In 1975 President Ford created the Committee on Foreign Investment in the United States (“CFIUS”) by an Executive Order, and Congress, particularly in 2018, has increased CFIUS’ power to monitor, review, modify, and unwind or prevent foreign takeovers and investments in certain American businesses in the interest of “national security.” CFIUS carries out that policy by exercising a variety of powers, including by requiring “Mandatory Declarations” when foreign entities achieve control over certain U.S. companies.
Often, foreign companies invest in U.S. companies in tranches, first obtaining minority rights in a company, and later gaining control with a subsequent tranche. Tranche investment lets venture capital and other investors inject vital cash into businesses over time instead of all at once, as the businesses achieve pre-negotiated milestones.
Recently, CFIUS issued guidance that moves up the date for certain “TID U.S. Businesses” – meaning companies involved with certain critical technology, infrastructure, or sensitive personal data – to file their Mandatory Declarations. Specifically, CFIUS now appears to take the position that the Mandatory Declaration must be filed in connection with the initial, minority passive tranche rather than the tranche that grants control rights or access and participation rights.
For TID U.S. Businesses with foreign state investors and for critical technologies businesses with any kind of foreign investors, parties should evaluate the risks and other considerations in either (i) unequivocally structuring the transactions as pure minority, passive investments or, (ii) in the event that is not feasible, filing Mandatory or Voluntary Declarations or Notices, which will add a minimum of 30 days (and possibly up to an average of 95 days (according to a recently released CFIUS Annual Report) to the transaction schedule.
Under the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), the Committee on Foreign Investment in the United States (“CFIUS”) is purposed and extensively empowered to monitor, review, modify, unwind or prevent foreign takeovers and investments in American businesses. The policy reflected in the legislation and regulations relates to “national security” concerns associated with foreign ownership, control and access to important information of U.S. businesses, citizens, properties and infrastructure.
In brief, FIRMMA organizes CFIUS jurisdiction into three transaction groups:
- “Covered control transactions,” in which a foreign person (unless excepted) acquires or otherwise gains equity and/or contractual control over a US business;
- “Covered investments,” in which a foreign investor (unless excepted) acquires a less than controlling equity percentage and is granted more limited access and participation rights (often called “non-passive rights”) in specific American companies classified as “TID U.S. businesses,” dealing in “Critical Technologies,” “Critical Infrastructure” and “Sensitive Personal Data;” and
- “Covered real estate transactions,” which provide foreign persons (unless excepted) with certain rights with respect to “covered real estate” located in proximity to designated ports and military or government facilities (not discussed in this Alert).
FIRRMA does not give CFIUS jurisdiction over a fourth group:
- Minority Passive Investment Transactions, in which the foreign investor (including a Foreign State) acquires less than 10% of the company, does not receive the foregoing control rights or non-passive rights and is limited to having only minority protective rights (discussed below) structured to meet the “solely for passive investment” exception to “covered control transaction,” to be under the 25% “Foreign State” threshold and to be excluded from being characterized as a “covered investment.”
Mandatory, Voluntary and CFIUS Initiated Filings.
Transactions come to the attention of CFIUS through mandatory disclosure requirements (imposed on the parties to the TID U. S. Business transactions), voluntary disclosure (available to all foreign takeover and investment transaction parties), and by CFIUS on its own initiative.
TID U.S. Business Mandatory Filing.
Mandatory Declarations are required only in connection with financings or acquisitions involving certain TID U.S. Businesses. In general, there are two groups of these transactions:
- Foreign State Transactions are Covered Control Transactions and Covered Investments in TID U.S. Businesses (including the Critical Technologies subset) in which a foreign state may acquire (directly or indirectly) a “substantial interest” (loosely, 25% or more) in a TID U.S. Business.
- Critical Technologies Transactions are Covered Control Transactions and Covered Investments in which a foreign person (including a Foreign State) may acquire any interest in one type of TID U.S. Businesses: Critical Technologies.
TID U.S. Business
A TID U.S. Business is any U.S. business that:
- Produces, designs, tests, manufactures, fabricates, or develops one or more critical technologies (discussed below) – the “T” in “TID”);
- Performs the functions listed in the regulations with respect to critical infrastructure – the “I” in “TID” (not discussed herein); or
- Maintains or collects, directly or indirectly, sensitive personal data of U.S. citizens – the “D” in “TID” (not discussed herein).
