Sovereign Wealth Funds and Domestic Political Risk

Sovereign Wealth Funds and Domestic Political Risk
Paul Rose, Ohio State University – Moritz College of Law
Abstract:
This chapter discusses sovereign wealth fund (SWF) governance as a tool to manage
domestic political risk. It adds to the literature on the domestic legitimacy of SWFs and
theorizes that legitimacy, broadly conceived, serves as a signal of appropriate entity and
political risk management. Sovereign fund legitimacy is a question of increasing
importance to sponsor countries as decreasing oil and gas prices force some governments
to decide whether the role of SWFs should be changed to deal with the loss of revenue
resulting from decreased oil and gas exports, or other budget shocks. Policymakers and
fund officials must structure and govern sovereign funds in such a way as to adequately
and legitimately fulfill their mandate. Threats to legitimacy include issues involving
ultimate ownership of the fund, corruption, unclear or shifting purposes and uses of the
fund, and misalignment of the fund with societal mores and interests.
Keywords: Sovereign wealth funds, political risk, governance, legitimacy, accountability,
transparency
Electronic copy available at: https://ssrn.com/abstract=2673112

7
Sovereign Wealth Funds and Domestic Political Risk
Paul Rose
Introduction
As sovereign wealth funds (SWFs) mature and as the literature describing and analyzing
them continues to develop, some of the primary concerns that initially animated SWF
analysis—namely, SWFs as a sign of shifting financial power, SWFs as potential political
actors, and protectionist responses from governments worried about SWF investment
activity—have turned to fundamental concerns about how SWFs are governed. Even
within this literature, however, questions of governance are often focused on SWF
governance as risk mitigation for foreign entities and governments rather than on the
domestic impacts of SWF governance. For some analysts and regulators, SWFs must be
quarantined; little thought is given to the health of the SWF itself, so long as it does not
adversely affect foreign entities.
This chapter fills this analytical gap by discussing SWF governance as a tool to
manage domestic political risk, and not merely as a tool for managing international risks.
In particular, this chapter adds to the literature on the domestic legitimacy of SWFs,1 and
theorizes that legitimacy, broadly conceived, serves as a signal of appropriate entity and
1
See, for example, Clark, G., Dixon, A., and Monk, A. (2013); Monk, A. (2009); Clark, G. and
Monk, A. (2009); ‘Grünenfelder, S. (2013).

political risk management. Sovereign fund legitimacy is a question of increasing
importance to sponsor countries as decreasing oil and gas prices force some governments
to face the question of whether the role of SWFs should be changed to deal with the loss
of revenue resulting from decreased oil and gas exports, or other budget shocks. It is
crucial that policymakers and fund officials structure and govern SWFs in such a way as
to adequately and legitimately fulfill their mandate. Among the threats to legitimacy are
issues involving ultimate ownership of the fund, corruption, unclear or shifting purposes
and uses of the fund, and misalignment of the fund with societal mores and interests.
The concept of legitimacy, though relatively recent, has inspired a rich literature
in political science, law, and management, among other areas. As argued by Weber,
legitimacy is a belief on which the authority of the government rests, and “a belief by
virtue of which persons exercising authority are lent prestige”2 (Weber 2009, p. 382).
Legitimacy may be conceptualized as having two aspects (Coglianese 2007, pp. 159–67).
First, legitimacy is often thought of as having a procedural aspect. Procedural legitimacy
is achieved through mechanisms such as domestic accountability, power-limiting or
power-sharing structures, such as a separation of legislation and judicial functions,
transparency of governmental activities and proceedings, and, in general, the rule of law.
Legitimacy can also be conceived as having a substantive aspect. Substantive legitimacy
typically refers to the basic rights held by citizens, individually and collectively.
An initial, unavoidable question is whether a concept such as “legitimacy” can or
should be used to analyze SWF governance. SWFs, after all, are often associated with
non-democratic regimes. A definition of legitimacy premised on democratic rule may
2
See also Peter, F. (2014).

seem inappropriate for the many SWFs which are not sponsored by democracies; indeed,
the majority of SWFs are sponsored by regimes that are not fully democratic. However,
the concept of legitimacy need not be so constrained; it does not necessarily reflect a
binary judgement, in which a regime is either legitimate or it is not by reference to a
common governance metric. This point is particularly salient when considering
autocracies and oligarchies. As Burnell notes, “[M]any autocracies can—do—enjoy some
measure of legitimacy among social groups or strata even while they may possess no
legitimacy at all among other subjects, a fact that is conveniently overlooked by much
present day talk of democracy as a ‘world value’.” (Burnell 2006, pp. 4–5).
As a second and related point, analysis of legitimacy along a continuum sheds
light on governance adequacy and political risk; relative illegitimacy may signal serious
domestic political risk for an SWF. (Grunenfelder 2013, p. 135). Political risk associated
with public funds may flow in two directions: the consequences of an Arab Spring affect
all governmental entities, including SWFs. And, as in Malaysia, political crises may even
develop from the governance failures of a public fund.
Political legitimacy may differ significantly depending on whether a fund has
been created by an autocracy, a democracy, or something in between. Following the
methodology of Barbary and Bortolotti (2012), one can track the connection between
SWFs and the politics of the sovereign creator. Using data compiled by the Sovereign
Wealth Fund Institute (SWFI) and the Polity IV Project, Table 7.2 shows the political
orientation of the SWF sponsor countries of the 15 largest funds in the SWFI database

(organized by size of assets under management), with the Polity Score ranging from –10
(strongly autocratic) to 10 (strongly democratic).3
Insert Table 7.2 here

Table 7.2
Political Orientation of SWF sponsor countries of the 15 Largest Funds in the SWFI
Country Fund AUM Polity Score

Norway Government Pension Fund Global $882 10
UAE–Abu Dhabi Abu Dhabi Investment Authority $773 –8
Saudi Arabia SAMA Foreign Holdings $757.20 –10
China China Investment Corporation $652.70 –7
Kuwait Kuwait Investment Authority $548 –7
China SAFE Investment Company $547 –7
China–Hong Kong Hong Kong Monetary Authority Investment $400.20 –7
Portfolio
Singapore Government of Singapore Investment $320 –2
Corporation
Qatar Qatar Investment Authority $256 –10
China National Social Security Fund $236 –7
Singapore Temasek Holdings $177 –2
UAE–Dubai Investment Corporation of Dubai $175.20 –8
Australia Australian Future Fund $95 10
UAE–Abu Dhabi Abu Dhabi Investment Council $90 –8
Russia Reserve Fund $88.90 4
Primarily because of the low Polity Scores for China and the Gulf States, the largest
funds tend to have much lower average Polity Scores, with the world’s largest SWF—
Norway’s GFGG—as the obvious outlier. Extending this analysis to all SWF sponsor
countries, one sees that smaller funds tend to reside in more democratic regimes.
Insert Figure 7.1 here
3
For a description of the Polity IV dataset and coding conventions, see Marshall, M., Gurr, T.,
and Jaggers, K. (2014).

