CFIUS Regulations and FINSA Compliance: Surviving Heightened Federal Scrutiny Leveraging Lessons from Recent CFIUS Cases

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Karalyn Meany Mildorf, Counsel, Kaye Scholer, Washington, D.C.

Anne Salladin, Special Counsel, Stroock & Stroock & Lavan, Washington, D.C.

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CFIUS Regulations and FINSA Compliance:

Surviving Heightened Federal Scrutiny

Karalyn Meany Mildorf Counsel Kaye Scholer LLP 202-682-3547 karalyn.mildorf@kayescholer.com

Anne W. Salladin Special Counsel Stroock & Stroock & Lavan LLP 202-739-2855 asalladin@stroock.com

Overview of the CFIUS Process The Committee on Foreign Investment in the United States (“CFIUS”) is an interagency committee that reviews foreign acquisitions of U.S. businesses that could raise national security considerations. • Legal Authority

Statute: Section 721 of the Defense Production Act of 1950 (the Exon-Florio Amendment of 1988), as amended by the Foreign Investment and National Security Act of 2007 (“FINSA”) (50 U.S.C. App. 2170).

Executive Order: EO 11858 (1975), amended most recently by EO 13456 (2008). Regulations: 31 C.F.R. Part 800, amended by 73 Fed. Reg. 70702 (2008). Guidance Concerning the National Security Review Conducted by CFIUS: 73 Fed. Reg. 74567 (Dec. 8, 2008).

• Composition Nine Full Members: Treasury (Chair), Justice, Homeland Security, Commerce, Defense, State, Energy, U.S. Trade

Representative, and the Office of Science and Technology Policy Two Non-Voting, Ex Officio Members: Director of National Intelligence and Labor Five Observers/Other Participants: Office of Management and Budget, Council of Economic Advisers, and the

Assistants to the President for National Security Affairs, Economic Policy, and Homeland Security and Counterterrorism

• Timing Prefiling: Generally, at least 5 business days Review: 30 calendar days Investigation: 45 calendar days Decision by the President: 15 calendar days

• Scope of review Voluntary process: Parties decide whether to file, though CFIUS may unilaterally initiate. No “Greenfield” transactions: Must be a “merger, acquisition, or takeover.” Concept of “control”: Transaction must be one that “could result in control” of a U.S. business by a foreign person.

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Covered Transactions • “Any transaction . . ., by or with a foreign person, which

could result in control of a U.S. business by a foreign person.” § 800.207 “Transaction” - § 800.224 “Foreign Person” - § 800.216 “Control” - § 800.204 “U.S. business” - § 800.226

• Numerous examples in these sections to illustrate these terms.

• Numerous examples in §§ 800.301 and 302 addressing, e.g., “could result in control,” collections of assets, multinational companies, joint ventures, supply contracts, and technology licenses.

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CFIUS Process • Prefile draft CFIUS notice (and exhibits) generally at least

5 business days before the formal filing.

• 30-day CFIUS Review Begins once formal notice has been filed and accepted as complete.

There are no “expedited” reviews.

• Investigation Required if an acquisition will result in foreign government control –

unless waived. Lasts up to 45 days after the 30-day review. Will follow if CFIUS wants more time to review the transaction, if a

member agency believes national security concerns require investigation, or if CFIUS is considering blocking the deal.

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CFIUS Process (cont.) • Presidential review/decision (rare) Lasts up to 15 days. If CFIUS cannot reach a decision, recommends that the

transaction be blocked, or requests a presidential decision.

• Review concludes when CFIUS has determined that there are no “unresolved national security concerns.” The transaction does not pose a national security risk; Any national security risk has been addressed by other

authorities; or Mitigation measures have been established to resolve the

risk.

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CFIUS Process (cont.)

• Cases can be initiated pursuant to: Voluntary notice - §§ 800.401(a) and 402 CFIUS request and notice filed by parties - § 800.401(b) Agency notice - § 800.401(c)

• CFIUS may pose questions to the parties, with responses due in 3 business days, unless extended.

