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Regulatory Challenges Arising from Sovereign Wealth Funds and National Security: Exacerbate Great Power Competition between China and the United States?

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Charles Ho Wang Mak* and I-Ju Chen**

China is now a major player in some of the United States’ (US) most important sectors. China’s impact can be found through the acquisition by some of its most influential companies, which are later acquired by the sovereign wealth funds (SWFs) of China. US’ companies, for example, Apple and IBM, and their distributors, are indirectly controlled by China. This dynamic and tension of the two great economic power may play a significant role in the US-China trade war. Moreover, concerns about regulations of the SWFs and national security have never ceased in the US. While the US presidential election is in fall 2020, the foreign relationship between China and the US is an essential agenda in both Trump and Biden’s campaigns. This post examines regulatory challenges arising from the SWFs and national security under this new era of great power competition between China and the US.

National security is closely associated with the concept of state capitalism. This is because the states’ governments mostly control the enterprises that existed in states that adopted state capitalism. Therefore, investors (with political agendas) may invest in some state enterprises, which might affect national security. National security will be negatively affected by the SWFs made by state-owned enterprises. Inward SWFs might affect individual strategic firms (investing in infrastructure) and different sectors in the host countries. This is because those state-owned enterprises, which invest in those host countries by SWFs, can access sensitive information and technology of those strategic firms and then misuse that information. States investors seek to get improved access to sensitive technologies of other countries through investment. Therefore, to safeguard national interests, policies and strong regulations are necessary.

The Santiago Principle could be a reference for governments to govern international investment. Establishment of the Santiago Principle aims to depoliticise foreign investment flows and to structure and implement transparent and sound governance.[1] The Santiago Principle covers the following areas: legal framework and coordination with macroeconomic policies; institutional framework and governance structure; and investment and risk management framework.[2] Hence, the Santiago Principle is one of the most important features in reframing international perceptions of SWFs.

The balance between the protection of national security and open investment policy of SWFs is complex. In addition, SWFs raise ‘potentially controversial questions for international financial regulation and governance’.[3] China’s SWFs, such as the China Investment Corporation (CIC), have sought more access to markets in the US after Chinese deals are under more and stricter scrutiny. Chinese firms have criticized the US’ investment regulations imposing unfair restrictions on funding coming from China. Moreover, in a high-profile talk with the US government in 2015, Xi Jinping raised the issue of SWFs and relevant regulations in the US. Xi addressed that the US government should relax regulations of foreign investment in high-tech sectors.[4]

However, the investment flow of China into the US has prompted US’ concerns about the government of the People Republic of China’s influence. This is because, from the perspective of the US government, there is a potential risk of national security of SWFs. Although it is clear that the national interest ensures long-term capital availability – because much of it must come from SWFs now – several US pressure groups still urge restricting foreign investors’ choices lest they ‘steal’ technology, trade secrets or jobs.[5] On this controversial point, Bu’s research, however, indicated that China has no intention of investing in sensitive sectors pursuing the controlling stake because it has steered away from deals that would trigger any political backlash.[6]

The US has a series of critical legal regimes applicable to SWFs. The US adopted a protectionist approach towards the SWFs inward investments. Since 2000, the companies in the US that were invested by SWFs became a major issue. In the US the principal regulations that burdened SWFs are the Securities Exchange Act 1934, Foreign Investment and National Security Act (FINSA) 2007, Foreign Corrupt Practices Act of 1977 and Defense Production Act of 1950. FINSA codifies the contemporary views of the Committee of Foreign Investment in the United States (CFIUS). FINSA has dramatically strengthened the regulations introduced by CFIUS, those about inward investment, particularly for state-owned entitled such as SWFs. For instance, critical infrastructure needs to be protected against those SWFs that are invested with a political purpose, since those critical infrastructures will give rise an issue of national security. However, with respect to the unpredictability for the transaction parties, an issue arises as to whether the FINSA can strike a balance between the economic benefits of foreign investment and national security concerns about technology and critical infrastructure.[7] Nonetheless, Chinese scholar, Feng, comments that FINSA is unnecessary and even likely to be detrimental to the US capital markets and the overall economy.[8]

Furthermore, the case of Cede & Co. v. Technicolor, Inc. showed that directors and managers owe the duty of loyalty to both the company and shareholders by providing protections from SWFs’ geopolitical agendas. [9] The US government has treated inward investment by SWFs as an issue of national security. Therefore, Congress has greatly strengthened the regulations on equity investment, especially of state-owned bodies. Also, regarding the definition of strategy towards the notion of national security between the US and China, the US is the most protectionist jurisdiction. Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which predecessor (Trans-Pacific Partnership Agreement, TPP) was led by the US, pertains to regulations of SWFs. Definitions for SWFs are at the start of Chapter 17 of CPTPP.[10] In addition, SWFs must be member(s) of the International Forum of Sovereign Wealth Funds or endorse the Santiago Principles, or such other principles and practices as may be agreed to by the parties of the CPTPP.[11]

The US might adopt the European Union (EU) model in the future. To regulate foreign direct investment (FDI) into the EU within the context of SWFs, the EU and its Member States rely on the treaties and EU legislation. The free trade theory – the free movement of capital within the European Common Market is the most fundamental feature of the EU approach to regulating the SWFs. However, this fundamental freedom is restricted in a limited number of cases. This is because the Treaty on the Functioning of the European Union (TFEU) awarded the EU with the competence to adopt different measures to regulate the establishment of foreign investors within the EU. There are two ways to regulate the movement of capital. According to Article 64 of the TFEU, firstly, the EU can impose measures on the movement of capital from third countries involving direct investment, by a qualified majority; secondly, direct investments can be restricted by measures that are introduced by the EU.[12] Since the TFEU explicitly covers the relationship between the Member States and the so-called third party countries, it seems that the EU laws are favourable to the foreign investors in terms of their important rights vis-à-vis their investments in the EU. However, the principle of free movement of capital is subject to two limitations. The limitations are derogations and safeguard clauses respectively. The scope of the limitations determines the extent to which the governments could restrict FDI within their territories. The narrower these limitations are, the easier it is for SWFs to enter the EU market. On the other hand, if the limitations are broader, governments can impose more restrictions to limit access to the Common Market.

