Sovereign Wealth Funds – Oversight and Accountability

Much has been written about how Sovereign Wealth Funds (“SWFs”) have developed over the years. But from the establishment of the Kuwait investment Authority in 1953 to those being currently developed or being contemplated, one overriding issue has always been at the fore – what is the optimum model for oversight and accountability – in effect ‘governance’. Different models apply for this also, but notwithstanding the differing set ups, the different cultures, the different purposes of Funds across the world, there are generally a number of key areas that need particular attention. This article examines some areas of such attention – and suggests some areas of emphasis.

First, it is worth considering why governance is so important. Although SWFs are governed by their own by-laws, normally set out in the formatory legislation creating the SWFs, SWFs will generally not be regulated by financial services regulators, since they do not have clients and merely act as asset owners investing for their own account. And, partly as a result of the lack of transparency that is a consequence of not being regulated by financial services regulators, over many years SWFs have developed a reputation for secrecy about almost all areas of their activities, including governance. That trend is now reversing, since all stakeholders – be they the citizens of the country whose assets are in the Fund, the government of the country, co-investors, partners, even employees, are keen to understand how oversight and accountability works. And if a SWF wants to be a successful participant in the world’s financial markets, and wants to have access to the best investments, it needs to be trusted. It will only gain that trust – and credibility – if it can demonstrate that it is subject to proper oversight and accountability. Getting this right will open doors to successful investment returns, getting it wrong will result in it being treated with suspicion and being cold shouldered by its stakeholders. There are many studies which indicate that for a commercial institution, good governance reduces the cost of capital and improves access to capital – nothing is different for SWFs, but they have the added aspect that they do not necessarily always have to raise capital on open markets, so sometimes that motivation of getting governance right to unlock that access is not as strong as it might be. The Santiago Principles – established by the IFSWF back in 2008 – are very helpful guidance about how good governance should work at SWFs. However, there are many practical considerations which can help achieve good governance also.

It is always worth remembering what ‘Governance’ is there for – the word ‘Governance’ derives, ultimately, from the Greek verb ‘kubernaein’, meaning to steer. Governance is all about setting and steering the organisation in the right direction; it is not therefore micromanagement of specific decisions, instead it is more about ensuring the right structures, delegations of authority, policies, processes and oversight practices are in place and are effective. And best decisions in relation to governance are made by groups of persons, not individuals acting alone – although of course sometimes there have to be exceptions.
The main areas where oversight and accountability comes to the fore are:

• Parliamentary Oversight;
• Appointment of the Chairman and the Board;
• Oversight of the Board;
• The need for a ‘Governance Strategy’;
• The three most important policies of a SWF;
• Oversight at Executive level;
• Alignment with the Santiago Principles;
• Other issues.

Parliamentary Oversight

In many countries with SWFs, the Parliament or other state body representing the people will want to have some oversight of the SWF and its activities. This is very understandable, as the SWF is in effect investing the funds of the citizens of the country – and indeed the activities and investments of a SWF will be a matter of keen public interest. The challenge is to find a mechanism that can provide that oversight but with efficiency.

A good method here is to create a mechanism whereby oversight is provided by those with some expertise in the financial sector. Some Parliamentarians may have backgrounds in business or finance or law or accountancy – and it may be helpful to provide training for others so that they are conversant with some of the technical aspects of the investment world. If a Parliament can find a mechanism to elect a cadre of representatives to a Parliamentary Oversight Committee of the SWF, including those with specific finance expertise but also some ‘lay members’, then that can provide a good combination. This can be similar to the Select Committee model that is used in the UK Parliament – introduced in its modern form in 1979, this provides a way for Parliament to oversight specific government departments or agencies, and is widely seen as successful.

Appointment of the Chairman and of the Board

The processes for this will normally be documented in the legislation setting up the Fund. But it is worth noting that a SWF can be as impactive and as high profile in some countries as the Central Bank, so if designing a structure from scratch, a model for appointing the Board of the SWF could be similar to that for appointing the Board of the Central Bank.

One model is that a Minister is the Chair, and is appointed by the government. The other Board and Board Committee members, including the Chief Executive Officer – or Governor – are appointed by the Chair through a traditionally Board selection process – but if the Minister is not the Chair it is helpful all such appointments are with Ministerial consent.

In appointing the rest of the Board, role specifications should be identified, and appropriate candidates sought. Any Board, to be effective, needs a mix of skills and experiences in its composition – for SWFs these may include persons with backgrounds in investment, finance, the public sector, governance, all with the ability to bring best practice in their own areas of expertise, and contacts for outreach, to the table. The Board should end up being a combination of ‘networkers’ – who can add value with their previous experiences, skillsets and knowledge of particular sectors, projects and practices in providing advice and guidance on how things can be done better, and ‘challengers’, who are able to use their experience and skills to challenge appropriately with knowing the right questions to ask in any specific situation and are not afraid to speak up.

