Special Report: Sovereign Wealth Funds

Will 1MDB and the Panama Papers lead to greater transparency in the government investment sector?

Banks and financial institutions should exercise caution when dealing with sovereign wealth funds (SWFs) and other government investment vehicles, many of which remain opaque and their investment strategies unclear, according to experts.

 The 1MDB scandal in Malaysia and the release of the Panama Papers in April have sharpened the focus on how governments and their officials structure and manage investments, and while analysts and academics say 1MDB is an especially egregious example of state money management gone awry, they stress the importance of thorough due diligence when dealing with government investments such as SWFs.

These funds are vast caches of global capital: according to a December 2015 paper from the Official Institutions Group of State Street Global Advisors, the 39 funds that together represent 95% of global sovereign wealth had assets under management totalling $5.5 trillion at the end of 2014 compared with $650 billion in 2002.

 SWFs are a useful way for countries to put money aside as a cushion against financial shocks or economic weakness, especially in countries that rely on commodity exports for much of their public finance income and are therefore subject to global market volatility. The notional importance of this financial buffer to a country’s millions of citizens is however not always reflected in the reality of a SWF’s governance standards.

“Many SWFs are either opaque or outright sources for corruption or patronage. Very few meet their macroeconomic objectives. There’s very little knowledge on how some operate, on who the beneficial owners are, on how their investment choices are made.” – Andrew Bauer, senior economic analyst at the Natural Resource Governance Institute

Concerns around the risks faced by banks dealing with government owned investment vehicles have escalated since allegations surfaced last year about Malaysian strategic development company 1Malaysia Development Berhad, widely known as 1MDB, which started life as a SWF but is no longer considered as such by many sector observers.

Several media outlets have alleged 1MDB was used to channel state funds to Malaysian Prime Minister Najib Razak. Reports in the Wall Street Journal have said $700 million was moved from 1MDB into bank accounts under Najib’s name, though Malaysia’s Anti Corruption Commission denies this.

In February this year, the US Federal Bureau of Investigation started looking into the connections between senior Goldman Sachs executive Tim Leissner, Najib and the bank’s dealings with 1MDB, since when the US Department of Justice has asked Deutsche Bank AG and JPMorgan Chase to provide information on their work with the Malaysian fund.

This is not Goldman’s first controversial interaction with a government investment vehicle. In 2014 the Libyan Investment Authority brought action against Goldman and Societe Generale, accusing the two banks of abusing their positions and giving advice to the fund that contributed to it losing billions of dollars while making the banks millions.

Amid legal wrangling over who runs the fund—Malta-based Hassan Bouhadi, who is backed by the internationally recognised Libyan government, or Tripoli-based former chairman Abdulmagid Breish—a report in Euromoney magazine says the case against Goldman will come to the UK’s High Court in June.

In a climate where banks demand thorough know-your-customer checks from individuals with even modest means, there’s increasing pressure on them to conduct more exacting due diligence on sprawling, multibillion dollar government vehicles. Still, they must find a balance between healthy scrutiny and deterring would-be big customers with regulation.

“Banks can be helpful in encouraging openness from SWFs but they also have to keep their clients happy. Each case is different,” Bauer said.

The quality of compliance due diligence may vary significantly across banks, according to Patrick J Schena, Adjunct Assistant Professor of International Business Relations at the Fletcher School, Tufts University, Senior Fellow of the Center for Emerging Market Enterprises and Co-Head of SovereigNet, The Fletcher Network for Sovereign Wealth and Global Capital.

“Of course banks are certainly obligated to and do perform KYC checks on SWFs as they do other clients.  However, it is also the case, as with KYC generally, that quality in performing such checks varies across banks and could in cases be influenced by the nature and magnitude of the relationship between a client and a bank,” he said.

“In some respects banks that enjoy long-standing relationships with clients – including central banks and SWFs – have considerably better information about those clients, especially with regard to size and value of financial assets, average balances, scale and frequency of transactions, ability to efficiently post collateral, levels of leverage, etc.  This of course includes regulators, hence banks’ complicit role in the monitoring function of regulation.”

Counterparty risks posed to banks by government-linked businesses are not specific to either central banks or SWFs, he added.

“To manage residual counterparty risk in this context, key would be first to accurately trace the identity, and specifically the ownership structure, of the counterparty.  Certainly this is difficult when the party is intent on deceiving and is a government or government linked entity.”

