ON MAY 16, 2008, Booz Allen Hamilton Inc. announced that it would be selling a majority stake in its U.S. government consulting business to the Carlyle Group (“Carlyle”). Several months before the announcement, rumors of a possible deal caused the Service Employees International Union (“SEIU”) to charge that the deal would raise national security concerns.1
The same concerns have now been voiced again by SEIU, which demanded immediate congressional attention “to examine any national security implications and to clarify present and future control issues before the deal receives regulatory approval.”2 Cause for such concerns is Carlyle’s September 2007 announcement that it had sold a 7.5% ownership stake to an affiliate of Mubadala Development Company (“Mubadala”), a sovereign wealth fund (“SWF”) wholly owned by the government of Abu Dhabi. Similar investments by SWFs in U.S. private equity firms, such as The Blackstone Group LP and Apollo Investment Management LP, have been announced over the last year. Such SWF investments in U.S. private equity firms, along with a shift generally in the investment strategy of SWFs into “alternative assets,” such as private equity funds, have resulted in demands for greater transparency and disclosure by U.S. private equity funds and their SWF investors.3
SEIU, in its report released on April 23, 2008, entitled “Sovereign Wealth Funds and Private Equity: Increased Access, Decreased Transparency” released on (the “SEIU Report”)4, proposed, among other things, that private equity funds should be required to disclose the ownership structure of their general partners and management companies as well as the identity of their limited partners. SEIU further proposed that investigations by the Committee on Foreign Investment in the United States (“CFIUS”) of all proposed acquisitions involving U.S. private equity firms and SWFs be mandatory. It is likely that SEIU will make similar proposals as part of the comments it is expected to submit to the U.S. Treasury Department’s proposed “Regulations Pertaining to Mergers, Acquisitions, and Takeovers by Foreign Persons,” published on April, 21, 2008, two days before the release of the SEIU Report.
The proposed regulations will implement amendments made by the Foreign Investment and National Security Act of 2007 (“FINSA”)5 to Section 721 of the Defense Production Act of 1950, as amended by what is commonly known as the “Exon-Florio Amendment,”6 and would supersede procedures governing CFIUS since enactment of the Exon-Florio Amendment. FINSA provides statutory authority for CFIUS to review acquisitions of U.S. businesses by entities controlled by foreign governments or other foreign persons to determine the impact of such transactions on the national security of the United States, and codifies certain aspects of the committee’s structure, process and responsibilities, including the role of certain executive branch departments, agencies and offices, in the review process.
Consistent with existing practice, the proposed regulations do not require mandatory CFIUS filings for transactions that could result in control of a U.S. business by a foreign person. Instead, reviews of such transactions are based on voluntary notices to CFIUS. However, since CFIUS has the authority to review all transactions, CFIUS filings are effectively required for transactions that impact our national security or critical infrastructure. Additionally, the proposed regulations make explicit CFIUS’s current practice of encouraging parties to contact and engage with CFIUS before submitting a formal filing for review, including providing a draft notice where appropriate. In a departure from existing practice, the proposed regulations significantly expand the mandatory disclosure requirements, increasing both the type and amount of information required in a CFIUS filing, including personal identifier information to allow background checks. Consistent with existing practice, information submitted to CFIUS with a voluntary filing is entitled to confidentiality and exempt from disclosure under the Freedom of Information Act. The proposed regulations require that the chief executive or another duly authorized designee of a party filing a notice with CFIUS sign a certification as to the accuracy and completeness of the notice and the information provided. The proposed regulations implement the FINSA requirement for civil penalties and give CFIUS the authority to impose civil penalties of up to $250,000 per violation.
The proposed regulations, following a long-standing approach, define “control” in functional terms as the ability to exercise important matters affecting a U.S. business. The definition of control “eschews bright lines”7 based on a specified ownership interest or number of board seats. Instead, all relevant factors, such as equity ownership, board representation and contractual rights, are considered in light of their potential impact on the ability of a foreign person or government to determine, direct or decide important matters affecting a U.S. business. The proposed regulations describe in some detail minority shareholder protection rights that do not by themselves confer control over a U.S. entity.
In addition, the proposed regulations provide that a transaction is not subject to CFIUS review if the transaction results in a foreign person holding 10% or less of the voting interests in a U.S. business “solely for the purpose of investment.” We would expect that these regulations, if finalized as proposed, will provide guidance to parties in structuring transactions involving investments of SWFs in private equity firms or funds being formed to acquire U.S. government contractors or other U.S. businesses with national security implications.
