In light of sequestration and other congressionally mandated budget cuts, investors should expect that certain industries that conduct business with the US government will become distressed, and that opportunities to acquire assets from distressed companies will rise. In particular, mid- and lower-tier government contractors are likely to face the greatest pressure. Anticipated bankruptcies and consolidation within the defense and other sectors linked to US national security will likely present significant opportunities for investors.
Investors may acquire struggling assets in several ways, including in bankruptcy proceedings via a public auction of a company’s assets pursuant to Section 363 of the US Bankruptcy Code (a 363 sale) or a restructuring that results in a debt-to-equity conversion in which the lenders to the distressed entity take ownership of the distressed company in exchange for cancelling their debt. In each of these transaction structures, foreign investors—as well as US investors with foreign ownership—should be aware of the US national security regulatory requirements and their implications.
One key national security regulatory consideration is the Committee on Foreign Investment in the United States (CFIUS) review process. CFIUS is a multi-agency executive branch committee that conducts national security reviews of transactions that could result in a foreign entity having control over a US business (a covered transaction). CFIUS is ostensibly a voluntary process, but not filing can carry significant risks for the buyer. In cases with a strong nexus to US national security—for example, where the US company holds a facility security clearance and is performing on classified contracts—filing is for all practical purposes mandatory.
The CFIUS process presents timing considerations that an investor must account for in developing an acquisition strategy. A CFIUS filing is a joint notice that includes information about both the foreign investor and the US company, and it can take several weeks to gather the information necessary for a CFIUS filing. CFIUS requests that parties “prefile” a draft version of the filing for at least five business days, after which they may formally file and begin the initial review period, which lasts 30 calendar days. After the initial review, CFIUS may conclude the process or proceed to a 45-calendar-day investigation. In rare cases, CFIUS can refer transactions to the US President for a decision, though typically cases are concluded after the review or investigation period. Approximately one-third of cases reach investigation, so a prudent investor should account for a full 75-day formal CFIUS process.
CFIUS review is likely to be appropriate in cases where a foreign buyer wants to acquire a distressed US contractor in a sector linked to US national security (e.g., defense), so it is critical to have a CFIUS strategy in place early in the process. For foreign buyers pursuing a US target via a 363 sale, bidders must establish themselves as qualified bidders. To be a qualified bidder, the foreign buyer will need to demonstrate that it has received or will be able to obtain CFIUS approval. Failing to do so can severely impair a bid. CFIUS will accept filings for “stalking horse” bidders (i.e., the lead bidder selected by the US company), and obtaining CFIUS approval early in the process can help put a foreign buyer on equal footing with US bidders and provide an advantage over competing foreign bidders. Even if a bidder does not obtain stalking-horse status or otherwise cannot practically obtain early CFIUS approval, presenting a strong CFIUS strategy and demonstrating the likelihood of CFIUS approval will strengthen the foreign bidder’s position and chances of success in the auction.
In the case of debt-to-equity conversions, the foreign ownership of the lenders who are converting their debt must be ascertained in order to assess whether the restructuring may constitute a covered transaction. Strategic decisions can significantly impact the CFIUS risks. For example, if the equity will be held by a syndicate of lenders that includes foreign entities, the transaction would not be subject to CFIUS jurisdiction as long as the agent for the syndicate is a US-owned and -controlled entity and the foreign owners will not be in a position to control the US business.
If the distressed US company—or one or more of its subsidiaries—holds a facility security clearance, the investor will need to assess whether the transaction will result in foreign ownership, control or influence (FOCI) over the cleared company. Under US law, in order for a company under FOCI to obtain or maintain a facility security clearance, its FOCI must be appropriately mitigated. The type of FOCI mitigation varies depending upon the nature and extent of the FOCI involved (e.g., majority FOCI requires more robust FOCI mitigation than minority foreign investments). Foreign ownership as low as five percent could trigger a FOCI mitigation requirement, so this must be carefully considered even for predominantly US transactions. If a buyer expects post-closing FOCI, it must develop and present a FOCI mitigation plan to the cognizant security office (such as the US Department of Defense’s (DOD) Defense Security Service, which administers the DOD’s FOCI program) to ensure continuation of the company’s clearances following closing.
Unlike the CFIUS treatment of debt-to-equity conversions, the act of foreign lenders in a lending syndicate ceding control to a US agent does not necessarily exempt the US company from FOCI analysis. Indeed, even if there is no foreign investor among a group of lenders that will directly or indirectly hold at least five percent of the US company, it is important to have a strategy for explaining the post-restructuring ownership to the cognizant security office to establish that a FOCI mitigation arrangement is not necessary and that the US company should be permitted to continue its classified activities without additional requirements.
Transactions involving distressed assets can present significant opportunities as well as a number of challenges, including both bankruptcy and national security regulatory considerations. Before pursuing the acquisition of distressed assets, it is critical to engage with counsel experienced in the relevant issues and sensitivities and establish a transactional and national security strategy.