Capital Markets Transparency
and Security: The Nexus Between U.S.-China Security
Relations and America's Capital Markets
SYSTEMIC SHORTCOMINGS
The U.S. financial system is ill-prepared at this time to address
adequately the concerns raised by "bad actors" accessing
the U.S. capital markets. In addition to governmental inattention
to this new security issue area, there are a number of systemic
shortcomings that merit review in the context of "capital
markets security" including government oversight, the purchasing
process and the evaluation of risk in the marketplace.
The three case studies reviewed in the previous section provide examples of
controversial foreign offerings that have been perceived by many market activists
as higher risk securities, or "bad actors," in the U.S. debt and
equity markets. The Gazprom, PetroChina/CNPC and Talisman examples also highlight
a number of the systemic shortcomings. Of primary concern have been: 1) disclosure
exemptions; 2) the adequacy of transparency and disclosure requirements; and
3) institutional investor attention to new material risk factors in the markets.
Capital Raising "Loopholes"
The U.S. capital markets are regulated by the Securities and Exchange Commission
(SEC), which has been provided the broad mandate of "investor protection." A
central component of its mandate is to ensure the proper disclosure by registrants
and listed companies of material risks to investors. The SEC also determines
what constitutes a material risk. With the exception of cases involving fraud,
insider trading and other forms of market manipulation, it is largely left
to investors to gauge the risks and invest accordingly.
This oversight becomes more complicated when considering foreign entities.
When overseas companies or state-owned firms seek to list on American stock
exchanges or raise capital in the U.S. debt markets (including the issuance
of sovereign debt), they are subject to many of the same disclosure rules as
domestic entities. There are, however, alternative means by which foreign firms
or governments can attract U.S. capital without adhering to otherwise rigorous
U.S. disclosure requirements. For example, a Chinese company can list in Hong
Kong and sell its securities to larger U.S. institutional investors through
certain established channels (i.e., exemptions).
On the "demand side," institutional investors seek to mitigate risks
attendant to a globally integrated financial system by diversifying their holdings.226 This
may be accomplished by owning various types of financial instruments (e.g.,
stocks, bonds, government debt, derivatives, etc.). They might also hold securities
from regional markets and companies of varying sizes and industries. For example,
a large public pension fund might have domestic portfolios for small-cap, mid-cap
and large-cap companies. It might also own an "emerging market" portfolio
as well as other investment categories divided by region or level of risk.
U.S. investors primarily invest in the securities of overseas entities by purchasing
American Depository Receipts (ADR's). ADR's are certificates for shares in
foreign companies that are held in the foreign branches of U.S. banks. In practice,
if a U.S. entity were to purchase one thousand shares of a Chinese "red
chip," its broker in Hong Kong would buy the shares and deposit them into
a Hong Kong branch of a U.S. bank. The American buyer would then receive an
ADR certificate indicating ownership.227 Similarly,
institutional investors can take on the debt of foreign governments and companies
through global debt offerings.
Regrettably, those ADR's not actively traded on U.S. exchanges are not required
to meet U.S. disclosure requirements before being marketed to American investors.
For example, "Level I" ADR's are traded in the so-called "over-the-counter" market
after providing what JP Morgan's ADR Reference Guide terms "minimal SEC
registration" (i.e., summaries of public reporting documents required
by the firm's home market).228 This investment
process allows small- to mid-sized foreign firms to float stock on marginal
exchanges, "test the waters" of the global investor community and
access U.S. investors seeking more exciting returns through riskier portfolios.
In the absence of robust reporting requirements, however, this process may
also allow front companies, firms engaged in dubious activities and other questionable
foreign firms to more easily navigate the international investment pool.
In 1990, an important new SEC regulation was promulgated that further facilitated
the purchase of unregistered foreign securities. Rule 144 (a) enables unregistered
securities to be sold to Qualified Institutional Buyers (QIB's) through private
placements without SEC oversight. 229 These
QIB's are subject to a "holding period" before fund managers are
allowed to resell the instruments to other U.S. investors.
Accordingly, if a foreign company lists on the Luxembourg Exchange, for example,
it can still access U.S. capital by exercising SEC exemptions without having
to disclose any one of a number of items that the SEC considers to be material
for domestic and foreign registrants.231 Through
what some view as the Rule 144 (a) "loophole," an element of non-transparency
is introduced to the portfolios of large U.S. institutional investors.
These and other disclosure exemptions are designed to enhance the efficiency
of the markets. With respect to global "bad actors," however, the
advantages of these looser regulations governing the purchase of overseas securities
are apparent. As Randolf Quon stated in Congressional testimony in 1997,
"Many of the Chinese and Russian securities and bonds are unable to meet
the rather strict registration requirements of the SEC. That is why they are
being sold to U.S. institutional investors through the exemptions under existing
securities laws."232
By listing on a foreign exchange, a "bad actor" can blur the investors'
understanding of its corporate identity and overseas activities of potential
concern. It can, nonetheless, still raise substantial funds from U.S. investors
by privately placing its securities with QIB's.233 In
choosing this strategy, foreign companies and/or governments can also help
avoid the type of U.S. political opposition encountered in the Gazprom and
PetroChina cases.
In 1998, a $1 billion Chinese government "yankee bond" illustrated
this point. Although listed in Luxembourg and Hong Kong, the offering was dollar-denominated
and offered to U.S. institutional investors through 144 (a).234 What
the prospectus likely failed to reference were a number of security- and human
rights-related issues associated with the PRC that American investors (on whose
behalf "QIB's" were purchasing the debt) may have considered material
to their willingness to subscribe to the offering. For example, would the funds
be used to advance China's military modernization? Would it free up funds that
Beijing could then use to suppress religious freedoms? With respect to financial
considerations, were repayment risks associated, for example, with a possible
future flare-up in the Taiwan Straits adequately disclosed? It is not difficult
to envision how complicated the process could become when subsidiaries, affiliates
and parent companies are added to the mix.