In many situations there is also a strong case for creating and appointing an ‘Advisory Board’. This is a separate grouping of individuals who can provide advice and guidance to the SWF on specific areas without legal liability issues. They can be brought together periodically – and would potentially consist of experts in outreach, specific investment type opportunities, governance, ESG, and also can include stakeholders from outside government – for example representatives from a civic society and other groupings which could provide helpful input into the SWF’s strategic thinking. This grouping can become a useful consultative forum to the Board, and can include overseas expertise in the particular subjects, thus enabling international expertise to be garnered without such individuals needing to be on the Board of the SWF, nor for expensive consultants to be appointed.

Board level governance

Here traditional Board governance tools can be used – but for a SWF key areas where there is added risk and therefore emphasis required is that it must be expected that Board members – who are highly qualified individuals whose skills, experience and judgement can assist the SWF in achieving its objectives – will have other professional responsibilities, perhaps in public office. And these interests may conflict with their duty to the SWF. However, they are appointed to the Board in their individual capacity – not as a representative of another government department, and there needs to be an understanding of the difference between ‘vested interests’ – which are interests which are known about, cannot be avoided, and arise because of public office – and potential ‘conflicts of interest’ which normally arise because of commercial interests. The former can be dealt with on the basis that they are understood by all Board members, the latter need to be disclosed as needed and measures need to be put in place to address these. Protocols need to be established to achieve this – and a specific Code of Conduct for Board Members is a useful vehicle for this.

Some key areas where Boards should keep in view duties and responsibilities are as follows:

Ensuring that, practically, the external auditors’ prime relationship and duty is to a governance Audit, Risk and Compliance Committee (“ARCC”) – rather than to the Board as a whole or the Executive. External audit firms also sometimes have governance or other issues arising within them, and it is helpful to have these explained by the firms as and when they happen – so that the SWF can be assured that there is no impact on the firm’s ability to discharge their responsibilities to the SWF;

• Ensuring that professional advisers are fully clear about to whom they owe their duties – the Board may find it helpful to consider using separate advisers who are not potentially aligned to the Executive for sensitive matters;
• Creating standardised Board reportage from the Executive, including regular reportage from the CEO, other disciplines as appropriate, and reportage to the ARCC from Finance and Governance functions;
• Ensuring that the Board paper submission process does not become a ‘sanitisation’ process;
• Having Board members spend time with the SWF’s departments;
• Ensuring the expenses of the most senior persons are reviewed by the ARCC or the Board;
• It is also helpful to demonstrate inclusivity to the Board members by seeking periodic feedback from Board members regarding the operation of the Board;

The need for a Governance Strategy

Many organisations regard ‘Governance’ as a ‘Hygiene Factor’ – ie something that everybody does and knows how to do because that is how they have seen it done throughout their career elsewhere, and there is no need to change habits and practices now. There is therefore a real risk of thinking that it’s just a necessary process, with no one really thinking it through properly, and perhaps nobody really paying too much attention to it.

But that is not the right way to approach ‘Governance’. ‘Governance’ is a ‘discipline’, just like any other business focus – such as Investments, Finance, Operations and the sub-categories thereunder. It too needs a Vision, a Mission Statement, a Strategy, a Plan, a Roadmap with milestones and all the other aspects of corporate project implementation.

And for a SWF it should start with a ‘Governance Risk Assessment’, which drives the priorities, structure and detail, including matters specifically applicable to the SWF such as:

• Alignment with the country’s ‘National Development Objectives’ – by whatever name – these could include matters such as:
• Increasing employment for nationals;
• Ensuring international investment has a demonstrable return into the country in terms of expertise as well as simply monetary;
• Alignment with other government aspirations, such as climate change considerations, education benefits, gender diversity in the workplace etc;
• Specific legal, regulatory and other constraints applicable to government agencies such as data sovereignty laws (which potentially affect the Fund’s activities if the data is deemed ‘government data’), state secrecy laws (which potentially place more restrictions on government data confidentiality than in a private sector corporation);
• Required observance of government practices on other specific matters – for example procurement practices;

A standard best practice model for governance within a financial institution – and is suitable for SWFs – is the ‘Three Lines of Defence Model’, defining roles of a:

• 1st line of defence whereby business leaders at executive level are responsible for establishing and maintaining effective control environments within their areas of responsibility;
• 2nd line of defence whereby oversight control functions of Risk and Compliance, advise on and oversee accountable areas, review the controls environment, have stewardship of company-wide risk and compliance policies, and independently investigate and resolve incidents across the institution. A Board Committee, on behalf of the Board, will oversee these functions.
• 3rd Line of defence whereby an Internal Audit function ,a as an independent functions reports to a Board Committee on the controls effectiveness, and provides assurance on the workings of the 1st and 2nd lines.