The fact that many of the largest SWFs are sponsored by autocratic regimes is a
primary concern for some observers focused on the international impact of SWFs. But
what is the connection between an SWF, the political orientation of a given regime, and
the regime’s sovereign fund? A public choice analysis might suggest that in democratic
regimes elected officials would not lock up large sums of money for a long period of
time, but would instead try to spend it in ways that ensure re-election. In autocratic
regimes, the government does not have the same concerns, although the rulers still may
face some pressure to reward an elite group of supporters. In broad terms, however, the
stated purposes, investment policies, and funding mechanisms of SWFs suggest that
SWFs play many of the same domestic political risk mitigation functions for a political
regime regardless of the regime’s political orientation. Nevertheless, significant
differences in political regimes, including the nature of political participation (if any) by
citizens of the regime, necessarily create differences in how the SWF should be expected
to operate. The salient point is that there is not a one-size-fits-all standard of legitimacy
for SWFs; likewise, the purposes for which the fund is created, the manner in which it
contributes to intergenerational wealth or current economic prosperity, and the legal
structure of the fund create important differences in how the fund should be governed. As
discussed below, these differences also suggest that the legitimacy of a fund, as well as
its particular domestic political risks, will vary significantly from fund to fund, regime to
regime.
This chapter proceeds as follows. First, the chapter argues that the concept of
legitimacy is useful as a way of characterizing appropriate entity and political risk
management for a fund, and that, as with state-owned enterprises, SWF legitimacy has

political and corporate dimensions. The chapter then focuses on the procedural legitimacy
of SWFs, and how procedural and governance mechanisms help to mitigate domestic
political risks associated with them. Following this, the chapter turns to a discussion of
structural legitimacy. Here the analysis moves from the what and how of SWFs to the
question of why a fund is created, and how the fund may be used to reflect the values of
polity, again showing how these uses are linked to domestic political legitimacy.
Sovereign Wealth Fund Risk: Political and Entity Dimensions
Examining SWFs through the lens of domestic legitimacy helps identify risks facing
them as both corporate entities and as governmental entities. Thus, legitimacy can be
seen as a risk-management measurement: legitimacy is a necessary characteristic of well-
managed SWFs. Because legitimacy is a function of the public’s opinion of the SWF,
however, legitimacy is not a sufficient characteristic of a well-governed fund; a fund may
be a whited sepulcher, deceptively appearing to be well managed from the outside, but in
reality proving to be corrupt and poorly governed when it is inspected more closely.
Legitimacy for SWFs is complicated by the fact that they present risks not merely
as political agencies, but as business entities, and so to analyze SWF risk one must
consider it as both a political and business entity. Although legitimacy has been primarily
used as a political concept, Coglianese (2007) shows that legitimacy can be usefully
applied to analyze corporate entities as well. In his view, the corporate law parallels are
clear: “What is called corporate governance is akin to procedural legitimacy . . . What is
the substantive legitimacy parallel? It is corporate regulation.” In this regard,
“[r]egulation imposed by government says that even properly constituted corporations

with fully functioning boards of directors (a test of procedural legitimacy) cannot take
actions that will pollute the environment, treat their workers badly, or take money from
investors” (Coglianese 2007, p. 162).
SWFs are entities operating within a political system—that is, from the
perspective of domestic constituencies, successfully-governed SWFs should be politically
legitimate entities—and yet are also entities typically operating as quasi- (or more fully)
independent business entities, subject to the same standards of entity legitimacy as other
business entities. Thus, SWFs should be expected to exhibit corporate legitimacy and
political legitimacy. Although in most cases the governance imperatives of either form of
legitimacy should correlate—for example, accountability is a virtue in both political and
corporate entities—there will also be instances in which the imperatives of one form of
legitimacy may predominate, the legitimacy of one form conceding to the imperatives of
the other form. For instance, transparency may be more important to the political
legitimacy of the SWF, particularly when the SWF sponsor nation is a democracy with a
strong tradition of transparency in governmental activities. However, transparency can
create difficulties for the SWF as a corporate entity, particularly where the tensions
between the SWF as a political actor and corporate actor are acute.
Tensions are apparent, for example, in the compensation arrangements of a
related type of entity, US public pension funds. With these funds, as compensation
arrangements for public fund officials are disclosed (as they often must be through public
disclosure laws regarding compensation for public servant pay), there is often strong
resistance—ironically, often from those who would most benefit from high quality
investment talent—if the compensation is even a significant fraction of what the official

could receive in a similar role for a private entity. This makes hiring talented officials
more difficult, and often results in the outsourcing of investment activity to external
managers, who often charge significantly more in management fees for results that could
be obtained as reliably in-house. However, this is not to argue that there should be no
transparency in compensation arrangements for SWF officials. Indeed, corporate
executives in most jurisdictions are required to provide significant disclosures about their
compensation. SWFs though, just like pension funds, must often face the difficulty of
explaining compensation arrangements for fund officials as public officials, all while
competing for and with private entity talent. Trade-offs are unavoidable when entities
have a foot in both the public and private spheres.
SWFs are like state-owned enterprises in that they have all of the standard
governance risks of the corporate entities, including the importance of transparency of
operations to the owner, the need for accountability, and the importance of compliance
with established procedures and governmental regulations (both of the sponsor country
and the countries in which the fund does business). However, they also have risks as
political entities, including the need to protect the fund from political interference, the
special risks that come from having a state entity engage in private markets (such as the
possible use of material, non-public information acquired through governmental
investigations, filings, or other governmental actions), and the risk of corruption, all of
which affect the legitimacy of the SWF. In the following section, we turn to the
procedural legitimacy of SWFs and how legitimacy is connected to domestic political
risk.

