USA Inbound Acquisitions & Investments Blog : Inbound Investment Lawyer & Attorney : Sullivan & Worcester Law Firm : Mergers & Acquisitions, Cross Border Investments

Ameek Ponda and Douglas Stransky, partners in Sullivan & Worcester’s Tax Department, co-authored the following article. Mr. Ponda is the director of the Tax Department and a member of the Firm's Management Committee. He concentrates his practice in structuring corporate mergers and acquisitions, advising emerging companies on financing and business issues, designing REIT transactions and financial instruments, and working on cross-border financings and acquisitions. Mr. Stransky concentrates his practice on international tax planning. He has structured numerous tax efficient international mergers, acquisitions, dispositions and reorganizations for a broad spectrum of public and private clients in the financial services, life sciences, manufacturing, private equity, technology and venture capital industries.

United States businesses of all sizes and sectors are more likely than ever to be targeted by buyers from around the globe, including buyers from rapidly emerging economies such as Brazil, China, India, Israel, and Russia. This “inbound” deal flow stems from the convergence of several trends, including globalization, the rise of sovereign wealth funds and a weakened U.S. dollar. In addition, the United States’ comparatively welcoming legal and regulatory environment signals to the rest of the world that “America is open for business.”

In Massachusetts, some notable inbound deals over the last 18 months included the $11.6 billion acquisition of GE Plastics by Saudi Arabian Basic Industries Corporation, the $8.8 billion purchase of Millennium Pharmaceuticals by Japan’s Takeda Pharmaceutical Co., the $3.9 billion acquisition of Putnam Investments by Canada’s Great-West Lifeco, Inc., the $2.6 billion purchase of Sepracor, Inc. by Japan’s Dainippon Sumitomo Pharma Co., and the $1.7 billion acquisition of Samsonite Corporation by United Kingdom-based CVC Capital Partners Ltd. 

Cross-border deals are always more complex than comparable domestic ones. They involve at least two sets of legal and regulatory frameworks, additional currencies, multiple languages and time zones, and potentially significant differences in business culture. Foreign investors and U.S. sellers exploring inbound deals should proceed with informed boldness when developing transaction strategies.

On the sell side, understanding the foreign buyer’s goals and recognizing its possible inexperience with U.S. laws and commercial customs and practices will go a long way toward maximizing value in the deal and ensuring a smoother process. For example, a foreign buyer will likely not be familiar with U.S. employment laws, tort litigation, etc., which are markedly different than those of many other countries.

On the buy side, it is critical for foreign investors to understand U.S. laws and commercial customs and practices. Successful execution is more art than science, and early involvement by experienced U.S. advisors will be important. For example, in contrast to market practice in other parts of the world, there is generally less emphasis on due diligence in the United States, particularly protracted, intrusive due diligence, and instead a reliance on seller representations and associated indemnities. Of course, exceptions to this general rule exist when statutes, cases, and regulations have expanded successor liability into particular areas, and thus more due diligence may be appropriate, for example, with respect to environmental, employment/benefits, money laundering and international trade issues. 

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Does 2010 mean a renewal of inbound M&A activity? We have put the question to well-qualified investment bankers to get professional views. Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey, an international investment bank, has some very positive views. Brian has been a banker for over 20 years, advising both publicly traded and privately held companies in various industries. He has advised on numerous cross-border transactions.

USAInbounddeals: Commentators have pointed out that the level of M&A activity in the United States for mid-market businesses was lower in 2009 that it had been for several years. Are you forecasting an increase in M&A activity involving mid-size U.S. businesses for the remainder of 2010 or 2011 over 2009’s activity level? Can you suggest what the reasons for any increase might be? 

Brian McDonald: At Houlihan Lokey, we expect to see an increase in activity in 2010 and beyond, and we have already seen an increase in deal backlog. There is both pent up supply and pent up demand for transactions due to the lull in activity during the recent period of market disruption. Now that equity valuations have stabilized and the financing markets have begun to recover, we expect an uptick in M&A activity as buyers and sellers return to the market.

After the recent volatility in the equity markets, shareholders of family owned businesses are much more cognizant of the risks inherent in holding a significant portion of their net worth in illiquid stock of a single, small private company. Many such shareholders are now considering a sale, even though valuations are down from their pre-crisis highs. Also, long-term capital gains tax rates are expected to increase from 15% currently to at least 20% or 25% in 2011, providing an additional incentive for sellers to sell now rather than later. 

Private equity sponsors with older vintage portfolio companies need to sell those companies to return cash to their limited partners, so the current stabilization in valuations provides an opportunity to market those transactions. Corporates are also rationalizing their portfolios and exploring divestitures to either deleverage or to redeploy capital in their core businesses. 

Buyers also have a strong rationale to transact. Many large corporates have built up significant cash reserves by cutting expenses, reducing capital expenditures and reducing dividends. In 2009, many corporates were able to increase earnings even as revenues declined, because they reduced expenses significantly. This cannot be easily repeated in 2010. And since the economy is not expected to grow rapidly, these corporates will try to grow by using their cash reserves to make acquisitions. 

USAInbounddeals: If you believe that an increase will occur, are you predicting an increase in the activity level of foreign-based buyers (including their existing U.S. businesses) in the U.S. market? Are you willing to estimate how significant this increase might be? 

Brian McDonald: In recent years, foreign buyers have increasingly been active in the U.S. middle market. We believe that their demand for U.S. businesses will further increase in 2010 for a couple of reasons. First, the U.S. economy is expected to recover from its recession sooner and more rapidly than Europe. Therefore, European buyers will likely continue to look to the U.S. for growth acquisitions. Also, the recent sustained appreciation of the Euro relative to the dollar appears to be headed towards a reversal, particularly with the fiscal crisis in Greece. If European buyers conclude that their window for buying U.S. assets at “sale” prices will soon be closing, they may decide to jump in before the window closes. 

Asian buyers, particularly Japanese and Chinese buyers, have also been active, but less consistently. We expect buyers from these countries to continue to appear in select middle market transactions.

USAInbounddeals: Do you believe that specific U.S. industries are more likely to see increased interest from foreign investors or buyers? What might those industries be? 

Brian McDonald: We have seen the most foreign buyer interest in the industrial sector, real estate, and infrastructure services and materials.

USAInbounddeals: Are sell-side clients actively asking you to seek out foreign buyer interest? 

Brian McDonald: Yes. Sell-side clients often seek foreign buyers for several reasons. Most importantly, sellers want to maximize value and they recognize that foreign buyers can often pay more due to a strong currency or unique strategic considerations. If a foreign buyer views a U.S. business as a way to establish a platform in the U.S. or gain access to U.S. distribution channels, they may place a significantly higher value on the acquisition than a U.S. acquirer would.

Another reason sellers like foreign buyers is that they often represent the least disruptive buyer for the employees. If the buyer does not already have a U.S. business with which to integrate the acquisition, the buyer will typically retain most employees.

USAInbounddeals: Are you aware of any concerns in the M&A marketplace that the U.S. government’s screening of inbound deals makes them more difficult to complete?

Brian McDonald: Yes. Companies that service the defense sector or that sell directly to the government are often reluctant to include buyers from sensitive countries on their buyers list. Even if the seller is willing to invite a foreign buyer into the sale process, some buyers are reluctant to participate if they are concerned that the U.S. government may reject the transaction due to national security concerns. We have even seen this behavior by private equity funds that have significant limited partner equity from countries in the Middle East, for example.

This article is intended for informational purposes only and reflects the opinion of Brian McDonald, a Managing Director in the M&A Group of Houlihan Lokey. The material presented reflects information known to the author at the time this article was written, and this information is subject to change. 

About Houlihan Lokey

Houlihan Lokey provides a wide range of advisory services in the areas of mergers and acquisitions, financing, financial restructuring, and valuation. The firm was ranked the No. 1 M&A advisor for U.S. transactions under $3 billion in 2009 and the No. 1 U.S. fairness opinion advisor over the past 10 years by Thomson Reuters. In addition, the firm advised on more than 500 restructuring transactions valued in excess of $1.25 trillion over the past 10 years. Notable engagements cover numerous sectors and virtually all of the largest U.S. corporate bankruptcies, including Lehman Brothers, General Motors, WorldCom and Enron. The firm has more than 800 employees in 14 offices in the United States, Europe and Asia. Each year Houlihan Lokey serves more than 1,000 clients ranging from closely held companies to Global 500 corporations.

For more information on Houlihan Lokey, visit www.HL.com.

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Kraft Foods’ acquisition of Cadbury PLC has led at least one prominent British policymaker and one prominent business leader to consider whether Britain should take steps they believe will discourage short-term investment in its companies and encourage long-term investment, as if the two can be distinguished.  They are suggesting that legal and regulatory changes may be necessary to offset the market’s focus on short-term trading in favor of what they perceive as Britain’s need to retain the benefits of long-term investment. They appear to be advocating these changes without regard to the detrimental effects that their protectionist actions will have on worldwide foreign direct investment (FDI), including that originating in Britain. 

In an opinion piece published in the Financial Times in mid-January, Peter Mandelson, Britain’s Secretary of State for Business, Innovation and Skills, asked what steps might be taken to better align the interests of short-term and long-term investors and the interests of the owners and managers of publicly listed companies. He argued that financial markets often separate financial assets from real assets, with the consequence that the trading of financial assets leads to insufficient recognition of the importance of real assets. Lord Mandelson convened a roundtable discussion with investors, fund managers and company executives to establish a dialogue between investors and management of the companies in which they invest. The implication is that the lack of alignment between these groups too often results in a takeover of a real asset which in turn leads to the loss of the business itself to Britain. Additionally, the inability to assemble a pool of “patient capital” may be at odds with Britain’s needs for new technologies and infrastructure investment.

Lord Mandelson made clear that he was displeased with the failure of mergers and acquisitions strategies to create additional long-term value during the past 20 years. Although acknowledging that M&A can create economies of scale and technology synergies, he advocated openness by acquirors with respect to their intentions and robust criticism by shareholders. It is difficult to disagree with his analysis of the problem.  The recommendations for cure are quite another matter. 

More recently, Roger Carr, the chairman of Cadbury who resigned on February 3, called for an overhaul of M&A regulation in the UK. Mr Carr is arguing that his country’s regulatory scheme for takeovers works against the long-term interests of British businesses. According to news reports, he cited takeover practices as predatory and stated that the current rules reward short-term traders at the expense of owners with longer-term views. He suggested that the rules had resulted in too many UK business being sold off to foreigners, and that the sale of a domestic business to a foreign business was a loss to the UK. His sentiments were plainly protectionist and sounded like those of a sore loser. He seems to have said little about those UK companies who have walked the globe, acquiring businesses for strategic and other reasons or those UK businesses, such as Cadbury itself, who build plants outside of the UK to enhance profits.  

The thrust of the comments of both Lord Mandelson and Mr. Carr is that differentiation should be made between those who will hold their shares for the long term and those who will not. However, a requirement that shareholders be locked in or locked up means that investors give up their ability to sell their shares when the situation warrants. This stratagem shifts risk to shareholders, who will expect and in fact be entitled to a greater reward. These types of restrictions have existed in the past and have often allowed management to be less accountable to owners, since the owners cannot exercise their right to show their ultimate displeasure—by exiting their investment. 