Another troubling systemic process involves the use of indices by QIB's to
purchase debt and equity on a mass scale. "Passive management," as
it is known in the industry, is the practice by which large institutional investors
buy baskets of stocks and bonds that have been chosen by indexing agencies
such as Morgan Stanley Capital International (MSCI) to serve as a benchmark
for an exchange or region. Rather than reviewing each Chinese stock it plans
to purchase, for example, a large public pension fund could simply invest in
MSCI's "China Free" index to increase its exposure to that country.235
MSCI's most important Asian index is the AC Far-East Free Ex-Japan index. Recently,
the MSCI decided to introduce fifteen new Chinese companies, some of which
were "red-chips," to the index.236 Almost
instantly, these Chinese firms were able to attract scores of U.S. institutional
investors that might have otherwise eschewed their purchase. The implications
of this investment vehicle are clear. Potentially problematic Chinese "red
chips" and other firms can not only list in Hong Kong and access U.S.
investors, but are almost automatically integrated into the portfolios of unwitting
American investors once added to regional indices. At minimum, the use of indices,
especially in the case of foreign firms for which material information may
not be readily available, should raise "yellow flags" for U.S. pension
and other funds. In an ideal world, U.S. fund managers would actively manage
all foreign purchases to ensure that "bad actors" are not slip-streaming
into their portfolios.
The broader institutional investing process also adds an element of concern
considering the way in which global "bad actors" raise capital. In
the case of public pension funds, in particular, fund managers often rely on
their "external fund managers" to build and administer diversified
portfolios. CalPERS, for example, contracts some ten external fund managers
to oversee parts of its portfolio. Contracts are renewed based on financial
performance.
Unfortunately, there is, at times, a close connection between external fund
managers and the Wall Street firms that underwrite foreign offerings. For example,
many Wall Street firms have subsidiary corporations that manage assets and
often contract to do so for large institutional investors. This corporate linkage
between underwriters and the external fund managers of this nations' larger
public pension funds can result in a conflict of interest. Much like Wall Street
firms have a financial incentive to minimize the possibility that its client
may be engaged in activities inimical to U.S. security and human rights interests,
the closely-connected asset management firms would presumably have little reason
to object to a foreign offering -- especially one underwritten by its parent
company -- on these grounds. This often symbiotic relationship makes it unlikely
that external fund managers will serve as reliable industry watchdogs with
respect to material national security, human rights and religious freedom concerns
in the future.
It is appropriate to note, however, that external fund managers are not given
unlimited latitude when it comes to purchasing foreign securities for large
pension systems. For example, CalPERS sets investment parameters with respect
to "permissible countries" to be brought into its portfolio. According
to Section D, part VI (c) of a report by CalPERS in 2000,
"The [external fund] Manager(s) shall operate under a set of specific guidelines
that shall outline the Manager(s)í investment philosophy and approach,
representative portfolio characteristics, permissible and restricted securities
and procedures, and performance objective.
The implementation of this Program shall comply at all times with CalPERS'
investment policies including, but not limited to: 1) Permissible Country Debt
and Equity Policies..."237
In the same CalPERS report, the "Permissible Country" debt and equity
lists are provided in Section I. China, among other countries, is listed on
the "Prohibited" list for both debt and equity. Although reunified
with China in 1997, Hong Kong appears separately on the list of appropriate
countries.238 This seeming inconsistency
was explained by CalPERS administrators to be a function of their policy bias
toward exchanges, rather than companies and governments. Put another way, the "Prohibited" list
are those foreign exchanges from which CalPERS will not purchase stocks or
bonds.239
This position raises a number of issues. Does it imply, for example, that CalPERS
would purchase Chinese sovereign debt if offered in the Hong Kong debt market,
but not if offered in Shanghai? Given the ability of foreign firms and governments
to offer their securities through a number of international exchanges, CalPERS'
policy seemingly suggests that material political risks related to a foreign
company or government are somehow mitigated by the location of the exchange.
Moreover, irrespective of their affiliations or business activities, Chinese
companies can be held by CalPERS as long as they are listed on the Hang Seng,
NYSE or elsewhere. Perhaps this helps explain China's determination to have
its SOE's listed internationally. To cite an extreme example, would a public
pension fund like CalPERS be willing to hold a suspected proliferator front
company in portfolio so long as the firm managed to list in Luxembourg or on
another acceptable exchange? As Casey Institute Chairman Roger Robinson stated
in a letter dated March 13, 2001 to Wilshire Associates, a consulting firm
charged with expanding CalPERS' risk assessment criteria,
"In this connection, it would also be short-sighted of CalPERS to focus
on the political conditions of the country or territory in which the relevant
stock exchange is located (e.g., Hong Kong), rather than where the company is
headquartered and doing the bulk of its business. Simply because a foreign company
is able to get itself listed on a "permissible" stock exchange does
not mean that the kind of expanded, politically-oriented "due diligence" CalPERS
claims to now favor can be given less weight or ignored altogether."240
Transparency and Disclosure
Problems arising from offshore "loopholes," cozy partnerships between
Wall Street underwriters and external fund managers and troubling fund policies,
while important, are manageable with proper attention. The larger systemic
challenge is two-fold: 1) the difficulty in identifying global "bad actors" is
exacerbated by inadequate transparency and disclosure requirements; and 2)
national security, human rights and religious freedom concerns have yet to
be integrated into the risk assessment methodologies of public and private
fund managers and were only recently introduced as potentially material risk
factors in the markets.
