• 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.