Ultimately, however, changes in risk allocation and the balance of management/owner power in one geographic market can disadvantage companies in that market in terms of global capital allocation. If investment in British companies is stickier than in U.S. or Australian companies, then British companies may well lose value in comparison with their non-British peers. Given choices, FDI will always seek investment opportunities that are less encumbered. 

Then again, Lord Mandelson and Mr. Carr may believe that it is Britain’s best interest to erect a wall around its industry, buying some time to create Britain’s future. Deflecting foreign ownership will, however, likely lead to retaliation. It would not be surprising if other countries were to preclude British business from investing in or acquiring their businesses. Worse yet, it could lead to rounds of similar restrictions on investment in other developed countries and then to trade restrictions. This could have a disastrous effect on FDI and the strong world economy that has been developing since 1945, despite the shocks of 2008. Lord Mandelson and Mr. Carr could better serve their countrymen by leading UK businesses to build stockholder loyalty through the creation of true stockholder value and to be strong competitors in the world economy. 

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The withdrawal of the Chinese acquirer in Firstgold transaction has ignited a debate over whether U.S. investment policy has become more restrictive with respect to China. In fact, Firstgold is unlikely to be a reliable indicator of the policy or regulatory direction of the U.S. government. Firstgold presented an unusual set of facts, did not truly involve U.S. critical infrastructure and has little economic significance. The regulatory outcome was determined well before the blowup between Google and the Chinese government occurred earlier this month. Commentators should be wary before generalizing from the Firstgold outcome, as incorrect observations may reduce offshore investment interest in the U.S.  

The Financial Times reported earlier this month in an article bylined by its Beijing-based reporter Kathrin Hille that Chinese companies are expecting tougher scrutiny in the United States. This change is linked to Google’s announcement that Chinese hackers had accessed its systems and those of 20 other companies. Google’s stand might affect both inbound investors and companies already present in the U.S. The article reported that the failure of the Firstgold investment is an indicator of the Obama administration’s enhanced scrutiny of Chinese investment infrastructure. 

The Firstgold investment was not a conventional inbound investment. The company’s SEC reports contain unusual facts. Firstgold has been an exploration stage company with only minor operations since 1995. Its assets are principally property and equipment for gold prospecting at four sites in Nevada. It is financially distressed. Its audit included a going concern qualification. It must raise capital to survive. Its two hedge fund investors sued it for securities fraud 10 months after making their loans. The Chinese investor, Northwest Non-Ferrous International Investment Company Limited, intended to not merely invest in Firstgold, but to acquire the outstanding senior secured debt from the hedge funds, loan additional funds to Firstgold and invest enough to own 51% of the Company’s equity. The total investment package was valued at $26,500,000 but less than $10,000,000 was an equity investment in the company itself. Firstgold did not file its application with the Committee on Foreign Investment in the United States (CFIUS) until three months after the deal was first announced. Firstgold did have a property located in Fallon, Nevada, 50 miles from a U.S. Naval air facility that tests advanced weapons. It was this proximity that led the staff of CFIUS to conclude that there were national security concerns.

Firstgold’s assets are not critical infrastructure. The regulations promulgated under the Foreign Investment and National Security Act of 2007 define critical infrastructure to be an asset so vital to the United States that the incapacity or destruction of the particular asset would have a debilitating impact on national security. Firstgold’s assets do not satisfy that standard. Critical infrastructure is not an issue in the case.

Firstgold has no economic significance. In its 15-year history, it has produced no material revenues. Because it is not an active mining operation, it is not a factor in the local Nevada economy. Its debt is in default, and it is subject to foreclosure proceedings. The real importance of the transaction was the bailout of its lenders who thought they could offload their position at a favorable price. The value of Firstgold’s stock is questionable, since there are outstanding cheap warrants equal to 26% of the outstanding shares, a significant overhang. In fact, there was a period during 2009 where Firstgold’s stock could not be traded since it had failed to file its reports with the SEC.

On the other hand, it truly is difficult to understand what CFIUS gained from blocking this deal, in which case it may be that its action can only be a signal for a new hawkish outlook. In November 2008 CFIUS published a list of 11 illustrative factors that it will consider in determining whether a covered transaction poses national security risk. The Firstgold deal seems to present none of them. The CFIUS Guidance also discussed transactions that have presented national security considerations because of the nature of the U.S. business over which control is being acquired. Geographic location is not mentioned as a determinative factor. Because Firstgold has no products, it is not able to have products that may have implications for U.S. national security. It is possible that CFIUS determined that the buyer was acting on behalf of the Chinese government. If so, CFIUS never mentioned it. Therefore, if CFIUS intended to send a message, the message may be that a Chinese investor has the burden of proving it is not acting for the PRC government. Given the size of the transaction and the relative obscurity of the parties, however, it is difficult that CFIUS meant for its action to be considered a bellweather for other China-originated transactions. 

It’s appropriate for the media to be alert to policy changes that result from Google’s startling announcement. Reading tea leaves is a tricky business, however, and in the world of commerce, the media should refrain from issuing baseless alarms when the U.S. economy is earnestly seeking foreign direct investment. The rational view is that, all in all, there was little compelling reason once the national security monitors raised doubt as to the real reason for the transaction, for CFIUS to permit the Firstgold deal to go ahead. Had there been some compelling showing that the deal had a rational basis as a business investment, CFIUS would have approved it.

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Earlier this month the United Nations Conference on Trade and Development released two significant new publications. On December 1, UNCTAD released its inital Global Investment Trends Monitor. The publication reported data on global foreign direct investment (FDI) for the second and third quarters of 2009. On December 4, the UNCTAD Secretariat published its first Investment Policy Monitor. The aim of the Monitor is to provide the international investment community with current developments in foreign investment policies at both the national and international levels.

UNCTAD intends to publish its Investment Trends Monitor quarterly to provide the international investment community with regular assessments of global FDI. UNCTAD has developed its own index to measure FDI, based on FDI data for 67 economies that comprise 90% of FDI flows. The Investment Trends Monitor recorded an increase in global FDI from Q1 to Q2 of 2009. Specifically, the index rose 65% to 115 on a quarter-over-quarter basis. The increase was the first posted in five consecutive quarters. The G20 countries alone produced a 38% increase, according to the Index, but the increase affected only certain countries in the G20. Increases in the emerging economies were more limited. The Monitor warns that a full global recovery might not yet be underway, citing two reasons. First, cross-border global M&A was flat during the first three quarters of 2009. Second, the number of international, greenfield investment projects declined for the fifth consecutive quarter. The publication predicts that FDI flows for the third quarter will not show material improvement and will remain significantly below the year-earlier levels, but offers the optimistic prediction that “the overall environment for international investment is slowly improving.”

The Investment Policy Monitor assesses the national policy frameworks reflecting attitudes toward FDI. The report notes that during 2009 the majority of the 51 changes analyzed were for the “liberalization, facilitation and promotion” of inbound FDI. The report interprets this majority to mean that countries continue to believe that FDI is a means to finance their economic recoveries and promote their economic growth. The remainder of the changes included prohibition of foreign participation in certain industries, modifications to screening requirements and tightenings of regimes on investments that may relate to national security. The analysis differentiates between changes in the G20 countries and in non-G20 countries. The Investment Policy Monitor also follows changes in the general legal framework relevant to foreign investors in taxation regimes, state aid and stimulus packages. The report notes that between July and November 2009, 34 countries undertook measures related to foreign investment and 31 enacted state aid or stimulus packages or otherwise enhanced earlier such initiatives. Also included are new international investment agreements (including bilateral investment treaties) and double taxation treaties. All together, 82 economies were direct parties to new agreements in 2009.

Both publications include useful hard data and metrics and, for that reason alone, should prove exceedingly useful in the months ahead as FDI participates in and generates the expected global recovery.

UNCTAD was established in 1964 with the goal of promoting sustainable development while integrating developing countries into the world economy.

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A relatively small proposed investment in Firstgold Corp. of Lovelock, Nevada, a development stage mining company, has lead to a flurry of press coverage of the refusal by the U.S. Treasury’s Committee on Foreign Investment in the United States (CFIUS) to permit the deal. 

The proposed investor is Northwest Non-Ferrous International Investment Company Limited of Xi’an, China. Firstgold is a small-cap, financially-challenged gold mining business with four tracts in Nevada, but little operating history—in its own words, “a junior mining and exploration company.” The deal size has not been disclosed and may be less than $10 million. The deal structure involves three parts—the acquisition of senior secured debt from a disgruntled private investor, an additional loan to Firstgold and a purchase of a control equity stake, making Northwest both Firstgold’s parent and secured lender. The deal was first announced in July 2009. The parties did not make their CFIUS filing until late September.

After both a review and an investigation, CFIUS is recommending that the President disapprove the transaction. According to CNNMoney’s report, CFIUS apparently based its rejection on the proximity of one of Firstgold’s properties to Fallon Naval Air Station and offered several mitigation possibilities, none of which Firstgold accepted. The company states that the air base is 50 miles away. 

There is other speculation that the investor would use Firstgold’s gold assets—even if undeveloped at this point—to add to China’s hoard of gold, now totaling a staggering estimated $1.95 trillion. China’s gold reserves exceed Switzerland’s. 

Other news reports and blogs covering the development include:

• Reuters
• Northern Miner
  
• Exec Digital
• As well as Firstgold’s own release

This blog, in its October 1 post, alerted readers to the possibility of an unfavorable CFIUS outcome. We noted that management did not seem to approach the CFIUS filing with seriousness and as recently as October had predicted that its CFIUS filing would not be problematic.

The furor surrounding this development has an interesting footnote. The California Gold Rush of 1848-52 began with the discovery on gold on Mexican soil, specifically on land owned by a Swiss farmer, John Sutter—and ultimately led to the annexation of California by the United States. So there may well be historical precedent for the concerns of CFIUS. 

Updated  On December 22, Northwest withdrew from the transaction, Reuters announced.  Therefore, President Obama will not have to take direct action to disapprove the deal. 

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Will President Obama’s recent trip to China product any inbound FDI results for the U.S.? According to the U.S.-China joint statement, the November 16-18 trip produced significant agreements in five key areas of bilateral interest. There were tangential, but not explicit, mentions of FDI into the U.S. either by way of mergers and acquisitions or Greenfield investments.

Judging from the tenor and substance of the joint statement, the meetings further developed the mutual confidence and trust that are the predicates for a favorable investment climate. The five key areas of agreement were:

• The importance and productivity of regular high-level exchanges to the growth of the overall U.S.-China relationship
• The building of a bilateral strategic relationship that is positive, cooperative and comprehensive
• Strengthened dialogue and cooperation on macro-economic policies leading to global recovery
• Shared responsibility to cooperatively address regional and global security challenges
• Vigorous responses to issues of climate change, energy and environment

The joint statement implicitly references the importance of FDI at several points. There was express recognition of the importance of the U.S.-China Strategic and Economic Dialogue. “Both sides believed that the first round of the Dialogue held in Washington, D.C., in July this year was a fruitful one and agreed to honor in good faith the commitments made and hold the second round in Beijing in the summer of 2010.” The bottom line is that the U.S.-China FDI relationship appears well and growing and on track to produce results. Those results may not be evident until later next year. 