Fortunately, due to the nature of the free market process, it should not be
difficult to incorporate these new, value-relevant considerations into the
U.S. capital markets. After all, material information is the cornerstone of
the markets. Were investors given the information required to include national
security, human rights and religious freedom concerns in their due diligence
assessments of overseas entities, the markets could, over time, largely self-regulate.
If a company were deemed a "bad actor" or politically problematic
and the markets were apprised of such evidence, they would likely penalize
the company for its activities (e.g., reduce the value and/or marketability
of the securities in question). The Talisman "Sudan discount," for
example, provides an illustration of how a market adjustment might work.
The existence of these new risk factors and the ability of the market to self-correct
has underpinned the aforementioned William J. Casey Institute's five year "Capital
Markets Transparency Initiative." Specifically, the Institute has promoted
the idea that prior to May 8, 2001, SEC disclosure requirements were not adequate
to address the new types of material risks illustrated by the Gazprom, CNPC/PetroChina
and Talisman cases. By expanding SEC disclosure requirements to include more
information about the global activities and identities of foreign firms and
governments, the markets would, in time, begin to factor these considerations
into their purchasing decisions. The specific efforts to achieve this important
milestone merit review.
As referenced earlier, some in the U.S. government and the media began paying
closer attention to "capital markets security" in 1998. At the time,
one of the primary concerns that surfaced was the dearth of transparency and
disclosure with respect to foreign entities seeking to enter the U.S. debt
and equity markets. As Representative Chris Cox stated at the time,
"But we also need to take a look at the degree to which disclosure...by
foreign borrowers and foreign users of our capital markets does not measure up
to disclosure by our own domestic companies."241
Similarly, the Deutch Commission was sufficiently troubled by disclosure shortcomings
that it recommended enhanced transparency as a first step to ensure that Americans
do not unwittingly underwrite proliferators of weapons of mass destruction
and ballistic missile delivery systems:
"[A National Director for combating proliferation should] assess options
for denying proliferators access to the U.S. capital markets. Options considered
should include ways to enhance transparency, such as requiring more detailed
reporting on the individuals or companies seeking access or disclosure of proliferation-related
activity, as well as mechanisms to bar entry of such entities into the U.S. capital
markets."242
The insights of Representative Cox and the recommendation of the Deutch Commission
reflect a basic concept: in order to thwart attempts by genuine "bad actors" to
access unwitting U.S. investors, those in government and the financial community
must first be able to identify these entities. In the event that expanded disclosure
revealed an actual or prospective "bad actor" in the course of the
registration process, institutional investors would play a significant role.
For example, were a foreign shipping company forced to disclose its involvement
in the transport of proscribed nuclear materials to a rogue nation, investors
would be better prepared to evaluate the company's political/financial risks.
Barring a U.S. government decision to sanction the company and/or deny it access
to the U.S. capital markets, however, this information would be useless if
those evaluating the risk simply ignored these types of corporate activities.
Strengthened transparency and disclosure is, therefore, a critical first step
-- but not a panacea. To be effective, the markets will have to utilize this
information in their decision-making processes, including valuation, risk assessment
and the willingness to hold such securities in portfolio.
Regrettably, at this time, most institutional investors do not perform such
expanded "due diligence" with respect to national security, human
rights and religious freedom concerns. Indeed, it can be stated quite authoritatively
at this writing that not one pension or mutual fund in this country currently
conducts national security-related "due diligence" assessments before
purchasing foreign stocks and bonds. Brad Pacheco of CalPERS underscored this
point in a 1999 Investor's Business Daily article, ì[National Security]
is not screened as part of our review."243 Human
rights-and religious freedom-related risk factors do not fare much better.
While those in the financial industry may argue that this is a problem for
the U.S. government, such a view is short-sighted in light of the publicly-available
information regarding such suspect companies. Congressional reports, opposition
campaigns of the type encountered in the PetroChina case, the company's global
activities and partnering arrangements and the print media would be a good
place to start in determining whether a company or government is involved in
business ventures that could impact adversely upon the value of its securities.
Disclosure Deficiencies
The case of a recent NYSE listing and initial public offering by China's second
largest energy concern, China Petroleum and Chemical Corporation, or Sinopec,
is emblematic of potential disclosure-oriented problems that may arise with
respect to foreign registrants. Some have argued that the company failed to
disclose adequately material business activities that may have negatively impacted
upon its share price. These alleged omissions are partly due to systemic shortcomings
referenced earlier regarding the nature -- and scope -- of political risk disclosure
required by the SEC. It is also the case, however, that U.S. institutional
investors seemingly did not have national security, human rights and religious
freedom risk factors on their "radar screens" when evaluating this
offering. As a result of this inaction by both regulators and purchasers, a
company deemed questionable by many activists across the political spectrum
is held by some of the most influential public and private investment funds
in this country.
Sinopec was originally slated to list on the NYSE in June, 2000 and attract
some $6 billion following what was expected to be the successful market debut
of PetroChina. Likely due, at least in part, to the "adverse market conditions" shaped
by the PetroChina controversy, Sinopec postponed its offering until October
of last year. The company also scaled-back its expected proceeds and eventually
raised some $3.4 billion.
