On October 10, 2018, the Treasury Department announced that the interagency Committee on Foreign Investment in the United States (“CFIUS”) had used its new authority under the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”) (which became law on August 13, 2018) to adopt a pilot program under which CFIUS will (i) exercise jurisdiction over certain non-controlling, non-passive foreign investments in U.S. businesses that involve critical technology and certain industry sectors and (ii) introduce a mandatory CFIUS filing requirement with respect to foreign acquisitions of control over, as well as certain non-controlling, non-passive foreign investments in, U.S. businesses that involve critical technology in certain industry sectors. This pilot program could have a substantial impact on foreign investments (both controlling and non-controlling) in a number of U.S. industry sectors.
The Treasury Department issued new regulations implementing the pilot program (which will go into effect on November 10, 2018), along with a second set of regulations making technical amendments to the existing CFIUS regulations to reflect both the pilot program and the changes brought about by FIRRMA (which went into effect on October 11, 2018). The pilot program will end on the earlier of (i) the day on which the Treasury Department issues regulations fully implementing FIRRMA or (ii) March 5, 2020.
Although Congressional sentiment in adopting FIRRMA was largely directed against the perceived threat posed by foreign investment from China, the pilot program regulations provide no exceptions for any countries, including allies of the United States. While these regulations (and the mandatory filing requirement) go into effect on November 10, 2018, they do not apply to any transaction
- that closes before November 10, 2018;
- where the transaction parties executed a binding written agreement or other document establishing the material terms of the transaction before October 11, 2018;
- where a party made a public offer to shareholders to buy shares of a U.S. business before October 11, 2018; or
- where a shareholder had solicited proxies in connection with an election of the board of directors of a U.S. business, or had requested the conversion of convertible voting securities, before October 11, 2018.
I. Expansion of CFIUS Jurisdiction to Cover Certain Non-Controlling Foreign Investments
Prior to the enactment of FIRRMA, CFIUS jurisdiction -- and the related ability of the President to block or unwind a transaction -- was limited to acquisitions, investments, and joint ventures that could result in foreign control over any U.S. business (direct or indirect). Subject to implementing regulations, FIRRMA expands the range of transactions subject to CFIUS jurisdiction to include certain non-controlling, non-passive investments by foreign persons in U.S. businesses that involve critical technology, critical infrastructure, or the maintenance or collection of sensitive personal data of U.S. citizens. In the pilot program, CFIUS has chosen to act only with respect to the first of these three areas -- i.e., critical technology -- and only in certain industry sectors.
Specifically, under the pilot program regulations, a non-controlling foreign investment in a U.S. business will now be subject to CFIUS jurisdiction where all of the following apply:
- the U.S. business produces, designs, tests, manufactures, fabricates, or develops a critical technology;
- the critical technology is (i) utilized in connection with the U.S. business’s activity in one or more pilot program industries or (ii) designed by the U.S. business for use in one or more pilot program industries (the regulations refer to a U.S. business that meets the requirements set forth in these first two bullets as a “pilot program U.S. business”); and
- the investment provides the foreign person with any of the following: (i) access to any material nonpublic technical information in the possession of the pilot program U.S. business, (ii) membership or observer rights on the board of directors or equivalent governing body of the pilot program U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body of the pilot program U.S. business, or (iii) any involvement (other than through the mere voting of shares) in substantive decision-making of the pilot program U.S. business regarding the use, development, acquisition or release of critical technology (the regulations refer to an investment that meets the requirements set forth in all three of these bullets as a “pilot program covered investment”).
With respect to the types of foreign investor rights that trigger categorization as a “pilot program covered investment” (as described above), the pilot program regulations provide that obtaining CFIUS clearance for such an investment does not provide protection with respect to an acquisition of additional equity in a “pilot program U.S. business” that is accompanied by additional triggering rights. For example, if transaction parties obtain CFIUS clearance for a foreign investor acquiring a 5% equity stake in a “pilot program U.S. business” that includes access to the U.S. business’s material nonpublic technical information, an acquisition by the same foreign investor of another 5% interest that includes the right to place an observer on the U.S. business’s board of directors would be a new transaction for CFIUS purposes.