Further, while addressing the need to support the global recovery, the statement made clear that both sides are committed to open trade and to jointly fight protectionism and to resolve bilateral trade and investment disputes. The joint statement articulated the explicit promise of the U.S. and China “to expedite negotiation on a bilateral investment treaty.”

Prior to the release of the joint statement, reports had appeared in the Chinese press, notably the South China Morning Post, that a specific agreement would be reached to promote acquisitions of small and mid-size U.S. financial institutions by Chinese lenders. No such agreement or memorandum of understanding appears to have emerged from Obama’s visit.

A recent transaction involving a proposed takeover by China’s Minsheng Bank of failed California-based bank, UCBH Holdings, illustrates the formidable difficulties to be overcome if U.S. regulators intend to encourage Chinese lenders to invest in U.S. banks. Minsheng Bank had acquired a 9.9% interest in UCBH in 2007 and recently raised US$3.86 billion in its initial public offering in China. According to a report in The Wall Street Journal, Minsheng Bank also sought to acquire United Commercial Bank before U.S. authorities closed the San Francisco-based lender earlier this month. 

UCBH operated the United Commercial Bank, with several branches in California and also in other key Chinese American areas, such as New York, Boston, Seattle, Atlanta and Houston. United Commercial suffered commercial lending losses from loans to developers and home builders during the housing boom. A financial scandal led to a management shake-up. 

The Federal Reserve rejected China Minsheng's proposal to buy United Commercial Bank because of regulatory restrictions on foreign investment in U.S. banks and instead closed the bank. Soon after the closure, East West Bank, based in Pasadena, California, took over United Commercial Bank's roughly $7.5 billion in deposits, as well as $10.2 billion in assets. The Los Angeles Times reports that its takeover of UCBH will greatly expand its reach of East West, which has concentrated on Southern California and the San Francisco Bay Area. Interestingly, East West has a full-service branches in Hong Kong. 

The plain result of the regulatory actions is that a domestic bank with no interest in UCBH was permitted to acquire the business, while a foreign bank that always was a part owner of UCBH was not. The broader implication seems to be that any federal policy determined to promote inbound FDI will have to be based on a full and complete alignment of regulatory agencies at all levels. Otherwise, well-intentioned policies will be incapable of being executed. 

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In the U.S. press, almost all mention of Huawei Technologies recites like a mantra the 2008 refusal by the Committee on Foreign Investment in the United States (CFIUS) to permit it to participate with Bain Capital’s in Bain's proposed acquisition of 3Com Corporation. The consensus line is that CFIUS determined that Huawei’s connections with the government of the People’s Republic of China might have been too strong and therefore refused to approve the deal. The failed transaction is often cited as evidence that the U.S. government will not permit Chinese investment in or acquisition of U.S. high technology businesses. Experts contend that the outcome continues to dissuade Chinese investors from acquisitions of U.S. businesses. 

According to an article by Kevin J. O’Brien in the New York Times on November 30, however, Huawei has in a remarkably short timeframe become a communications equipment powerhouse without the 3Com acquisition and now wields significant market power both with China's mobile networks and around the globe.  

According to the article, Huawei now is established as a serious competitor, winning contracts from major phone networks in Europe and elsewhere on the globe, beating the likes of Ericsson and Nokia Siemens Networks. Huawei has a 20.1% market share of the global equipment market. It ranks as the number 2 supplier of mobile phone systems in the world. Its quarterly sales now are greater than Alcatel-Lucent and Nokia Siemens. It supplies 36 of the top 50 mobile operators, including Cox Communications, Leap and Clearwire in the U.S. The article reports that customers have investigated the ownership of Huwaei, said to be a private company, and concluded that its ownership would not be a factor.

It seems likely that U.S. companies will increasingly become customers of Huawei because of its versatile products and their low cost of operation. Huawei has obviously found a way to prosper here and elsewhere–even if the U.S. government did not think it a suitable owner for a U.S. business. It’s not clear whether the CFIUS decision produced any long-term benefit here at all. And it’s certainly not clear from what national security risk CFIUS protected the U.S.

The ascension of Huawei to prime global competitor status illustrates that a robust multinational high technology enterprise does not need a U.S. base, whether bought or built. Regrettably, it also demonstrates that as a result of the CFIUS decision, the U.S. has lost out on direct contributions to its economy through jobs, purchases from local U.S. vendors and the use of U.S-created R&D. 

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The proposed business combination between India’s Bharti Airtel and South Africa’s MTN Group collapsed at the beginning of last month. Local and international politics appear to have played a substantial role in its demise. Therefore, some important questions should be posed. To what extent was the collapse a result of nationalism or protectionism masquerading as a different public policy? Is the withdrawal of that deal evidence of a wider global trend that may make foreign direct investment (FDI) more difficult to execute? As government stimulus programs end, will governments—U.S. and otherwise—use their power to shield companies that have been nursed through the downturn from foreign takeovers? 

Bharti is Asia’s leading integrated telecom services provider, with operations in India and Sri Lanka. MTN is South Africa’s leading mobile and fixed-line telecom company, with over 100 million subscribers and operations in over 20 countries in Africa and the Middle East. Their proposed combination was negotiated from the end of May to the end of September and had a value of approximately $24 billion. Bharti would have received a 49% stake in MTN, while MTN and its shareholders would have received a 36% stake in Bharti. The combined enterprise would have been the world’s third largest telecom company. 

The ominous notes for FDI come from reports in Dealbook and elsewhere that the South African government failed to approve the transaction because of protectionism and nation-building policies. This outcome was not necessarily predictable because both the Indian and South African governments have supported increased trade among developing countries in sub-Saharan Africa and South Asia. That “South–South” trade is intended to offset growing Chinese economic influence in the region.

Dealbook also reported that interventions by both Indian and South African governments imposed conditions that led to the end of the deal. The South African government required that MTN keep South African management in place and maintain a listing on the Johannesburg stock exchange in addition to its listing on the Mumbai exchange. Indian financial regulators were unwilling to waive their rules against dual listings. 

The South African blog SAgoodnews pointed out that there is a long history of dual listed companies and saw no reason why that requirement should have been terminal for the transaction. The blog also dismisses arguments that national political and labor pressures were at fault.

The Indian blog Trak.in News asserts that the Indian government had backed the deal at the highest level, with Prime Minister Manmohan Singh expressly giving the combination his support. The blog also suggests that the real issue was whether the national character of the combined business would be Indian of South African. South Africa’s insistence on the dual listing was a cover for this point. On the other side, the Indian authorities believed, but seem not to have stated, that the dual listing would effectively set a conversion rate for the rupee that could differ from the official rate of exchange. 

Both companies’ share prices rose after termination was announced. Stock analysts who had trepidations were pleased to see the transaction crater. It therefore is possible that, in addition to political agendas, there were financial issues underlying the headline events. Investors may not have been as supportive of the transaction as were the managements of Bharti and MTN. 

After September 30, both governments issued the usual palliatives, saying that they remain open for business and underscoring the importance of FDI. Rather than helping business decide whether to pursue cross-border deals in emerging economies, however, these positions and unarticulated rationales only obscure the facts. The recovery from the worldwide turndown is in its early stages. Obfuscations and half-truths do not bring recovery any nearer, as they only add uncertainty where business strategists would prefer to deal with articulated policies and certainties. 

What is true for developing economies such as South Africa and India is also true for the United States. Efforts to generate inbound investment must be very transparent and free from hidden conditions. Actual decisions and measures must align with policy pronouncements. In an environment in which the U.S. is hotly competing with other countries for inbound FDI, the U.S. government cannot afford to be less than utterly committed to inbound investors. Anything less will lead those investors to look for greener pastures—a lesson that South Africa may yet learn. 

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Although multinational enterprises (MNEs) from developed economies are likely to provide substantial outbound foreign direct investment to the United States by way of M&A transactions, buyers from other nations are gaining presence. The role of Russian MNEs and investors as buyers may be increasing. 

A publication earlier this month by the Vale Columbia Center quantifies the importance of Russia as a source of outbound foreign direct investment (OFDI) for the United States and other developed nations. Professor Andrei Panibratov, Associate Professor of the Graduate School of Management of Saint Petersburg State University, and Kalman Kalotay, Economic Affairs Officer at UNCTAD in Geneva, Switzerland, authored the profile to highlight the increasing importance of Russia’s FDI program. The profile demonstrates that Russian direct investors are continuing to penetrate foreign markets and undergo a process of internationalization. The authors suggest that a carefully considered policy from Russia’s government would significantly enhance the benefits to Russia from its OFDI.  

According to the publication, various motives drive Russian OFDI: 

• The desire of managers and owners to control or offset Russia’s political and economic risks 
• Expected profitability of the investments themselves
• Expectations for better global recognition

Although Russia’s OFDI fell by 15% in the first quarter of 2009, compared with the first quarter of 2009, at the end of 2008 Russia held the second largest stock of foreign direct investments among the emerging economies, aggregating US $203 billion. This stock exceeds the investments held by Brazilian, Chinese and Indian multinationals. Between 1995 and 2007, Russia’s offshore investments grew more rapidly than did the investments of Brazil, China and India. Mergers and acquisitions by Russia’s multinationals from January 2005 through June 2008 were over ten times the volume during the 2001 through 2004 period. There are 50 to 60 Russian multinationals that account for a significant part of offshore acquisitions. The total number of Russian MNEs investing offshore exceeds 1,000, the authors believe. 

Among the 2009 inbound U.S. transactions was the purchase by Trubnaya Metallurgicheskaya Kompaniya OAO (TNK) of a 49% interest in Kentucky-based NS Group Inc. for an undisclosed amount. NS Group is a manufacturer of tubular goods.

It’s worth noting that the 2007 acquisition of publicly-owned Oregon Steel Mills by Evraz Group SA, a Luxembourg company with Russian affiliation, cleared the Committee on Foreign Investment in the United States (CFIUS) without much apparent problem, unlike transactions originating in other emerging market economies. Most of these business operate in the oil and gas, metallurgy, finance and communications industries. 

All of which suggests that Russia may provide fertile soil for inbound deals. 

The report is the first in a series of Columbia FDI Profiles that the Vale Columbia Center on Sustainable International Investment has recently launched. Material in this post is reprinted with permission from the Center (www.vcc.columbia.edu). 

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Late last week reports surfaced that the China National Offshore Oil Corporation (Cnooc), China’s state-owned energy company, was in unconfirmed discussions with Norway’s StatoilHydro ASA to acquire oil lease interests in the Gulf of Mexico. A completed transaction would open up oil reserves in the U.S. Gulf to China for the first time. The fact that a Chinese company is involved has led to speculation whether the U.S. will resist this particular foreign direct investment, recalling the political furor that resulted in Cnooc’s unsuccessful 2005 bid to acquire Unocal Corp. 

Environmental Capital blog linked to a Wall Street Journal’s report that StatoilHydro had put five prospects up for sale, a small portion of its Gulf of Mexico assets. The Financial Times wrote that the transaction would have a value of approximately $100 million and that the proceeds would be used to cover the costs of drilling wells rather than to obtain acreage. According to Energy-pedia, StatoilHydro will remain majority owner of any projects for which it brings in partners, noting that oil companies typically offer partnerships in large exploration projects to help pay for drilling and spread risk. 