Roughly one week before Sinopec came to market, a troubling Wall Street Journal
article by Peter Wonacott appeared that raised awareness of the company's possible
ties to Sudan. According to the article,
"China Petroleum & Chemical Corp., which is promoting plans to raise
as much as $3.5 billion in a global stock issue, held an investment until June
similar to one that nearly sank the initial public offering of its rival [CNPC/PetroChina]:
It had business ties to the pariah state of Sudan."244
Although the firm had reportedly transferred its Sudan assets -- which reportedly
included a $30 million joint venture to conduct surveys and drill at least
four wells in the "Sudan 6î oilfield -- to CNPC in July, 2000 for
undisclosed terms, the Journal account exposed inconsistencies between claims
that an authentic transfer had taken place and activities on the ground.245 For
example, the article observed that Sinopec still maintained an office in Sudan.
Moreover, according to both a Chinese embassy official in Sudan and an on-site
Sinopec executive, "Sinopec's work has continued on the oil field."246
While the true nature of Sinopec's activities in Sudan, if any, remains unclear,
the market implications of this revelation are more difficult to contest: ties
to Sudan can disrupt an offering and/or impact upon share value following the
float.247 The Journal article, as might have
been expected, stimulated a flurry of activity by the Sudan community and other
NGO's that had opposed PetroChina on similar grounds. In the week before the
Sinopec listing, the SEC reportedly rece ot;a veritable flood of e-mails' seeking
disclosure of this business venture in Sinopec's filing.248 The
SEC also received a communication from the U.S. Commission on International
Religious Freedom (USCIRF) on this matter. The letter recommended that the
SEC investigate the "accuracy and adequacy" of Sinopec's material
disclosure. According to USCIRF,
"American investors who may be considering investing in Sinopec may consider
it material to their investment decisions to know whether the registration statement
of Sinopec is adequate and accurate in its disclosure about that company's possible
ongoing business interests in Sudan."249
At the time, the SEC did not specifically seek to clarify the overseas business
activities of registrants such as Sinopec that could pose national security-,
human rights- or religious freedom-related risks to investors. Given the potent
impact of Sudan-related operations on the market activities of PetroChina and
Talisman, a strong argument was made that this information was material to
the investor's consideration of Sinopec. Nevertheless, Sinopec did not reference
in its SEC registration statement the firm's recent Sudan activities before
going forward with its IPO and NYSE listing.250
In January, 2001 (some 90 days after its IPO), new allegations surfaced regarding
the international activities of Sinopec. Specifically, the company signed contracts
with the National Iranian Oil Company totaling some $163 million to explore
oil in Zavareh, Kashan and upgrade Iran's Tehran and Tabriz refineries. The
deal also included assistance in the design and building of the so-called "Nekaî oil
port in the Chtmian Sea. The Iran energy development project exceeded the $20
million threshold allowed by the Iran-Libya Sanctions Act (ILSA), technically
constituting a violation of U.S. law. If enforced, Sinopec could be subject
to sanctions by the U.S. government.251
This case highlights a number of disclosure concerns. Any ongoing or former
Sudan-related activities should probably have been disclosed given the Talisman
and CNPC/PetroChina precedents. If the company had indeed severed its ties
with Khartoum, the details of its past business activities and transfer of
assets could have been made clear to investors. Equally troubling, Sinopec
chose not to disclose an imminent multi-million dollar deal with Iran that
eclipsed the ILSA threshhold. It is somewhat difficult to imagine that the
company was not aware of the possibility of U.S. government sanctions. It is
also doubtful that the company was able to enter into complex negotiations
and sign such a sizable energy agreement with Iran in the three month period
following its registration with the SEC. Potential sanctions would seem to
represent a material risk to investors. It has since been learned that the
U.S. State Department discussed this matter with Sinopec prior to its offering.
According to a Department official,
"In light of our [Chtmian] policies, we have long been concerned about the
Neka project. We have expressed those concerns to the government of China, to
Sinopec and to other companies which have been reported to have been interested
in the project."252
Due to SEC policy, it is not known whether the company is currently under investigation
for possible material omissions. It is likewise not clear to what degree these
political concerns contributed to, what was for a period of time, a roughly
30 percent drop in Sinopec's share price from its IPO level. What is clear
is that some U.S. investors are holding in portfolio a Chinese entity that
is doing business with at least one State Department-designated terrorist-sponsoring
state and could be subject to U.S. sanctions in the future.
Expanding Disclosure Requirements
In the absence of SEC attention to these new categories of material risk, in
August, 1999 U.S. Representatives Spencer Bachus and Dennis Kucinich (referenced
above in connection to their reintroduction of the U.S. Markets Security Act
of 1999) took the unusual step of introducing this new challenge to the fifty
states. In a communication to all fifty state treasurers and attorney generals,
the Representatives wrote:
"We are writing to bring to your attention a challenge to U.S. national
security which may be relevant to your state's management of pension funds and
other investment tools...Given the increasingly sophisticated financial engineering
employed by potential adversaries, "due diligence" needs to be expanded
to encompass these largely unprecedented concerns."253
In a follow-up letter to those state officials of November 8, 1999, the Representatives
went on to recommend that states conduct a national security audit of their
existing overseas investments. Regrettably, at the time, the concept of higher
risk "bad actors" had not been clearly defined and it was difficult
to capture exactly what pension funds and other investment firms might be seeking
in such a portfolio review. Put another way, the operative question became "how
does one identify a "bad actor?'"
Working with those in Representative Bachus' office and the staff of Senator
Sam Brownback, the Casey Institute sought to answer that question in the spring
of 2000. A bill, with the working title of "The U.S. Investor Protection
Act of 2000,î was envisioned by some on Capitol Hill to legislate expanded
disclosure requirements by the SEC for foreign entities. It was determined
that new transparency requirements that sought information with respect to
a firm's ties to -- or business activities with -- their home country's national
military or intelligence services would help indicate whether U.S. investor
proceeds could end up benefitting the wrong sorts of activities. Similarly,
more detailed disclosure was sought regarding the end-use of proceeds by both
foreign firms and governments as was more explicit information with respect
to the principal ownership and senior management structures of the foreign
entity.