• Safe harbor defined in § 800.601 CFIUS advises parties that transaction is not a covered transaction; CFIUS advises parties that it has concluded all action; or The President has announced his decision not to exercise his authority.

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Recent Developments In CFIUS • Significant increase in Chinese investments 23 notices in 2012, up from 10 in 2011 and 6 in 2010. Overtook the United Kingdom for the most filings.

• Timing In 2012, about 40% of cases went into the 45-day investigation, which

was up from 36% in 2011. Transactions involving foreign government control often move to

investigation. 2012 marked a stark increase in abandoned transactions, with 22

cases withdrawn and only 12 refiled. Cases are often withdrawn and refiled to provide additional time to complete

the CFIUS process.

• Close Proximity Proximity has always been a national security consideration, but has

gained higher prominence in recent years after being a key factor in several transactions. Ralls Corporation is a notable recent example of close proximity concerns

impacting a transaction. 10

Recent Developments in CFIUS • Cyber Security Cyber security is an important national security consideration

for CFIUS given greater incidents of cyber intrusions and increased infrastructure vulnerabilities. There is often heightened sensitivity in transactions related to cyber

security and identity authentication. The Department of Homeland Security just released a Federal Register

notice regarding procedures for critical infrastructure assets for which it has been determined that a cyber-security incident could reasonably result in catastrophic regional or national effects on public health or safety, economic security, or national security. (79 Fed. Reg. 21780 (2014))

• Mitigation CFIUS continues to require mitigation measures in order to clear

transactions in about 8% of cases, which has been the trend since 2010. In 2012, 8 transactions resulted in mitigation, covering U.S. companies

engaged in software, information, mining, energy, and technology industries.

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Notable Cases: Smithfield Foods • Shuanghui International Holdings Limited

(“Shuanghui International”), a private Chinese company, acquired Smithfield Foods, Inc. (“Smithfield”) in 2013 for $4.7 billion (total deal value, including debt, of $7.1 billion). Largest ever Chinese acquisition in the United States.

• Shuanghui International owns a variety of businesses, including food and logistics companies. It is the majority shareholder of China's largest meat

processor. • Smithfield is the world’s largest pork processor

and hog producer. 12

Notable Cases: Smithfield Foods • CFIUS analysis may have considered food safety, which is

part of critical infrastructure, and market considerations. Smithfield was also reportedly a supplier to the U.S.

Department of Defense and other government agencies. • CFIUS conducted both an initial review and a follow-on

investigation of the transaction, completing the process in one cycle.

• CFIUS ultimately approved the transaction, apparently without requiring mitigation measures.

• There was significant concern raised about the transaction from both Congress and industry groups. Highlights that CFIUS focuses on its national security

review and is not a political process.

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Notable Cases: Sprint • SoftBank Corp. (“SoftBank”), a Japanese company,

acquired an approximately 78% stake in Sprint Nextel Corporation (“Sprint”) for $21.6 billion.

• SoftBank is engaged in various information technology and internet-related businesses, including mobile communications, broadband services, fixed-line telecommunications, e-commerce, and web portal services.

• Sprint is a provider of wireless and wireline communications services.

• In connection with this transaction, Sprint also completed its acquisition of Clearwire Corp. (“Clearwire”), a wireless broadband company and spectrum holder.

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Notable Cases: Sprint • Transaction underwent both CFIUS and Team Telecom review.

The CFIUS process concluded after a review and investigation.

• CFIUS approved the transaction subject to a National Security Agreement (“NSA”) between the parties and the Departments of Defense, Justice, and Homeland Security (“USG Parties”) requiring certain mitigation measures: SoftBank and Sprint must appoint an independent Security Director to the

Sprint board to oversee Sprint’s compliance with the NSA and interact with the USG Parties on all security-related matters. The Security Director must be approved by the USG Parties, have expertise and

experience with national security matters, be a U.S. resident citizen, and hold appropriate security clearances.