Generating alarmism, Business Insider first claims that China’s overseas acquisition program is approaching the U.S. and then becomes somewhat more balanced: 

[T]he political tides have changed. In 2005, it was easy to block investments on political grounds, because there was no shortage of cash. Plus, this is just a few leases -- putting their toe in the water, it looks like -- not an $18.5 billion bid for a U.S. company.

Still expect all kinds of howls before this goes through.

Assume that the media has accurately outlined the transaction. Will the transaction between StatoilHydro and Cnooc be a “covered transaction” under the Foreign Investment and National Security Act of 2007 (FINSA)? If so, will the parties then make a voluntary filing with the Committee on Foreign Investment in the United States (CFIUS)?

Not every transaction involving a non-U.S. investor and a U.S. business is subject to FINSA. Only a transaction that “could result in control of a U.S. business by a foreign person” is. A transaction that satisfies this transfer of control test is a “covered transaction.” But not every “covered transaction” is subject to FINSA. The general structure of FINSA is that parties to a covered transaction may file a notice with CFIUS for its review and, possibly, further investigation or Presidential action. If the parties do not file a notice, then CFIUS can block the transaction or later unwind it. The purpose of the CFIUS review and investigation is to determine whether the proposed transaction might impair U.S. national security. 

CFIUS has published regulations that detail the coverage of FINSA, the review process and the contents of the voluntary filing. Applying the facts of the Cnooc discussions to the regulations produces some interesting results:

Does the fact that a Norwegian entity owns the oil leases save the deal from regulatory review? No. A U.S. business is subject to the regulations and to FINSA regardless of the nationality of the person that controls it.^[1]

Are the oil leases a U.S. business? To be a U.S. business, the leases must be an entity engaged in interstate commerce in the United States.^[2] Are they? The regulations define “entity” to include “assets (whether or not organized as a separate legal entity) operated by any [other entity] as a business undertaking in a particular location or for particular products or services.”^[3] Therefore, the leases could be an “entity.”

If the leases are an entity, is the entity engaged in interstate commerce in the United States? The wells are offshore, and not located within the boundaries of any state of the United States, as can be seen from the map published by Energy-pedia. The media coverage says that the leases are located in the “U.S. Gulf.” Is that a state or is it not?

Also, since the wells appear to not yet be operating, are the assets engaged in any commerce at all?

Under the regulations, certain transactions are not covered transactions, including the “acquisition of any part of an entity or of assets, if such part of an entity or assets do not constitute a U.S. business.”^[4] There is an example in the regulation of a foreign person acquiring individual discrete assets -- including land -- from a U.S. business. The example concludes that the acquisition is not a covered transaction. 

If its purpose is to finance drilling, rather than to obtain acreage, then the proposed transaction is an investment, not an acquisition. FINSA, however, applies to investments if control is tranferred. The structure of the deal may be that Cnooc will obtain lease interests. If these interests do not have rights to vote for directors or vote on other matters affecting the entity, then the interests are not voting interests and there may be no “control” aspect to the transaction at all.^[5]

Lastly, if Cnooc is acquiring interests from StatoilHydro without any intent to exercise control, then Cnooc may be acquiring the interests or the leases “solely for the purpose of passive investment,” and the investment may be exempt from FINSA on that basis.^[6] The observation that StatoilHydro intends to remain in operating control supports this view. 

Overall, there could be several bases for the legal conclusion that the proposed deal would not be a covered transaction under FINSA. Cnooc and StatoilHydro will no doubt take their own business assessment of their situation. It will be interesting to see if the views coalesce or diverge. 

All references are to Sections of the CFIUS regulations: 

^[1] Section 226

^[2] Section 226

^[3] Section 211

^[4] Section 302(c)

^[5] Section 228

^[6] Section 302(b)

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If imitation is the sincerest form of flattery, then the architects of the Foreign Investment and National Security Act of 2007 (FINSA) and its regulatory agency CFIUS can be proud. The Canadian government is revising its Investment Canada regulatory scheme. The result resembles the regulatory system here south of the Canadian border.

Recent Canadian statutory enactments and proposed regulations introduced a new national security review mechanism into the screening process. In 2007, FINSA amended the then-existing U.S. statute, known as Exon-Florio, to specify that national security was to be the sole focus of U.S. regulation. The new Canadian structure authorizes the government to review, block or limit inbound investments by non-Canadians based on national security concerns. One commentator has noted that although the legislation does not define “national security,” it remains to be seen whether the regulators will also consider issues of economic security under the national security umbrella.

Under the new regime, Canada’s national security process starts with a preliminary review of the transaction. If the initial review indicates that there are national security concerns arising from the proposed deal, then the Cabinet reviews and determines whether a full review is required. The review applies the standard, “injurious to national security.” If the transaction fails that standard, then the government may order the transaction blocked, restricted or, if closed, unwound. The maximum length of the review is approximately 3 ½ months. Once the time for review has expired, the Canadian regulators cannot challenge a reviewable foreign investment on national security grounds.

Under the legislation the government retains the authority to initiate a review of non-reviewable transactions, including minority investments, at any time within 45 days after completion.

Recent statutory changes will significantly modify the monetary thresholds for review of inbound transactions. If and when the proposed regulatory changes are made, the threshold will be applied to the enterprise value of the target, not the book value of its assets as is currently the case. The threshold itself is set at enterprise value of Cdn $600 million and will increase to Cdn $1 billion over the next four years.

FINSA and CFIUS are, of course, not the only national security-based regulatory schemes in place today. China, France, Germany, Japan, Poland, Russia and the United Kingdom, among others, based their regulatory reviews of inbound deals on national security grounds.

Canada is frequently mentioned together with Australia as the leading developed, resource-rich nations that are targeted for foreign investment by China and others aggressively looking to source commodities. Australia, by contrast, recently revamped its FDI regulatory scheme to limit the range of deals subject to review. Like Canada, it raised the threshold for review. That change and others are reviewed by our recent August 13 posting in this blog.

Unlike Canada, Australia did not adopt a regulatory scheme that specifically vets national security issues.

For a discussion of the role of national security in the CFIUS review process, please access the white paper located on our firm’s Web site.

Howard Burshtein of Torkin Manes LLP, Toronto, Ontario, contributed to this post.

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September produced two transactions worthy of comments because of CFIUS’ role.

Last July gold mining company Firstgold Corp. of Lovelock, Nevada, announced that it had entered into a binding agreement with a new investor, Northwest Non-Ferrous International Investment Company Limited of Xi’an, China, located in Shanxi province (northern central China). Firstgold is a development stage company with total assets of $19.8 million and a net worth of $5.0 million according to its last annual report filed with the SEC for its year ended January 31, 2009. Its financials are subject to a going concern qualification. Firstgold has been caught up in litigation with two holders of senior secured promissory notes. Northwest agreed to acquire those notes, lend an additional $5.5 million to Firstgold and buy shares representing 51% of the company’s equity, making Northwest both the parent and senior lender to Firstgold. The July announcement stated that the proposed transaction was subject to obtaining all required governmental and regulatory approvals. The deal documentation did not specify Committee on Foreign Investment in the United States (CFIUS) approval, only “regulatory approvals” generally.

Flash forward to September 21, when Firstgold announces that it and Northwest have agreed to extend the time to close their transactions until December 1, 2009. Firstgold’s September 21 press release suggests that Northwest had determined in the interim that it was advisable or necessary for it to file a voluntary notice with CFIUS. In the release, Firstgold takes the position that the CFIUS notice “will not prove to be an obstacle to our closing the transactions we have previously announced.” No doubt it would have been even less of an obstacle if filed in July or August. 

The filing could prove to be more complex than Firstgold believes. CFIUS review of Chinese purchasers tends to be quite exhaustive, particularly on the point of any connections between the purchaser, its board of directors and its principal shareholders and the PRC government. Chinese language submissions are not allowed.

There is a larger question that the Firstgold/Northwest deal raises. Does the U.S. really need CFIUS review for a company that is relatively small and financially weak? Why did Congress not provide a small reporting company-type exemption from FINSA’s notice scheme? Given the scarcity of risk capital in current markets for development stage companies, wouldn’t the U.S. be better served if there were thresholds for U.S. targets before FINSA review is required? 

Updated October 12, 2009--  On October 7 Firstgold updated investors on the status of its proposed refinancing transaction.  Firstgold has made filings with the Ontario Securities Commission so that trading of its stock could resume.  With respect to CFIUS review, the company said that it expects by late October or early November to receive notice from CFIUS that the ongoing review under FINSA is complete and that no further action will be taken.

The New York Times Dealbook blog commented on the September 16 announcement by Chemring Group PLC that it had agreed to acquire aerospace company Hi-Shear Technology for $132,000,000. Hi-Shear is a defense business based in Torrance, California, while Chemring is an English company. The Dealbook blog voices a concern that the parties to the deal have not committed outright to pursue CFIUS and other regulatory approvals. The post points to language in the merger agreement for the proposed deal that requires the parties only to use “reasonable best efforts” to close. But in the following sentence, the agreement requires the parties “to make appropriate filings” under what it refers to as Exxon-Florio. The Foreign Investment and National Security Act of 2007 (FINSA) replaced Exxon-Florio in late 2007. There is a specific provision in the merger agreement that elaborates on the allocation of responsibilities for the parties to file their notice with CFIUS and also sets a timetable. The agreement also specifies a process for the required submission to be made under the International Traffic in Arms Regulations. Receipt of a notice from CFIUS stating that there are no national security concerns or that the CFIUS service has been completed without further investigation is an express condition to completion of the deal. The commentary in Dealbook seems misplaced. Compared with similar language in other merger agreements, the language in the Chemring deal is quite clear and well-drafted.

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The global economy is struggling with some success to recover from the turmoil of the last two years. Attorneys, investment bankers and other professionals now are trying to predict where global mergers and acquisition activity will begin to increase. What markets are likely to first benefit from the return of global FDI?

Earlier this year, the United Nations Conference on Trade and Development (UNCTAD) released its World Investment Prospects Survey for 2009-2011 (WIPS). WIPS provides an outlook on future trends in FDI by the largest multinational business enterprises. WIPS compiled the results obtained from a sample of 241 company executives of the large non-financial multinationals and from 20 direct interviews. 

WIPS predicted the top 15 countries that will receive FDI for 2009 - 2011:

1. China
2. United States
3. India
4. Brazil
5. Russian Federation
6. United Kingdom
7. Germany
8. Australia
9. Indonesia
10. Canada
11. Vietnam
12. Mexico
13. Poland
14. France

The United States improved its position by one step over last year’s survey, replacing India in the number 2 slot. Brazil moved past Russia, achieving the 3^rd place position.

