IFLR's journalists in London, New York and Hong Kong all agree: people are overreacting to sovereign wealth funds.

These controversial investment vehicles have become increasingly political since the turn of the year. French President Nicolas Sarkozy spoke out against them and German Chancellor Angela Merkel reinforced her stance against them. Even in the midst of the US race for President, Hillary Clinton tried to turn the topic into a vote winner.

But lawyers all round the world say the same thing: sovereign wealth funds are old news, there is no need to panic and any reaction needs to a considered one.

At the moment, it is estimated that the top sovereign wealth funds hold around $2.5 trillion in assets. By 2015, this is expected to have risen to $12 trillion. China Investment Corporation can already afford to buy Morgan Stanley four times over. Imagine what it could purchase by the middle of the next decade.

After the whirlwind of speculation at the turn of the year, the inevitable regulation of sovereign wealth is starting to take shape. Lawyers were worried that a regulatory response could turn into protectionism, but it looks like action will not be as over zealous as many feared.

Europe outlines regulation

The European Commission (EC) is pressing ahead with a voluntary code of conduct for sovereign wealth funds.

At the end of February, European Commission president José Manuel Barroso issued a statement during his official visit to Norway. While admitting that sovereign wealth is "not a big bad wolf at the door", he drew upon the transparency of Norwegian funds as a paradigm for other funds in Europe.

"A code of conduct has been inevitable since the furore over sovereign wealth started at the turn of the year," said a funds partner at one US law firm. "But that doesn't mean it was required. This will just quieten political panic and make it look like serious action is being taken."

But Barroso justified his statement by saying that a level playing field will benefit Europe as a whole: "We will propose a common approach at European level, avoiding distorting the single market with incompatible national responses. This EU approach should benefit both investor and recipient countries."

Barroso's plans were confirmed later in the same week in Commission proposals released, which were designed to direct discussions of European leaders at the spring European Council on March 13 and 14.

The proposals called for the leaders to agree to a voluntary code of conduct. In particular, it hoped this would encourage some "opaque" funds to disclose the value of their assets, investment objectives and the nature of their risk management systems.

The political (over)reaction
	"This is about protecting important industrial sectors"
German Chancellor Angela Merkel
	"We will protect innocent French managers from the extremely aggressive funds"
French President Nicolas Sarkozy
	"China Investment Corporation is entirely commercial"
China's Premier Wen Jiabao
	"We need to have a lot more control over what they do and how they do it"
US presidential candidate Hillary Clinton
	"The British commitment to open markets means we will welcome sovereign funds"
UK government official

Ironically, these proposals may have prevented stronger regulation. By calling for a code of conduct the Commission has stumbled across a middle ground. European leaders such as German Chancellor Angela Merkel and French President Nicolas Sarkozy will have found it hard to get backing for legislation with a more moderate proposal on the table. Neither has publicly declared their desire for heavy regulation, but their stance has been obvious from anti-sovereign wealth statements.

Indeed, the Commission's proposals seemed to strike a chord with the Economic and Financial Affairs Council (ECOFIN) who met on March 4 to discuss sovereign wealth funds to prepare the discussion of the full council nine days later. As a result, the presidency conclusions from the mid March meeting in Brussels said:

"The European Council agrees on the need for a common European approach taking into account national prerogatives, in line with the five principles proposed by the Commission, namely: commitment to an open investment environment; support for ongoing work in the IMF and the OECD; use of national and EU instruments if necessary; respect for EC Treaty obligations and international commitments; proportionality and transparency.

"The European Council supports the objective of agreeing at international level on a voluntary code of conduct for sovereign wealth funds and defining principles for recipient countries at international level."

But opponents to sovereign wealth regulation should not rest easy. Any voluntary code of conduct could be hardened at a later date. This was a lesson learnt by the private equity code of conduct in the UK last year.

