The Committee on Foreign Investment in the United States (CFIUS) recently approved the largest ever takeover of a US business by a Chinese company. Shanghui International Holdings Limited’s $7.1 billion acquisition of US pork processer Smithfield Foods, Inc. was completed after receiving approval from CFIUS in September 2013 following its 45-day investigation into the national security implications of the transaction. The deal triggered heated debate over foreign takeovers in the US and the transparency of the government review process.
Chinese interest in US companies has not been without controversy, even though the vast majority of Chinese investments in the US have been approved, or have not required approval, under CFIUS. The outcome of the Smithfield transaction has been much anticipated as it is expected to lead to more investments from China into the US (see “Could the Smithfield Deal Evidence a New Trend in Chinese Investment in the US” in the July 2013 issue of the Corporate Practice Newswire). It also encourages Chinese companies seeking to acquire controlling interests in US companies to plan ahead and notify CFIUS of proposed transactions that may or may not have national security implications early in the investment process.
What is CFIUS?
CFIUS is an interagency committee chaired by the Secretary of the Treasury that consists of members representing major executive departments and agencies. It is charged with reviewing deals that would result in a foreign person having “control” of a US trade or business — so called “covered transactions.”
Control is broadly defined in the CFIUS regulations but, essentially, means the power to direct or decide important matters affecting the business. For example, the power to appoint and dismiss officers, select new lines of business or control the finances of a company are indicative of control. The control can be direct or indirect, and side agreements or disproportionate voting rights could cause a minority interest holder to control the business. The regulations specify certain minority shareholder protections that do not convey control, such as the power to prevent the sale of all or substantially all of the company’s assets. The threshold question in any CFIUS review is whether it involves a covered transaction, which in turn depends on an analysis of control. If there is no covered transaction, CFIUS does not have the authority to review the deal.
The committee focuses on the national security implications of foreign investments in the US that constitute covered transactions. “National security” is not defined for CFIUS purposes. However, the enabling statute lists factors considered by CFIUS in determining whether a covered transaction poses a national security risk. Such factors include the potential national security effects on US critical technologies, the long-term projections of US requirements for sources of energy and other critical resources and critical infrastructure. Critical infrastructure means a physical or virtual system or asset so vital to the United States that its incapacity or destruction would have a debilitating impact on national security.
Guidance issued by the Department of the Treasury makes it clear that the concept of national security should be broadly interpreted and that it includes acquisitions of US businesses outside of the traditional defense sector. The committee does not focus on any particular US business sector. The guidance focuses on two characteristics of a deal: the nature of the US business being acquired and the identity of the foreign person acquiring control of the business. CFIUS has found that transactions present national security considerations because they involve US businesses that provide goods or services that directly or indirectly contribute to US national security. The acquirer’s identity is particularly relevant if it is controlled by a foreign government.
Notifying CFIUS of a transaction is voluntary; however, the committee may initiate its own review in some circumstances. A transaction may be reviewed — and prohibited — after it has been concluded.
CFIUS Review and Investigation
The CFIUS process consists of four phases. First, there is a pre-filing stage during which the parties to a transaction prepare the notice and preliminary consultations with committee staff may occur. Such early engagement of CFIUS staff is advisable, including the submission of a draft filing. CFIUS does not issue advisory opinions. However, the pre-filing period gives CFIUS staff an opportunity to familiarize itself with the transaction and ask questions, which helps submitters prepare and file a complete notice.
The second phase — a 30-day review period — begins once parties submit the notice and CFIUS deems it complete and disseminates it to CFIUS members. During this phase, the committee reviews the transaction to determine the effects of the transaction on national security, using various factors set forth in the CFIUS regulations to make that determination. It may enter into mitigation agreements or impose conditions on the transaction to address any national security concerns it may have.