The reasons underlying the selection of these countries were predictable and included:

• market size
• market growth
• availability of less expensive labor
• access to natural resources
• quality of the business environment

Of even greater interest, however, is the distribution of the responses from the survey participants. First, the top 15 countries accounted for 74% of the total responses. This is close to the 80/20 phenomenon seen in other measure of voluntary market participant choices—such as favorite websites or favorite books—in which 80% of the respondents pick the same 20% or less of available choices. Second, as shown in the accompanying chart from WIPS, China, the United States and India appear to have more favorable responses than do the other twelve nations. This type of sharp drop off from highest to lowest in frequency of choice is referred as a power law curve. The power law curve is an algebraic graph plotting data in which the N position has 1/N^th of the first position’s rank. This distribution occurs where the responses represent free choices and is at odds with a normal bell curve distribution.* 

Then, what are those attributes that make a country attractive to FDI. WIPS recites:

• “For market growth, developing and transition economies are generally favored, such as China, India, Brazil, the Russian Federation, Indonesia, Vietnam, Poland and Thailand.
• For market size, the largest economies are favored, either developed ones such as the United States, Germany and Canada, or emerging ones such as China, the Russian Federation and Brazil.
• For access to regional markets, countries that are integrated into large markets, or which are close to large and growing economies, are favored, such as Mexico, Germany, Vietnam and Poland.
• For presence of suppliers, mostly developed countries are favored, such as the United Kingdom, Germany and France, and, to a slightly lesser extent, some developing countries such as India.
• For their business environment (including government effectiveness, stability and quality of infrastructures), developed countries such as the United States, Germany and Australia are favored. France is frequently mentioned for the quality of its infrastructure.
• For skills and talent, developed countries such as the United States, Germany, the United Kingdom and France are favored, but also some developing countries, such as India and Thailand.
• Cheap labor is cited for favoring developing countries, mostly in Asia, such as China, India, Vietnam, Indonesia and Thailand.
• For access to natural resources, countries well endowed with them, such as Canada, Australia and Indonesia, are favored.
• Access to capital markets is frequently mentioned as an asset for the United States, the United Kingdom and Canada. 
• Incentives is frequently mentioned for Australia, Vietnam and Brazil.” 

WIPS concludes on an optimistic note, expressing the view of its respondents that a progressive recovery will start slowly in 2010 and gain momentum in 2011. The basis for the optimism is that the growing internationalization of business enterprises will lead to a new wave of international investment projects as the recovery takes hold. When and if that occurs, these key factors are likely to play a major role in deciding where FDI is targeted. 

Implicit in these findings, and in the power curve as well, is a warning for the United States. The United States could fall behind its competitors for any one or more reasons – a slower recovery, unfavorable tax policies, protectionist trade practices or restrictive regulation of which investments, to name just four. The power curve is a slippery slope. If the U.S. falls to 4th or 5th place, it will fail to receive substantial amounts of FDI and may be unable to require the 1st or 2nd position for years to come.

*For a compelling discussion of the power law curve and its application in the context of social media, see Clay Shirkey's Here Comes Everybody: The Power of Organizing Without Organizations.

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China’s outbound foreign investment strategy continues to make news. TheStreet.com and other business media reported today reported yesterday that China Investment Corp. (CIC), China’s sovereign wealth fund with approximately $300 billion in assets, may be discussing an investment into, or joint venture with, The AES Corporation of Arlington, Virginia. AES operates electrical generating facilities and distribution systems across the globe, has more 25,000 employees and a market capitalization of $9.8 billion. Reuters has reported that last week a senior CIC official said that CIC is seeking minority investments in infrastructure projects as well as green energy projects. 

To view these media reports in proper context, it may be well to review a few basic facts about China’s current outbound foreign direct investment (OFDI) program, as reported by Xinhuanet on September 8. Xinhuanet based its story on a report jointly issued by China’s Ministry of Commerce, the National Bureau of Statistics and the State Administration of Foreign Exchange that same day.

• China’s OFDI added up to US$183.97 billion by the end of 2008. 
• The source of China’s OFDI is more than 8,500 domestic investors, whose overseas corporate assets in 2008 exceeded US$1 trillion. 
• Chinese overseas enterprises employed about 1.03 million people, including 455,000 overseas employees.
• China’s net OFDI in 2008 was US$55.91 billion, an increase of 111% from 2007.
• Chinese investors have established approximately 12,000 enterprises overseas in 174 countries or regions. Approximately 71% of these enterprises were in Asia and Europe.
• Among Chinese outbound investors, 50.2% were limited companies, 16.1% were state-owned enterprises and 9.4% were private companies. 
• Investment by state-owned companies declined 3.6% from 2007.

Australia is a key target for China’s OFDI, because of that continent’s abundant raw materials and other material resources. Xinhuanet also reported that Australia is seeking to attract increased amounts of Chinese investment and deepen their bilateral economic cooperation, especially in the energy and natural resource sectors. The senior trade commissioner of the Australian Trade Commission confirmed Australia’s intentions at a international trade forum held in coastal Xiamen, Fujian Province, on September 8. 

Data from Australia’s foreign review board show that Chinese investment interest in Australia is on a strong upward trend. Even so, at the end of 2008, China’s total investment stock in Australia was only $6.83 billion, and represented an increase of 26.7% from the position at the end of 2007. With this significant increase, China ranked as Australia’s 13^th largest foreign investor.

China’s surge in OFDI may be rooted in its internal $585 billion recession-fighting stimulus package. That package represented 13.2% of China’s gross domestic product for 2008. During Q1 of 2009, Chinese state-owned banks increased their lending by more than one trillion dollars, or more than half of the national GDP on an annualized basis. According to published reports, over half of the new loans went into China’s stock and property markets, generating speculation-driven increases in prices. The remainder went into the Chinese economy and is likely to be doubt a substantial factor driving China’s OFDI. Recognizing that increased China OFDI may be more than desirable for generating and maintaining its economic recovery, Australia’s recently revised foreign investment rules raised the dollar threshold for investments that require regulatory review. The change is expected to result in an increase in the number of Chinese investments in smaller Australian natural resource and energy companies. According to the Australian trade official referenced above, Chinese investment has not harmed Australia’s economic security and has enhanced the reputations of the investors. 

The U.S. is on a slower path with China. It is possible that if the AES discussions mature into a deal and if CFIUS and other regulatory review supports the deal, the pace of China’s OFDI into the United States will accelerate. Adverse regulatory responses will likely have a dampening effect when this country can least needs it. 

Updated: On September 16, in a follow-up article, Xinhuanet reported that, according to China’s Ministry of Commerce, OFDI by China's 136 centrally-administered state-owned enterprises (SOEs) in 2008 was $35.74 billion.  The investment accounted for 64% of China's total OFDI for the year.   This appears to be a significantly larger share than had been previously reported.

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How likely is it that the remainder of 2009 will see an upsurge of mergers and acquisitions or other investment activity from China?

Financial Web site 24/7 Wall St. provided its answer in a September 1 post, arguing that, in spite of China’s insatiable appetite for energy deals, that nation is more than reluctant to invest in the U.S. 24/7 Wall St. catalogued announced deals over the past year with public companies across the globe and tallied $50 billion of oil and gas purchases, as well as uncounted unannounced deals, without the merger or acquisition of a single U.S. public oil company:

As asset prices sink, it is easier for China and its central government to buy more and more of whatever it wants on the cheap. . .  . [T]he pace at which China is locking in energy supply deals seems to only be increasing. And it is effectively doing it without a single handshake taking place on U.S. soil and without U.S. oil.

The post suggests that the 2005 CFIUS action that blocked Chinese National Overseas Oil Corporation from acquiring Unocal—later acquired by Chevron—still looms as a basis for Chinese buyers to avoid U.S. deals. This view discounts the Obama Administration’s desire to turn the page on the actions of the prior Administration, as recently shown by the July Chinese/U.S. cabinet-level meetings held in Washington, discussed in this blog’s August 6 post.

As Exhibit I to 24/7 Wall St.'s position, there was the August 31 announcement from Athabasca Oil Sands Corp. of its joint venture with PetroChina International Investment Company Limited, a wholly-owned subsidiary of Asia’s largest oil and gas company. Through the venture, PetroChina has agreed to acquire a 60% working interest in AOSC's MacKay River and Dover oil sands projects for $1.7 billion. The agreements also provide for certain financing arrangements for AOSC. The projects are located in the centre of the Athabasca area in northeastern Alberta and have been independently assessed to contain approximately 5 billion barrels of bitumen resource.

Looking more broadly, however, there is a significant amount of FDI that is directed at the United States, particularly in areas other than the energy sector, and the future seems quire promising. The International Trade Administration (ITA) of the U.S. Department of Commerce recently reported that from 2004 to 2008 the FDI position of the Asia-Pacific nations in the U.S. grew at an average annual rate of 10%, exceeding the global average growth rate by 25%. The annual growth rate of FDI from China into the U.S. during that period was 23%. Although this growth rate was not as high as that of Singapore (49%) or India (48%), it approximates that of South Korea. It can hardly be considered to be negligible.

The ITA cites three motivating factors that drive FDI: access to innovation, markets and resources. The ITA makes that case that the U.S. excels in each category, noting that, "In many cases, Asian-Pacific companies do not invest in the United States solely to minimize the cost of inputs, such as . . . natural resources . . . ." Therefore, although the U.S. can offer a workforce with high productivity to offset its higher cost, a highly efficient transportation system and openness and transparency, in the natural resources sector, our assets may come with costs that compare unfavorably to Canada, Australia and other markets.

The ITA report states that "the United States should expect large increases of FDI flows, especially from China and India . . . ," the third and twelfth largest world economies. Based on trend evidence accumulated over the past 50 years for other economies such as Japan, the relative and absolute amounts of their OFDI into the U.S., ITA predicts that OFDI from those nations will increase to be in line with their rankings. The report also points to academic studies demonstrating that developing nations generally promote OFDI and eventually become net outward bound investors. Those trends cannot occur without significant investment into the US from Asia-Pacific nations in general and China in particular.

The ITA report asserts that inbound FDI will occur. Nonetheless, the predicted influx seems to not yet be occurring, as 24/7 Wall St. points out. Q4 of 2009 may reveal more as to which camp has the better argument.

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Investment bankers, lawyers and other professionals often overlook the importance of other third parties in facilitating inbound FDI transactions. A prime example is the increasingly critical role that the economic development community may be able to play in bringing inbound mergers and acquisitions to the United States to stimulate recovery. 

Worldwide, there are over 7,000 economic development organizations (EDOs) and investment promotion agencies (IPAs) operating on behalf of cities, towns, regions and countries. There are over 4,500 members of the International Economic Development Council (IEDC) in the U.S. Since the economic turndown has resulted in significant businesses closures and job losses, U.S.-based agencies now may be looking to continued foreign investment to restart their economies.  Their search for inbound investment leads to rivalry and competition because demand for investment greatly exceeds supply. 

Economic development efforts are at an inflection point. Until 2008 or this year, EDOs have been seeking “greenfield investment”— the startup of a new business or the relocation of a existing business to their area. The worldwide economic crisis has, however, led to business consolidation. 

In a business consolidation phase, expansion is unlikely to take place. Instead, business combinations — mergers, consolidations or takeovers — occur. The aim is to spread greater business activity over lower expenses.