And Barroso refused to rule out further action: "We will not propose European legislation. Though we reserve the right to do so if we cannot achieve transparency through voluntary means."

Australian regulation

But sovereign wealth fund regulation started in the southern hemisphere in February. Australia issued specific international guidelines on government-backed investors before the EC announcements.

The country unveiled a set of screening criteria governing sovereign wealth fund investments, which will be used by regulators to judge foreign, namely sovereign wealth fund, bids. Among the six guidelines is whether the investors "are independent from the relevant foreign government," including the extent to which they operate at arm's length from its government and whether they are controlled by a foreign government, including funding arrangements.

Others include whether the fund follows common standards of business behaviour showing clear commercial objectives and good corporate governance practices.

As a member state of the OECD, the body responsible for designing a code of conduct for recipient countries, it is likely that Australia's set of six principles will be similar to the organisation's final suggestions. And although the announcement is the first solid piece of regulation on the matter, the six principles are little more than official statements on current practices.

"This seems to be the beginning of a very long process for sovereign wealth fund regulation. The Australian government appears to be saying that this isn't the last word but the beginning of the conversation," said Stephen Harder, a China partner at Clifford Chance. "Also, calling them six principles makes them sound more tangible than they are. We have to remember that [the Australian government] is reiterating several powers that it already has," said Harder.

Harder also believes that through a cumulative process of failed and successful bids investee countries and the corresponding foreign sovereign wealth funds will develop an almost common law-style set of precedents for which types of transactions go forward and which do not. "But once we start seeing really large investments, very few countries will not reserve the right to consider political issues raised by the target's new ownership structure," he added.

Europe: stop panicking

In January, IFLR's journalists brought together the opinions of lawyers world wide on the issue of sovereign wealth. The overwhelming message was: "don't panic".

For example, Standard Chartered claimed that sovereign wealth funds are potentially "irresponsible participants in the world economy." This was an overreaction, according to UK counsel.

In an interview in mid-January, the bank's chairman Mervyn Davies called for a code of conduct to create more transparency. This was significant given that Temasek, the Singapore state fund, holds an 18% stake in Standard Chartered.

One UK corporate partner reacted by saying: "I don't understand all this fuss about sovereign wealth funds. Qatari funds have been active in London since the early nineties and no one has ever made a big deal about it.

"The national papers have suddenly latched onto them in much the same way that they did with private equity last year. It's pure scaremongering."

But it was exposure in the media and public pressure that led to Sir David Walker drafting a private equity code of conduct in November last year.

The focus on sovereign wealth funds can be attributed to the governments of Kuwait, Singapore and South Korea providing most of the $21 billion lifeline to Citigroup and Merrill Lynch earlier in January. The media sunk its teeth into this and it is unlikely to let go easily.

"A code of conduct would only serve to quieten people who are panicking for little reason," the UK corporate partner continued. "No one was concerned about transparency of sovereign wealth funds before, why should they start now?"

Lessons should also be learned from last year's UK private equity code. People quickly realised that the code was merely a sop to their concerns and there is now pressure to strengthen it. If a similar code is drawn up for sovereign wealth funds, it will have to have more weight to it.

Some at an international level are also arguing that policy makers need to avoid over-zealous regulation that could smack of protectionism. The day after Davies' comments, secretary general of the OECD Angel Gurria issued a warning to regulators.

"The OECD is saying buyers have to have transparency, abide by market rules. But sellers: don't overreact, don't over-regulate, don't over-control, don't over-legislate. They are helping investments, solving some of the problems, like global imbalances. They could become sovereign development funds," he said.

US: It's a liquidity boost

Lawyers in the US also say that sovereign wealth should not be feared. Indeed, it will help improve liquidity.

"One factor is their huge dollar surplus, which needs to be invested. Putting that in the US is a good thing overall," said Paul Lee, partner at Debevoise & Plimpton.