The third phase consists of an additional 45-day investigation of the effects of a covered transaction on national security. CFIUS must conduct this additional investigation if, during the initial review period, (i) it determines that the transaction (a) is a foreign government-controlled transaction, (b) would result in foreign control of any critical infrastructure of or within the US and could impair national security, and such impairment was not mitigated during the initial review period, or (c) threatens to impair national security and the threat was not mitigated during the initial review period, or (ii) the lead agency recommends, and CFIUS agrees, that an investigation should be undertaken. However, an investigation of a foreign government-controlled transaction or a transaction involving foreign control of critical infrastructure is not required if the Secretary of the Treasury and the head of the lead agency determine, based on the committee’s initial review, that the transaction will not impair national security. As in the initial review phase, CFIUS may enter into mitigation agreements or impose conditions on the transaction to mitigate its national security concerns during the investigation phase. It is common for the parties to meet with CFIUS staff members during both the initial review and investigation phases.
If CFIUS determines not to conduct the additional investigation, or if, after the additional investigation, it determines that there are no remaining unresolved national security concerns, then the transaction qualifies for a safe harbor. Subject to the terms of the safe harbor and any mitigation agreement or conditions imposed by CFIUS, the transaction may proceed without the possibility of suspension or prohibition. If, however, the committee decides to recommend that the President suspend or prohibit the transaction, requests that the President make a determination with regard to the transaction, or is unable to reach a decision on whether to recommend that the President suspend or prohibit the transaction, the process will enter a fourth phase in which CFIUS sends a report to the President requesting the President’s determination as to whether to block or unwind the transaction.
If CFIUS refers a transaction to the President, the President has the authority to block the transaction if he has credible evidence that the foreign investment will threaten to impair national security. However, to invoke this authority, the President must determine that other US laws are inadequate or inappropriate to protect national security. The President’s decision must be made within 15 days of the completion of the investigation.
If the review process or investigation is not going well, often the parties will voluntarily withdraw their notice rather than risk presidential suspension or prohibition. Thus, it is rare for CFIUS to complete its review with a recommendation that the President block the transaction. From 2009 to 2011, 269 transactions were reported to CFIUS. Of those, 12 were withdrawn during the initial review. There were investigations of 100 transactions, with 13 notices withdrawn during the investigation. No transactions were blocked during the period, although, as discussed below, President Obama issued a high profile order blocking a transaction for national security reasons in 2012.
All information submitted to CFIUS, including during the pre-filing stage, is confidential.
Recent Chinese Experience with CFIUS
From 2003 to 2010, there were more than 200 Chinese investments in the US, and the number is growing exponentially with investments expanding across high technology, natural resources and infrastructure. Half of the recorded deals involve greenfield investments which do not require national security screening by CFIUS. For all other investments, Chinese ownership may be subject to review by CFIUS. From 2005 to 2011, 30 of the 737 covered transactions reported to CFIUS involved a Chinese acquirer with the number slowly increasing over that time period. Although notification is voluntary, recent deals such as Smithfield have shown that investors should consider the applicability of CFIUS prior to acquiring interests in businesses with US operations, whether or not the target business is a US or non-US company. Chinese acquirers of controlling stakes in large US enterprises are advised to notify CFIUS of proposed transactions ahead of time even if the national security threats of the transactions are not obvious.
Failure to notify CFIUS of a transaction with potential national security concerns involves significant risks to the investor. CFIUS is increasingly initiating post-closing reviews and has the power to force the investor to divest assets after completion of the deal, potentially resulting in material losses and damage to the reputation of the investor.
In September 2012, President Obama issued an executive order formally prohibiting the acquisition by the Ralls Corporation of four wind projects located near a US naval facility in Oregon and ordering Ralls to divest itself of the wind farms based on CFIUS’s determination that the transaction threatened to impair national security. Ralls is owned by executives at Chinese manufacturer Sany Group, a state-owned entity. The wind turbines were located near a naval facility where drones are tested. The company did not submit notification to CFIUS until two months after the transaction was closed and construction had begun, and it did so only at the request of CFIUS.
After the initial 30-day review period, CFIUS determined that further investigation was warranted based on national security concerns. It also determined that interim mitigation measures were necessary and issued interim mitigation orders that, among other things, stopped all construction and operations and prohibited access to project sites. To that point, Ralls had proceeded confidently with construction based on the assumption that the project posed no national security concerns as three of the four projects were outside restricted airspace, and the fourth project was moved with the cooperation of the US Navy. Furthermore, renewable energy cooperation between the two countries was encouraged by the Chinese and US governments, and other foreign companies operated in the same area.
