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

The regulatory clearance process for inbound acquisitions is playing a central role in the ongoing takeover contest for Terra Industries, Inc. A second buyer has made a higher bid and has cited Terra’s need for regulatory approvals and regulatory delays in the agreed-upon deal in arguing its case to Terra’s shareholders. That and other factors now seems to have won the day for the second buyer. 

Terra is based in Sioux City, Iowa and produces and markets nitrogen and methanol products, predominantly agricultural fertilizers. In February, Norway’s Yara Iternational ASA, the world’s largest fertilizer company, agreed to pay $4.1 billion to acquire Terra in a merger transaction. The merger requires the approval of the stockholder of both companies. According to the Alfidi Capital blog, Yara’s bid for Terra was valued at $41.10 per share. The parties have agreed that the transaction is expressly subject to review by the Committee on Foreign Investment in the United States (CFIUS).

Terra’s merger agreement, as filed with the SEC, illustrates the operation of the U.S. statutes and regulations that apply to an inbound investment. First, the U.S. business that is the target warrants to the buyer – Yara in this case – that the approval of CFIUS is among those governmental consents that are required for the transaction to be completed legally. Second, the U.S. target and the foreign buyer then agree to cooperate to make the necessary filings with CFIUS and to update those filings as necessary. Third, as a condition to completion of the transaction, full regulatory compliance must have been achieved. For a more complete analysis of these and other contractual provisions that are used in acquisitions, please visit the Sullivan & Worcester Web site and review our white paper that discusses contractual provisions.

On March 2, CF Holdings Industries, Inc. of Deerfield, Illinois announced that it was offering $47.40 per share for Terra, or $620 million higher than Yara’s bid. Earlier this year, CF had ended its year-long attempt to acquire Terra. CF’s new bid is $840 million higher than its last bid. Because CF Industries, Inc. is not a foreign buyer, review by CFIUS is not a factor. In its press release, CF says that its offer not only has higher value than Yara’s but is not burdened with the various conditions that apply to Yara’s offer. CF’s letter to Terra’s directors cites “numerous conditions beyond Terra’s control [that] will not be satisfied, including regulatory, legislation and stockholder approvals.” Obviously, CFIUS approval falls under the first of these categories. The Daily Finance blog also handicaps the Yara offer because of CFIUS screening. CF gives Terra the opportunity to make a quick deal.

Going back to the Yara deal, it may be interesting to speculate what factors in its business drove the decision to file with CFIUS. Submitting a notice to CFIUS is optional. If there is no filing and CFIUS later determines that the acquisition adversely affected U.S. national security, CFIUS can attempt to unwind the transaction. The mere prospect that an unwinding might subsequently occur is sufficient to lead parties, their advisors and their financing sources to play the game conservatively and engage in the CFIUS screening process.

Viewed from a less conservative perspective, however, perhaps Terra’s transaction does not affect U.S. national security. Terra’s last annual report did not disclose that it had contracts with the U.S. government or that it was satisfying U.S. defense requirements. Additionally, Norway is a NATO ally and is not a proliferation risk. It is more likely that Terra’s fertilizer products are considered critical resources and material in U.S. agricultural markets. Interestingly, among the risk factors in its annual report is Terra’s disclosure that its fertilizers can be used as explosives and that “governments could impose limitations in the sale, use or distribution of [its products],” so there may well be a general security consideration in the background. On balance, the more conservative position with respect to CFIUS seems warranted.

CF appears to have gained the initiative with its heftier price and its arguments that rely on conditions that apply only to Yara’s deal. Today, Terra announced that its board had notified Yara that CF’s offer constituted a superior offer and that, barring an overbid from Yara within 5 days, Terra would terminate its merger agreement with Yara. Although not the only factor by any means, CFIUS review is tilting the contest toward the domestic buyer. 

We are forced to ask whether that was among the intended results of the legislation that regulates foreign direct investment. 

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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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Foreign direct investment has often created dismay and resistance in the investee nation. Self-appointed pundits may try to gain populist following by decrying the sale of local assets to foreign buyers with no regard to the historic contribution foreign ownership has made to the growth of their own economies.

Governmental regulation of foreign direct investment is implemented in part to allay these emotions by screening out those investments judged harmful according to legislated standards. It therefore is counterintuitive when the exercise of regulatory power to screen foreign direct investment also inspires equally ill-tempered reactions. Often, the sound and fury of those reactions do not withstand factual analysis, especially when journalists seek to stir the pot of public emotions. 

Take, for example, “US inquiry into sale of Virgin Galactic stake to Arab investor” which appeared in the online version of The Times of London earlier this week, written by Abu Dhabi based-reporter David Robertson. The Rocketeers and ParabolicArc blogs posted the same story. The story questions why the U.S. has elected to subject the proposed sale of a 32% stake in Sir Richard Branson’s privately-held space travel venture to Abu Dhabi-based Aabar Investments for $280 million to “a national security investigation” and whether the investigation genuinely serves the legitimate interests of the United States. 

Virgin Galactic and Aabar Investments had originally announced their deal in July 2009. The deal includes not only the equity investment but also Aabar’s commitment to fund a small satellite launch capability. 

Timesonline does not point out that the Committee on Foreign Investment in the United States (CFIUS), has reviewed over 300 transactions during the three years ended December 31, 2008 or that filings with CFIUS that seek its review are optional. However, CFIUS may initiate its own review of inbound transactions and, if it finds that a transaction may adversely affect U.S. national security, it can take remedial steps, including rescission. As a result, a prudent inbound investor and its investee will seek CFIUS review to insure that the transaction is permanently settled. Review is the first level of the regulatory process. Investigation is the second level. If review of a filing finds that the transaction could result in control of a U.S. business by an entity that is controlled by a foreign government, then FINSA and its regulations require an investigation unless CFIUS otherwise determines. Given this legal framework, CFIUS could have had sound reasons for subjecting Virgin’s deal to the second level of investigation. The fact that there is an investigation does not, however, suggest that the outcome will be adverse to Aabar.