The Procedural Legitimacy of a Sovereign Wealth Fund
Procedural legitimacy, when applied to an agency of a government or other governmental
body, implies, inter alia, “that the agencies are created by democratically enacted
statutes, which define the agencies’ legal authority and objectives; that the regulators are
appointed by elected officials; that regulatory decision making follows formal rules,
which often require public participation; that agency decision must be justified and are
open to judicial review” (Majone 1996, p. 291). In basic terms, legitimacy depends on the
governmental instrumentality being created and governed according to the rule of law.
Legitimacy also depends on general principles—applicable to both business entities and
political entities—of accountability, transparency of proceedings and agency activities (at
least to the sovereign, if not to the public at large), and power-limiting or power-sharing
structures.
This section will focus particularly on the foundational concepts of accountability
and transparency, both of which implicate corporate and political legitimacy. We then
turns to two prominent instances of procedural governance failure—Malaysia’s 1MDB
fund and Equatorial Guinea’s Fund for Future Generations—and how these contributed
to both entity and political illegitimacy.
Accountability and Transparency
Accountability is a core component of entity governance; corporate codes and governing
documents, such as articles of association or incorporation, are replete with mechanisms
imposing accountability on managers and directors. Likewise, accountability has been
identified as a key issue in SWF governance, both as political and business entities.

Gelpern (2010), for example, identifies four types of accountability for SWFs: public
internal accountability, private internal accountability, public external accountability, and
private external accountability. The first two are particularly useful to the analysis here,
as they relate to the legitimacy of SWFs as domestic political entities and as domestic
business entities. Public internal accountability quite simply refers to the necessity of the
sovereign fund to be accountable to the sovereign itself: “The state may be democratic, in
which case SWFs answer to elected officials, or not, in which case they might answer to
the monarch and her five cousins” (Gelpern 2010, p. 25). Clark, Dixon and Monk have
noted that public support for Norway’s Government Pension Fund-Global (GPFG)
“depends upon the process whereby the public interest in its decision-making is
governed” (Clark, Dixon, and Monk 2013, p. 83). The GPFG’s legitimacy also flows
from its public accountability mechanisms, “represented by the Minister of Finance and
the accountability of the Minister to government and ultimately Parliament. This process-
based claim of institutional legitimacy has been quite successful” (Clark, Dixon, and
Monk 2013, p. 83).
Private internal accountability refers to SWFs’ duties to a subset of shareholders,
creditors, or other stakeholders, which stem predominantly from their charters and
contracts. The tension between these two spheres of accountability may develop where,
for example, “a fund formed to save for future generations is raided to advance unrelated
strategic goals” (Clark, Dixon, and Monk 2013, p. 83).
The concern with accountability is also reflected in several places in the Santiago
Principles, including in:

Principle 1. The legal framework for the SWF should be sound and support its
effective operation and the achievement of its stated objective(s).
Principle 1.1. Subprinciple. The legal framework for the SWF should ensure legal
soundness of the SWF and its transactions.
Principle 1.2. Subprinciple. The key features of the SWF’s legal basis and
structure, as well as the legal relationship between the SWF and other state
bodies, should be publicly disclosed.
Principle 6. The governance framework for the SWF should be sound and
establish a clear and effective division of roles and responsibilities in order to
facilitate accountability and operational independence in the management of the
SWF to pursue its objectives.
Principle 10. The accountability framework for the SWF’s operations should be
clearly defined in the relevant legislation, charter, other constitutive documents,
or management agreement.
“Accountability” and “operational independence”, as noted in the Santiago Principles,
need not conflict in theory, although there are often unavoidable tensions in practice.
Accountability in the context of an SWF means that the managers of the fund are
accountable to the sovereign for the fund’s performance. Operational independence may
be unaffected by this accountability; the fund managers may operate independently, and
it is only after poor performance that the managers face accountability. However, to the
extent that the general polity exerts pressure on public officials with respect to fund
performance—and particularly expected where the polity has much at stake with the
performance of the fund, as with the payment of a dividend to citizens of Alaska based on

the performance of the Alaska Permanent Fund—public officials may correspondingly
pressure fund managers in ways that jeopardize their independence.
Accountability with sovereign funds is also complicated when the SWF does not
have a “single bottom line”, but is operated for a variety of public purposes, some of
which may be difficult to quantify. Indeed, if an SWF’s purposes include difficult-to-
quantify imperatives, standard business entity accountability mechanisms may be
counterproductive. This concern is reflected in the Santiago Principles, Principle 2, which
simply states that “the policy purpose of the SWF should be clearly defined and publicly
disclosed.”
Clear disclosure of fund purpose should also be coupled with financial reporting
reflecting fund purposes. As Capalbo and Palumbo (2013) argue with reference to state-
owned enterprises, “the financial reporting model SOEs derive from their legal form need
then to be integrated and adapted to reflect the different control and information needs
generated by the public nature of purposes pursued and resources used” (Capalbo and
Palumbo 2013, p. 46). They offer suggestions that are equally applicable to SWF
reporting, including offering a Statement of Intent to the financial statements “to describe
the non-business-like purposes of the company and the levels at which they have been
achieved,” and adapting the financial reporting model “to reflect the enlargement that the
use of public funds generate in the accountability chain” (Capalbo and Palumbo 2013, p.
46). Another important difference with SWF reporting is that, as long-term investors,
SWFs should provide appropriate context for their performance, including appropriate
benchmarks that reflect long-term metrics as opposed to short-term equity market
performance. Providing transparency with respect to fund purposes and appropriate

benchmarks helps increase legitimacy and decrease the risk of the public misinterpreting
fund performance.
Transparency also functions to reduce what in a corporate governance context are
referred to as “agency costs,” including tunneling and rent-seeking. By reducing these
costs, transparency thus helps increase legitimacy and reduce governance and political
risks. As Gelpern writes, “transparency can expose internal accountability tensions. A
transparent SWF set up to maximize financial returns may have to forego opportunities in
politically unpopular sectors or countries to maintain public support” (Gelpern 2010, p.
25).
Transparency does not simply reduce the risk of intentional harms to the fund, but
also reduces the risk of negligence. Transparency of operations, which includes
transparency of governance structures and decision-making processes,4 reduces
negligence as fund managers recognize that both the decision-making process and the
ultimate decision will require justification before the sovereign and, perhaps, the polity.
Again, in terms of agency costs, transparency and accountability help to reduce the costs
of negligence through shirking and poor decision-making, as well as reducing the
likelihood of intentional actions such as rent-seeking. To varying degrees, all of these
costs pose political risks to the fund and the sovereign.
4
Public disclosure of decision-making process and operations more generally will, of course, be
somewhat limited compared to the disclosure provided to the sovereign itself.