The pilot program regulations define “investment” as “the acquisition of equity interest, including contingent equity interest,” and they define “contingent equity interest” as “a financial instrument that currently does not entitle its owner or holder to voting rights but is convertible into an equity interest with voting rights” (for example, convertible debt). As for “critical technologies” the new regulations define this term by reference to a list of different types of regulatory controls (most of them export controls). Specifically, a “critical technology” means any of the following:
- defense articles or defense services included on the United States Munitions List set forth in the International Traffic in Arms Regulations (22 CFR parts 120–130);
- items included on the Commerce Control List set forth in Supplement No. 1 to part 774 of the Export Administration Regulations (15 CFR parts 730–774) and controlled (i) pursuant to multilateral regimes, including for reasons relating to national security, chemical and biological weapons proliferation, nuclear nonproliferation or missile technology, or (ii) for reasons relating to regional stability or surreptitious listening;
- specially designed and prepared nuclear equipment, parts and components, materials, software and technology covered by 10 CFR part 810 (relating to assistance to foreign atomic energy activities);
- nuclear facilities, equipment and material covered by 10 CFR part 110 (relating to export and import of nuclear equipment and material);
- select agents and toxins covered by 7 CFR part 331, 9 CFR part 121 or 42 CFR part 73; or
- emerging and foundational technologies controlled pursuant to section 1758 of the Export Control Reform Act of 2018.
Consequently, determining whether a U.S. business that is the target of a foreign acquisition or investment produces, designs, tests, manufactures, fabricates or develops a critical technology will require performing an export control assessment of the products, materials, equipment, software and technology/know-how possessed and used by the U.S. business. The last category listed above -- emerging and foundational technologies -- is particularly interesting, both because no list of such technologies exists yet and because, when such a list is issued, it could substantially expand the range of transactions that trigger the new mandatory filing requirement. An interagency group, chaired by the Commerce Department, is presently working on a such a list of emerging and foundational technologies and the new export control requirements that will apply to this list – which, when completed, will be issued in the form of Commerce Department amendments to the Export Administration Regulations. It is not yet clear what technology areas will be captured under this new category of “emerging and foundational technologies,” but there is considerable speculation that it may include at least portions of such technology sectors as artificial intelligence, biotechnology, the internet of things, robotics, augmented reality and blockchain technology.
As for what constitutes a “pilot program industry,” the new regulations provide that this term refers to any industry identified in the following list by reference to the North American Industry Classification System (“NAICS”):
- Aircraft Manufacturing, NAICS Code: 336411;
- Aircraft Engine and Engine Parts Manufacturing, NAICS Code: 336412;
- Alumina Refining and Primary Aluminum Production, NAICS Code: 331313;
- Ball and Roller Bearing Manufacturing, NAICS Code: 332991;
- Computer Storage Device Manufacturing, NAICS Code: 334112;
- Electronic Computer Manufacturing, NAICS Code: 334111;
- Guided Missile and Space Vehicle Manufacturing, NAICS Code: 336414;
- Guided Missile and Space Vehicle Propulsion Unit and Propulsion Unit Parts Manufacturing, NAICS Code: 336415;
- Military Armored Vehicle, Tank, and Tank Component Manufacturing, NAICS Code: 336992;
- Nuclear Electric Power Generation, NAICS Code: 221113;
- Optical Instrument and Lens Manufacturing, NAICS Code: 333314;
- Other Basic Inorganic Chemical Manufacturing, NAICS Code: 325180;
- Other Guided Missile and Space Vehicle Parts and Auxiliary Equipment Manufacturing, NAICS Code: 336419;
- Petrochemical Manufacturing, NAICS Code: 325110;
- Powder Metallurgy Part Manufacturing, NAICS Code: 332117;
- Power, Distribution and Specialty Transformer Manufacturing, NAICS Code: 335311;
- Primary Battery Manufacturing, NAICS Code: 335912;
- Radio and Television Broadcasting and Wireless Communications Equipment Manufacturing, NAICS Code: 334220;
- Research and Development in Nanotechnology, NAICS Code: 541713;
- Research and Development in Biotechnology (except Nanobiotechnology), NAICS Code: 541714;
- Secondary Smelting and Alloying of Aluminum, NAICS Code: 331314;
- Search, Detection, Navigation, Guidance, Aeronautical and Nautical System and Instrument Manufacturing, NAICS Code: 334511;
- Semiconductor and Related Device Manufacturing, NAICS Code: 334413;
- Semiconductor Machinery Manufacturing, NAICS Code: 333242;
- Storage Battery Manufacturing, NAICS Code: 335911;
- Telephone Apparatus Manufacturing, NAICS Code: 334210; or
- Turbine and Turbine Generator Set Units Manufacturing, NAICS Code: 333611.