The Timesonline report suggests that investors in the Arab Middle East will become concerned that their investments in the U.S. are subject to CFIUS review. According to the public version of the CFIUS annual report released last month, during 2006, 2007 and 2008, 11 transactions involving UAE investors or acquirers were filed for CFIUS review. During the same period, 14 transactions from Bahrain, Kuwait, Lebanon, Qatar and Saudi Arabia were filed. Deals originating in Saudi Arabia alone comprised 7% of the total value of completed transactions. Without regard to this body of facts, the writer drags up the divestiture outcome that followed Dubai World’s acquisition of P&O, a deal that CFIUS found did not impair national security and that did close. 

It certainly is legitimate to argue that the statute that CFIUS enforces has an incorrect premise with regard to government-controlled entities. It also is legitimate to argue that the term “national security” is not sufficient well-defined and gives CFIUS too much discretion and the overwhelmingly powerful argument is that Sir Richard Branson is not very likely to have transferred control of Virgin Galactic, despite the size of Aabar’s investment. But, in a government where the legislative branch makes the laws and the executive branch is charged with carrying out those laws, CFIUS is performing as it must. Moreover, CFIUS has taken steps to make the public aware of its views by publishing guidance regarding the types of transactions that it has reviewed and that have presented national security implications.

There is an additional fact that would have put much of this faux fury into perspective. Aabar now owns 4% of U.S.-based Tesla Motors, the electric car company that is a contender to lead the United States into the age of the electric car. In July 2009, Aabar acquired its investment stake in Tesla from Daimler. Because of the confidentiality of the proceedings of CFIUS, there is no way to know whether CFIUS reviewed the transactions that led to Aabar’s stockholding in Tesla. At a minimum, Aabar and its controlling family are not strangers to CFIUS. They have been welcomed into the U.S. in the past and no doubt they will be welcomed here again.

The New York Times coverage of the Virgin Galactic deal, published today, is infinitely more balanced and informative. Reporter Eric Lipton went into the subtleties and difficulties that underlie regulatory judgments regarding FDI. Factual reportage supports constructive public debate that can lead to public policies that enable FDI to produce its best results. 

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Foreign direct investment has often created dismay and resistance in the investee nation. Self-appointed pundits may try to gain populist following by decrying the sale of local assets to foreign buyers with no regard to the historic contribution foreign ownership has made to the growth of their own economies.

Governmental regulation of foreign direct investment is implemented in part to allay these emotions by screening out those investments judged harmful according to legislated standards. It therefore is counterintuitive when the exercise of regulatory power to screen foreign direct investment also inspires equally ill-tempered reactions. Often, the sound and fury of those reactions do not withstand factual analysis, especially when journalists seek to stir the pot of public emotions. 

Take, for example, “US inquiry into sale of Virgin Galactic stake to Arab investor” which appeared in the online version of The Times of London earlier this week, written by Abu Dhabi based-reporter David Robertson. The Rocketeers and ParabolicArc blogs posted the same story. The story questions why the U.S. has elected to subject the proposed sale of a 32% stake in Sir Richard Branson’s privately-held space travel venture to Abu Dhabi-based Aabar Investments for $280 million to “a national security investigation” and whether the investigation genuinely serves the legitimate interests of the United States. 

Virgin Galactic and Aabar Investments had originally announced their deal in July 2009. The deal includes not only the equity investment but also Aabar’s commitment to fund a small satellite launch capability. 

Timesonline does not point out that the Committee on Foreign Investment in the United States (CFIUS), has reviewed over 300 transactions during the three years ended December 31, 2008 or that filings with CFIUS that seek its review are optional. However, CFIUS may initiate its own review of inbound transactions and, if it finds that a transaction may adversely affect U.S. national security, it can take remedial steps, including rescission. As a result, a prudent inbound investor and its investee will seek CFIUS review to insure that the transaction is permanently settled. Review is the first level of the regulatory process. Investigation is the second level. If review of a filing finds that the transaction could result in control of a U.S. business by an entity that is controlled by a foreign government, then FINSA and its regulations require an investigation unless CFIUS otherwise determines. Given this legal framework, CFIUS could have had sound reasons for subjecting Virgin’s deal to the second level of investigation. The fact that there is an investigation does not, however, suggest that the outcome will be adverse to Aabar.

The Timesonline report suggests that investors in the Arab Middle East will become concerned that their investments in the U.S. are subject to CFIUS review. According to the public version of the CFIUS annual report released last month, during 2006, 2007 and 2008, 11 transactions involving UAE investors or acquirers were filed for CFIUS review. During the same period, 14 transactions from Bahrain, Kuwait, Lebanon, Qatar and Saudi Arabia were filed. Deals originating in Saudi Arabia alone comprised 7% of the total value of completed transactions. Without regard to this body of facts, the writer drags up the divestiture outcome that followed Dubai World’s acquisition of P&O, a deal that CFIUS found did not impair national security and that did close. 

It certainly is legitimate to argue that the statute that CFIUS enforces has an incorrect premise with regard to government-controlled entities. It also is legitimate to argue that the term “national security” is not sufficient well-defined and gives CFIUS too much discretion and the overwhelmingly powerful argument is that Sir Richard Branson is not very likely to have transferred control of Virgin Galactic, despite the size of Aabar’s investment. But, in a government where the legislative branch makes the laws and the executive branch is charged with carrying out those laws, CFIUS is performing as it must. Moreover, CFIUS has taken steps to make the public aware of its views by publishing guidance regarding the types of transactions that it has reviewed and that have presented national security implications.

