On September 28, President Obama signed an order prohibiting the acquisition and ownership of four U.S. wind farm project companies by Ralls Corporation, its owners, subsidiaries and affiliates (collectively, “Ralls”) and directing Ralls to divest the interest that it had acquired in the farms earlier in 2012 and to take other actions related to that divestment. President Obama’s order is the first time since 1990 that a president has invoked his authority under Section 721 of the Defense Production Act of 1950, as amended (“Section 721”) to reverse or to prohibit a transaction. The impact of the President’s order on the Ralls acquisition serves as a powerful reminder to all parties and prospective parties to transactions in which a foreign person may be acquiring a controlling interest in a U.S. business to consider the potential impact of Section 721 on the transaction and to ensure appropriate strategic planning in the due diligence and transaction scheduling process.

Background on Section 721 and Reviews with CFIUS:

Section 721 authorizes the President to investigate, and to suspend or to prohibit, any transaction that could result in control of a U.S. business by a foreign person (a “Covered Transaction”) where the President determines that such transaction threatens to impair U.S. national security, and no other adequate and appropriate means are available to address that threat. This is as constitutionally broad a grant of authority as is possible for Congress to give, particularly in light of the historic deference of both Congress and the federal courts to the President’s power in the conduct of the nation’s foreign affairs and national defense. The only statutory means for parties to a Covered Transaction to limit that presidential power is to file a voluntary notification of that transaction with the inter-agency Committee on Foreign Investment in the United States (“CFIUS”), on which the President relies in the exercise of Section 721 authority, and then to allow the time period for the conclusion of CFIUS’s review (and, if needed, investigation) to elapse without any action being taken or with a favorable affirmative response from CFIUS.

There is no statutory requirement to file a notice of a Covered Transaction with CFIUS, but CFIUS itself may self-initiate an investigation without being notified by the parties. Further, if the parties to a Covered Transaction do not file a notice with CFIUS or if CFIUS does not self-initiate an investigation, then the President maintains the authority to conduct an investigation into, and to suspend, to prohibit, and to reverse a Covered Transaction. Accordingly, it is customary and best practice to file a joint voluntary notice with CFIUS in order to secure timely CFIUS consideration of a Covered Transaction.

Upon initiation of a review of a Covered Transaction by CFIUS, Section 721 provides for a potentially three-stage process of consideration. Initially, CFIUS conducts a review, which must be completed no later than 30 days after initiation. In this review stage, CFIUS may either conclude consideration of the Covered Transaction after determining that there are no national security issues that warrant further action, or it may determine to initiate an investigation. If CFIUS initiates an investigation, then the investigation must be completed no later than 45 days after it commences. (If the foreign party is owned or controlled by a foreign government, then the 45-day investigation is mandatory.) Upon the completion of its investigation, CFIUS may either determine that no further action is warranted (including by reason of a mitigation agreement), or it may determine to refer the matter to the President, with its report and recommendations. If CFIUS refers the matter to the President, then the President may take up to another 15 days to reach a final determination.

The Ralls Acquisition and Earlier Transactions Meeting a Similar Fate:

In his order regarding the Ralls acquisition, President Obama indicated that there was credible evidence that led him to believe that Ralls, a U.S. company ultimately owned by Chinese nationals and affiliated with a Chinese equipment company that makes wind turbines, might take action that threatens to impair the national security of the United States. President Obama further stated that other U.S. law did not provide adequate and appropriate authority for him to protect the national security. Although President Obama’s order did not state the precise credible evidence that led him to believe that Ralls might take action that threatens to impair U.S. national security, the Treasury Department’s own press release indicated that the four wind farm projects in which Ralls was to acquire an interest are all located within or near restricted airspace at the Naval Weapons System Training Facility in Boardman, Oregon. The Treasury Department’s press release also confirmed that CFIUS received a thorough analysis of the threat posed by the Ralls transaction from the Office of the Director of National Intelligence.