1MDB and the FFG: Case Studies in Procedural Legitimacy and
Political Risk
Despite most of the fears about the use of SWFs as neo-mercantilist tools, they are at
least as likely to be used for nefarious domestic purposes as nefarious international
purposes. In the simplest form of this type of corruption, SWFs can be used to buy votes
or reward supporters. Although it has been argued that SWFs serve as a tool for smaller
states to preserve autonomy through outsized influence in the financial markets (Dixon
and Monk 2010), SWFs can also be part of a much more common scheme of political
patronage, and thereby decrease domestic legitimacy.
An important, cautionary example of procedural illegitimacy comes from the
recent scandal involving not a true sovereign wealth fund, but the sovereign development
fund 1MDB.5 1MDB was created to drive “the sustainable long-term economic
development and growth of Malaysia” (1MDB 2014). The fund engages in a variety of
energy and real estate projects, often serving as a catalyst and partner for foreign
investment. 1MDB is, for example, the master develop of the Tun Razak Exchange
financial district in Kuala Lumpur, and is developing land around the Sungai Besi airport
5
As a general matter, sovereign development funds (SDFs) may present more domestic political
risk in that they can be more easily (or at least more directly) used for rent-seeking activity than a
sovereign wealth fund. SDFs typically invest a portion, if not all, of their assets within the
country. As the name implies, the goal of an SDF is to spur development of the country, a region,
and/or other countries. SWFs, on the other hand, typically invest abroad for macroeconomic
purposes or to provide for intergenerational equity. The risk of political corruption through
improper “investments” in domestic companies is thus higher with SDFs.

into “a new urban mixed-use development that we envisage will serve as a benchmark for
sustainable communities in the region” (1MDB 2014). The fund has also invested in
desalination plants and power plants.
1MDB is not funded directly by the government; the fund managers claim to have
received only RM1 million in equity from the government. It primarily obtains funding
through local and international debt offerings (although, as discussed below, these too
have raised serious questions). The fund has incurred large debts through its business
activities, and was forced to reschedule debt payments in 2015, in addition to receiving
$1 billion from an Abu Dhabi state fund. The Wall Street Journal reports that 1MDB
played a role in financing Prime Minister (and Finance Minister) Najib Razak’s re-
election campaign. 1MDB allegedly made overpriced purchases from a subsidiary of
Genting Group, which then made a donation to a charity called Yayasan Rakyat
1Malaysia (YR1M). Najib stated during his re-election campaign that YR1M would
donate a large amount of money to certain schools, which many interpreted as simply a
form of vote-buying.
The Wall Street Journal also reports allegations that 1MDB funds flowed into
personal accounts controlled by Najib or his friends and family. According to the
Journal, 1MDB received a loan from PetroSaudi as part of a joint venture arrangement,
and set up a loan repayment program for 1MDB to pay back the loan. Payments of $700
million, $160 million and $300 million were made in 2009, 2010, and 2011, respectively,
to a company called Good Star Limited, controlled by an infamous associate of Najib—
Jho Low. Low claimed that Najib controlled the disposition of the funds, stating, “Guys,
it’s very simple, there’s a board, who’s the shareholder? . . . Are you telling me the prime

minister doesn’t make his own decisions? No one seems to ask the question who is the
ultimate decision-maker on 1MDB? No one asks that. No one ever asks about the
shareholder’s role” (The Malaysian Insider 2015).
Frank (though self-serving) comments such as this undoubtedly raise concerns
with regulators tasked with evaluating investment activity by state-controlled funds and
enterprises. Indeed, the purpose of governance efforts such as the Santiago Principles is
to reduce the risk and fear that funds could be used as vehicles for corruption. The
comments also highlight a peculiar tension with SWFs, SDFs and other government
funds: in an era of shareholder activism, where fiduciary owners, particularly, are
expected to be vigilant defenders of the interests of their beneficiaries, how can state-
owned funds at once be active owners yet reassure regulators and portfolio companies
that the fund will only pursue appropriate goals and use its power as a shareholder in
appropriate ways? The answer lies in fund governance and procedural legitimacy, just as
the answer to political corruption generally lies in a procedural system that protects
against rent-seeking, pay-to-play, and other forms of corrupt market distortions. As
discussed above, procedural legitimacy in the context of a sovereign fund includes,
among other things, a clear purpose for the fund and rigorous adherence to the investment
policies that enact that purpose. Accountability, transparency, and robust auditing, as
with other business entity forms, ensure that investments have been made according to
policy.
1MDB does not merely provide lessons about political corruption and political
legitimacy. It is also a case study of a failure of business entity legitimacy. As might be
expected from a fund that has such a large governance and legitimacy failure, the

Frequently Asked Questions section on its website reveals a fund that has been dogged
with questions over numerous “smaller” governance failures over the years, including the
use of offshore accounts, fees paid to investment bankers (particularly Goldman Sachs),
accounting treatment, and acquisition of certain assets and contracts. Regardless of
whether the underlying accusations are true, the fact that 1MDB must publicly defend
against such accusations signals a failure of legitimacy of the fund, arising from
inadequate transparency and poor accountability mechanisms. Because 1MDB is a
sovereign fund, this failure of entity legitimacy is also accompanied by a domestic
political crisis.
The small but oil-rich country of Equatorial Guinea also provides important
lessons on the importance of governance and procedural legitimacy. Equatorial Guinea
started large-scale production of its hydrocarbon resources in 1996, and a large majority
of the government’s revenues are derived from these resources. Equatorial Guinea’s
governance structures were not equipped to handle the flow of vast amounts of new
wealth into its governmental finance structure, however; the effect seemed like attaching
garden hose governance to fire hydrant resource flows: much of the value from the
resources appear lost to corruption.
With a view to ensuring that some of the resource windfall was received by the
citizens rather than collected and distributed only to the ruling elite, Equatorial Guinea
was advised to create an SWF. It accomplished this in 2002 with the creation of the Fund
for Future Generations (FFG). In what was an important governance decision, the
government agreed to send funds for the FFG to an African regional bank, the Bank of