To improve standards in the SWF and government investment  sector, NRGI is pushing for more transparency among funds, greater levels of oversight and for funds to deliver their stated mandate to build cash reserves to fund development or insulate against financial turmoil.

There are guidelines in place that lay out best practice for SWFs. These guidelines, called the Santiago Principles, were proposed in late 2008, since when 25 countries have signed up to them, but some analysts say the rules don’t go far enough and that after early signs countries were sticking to the principles, the conversation around SWF transparency has quietened down.

 According to Swiss-based political risk management firm GeoEconomica, “it appears that the public debate on SWF transparency and good governance has faded away”.

“In a way, an implicit and tacit understanding has been reached that as long as SWFs remain rather quiet investors, recipients are not going to ask them to further improve their transparency and governance performance…In a way, an informal equilibrium has been found, which for the time being is acceptable to most concerned,” GeoEconomica managing director Sven Behrendt said in a recent note.

“That equilibrium, however, is exposed to the risk that the implementation of the Santiago Principles remains unfinished business. A substantial number of SWFs still have not reached satisfactory levels of disclosure. Though most signatories have disclosed self- assessments on their implementation of the Principles, the quality of these assessments in most cases leaves substantial room for improvement,” he added.

Of the funds measured by the firm’s Santiago Compliance Index, the Petroleum Fund of Timor Leste and Chile’s Economic and Social Stabilization Fund/Pension Reserve Fund rated most highly, while the Qatar Investment Authority was judged to be non-compliant with the principles.

While it registers as ‘broadly compliant’ on the index and is a member of the International Forum of Sovereign Wealth Funds, Angola’s SWF, Fundo Soberano de Angola (FSDEA), is an example of a fund where observers would like to see more transparency in its management and more clarity on its mandate.

Concerns centre on the role of fund chairman José Filomeno de Sousa dos Santos (known as Zenu), son of longstanding Angolan president José Eduardo dos Santos, and a lack of information about the fund’s management and operations.

Links between the fund, Swiss finance house Quantum International and Angola-based Banco Kwanza Invest have also raised concerns, largely due to the connections between both current and previous senior executives at the three entities. Quantum acts as the fund’s external manager; while FSDEA says it was hired on the basis of previous work with the Angolan authorities, Quantum’s ties inside Angola raise questions over its independence.

Zenu dos Santos formerly sat on the board of Banco Kwanza. Ernst Welteke—a former head of Deutsche Bundesbank—is chairman of Banco Kwanza and sits on the board of Quantum. Jean Claude Bastos de Morais is chairman of Quantum and founder of Banco Kwanza. Marcel Krüse was a director of Quantum Capital before becoming CEO and head of investment banking at Banco Kwanza.

These links were known before the release of the Panama Papers, though the leak has prompted fresh questions in the light of allegations made by the African Network of Centres for Investigative Reporting and the International Consortium of Investigative Journalists that money from the Angolan fund was laundered through Banco Kwanza.

Krüse and de Morais were both convicted in Switzerland in 2011 on charges of repeated qualified criminal mismanagement. Though de Morais’ spokespeople have since said he was acquitted on all major charges, the case added to questions about his involvement with Angola’s SWF.

In addition, the power held by President dos Santos over the fund makes it “unusual” compared with its peers, according to Geoeconomica’s Behrendt.

“The current set up of governance arrangements will challenge the aspiration to align [the fund’s] policies with the [Santiago] Principles. We note…the substantial powers of the President of Angola, who is given the authority to approve the FSDEA’s investment policy, activity plans, annual and multiyear budgets, management reports, financial statements, annual investment strategy and staffing policy, as well as management regulations or internal regulations,” he writes.

While scrutiny around governments’ investments has increased following the 1MDB saga and the release of the Panama Papers, neither factor is likely to persuade SWFs, governments, or national regulators of the need for a sudden, wide-ranging drive towards greater transparency. .

“I don’t think [we’re in a climate of increased pressure] because SWFs are largely in oil-financed countries and in countries where oil dominates the economy the governments are often authoritarian so public pressure doesn’t have a huge amount of influence…1MDB isn’t, I don’t think, representative of most SWFs. Many may be mismanaged, they may be opaque, but they’re not blatant examples of corruption,” Bauer said.

Goldman Sachs, Deutsche Bank and Wells Fargo declined to comment when contacted by KYC360. Societe Generale and JP Morgan did not respond to a request for comment.

www.assetforfeiturelaw.us