By: Elena F. Mitchell and Frank Schall.

The U.S. Department of the Treasury (“Treasury”) recently published a proposed rule that would modify the mandatory filing requirements in place throughout the pilot program for certain foreign investment transactions subject to review by the Committee on Foreign Investment in the United States (“CFIUS”) pursuant to the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”). The proposed rule modifies the mandatory filing requirement for “critical technologies” transactions involving a U.S. business that produces, designs, tests, manufactures, fabricates, or develops one or more critical technologies, as well as clarifies when a foreign interest has a “substantial interest” in a company.

Importantly, the proposed rule does not modify the definition of “critical technologies,” but rather modifies the manner in which transactions qualify as requiring a mandatory filing based on the need for U.S. government authorization as opposed to using the North American Industry Classification System (“NAICS”) code criteria. Under the proposed rule, the trigger for the mandatory filing requirement would depend on whether or not U.S. export licenses are required for shipments of a U.S. target’s products or technology to a foreign investor’s country of origin. This would replace the current system in which the determination of whether a filing is required is determined by whether the U.S. company engages in certain activities related to a critical technology in one of 27 industries identified in CFIUS regulations based on their classification under the NAICS. Although the proposed rule may provide greater clarity regarding which transactions involving critical technology businesses will be subject to mandatory filings, it likely will disproportionately increase mandatory filings for investors from countries subject to more rigorous U.S. export controls (e.g., China).

The proposed rule also makes clarifying edits to the definition of “substantial interest”—which is relevant for determining whether transactions involving foreign government interests are subject to mandatory filing requirements. Under the proposed rule, the focus of the analysis of a “substantial interest” moves away from a strict voting percentage analysis, and adds in another qualifying layer that the general partner, managing member, or equivalent also primarily directs, controls, or coordinates the activities of the entity. This revision offers significant relief for majority interest holders that do not primarily manage the activities of the company.

The Treasury is accepting comments on the proposed rule through June 22, 2020.

Background

CFIUS is an interagency committee chaired by the Treasury and tasked with evaluating certain foreign investments and transactions for national security-related concerns. In connection with these reviews, and as advised by CFIUS, the President may suspend or prohibit a transaction when there is credible evidence that the transaction may threaten national security. Thus, failing to receive CFIUS’s approval of a transaction can subject that transaction to substantial risk if national security concerns are determined to be involved. On the other hand, once CFIUS approves a transaction, that transaction generally will not be subject to further review unless false, incomplete, or misleading information was provided to CFIUS during the review and approval process.

Originally, CFIUS’s authority to review transactions was limited to transactions pursuant to which a foreign person would obtain control over a U.S. business. FIRRMA maintains CFIUS’s jurisdiction over such transactions and broadens CFIUS’s authority to review other investments and transactions for national security concerns. In October 2018, the Treasury issued regulations as the first part of a phased implementation of FIRRMA. Those regulations launched a pilot program implementing CFIUS’s expanded jurisdiction over certain non-controlling foreign investments in U.S. businesses involved with critical technology that did not take effect upon FIRRMA’s enactment. They also established mandatory filing requirements in connection with such transactions. As discussed in our related February 12, 2020 post, the Treasury issued additional regulations earlier this year implementing significant changes to CFIUS’s jurisdiction and review process as follows:

• Provisions Pertaining to Certain Investments in the United States by Foreign Persons: These regulations implement changes to CFIUS’s jurisdiction and process with respect to transactions that could result in foreign control of any U.S. business, as well as certain non-controlling other investments that give a foreign person certain access, rights, or involvement in certain types of U.S. businesses involving critical technology, critical infrastructure, and sensitive personal data.
• Provisions Pertaining to Certain Transactions by Foreign Persons Involving Real Estate in the United States: These regulations implement CFIUS’s authority to review the purchase or lease by, or concession to, a foreign person of certain real estate in the U.S.

New Scope of Mandatory Filing Requirements

Under the proposed rule, parties would have the option to make the required filing either by a short-form declaration or a full notice, for any foreign investment transaction involving a U.S. business that produces, designs, tests, manufactures, fabricates, or develops one or more critical technologies for which “U.S. regulatory authorization” would be required for the export, re-export, transfer (in-country), or retransfer of such critical technology to a foreign person that is a party to the transaction.

“U.S. regulatory authorization” is defined to mean any authorization that is required under the following U.S. export control regimes:

•  license or other approval issued by the Department of State under the International Traffic in Arms Regulations (“ITAR”);
• A license from the Department of Commerce under the Export Administration Regulations (“EAR”);
• A specific or general authorization from the Department of Energy under certain regulations governing assistance to foreign atomic energy activities; and
• A specific license from the Nuclear Regulatory Commission under certain regulations governing the export or import of nuclear equipment and material.