Many say the increased deal speed that is possible at sovereign funds will help the US steer clear of recession. It could reduce liquidity problems at America's large banks, and help to keep loans flowing.

Deals are often processed faster within sovereign funds as they are subject to less regulation and have a streamlined internal decision-making process, unlike pension funds and other large investors.

That lack of regulation could be a cause for concern, but lawyers point out that the funds rarely take more than a 5% stake in the company, suggesting they do not intend to take over any part of it. The acquisition of less than 5% of voting securities establishes the presumption that the acquirer is not taking control.

Investors would only gain a voice in the management of the company if they held more than 5%. That would involve greater regulation and so transparency. An acquirer of 5% or more of voting securities of a public company must report the acquisition to the SEC; 4.9% acts as a reporting and regulatory clearance threshold.

"The natural inclinations of sovereign funds are consistent with the natural inclinations of investors in the US financial sector. Those normally mean acquiring no more than 4.9%, or in some cases 9.9% of the financial institution," said Lee.

These sovereign funds also don't rely on leverage, which has been a source of concern around hedge fund investments. Sovereign funds have a more stable capital base, which permits long-term investments. They can also tolerate greater risk.

Some in the US are scared that these funds will dominate financial institutions. But even though Wall Street has already accumulated $59 billion of investment, Lee said that "in the financial sector, it's less likely that one would see sovereign foreign investors acquiring a controlling stake".

One suggested solution for concerns over transparency is for sovereign funds to agree to a code of conduct, rather like that imposed by private equity funds on themselves. Canada has already declared something similar, with funds being required to have independent Canadian boards and commit to selling to Canadian consumers (see box at the end of this story).

Some also point out that, despite the high-profile investments in Citigroup and Merrill Lynch, these funds are nothing new to the US. Foreign states have been recycling the dollar back into the US for years. The difference now is that the declining dollar encourages foreign investors to turn away from treasuries and into stock.

Australia: Controversial, but here to stay

Sovereign wealth funds are creating the same reaction in the southern hemisphere. They may be causing equal measures of panic and glee among central governments and flailing investment banks, but it would appear that the legality of their dealings cannot be questioned.

China's State Administration of Foreign Exchange (Safe) purchased stakes in three of Australia's largest banks in late December, attracting some opposition. Complaints centred on Safe's denial of the investments, and its request that the Financial Times not publish details of the stake. Some observers also questioned why Safe is making the kind of risky investment that China Investment Corp, the country's sovereign wealth fund, is supposed to be responsible for.

However, the investments are comparatively small, with each stake worth A$200 million ($176 million), and fly well below the threshold of equity investments needing regulation in Australia.

Australia and New Zealand Bank and Commonwealth Bank of Australia said Hong Kong-registered Safe Investment Company had bought stakes of less than 1% in each of the lenders.

"We're speaking about very minor levels here," said David Olsson, capital markets partner at Mallesons Stephen Jaques' Melbourne office.

"There is a political element to these complaints. But providing everyone follows the same rules, there can't be too many objections. From an Australian perspective, once we reach 10% to 20% and there is a significant equity interest, there is obviously an increase in regulation," he added.

As already mentioned, Australia has since outlined its regulatory response to sovereign wealth. Australia also has a foreign investment review board which would evaluate any investments on national merits should they reach such a level.

Inevitable change

Despite the fact that they are nothing new, sovereign wealth funds will continue to strike fear into politicians. This is because the central issue is a lack of transparency, and so a lack of control.

Sovereign wealth funds will have to change the way they operate. In Europe, private equity has had to succumb to a code of conduct. And hedge funds have begun to follow a similar route. If they want to maintain their investment plans overseas, sovereign wealth funds will have to find similar ways to mollify opposition. Adhering to the rules set down by regulators would go a long way to pacifying the sensational focus on sovereign wealth so far in 2008.

Largest sovereign wealth funds

By Lynann Butkiewicz, Nicholas Pettifer and Tom Young