Sovereign Wealth Funds and Corporate Governance: A Minimalist Solution to the New Mercantilism

Ronald J. Gilson & Curtis J. Milhaupt

Posted in , ,

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, sovereign wealth funds 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 absentee holders.2  Calls for both domestic and international regulation of sovereign wealth funds’ investments are now a daily occurrence.  In this essay we sketch a minimalist response to concerns over SWFs.

The high profile controversy over the rise of SWFs and their shift to equity investments 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—what  we term the new mercantilism versus market capitalism.  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 rules and those of the European Union 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 which 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 at the company level increases GDP at the national level is an article of faith: the market polices the tautology.  For developing economies, the state, acting through institutions like 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.  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.”3 

Looking behind the rhetoric, SWF 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 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.  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.4 

Also, reserve-rich countries have begun to change their investment strategy. Until recently, these surpluses were invested heavily in U.S. treasury securities and other national government bonds.  Capital was recycled without economic or political disruption.  That pattern has changed—for economic reasons, not due to 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.5  The announced reason for these changes in portfolio strategy is straightforward.  Reserve-rich countries 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.  A few examples include the Abu Dhabi Investment Authority’s (“ADIA”) recent acquisition of Citibank debt convertible into 4.9 percent of its common stock, which would make ADIA one of the bank’s largest shareholders, and the purchase by another Abu Dhabi entity of 8.1 percent of the common stock of Advanced Micro Devices, a U.S. chipmaker with Defense Department contracts.  Somewhat less controversially, but no less significantly, SWFs have recently made multi-billion 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.

The regulatory reason for the controversy over SWFs is slightly more nuanced.  The tension between new mercantilist- 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.  Although the national regulatory mechanics differ, virtually all major countries, including the United States, already have regulatory protections in place to guard against threats to national interests which take the form of acquisitions of control.6

The current controversy over SWFs, and our attention here, concerns a second kind of equity investment: the acquisition of significant, but non-controlling, stakes in domestic companies by portfolio investors affiliated with foreign governments.  For example, all of the SWF investments noted above are of this second type, and only a small number of SWFs pursue investment strategies involving control acquisitions of foreign companies.  At present, there is no specific regulation of portfolio investments by foreign governmental entities at the national or multilateral level.  Yet even ostensible portfolio investments of minority stakes on the part of foreign entities are said to pose a variety of problems, including most provocatively a national security concern raised by a minority shareholder’s potential to influence a company’s actions.  In response, the United States, the European Union, Germany, and the United Kingdom have all taken up the call for a regulatory response.  Proposals have ranged from widespread demands for increased disclosure and transparency, to restrictions on the types of equity instruments in which SWFs may invest, to calls for multiple-round, multilateral negotiations.7  The European Commission recently recommended to the European Parliament and other EU agencies the shape of a common EU approach to SWFs, including detailed governance and disclosure requirements.8  The international lending organizations have also taken up the call, with the IMF, for example, calling for a code of best practices for SWFs.9

But calls for good corporate governance and transparency, however useful in their own right, do not address the legitimate concern, but of which there is so far no observed example, that some SWFs may invest for strategic, non-economic, rather than economic, motives.  A thoughtful response to the SWF controversy requires that we clearly recognize the tension between the two very different faces of ostensibly non-controlling equity investments by foreign government entities.  In fact, voluntary codes of conduct and transparency simply cannot effectively distinguish between SWFs making traditional economic investments and those making, or transforming existing positions into, mercantilist investments.

Viewed from one side, SWF investments are simply a different means of recycling trade surpluses through the capital market.  This new source of equity investments provides liquidity to the equity markets and lowers the cost of equity for private corporations, just as foreign government investment in U.S. debt instruments has reduced long-term U.S. interest rates (by an amount recently estimated as 130 basis points).10  Moreover, the withdrawal of foreign government investments from the equity market may be less of a strategic threat than if the investments had remained entirely in U.S. government debt; equity need not be refunded.  The recent capital infusions provided to Citigroup, Morgan Stanley, and other U.S. financial institutions also softened the effects of the subprime mortgage crisis.