Various news agencies including the Associated Press and publications including The New York Times have indicated that the military has said that it used the Oregon facility to test unmanned drones and the EA-18G “Growler” aircraft, which, according to the Associated Press, is “[t]he electronic warfare aircraft [that] accompanies U.S. fighter bombers on missions and protectively jams enemy radar, destroying them with missiles along the way.” As referenced above, the Ralls case marks the first time in over 20 years that a President has invoked his power under Section 721 to reverse a deal. In 1990, President George H.W. Bush ordered that the China Aero-Technology Import & Export Corp. sell its interest in MAMCO Manufacturing, Inc., a small aircraft manufacturing subcontractor to Boeing.

Similar to the Ralls and MAMCO transactions, in June 2010, Emcore Corporation, a U.S. fiber optics and photovoltaic cell developer and manufacturer based in New Mexico, abandoned its plans to form a joint venture with China’s Tangshan Caofeidan Investment Corporation because of U.S. national security concerns. Emcore was to sell a 60% stake in the joint venture to Tangshan Caofeidan in exchange for a cash investment of approximately US$28 million. Emcore announced that it was abandoning its plans after issuing a statement that it had withdrawn a voluntary filing with CFIUS after the Obama Administration had indicated it had concerns. In December 2009, Firstgold Corporation, a Nevada-based gold mining and exploration company, announced that it expected CFIUS to recommend rejection of a planned investment by China’s Northwest Non-Ferrous International Company to buy a 51% stake in Firstgold. In its press release, Firstgold indicated that CFIUS believed that the planned transaction posed national security concerns for CFIUS because of Firstgold’s proximity to Fallon Naval Air Station in Nevada.

Lessons to be Learned from these Transactions:

Many foreign buyers and U.S. targets often do not fully appreciate the sweeping power that the President has under Section 721 and may even mistakenly believe that, if they do not file, they can somehow escape coverage under Section 721. However, as evidenced by the cases cited above, the President can act to reverse a Covered Transaction, even years after closing, if the parties do not seek to eliminate that presidential power under Section 721 by filing a voluntary notification of the transaction with CFIUS and obtaining a CFIUS clearance.

Just as foreign buyers and U.S. targets would conduct necessary due diligence to determine whether an antitrust or other government filings must be made, such parties should also conduct necessary due diligence to determine if the transaction could fairly be considered a Covered Transaction under Section 721. Although there is no “bright-line” test in determining whether a transaction is a Covered Transaction, the parties should assess, at a minimum, information related to: (a) the U.S. business’s products, technology and software and whether any of those items are controlled for export purposes by specific entries on the Commerce Control List (“CCL”) of the Export Administration Regulations (the “EAR”) or on the U.S. Munitions List (“USML”) of the International Traffic in Arms Regulations (the “ITAR”); (b) the nature and extent of any contracts that the U.S. business might have with the U.S. Government or with prime or sub- contractors to the U.S. Government; (c) if the U.S. business is such a U.S. Government contractor, the nature and extent of any “sole source” contracts of the U.S. business; (d) the U.S. business’s security or personnel clearances to deal with classified U.S. government information to perform such contracts; (e) the proximity of the U.S. business’s facilities to U.S. Department of Defense and U.S. Department of Energy bases and facilities; (f) the U.S. business’s impact on U.S. critical infrastructure; (g) the U.S. business’s role in supplying sources of energy and other critical resources and material to the U.S. Government and to the country as a whole; and (h) the ownership of the foreign person, particularly whether the foreign person is owned or controlled by a foreign government.

If the parties to a transaction decide that the transaction is a Covered Transaction, the parties should consider the timeline cited above as to CFIUS’s review and potential investigation and should ensure that the transaction documents account for this schedule. Moreover, in the typical case, the parties should work together to file any notification with CFIUS jointly. Drafting a careful and complete joint voluntary notification to be filed with CFIUS typically takes several weeks and so the parties to any Covered Transaction should also consider this timing in developing any closing schedule. The information disclosed to CFIUS is treated as confidential and is not subject to disclosure under the U.S. Freedom of Information Act.