There is an additional fact that would have put much of this faux fury into perspective. Aabar now owns 4% of U.S.-based Tesla Motors, the electric car company that is a contender to lead the United States into the age of the electric car. In July 2009, Aabar acquired its investment stake in Tesla from Daimler. Because of the confidentiality of the proceedings of CFIUS, there is no way to know whether CFIUS reviewed the transactions that led to Aabar’s stockholding in Tesla. At a minimum, Aabar and its controlling family are not strangers to CFIUS. They have been welcomed into the U.S. in the past and no doubt they will be welcomed here again.

The New York Times coverage of the Virgin Galactic deal, published today, is infinitely more balanced and informative. Reporter Eric Lipton went into the subtleties and difficulties that underlie regulatory judgments regarding FDI. Factual reportage supports constructive public debate that can lead to public policies that enable FDI to produce its best results. 

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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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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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Developments in corporate restructurings suggest that the Foreign Investment and National Security Act of 2007 (FINSA) may soon become a factor in debt/equity swaps. As U.S. companies in the telecommunications, defense and other national security-related businesses encounter difficulty in refinancing their debt and seek out-of-court workouts with foreign bank lenders or offshore hedge funds, FINSA’s regulations may apply and could impede those settlements.

The Wall Street Journal reported on September 19 that as a result of the credit crisis, lenders are taking sizable equity stakes of companies that borrowed from them and now must restructure their debt. These lenders are confronting the issues raised by Federal limits on ownership of media businesses in conjunction with equity-for-debt swaps transacted with radio, TV and newspaper companies in distress. The FCC rules have made restructurings more complex. The FCC must approve changes in ownership for a broad range of media businesses. FCC rules limit ownership of multiple media outlets in different markets and apply to all persons, regardless of nationality. But for foreign hedge funds and other foreign lenders, there is an additional set of issues. Federal law also fixes caps on equity ownership of broadcasters by foreign entities. The application of these rules has made restructuring far more difficult to achieve because it limits the amount of equity that can be swapped for debt.

There is a parallel to FINSA and its rules. FINSA applies to transactions between U.S. businesses and foreign entities that acquire control of the U.S. entity. In that case, the parties may file a voluntary notice with the Committee on Foreign Investment in the United States (CFIUS). To determine whether U.S. national security might be impaired as a result of the change in control of the U.S. business, the filing leads to a review process and, in some cases, an investigation and, even more remotely, Presidential review. If CFIUS does not object to the transaction or require that the parties enter into a mitigation agreement with it, then the transaction can proceed and further review is precluded. If the parties do not file a notice and comply with requests for information from CFIUS, then CFIUS can later unilaterally review and investigate the transaction and, in an admittedly extreme case, order divestment. 

Where might these issues arise? The fact pattern would involve:

• A U.S.-based company operating in an industry which is relevant to U.S. national security -- examples include, mineral extraction, energy, defense, telecommunications and certain manufacturers of highly engineered products
• A foreign lender -- traditional or otherwise, including hedge funds -- that now finds that it has little choice other than to take an equity stake
• The equity stake issued in exchange for the debt exceeds 10% of the voting equity of the business on an after-issued basis or has other rights, such as board membership, that give the lender a role in the management or operation of the business

The presence of other factors would exacerbate CFIUS concerns:

• One or more of the lenders is controlled by a foreign government -- as a result of the financial turmoil of the last several years, these categories include all of those bank lenders which, although formerly private, have since been nationalized
• The foreign lenders or offshore funds taking the equity enter into agreements with each other for the operation or management of the U.S. business

Under the FINSA statute, CFIUS has an unlimited period of time to look back and order reviews of previously completed transactions. Therefore, if an offshore lender’s strategy is to restructure today with a debt-for-equity swap and then sell the equity to a buyer -- U.S.-based or foreign -- in a year or two, a background legal issue may appear: Do the sellers have full, indefeasible legal title to the shares they are seeking to sell? Will their buyer in turn become sensitive to the possibility -- however remote -- that a CFIUS investigation may materialize in the future if a competitor brings the absence of a filed notice to the attention of CFIUS? Or if a voter brings the issue to the attention of a Congressperson who in turn will pressure CFIUS?

This chain of events may be far-fetched. But the provisions of FINSA and its regulations make this outcome possible, whether or not likely. Foreign lenders and their advisors may well have no choice but to consider the applicability of these requirements.

L. Elise Dieterich, a partner in the Washington, D.C. office of Sullivan & Worcester LLP, contributed to this post.

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 A new publication by Theodore Moran of the Peterson Institute for International Economics addresses what it considers to be the two most important questions relating to the screening of inbound investment. Entitled “Three Threats: An Analytical Framework for the CFIUS Process,” Moran’s work responds to

• Under what circumstances might the foreign acquisition of a U.S. company constitute a genuine national security threat to the U.S.?
• How should CFIUS assess the risks and threats so as to separate what is serious from what is not?

According to a policy brief that summarizes the publication, as a platform for his analytical model, Moran sets out three categories of threats that might arise from inbound acquisitions:

1. that a foreign-controlled supplier will deny goods or services to U.S. consumers
2. that a foreign-controlled entity will access U.S. technology or expertise previously not available to it
3. that the acquisition will be a means for infiltration, surveillance or sabotage in the U.S.

To analyze these threats properly, argues Moran, CFIUS must understand the “criticality” of the goods or services that the target provides, combined with a second-level assessment of whether alternative suppliers are available and how easily consumers can switch from one supplier to another. 

Moran reviews several of the most high-profile CFIUS involvements of the past 8 years and concludes that most inbound acquisitions pose no credible threat to national security. 

For professionals whose work involves inbound M&A, this publication is essential reading.

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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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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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The Foreign Investment and National Security Act of 2007 (FINSA) and its regulations are intended to strike a balance between the opportunities and threats associated with inbound investment into the United States. The regulatory structure for addressing the conflicts often created by inbound investments is review by the Committee on Foreign Investment in the United States (CFIUS), and its approval or disapproval of acquisitions and investments that might harm genuine U.S. interests.