The other face of foreign sovereign equity investments is the source of the controversy.  Viewed from this side, national security concerns anchor one end of a continuum of circumstances when the interests of a foreign government, and therefore of the SWF, may differ from those of an ordinary shareholder.  Consider again SWFs’ rapid infusion of capital into U.S. commercial and investment banks in the wake of the subprime write downs.  Few domestic financial institutions provided capital.  If the investment opportunity was attractive in purely economic terms, why were the SWFs the principal investors?  Perhaps the investments were attractive to SWFs because they got something more than a purely financial investment.  Or perhaps SWF investments were particularly attractive to the current managers of the investment banks struggling with subprime write downs because they could act quickly and were thought unlikely to agitate for change, an unusual combination of characteristics for investors in companies whose operating strategies created the need for massive capital investments in the first place. 

The point is that an SWF’s investment motives are not transparent regardless of the extent of its formal disclosure—its public statements, reports or filings.  Suppose that pursuant to a new requirement of an NGO-promulgated code of best practices, an SWF states that it operates entirely independently of its government owner.  Why would anyone believe the statement, since even if true in the past, it will be true in the future only if the government so chooses.  In effect, the government owner always retains the option to behave strategically.  Could anyone genuinely believe that the investment managers of China Investment Corporation or Singapore’s Temasek would hang up the phone if a senior government official called to offer advice on the fund’s handling of a particular investment to the end of advancing the country’s, rather than the portfolio company’s, interests?  Additional disclosure or pledges of independence simply cannot distinguish between economic and mercantilist investors.

Efforts to diffuse this tension between the benign and threatening faces of sovereign wealth fund equity investments requires a strategy of regulatory minimalism, one that does not spill over beyond addressing the potential conflict of interest between the foreign government and ordinary shareholders to impair the critical capital market benefits that flow from recycling large trade deficits.  This is where corporate governance enters the analysis:  policing conflicts of interest among participants in the firm—for SWFs, where the sovereign investor’s interests are different than those of the other shareholders—has always been a central focus of corporate governance regimes.

A simple corporate governance fix provides the needed minimalist approach.  We propose that equity of a U.S. firm acquired by a foreign-government-controlled entity would lose its voting rights, but would regain them when transferred to non-state ownership.  This voting suspension separates the ability to influence control from investment value.  The expected returns to a foreign sovereign equity investor remain identical to those of other shareholders; an SWF would both buy and sell voting shares.  It would lose only the direct influence over management through voting and the indirect influence that the threat of voting provides.  Sovereign investors with purely economic motives will still invest; the proposal does not raise the cost of or lower the returns from their investments.  Sovereigns seeking mercantilist benefits from equity investments, however, will find SWFs to be a less attractive vehicle by which to achieve their ends.  This adjustment mitigates the potential conflict of interest concern that animates the SWF debate without telling sovereign governments the way they should organize and operate governmental entities.

Some might perceive our proposal as protectionist.  But to do so is to misconstrue the impact of vote suspension.  Vote suspension is protectionist only in the sense that it operates on the frictions between competing versions of capitalism; market-based capitalist regimes are protected against incursion by new mercantilist regimes.  But unlike a truly protectionist measure designed to protect domestic companies’ commercial interests rather than the integrity of the structure of a form of capitalism, our proposal would not lower investment values for foreign investors on account of their nationality or sovereign affiliation per se.  Moreover, we fully anticipate that other countries would respond by imposing reciprocal treatment on investment funds controlled by U.S. government entities.

Our proposal is not a perfect solution to the tensions raised by SWFs.  It is under-inclusive in that influence can be exercised by means other than voting; a significant shareholder need not always cast a vote to sway management.  It is also over-inclusive in that even regulatory minimalism will spill over to unintended areas.  As just noted, we expect that countries whose SWFs are subject to the vote suspension rule in the United States would respond in kind; thus, U.S. state investment funds such as the Alaska Permanent Revenue Fund (among the largest SWFs in the world) may be treated reciprocally by other countries.11  Despite its imperfections, vote suspension does serve to constrain a major source over concern over SWF investment without creating a barrier to recycling trade surpluses. 