Lower expenses, however, often mean job losses, reduced requirements from vendors and fewer outflows in general. These effects are not the effects that EDOs desire to create. EDOs advocate for more jobs, more business for local vendors and increased outflows from new business into their community. So it becomes challenging for EDOs to advocate mergers, takeovers or other business combinations when the result may be to exacerbate conditions that already are bad. 

But, in a downturn, if businesses already are devastated, business combinations that take advantage of companies already shuttered or whose fate is clear unless repositioned can have salutary effects. It’s a question of public perception. That’s where marketing and education come in.

So the EDO agenda now has two goals. First, win public support for all forms of inbound investments, including business combinations with inbound buyers. Second, continue convincing inbound buyers of the significant benefits to be gained from owning and operating businesses in the U.S. 

The Strengthening Brand America Project aims to have U.S. EDOs place a higher priority on FDI attraction as a strategy for accelerated economic recovery. Founded by Edward Burghard, the Project is a community of practice targeted to EDO professionals. The Project’s goal is to facilitate the transfer of private sector product and corporate branding principles to the public sector.

The Project has succeeded in making publicly available data for inbound capital investment on a state-by-state basis for 2003 through 2008. fDi Intelligence, a specialist division of Financial Times, harvested and analyzed the data. The data gives an excellent perspective on the comparative successes of state-level EDO campaigns. For the five-year period:

• the top 10 states picked up more than 45% of the inbound investment
• the results vary considerably from $57,320 million for top-rated Texas to $287 million for bottom-rated Vermont
• among the bottom 80% of states, no state received more than 2.9% of the incoming funds

Results for 2009 are likely to differ significantly because the total incoming amount will be significantly less.

The overall challenge looms large—to replace these meaningful amounts of inbound capital investment with inbound M&A. With the support of the Strengthening Brand America Project and the data it provides, states and localities have superior tools to take on the task ahead. 

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Intuitively, FDI into the U.S. should be increasing. An increasing chorus of economists is declaring that the recession at or near to an end. Asset prices remain low. IPO’s in the stock markets have begun to stir, raising hopes for exits from investments and for capital to recast balance sheets. The anecdotal evidence is that FDI continues to stream toward other developed economies such as Australia, and transitional economies, such as China and Brazil. Is the U.S. likely or not likely to be an early beneficiary of FDI flows as the world economy recovers?

OCO Global develops strategies for economic development organizations and investment promotion agencies worldwide. Led by its CEO, Mark O’Connell, earlier this year OCO’s editorial team published “A New Investment Paradigm,” a forecast of near-term market directions for FDI.

The findings of OCO’s report include:

• a prediction for a bounce in M&A from companies that normally would have expanded through greenfield investments
• firms from emerging markets have entered the world FDI market in force and are formidable competitors; these firms will use M&A as the pathway for investing in host economies; for example, Indian FDI into the U.S. could triple over the five years ending 2014
• OFDI from China nearly doubled and the trend is likely to continue, following the government’s promotion of a “go global” policy, particularly in service industries
• the vast majority of recorded OFDI from China has been from large state-owned enterprises (SOE’s); future OFDC is more likely to originate within its private sectors
• less than 5% of China’s OFDI has been directed at North America; there are at least two rationales for this relatively small percentage:
  • a lack of readiness by Chinese businesses to compete with large U.S. companies on their home turf; and
  • a fear of U.S. protectionism hiding behind a regulatory screen
• in China, the availability of foreign exchange reserves combined with credit availability makes OFDI affordable and inviting, particularly if targets with existing market share and recognized brands are cheap

One could connect the dots among these factors and conclude:

• the greater availability of credit to offshore businesses -- plus a strategic need to bolt on the right target -- gives inbound acquirers significant advantage
• the “buy versus build” scale may have tipped to the “buy” side for multi-national enterprises and investors
• low visibility of revenue growth for U.S. based companies may hold down valuation multiples, making acquisitions more affordable
• the need for capital, especially capital that increases employment and capital expenditures, may make inbound acquisitions more palatable -- even desirable -- in parts of the U.S.
• as more foreign buyer become truly privately-owned, and fewer are SOE’s, U.S. businesses and their constituencies (i.e., labor, localities, vendors) may become less averse to inbound deals

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Observers of the FDI scene might have come to believe that China’s outbound foreign direct investment (OFDI) program would be unequivocally welcome for its global stimulus effect.  A recent editorial in the Financial Times initially concedes that China’s investment strategy will benefit both Europe and the investing companies. It then asserts a contradictory view.

In a piece decidedly protectionist, two Dutch researchers assert that Europe needs to screen Chinese investment. 

The main issue is not the Chinese taking over European companies of great strategic importance; it is how to respond to the longer-term accumulation of economic power in Europe by a country such as China. 

The writers suggest that the EU emulate the U.S. and establish a regulatory body similar to CFIUS with jurisdiction over all of its member nations. The union-wide solution is necessary to prevent Chinese investors from playing one country against another, say the authors. The editorial then raises the Trojan Horse rationale for regulation:

What has already caused anxiety in some European countries, particularly Germany and France, is the fact that the leading Chinese companies, banks and investment funds are state-controlled. Because Europeans regard China’s autocratic political system as incompatible with their own democratic norms, the growth of Chinese influence in European companies is a highly sensitive issue.

An effective, non-politicized regulatory body that screens solely for issues of national security, and not broader issues of economic security, may or may not be beneficial to the EU. Conjuring up threats of stealth investment by Chinese state-owned enterprises is not likely to lead to a dispassionate, reasoned evaluation of the proposal. There is also the equally important question of how to insure that a regulatory screening body chartered to protect national security does not morph into a Trojan Horse for wider nationalist or protectionist agendas. 

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Last week Wayne Swan, Australia’s Treasurer, announced significant reforms to Australia's foreign direct investment (FDI) screening framework. The reforms will invite addition mergers and acquisition activity, with a view to supporting economic growth and positioning Australia for a more competitive recovery beyond the global recession. 

There are concerns that the current economic turndown may lead countries to restrict inbound mergers and acquisitions. Australia nevertheless has taken commendable steps. Swan’s steps -- clearly anti-protectionist and pro-globalization -- reflect his assessment of the best interests of Australia’s economy. The reforms upsize the investment screening thresholds, set as fixed dollar amounts.

According to Mr. Swan’s press release, Australia’s government has recognized that the health of its economy is linked to the global economy. The government seeks to eliminate certain impediments to further FDI by removing itself from uncontroversial business transactions. The announcement makes clear that “Foreign investment is vital to Australia’s future growth and prosperity.” Reasons underlying this linkage are that FDI:

• creates jobs
• increases innovation
• promotes healthy competition

The current regulatory regime has six thresholds. The proposed regulations:

• replace the four lowest thresholds with one threshold of AUD 219 million
• replace those threshold that apply to U.S. investors with one threshold of AUD 953 million
• index the threshold amounts annually against the GDP price deflator
• eliminate the notice requirement that applies when foreign investors (other than U.S. investors) make a greenfield investment of more than AUD 10,000,000

Directly on the heels of Mr. Swan’s announcement, Yanzhou Coal Mining Co. reportedly launched its cash bid to acquire Felix Resources Ltd., based in Brisbane. Talks between the companies had begun over a year ago. According to Dealbook, Yanzhou’s bid is valued at more than AUD 3.5 billion. The offer may well test Australia’s liberalized outlook. 

To put the matter in context, China's direct investments in Australia reportedly grew from US $1.4 billion in Q1 2008 to US $13 billion in Q1 2009, a staggering 830% increase.

Dr. Peter Drysdale, emeritus professor at the Australian National University, buttresses Swan’s rationale. Dr. Drysdale, a noted Australian economist, speaks out against protectionism and in favor of cooperative, bilateral frameworks. He has told Xinhua, the official press agency of the government of the PRC  that “Anxiety over the growth of foreign investment in resources by China is unfounded.” Dr. Drysdale’s premise is that increased international cooperation brings benefits to both the investor and the host country. Outbound investments secure stakes in projects that can provide long-term supplies to China’s rapidly growing markets and also bring management know-how and technology to China. The host country receives capital, know-how and access to markets. The Australian government has clearly heard Dr. Drysdale’s appeal to put market solutions ahead of regulatory solutions. 

The Australian Government’s reform is particularly courageous in light of the current controversy over China’s July 5 detention of four Rio Tinto Ltd. employees, one of whom is an Australian national. Yesterday, there were reports that Shanghai prosecutors had approved the arrest of the employees. There is a predictable home-base backlash against FDI from China into Australia arising from China’s steps to deal with alleged thefts of secrets, particularly data with great value to China’s steel manufacturers, as well as bribery of non-governmental officials. 

Our July 16 post to this blog discussed the U.S. State Department’s support for inbound FDI into the U.S. As the Australians are proving, however, actions are louder than words.

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The Committee on Foreign Investment in the United States (CFIUS) figured prominently in the high level discussions held last week in Washington between representatives of the People’s Republic of China and the U.S. government.

According to the “The First U.S.-China Strategic and Economic Dialogue Economic Track Joint Fact Sheet,” the U.S. committed unequivocally that the CFIUS screening process would be non-discriminatory:

In addition, the United States confirms that the Committee on Foreign Investment in the United States (CFIUS) process ensures the consistent and fair treatment of all foreign investment without prejudice to the place of origin. The U.S. reaffirms its commitment to the open and non-discriminatory principles for recipients of sovereign wealth fund investment as identified by the Organization for Economic Cooperation and Development.

Two days of meetings were held among U.S. Secretary of State Hilary Rodham Clinton and U.S. Secretary of the Treasury Tim Geithner, as special representatives of President Obama, and Chinese Vice Premier Wang Qishan and State Councilor Dai Bingguo, as special representatives of President Hu Jintao.

Underscoring the importance of the meetings to the U.S. economy, President Obama addressed the opening session of the Dialogue. Twelve U.S. cabinet secretaries and heads of executive agencies also attended. The Fool’s Mountain blog carries an extended excerpt from the President’s address. There is no question but that the White House is taking substantive steps to acknowledge the importance of China’s investor status to the improvement of the U.S. economy.

Secretary Geithner’s closing statement, released on July 28, reflected the high profile that CFIUS has in these discussions. He reaffirmed U.S. commitments “to open and rules-based trade and investment” and to avoiding protectionist measures. In return, China agreed to increase its thresholds for “foreign direct investments that must obtain central government approval.” The accompanying release clarifies that China’s commitment means less regulation of inbound investment into China, particularly by its opening service markets to private investment.

The Administration seems determined to confront and allay the misgivings that Chinese investors and businesses have about the U.S. regulatory screening process. The prior experiences of Huawei Technologies and CNOOC are often cited to substantiate doubts, without equal time given to those transactions that proceeded without incident. In the conventional view of Chinese investors and businesses, any overall effort to increase investment from China requires clarity from CFIUS as to what U.S. industries, if any, are off limits. Congress has given CFIUS the gatekeeper role for inbound FDI. To keep CFIUS as far away from politics as possible, CFIUS must keep its profile low, remain nimble in its dealings and maintain intact its process for dealing with filed notices on a case-by-case basis. Pronouncements that characterize specific industries as in bounds or out of bounds will only attract the degree of attention that has been hostile to FDI in the past. Although foreign investors may genuinely desire more definitive guidance, that guidance may be better obtained from experienced U.S. advisors rather than backing CFIUS into unwelcome positions.