For example, if a foreign nation with intent inimical to the United States were to acquire a high-tech business whose products were, or had the potential to be, essential for the critical functioning of large portions of the U.S. economy, the regulators would scrutinize the risks arising from the transaction. If necessary, the regulators would impose conditions to mitigate those risks or perhaps even block the transaction. Because it is based on national security grounds rather than economic security grounds, the system is designed to be less susceptible to undue political influence. 

A reasonably designed system would also designate a class of transactions between a foreign buyer and a U.S. target that need not be scrutinized. One reason for doing so would be that certain transactions as a class present low risks to U.S. national security. Therefore the costs of review far outweigh possible benefits. Similarly, the efficient and timely functioning of the regulator may require that fewer than all transactions be reviewed. In defining the class of transactions that is except from the system, legislators often use quantitative, rather than principle-based, measures. So, for example, review by CFIUS does not reach investments of less than 10% of outstanding voting stock of a U.S. business if the investment is passively held. The exemptive rule applies both to an initial investment in a U.S. business and to subsequent transfers that the investor may make to foreign persons. The rule applies to transfers made by the transferee and by any subsequent transferee as well.

The exemption, however reasonable, can lead to questionable results. For example, after a recent transaction Aabar Investment PJSC of Abu Dhabi has now come to own approximately 4% of Tesla Motors Inc. of San Carlos, California. Tesla is perhaps the most advanced developer of commercial all-electric cars in the United States. Aabar is an investment company whose largest stakeholder is the International Petroleum Investment Company, which in turn is wholly-owned by the Government of the Emirate of Abu Dhabi. Aabar’s shares also trade on the Abu Dhabu Securities Exchange. Aabar acquired its interest in Tesla from Daimler, AG, based in Stuttgart, Germany. Daimler had acquired an interest of slightly less than 10% in March of this year in exchange for an infusion of $50 million into Tesla. Aabar holds 9.1% of Daimler, making it Daimler’s largest shareholder. According to the blog earth2tech, Daimler never intended to keep the full investment for long. Daimler and Tesla apparently tried to make the original investment jointly, but terms could not be fully worked out between them in March.

There is no indication that either Daimler’s original investment or its resale to Aabar underwent CFIUS scrutiny, even though Aabar is a government-controlled entity. Both seem to have relied on the exemption for acquisitions of less than 10% of shares. 

Now to engage in a law school-styled hypothetical. What if the participants were other than Daimler or Aabar? Suppose the shares wound up in the hands of a nefarious investor who intended to use its position to retard Tesla’s technology or to put it in the hands of an ill-willed competitor. As noted above, reasonable standards for exemption may be necessary to prevent bureaucratic overreach. Reasonable standards can, however, morph into a pathway for circumvention. 

Tesla has presumably protected its own interests. It may have retained the ability to approve or limit transfers and subsequent transfers of its shares. It may have restricted by contract its obligation to share its technology with stockholders. It may have imposed legal limitations on the ability for any investor who has access to its technology to use or transfer it. These protections are normal and sound, as long that the company has the bargaining power to obtain them while negotiating the deal with its prospective investors.

As a final note, there must be something about the name Tesla that attracts the possibility of bad acts. Nikola Tesla was a Serb-American physicist and electrical engineer, inventor of the radio and the electric motor and generator. He is regarded as one of the major forces in the development of commercial electricity. Although famous in his day, Tesla became embroiled in disputes with Marconi others about his intellectual property. No doubt the responsible executives at Tesla Motors are aware of the burden of history.   

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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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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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A Primer for the U.S. Business on the Required Information for the CFIUS Filing

A previous post described what the foreign party needs to disclose in its filing to the Committee on Foreign Investment in the United States, or CFIUS, when it wants to merge with, acquire or otherwise take over a U.S. business. Today’s post summarizes the information required from the U.S. business.

From the perspective of the U.S. business, the filing should provide a thorough presentation of those aspects of its business and operation that could raise what CFIUS deems to be national security considerations. In the case of the acquisition of some, but not all, of the assets of an entity, the U.S. business is to provide the requested information only with respect to those of its assets that have been or are proposed to be acquired. In all events, the notice that the U.S. business files should cover six general areas:

1.         What’s your business? The U.S. business must describe its business activities, including:

•  product and service categories;
• market share estimates;
• a list of direct competitors; and
• the address of facilities manufacturing certain products or services. 

2.         Really, what’s your business? The U.S. business must further respond to detailed questions regarding its business operations and critical technologies (as defined by FINSA) that it owns or licenses. If the U.S. business responds affirmatively to any of those questions, it also must provide additional disclosures. The questions include whether the U.S. business:

• supplies products or services to the U.S. government and whether it is the single qualified source for those products or services;
• manufactures or provides services for other parties that it knows are rebranded by the purchaser or incorporated into the products of another entity;
• produces products or provides services subject to various defense-related statutes or regulations;
• holds other licenses, permits or authorizations from the U.S. government; and
• has any technology with military applications.

3.         Have You Any Government Contracts? The U.S. business must state whether it:

• is or has been a party to contracts with the U.S. government involving classified information or technology or with agencies with responsibility for national defense, homeland security or other aspects of national security; and
• is or has been a party to any priority-rated contracts or orders under the Defense Priorities and Allocations System (DPAS regulations).

These questions require information going back three years in some cases and five years in others.

4.         What’s the CyberPlan? CFIUS requires that the U.S. business indicate whether it has a cyber-security plan. If so, it must attach a copy of the plan.

5.         Attach your Reports. The U.S. business must attach its most recent annual report. If the financial results of the U.S. business that is the target are consolidated with the results of its parent, the report of the parent may, in some cases, be sufficient. If the U.S. business does not prepare an annual report and its results are not included elsewhere, the filing need only include the business’s most recent audited financial statements. If there is none, then the business must attach its most recent unaudited financial statements.