The USG Parties will have a one-time right to require Sprint to remove and decommission by December 31, 2016 certain equipment deployed in the Clearwire network.

The USG Parties will have the right to review and approve certain network equipment vendors and managed services providers of Sprint and Clearwire.

• CFIUS mitigation focused on security oversight and supply chain control.

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Current Deals: Lenovo/IBM & Lenovo/Motorola • Lenovo Corporation

World’s largest personal-computer maker. Beijing-based company. In 2005 acquired IBM’s PC-making business arm.

• IBM Deal: Lenovo to buy IBM’s low-end server business A $2.3 billion deal, announced in January, would be the largest overseas

tech acquisition by a Chinese company, according to research firm Dealogic.

Possible National Security considerations: Possible use of the low-end servers by the U.S. Government in connection with

sensitive activities.

• Motorola Deal: Lenovo to buy Google-owned Motorola Mobility A $9.2 billion deal to secure Lenovo’s entry into the smartphone business. Possible National Security considerations:

How are the phones and technology used by the U.S. Government?

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Foreign Ownership, Control or Influence • A company under foreign ownership, control or influence

(“FOCI”) is not eligible to be issued a facility security clearance (“FCL”) or continue to hold an FCL unless its FOCI is mitigated in accordance with the National Industrial Security Program Operating Manual (“NISPOM”) in a manner acceptable to the U.S. Government.

• FOCI Criteria: A U.S. company is considered to be under FOCI when a foreign

interest has the power, direct or indirect, whether or not exercised, to direct or decide matters affecting the management or operations of the company in a manner which may result in unauthorized access to classified information or may affect adversely the performance of classified contracts (NISPOM, paragraph 2-300a).

Even a minority interest can constitute FOCI.

• FOCI mitigation can be standalone or in addition to CFIUS-based mitigation.

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FOCI Mitigation Arrangements • In majority foreign ownership cases, FOCI is mitigated via a Special

Security Agreement, a Proxy Agreement, or a Voting Trust. Special Security Agreement (“SSA”): Premised on the concept of risk

mitigation. Minority foreign representation on the board. Requires the appointment of independent Outside Directors. Under an SSA, National Interest Determinations (NID) are required

for access to “proscribed” classified information, i.e., Top Secret, Sensitive Compartmented Information, Special Access Program, Communications Security (excluding controlled cryptographic items when unkeyed or utilized with unclassified keys), and Restricted Data.

Proxy Agreement/Voting Trust: Premised on the concept of risk avoidance. Foreign representation on board prohibited. Proxy Holders/Trustees control the company, subject to limited

authority of foreign owner. 18

FOCI Mitigation Arrangements • In minority foreign ownership cases, the FOCI mitigation

arrangement depends on whether or not the foreign investor is entitled to board representation.

Board Resolution: Used in cases with no foreign investor board

representation. Security Control Agreement (SCA): Used in cases of minority foreign investor board

representation. Requires appointment of at least one independent

Outside Director.

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Export Controls • The United States has two primary export-control regimes: International Traffic in Arms Regulations (“ITAR”): administered by

the U.S. Department of State and control defense articles and defense services.

Export Administration Regulations (“EAR”): administered by the U.S. Department of Commerce and control commercial and “dual use” items. Generally, everything that is not ITAR-controlled is subject to the EAR.

• Key Considerations Thorough due diligence is critical. Under ongoing export control reform efforts, many items formerly

controlled under the ITAR are transitioning to EAR control, which can yield significant administrative time and cost savings.

60-day advance ITAR notice letters to State Department and post-closing notices.

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Team Telecom • Team Telecom is an informal group of officials from the Departments of Homeland

Security, Justice (including the FBI), and Defense.