The net result of the meeting and the dialogue may well be that offshore buyers and investors — Chinese and other — see their way clear to proceeding with U.S.-targeted deals. This will be welcome news for private equity, venture and buyout funds with portfolio companies in need of cash. It will also be welcome news for M&A advisory firms, especially those who have built relationships in the developing world.

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Is it reasonable for U.S. businesses to expect mergers and acquisitions activity and investments from Chinese businesses?  In pursuit of a reliable answer, last week we posted Part I of our interview with Dr. Daniel H. Rosen.  Dr. Rosen is an economic advisor specializing in China’s commercial development and writes and speaks extensively on US-China economic relations. He is the Principal of Rhodium Group, a specialized practice helping decision-makers analyze and understand commercial, economic and policy trends in Greater China. He is a graduate of the Graduate School of Foreign Service at Georgetown University and the Department of Asian Studies at the University of Texas, Austin. He is a Member of the Council on Foreign Relations and the National Committee on U.S.-China Relations. He is the author of Behind the Open Door: Foreign Enterprises in the Chinese Marketplace. 

Our interview continues:

China’s State Administration of Foreign Exchange has recently announced policy changes intended to encourage OFDI, including broader access to foreign exchange to finance acquisitions.  Will these changes result in increased acquisition activity, as intended?

Rosen: Yes, but not by themselves.  Global asset price volatility is particularly distasteful to Chinese firms, which face political pressure from units of government other than SAFE if their undertakings abroad underperform.  There remains a discouraging schizophrenia in China’s policy toward investing abroad.

The July 5 detention of Stern Hu, Rio Tinto’s lead negotiator with China’s iron ore importers, was initially perceived as a step backward for both inbound and outbound investment in China.  More recently, statements by Chinese officials suggest that the government was acting to protect its legitimate interests.  Are you willing to predict the outcome of the affair?

Rosen: It is impossible to say how his will be resolved.  However the lesson learned is that China has a business planning and market transparency problem, which will poison commercial practices and create inefficiencies as long as it remains unaddressed.

How do Chinese businesses and governmental officials perceive the U.S. regulatory structure for reviewing inbound investments? 

Rosen: They are unhappy with them, and believe that the US is disingenuous when it says that we have no “no go” sectors or strategic industries apart from national security concerns.  They want clarity on US sensitivities. 

Do the CFIUS regulations provide sufficient clarity for those required to provide information to that agency?

Rosen: Not necessarily, but usually.  The system is inherently subjective, in part because the motivation of the buy side is inscrutable and yet relevant to the outcome.

Is CFIUS considered to be a fair or non-politicized regulator?  Is there a perception of bias against Chinese acquirers? 

Rosen: Generally CFIUS works ok, but CFIUS is not the only factor impacting China’s OFDI to the US.  It is the process of record, but super-regulatory forces can impede a given deal, as they did in the Unocal case.

If Chinese investors were to suggest changes to the U.S. regulatory structure, what might those changes be? 

Rosen: They have asked for a “negative list” of areas that are off-limits.  What is equally important is what they do not want to see, which is an expansion of the CFIUS mandate to include any sort of national “economic security” considerations. 

Thank you, Dr. Rosen. 

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Is it reasonable for U.S. businesses to expect mergers and acquisitions activity and investments from Chinese businesses? Our posts of July 10 and 13 highlighted a policy brief on China’s Changing Outbound Foreign Direct Investment Profile published by the Peterson Institute for International Economic and written by Daniel H. Rosen and Thilo Hanemann. Dr. Rosen agreed to respond to questions that we posed regarding China’s approach to mergers and acquisitions and other direct investments in the U.S.  Part I of our interview follows.

Dr. Rosen is an economic adviser specializing in China’s commercial development and writes and speaks extensively on US-China economic relations. He is the Principal of Rhodium Group, a specialized practice helping decision-makers analyze and understand commercial, economic and policy trends in Greater China. He is a graduate of the Graduate School of Foreign Service at Georgetown University and the Department of Asian Studies at the University of Texas, Austin. He is a Member of the Council on Foreign Relations and the National Committee on U.S.-China Relations. He is the author of Behind the Open Door: Foreign Enterprises in the Chinese Marketplace. 

Your recent policy brief addressing China’s changing outbound foreign direct investment (OFDI) makes a strong case for an expectation of increased OFDI.  In fact, you write that China’s OFDI is at an inflection point and that the geographical distribution of OFDI will shift toward the OECD countries. Do you expect OFDI into the United States to accelerate? 

Rosen: Yes.  Wherever Chinese producers are already OEMs or producers in value chains that lead to the US, they should be expected to move up and down those value chains toward US assets.

What are the characteristics of those American businesses that would be most attractive as investments for Chinese strategic investors?  

Rosen: Complementarily to Chinese capabilities, low price, non-union.

How important is the price level for those businesses?  Are distressed U.S. assets attractive to Chinese investors as an investment class?

Rosen: Price is important to Chinese firms, but not if it reflects extremely complicated situations.  China has little ability to work-out regulatory, labor or legal complexities, and so will tend to avoid them, or else have to rely on co-investors to deal with them. 

At various times in the past, both strategic and financial buyers have acquired or invested in U.S. companies.  How close are we to a time when Chinese financial buyers, as opposed to strategic buyers, will acquire U.S. businesses? 

Rosen: I think Chinese investment will be weighted toward strategic buyers who can generate value through expanded scope for a long while.  Financial investors from China have little ability to add value in the US.

You have written about the imperative for China’s firms to capture a greater share of the production chain.  The 2005 Lenovo transaction with IBM was a precursor of this type of transaction.  Do Chinese businesses and the Chinese government perceive the Lenovo transaction as a model to be followed?

Rosen: Lenovo is still considered an exceptional case, involving exceptional entrepreneurship.  Even still, it is not considered a home run in terms of performance.  It is a healthy example of the real, normal business challenges that will arise in even better Chinese forays abroad.

Part II of the interview with Dr. Rosen will be posted on August 3, 2009.

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How much merger and acquisition and other investment activity is directed into the United States? Is the level of foreign direct investment into U.S. businesses increasing or decreasing?

The Commerce Department’s Bureau of Economic Analysis has released three reports that provide measurements. The first, by Thomas Anderson, addresses new investments made to acquire or establish U.S. business in 2008. The chart included in this post shows annual outlays measured by this report. 

Significant findings contained in the report include:

• Foreign direct investors made outlays of $260.4 billion of outlays in 2008 to acquire or establish U.S. businesses. This level is the third highest on record.
•  46% of these outlays were for large-sized transactions ($5 billion or more), double the percentage of large-sized transactions for 2007.
•   2008’s level of these outlays was a 3% increase over 2007’s level of $252 billion. The rate of increase for 2007 over 2006 was 52%.
• Outlays for manufacturing businesses accounted for the majority of spending in 2008, with outlays for financial services businesses a distant second.
•  European investors made 61% of the outlays; Asia and Pacific made 17%. Outlays from Canada and the Middle East fell to 10% and 5% of the total.
•  Of the $260.4 billion total, 93% of the outlays were made to acquire existing businesses, with the balance to start up new businesses.

In April, the BEA had released its report on U.S. international transactions for 2008. Net financial inflows for foreign direct investment into the U.S. were $325.3 billion, an increase of 37% over 2007’s level. These inflows included financing of both existing and new U.S. affiliates and also reflected sell-offs and other subtractions and additions. They also excluded domestic-sourced funds that are used to make new investments. 

Earlier this month, BEA revised the $325.3 billion number for 2008 FDI downward by $5.5 billion to $319.7 billion. Because of a substantial upward revision to FDI reported for 2007, the new 2008 level represented a 16% year-over-year increase.

BEA has discontinued its survey that measures new foreign direct investment. Therefore, there will be no future reports on new FDI comparable to the first report referred to above in this post. Future surveys will collect related information on greenfield investments by foreign direct investors and their U.S. affiliates. BEA will also collect extensive data on FDI in the U.S. through its quarterly and annual surveys.

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Chinese regulatory authorities have taken an important initiative to encourage outbound FDI from China. U.S. private equity funds and other owners of businesses desiring investment should take note of these changes. These developments also are significant for investment bankers and other intermediaries, as the steps should enhance their ability to broker strategic arrangements. 

In June, China’s State Administration of Foreign Exchange (SAFE) announced that new regulations loosening its control on outbound investment procedures would take effect on August 1. SAFE will also modify its controls over foreign exchange management of domestic companies with overseas investments. The announced policy purposes of the modifications are to:

• stabilize external demand for domestic products;
• increase the efficient use of funds by Chinese enterprises; and
• support the “go global move” of enterprises “of diverse ownership” to stimulate exports.

The major changes that SAFE announced are:

•  “qualified enterprises of diverse ownerships” now can make overseas loans;
• sources of funds for overseas ownership are expanded and can include self-owned foreign exchange and foreign exchange purchased with Chinese currency;
• streamlining of procedures for overseas lending, which will be decentralized; and
•  improvements to statistical monitoring of, and risk prevention for, overseas lending.

In a related development, a former assistant professor of economics at an Indiana university has been promoted to chief of SAFE. The appointee, Yi Gang, is also a vice governor of the Peoples Bank of China. Mr. Yi taught at Indiana University-Purdue University Indianapolis from 1986 to 1994.

The changes announced by SAFE are likely connected to China’s accumulation of foreign exchange. The Financial Times reported on July 15 that China’s foreign reserve position had increased beyond $2.1 trillion. The merge results from capital inflows to take advantage of faster economic growth and inflating asset prices. These trends arise from the view that China’s economic recovery will be sustained, with GDP growth for the second quarter of 2009 expected to approximate 8%.

The Contrarian Investor’ Journal has opined that the next logical step will be towards the eventual float of the RMB, cautioning that the float will not happen imminently.  

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Earlier this month the U.S. State Department clarified its position on the importance of inbound foreign direct investment (FDI) to the U.S. economy. State released a fact sheet on July 1 entitled "The State Department, Open Investment, and American Jobs."  The fact sheet underscores the importance of FDI to economic growth and job creation in the U.S.

The fact sheet credits the Committee on Foreign Investment in the United States (CFIUS) with concluding action on over 150 transactions in 2008. This represents an increase of at least 9% over the 138 transactions that CFIUS reviewed in 2007. Of the 2008 transactions, 92% were mergers and acquisitions of U.S. businesses. The balance was likely to have been joint ventures or loan transactions. The State Department points out that, as a result of its membership on CFIUS, it has a direct role in the rulings that the panel makes.

Without doubt, inbound acquisitions and investments are quantitatively significant. In 2006, U.S. inbound FDI totaled $236.7 billion, or 1.8% of GDP. U.S. affiliates of foreign firms spent $395.8 billion on U.S. payrolls and $34.3 billion on U.S. R&D.

Because of these direct economic effects, the State Department wants its message to be crystal clear:

The United States has a significant stake, as both the world’s largest source and recipient of foreign direct investment, in working with our economic partners both multilaterally and bilaterally to implement policies that facilitate global investment flows.

State’s pronouncements and their forceful delivery add to the expectation that inbound FDI will assist in pulling the U.S. economy out of its current slump.