6.         Jointly Presented Information. The CFIUS regulations require that, except for a hostile takeover, the U.S. business and all other parties to the covered transaction must disclose certain information, which is best accomplished when all parties file one notice. The information includes:

• general identifying information about the parties, and their parent entities;
• a description of the transaction in sufficient degree to permit CFIUS to determine whether the transaction’s structure brings it within the definition of “transaction” for purposes of its regulations;
• the anticipated completion date;
• the approximate value of the transaction;
• the identities of all financial advisors, underwriters and financing sources for the transaction; and
• the history of prior dealings between the parties and CFIUS, including whether any party is or has been a party to a prior mitigation agreement with CFIUS.

Of course, the descriptions of the six items above are summaries only. Reference should be made to the CFIUS regulations for the complete and definitive requirements. The assistance of a competent legal advisor in responding to these requirements is recommended.

More complete information about the filing can be found in our white paper, “Complying with the Voluntary Review Process When Investing in or Acquiring a U.S. Business.”

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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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A Primer for the Non-U.S. Party on the Required Information for the CFIUS Filing

Mergers, acquisitions and other takeovers of U.S. businesses by non-U.S. parties may require that the parties file a notice with the Committee on Foreign Investment in the United States, or CFIUS. Though much of the information required in the filing by the foreign party and its parent entities is quite detailed and technical, it can be organized into eight general areas.

1. Are You a Foreign Government? The foreign party must state whether a foreign government or a person controlled by or acting on behalf of a foreign government:
   • holds or controls any of the acquirer’s ownership interests;
   • holds the right to appoint any of its principal officers or any members of its board of directors;
   • holds any rights that relate to control; or
   • has any arrangements with other foreign persons that hold any interests in the acquiring foreign person.
2. Are You Planning On Materially Altering the U.S. Business? The notice must include any plans of the foreign party and its parents to materially alter the U.S. business in certain aspects, including any plans to:
   • reduce or sell research and development facilities;
   • change product quality;
   • shut down facilities or remove them from the U.S.;
   • consolidate or sell any product lines;
   • modify or terminate contracts involving classified information or contracts with certain governmental agencies; or
   • eliminate domestic supply.
3. Whose Deal Is This? CFIUS wants to know whether the actual party in interest is the named party to the transaction or a parent of the named party.
4. Who Are Your Directors, Officers and Substantial Shareholders?  Each acquiring foreign party must provide detailed information as to:
   • each member of its board of directors, including non-affiliated directors;
   • each executive officer; and
   • each individual owning more than five percent or more of the foreign party.
5. Who Is Your Parent? Each immediate, intermediate and ultimate parent (defined as an owner of fifty percent or more) is required to provide the same information as to its directors, officers and owners.
6.  What Is Your Name, Rank and Serial Number? The information to be disclosed by individuals is name, address, date and place of birth and national identity number, plus a curriculum vitae or an equivalent. In an effort to determine national security ramifications, individuals must also provide the dates and nature of service with a foreign government and foreign military service. CFIUS permits this information (other than the curriculum vitae) to be contained in a separate appendix.
7. Don’t Forget the Attachments! The completed notice requires the foreign party to submit several attachments:
   • annual reports, in English (with a certified translation), of the acquiring foreign party, unless its results are consolidated with those of a parent;
   • annual reports, in English (also with a certified translation), of the intermediate and ultimate parents of the foreign party;
   • organizational charts that illustrate all of the entities above the foreign party, up to and including the ultimate control person, including ownership percentages;
   •  the opinion of the filer as to whether it is a foreign party or is controlled by a foreign government and whether the transaction could result in foreign control of a U.S. business; and
   • any documents or agreements setting forth any arrangements among foreign parties that hold ownership interests in the foreign party to act in concert on matters affecting the U.S. business.
8. Have There Been Any Critical Changes? While the matter is pending before CFIUS, each filing party must promptly advise of any critical changes in the plans, facts and circumstances addressed in the notice and in the information that was provided. Each filing party must also file amendments to the notice describing those material changes. This requirement presents a significant challenge for a foreign party to “freeze” the affairs of its corporate parents and to be aware of (a) all material changes in ownership, (b) certain changes in the management of businesses over which the filing persons may have no control and no knowledge and (c) any other proceedings before CFIUS in which any other member of the corporate family may be engaged. Therefore, best practices for the filing parties are to involve each of their ultimate parents fully in the preparation of the filing and its processing, to ensure that all relevant changes are properly communicated and advised to CFIUS.   

Of course, the descriptions of these 8 items are summaries only. Reference should be made to the regulations for the complete and definitive requirements. The assistance of a competent legal advisor in responding to these requirements is recommended.  

Later posts to this blog will address the information that a U.S. business who is a party to a covered transaction must provide in its notice filed with CFIUS, as well as other tips for filing. More complete information about the filing can be found in our white paper, “Complying with the Voluntary Review Process When Investing in or Acquiring a U.S. Business.” 

Many thanks to summer associate Michael Litrownik from the Washington University School of Law for his assistance with this post. 

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It’s well to remember that CFIUS is not the only regulator of cross-border deals that affect U.S. businesses. 

The Wall Street Journal’s Deal Journal on June 11 quoted Liu Shanwen, the CTO of Dongfeng Motor Group, who discussed Sichuan Tengzhong Heavy Industrial Machinery’s pending purchase of Hummer.  Mr. Liu estimated the transaction has less than a 30% chance of being approved by China’s Ministry of Commerce.  Hummer’s buyer does not have a high profile in China, and the Hummer product seems to be the opposite of the fuel-efficient automotive technology that the Chinese government is actively promoting.  According to Automotive News, Sichuan Tengzhong is privately owned and manufactures heavy special-use vehicles, structural components for highways and bridges and construction machinery. Hummer’s management is optimistic about an enhanced product line after the deal closes later this year, including changes to current products.

