Tamed Tigers: Sovereign Wealth Funds as Passive Investors

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

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

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
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
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
CFIUS.  They are forced to be tamed

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

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.

[1] Sovereign Wealth Funds
2008, IFSL Research, Apr. 2008, http://www.ifsl.org.uk/upload/CBS_Sovereign_Wealth_Funds_2008.pdf.

[2] Id. at 2.

[3] Id. at 1.

[4] Id. at 2.

[5] Id. at 3.

[6] Christopher Cox, Chairman, Sec. & Exch. Comm’n, Keynote Address and Robert
R. Glauber Lecture at the John F. Kennedy School of Government, Harvard
University, The Role of Government in Markets (Oct. 24, 2007), http://www.sec.gov/news/speech/2007/spch102407cc.htm.

[7] 50 App. U.S.C.A. § 2170(b)(1)(A) (Supp. 2007).

[8] 50 App. U.S.C.A. § 2170(b)(2)(B)(i)(III).

[9] 31 C.F.R. § 800.204 (2008).

[10] 50 App. U.S.C.A. § 2170(d)(1, 3).

[11] Banner Will Sell Fairchild Division, N.Y. Times, Jun. 1, 1989, http://query.nytimes.com/gst/fullpage.html?res=950DE2D91E3CF932A35755C0A96F948260.

[12] Ralph Folsom, Michael
Gordon, John Spanogle, Jr., Peter Fitzgerald, International Business
1172-1173 (West Publishing Co., Thomson/West 2006) (1987) [hereinafter

[13] Evan Bayh, Op-Ed., Time for Sovereign Wealth Rules, Wall
St. J.
, Feb. 13, 2008, http://bayh.senate.gov/news/speeches/release/?id=d27c1d1b-b32f-4214-aa63-bfee1bab50e8.

[14] Id.

[15] Id.

[16] Id.

[17] Andy Serwer and Barney
Gimbel, Prince Alwaleed: Why Chuck Had to
, Fortune, Nov. 16, 2007, http://money.cnn.com/2007/11/08/news/companies/citigroup_alwaleed.fortune/index.htm.

[18] IBT, supra note 12, at 1173.

[19] Id.

[20] Id.

[21] Id.

[22] While more research and
time might be needed to determine how much sovereign wealth funds are avoiding
investing in the United States because of these regulations, the current
environment seems to suggest that those sovereign wealth funds with investments
in the United States have been taking a very passive approach to their
investments. See Christopher Rugaber, Offshore
Investors Take Low Profile to Avoid Political Resistance to Deals,
, Dec. 2, 2007, http://www.thestar.com/Business/article/281708.

[23] Asset-Backed Insecurity, The Economist, Jan. 17, 2008, http://www.economist.com/finance/displaystory.cfm?story_id=10533428.

[24] David Jolly, Financial Tempest Spreads to the Gulf States,
Int’l Herald Trib., Oct. 26, 2008, http://www.iht.com/articles/2008/10/26/business/gulf.php.

[25] Paul Rose, Sovereigns as Shareholders, 87 N.C. L.
Rev. 101 (forthcoming 2008).