Critical Technologies are goods, services, software and/or technical information requiring a U.S. license or regulatory authorization to export, reexport or retransfer to the foreign investor (or a foreign person holding a significant ownership or control stake in a foreign investor) under the following U.S. control regimes:
- the Department of State’s International Traffic in Arms Regulations (the “ITAR”);
- the Department of Commerce’s Export Administration Regulations (the “EAR”);
- the Department of Energy’s regulations governing assistance to certain foreign atomic-energy activities;
- the Nuclear Regulatory Commission’s regulations governing the export and import of certain nuclear equipment and material;
- the Department of Agriculture’s and the Department of Health and Human Services’ regulations governing select agents and toxins.
Covered Control Transactions
In addition to ownership of a majority of the total outstanding voting interest in a U.S. entity, Covered Control Transactions provide the foreign investor with the power, direct or indirect, whether or not exercised, through the ownership of a dominant minority of the total outstanding voting interest in such an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine, direct, or decide important matters affecting an entity; in particular, but without limitation, to determine, direct, take, reach, or cause decisions regarding the following matters, or any other similarly important matters affecting an entity:
- The sale, lease, mortgage, pledge, or other transfer of any of the tangible or intangible principal assets of the entity, whether or not in the ordinary course of business;
- The reorganization, merger, or dissolution of the entity;
- The closing, relocation, or substantial alteration of the production, operational, or research and development facilities of the entity;
- Major expenditures or investments, issuances of equity or debt, or dividend payments by the entity, or approval of the operating budget of the entity;
- The selection of new business lines or ventures that the entity will pursue;
- The entry into, termination, or non-fulfillment by the entity of significant contracts;
- The policies or procedures of the entity governing the treatment of non-public technical, financial, or other proprietary information of the entity;
- The appointment or dismissal of officers or senior managers or, in the case of a partnership, the general partner;
- The appointment or dismissal of employees with access to critical technology or other sensitive technology or classified U.S. Government information; or
- The amendment of the Articles of Incorporation, constituent agreement, or other organizational documents of the entity with respect to the matters described in paragraphs (a)(1) through (9) of this section.
Minority Protective (Passive) Rights
Under FIRRMA, however, the following minority shareholder protections are not in themselves deemed to confer control over an entity (but should be granted only after careful review of the particular facts and circumstances of the transaction):
- The power to prevent the sale or pledge of all or substantially all of the assets of an entity or a voluntary filing for bankruptcy or liquidation;
- The power to prevent an entity from entering into contracts with majority investors or their affiliates;
- The power to prevent an entity from guaranteeing the obligations of majority investors or their affiliates;
- The right to purchase an additional interest in an entity to prevent the dilution of an investor’s pro rata interest in that entity in the event that the entity issues additional instruments conveying interests in the entity;
- The power to prevent the change of existing legal rights or preferences of the particular class of stock held by minority investors, as provided in the relevant corporate documents governing such shares; and
- The power to prevent the amendment of the Articles of Incorporation, constituent agreement, or other organizational documents of an entity with respect to the matters described above.
Covered Investments (and Non-Passive Rights).
Covered Investments are investments (in any amount), direct or indirect, by a foreign person in a TID U.S. business that do not have the ownership and control characteristics of the covered control transactions discussed above but nonetheless grant the foreign person any of the following access and participation rights (sometimes called “non-passive rights”):
- Access to any material nonpublic technical information in the possession of the TID U.S. business;
- Membership or observer rights on, or the right to nominate an individual to a position on, the board of directors or equivalent governing body of the TID U.S. business; or
- Any involvement, other than through voting of shares, in substantive decision making of the TID U.S. business regarding: (i) the use, development, acquisition, safekeeping, or release of sensitive personal data of U.S. citizens maintained or collected by the TID U.S. business; (ii) the use, development, acquisition, or release of critical technologies; or (iii) the management, operation, manufacture, or supply of covered investment critical infrastructure.
Minority Passive Investments
Mandatory Declarations with respect to minority, passive investments are generally not required. These are transactions with TID U.S. Businesses in which the foreign investor (including a Foreign State) acquires less than 10% of the company, does not receive the foregoing control rights or non-passive rights and is limited to having only the foregoing minority protective rights to meet the “solely for passive investment” exception to “covered control transaction,” to be under the 25% “Foreign State” threshold and to be excluded from being characterized as a “covered investment.”