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Our latest post last week referenced the June 2009 Peterson Institute policy brief discussing China’s outbound foreign direct investment, authored by Daniel H. Rosen and Thilo Heinmann. The paper points out that global economic turbulence has made potential outbound investors in China hesitant to go abroad, citing three compelling pieces of evidence:

• The value of approved nonfinancial overseas projects announced in Q1 2009 decreased to $3.7 billion from more than $10 billion in Q1 2008.
• A recent study reported that more than 50% of Chinese firms are scaling back their overseas investment plans. 
• Chinese government has withheld approval for deals in the financial sector and chastised firms in other sectors for their overseas investment plans.

The brief predicts that despite these “short-term anxieties,” OFDI by China will increase substantially in both the medium and long terms. The key driver behind the increase is China’s need to transform its model for achieving internal growth from domestic manufacturing alone to more integrated activities carried on internationally. 

If, however, there is reluctance or unwillingness on the part of Chinese firms to make outbound direct investments, then to what extent are these attitudes attributable to changes in investment review policies of investee nations.

The issue of review policies by recipient nations is taking central stage. The brief predicts that China’s OFDI will increasingly target higher-value assets in advanced economies, such as high technology firms. As it targets these businesses, governments and businesses alike may raise national security rationales to impede the investments. In anticipation of this transformation the brief warns that potential recipients of Chinese investments may use national security inappropriately as a basis for blocking investments and requests clarity as to which business sectors are not available for OFDI investment. 

With specific reference to the U.S., the brief notes that earlier efforts to expand the U.S. investment review system to include economic security were resisted. The discussion, however, is restarting. This reaction is due to the perception that China’s government is robustly involved in its nation’s businesses. The brief argues that

• Chinese executives need clear U.S. policy to determine beforehand whether bids may be rejected on national security grounds and
• greater clarity on this issue would benefit the United States by maximizing its asset values and preventing retaliatory treatment abroad.

The brief points out that many governments have tightened investment rules in recent years in response to increased outbound investments from China and the Middle East. A chart included makes the point convincingly: 

On that basis, the brief asserts that in many countries investment protection is growing, investment rules lack transparency and domestic interest groups affect the review process. The attempted takeover of Unocal by Chinese National Offshore Oil Corporation and the involvement of Huawei Technologies in Bain Capital’s attempted acquisition of 3Com Corporation are cited as examples.  As a result, politicized reviews are an obstacle in the view of outbound investors. 

Businesses throughout OECD economies are likely to receive investment offers from Chinese firms in the near future. Consequently, the brief advises that it is imperative, in light of the many benefits to arise from China’s OFDI, that each country, including the U.S., consider the broad image of policy issues and articulate an approach conducive to that incipient inbound investment.

Last week also brought reports that Chinese security officials had detained four Rio Tinto executives on grounds that the four had stolen state secrets.  According to the Australian CEO World blog, the arrests have shocked both the business world and the Australian government.  Sources cited in the blog attributed the arrests to sensitivities in the Chinese leadership arising from economic stagnation and a search for scapegoats.  Australian press is reporting that China’s spy and security agencies have been promoted to top strategy-making positions for the purpose of managing China’s economy through the downturn.  Demonstrating that virtually every issue has an OFDI aspect, however, the China Securities Journal reported that shortly before last Thursday’s detentions the state-controlled Aluminum Corporation of China (Chinalco) bought $1.5 billion of Rio Tinto shares.  

The international reactions and press allegations are likely to make Chinese executives and officials even more reluctant to proceed with their OFDI plans and affect the receptivity of recipient economies as well. Resolution of the conflict will provide greater insight into when and in what ways expanded OFDI by China may materialize.  

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A lawsuit that could have determined whether a filing made with CFIUS can be considered customary has ended. In May 2009, husband and wife Joseph and Judy Ehrenreich sued 3Com Corporation for damages they allegedly suffered from the loss in value of their 3Com shares. The case was brought under the provision of the federal securities laws that enables purchasers of stock to recover losses arising out of incorrect or incomplete statements made by the issuer of the shares. 3Com is a Massachusetts-based enterprise networking solutions provider.

The Ehrenreichs claimed that the cause of their loss was 3Com’s failure to specify that CFIUS review of its proposed merger with affiliates of Bain Capital was a significant risk. 3Com had published a press release announcing the proposed merger on September 28, 2007. The press release stated that the merger was subject to “customary regulatory approvals.” CFIUS review was not mentioned. The plaintiffs purchased 13,000 shares of 3Com stock after the announcement of the proposed merger.

The basis of the plaintiff’s case was that the proposed merger did truly raise serious national security concerns and that, as a result, CFIUS review was not customary. The plaintiffs interpreted “customary” to mean perfunctory or ministerial. The aspect of the merger that triggered CFIUS review was that, as part of the transaction, affiliates of China’s largest network equipment company, Huawei Technologies, were to acquire an interest in 3Com. Press reports associated Huawei with China’s military and possible links to Chinese cyber warfare efforts against the U.S. and the U.S. military. Although 3Com disclosed on October 4, 2007 that it intended to make a CFIUS filing, the plaintiffs contended that 3Com’s announcement omitted the reasons for seeking the review and downplayed the risk that CFIUS could block the transaction. Five months later, 3Com withdrew its CFIUS filing. One month later, the parties terminated their merger. The announced reason was that CFIUS intended to prohibit the deal. The price of 3Com stock plummeted from its level at the time of the original announcement.

The complaint claims that the peculiar structure of FINSA – its voluntary and not mandatory filing requirement -- gives parties an incentive not to mention the possibility of CFIUS review. It suggests that parties might try to “fly under the radar screen” and not provoke public reaction to a deal.

We will not know from this case whether 3Com’s initial failure to specify CFIUS review and the basis on which CFIUS could review the transaction was an incorrect or incomplete statement. The plaintiffs voluntarily withdrew on June 30, dismissing their case with prejudice. A settlement may have occurred. Even if abandoned at this stage, the case stands as a warning to parties contemplating a CFIUS filing. When communicating to the markets, it’s best to say more about the likelihood of a CFIUS review rather than less. Parties now are on notice that CFIUS review may be more than perfunctory. It’s safer to make that clear if the review leads to an unexpected end to the deal.

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The Obama administration has formally appointed Mark Jaskowiak, the acting head of the agency since last July, to be the staff chairperson of CFIUS.  According to an article by Roxana Tiron and Silla Brush appearing earlier today in The Hill, Mr. Jaskowiak will become the Treasury Department's Deputy Assistant Secretary for Investment Security.  The Treasury Department is the lead agency in inter-agency CFIUS. 

The Hill gave additional details on Jaskowiak's resume:

Jaskowiak is a former legislative aide to Sen. Charles Schumer (D-N.Y.), a critic of the Dubai Ports deal who also played a role in efforts to reform CFIUS in the wake of the controversy. Jaskowiak also served previously as director of the Office of Multilateral Development Banks.
 

The Hill quoted Nancy McLernon, the president and CEO of the Organization for International Investment, a business association whose members are U.S. subsidiaries of foreign firms.  Ms. McLernon's statement supported Mr. Jaskowiak's appointment. 

The staff chairperson's mandate is to manage the Treasury's role in CFIUS and to provide reports to Congressional leadership and members of Congressional committees on its activities.

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Foreign direct investment into the United States has generally grown in the aftermath of prior recessions and economic downturns.  As the U.S. economy was entering the current downturn in mid-2007, however,  the U.S. Congress enacted the Foreign Investment and National Security Act, known as FINSA.  FINSA empowered an existing multi-agency regulatory body in the Executive Branch, the Committee on Foreign Investment in the United States, to regulate inbound acquisitions and investments that might impair U.S. national security.  In the ongoing discussion over the destiny and direction of the U.S. automotive industry, there seems to be little discussion of what the Obama Adminstration's policy is with respect to foreign ownership of or investment in key U.S. industries.  The conversation is dominated by the need to maintain or restructure the businesses, without regard to ownership of the industry's participants.  There is no doubt that a vigorous economic rebound will require full international participation in the form of inbound investment.  It is critical, however, for the Administration to articulate its stance on inbound investment so that foreign buyers and investors know what regulatory hurdles and consequences they may face. So it now seems opportune for CFIUS to address publicly the question of how the welfare of the U.S. automobile industry, in particular, relates to U.S. national security. 

According to The Wall Street Journal of May 7, 2009, international buyers are showing strong interest in purchasing businesses, assets and subsidiaries of both Chrysler and GM.  The interest of Italy's Fiat, France's Renault and China's Geely Automotive suggests that these transactions, if they come to fruition, would be "covered transactions" as defined by FINSA and therefore potentially subject to CFIUS review.  

Daimler's newly-announced investment in Tesla Motors might also be a covered transaction.  Although Daimler is acquiring 10% of Tesla's shares, a board seat has been set aside for a Daimler executive.  Under CFIUS rules, a board seat indicates a control position.  There is a strong suggestion that Daimler is making its investment to gain access to Tesla's highly regarded advanced battery technology, arguably a major U.S. strategic asset.   

Will these purchasers and their U.S. investees make voluntary notice filings with CFIUS?  Will CFIUS review and investigate the filings?  If so, will the review require the full 30 days?  If there is an investigation, will the investigation require the full 45 days?  Will CFIUS pass the application on to President Obama for him to decide?

CFIUS operates under complete confidentiality.  Prospective investors and buyers may not know what regulatory filings may be required and how their filings, if made, will fare.  The Freedom of Information Act is not available as a means for gaining access to those notices that parties have filed with it.  None of the press surrounding the proposed Fiat transaction with Chapter 11- embedded Chrysler has mentioned any role for CFIUS.  Similarly, Barclay's purchase of the brokerage business of Lehman Brothers out of Chapter 11 proceedings may not have been accompanied by a filing with CFIUS. 

The principal question is whether the connection between the U.S. automobile industry and U.S. national security is sufficiently strong for Treasury and Homeland Security policymakers to consider.  One might well begin by assessing what portion of the tanks, armored personnel carriers, other transport vehicles or parts that the Department of Defense purchases are made by Chrysler or GM.  The U.S. automobile industry today is a distant cry in many ways from the Second World War.  But those with long memories will recall that the Roosevelt Administration turned to our domestic automobile manufacturers to produce tanks as well as airplanes during that war.  There are alternative sources for production today, to be sure, including defense contractors whose core business it is to manufacture the equipment that our armed forces rely on.  But, with two ongoing wars and the world far from peaceful, is it prudent to assume no risk of impairment to U.S. national security from the transfer of these assets into foreign hands? 

It would be interesting to know whether CFIUS expects to receive filings for these deals if, as and when they mature. 

Readers who may not be familiar with FINSA, its regulations and the regulatory regime that CFIUS oversees can find resources and informative analysis on these and related topics at the page in the Sullivan & Worcester LLP Web site that describes its U.S. Inbound Investments Group. 

This post is the first on this blog.  It is the mission of this blog to generate discussion on topics relating to inbound acquisitions and investments into the United States economy at all levels and become a forum on this topic.  Readers are encouraged to comment.

The above picture is reproduced from Volume II of American Military History by the U.S. Army.

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