At the core of the draft legislation, however, was the concern that foreign
entities may be utilizing funds raised in the U.S. to finance business activities
in those countries under U.S. sanctions regimes. To minimize this prospect,
it was recommended that the SEC require a detailed accounting of the operations
of foreign registrants in countries that fall on the State Department's list
of terrorist-sponsoring nations as well as other countries subject to U.S.
sanctions. It bears repeating that such disclosure would help reconcile a fundamental
contradiction in U.S. foreign policy: namely, that Americans can underwrite
the activities of foreign companies that operate in locales that are off-limits
by law to U.S. firms.
A second motivation was present as well. Specifically, it was determined that
those firms that have been suspected of being "bad actors" were often
the same companies that were partnering with those countries cited by the U.S.
government for wrong-doing. It is sometimes the case that EU and other Western
firms are somewhat reluctant to do business with countries sanctioned by the
U.S., even if the efficacy of those sanctions is doubted. Regrettably, it is
often Chinese, Russian and other non-Western firms that choose to fill this
gap.
There are other advantages associated with strengthened disclosure. In its
most basic form, investor's can make more informed decisions when provided
additional information about a prospective investment candidate. Moreover,
these changes would not require additional bureaucracy and could be, in almost
all cases, effected with almost no SEC rule changes. Most importantly, however,
is the potential knock-on effect of such transparency enhancements. Taking
their cue from the SEC, fund managers would likely begin to assess material
national security-, human rights- and religious freedom-related risks when
evaluating the securities of foreign firms and governments. In this manner,
the "demand side" of the markets could help better discipline the
system through its purchasing decisions.
While the "U.S. Investor Protection Act of 2000" was never introduced,
this SEC "disclosure scenario" came to a head in April-May of this
year. Equipped with empirical evidence of disclosure shortcomings, the faltering
share values of certain perceived "bad actors" due to successful
divestment campaigns and the impact of negative publicity and Congressional
attention on the market activities of foreign companies, Rep. Frank Wolf --
a long-time human rights advocate and Chairman of the House Appropriations
Subcommittee on Commerce, Justice, State and the Judiciary -- sent a groundbreaking
correspondence to Acting SEC Chairman Laura Unger on April 2, 2001. In addition
to seeking an investigation into suspected disclosure omissions by PetroChina
and Talisman, the Congressman recommended a series of additional disclosure
requirements for foreign firms doing business in Sudan and other countries
under U.S. sanctions regimes.255 Stating
his case for these new measures, Congressman Wolf noted,
"The PetroChina and Talisman examples underscore the material shortfalls
regarding information available to U.S. investors with respect to foreign entities.
Not only are material "Risk Factors" often omitted due to inadequate
SEC disclosure requirements -- raising the prospect of significant losses for
U.S. investors -- but inadequate information flows make it more difficult for
investors to judge both risk and whether the firm's operations reflect their
values. As a result, investors often end up unwittingly helping finance companies
whose global activities are in contravention to American security interests and
values.
Specifically, the SEC's disclosure requirements for foreign entities do not
currently include: the electronic listing of the foreign entrants" filings;
information regarding the operations of parent companies, subsidiaries or affiliates
of the prospective entrant (thereby creating the impetus for "cut-out" companies
such as PetroChina to serve as funding vehicles); sufficient information with
respect to the Board of Directors of the companies and pertinent corporate
governance issues; notification of where the company is doing business globally
and with whom (e.g., with a country on the State Department's list of terrorist-sponsoring
nations, etc.); or sufficient protection of minority shareholder rights."256
Building on research efforts by the Casey Institute and others on Capitol Hill
who had previously called for enhanced transparency criteria, Representative
Wolf recommended, among other steps, that the SEC require electronic filings
for all foreign registrants and more information regarding the activities of
those registrants doing business in U.S.-sanctioned countries:
"Global Operations: Foreign companies should disclose their operations --
as well as those of their parent companies, subsidiaries and affiliates -- in
countries which are listed on the following U.S. government lists:
• CIA List of Acquiring and Supplying Nations as cited in its annual report
to Congress on The Acquisition of Technology Relating to Weapons of Mass Destruction
and Advanced Conventional Munitions
• U.S. State Department List of State Sponsors of Terrorism
• U.S. State Department-Designated Countries of Particular
Concern for Violations of Religious Freedom
Companies should also disclose their business relationships -- as well as those
of their parent companies, subsidiaries and affiliates -- with companies from
countries which appear on these lists."257
Following weeks of intensive study of these proposed new areas of material
risk, the SEC responded to Representative Wolf by promulgating a series of
sweeping "process biases" designed to broaden the SEC's view of what
constitutes material risk with respect to foreign companies doing business
in countries off-limits to U.S. firms.258 As
the Financial Times' Ted Alden noted in breaking the story on May 11, 2001,
"The SEC, under its existing authority to require full disclosure, has declared
that investments in countries under U.S. sanctions are a significant material
risk to investors...[This] decision will also put new pressure on mutual funds
and pension funds to expand their assessments of the political risks of investing
in certain companies."259
In a six-page letter from Acting Chairman Unger to Representative Wolf -- accompanied
by a detailed memorandum from the SEC's Director of Corporation Finance, David
Martin, to Ms. Unger ñ the SEC outlined its "Initiatives to be
Undertaken." (See Appendix 6.) According to Acting Chairman Unger,
"U.S. Sanctions administered by OFAC prohibit American companies from investing
or doing business in [countries under U.S. sanctions]. Those sanctions do not,
however, prohibit foreign companies from doing so. Foreign companies that do
business in Sudan, or any other country subject to OFAC sanctions, may list on
U.S. securities exchanges and offer their stock to investors in U.S. markets...