Impact of Mandatory and Voluntary Filings on Transaction Scheduling
Processing Mandatory Declarations, Notices (and possible investigations with respect thereto) extends deal closings. Parties who file (generally 30 days prior to the expected closing) Declarations (generally required to be completed by CFIUS in 30 days) can be asked thereafter to file the more extensive Notices (generally required to be completed by CFIUS in 45 days) which add additional time to the review process – not to mention the time spent informally with CFIUS prior to any filing. Furthermore, in some cases, CFIUS has determined to undertake investigation in connection with the filings, adding additional time to the closing schedule.
Annual Report to Congress for 2021 Regarding CFIUS Activities
In its recently released Annual Report to Congress for 2021, CFIUS reported that it requested the parties to 30 of the 47 Mandatory Declarations filed in that year to thereafter file Notices, that it averaged 30 days to complete its review of a Declaration, 46 days to complete its review of a Notice that did not involve an investigation, and 65 days to complete its review of a Notice that did involve an investigation. Furthermore (and with the likely consequence of creating additional delays), in another recent FAQ, CFIUS has indicated that it may now insist on detailed information regarding all LPs and other co-investors in a fund or other investment vehicle involved in a covered transaction, regardless of the fact that such LPs may be passive, financial investors.
Previous Investment Structures
Some of the previous investment transactions provided for multiple tranches of financing contingent on the company’s achievement of certain milestones and on a subsequent CFIUS filing. The follow-on, contingent tranches were often accompanied by the grant of non-passive rights or control rights upon the occurrence of such contingencies. The parties typically had not filed a mandatory declaration (thus providing earlier access to the funds and more time to file with CFIUS and/or for the CFIUS process to proceed prior to the next tranche) in connection with the initial round and had thereafter filed the declaration during or prior to the mandatory notification period applicable to the contingent tranche with respect to which the increased equity ownership or non-passive or control rights were to become effective (“tipping point”).
Impact of new FAQ
The advisability of these contingent, multi-tranche structures which deferred a CFIUS Declaration or Notice filing until the tipping point has recently been called into question. On May 11, 2023, the Treasury published the following FAQ, basically moving the tipping point forward to the initial financing tranche:
“How does CFIUS determine the “completion date,” in assessing when a mandatory filing should be submitted, where the foreign person first acquires equity interest but will not receive control or covered investment rights until after CFIUS’s review?
“The ‘completion date’ is the earliest date upon which any ownership interest is conveyed, assigned, delivered, or otherwise transferred to a person [31 C.F.R. § 800.206]. In a transaction where the ownership interest is conveyed before the foreign person receives the corresponding rights, the ‘completion date’ is the earliest date upon which the foreign person acquired any of the equity interest. For example, if Company A acquired a 25 percent ownership interest in Company B on July 1, but its right to control Company B was deferred until after CFIUS reviews the transaction, the ‘completion date’ for the transaction is July 1. If the transaction is subject to the mandatory declaration requirement pursuant to 31 C.F.R. § 800.401, the latest date that the parties can file the transaction with CFIUS is June 1….”
The new guidance is inconsistent with language in the preamble to the regulations implementing FIRRMA, examples provided in the regulations, and the practice of transaction parties for the last several years. On the other hand, the guidance is consistent with Section 1702(c)(2) of FIRRMA, which provides that CFIUS may consider “the cumulative control of, or pattern of recent transactions” and Section 3(i) of Executive Order 14083 issued on September 15, 2022, where CFIUS is admonished to be mindful of creeping control.
Neither FIRRMA nor the regulations give CFIUS jurisdiction over purely passive, less-than-10% investments, but the recent FAQ provides a basis for CFIUS to assert such jurisdiction over these investments if they are structured as multi-tranche transactions contingent on CFIUS compliance at a later tranche tipping point. Pre-negotiated tranched investments can provide parties with greater longer-term certainty regarding access to capital and associated lower risks of investing. On the other hand, the recent CFIUS Annual Report for 2021 indicates that undertaking CFIUS filings may extend the closing of transactions by as much as 95 days or more. Accordingly, while CFIUS risks and deal considerations should always be assessed on a case-by-case basis, this latest CFIUS guidance adds further challenges to assessing whether or not to engage in a multi-tranche transaction and/or file a Declaration or Notice. This is particularly difficult when considering that a precautionary filing of a Declaration or Notice not unequivocally mandated may unnecessarily and substantially extend the closing of the transaction.
This Client Alert is a summary published for the purpose of raising awareness. Consequently, it is not comprehensive but attempts to simplify complex and detailed subject matter. This Client Alert is not legal advice. If you have questions, please contact C. Russel Hansen, Jr. (email@example.com; 617-456-8036).