With trillions of dollars in assets, sovereign wealth funds (SWFs) play a major role in financial markets around the world. With billions (and perhaps trillions) of dollars’ worth of equity investments around the world, the investment behavior of SWFs is of primary concern to regulators, portfolio firms, and other investors. Most work on SWF equity investments has focused on the challenges that SWFs present to regulators, portfolio companies, or their own domestic constituencies. In a forthcoming essay, I seek to provide a realistic appraisal of the benefits and potential costs of SWF investment for other investors.
As numerous scholars have noted, shareholders may have heterogeneous interests and will sometimes pursue interests that are adverse to other shareholders.[1] And if we believe that shareholders sometimes have heterogeneous interests—even though they may also share, in most cases, a desire to maximize profits—then we can see the shareholders as not a single principal with a unitary goal, but as a group of independently minded principals sharing a common agent in the corporate management.
This common agency problem creates several concerns. First, managers must deal with competing (and perhaps conflicting) interests among shareholders. To whom will they listen? Second, how will shareholders be able to track and counter the influence of other shareholders with competing views?
The common agency problem is readily apparent in the context of sovereign wealth fund investment. Many commentators have highlighted the risk that sovereigns’ investments could be used for political purposes. On the other hand, investors may be concerned not that SWFs will use their investment power to act politically, but that they will instead act as dumb money—that, despite a large position in the company’s stock, the SWF determines that it should act passively in order to avoid scrutiny by regulators in jurisdictions in which the SWF invests. As a result, SWFs risk becoming deadweight shareholders, who provide no benefit to other shareholders despite their (possibly) large shareholdings. Other shareholders may sell because of the managerial agency costs exacerbated by inert block-holding.
In the essay I argue that, although SWFs do not owe a duty by sovereign owners to act as good corporate citizens, sovereign investors should think in terms of responsibilities they have to other investors. The recognition of responsibilities flows from the common agency problem at the heart of SWF equity investment. As a deep-pocketed and unusually powerful investor, SWFs present particularly strong risks to investors who share a common agent with the SWF. Regulation helps mitigate some of these concerns, but not all host countries have similarly robust regulations and protections for investors. SWF responsibility to other investors can help fill these gaps.
Using the idea of common agency costs as a starting point, one can derive several crucial investment principles that fulfill this responsibility. First, investors should be transparent in their investment purpose. This principle is particularly important (and, admittedly, perhaps only important) when the investor is able to exercise significant influence on the corporate governance and corporate decision-making of the portfolio company. And while the principle may seem a radical departure from the principle of selfish ownership described above, such transparency of investment purpose has been a feature of U.S. federal securities laws for decades. Under Schedule 13D,[2] investors who acquire 5 percent or more of a public company’s securities must disclose, among other things, their identity, provide basic background information, and disclose the purpose of their investment, including any plans or proposals that would change the management of the company, its business, or corporate structure, or would result in an extraordinary corporate transaction.
Second, investors should be predictable in their investment behavior. This is not to say that SWFs or other investors should signal their intentions to buy or sell a particular stock, but merely that their behavior should follow patterns suggested by their investment purpose. This is particularly true of SWFs and other large, potentially influential investors for whom the common agency risks are much greater to other investors.
Finally, large investors arguably—and SWFs more certainly—have a responsibility of presence, by which I mean they should make their presence as engaged investors apparent to management. The reason for this is simple: By remaining completely passive investors with no voice, SWFs cede the floor to other investors who are not shy in making their voices heard. This is a detriment not just for the SWFs’ beneficiaries, but for other investors and corporate constituencies. As institutional investors who do not have either short- or medium-term liabilities (like pension funds) and theoretically enjoy extremely long-term investment horizons (if they can be said to have any horizon at all), SWFs have unique perspectives on long-term, patient capitalism.
As a final point, SWFs themselves have much to gain from responsible sovereign investment. As large investors with significant economic stakes in many firms, SWFs also face the greatest financial risk from common agency problems caused by other large institutional investors, such as hedge funds and other SWFs. On the other hand, they would benefit greatly from the network effects of other SWFs’ focus on reducing agency costs through transparency, predictability, and presence.
ENDNOTES
[1] See Paul Rose, Common Agency and the Public Corporation, 63 Vand. L. Rev. 1353 (2010).
[2] See 17 C.F.R. § 240.13d-101 (Schedule 13D, Information to be included in statements filed pursuant to § 240.13d-1(a) and amendments thereto filed pursuant to § 240.13d-2(a)).
This post comes to us from Paul Rose, Bazler Designated Professor in Business Law at Ohio State University’s Moritz College of Law. It is based on his recent article, “What Responsibilities Do Sovereign Funds Have to Other Investors,” which is part of a Wake Forest Law Review symposium on sovereign wealth funds and is available here