The SEC does, however, have the statutory authority to require that U.S. investors
receive adequate disclosure about where the proceeds of their securities investments
are going and how they are being used. The federal securities laws are founded
on the principle that the best way to protect investors is to ensure that they
have access to material information about the companies and securities in which
they are considering investing...
The fact that a foreign company is doing material business with a country,
government, or entity on OFAC's sanctions list is, in the SEC staff's view,
substantially likely to be significant to a reasonable investor's decision
about whether to invest in that company. Therefore, in accordance with existing
disclosure rules and the SEC's investor protection mandate, the staff of the
Division of Corporation Finance will seek information from registrants about
material business in, or with, countries, governments or entities with which
U.S. companies would be prohibited from doing business under economic sanctions
administered by OFAC."260
According to the Unger letter, the SEC will effect one rule change (e.g., require
electronic filing for all foreign registrants) and adjust its interpretation
of existing disclosure requirements in three categories. As described by Casey
Institute Chairman Roger Robinson in a draft Wall Street Journal editorial,
the SEC will henceforth ì1) seek to review all filings with respect
to foreign firms doing material business in countries under U.S. sanctions
regimes "or with persons or entities in those countries;" 2) seek
[additional] information from foreign registrants about material business in
or with countries, governments or entities with whom U.S. firms are barred
from doing business due to official sanctions; and 3) cooperate with appropriate
U.S. federal agencies...to help ensure enforcement of existing U.S. sanctions."261 The
groundbreaking nature of these new SEC measures merits an expanded review beyond
the scope of this report. A brief discussion, however, would prove useful.
Upon successful completion of the necessary rule change, the SEC will henceforth
require all foreign firms to file electronically their SEC documentation. This
will allow investors to access more efficiently information regarding the securities
of foreign firms of interest.
With respect to disclosure requirements, the SEC already calls on applicants
to declare those foreign markets in which they have material operations. From
this point forward, however, those foreign registrants that disclose business
activities in countries under Office of Foreign Asset Control (OFAC) administered
sanctions will be accorded largely automatic -- and closer -- scrutiny by the
agency.262 This could often include SEC requests
for additional information from the registrant to ensure that any material
risks (e.g., those emanating from divestment campaigns, the possible imposition
of U.S. sanctions, negative publicity, etc.) are properly disclosed to investors.
Although "materiality" was broadly defined in the SEC correspondence,
given the fact that U.S. companies cannot have any business ties to countries
under OFAC sanctions, the threshold for disclosure could be interpreted to
be any business activities of the foreign registrant in the designated countries,
irrespective of the financial value of those dealings.
The SEC also committed to work closely with OFAC in relevant cases. By doing
so, the agency validated the assessment that some foreign registrants may raise
security-related issues that exceed the SEC's traditional oversight. Similarly,
the SEC referenced its support for the creation of an inter-agency capital
markets working group that could review those foreign filings pertinent to
Sudan and presumably other problematic national security, human rights and
religious freedom concerns. It is reasonable to expect that some of these "complex
issues," as Ms. Unger termed them in her letter, would be best considered
by other government agencies.263
While the systemic knock-on effects of the SEC's new disclosure measures will
likely not be clear for some time, investors should benefit in a number of
respects. Specifically, the SEC will be requiring more detailed information
with respect to the global operations of foreign firms, especially as relates
to countries under U.S. sanctions. This type of information will allow investors
to better judge the political risks attendant to the foreign firm. It should
likewise help illuminate those risks created by increased activism in the markets
(e.g., NGO campaigns, Congressional opposition, etc.). As the Los Angeles Times
wrote, "Investors said [the SEC changes] should, however, make it easier
to evaluate foreign firms that don't have the same level of openness as U.S.
firms."264
It is expected that there are a limited number of foreign firms that are doing
material business in OFAC-sanctioned countries and seeking to access the U.S.
debt and equity markets. There is, however, reason to believe that those foreign
firms tagged by the new SEC "process biases" and subject to expanded
disclosure will include some Chinese firms -- not to mention the Chinese government
itself -- that have ties to one or more of these "off-limits" states.265 This
additional information about Chinese companies should help the Commission evaluate
the degree to which unfettered PRC access to the U.S. capital markets could
pose national security and other risks to this country.
Although it is difficult to dispute the SEC's determination that new material
risks exist, a number of political objections have surfaced. The first is the "slippery
slope" argument which maintains that the SEC decision has set the stage
for the ultimate denial of U.S. market access for select foreign firms. This
argument is speculative and beyond the statutory authority of the SEC. An interagency
working group could be formed and provided with the power to recommend that
the President take such a step in extreme cases. Nevertheless, a carefully-crafted
interagency group could actually reduce the chances of creeping "capital
controls" by setting strict parameters for review of potentially problematic
foreign firms or governments. In the event that a foreign firm seeking market
access is judged to be damaging U.S. security interests, it would still likely
take Presidential authority or Congressional legislation to deny market access
on security grounds.266
A second concern may be raised by allies and those in other foreign governments.