Even if it were predictable that Chinese regulators would be less than enthusiastic with Hummer’s becoming a Chinese product, there may have been another Chinese contender for the purchase of Hummer—Beijing Automotive Industry, Daimler’s China partner. According to several reliable media sources, Beijing Automotive has also expressed interest in acquiring Volvo from Ford, having been unable to capture GM’s Opel unit. Beijing Automotive and Geely Automotive Holdings are reportedly in competition for Volvo. Geely, China’s biggest private automobile maker, had been mentioned as an interested purchaser of some of GM’s models. There is no indication yet whether China’s regulators will weigh in on the Volvo transaction.

Not to be outdone, even if in Chapter 11, GM too is looking to shed its Scandinavian unit, Saab Automotive AB. According to MarketWatch, a Swedish TV station has reported that Saab has agreed to be bought by Koenigsegg Automobile AB, a niche sports-car maker that employs only 45 full-time workers and produces only a few cars a year. The deal apparently has the backing of the Swedish government, which may be prepared to issue a loan guarantee to support Saab going forward. Unlike Beijing, there do not appear to be regulatory hurdles in Stockholm.

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As of yesterday evening, the U.S. Supreme Court allowed the purchase of Chrysler’s business to proceed as part of Chrysler’s Chapter 11 proceedings. The sale now has closed. A consortium that includes Italy’s Fiat SpA will acquire key assets of Chrysler’s international operations, including the core U.S. business, within a matter of days. The deal has been prominent in the news, particularly when the appeal by pension funds and consumer groups generated some uncertainty. The deal also is historic because of the extent of the U.S. government’s direct involvement as a party and as a dealmaker.

The sale of Chrysler provides a case study for applying the Foreign Investment and National Security Act of 2007 (FINSA) and its implementing regulations, administered by the Committee on Foreign Investment in the United States (CFIUS). 

Fiat and its wholly-owned subsidiary--the buyer that will carry on Chrysler’s business--have entered into a “Master Transaction Agreement” with Chrysler and most of its subsidiaries. The U.S. Treasury, the Canada Development Investment Corporation and an independent health care trust have entered into agreements to subscribe for equity membership interests and become Class A members of the buyer. The buyer will apply the proceeds of those subscriptions to pay its $2 billion cash acquisition price to Chrysler. Fiat has agreed to contribute to the buyer certain rights to Fiat technology--including product platforms, powertrains and other key technology, management services, access to international markets and other distribution enhancements--and retains a 20% membership interest. The buyer can increase its 20% interest to 35% in three tranches of 5% each by satisfying certain performance metrics. Fiat also has the option to own a 51% membership interest in the buyer. Fiat and the buyer will be cooperating in the development of joint purchasing programs, the sale of Fiat products in North America and the sale of the buyers products elsewhere through Fiat’s network, R&D activities and branding opportunities. 

According to the White House’s initial announcement of the deal on April 30

• The U.S. Treasury will receive 8% of the equity of the new Chrysler and also has the right to select the initial group of four independent directors of the buyer; and
• The Canadian participant will receive 2% of the buyer’s equity of the buyer and will have the right to select one independent director on the same basis as the four independent directors initially chosen by the U.S.

Analyzing these parties and their relationship to each other under the U.S regime for regulating foreign investment leads to a conclusion that their deal is a “covered transaction.” Covered transactions are subject to the voluntary notice procedures that CFIUS administers and to unilateral CFIUS review if no filing has been made. If a deal is a “transaction” with “foreign person,” and if as a result the foreign person acquires “control” or could acquire “control” of a U.S. business, then the transaction is a covered transaction. The FINSA regulations give the words in quotation marks special meanings. Applying those special meanings to the facts of the deal determines whether the voluntary filing requirement apples. 

• First, since the transaction among Chrysler and the other parties is an acquisition, it is a “transaction.”
• Second because Chrysler is a business entity engaged in U.S. interstate commerce, it is a “U.S. business.”
• Third, is the buyer a “foreign person”? Under the rules, a “foreign person” is any entity over which a foreign person exercises control. Fiat is a foreign person. Before the deal it owns 100% of the buyer. After the deal it owns 20% of the buyer with the right to own 51%. The rules define control to mean the power to “determine, direct or decide important matters affecting an entity.” The basis for the right need not be a majority position; a “dominant minority” is sufficient. Fiat’s business arrangements with the buyer, the board members it presumably will be able to appoint and its ability to achieve 51% ownership satisfy the requirements for control to exist.  The public's perception, expressed by Carcorner, is that Fiat is in control.
• Fourth, the buyer--a foreign person--is conclusively acquiring control of Chrysler.

If the parties have entered into a covered transaction, have they filed with CFIUS? Although their agreement details what antitrust filings the parties will make, it uses general, non-specific language for all other governmental filings. The receipt of governmental approvals was a condition to closing for all parties. Was the condition met or was it waived to close ASAP? The details of what filings were being made are in annexes to the agreement that do not appear to be publicly available. 

It may be interesting to speculate here. In all likelihood, the parties have made their CFIUS filing. If Chrysler and Fiat have not filed, however, it may be because they perceive no national security aspect to their deal and therefore no risk that, because of the absence of a filing, CFIUS will challenge their deal--a risk that few others might take. In its December 2008 Annual Report, CFIUS provided data on filed transactions in the transportation segment of the manufacturing sector. This means that other parties in the industry concluded that there was sufficient connection between the segment and U.S. national security to justify the time, expense and delay of filing a notice with CFIUS. The Report also points out that CFIUS monitors surface transportation and industrial automation as “critical technologies.” 

Since all CFIUS filings are shielded from public access, until CFIUS issues its next annual report the public may not know whether Fiat and Chrysler filed. If they haven’t, could CFIUS challenge the deal when a different administration is elected? 

