Common ground

Transparency, accountability and systemic risk issues are top of mind for both Wall Street and the global financial community since the latest crisis unraveled.

Sovereign wealth funds had already attracted the close scrutiny of regulators even before September. Despite the vigorous debate between SWFs and the recipient countries receiving foreign investment from them, it is clear that some compromise on the formal regulation of SWFs will need to be reached, given the economic imperative of all parties to do so.

SWFs require access to the well-developed and liquid financial markets of recipient countries to ensure that their large capital surpluses remain invested in a diversified portfolio of higher-yield investments. Many recipient countries remain in desperate need of such foreign investment, either to shore up the balance sheets of ailing financial institutions or to fund large national account deficits. The nature of such regulatory compromise now remains the challenge.

Any effective regulation (and indeed sanction in the case of non-compliance) will have to be coordinated at the international multilateral level through financial institutions such as the International Monetary Fund, the World Bank, G7 and the Organization for Economic Co-operation and Development rather than at national (and in the case of the U.S., state) level. Indeed, most of the current efforts to crystallize a broad set of principles to govern the conduct of SWFs as well as recipient countries (most recently those of the European Union as well as the U.S., Abu Dhabi and Singapore) have stressed that such measures are merely precursors to the development and adoption of a comprehensive international framework of principles to be developed by the IMF and the OECD.

The OECD has already published its report dealing with best practices for recipient countries. The IMF International Working Group of Sovereign Wealth Funds has announced that it has reached a preliminary agreement on a set of 24 voluntary principles known as the "Generally Accepted Principles and Practices for Sovereign Wealth Funds," or GAPP, designed to address key concerns such as institutional structure, risk management and political neutrality in investment management.

Compromise in this context requires recipient countries to resist financial protectionism by embracing these best-practices guidelines to accept a form of voluntary regulation in accordance with GAPP.

But the voluntary and substantively vague nature of GAPP represents the greatest danger to the effectiveness of the proposed compromise. In order to stress the nonbinding nature of the principles, SWFs have rejected the use of terminology such as a "code of practice" or "rules of conduct" to describe GAPP as well as any suggestion from the IMF that it will monitor ongoing SWF compliance with GAPP. Furthermore, GAPP seemingly will not require SWFs to disclose their size, details of their portfolio holdings or voting records in respect of investments, thereby doing little to address the key concern of transparency.

Given the voluntary and substantively vague nature of GAPP, certain SWFs are likely to do little in the short to medium term to fully embrace the guidelines on a purely voluntary basis, with the inevitable consequence being a backlash by some recipient countries in the form of a range of fragmented individual and protectionist regulatory measures in clear violation of the OECD principles. This could further severely damage global economic growth.

The most effective policy response remains the adoption of a mandatory international code of regulatory conduct to govern SWFs and recipient countries premised on the basis of the broad policy principles proposed by both the OECD and the IMF, with active and effective policing of such code by those international bodes and the G7 and World Bank. This policy response does not presume that the mere act of labeling such a code as "mandatory" or "binding" will in itself provide sufficient leverage to ensure compliance without enforcement, but it is clearly more attractive than the current proposal, which is destined to render the code a "toothless tiger" from the outset.

The proposed alternative is more likely to achieve the regulatory compromise and the maintenance of global capital flow efficiency while at the same time addressing the legitimate political and economic systemic issues that are inherent in the global investment activities of SWFs.

Simon Firth is a partner and Damian Juric is an associate in the corporate and finance department of the London office of Kaye Scholer LLP.