The "extraterritoriality" argument suggests that these new disclosure
measures are politically motivated and designed to impose U.S. foreign policy
preferences on the companies and governments of other countries.267 This
concern should be allayed by the SEC's apolitical determination that activities
in OFAC-sanctioned countries represent a material risk to investors. In other
words, the SEC is not seeking to dissuade a foreign firm from doing business
in, for example, Iran. By compelling the firm to disclose this activity and
the potential downside consequences for its share value, the SEC is merely
protecting the investor, not engaging in any political or moral judgements.
Moreover, the SEC is suggesting that irrespective of one's views regarding
the efficacy or merit of sanctions, the reaction of the American people and
government can influence the value of certain securities.
Risk in the Market
To understand the potentially momentous nature of the May 8 SEC determinations,
the role of risk in the marketplace warrants treatment. In the United States,
disclosure is a function of risk. If past precedents indicate that the value
of a company may be affected due to a risk factor, the SEC -- if it deems the
risk "material" -- will seek disclosure of the matter. By so doing,
the investor is able to make a more informed decision when purchasing the securities
of the firm. Similarly, risk is a function of market forces. If the markets
perceive a company's decision or direction to be detrimental to the value of
the firm, it will express this determination in terms of risk, revise its valuation
and act accordingly. The markets may choose to penalize the firm by paying
less for its debt or equity or eschew its securities altogether if the risk
is sufficiently great.
Conversely, disclosure may also serve as a determinant of risk for market players.
Put another way, the markets may not adequately understand or address new risk
factors. Expanded SEC disclosure requirements (or revised methods for reviewing
existing disclosure) can, therefore, occasionally signal to the markets that
new risks have emerged that merit attention. For example, the markets may take
account of the impact of an IPO opposition or divestment campaign on the demand
for a certain stock. It may not, however, have made the leap to the broader
market trends evidenced. As Prudential Analyst James Lucier, Jr. stated at
the height of the PetroChina controversy, "There is a whole new political
risk equation that Wall Street is not prepared to deal with."268 By
acting on this trend, the SEC has, in effect, cued the markets to evaluate
new risks in future purchasing decisions.269
It should come as little surprise that new risks emerge naturally in the evolution
of the markets. Indeed, the prospective impact of U.S. public opposition to
a foreign company's business practices was foreshadowed at the time of the
South Africa divestment campaign. Given the market's more recent sensitivity
to issues related to corporate governance and accountability, it was only a
matter of time before national security, human rights and religious freedom
activists began targeting the overseas activities of foreign companies to advance
their agendas. By successfully lobbying market-moving institutional investors,
in select cases debt and equity values were altered. Upon demonstrating a track
record of success in impacting on the value of targeted securities, new market
risks were born.
The SEC's affirmation of the existence of these new material risks could have
historically important systemic implications. For example, these new disclosure
interpretations should signal to the markets that robust forms of political
opposition or activism need to be taken into consideration in investment decisions.
Beginning with institutional investors and trickling down to individual players,
new layers of "due diligence" incorporating these potentially material
factors, over time, will likely be added to the assessments of foreign securities.
Specifically, the markets should begin to evaluate the potential impact of
a company's overseas and other activities as they relate to national security,
human rights and religious freedom concerns.
Theoretically, a self-regulating market, based on disclosure and investor choice,
would likely penalize foreign firms if their corporate activities have resulted
in serious U.S. political opposition and/or market activism. For example, the
markets may downgrade their projections for a targeted firm's profitability
-- thereby reducing the market value of the stock -- as long as the company
continues to follow controversial business strategies. Given the potent nature
of these issue areas, however, it might also be the case that U.S. institutional
investors would decline to purchase such a firm's securities altogether rather
than face negative public reaction to its investment.
In a dynamic, free market system, demand for stocks and bonds (in part determined
by risk assessments) should influence the decisions of a company. If a foreign
firm faces a substantial contraction in the liquidity of its stock or its market
capitalization due to these new political risk considerations, senior management
may be forced to adjust or abandon certain business plans. Moreover, the possibility
of market unrest or even "street theater" by activists may persuade
the targeted entity to avoid global activities that could be deemed to conflict
with U.S. national security, human rights or religious freedom concerns.270 The
possibility of this kind of defacto privatization of foreign policy was considered
by the Economist -- widely viewed to be a barometer of important economic and
political developments:
"The new rules could affect foreign firms in a more evolutionary way. They
may force American portfolio managers to take account of newly revealed political
risks, or face lawsuits from aggrieved shareholders. If so, market caution could
end up extending America's sanctions regime in a way that no amount of government
posturing could achieve."271
An important "real world" case study of this theory may already be
underway in California and elsewhere at the state public pension system level.
The Congressional letter to state treasurers referenced earlier and an incendiary
Investor's Business Daily article by John Berlau compelled some California
state legislators to inspect more closely the holdings of that state's public
pension systems in 1999.272 An article in
the Pittsburgh Tribune Review later stimulated similar actions in Pennsylvania.273
A two year clash ensued in California concerning the alleged existence of "bad
actors" in the portfolios of its state employees that included a security-minded
state audit of existing foreign holdings, legislation calling on CalPERS and
CalSTRS to report publically all new foreign holdings and a second bill that
called for the creation of a "capital markets task force" in the
state legislature to review this matter. California's giant pension fund systems
resisted these attempts to redress what some, including California Treasurer
Phil Angeles, viewed as systemic flaws and denied the existence of "bad
actors" in their portfolios.274
For example, CalPERS consistently denied the possibility that its "red
chip" holdings could be associated with China's People's Liberation Army.
CalPERS' initial response to the Investor's Business Daily (IBD) article that
launched this issue in California set the tone for this financial policy dispute.