In terms of the securitisation of national security, Article 65 of the TFEU is the most important provision as it describes the power retained by the Member States to restrict the concept of free movement of capital within the European Common Market in the name of protection of public order or public security. It also sets out potential obstacles to SWFs that invest in the EU. O’Donnell acknowledged that there are several Member States in the EU which had adopted various measures to restrict investments of SWFs in the defence sector.[13] In Sanz de Lera and Others, the Court of Justice of the European Union (CJEU) produced mixed results for the development of the EU law on capital movements.[14] In this case, CJEU clarified the unconditional nature of Article 65 TFEU, that the principle of free movement of capital prohibits those obstacles between the Member States, and between third countries and the Member States. Until mid-2015, Article 65 had never been applied by any of the Member States to regulate SWFs. In October 2020, an EU regulation establishing a framework for the screening of FDI into the Union has entered into force.[15] This new EU regulation aims to better scrutinise direct investments coming from third countries on the grounds of security or public order. It enhances the European Commission’s existing powers to review foreign investments under the existing merger control rules and sector-specific legislations of the EU.

Currently, some commentators might argue that there are only a few rules that can be applied to regulate SWFs within the EU. Nonetheless, in no small extent, it seems that the legal framework of the EU has provided a comprehensive regime to tackle the phenomenon that the US can take as a reference. For instance, the US can take the new free trade agreement between the EU and, Singapore and Vietnam, and the parallel EU-Vietnam Investment Protection Agreement as a reference, to incorporate SWF provision in the future free trade agreement with China.

To conclude, it is a well-established principle of international law that sovereign immunity does not extend to a state’s commercial activities in another jurisdiction. Thus, SWFs are subject to be assessed by investment host countries’ national laws. However, too excessive scrutiny of SWFs investment is likely to fuel nationalism, and will further hamper the free foreign capital flow. Hence, it has been suggested that the potential consequence of protectionism caused by strict examinations of SWFs should be avoided.[16] Nevertheless, it has been unclear whether the Trump administration would take a tougher stance on trade and investment with China. Since the trade war between China and the US has not ceased yet, the new president of the US would have to deal with the SWFs issue for a mutually beneficial future of the two countries.

*Charles Ho Wang Mak is a PhD Candidate in international law at the University of Glasgow. He studied law at the University of Sussex in England (LL.B. (Hons.)), The Chinese University of Hong Kong (LL.M. in International Economic Law), and the City University of Hong Kong (LL.M.Arb.D.R.(with Credit)).

**Dr I-Ju Chen is assistant lecturer at Birmingham City University in the UK. She holds PhD in law from the University of Birmingham and LLM from University College London. She studied law at National Chung Hsing University in Taiwan (LLB and LLM).

  1. International working group of sovereign wealth funds: Generally accepted principles and practices, “Santiago Principles” 3, 2008. https://www.ifswf.org/sites/default/files/santiagoprinciples_0_0.pdf ↑
  2. Id. at 5. ↑
  3. Benjamin J. Cohen, Sovereign Wealth Funds and National Security: The Great Tradeoff 85(4) International Affairs (2009) 713, 713. ↑
  4. Sui-Lee Wee, China’s $800 Billion Sovereign Wealth Fund Seeks More U.S. Access, Nytimes.com (2020), https://www.nytimes.com/2017/07/11/business/china-investment-infrastructure.html (last visited Aug 30, 2020). ↑
  5. Patrick DeSouza & W. Michael Reisman, Sovereign Wealth Funds and National Security, in SOVEREIGN INVESTMENT: CONCERNS AND POLICY REACTIONS 283, 290 (Karl P. Sauvant, Lisa E. Sachs, and Wouter P.F. Schmit Jongbloed ed., 2012). ↑
  6. Qingxiu Bu, ‘China’s Sovereign Wealth Funds: Problem or Panacea?’ 11(5) The Journal of World Investment and Trade (2010) 849, 868. ↑
  7. Id, at 870. ↑
  8. Zhao Feng, How Should Sovereign Wealth Funds be Regulated?, 3(2) Brook. J. Corp. Fin. & Com. L. 483, 484 (2009). ↑
  9. Cede & Co. v. Technicolor [1988] 542 A.2d 1182. ↑
  10. See Article 17.1, CPTPP. ↑
  11. Id. ↑
  12. Treaty of Lisbon amending the Treaty on European Union and the Treaty establishing the European Community [2007] OJ C306, Article 64. ↑
  13. O’Donnell C. M., ‘How should Europe respond to sovereign investors in its defence sector?’ (Centre For Euroopean Reform- Policy Brief, September, 2010), PAGE <http://www.cer.org.uk/sites/default/files/publications/attachments/pdf/2011/pb_swf_defence_sept10-203.pdf> accessed 21 June 2020. ↑
  14. Sideek M Seyad, European Community Law on The Free Movement of Capital and EMU (Kluwer Law International 1999) 101-102. ↑
  15. Regulation (EU) 2019/452 of the European Parliament and of the Council of 19 March 2019 establishing a framework for the screening of foreign direct investments into the Union, OJEU, L 79I , 21.3.2019, p. 1–14, https://eur-lex.europa.eu/eli/reg/2019/452/oj. ↑
  16. Bu, supra note 6, 871. ↑
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