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The 2008 crisis in financial markets has led to increased government control and nationalization, of many financial institutions, including those based in the UK, Ireland and Europe. The financial institutions affected by these changes include banks that lend to U.S. businesses, directly or through subsidiaries. Among the results of partial or full nationalizations of those lenders could be greater regulation by the Committee on Foreign Investment in the United States, or CFIUS, the watchdog agency that monitors foreign direct investment into the United States. Along with increased regulation may come the unintended consequence that those foreign lenders that have become subject to increased government ownership and control may encounter restrictions or difficulty in enforcing their rights against U.S. borrowers. 

CFIUS administers the Foreign Investment and National Security Act of 2007, or FINSA. In November 2008, CFIUS published its final regulations, including rules that apply to non-U.S. lenders. The purpose of FINSA was to require approval for certain acquisitions and investments by foreign investors – those that could impair U.S. national security. The statute placed certain classes of transactions under a higher level of scrutiny by subjecting them not only to a first level of review by CFIUS but to a second level of investigation, unless CFIUS determines the investigation not to be necessary. One class of transaction requiring the enhanced investigation are those that could result in control of a U.S. business being held by

• a foreign government, or
• an entity that is controlled by a foreign government or that acts on behalf of a foreign government. 

When CFIUS wrote its regulations, it intended to include sovereign wealth funds because of the influence they were projected to have in the international economy. CFIUS may not have intended to include banks that were brought under the control of a foreign government as a result of major interventions as a result of an international fiscal crisis.

Transactions between foreign lenders and U.S. borrowers, whether secured or unsecured, are subject to a bifurcated regulatory approach: 

• Generally, there is no regulatory involvement when the parties enter into a conventional loan agreement; but 
• The regulatory scrutiny moves into place if and when the loan enters default or is about to enter default, since CFIUS considers the foreign lender’s enforcement of its rights to be a “covered transaction,” or a “takeover” of the U.S. borrower. 

Under FINSA, parties to a covered transaction may opt to file an extensively detailed notice with CFIUS. Failure to file the voluntary notice empowers FINSA, if it determines that the change in control will impair the U.S. national security, to block the covered transaction or to unwind it at a later time. For a negotiated merger or acquisitions deal, the risks of being blocked or unwound, if national security is involved, are generally of sufficient severity to transform the voluntary filing into a compulsory filing.

CFIUS does not report its determinations. As a result, it’s difficult to know with any precision what transactions with what U.S. businesses have raised U.S. national security considerations. A review of the last report that CFIUS made available to the public shows that parties to transactions with U.S. businesses in the following business segments filed notices:

• information technology
• telecommunications
• transportation equipment and services
• electric power generation, transmissions and distribution

In December 2008, CFIUS published its Guidance to describe what it believes are those parties whose involvement in covered transactions may raise national security implications. The Guidance also clarifies that the nationality of the foreign buyer and its nexus to the government of its domicile is important. CFIUS also takes into account the conformity of certain policies of the domicile’s government with critical U.S. policies, such as nuclear deterrence. It would not be much of an exaggeration to say that the acquisition of a retail outlet in a strip mall in foreclosure by a North Korean lender would, under the terms of its Guidance, trigger CFIUS review. The conclusion is that, for assessing national security risks, who the lender is matters as much as what the business of the target is.

To be fair, the CFIUS regulations attempt to provide some relief to foreign lenders. If a lender engages U.S. persons to manage the U.S. borrower of the foreclosure, CFIUS must consider that fact in making its determination. If foreign lenders are part of a syndicate controlled by U.S. lenders, and do not control the syndicate, the enforcement or foreclosure is exempt from CFIUS review. But if a lender is not able to comply with these narrow requirements, the foreign lender is left to deal with the CFIUS filing requirement. Since the borrower’s cooperation is required, the lender may well find itself in a surprising situation of asymmetrical power held by the U.S. borrower. For more detailed discussion of this unusual and anticipated outcome, subscribers are encouraged to read our white paper Treatment of Loan Transactions by Foreign Lenders as Regulated Foreign Direct Investments posted on the Sullivan & Worcester LLP Web site.

Foreign lenders now operating under the control or ownership of their governments face a broad array of challenges. The prospect of operating under a U.S. bureaucracy that examines their business dealings with defaulted borrowers is, no doubt, an unintended consequence. It may even be an unintended consequence of little consequence to the bank. To recover from the downturn of the past 18 months, however, the U. S. credit market, however, requires every bit of lender participation it can muster. To have any bank lenders step out of the market—particularly the market for mid-size and small businesses—would retard the recovery just as it seems to be gaining traction. The Obama Administration has spent months of efforts and billions of taxpayer dollars in coaxing the economy into recovery. CFIUS, being part of the Administration, might do to step forward and advise the community of foreign lenders the role it intends to play with regard to loan defaults by U.S. borrowers that result in foreclosures and other enforcement proceedings. 

The illustration above is courtesy of Joseph Rank. 

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Analysts and others who follow mergers, acquisitions and other foreign direct investment into the United States can often be frustrated in their attempt to learn what inbound deals are being subjected to U.S. governmental scrutiny.  Other than occasional press releases, little useful information that is transaction-specific seems to be available. There was press coverage of  the proposed merger transaction among affiliates of Bain Capital Partners, 3 Com Corporation and Huawei Technologies of China in 2007 and 2008.  That transaction did not survive govenmental scrutiny.  More recently, in mid-May of this year, Rio Tinto and Chinalco announced that they had obtained U.S. government approval for both the proposed issue of convertible bonds to Chinalco and the indirect minority investment in Kennecott Copper Coporation, as contemplated by their February 2009 strategic transaction. 

The Committee on Foreign Investment in the United States, known by its acronym CFIUS, is the regulator that oversees foreign direct investment, make certain limited information available.  On November 14, 2008, CFIUS, sent its most recent Annual Report to Congress.  CFIUS operates under The Foreign Investment and National Security Act of 2007, or FINSA .  FINSA mandates that CFIUS prepare and send this report.    One month later, CFIUS made available to the public an unclassified version of the report  that presents only aggregate information.  The 2007 Annual Report  covers the years 2005, 2006 and 2007, when there was considerably more inbound M&A and inbound investment activity into the U.S., as well as more cross-border transaction activity generally, than currently.