At a public hearing on the proposed regulations held by the U.S. Treasury Department, many comments focused on the manner in which the proposed regulations may affect investments by SWFs in U.S. private equity firms.8 Specifically, comments were made that the proposed regulations were unclear on whether a U.S. private equity fund would have to submit acquisitions for CFIUS review simply because a SWF is one of its limited partners.9
Background of the Proposed Regulations
FINSA, which President George W. Bush signed into law on July 26, 2007 and which became effective on Oct. 24, 2007, formalizes the process by which CFIUS conducts national security reviews of acquisitions of U.S. businesses by foreign persons. FINSA provides for a 30-day CFIUS review of a covered transaction to determine its impact on national security and address any threat. In certain cases, including where the transaction is a foreign government-controlled transaction, FINSA requires an additional 45-day investigation. Where a transaction with a foreign person raises national security concerns, FINSA provides statutory authority for CFIUS to enter into a mitigation agreement with parties to the transaction or to impose conditions on the closing of the transaction to address such concerns. This authority allows CFIUS to mitigate the national security risks posed by a transaction, rather than simply recommending to the President that the transaction be prohibited because it could impair U.S. national security.
Details of Certain Proposed Regulations
1. Covered Transactions
The term “covered transaction” was introduced by FINSA to identify the types of transactions that are subject to CFIUS review. The proposed regulations define “covered transaction” as any merger, acquisition or takeover “that is proposed or pending after the effective date by or with any foreign person, which could result in control of a U.S. business by a foreign person.”10
Examples of transactions that constitute covered transactions for purposes of CFIUS review include the following:
- a transaction which, irrespective of the actual arrangements for control provided in the terms of the transaction, could result in control of a U.S. business by a foreign person;
- a transaction in which a foreign person conveys its control of a U.S. business to another foreign person;
- a transaction that results or could result in control by a foreign person of assets that constitute a U.S. business; and
- a joint venture in which the parties enter into a contractual arrangement, including an agreement on the establishment of a new entity, but only if one of the parties constitutes a U.S. business and a foreign person gains control over that U.S. business by means of the joint venture.11
Transactions that do not constitute covered transactions include, among other things:
- a stock split or pro rata stock dividend that does not involve a change of control;
- an acquisition of a convertible voting instrument that does not involve control;
- a transaction that results in a foreign person holding 10% or less of the outstanding voting interests in a U.S. business, but only if the transaction is solely for the purpose of investment; and
- an acquisition of securities by a person acting as a securities underwriter, in the ordinary course of business and in the course of underwriting.1
The proposed regulations define “control” as the “power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine direct, or decide important matters affecting an entity” and provide a number of examples of such power.13
The definition strikes an important, but delicate, balance between protecting national security interests and promoting foreign investment in U.S. businesses. The proposed regulations are intended to clarify that control can be exercised in a number of ways besides traditional equity ownership. The proposed regulations recognize that certain types of rights that are intended only to protect the investment-backed expectations of minority shareholders, and that do not affect strategic decisions on business policy or other important matters affecting the U.S. entity, do not constitute control. Such minority shareholder rights cited in the proposed regulations include the following:
- the power to prevent the sale or pledge of all or substantially all of the assets of an entity;
- the power to prevent an entity for entering into contracts with majority investors or their affiliates;
- the power to prevent an entity from guaranteeing the obligations of majority investors or their affiliates;
- the power to purchase additional shares to prevent dilution of an investor’s pro rata interest in an entity in the event that the entity issues additional interest; and
- the power to prevent the amendment of the organizational documents of an entity with respect to the foregoing matters.
3. Prefiling Procedures
The parties to a covered transaction are encouraged to consult with CFIUS in advance of filing a notice of a covered transaction and, in appropriate cases, to file with CFIUS a draft notice to aid CFIUS’s understanding of the transaction and to provide an opportunity for CFIUS to request additional information for inclusion in the notice.14 This prefiling communication is designed to assist CFIUS and the parties to each covered transaction to identify and resolve national security issues as efficiently as possible. Information provided to CFIUS as part of a prefiling consultation becomes part of the formal notice and is considered confidential.
4. Required Disclosures in Formal Notification
The proposed regulations specify the information relating to the transaction that must be included in a voluntary notice.15 Much of the required information is consistent with past practice. However, the proposed regulations also require disclosure of certain information not previously required, including:
- the name, address and nationality or place of incorporation of the immediate parent, the ultimate parent and each intermediate parent of the foreign person that is a party to a transaction;
- where the ultimate parent is a private company, the ultimate owners of such parent;
- where the ultimate parent is a public company, any shareholder with an interest of greater than 5% in such parent;
- the price paid for the interest in the U.S. business in U.S. dollars and the financial institutions involved in the transaction, including as advisors, underwriters, or a source of financing for the transaction;
- any contracts between the U.S. business and U.S. government agencies in effect within the past three years;
- any products or services supplied by the U.S. business to any agency of the U.S. government; and
- biographical information for members of the board of directors, senior management and the ultimate beneficial owner of 5% or more of the foreign acquiror and its immediate and ultimate parent entities.16
The proposed regulations give CFIUS the authority to impose civil penalties, up to a maximum of $250,000 per violation, upon any person who, intentionally or through gross negligence, submits a material misstatement or omission in a notice filed with CFIUS, or violates a material agreement or condition entered into with CFIUS.17 Additionally, a mitigation agreement between CFIUS and the parties to a covered transaction may include a provision providing for liquidated damages, as a reasonable assessment of the harm to national security that could result from a breach of the mitigation agreement.18