Central African States (BEAC); Equatorial Guinea could thus be seen as leveraging
regional governance as a means of overcoming its own limited governance capabilities.
The World Bank noted problems with the arrangement, however, as the
government had difficulty identifying and segregating assets from various sources. (Toto
Same 2008). One commentator noted that “government’s statistics on money held at the
BEAC appear to present global figures rather than a breakdown, suggesting that the
money could be spent without safeguards—and that the rhetoric behind the initiative is
designed to satisfy an external constituency while the substance of policy and practice on
the ground effectively remains little changed” (Goldman 2011, p. 9).
Equatorial Guinea’s FFG offers a reminder that while SWFs can be used to help
mitigate domestic political risks, they do not themselves confer strong procedural
legitimacy; indeed, they can create risks of illegitimacy unless they benefit from
institutionalized procedural safeguards. As Monk has noted, “[a]n SWF is not a
mechanism to bypass weak institutions and poor governance at the local level. Rather, it
should be the manifestation of these effective institutions and good governance” (Monk
2012).
The Substantive Legitimacy of Sovereign Wealth Funds
SWFS, like other government-owned enterprises and funds, will reflect the legitimacy of
the sponsor government. It is less likely (though, if the fund is structurally independent,
certainly not impossible) that a sovereign fund will be considered to be procedurally
legitimate even if the sponsor government is not. However, one can imagine some level
of procedural legitimacy simply as a tool used to decrease host country fears about an

SWF. In this way, reduced domestic political risk may be a positive spillover effect of
legitimacy-enhancing procedures designed to reduce international political risk.
Substantive legitimacy also effects how the SWF is perceived internationally, but because
the question of substantive legitimacy implicates the purpose and values of an SWF, it is
of greater importance domestically.
Substantive legitimacy, as described above, refers to the basic rights held by
citizens. Broadly speaking, a fund that is substantively legitimate should reflect the basic
values of the citizens, to the extent that the SWF is managed for the benefit of the citizen.
Fund legitimacy is linked to fund purpose, not merely because the fund is a governmental
instrumentality; funds are subject to the same legitimacy constraints that should guide the
behavior of all government agencies. However, SWFs sometimes serve as much more
than a just a governmental agency: they can be understood as the projection of domestic
public policy through private markets (Cata-Backer 2010), and as a savings vehicle for all
of a country’s citizens. Each citizen, then, has a stake in the purpose and legitimacy of the
SWF in a way that she or he might not in, for example, a state-owned company.
Countries create SWFs for a variety of reasons, and in many cases funds are
created for multiple reasons. Justifications for funds are as different as the economic and
political environments of each sponsor country, and the justifications described below
should be understood as complementary, rather than competing, explanations for the
existence of SWFs.
The Public Purposes of Sovereign Wealth Funds

Numerous academics, politicians, regulators and sovereign fund managers have
explained SWFs from various perspectives, including financial and economic, foreign
policy, and domestic political justifications. Non-commodity funds, such as the China
Investment Corporation, typically start life for financial purposes. As Kimmitt (2008)
summarizes, these SWFs are funded through excess foreign exchange reserves: “[l]arge
balance-of-payments surpluses have enabled noncommodity exporters to transfer ‘excess’
foreign exchange reserves to standalone investment funds that can be managed for higher
returns” (Kimmitt 2008, p. 121). Other kinds of non-commodity funds are created as “an
exchange-rate intervention involving a domestic liquidity increase that has to be absorbed
by issuing domestic debt to avoid unwanted inflation” (Kimmitt 2008, p. 121). These
funds operate as a kind of “SWF carry trade” as they attempt to earn more on their
investments than they must pay on their domestic debt.
Funds may also shift purposes over time, from purely financial purposes to a
broader role within the sponsor country. For example, many SWFs formed by capturing
funds generated by commodity exports—most commonly oil and gas—have developed
additional roles beyond their original financial purpose. As Kimmitt states, “[t]hese funds
serve different purposes, including fiscal revenue stabilization, intergenerational saving,
and balance-of-payments sterilization (that is, keeping foreign exchange inflows from
stoking inflation). Given the current extended rise in commodity prices, many funds
initially established for the purposes of fiscal stabilization or balance-of-payments
sterilization have evolved into intergenerational savings funds” (Kimmitt 2008, p. 120).
SWFs may also reduce the dependence of the economy on a single export such as oil or
liquid natural gas (LNG). As put in a report urging the creation of an SWF in the UK,

“[SWFs] help to protect the economy against the high volatility of resource prices and the
unpredictability of extraction. Resource-rich countries can reduce their dependence on a
single commodity by investing the returns in a greater range of industries. In doing so,
they can create a more complex infrastructure and a greater number of jobs on a national
scale” (Wedmore 2013, p. 7).
SWFs can also provide for a more stable economy because they can serve as a
mechanism for financial infrastructure transfer for an economy. For example, SWFs can
be thought to serve as a mechanism to acquire investment expertise that would enable an
SWF to make its own investments. A natural progression of this explanation is that SWFs
first hire external managers, then perhaps “internalize” external manager expertise
through secondment arrangements, then perhaps begin to co-invest with an external
manager as a co-principal. Finally, the SWF may invest on its own as a sole principal,
and, as has happened with the Ontario Teachers’ Pension Plan fund, the fund may even
act as a general partner and invest on behalf of other limited partners, including other
SWFs. Less discussed, however, is the importance of the larger financial ecosystem that
allows such deals to take place, including the importance of highly experienced and
skilled attorneys and accountants. These professionals are key players in every significant
investment, and as SWFs grow in size and become more active in international financial
markets, such service providers compete for SWF business. As service providers open
offices in new financial centers (perhaps in part to be near new SWFs), and as SWFs
complete deals staffed by the most experienced and sophisticated service firms, the firms
also provide important network effects. Indeed, it is likely that many service firms would

not maintain offices in far-flung locations such as Doha were it not for the presence of an
SWF with a regular stream of deals to be managed.
Another possible positive effect, besides the positive network effect of
professional service firms operating in developing economies, is the possibility of other
kinds of “professionalism” transfer. Much of this occurs as professionals from, for
example, China, who have been educated and trained in large financial centers return to
work for SWFs of SWF service providers in their home countries. Foreign professionals
may also train native SWF employees, who may in turn leave the SWF to work in other
enterprises. And, of course, other kinds of knowledge transfer may occur as SWFs learn
about and invest in technology-driven companies. Some have feared that the government
of the SWF could use such information to gain military advantages or to compromise the
security of the portfolio company’s home country. However, with national security
restrictions in place around the world prohibiting investments of appreciable size by
state-controlled entities such as SWFs, the more likely outcome of such SWF investment
activity and knowledge transfer is that it could be used in domestic (SWF home country)
industry.
Dixon and Monk ( 2010) add a political dimension to these financial
justifications. They argue that SWFs must be understood within a broader context of the
evolving nature of sovereignty in an era of increasing globalization and financialization.
SWFs “reflect the recognition on the part of nation-states that their economic and social
wellbeing has become dependent on, or at least vulnerable to, the functioning of foreign
markets and the behavior of foreign countries and firms” (Dixon and Monk 2010, p. 27).
Some sovereigns have recognized that they suffer from what Dixon and Monk term a