Generally, qualifying for a license exemption under the ITAR or the EAR is not sufficient to avoid the mandatory filing requirement. However, the proposed rule specifies a few exceptions. In particular, a U.S. regulatory authorization is not required if satisfied by eligibility for any of three license exceptions in the EAR:

• The license exception at 15 C.F.R. 740.13 (related to the transfer of broadly available technology (“License Exception TSU”));
• The license exception at 15 C.F.R. 740.17(b) (related to encryption items (“License Exception ENC”)); or
• The license exception at 15 C.F.R. 740.20(c)(1) (higher controlled items and technology authorized to be transferred to close allies without a specific U.S. government approval (“License Exception STA”)).

In determining whether a U.S. regulatory authorization would be required, CFIUS will consider:

• For an entity—the foreign entity’s principal place of business, meaning the primary location where an entity’s management directs, controls, or coordinates the entity’s activities, or, in the case of an investment fund, where the fund’s activities and investments are primarily directed, controlled, or coordinated by, or on behalf of, the general partner, managing member, or equivalent.
• For an individual—such foreign person’s nationality or nationalities under the relevant U.S. regulatory authorization.

The proposed rule provides that if a U.S. regulatory authorization would be required with respect to a foreign person, a filing with CFIUS would be required if that foreign person:

• Could directly control the U.S. business as a result of the transaction;
• Is directly acquiring an interest that constitutes a “covered investment”—meaning that the foreign person is acquiring any equity interest along with certain rights, such as a board seat, board observer, or access to material nonpublic technical information—in the U.S. business;
• Already holds an equity interest and is acquiring certain new rights with respect to the U.S. business;
• Is involved in a transaction, transfer, agreement, or arrangement, designed or intended to evade or circumvent CFIUS jurisdiction; or
• Individually holds, or is part of a group of foreign persons that, in the aggregate, holds, a “voting interest” in any entity that meets the foregoing criteria. “Voting interest” is defined for these purposes as a voting interest, direct or indirect, of 25 percent or more. For entities that are controlled by a general partner, managing member, or equivalent, such as most investment funds, only interests in the general partner, managing member, or equivalent will be considered to be a “voting interest”; limited partner or similar interests will be disregarded. Further, for purposes of calculating whether the 25 percent voting interest threshold is met, any interest by a “parent”—meaning any entity holding a greater than 50 percent interest—will be deemed to be a 100 percent interest in the entity of which it is a parent.

Clarifications to the Definition of “Substantial Interest”

FIRRMA requires filings with CFIUS for certain transactions involving foreign government ownership and “TID U.S. businesses”, or U.S. businesses involved with critical technology, critical infrastructure, and sensitive personal data. Specifically, a filing is required for any transaction through which a “foreign person in which a foreign government holds a substantial interest” acquires a “substantial interest” in a TID U.S. business. Under current regulations, “substantial interest” is defined as a 49 percent or greater interest, directly or indirectly, between the foreign government and the foreign person, and a 25 percent or greater interest, directly or indirectly, between the foreign person and the TID U.S. business.

The proposed rule makes two clarifying edits to the substantial interest definition:

• First, current regulations provide in the case of an entity “with a general partner, managing member, or equivalent, the national or subnational governments of a single foreign state will be considered to have a substantial interest in such an entity only if they hold 49 percent or more of the interest in the general partner, managing member, or equivalent of the entity.” The proposed rule revises the definition as follows: “In the case of an entity whose activities are primarily directed, controlled, or coordinated by or on behalf of a general partner, managing member, or equivalent, the national or subnational governments of a single foreign state will be considered to have a substantial interest in such entity only if they hold 49 percent or more of the interest in the general partner, managing member, or equivalent of the entity.” (emphasis added).
• Second, the proposed rule clarifies that regardless of the type of entity at issue, a parent will be deemed to have 100 percent of the applicable interest in any entity of which it is a parent.

Exemptions

Significantly, certain foreign investment transactions remain exempt from the mandatory filing obligations, including transactions involving “excepted investors”, certain encryption technologies, and certain investment funds managed and controlled by U.S. nationals.

Conclusion

As stated previously, the proposed rule provides greater clarity regarding which transactions involving critical technology businesses will be subject to mandatory filings. The prior industry analysis test was widely viewed as ambiguous and difficult to administer. The proposed rule may also increase the number of mandatory filings required because the trigger for transactions involving critical technology businesses is no longer tied to a U.S. business’s connection to certain industries. Investors from countries subject to more rigorous U.S. export controls (e.g., China) will find more of their investments to be subject to mandatory filings. Conversely, investors from countries subject to lighter U.S. export controls (i.e., countries that are close allies of the U.S.) may see some relief. We will continue to track CFIUS-related developments.