Organisational Design

One of the first priorities will be to create an Organisational Design to incorporate effective but proportionate oversight and governance. A sample design is as follows:

As can be seen the idea here is to have a traditional structure with a Board and Board Committees and then with a CEO running the executive functions. Whatever the structure, in general there are pillars for Investments under a Chief Investment Officer, for Finance under a Chief Finance Officer and for Operations under a Chief Operations Officer. There are many other functions which could normally report into a CEO – Public Relations, Strategy, and the like, but in order to reduce the number of direct reports of the CEO, these have been garnered under a Chief of Staff, who in effect becomes the co-ordinator for the CEO of all the various functions – thus leaving the CEO time for outreach, dealing with stakeholders and strategic issues.

The three most important policies of a SWF

In any institution, there will be a Delegation of Authority, determining – amongst other things – which policies need to be approved by the Board, and which can be delegated to the CEO and Executive Management. There are a myriad of policies to be concerned about, but it is generally accepted practice that the Board should set the three most important policies at a SWF – policies which should not be delegated to the Executive to design and approve.

These policies are:

• The Investment Policy Statement – this will include:
• A Sanctions Policy, indicating which jurisdictional sanctions the SWF chooses to comply with – for example, US, EU, UK. The Sanctions policy should generally follow that of the SWF’s host country;
• Diplomatic Restrictions – there may be countries which the SWF’s host country does not deal with, or has not got diplomatic relations with, this should again be aligned to the country’s governmental policy;
• Financial Product Restrictions – this is where a policy states whether or not the SWF should invest in specific products such as crypto-currencies, derivatives etc or in what circumstances;
• Investment Categories – there may be desires not to invest in specific categories, either because of local legislation – eg organisations with material revenues from alcohol, gambling, pornography, military weapons and the like or, indeed, recognising the prohibition of investment into tobacco under the UN Convention. Other categories exist also.

• The Risk Appetite Statement – this sets the authorised parameters for the taking of risk, and establishes a structure for measuring and reporting deviations.
• The Code of Conduct – this sets the behavioural guidelines for all employees of the Fund. As noted above, a separate Code of Conduct for Board Members can be very helpful also.

Oversight at Executive level

Once the Board is in place, and the CEO has been appointed, the next task is for the CEO to create a Management Team and establish an Executive Committee, define a ‘Delegation of Authority’ schedule, and then begin to establish sub-committees such as the important Executive Investment Committee, which should consider all investments prior to their being reviewed by the Board

The three lines of defence model, as noted above, can be a helpful way to ensure that responsibilities for executive level governance functions such as Risk, Compliance and Internal Audit are laid out, together with Divisional Management responsibilities being articulated and well understood.
Roles, policies and processes for relevant areas can be defined, in particular:

• The Investment Process;
• Underlying policies of the Code of Conduct – including Financial Crime issues such as bribery and corruption and ani money laundering policies, confidentiality requirements;
• Other divisional policies as for any corporate organisation, ensuring internal controls and checks are embedded therein;

Monitoring architecture needs to be designed and implemented which can provide the Board with confidence that the activities of the Fund are being oversighted effectively by the CEO through the Executive Committee and the governance functions. Providing such confidence to the Board is absolutely key to the success of the Executive!

Alignment with Santiago Principles

The Santiago Principles represent an excellent guide as to the areas to be addressed in respect of being able to demonstrate overall good governance at a SWF. But they can look quite daunting at first glance, and may seem quite challenging to reach a point of full compliance with them all.

Full compliance will not happen instantly, and indeed there may be some areas where – by reason of the purpose, set up or driver of the SWF – there may be no expectation of full compliance for a number of years. So, like other areas of governance, it is helpful to have an aspirational level of compliance with the Principles and a timescale and put in place a roadmap to chart out the journey to get there.

Although some institutions like to measure compliance on a ‘Principle by Principle’ basis with judging percentages against each Principle and sub-Principle, a good overall sense of the state of alignment can be arrived at by simply analysing all the Principles and measure compliance through using the IMF categorisations of Fully Compliant, Partially Compliant, Non-Compliant – showing aspirations for the coming years, for example.

This format also makes it easier for reportage – it becomes simpler to make visually impactive for Board presentations, for example. Boards should request reportage on the Principles as a Standing Agenda item, perhaps initially after commitment to the Principles on a quarterly basis, but after a couple of years on say a six monthly basis.

Other issues

Lastly, getting proper oversight and accountability embedded into any institution is a journey, and as such the road is subject to trip hazards, pitfalls and potholes. ‘Stuff happens’, as the phrase goes – for example, some appointments of key individuals may not work out, external market factors may present other impediments, relations with stakeholders may not be a successful as wished, and incidents can occur.

But as long as the institution is on a path that is ‘directionally correct’ in terms of governance, with a proper strategy, plan and roadmap, then it’ll get there in due course.