“sovereignty deficit”, thus necessitating the need to use financial power to preserve and
even expand their sovereignty. They conclude that “the rise of SWFs is symptomatic of a
new economic and political reality; they demonstrate that 21st-century global capitalism
favors the holders of financial assets over simply the domestic institutions and
macroeconomic circumstances of western countries” (Dixon and Monk, 2010 p. 27).
Hatton and Pistor seek to amend Dixon and Monk’s explanation by recasting
SWFs not as tools of state sovereignty, but as tools of elites within a sovereign state:
We argue that the true stakeholders in the SWFs analyzed in this paper are
the ruling elites in the sovereign sponsor, and that as such, it is the
interests of these elites that SWFs advance. To these elites, SWFs serve as
a valuable tool for protecting their interests. Limiting the interests of the
ruling elite to state sovereignty, as would be necessary to justify a singular
focus on sovereignty-maximization, appears to miss the complex
geopolitical and geoeconomic conditions to which these elites feel
compelled to respond. In fact, one can point to instances where the elites
have been quite willing to compromise on their monopoly on the
legitimate use of force within state borders (the key aspect of Westphalian
sovereignty) but not control over SWFs (Hatton and Pistor 2011, p. 13).
These financial and political uses of SWFs reduce political risk by creating a more stable
and secure political state and economy. Note, however, that a more stable system does
not necessarily mean a more legitimate political system, as seems the case with
Equatorial Guinea. Indeed, as elites use an SWF not just to project power but to reward
domestic and foreign rent-seekers, an inevitable issue arises: What happens when the

flow of funds dries up? This issue seems particularly salient as low oil prices have
dramatically reduced revenues for many countries. In such a case, what may have seemed
a stabilizing governance strategy becomes a political risk as rent-seekers become
dissatisfied with decreased rents.
SWFs are also used as tools to promote intergenerational justice, and it is this use
that presents the greatest risk and reward for the SWF. Many SWFs, and particularly
those whose funds are derived from natural resource wealth, are explicitly set up in order
to ensure that wealth from present extraction operations is available for future
generations. There are other, equally important intergenerational conflict issues, however,
that SWFs can help resolve. As Cappelen and Urheim (2012) explain, “There is a direct
link between intergenerational justice and the size of these funds because these funds
represent private and national savings. Future generations benefit from high savings
today because high savings imply less consumption by the current generation and more
investment that will benefit the future generation” (Cappelen and Urheim 2012, p. 3).
However, they also identify a second, indirect link between SWFs and
intergenerational justice: the growth of SWFs means that “these funds potentially get
more influence as owners,” and that the funds can use this influence to affect the
development of the world economy. They argue that SWFs and public pension funds can
use their influence to reduce what they refer to as “intergenerational externalities,”
defined as “the unintended consequences on future generations of decisions made today”
(Cappelen and Urheim 2012, p. 4). Corporations may create intergenerational
externalities when they take actions that may not have a large present impact—and are
thereby not taken into account by corporations (and, one might add, by regulators)—but

have a significant negative impact on future generations. For example, “[e]missions of
greenhouse gases due to human activities alter the atmosphere in ways that are expected
to affect the climate. The cost of climate change will be primarily carried by future
generations” (Cappelen and Urheim 2012, p. 4). Applying a legitimacy analysis to the
reduction of intergenerational externalities is complicated by the obvious fact that
legitimacy is a concept attached to present sentiment about the government and its
instrumentalities, and it is not always clear that present public opinion will support efforts
to reduce uncertain future harms. Indeed, the rancorous arguments about how to tackle
complex problems such as climate change suggest that it is politically risky for a fund to
press too strongly on issues without a clear public consensus. This is not to say that
measures designed to tackle negative intergenerational externalities are not justified, but
merely to acknowledge the relationship between fund purpose and legitimacy. The
difficulties in managing this relationship will now be explored, focusing on Norway’s
Government Pension Fund-Global.
Sovereign Wealth Funds as an Extension of Public Values: Norway’s
GPFG and Substantive Legitimacy
As would be expected from a governance framework designed to assuage host country
regulators as much as to guide sovereign investors, the Santiago Principles contemplate
investment focused on financial returns. For example, Principle 19 states that “SWF’s
investment decisions should aim to maximize risk-adjusted financial returns in a manner
consistent with its investment policy, and based on economic and financial grounds,” and
deviations from this orientation “should be clearly set out in the investment policy and be

publicly disclosed.” Likewise, Principle 21states that if an SWF chooses to exercise its
ownership rights, “it should do so in a manner that is consistent with its investment policy
and protects the financial value of its investments. The SWF should publicly disclose its
general approach to voting securities of listed entities, including the key factors guiding
its exercise of ownership rights.”
Norway goes beyond the financial orientation promoted by the Santiago
Principles (Cata-Backer 2013), as least as far as the term “financial” is reflective of
easily-quantified returns on investment (one could argue, of course, that a focus on
environmental, social and governance (ESG) issues contribute to better returns, not just in
the long term but also in the short term; however, the long-term effects of ESG efforts are
difficult to quantify, and the short-term effects are typically negative) (Eccles and
Serafeim 2013).
Given their portfolio size, Norway has a unique opportunity to affect the
corporate governance of many companies, particularly across Europe and in North
America. Generally, Norway uses its power in two ways. First, and quite notably,
Norway may decide to exclude certain companies from the available pool of investments,
based either on the products the companies make or on the way that the company is
operated.6 Product-based exclusions include companies that:

6
Norway recently reformed the Council on Ethics as part of a broad governance reform at the
GPFG (and, in part, because of the recommendation of the panel noted above).
At the beginning of 2015, the Ministry of Finance issued revised guidelines for
observation and exclusion from the fund and five new members were appointed
to the Council on Ethics. This annual report has been prepared by the outgoing
Council. The criteria for observation and exclusion from the fund remain the

a) produce weapons that violate fundamental humanitarian principles through
their normal use;
b) produce tobacco; and/or
c) sell weapons or military materiel to states that are subject to certain investment
restrictions (such as trade embargoes).
Norway may put companies under observation or may exclude investment if there is an
“unacceptable risk that the company contributes to or is responsible for”:
a) serious or systematic human rights violations, such as murder, torture,
deprivation of liberty, forced labor and the worst forms of child labour;
b) serious violations of the rights of individuals in situations of war or conflict;
c) severe environmental damage;
d) gross corruption; and/or
e) other particularly serious violations of fundamental ethical norms.
Currently more than four dozen companies, including Airbus, WalMart, Rio Tinto and
Textron, have been excluded from Norway’s sovereign fund portfolios.
Second, Norway provides an interesting study not just because of its exclusion
list, which deservedly gets a large amount of attention from the press, but also because of
same. The Council on Ethics previously advised the Ministry of Finance. Under
the revised guidelines the Council will advise Norway’s central bank, Norges
Bank, which will decide whether or not to exclude companies or place them
under formal observation1. One of the objectives of changing the guidelines is to
achieve better coordination of the work on exclusions and active ownership.
(Council on Ethics for the Government Pension Fund Global 2008, p. 8, accessed
at http://etikkradet.no/files/2015/01/Council-on-Ethics-2014-Annual-Report.pdf

its active efforts as a shareholder. In the US, this engagement manifests itself primarily
through active proxy voting and, occasionally, behind-the-scenes negotiations with
company management. Rarely, when companies are not responsive to shareholder
concerns, Norges Bank Investment Management (NBIM) may make a formal shareholder
proposal. In the last five years, NBIM has made nine such proposals (see Table 7.1).
Insert Table 7.1 here

Table 7.1
Norges Bank Investment Management formal shareholder proposals (2010–2014)
Year Company Proposal As Percentage of Votes

Cast
For Against Abstain
2010 Constellation Energy Independent Board 18.3% 81.3% 0.4%
Group, Inc. Separate Chair-CEO
2012 Charles Schwab Adopt Proxy Access 30.9% 68.9% 0.2%
Corporation
2012 CME Group Inc. Adopt Proxy Access 37.8% 61.8% 0.4%
2012 Wells Fargo & Company Proxy Access 32.3% 67.3% 0.4%
Adopt
2012 Western Union Company Adopt Proxy Access 33.4% 66.2% 0.4%
2013 Charles Schwab Adopt Proxy Access 31.5% 68.0% 0.5%
Corporation
2013 CME Group Inc. Adopt Proxy Access 32.8% 67.0% 0.2%
2013 Staples, Inc. Adopt Proxy Access 36.7% 62.8% 0.5%
2014 UMB Financial Corporation Independent Board 14.9% 84.6% 0.5%
Separate Chair-CEO
Because shareholder proposals are precatory under US law, a majority vote in
approval does not bind a board to act. Furthermore, given the relatively small positions
held in any single company (limited by law to less than 10%, (NBIM 2015) and in
practice typically much lower), the financial impact will likely be negligible, even
assuming that the proposal has an impact. Norway’s activism thus begs the question:

Why engage in such activism, when it is both merely episodic and not likely to make a
significant impact on the portfolio? For example, suppose that Norges Bank sponsors a
shareholder proposal for Charles Schwab, as it did in 2013. As of the end of 2013, the
GPFG owned approximately $80 million worth of Charles Schwab stock. And, as of the
end of 2013, the GPFG had a market value of approximately $830 billion. The
investment in Charles Schwab thus represents less than 0.01% of the GPFG, and so any
change in the value of Schwab is immaterial to the overall value of the portfolio.
This question is part of a bigger debate that has been the subject of a large amount
of research among finance and legal scholars: Does shareholder activism produce
shareholder value? In recent years the debate has primarily turned to the value of hedge
fund activism, which, as it turns out, tends to result in not only a positive stock price
impact, but also improved financial performance over longer time periods. Recently, for
example, Bebchuk, Brav, and Jiang (2015) find that shareholder activist interventions are
followed by improved operating performance during the five-year period following the
intervention. They also find no evidence that the initial strong positive stock price impact
following activist interventions fails to take into account the long-term effects of such
interventions.
More specific to the type of defensive activism engaged in by Norges Bank
shareholder proposals, several recent papers also identify a positive impact from such
activism. Bach and Metzger (2014) find, for example, that majority-supported shareholder
proposals generate positive shareholder returns, which they attribute not necessarily because
their content has intrinsic value, but because they increase pressure on the board of directors
(Bach and Metzger 2014). Similarly, Cuñat finds that increasing shareholder “voice” in
corporations through say-on-pay rules leads to a 7% increase in market value, as well as

increases in firm profitability and firm performance (Cuñat, Gine and Guadalupe 2013).
Cunat, Gine and Guadalupe (2010) also find that adoption of shareholder proposals on
governance matters leads to significant positive abnormal returns.
In the case of Norway (and with other very large investors), such activism is
justified for several reasons. As Hawley and Williams (2000) have argued, investors such
as NBIM are “universal owners”—and, given the size of the GPFG there is perhaps no
investor more “universal” than NBIM—who cannot escape bad governance by
diversifying. This is particularly true as Norway limits its scope of potential investments
through ethical considerations. When a fund has nearly a trillion dollars to invest, it looks
for value wherever it can find it. Thus, if the fund can enhance value of its current
investments through activism with a positive return on investment (ROI), it should do so.
And the larger the amount invested in a particular company, the more incentive the fund
has in engaging in corporate governance-enhancing activism. Further, it is also the case
that other investors are more likely to support corporate governance-enhancing activism
by large investors such as NBIM and SWFs because as the percent invested in the
portfolio company increases, the more value the fund is likely to obtain through improved
performance as opposed to private benefits from firm influence.7 Thus, other investors
7
There is a tension between economic incentives of ownership and the legal rules designed to
limit control and influence, such as the rules imposed through the US Foreign Investment and
National Security Act (FINSA), which tend to limit the amount of investment a fund may make to
a non-controlling and even non-influential percentage. From an economic perspective, a
significant minority shareholder can have an important effect in limiting managerial agency costs
through more active oversight. It is the very fact that the investment is large enough that makes
the minority investor determine it is worth the effort to actively monitor the firm. However,