According to a press release by CalPERS' Investment Chairman Charles Valdes,
the IBD piece was "inflammatory and inaccurate" and "modern
day McCarthyism at its worst."275 Indeed,
some two years after this issue surfaced, CalPERS sponsored a Washington D.C.
symposium on the role of national security in the markets, primarily seeking
to refute allegations regarding specific CalPERS holdings.276
In addition to its efforts to disprove concerns raised with respect to its
Chinese "red chip" holdings, CalPERS maintained that national security
is the exclusive purview of the federal government.277 According
to those in CalPERS' government affairs office, the pension system is not comfortable
with determining what constitutes a national security risk and has gone so
far as to argue that such a determination would usurp the discretionary authority
of the federal government to conduct foreign policy.278 In
a letter to Wilshire Associates -- a firm that is contracted to help CalPERS
expand its definition of political risk -- of March 13, 2001, Casey Institute
Chairman Roger Robinson addressed this claim:
"In addition, CalPERS would be well-advised to reevaluate its present argument
that national security-related transgressors are the exclusive purview of the
federal government and that public pension funds cannot be expected to equip
themselves with the expertise to review security-related risk factors. CalPERS
properly acknowledges that such new risk factors can detract from the value of
such a firm's securities. Although it is true that the federal government should
be considerably more active with regard to providing timely and accurate guidance
on national security-related risks for the public pension funds of this country,
a seemingly rigid CalPERS position of seeking to offload the entire problem onto
the shoulders of the U.S. government is not credible or sustainable. While the
federal government can and should decide which emerging market firms or governments
should be denied access to the U.S. capital markets for egregious activities,
CalPERS has the authority -- and, indeed, the obligation -- to determine if a
company's global activities pose a risk to its stock value and other financial
equities."279
In claiming that national security is solely the concern of the federal government,
CalPERS failed to acknowledge a critical point, namely, that the global activities
of foreign firms can have national security-related implications that may,
in turn, reverberate in the markets. Indeed, while the question of whether
specific CalPERS "red chip" and other Chinese holdings constitute
security risks merits additional review, it can be argued that CalPERS has
a fiduciary responsibility to determine whether the global activities -- including
in the areas of national security, human rights and religious freedom -- of
a foreign holding can impact on the value of its debt or equity. Another correspondence
from Mr. Robinson -- this time to the Board of Directors of the nine public
pension systems that were represented at the CalPERS-sponsored Washington D.C.
symposium referenced earlier -- highlights these new political risk factors
and prospective actions that might be undertaken by pension systems to help
mitigate these risks:
"In the meantime, your system can play a proactive role in helping manage
and take account of the intensifying impact of these new political risk factors
on portfolio values. An analogy may be constructive. Currently, most public pension
funds factor environmental risks into their "due diligence" criteria.
This does not imply, however, that the fund is determining whether the company
is a despoiler of the environment. Should the fund decide not to invest in the
company, that decision would be a reflection of the fund's determination that
the activities of the company may result in negative publicity, activism and/or
other measures that could adversely affect the value of the stock or bond in
question.
Were a public pension fund similarly to factor national security and human
rights criteria into their purchasing decisions -- particularly with regard
to emerging market entities -- it would not be classifying that company as
a national security threat. It would simply be determining that the company's
international activities could result in national security- and/or human rights-related
measures or activism that degrades the value of the stock. In other words,
what we are recommending is merely an expanded form of political risk assessment.
In the absence of an official list of "bad actors" supplied for this
purpose, pension fund managers could be guided by lists of companies that have
been publically cited as playing a role in the proliferation of weapons of
mass destruction. Similarly, fund managers could consult the CIA's list of
proliferating countries and factor that information into their risk assessments.
This would be the type of useful, national security-relevant information fund
managers would benefit from acquiring.
At a minimum, public pension funds would be well-advised to consider where
a company seeking underwriting in the U.S. capital markets and its parent company,
subsidiaries and affiliates do business in the world, and with whom. If a company
has extensive activities, for example, in Iraq, Iran or Sudan, fund managers
need to recognize that pressure may arise from non-governmental organizations
and/or Capitol Hill to divest such investments at risk of penalty to the fund
for providing material assistance to terrorist-sponsoring "rogue nations." Another
possibility is that unflattering media attention could be precipitated by investments
in such companies as investors are linked to the unsavory activities of those
whose paper they hold. A case in point may be found in the harm done to funds
that came to be associated with apartheid policies simply because they were
invested in companies that had business links to South Africa. In either case,
pension funds can and should include these sorts of considerations in their
risk assessment of overseas companies."280
Regrettably, this nation's public pension systems have yet to treat adequately
the now-acknowledged new material risk factors in the markets and take steps
to expand their "due diligence" assessments to account for these
considerations. It is hoped that the SEC's detailed explanations and rationale
outlined in its May 8 correspondence to Representative Wolf will prompt a second
look at this issue by public pension fund managers. If so, an important first
step in ensuring that U.S. investors are better protected will have been taken.
Conclusion
While transparency and disclosure enhancements may, over time, have a significant
impact on the ability of perceived "bad actors" to raise capital
in the U.S. markets, there remain broader policy concerns that require active
attention by the federal government. In addition to studies, policy debates
and other measures that could be undertaken to determine the true extent of
this security problem, it may be appropriate to take steps to correct systemic
shortcomings and develop a review mechanism for those rare occasions when problematic
foreign firms are seeking to access the U.S. capital markets. Moreover, the
growing success of opposition campaigns and other forms of market activism
has given rise to a new policy tool. Specifically, policy practitioners and
those in the NGO community are increasingly seeking to leverage the global
dominance of the U.S. capital markets to advance foreign policy objectives.
The efficacy of "capital markets leverage" is considered in the next
section.