Controlling Interests

Two Columbia Law School professors take aim at a key problem swirling around the multitrillion-dollar world of sovereign wealth fund


By Peter Coy

As the world’s largest debtor, the United States, like Blanche DuBois, depends on the kindness of strangers. But does that mean the U.S. should embrace all foreign investments, even if they come with strings attached to potentially unfriendly governments? Is it possible to keep other nations from exercising undue influence without cutting off the flow of much-needed capital from abroad?

Columbia Law School Professors Ronald J. Gilson and Curtis J. Milhaupt ’89 are trying to crack at least part of that conundrum. Their idea is aimed at sovereign wealth funds—those huge, government-controlled pools of investment money that are pouring billions into the likes of Citigroup and Merrill Lynch. The two scholars argue that sovereign wealth funds should be denied voting rights on the shares they acquire. Under their plan, voting rights would revert to the shares if the funds sell them later to investors that aren’t government-controlled. The intent is to diminish the funds’ influence and stave off a clash between what the professors call “the two systems of capitalism”—private versus state-owned. In “Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Mercantilism,” the article that introduced the proposal in the March 2008 issue of the Stanford Law Review, Gilson and Milhaupt write: “If vote suspension reduces the risk of a protec-tionist response, it will allow the global capital markets to demonstrate that, in the long run, governments make ineffective capitalists, especially where innovation is the ultimate currency.”

If nothing else, Gilson and Milhaupt’s idea is well-timed. Lawyers and the general public have just begun to realize that “SWF” can mean something other than “single white female.” Over the past year, funds from the wealthy Gulf oil state of Abu Dhabi have bought big stakes in Citigroup, Advanced Micro Devices, and the Carlyle Group, while a Dubai fund bought into Sony, and Singapore’s Temasek Holdings took a big stake in the struggling Merrill Lynch. The International Monetary Fund recently predicted that within five years, sovereign wealth funds’ assets could reach $6 trillion to $10 trillion, versus $2 trillion to $3 trillion currently.

The professors are quick to admit that their idea is no panacea. Sovereign wealth funds with trillions in assets can’t be tamed by one act of Congress. Still, the sheer simplicity of their concept, like a swift slice through a Gordian knot, has gained it a good deal of attention from experts in the field. A brief essay drawn from the work is part of a forthcoming volume commemorating the 150th anniversary of Columbia Law School.
What irked Gilson and Milhaupt, and served as an impetus for their article, was that policy-makers seemed to be throwing up their hands at the issues raised by sovereign wealth funds. The federal government has a stringent mechanism for reviewing cases in which national security is at stake and in which foreigners gain controlling interests in U.S. companies, via the inter-agency Committee on Foreign Investment in the United States (CFIUS). But CFIUS doesn’t review investments in which national security is not at stake. And CFIUS ignores non-controlling investments, which is what sovereign wealth funds usually take. For its part, the International Monetary Fund has pressed sovereign wealth funds to be more transparent, on the assumption that openness discourages bad behavior. It launched an effort earlier this year to help the funds learn to “run sound organizations, with good governance structures, robust risk management frameworks, and appropriate transparency.”

Gilson disparages the transparency initiatives as ineffectual Kabuki theater. The issue, he says, deserves more attention from policy-makers. “[The emergence of sovereign wealth funds] raises in really stark fashion the question of what role government plays, and how much intrusion into the economy is appro--priate,” he adds. “That’s not something that we should sweep under the rug.” Gilson and Milhaupt have thought about the law long enough to recognize a futile gesture when they see one.
Gilson, the Marc and Eva Stern Professor of Law and Business, is an expert in corporate governance who joined the Columbia Law School faculty in 1992. He teaches at Columbia during the fall and at Stanford Law School in the spring semesters. Milhaupt, a fluent speaker of Japanese who is the Fuyo Professor of Japanese Law and Professor of Comparative Corporate Law, joined the Columbia Law faculty in 1999. His academic specialties include corporate governance and the importance of legal institutions to economic growth.
Gilson and Milhaupt concluded that public commitments by sovereign wealth funds to do the right thing are worthless because the funds are, after all, sovereign and therefore free to change their minds at any time. It is impossible to judge from words alone which funds really are passive investors and which might abruptly turn statist.
That’s where the voting-rights suspension comes in. If a sovereign wealth fund truly cares only about financial returns, the professors say, it shouldn’t much mind losing voting rights. Funds that want to preserve the intervention option would be put off by the loss of voting rights and might go elsewhere. Thus the voting-rights suspension causes the two types of funds—passive and active—to reveal their concealed differences. In game-theory terminology, the gambit produces a “separating equilibrium”—an idea from the field of information economics that won a Nobel Prize in 2001 for Columbia’s Joseph E. Stiglitz, Stanford’s A. Michael Spence, and the University of California at Berkeley’s George A. Akerlof.
Gilson believes Columbia Law School is a perfect place for the kind of interdisciplinary work exemplified by his and Milhaupt’s mash-up of information economics and corporate law. “You can have schools that are a bunch of silos, and you can have schools where ideas grow,” Gilson says. “Both the quality of work and the quantity grow dramatically with the Columbia model. More than any other place I’m aware of, there’s a pattern of people collaborating.” Milhaupt agrees. “A lot of sparks fly around here,” he notes. “The Columbia students are extraordinary. They’re not only smart, but they’re incredibly worldly.” One inspiration for the paper was a seminar the professors team-taught recently called “Law, Governance, and Capitalism.” In the classroom setting, daily headlines about cross-border deals fueled intense discussions among J.D. students, as well as LL.M. students from Brazil, China, France, Japan, and Taiwan. “That hothouse environment,” Milhaupt recalls, “with all those different viewpoints coming together to examine a topic, was just a wonderful way to generate ideas.”
Of course, since Gilson and Milhaupt are dealing with such a layered and complex issue, many facets remain for exploration and scholarly thought. As Rutgers University School of Law Professor Anna Gelpern, a former Treasury Department official, notes, the professors “are addressing a very specific concern with a very specific fix.” A sovereign wealth fund can throw its weight around even without voting rights—threatening to sell its shares or to stop buying more, for example. In other respects the proposal may go too far. The authors admit that foreign governments would likely respond by denying voting rights to U.S. public pension funds, such as the activist California Public Employees’ Retirement System (CalPERS). That’s a strike against the idea, Edwin M. Truman, senior fellow at the Peterson Institute for International Economics, wrote in an April policy brief. 
Still, Gilson and Milhaupt have diagnosed the problem more clearly than most scholars and have at least begun to think about a solution. “This particular idea may not gain traction,” says Milhaupt. “It may not be implemented. But the thought process which led us to this proposal, that, I think, is a contribution in and of itself.”
Peter Coy is economics editor of BusinessWeek.
To view this story as it appeared in Columbia Law School Magazine (Fall 2008.)