will tend to support proposals coming from larger investors, or from investors proposing
governance arrangements that empower larger investors, as opposed to empowering
smaller investors (Rose 2014). There is, then, a plausible (if not strong) financial case for
governance activism from large investors such as SWFs. In addition, by engaging instead
of remaining passive, large public investors can drive the governance agenda towards a
more long-term, sustainable orientation.
Norway offers another reason for engaging in such activism, however: the
legitimacy of the GPFG is linked to the way in which the fund’s financial power is
exercised. The Norwegian Ministry of Foreign Affairs, in a report to the Norway’s
legislature, stated,
The Government expects enterprises in which the state has ownership
interests to actively follow up social responsibility in their activities . . .
[C]ompanies in which the state has ownership interests should take the
lead in exercising social responsibility. The . . . state’s legitimacy could be
weakened, for example as legislator and in matters concerning foreign
policy, if, in its role as owner, it failed to comply with high standards in
this area (Norway Ministry of Foreign Affairs 2009).
FINSA encourages smaller investments by public investors because it imposes significantly
higher transaction costs for deals involving “influential” amounts of ownership, even when the
stock ownership amounts to 5% or less of the company. Furthermore, other US laws, such as
regulations designed to limit insider trading, (e.g. Section 16 of the 1934 Act) also discourage
larger block investments by imposing reporting requirements and effectively restricting some
types of trades for investors owning 10% or more of a company’s stock.

The difficulty faced by fund owners such as Norway, which acknowledges that
legitimacy is tied to more than the financial returns offered by the fund, is to reconcile the
sometimes shifting view of what constitutes “legitimate” ownership with fund policies.
For example, ten years ago a fund may have had relatively less pressure to consider ESG
issues generally, and specific concerns within the sphere of ESG, such as the need for
multinational tax reform, were not widely acknowledged as serious issues. Likewise, as a
new government takes office (if, as in a democracy, a new party takes control of the
legislature, or a new generation of leaders takes control of a sovereign in the case of a
monarchal government), there may be shifts in the scope of legitimate activity, and the
new government may believe that they have a mandate to change direction entirely; in
other words, legitimacy is a fluid concept, particularly in democracies where the
government operates under a high standard of accountability. For this reason, even funds
such as Norway’s tend to stay on rather safe political ground of financial returns, which
operate as a lowest common denominator for fund legitimacy. They may engage in ESG
efforts, but even these tend to be couched in either performance-related explanations, or
as exclusions of companies that are viewed as illegitimate investments.
With respect to company exclusions, Norway’s legitimacy calculation is
somewhat similar to Sharia-based exclusions used by certain funds. Just as non-Sharia-
compliant companies would not be legitimate investments to the citizens or powerful elite
in predominantly Muslim countries, so are certain arms-manufacturers (for example)
illegitimate investments for the GPFG. Almost no set of investors would accept financial
returns at any ethical price. Sovereign fund managers and ethics committees should (and
most likely do) make such legitimacy calculations with each investment and each

investment mandate. This is not to say, of course, that every Norwegian agrees with all of
the suggestions made by the Council of Ethics. Robust and continuous debate is to be
expected on investment policies.
Investment limitations such as Sharia-compliant investment and Norway’s
exclusion list teach an important lesson about legitimacy: substantive legitimacy for
SWFs tends to be defined negatively. Just as a body is “healthy” if it is free from disease,
so a fund may be “legitimate” if it does not hold illegitimate investments. This is perhaps
an unwelcome observation for those who would have SWFs positively define themselves
as ESG investors that aggressively pursue investments and governance changes that, for
example, reduce intergenerational externalities. However, beyond the idea that a fund
should maximize returns, it is difficult to achieve popular and political consensus on the
types of objectives a fund should pursue. This recognition suggests that although some
public funds may devote a small segment of their portfolio to pursuing purely ESG
objectives, such as green investments, most funds will not have any such objectives. To
the extent that funds have any non-financial considerations in their mandates at all, the
consideration will be whether to exclude certain investments, rather than explicitly
include certain investments.
This hypothesis is borne out in the publicly-disclosed policies of the largest
SWFs. A review of the policies of the 26 largest SWFs shows that while ESG exclusions
and requirements to “consider” ESG factors are relatively uncommon, ESG mandates are
unheard of (Rose, 2014a). Only four of the SWFs reviewed (16%) report any ESG
restrictions or considerations, and no fund reports a specific mandate to invest in certain

companies to promote ESG objectives. Legitimacy for SWFs is determined as much, if
not more, by what they don’t invest in as what they do invest in.
Conclusion
SWFS, as government instrumentalities, face questions of both procedural and
substantive legitimacy. Procedural legitimacy requires the creation and maintenance of
appropriate governance mechanisms that will ensure transparency and accountability of
the fund. The Santiago Principles, and other governance efforts, are designed to increase
procedural transparency, although the goal of such efforts has primarily been to increase
the legitimacy of SWFs in international markets and with host country regulators. This
chapter argues, however, that such efforts can also promote the procedural legitimacy of
the fund domestically, and that legitimacy can serve as an indication of appropriate risk
management.
The substantive legitimacy of the fund depends on the fund’s adherence to general
societal values. Most commonly, legitimacy is tied to the exclusion of investments that
are inconsistent with societal norms, such as non-Sharia-compliant investments by SWFs
owned by predominantly Muslim countries, or, as in Norway, investments in companies
engaged in the production of certain harmful products or engaged in harmful practices,
including human rights abuses. Legitimacy, however, is a fluid concept, so one can
expect that substantively “legitimate” investment policies will shift over time as funds’
political environments shift and evolve. As what constitutes legitimate governance shifts
over time, so too does the calculation of domestic political risk associated with a
sovereign fund.

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Sovereign Wealth Funds and Domestic Political Risk

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Sovereign Wealth Funds and Domestic Political Risk

Paul Rose, Ohio State University – Moritz College of Law

political risk management. Sovereign fund legitimacy is a question of increasing

Keywords: Sovereign wealth funds, political risk, governance, legitimacy, accountability,

Electronic copy available at: https://ssrn.com/abstract=2673112