II. New Mandatory Filings with CFIUS
Using authority provided by FIRRMA, the pilot program regulations impose a mandatory filing requirement on two types of transactions, both related to critical technology and pilot program industries. Those two categories of transaction are as follows:
- any “pilot program covered investment” (as defined in Section I above); and
- any transaction by or with any foreign person that could result in foreign control of any “pilot program U.S. business” (as defined in Section I above), including such a transaction accomplished by means of a joint venture.
In other words, mandatory filings are now required for the following:
- foreign acquisitions of control over “pilot program U.S. businesses” (which were subject to CFIUS jurisdiction, but not mandatory filings, prior to adoption of FIRRMA); and
- foreign non-controlling investments that quality as “pilot program covered investments” (which were not subject to CFIUS jurisdiction prior to the adoption of FIRRMA).
As noted above, this mandatory filing requirement applies regardless of what foreign country or countries the foreign person is associated with. The mandatory filing can, at the discretion of the transactions parties, take the form of either a traditional notice (which is a substantial filing) or the new short-form declaration that was introduced under FIRRMA. The advantages of filing the declaration are (i) that Congress intended it to be a much shorter and less labor-intensive filing than the traditional notice and (ii) that, once the declaration has been accepted as complete by the Treasury Department, CFIUS has 30 days in which to respond.
Unfortunately, the potential advantages of filing a declaration are undercut by three important factors: (i) CFIUS’s broad discretion in how it responds to the filing, (ii) the requirements for declarations that CFIUS has imposed under the pilot program regulations, and (iii) the reduced protection that the new regulations provide for CFIUS clearances that are obtained based on declarations rather than notices in the case of “pilot program covered transactions” in which the foreign person is acquiring control of a “pilot program U.S. business.” Specifically,
- First, at the end of the 30 days, while CFIUS is empowered under FIRRMA and the new regulations to clear the transaction, it is also empowered to ask the parties to file a traditional notice (at which point significant time has been lost that could have been committed up front to drafting and submitting a notice).
- Second, the new regulations impose substantial requirements on the content of declarations, including certain requirements that do not even apply to traditional notices. Given these requirements, it is very difficult to envision situations in which declarations would come close to meeting the Congressional intent that they “would not generally exceed 5 pages in length” (as stated in FIRRMA).
- Third, where the transaction parties involved in a “pilot program covered transaction” in which the foreign person is acquiring control of a “pilot program U.S. business” choose to file a notice, a CFIUS clearance protects not only the transaction in front of CFIUS but also any subsequent acquisition of an additional interest in the “pilot program U.S. business” by the same foreign person (for example, the foreign investor raising its stake from 60% to 100%). However, the pilot program regulations provide that this safe harbor for subsequently acquiring a larger interest in a “pilot program U.S. business” do not apply where a CFIUS clearance is based on a declaration rather than a notice.
In light of these challenges, declarations seem most likely to be used in connection with acquisitions and investments that trigger the new mandatory filing requirement but where
- in the absence of this requirement, transaction parties would not have been inclined to make any filing with CFIUS based on assessing the target U.S. business and the foreign acquirer or investor; and
- for a transaction where the foreign investor is acquiring control of a “pilot program U.S. business,” the foreign investor is acquiring 100% ownership of the U.S. business.