To be sure, vote suspension does not (and is not intended to) address the more deeply rooted and significant frictions that arise from the interactions of different capitalist systems, which do involve issues of real protectionism.  However, it does effectively address the high profile concern over SWFs that, left unaddressed or addressed too broadly, has the potential to seriously disrupt the global capital market through heavy handed regulation and protectionism.dingbat



Copyright © 2009 Stanford Law Review.

Ronald J. Gilson is Stern Professor of Law and Business, Columbia Law School; Meyers Professor of Law, Stanford Law School; Fellow, European Corporate Governance Institute.

Curtis J. Milhaupt is Fuyo Professor of Japanese Law & Professor of Comparative Corporate Law, Columbia Law School; Director, Center for Japanese Legal Studies at Columbia Law School.

This Editorial is based on the following full-length Article:   Ronald J. Gilson & Curtis J. Milhaupt, Sovereign Wealth Funds and Corporate Governance: A Minimalist Solution to the New Mercantilism, 60 STAN. L. REV. 1345 (2008).

  1. See John Maynard Keynes, National Self Sufficiency, 22 YALE REV. 755 (1933).
  2. David R. Francis, Will Sovereign Wealth Funds Rule the World?, CHRISTIAN SCI. MONITOR, Nov. 26, 2007, at 16 (quoting Warren Buffett).
  3. Sovereign Wealth Fund Acquisitions and Other Foreign Government Investments in the United States: Assessing the Economic and National Security Implications: Hearing Before the S. Comm. on Banking, Housing and Urban Affairs, 110th Cong. (2007) (testimony of Edwin M. Truman, Senior Fellow, Peterson Institute for International Economics).
  5. See, e.g., Stuart E. Eizenstat & Alan Larson, The Sovereign Wealth Explosion, WALL ST. J., Nov. 1, 2007, at A19.
  6. See, e.g., CYNTHIA DAY WALLACE, THE MULTINATIONAL ENTERPRISE AND LEGAL CONTROL: HOST STATE SOVEREIGNTY IN AN ERA OF ECONOMIC GLOBALIZATION (2002). Most recently, Germany has announced that it will adopt a new law providing government review of SWF investments of more than 25 percent of a German company. Huhj Williamson, Germany Prepares Law to Block Unwelcome Sovereign Funds, FIN. TIMES, April 10, 2008, at 1. In the U.S, inbound foreign investment is governed by the Exon-Florio statute, 50 U.S.C.A. app. § 2170 (West 2008), most recently amended in 2007. The Foreign Investment and National Security Act of 2007 (FINSA), Pub. L. No. 110-49, 121 Stat. 246, codifies and clarifies the process by which foreign acquisitions of control are processed and approved.
  7. See e.g., Joshua Aizenman & Reuven Glick, Sovereign Wealth Funds: Stumbling Blocks or Stepping Stones to Financial Globalization?, FRBSF ECON. LETTER (Federal Reserve Bank of San Francisco, San Francisco, Cal.), Dec. 14, 2007, available at (encouraging SWFs to invest solely in index instruments); Bob Davis, How Trade Talks Could Tame Sovereign-Wealth Funds, WALL ST. J., Oct. 29, 2007, at A2 (urging multilateral trade negotiations); Edwin M. Truman, Sovereign Wealth Funds: The Need for Greater Transparency and Accountability (Peterson Institute for International Economics, Policy Brief PB07-6, 2007), available at (arguing for greater transparency).
  8. Commission on the European Communities, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, A Common European Approach to Sovereign Wealth Funds, COM (2008) 115 final (Feb. 27, 2008).
  9. John Burton & Chris Giles, IMF Urges Action on Sovereign Wealth, FIN. TIMES, Jan. 24, 2008, at 4.
  10. MCKINSEY & CO., supra note 4, at 84.
  11. Although it does not share some of the key characteristics of a sovereign wealth fund, we expect that even CalPERS could be subject to reciprocal treatment abroad.

Post a Comment (all fields are required)

You must be logged in to post a comment.