After President Obama’s order, which, among other things, required Ralls to divest itself of any interest in the project companies within 90 days and to remove all physical installations that it had put on the project sites within 14 days, Ralls filed a lawsuit challenging the President’s authority to block the transaction. The lawsuit has since been dismissed because the court ruled that the President’s decision was not subject to judicial review. The Ralls case serves as a warning to parties who fail to notify CFIUS of a transaction before closing.
Ralls also highlights a national security consideration of the committee: the proximity of acquired assets to military or defense installments or activities. In November 2012, a similar issue arose in the CFIUS review of Procon Resources’s private placement deal with Lincoln Mining Corporation, a mining company with its principal mining operations in the US, that resulted in Procon owning almost 30% of Lincoln’s shares. Procon also had the right to appoint four of Lincoln’s seven directors. China National Machinery Industry, also a state-owned enterprise, indirectly owned 60% of Procon’s shares. As such, Procon’s acquisition of control over Lincoln’s US business was subject to the jurisdiction of CFIUS. Voluntary notification was submitted more than four months after closing and again at the request of CFIUS. In June 2013, the parties agreed that Procon would divest its investment in Lincoln subject to the review and approval of CFIUS. Like Ralls, the proximity of the target’s assets to US military bases in Nevada and Arizona appeared to be a primary national security concern. This was at least the second time CFIUS had prevented Chinese investment in mining operations in the area.
The parties in the Smithfield deal may have learned their lesson from the Ralls and Procon experiences as the parties filed a voluntary notice with CFIUS prior to closing the transaction. Although there were no obvious national security threats posed by the deal, the acquisition was conditioned upon clearance from CFIUS. The parties also offered assurances to mitigate any perceived national security concerns. A 45-day investigation was undertaken by CFIUS against a highly political backdrop, with CFIUS being asked to look into how food safety and food security threats may affect national security and the role the Chinese government played in the deal. The parties argued that the transaction did not result in any major changes to Smithfield’s management or workforce. Furthermore, the merger was driven by growing pork demand in China, so it failed to raise antitrust concerns as it did not give Smithfield, already the world’s largest pork manufacturer, a larger share of the US pork market. The transaction was eventually cleared without imposing any further conditions.
In some cases, a mitigation agreement is sufficient to quell the committee’s national security concerns. In February 2013, CFIUS cleared the acquisition of Nexen, Inc., a Canadian oil and gas company, by CNOOC Limited, a Chinese offshore oil and natural gas producer. Nexen owns US assets in the Gulf of Mexico, including offshore assets reportedly close to a major US military base. CNOOC’s controlling shareholder is China National Offshore Oil Corporation, a state-owned enterprise. The parties submitted a voluntary notice before the deal closed. News reports indicated that CNOOC agreed to transition Nexen to non-operator status so that it would no longer be responsible for making decisions with respect to the US assets. However, CNOOC could continue to own and earn revenue from the properties.
Other Chinese acquisitions have received approval without running into problems. For example, early this year, CFIUS approved the acquisition of lithium ion battery manufacturer A123 Systems, Inc. by a US subsidiary of Wanxiang Group, a Chinese auto parts manufacturer. A123 had military and government contracts and had been awarded a Department of Energy grant of approximately $250 million. For these reasons, some politicians opposed the deal. Despite political opposition to the acquisition, CFIUS approved the deal. Reports indicate that the deal was structured so that A123 divested its government and military contracts and Wanxiang would not have access to A123’s technology or assets. Such proactive structuring likely alleviated the anticipated national security concerns.
Recent CFIUS reviews of Chinese deals offer additional insight into how Chinese investors can successfully navigate the CFIUS review process. The cases show that Chinese investments may attract additional scrutiny, particularly if the acquirer is state owned. The Smithfield deal should set an example for future Chinese investment. Chinese buyers should be prudent by voluntarily seeking CFIUS review where any possibility of national security threats are present. While assets located near sensitive US government property or critical infrastructure are clearly an area of heightened scrutiny for CFIUS, other areas may also raise concerns. It is important to plan ahead and engage CFIUS in the early stages of the transaction in order to accommodate a timely and efficient review and avoid the costs of forced divesture and mitigation conditions down the road.