By contrast, where an acquisition or investment that triggers the new mandatory filing requirement also seems to raise meaningful national security issues, or where the foreign investor is acquiring control but less than 100% ownership of the U.S. business, it seems likely that transaction parties will generally file a traditional notice.
Finally, it should be noted that, in a mixed blessing for U.S. and U.S.-controlled investment funds and their foreign investors, CFIUS chose to clarify -- and in some ways to modify -- the limited protection that FIRRMA provided for foreign persons making indirect investments in U.S. businesses through investment funds where those foreign investors have the right to place a representative on the fund’s advisory board or a fund committee. Specifically, the pilot program regulations provide that “an indirect investment by a foreign person in a pilot program U.S. business through an investment fund that affords the foreign person (or a designee of the foreign person) membership as a limited partner or equivalent on an advisory board or a committee of the fund shall not be considered a pilot program covered transaction with respect to the foreign person if [all of the following requirements are met]”:
- the fund is managed exclusively by a general partner, a managing partner or an equivalent;
- the foreign person is not the general partner, managing member or an equivalent;
- the advisory board does not have the ability to approve, disapprove or otherwise control
- investment decisions of the investment fund; or
- decisions made by the general partner, managing member or equivalent related to entities in which the investment fund is invested;
- the foreign person does not otherwise have the ability to control the investment fund, including the authority
- to approve, disapprove, or otherwise control investment decisions of the investment fund;
- to approve, disapprove or otherwise control decisions made by the general partner, managing partner or equivalent related to entities in which the investment fund is invested; or
- to unilaterally dismiss, prevent the dismissal of, select or determine the compensation of the general partner, managing member or equivalent; and
- the foreign person is not provided with
- access to material nonpublic technical information of the “pilot program U.S. business”;
- membership or observer rights on the board of directors or equivalent governing body of the “pilot program U.S. business” or the right to nominate an individual to a position on the board of directors or equivalent governing body; or
- any involvement in substantive decision-making of the “pilot program U.S. business” regarding the use, development, acquisition or release of critical technologies.
While these requirements should be manageable in most cases, U.S. and U.S.-controlled investment funds that permit foreign limited partners to sit on advisory boards and fund committees will have to be alert to these criteria for remaining within the safe harbor, particularly given the new mandatory filing requirement. It should be noted that these criteria are relevant not only at the time a U.S. or U.S.-controlled investment fund is considering the admission of a new foreign investor, but also (with respect to existing foreign investors) when the fund is looking at acquiring or investing in any “pilot program U.S. business.”
The pilot program regulations surprised many CFIUS observers in terms of the broad sweep of transactions that will now be subject to a mandatory CFIUS filing requirement -- including many transactions involving acquisitions or investments by well-known companies based in countries that are U.S. allies where, in the absence of the mandatory filing requirement, the transaction parties would have been unlikely to make a CFIUS filing. Given that CFIUS was having difficulty handling the number of cases being filed before the pilot program regulations were issued, and given that the new mandatory filing requirement will substantially increase the number of cases being filed, it is safe to assume CFIUS is going to encounter a very challenging adjustment period once the pilot program regulations go into effect -- and that transaction parties that have cases before CFIUS are going to feel the impact of this adjustment period.
Whether these substantial challenges will cause CFIUS to rethink the breadth of the new mandatory filing requirement remains to be seen. In the meantime, foreign acquirers and foreign investors (as well as U.S. sellers and U.S. targets) will have to be very sensitive to the export control profile and industry sector of U.S. target businesses. Failing to comply with the mandatory filing requirement, assuming it is discovered by CFIUS, could result in the foreign acquirer or investor facing a very unpleasant CFIUS case after the deal has closed, potentially ending with the imposition of a divestment order or onerous conditions. Moreover, failure to comply with the mandatory filing requirement can subject both the foreign acquirer/investor and the seller to substantial civil penalties, up to the value of the transaction that was not submitted for CFIUS review.