The unclassified version of the report does not identify the foreign persons or the U.S. businesses involved. The data is segmented by business sector of the U.S. business and by nationality of the foreign person. There is no specification of whether the basis of the national security considerations was the nexus of the U.S. business with U.S. national security or the identity of the acquiring foreign party.

Some of the data in the report, however, is helpful in determining those standards that buyers and sellers are following. CFIUS’ annual report states that, in 2007, parties filed 138 notices of transactions with CFIUS. The unclassified version of the report provides only aggregate data with respect to the filed submissions. To summarize, for 2007:

• of the 138 filed notices, ten notices (7%) were withdrawn during the CFIUS national security review and five (4%) were withdrawn during the CFIUS national security investigation;
• the parties to three of the five transactions that withdrew their filings during investigation subsequently refiled them, and the refilings led to conclusion without action;
• the parties to two other transactions withdrawn during investigation abandoned their transactions; and
• the parties to the remaining withdrawn application restructured the transaction such that the foreign party no longer gained control over the U.S. person.

The report does not indicate whether or how many of the transactions that were withdrawn during the national security review were later resubmitted with or without restructuring. Unlike 2006, when the President acted to suspend two transactions, the President did not suspend or prohibit any transactions during 2007.

In response to FINSA’s mandate that the report provide “[s]pecific, cumulative and, as appropriate, trend information,” the annual report presents aggregate statistics regarding 313 transactions for the period 2005 through 2007. In summary, during those three years, 24 notices (8%) were withdrawn during the CFIUS national security review, 15 notices (5%) resulted in investigations and 2 notices (1%) resulted in a Presidential decision. Although the statistics indicated that the number of notices filed increased year-to-year from 64 to 111 to 138, the data, presented below, show no other clear trends. 

Source:  CFIUS 2008 Annual Report

To put these numbers of filings in to context, the number of transactions in which foreign buyers acquired U.S. business were substantially larger. CFIUS filings were made only in a small fraction of cases. According to Capital IQ, there were 657 completed inbound acquisition transactions in 2005, 889 in 2006 and 1,076 in 2008. The percentage of these transactions as to which the parties filed CFIUS notices were 10% in 2005, 12.5% in 2006 and 12.8% in 2007, or an overall percentage of 11.9% for the three-year period. The trend line is moving upward, although only slightly so.

Pursuant to the mandate in FINSA, the report analyzes the notices that were filed during the three-year period by business sector and the countries originating the transactions. This is the data that may be most useful to determine what parties have chosen to voluntarily submit their notices. The business sectors represented and the most-often reported business segments within those sectors, measured by percentage of the total 313 filings, were:

 Source:  CFIUS 2008 Annual Report

Business sectors of business segments with respect to which parties made filings, but not in statistically significant (i.e., 5% or more) numbers, included:

• Chemical (within Manufacturing)                   –      12 filings
• Primary metal (within Manufacturing)           –         7 filings
• Machinery (within Manufacturing)                  –       16 filings

Within the 51 Computer and Electronic Product segment filings were filings by businesses that manufacture semiconductors and other electronic components (21 filings) and that manufacture navigational, measuring, electromedical and control instruments (13 filings). Within the 52 Professional, Scientific and Technical Services segment filings were businesses that provided architectural, engineering and related services (21 filings) and that provided computer systems designed related services (also 21 filings). 

Because FINSA prohibts CFIUS from presenting transaction-by-transaction data, parties looking for  precedent or practices by others will benefit by keeping these statistics in mind.  Given the business risks for failing to file the voluntary notice, the parties are well-advised to make conservative judgments and build compliance with the filing process into their deal budgets and timelines.  Qualified legal advisors can assist buyers, sellers, investors and investees in complying with U.S. government review efficiently and effectively. 

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Foreign entities that wish to invest in or acquire U.S. government contractors must consider the effects of such investment or acquisition on the target’s facility security clearances (“FCL”’s). Briefly put, a U.S. company that is determined to be under foreign ownership, control, or influence (“FOCI”) is ineligible for an FCL, and the investor or acquirer must take steps to negate the FOCI in order for the FCL’s to remain in force.

Although the U.S. has several industrial-security regimes, the Defense Security Service (“DSS”) is responsible for administering the largest such regime - covering the Department of Defense and many other agencies. The DSS’s National Industrial Security Program Operating Manual (“NISPOM”) mandates a holistic analysis for determining FOCI in which no single factor is dispositive. The following factors, among others, are suggestive of FOCI:

• Ownership or beneficial ownership, direct or indirect, of five percent or more of the target company’s voting securities by a foreign person;
• Ownership or beneficial ownership, direct or indirect, of 25 percent or more of any class of the target company’s nonvoting securities by a foreign person;
• Management positions, such as directors, officers, or executive personnel of the target company held by non-U.S. citizens; and
• Foreign-person power, direct or indirect, to control the election, appointment, or tenure of directors, officers, or executive personnel of the target company and the power to control other decisions or activities of the target company.

Where FOCI is found, the NISPOM authorizes a number of FOCI-negation action plans:

• Board resolution: used when a foreign person does not own voting stock sufficient to elect - or otherwise is not entitled to representation on - the target company’s board of directors.
• Voting trust agreements and proxy agreements: vests the voting rights of the foreign-owned stock in cleared U.S. citizens approved by the Federal Government; by definition, therefore, the foreign shareholder is not represented on the target’s board of directors.
• Special Security Agreements and Security Control Agreements: impose substantial industrial-industry and export-control measures on the target (including the establishment of a Government Security Committee) but preserve the foreign shareholder’s right to be represented on the target’s board of directors.  

Because of the complexity of the DSS’s requirements, foreign entities that wish to invest in or acquire U.S. government contractors should consult government contracts counsel who are well versed in these requirements.

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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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