.S. financial organization may be involved, a strong argument could be made that its role in the U.S. payments system process should be deemed a “critical infrastructure” component for the U.S. economy with national security implications. After all, it is the U.S. payments system that provides the oil that lubricates the U.S. economy.
In light of the difficult financial situation that a number of major U.S. financial services organizations face, the growing number of investments in such U.S. organizations by SWFs generally and the July 2007 amendment to Exon-Florio, it is possible that CFIUS may have a new perspective in deciding which investments are consistent with U.S. national security. CFIUS is currently investigating the $1 billion cross-investment between Bear Stearns and the Chinese investment bank CITIC.
The SWFs are arriving on the scene at a very propitious time. However, unless they are willing to adhere to a profile of greater transparency and true accountability, it is unlikely they will be afforded the full opportunity to invest their extensive financial resources in the most attractive and productive entities in the United States and in the Western Economies.