• It reviews Federal Communications Commission (“FCC”) licenses as part of the FCC’s obligation to consider the “public interest” with respect to various applications, including:

FCC Section 214 authorizations;

Cable landing licenses; and

Applications that involve more than 25 percent indirect foreign ownership.

• Team Telecom often operates on a parallel track with CFIUS where foreign investment transactions involve communications licenses or the foreign investment may jeopardize or compromise U.S. law enforcement access to and use of telecommunications channels.

• Team Telecom can require parties to enter into a Network Security Agreement.

• Because it is not a creature of statute or regulations, Team Telecom has no formal rules, procedures, or timetables.

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Strategic Considerations: Determining Whether (and When) to File • The CFIUS regulations contain few bright lines and

CFIUS is a voluntary process, so it is important to assess at the outset whether to notify a transaction to CFIUS.

• Two fundamental questions in deciding whether to file: Is the transaction a covered transaction? If a covered transaction, should the parties submit a CFIUS

filing?

• CFIUS does not issue advisory opinions, so parties must submit a full filing to get CFIUS to advise whether it has jurisdiction. CFIUS tends to interpret its jurisdiction broadly.

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Strategic Considerations: Determining Whether (and When) to File • Determining whether to file is a matter of risk

assessment and tolerance. In some cases, filing is essentially mandatory (e.g.,

acquisition of a cleared contractor). In other cases, there may be transaction-related factors that

argue strongly in favor of filing, such as the target being engaged in sensitive business areas and/or the buyer coming from a country generally viewed with greater scrutiny.

• Risk of not filing is that CFIUS will review the transaction and impose mitigation requirements after closing that the parties find unacceptable or that CFIUS may recommend that the President order divestment. Parties can close the transaction before completing the

CFIUS process, but this does not eliminate these risks. 23

Strategic Considerations: Engaging with CFIUS and Others • The post-FINSA regulations explicitly encourage parties to a

transaction to consult with CFIUS in advance of filing a notice and/or to file a draft notice. Companies should take this seriously and have a broad and robust pre-filing engagement strategy.

Engage with the Committee: Be forthcoming and constructive with CFIUS. Trust is key.

Engage with individual agencies: Prior to filing, address specific national security considerations where

agencies have specific oversight authorities.

Engage with Congress and the public: Where necessary, demonstrate that the foreign acquirer is a responsible

actor and that the transaction will benefit U.S. companies and American workers.

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Strategic Considerations: Managing the Timeline • It is important to plan sufficient time for the CFIUS process, including

preparing the information for the filing, prefiling, and a review and investigation. Having a complete (or nearly complete) prefiling can help the process

move more smoothly. For cases that are anticipated to be sensitive, it may be advisable to

build in additional time in case more than one CFIUS review cycle proves necessary.

• Since CFIUS operates pursuant to statutory timelines, preparation is key. Assess whether it may be advisable to brief CFIUS on the transaction

and plan accordingly. To the extent possible, anticipate questions so that responses can be

prepared expeditiously.

• If the statutory timeline is coming to an end and more time seems necessary to resolve issues, parties should consider withdrawing and refiling to restart the statutory review period.

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Five Biggest Mistakes Made by Filers • Failure to develop a comprehensive strategy up front –

when the transaction is structured. Many transactions can involve several different government approvals,

potentially raising complicated timing questions that need to be carefully thought through.

• Failure to carefully consider whether a transaction poses national security concerns before closing the transaction – potentially tying the hands of the investor. It’s a lot harder to unwind a transaction that has been consummated

than it is to abandon one – and in many cases, if mitigation is required, it will necessarily be more onerous.

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Five Biggest Mistakes Made by Filers (cont.) • Failure to respond to questions promptly and transparently.

Because of statutory deadlines, information needs to be provided promptly. If CFIUS has to “tease” the answers out of parties, it can delay the

process.

• Assuming that if the acquirer comes from a country that is an ally, that a transaction will not present national security concerns.

• Failure to take advantage of the prefiling process. This allows CFIUS and the parties to address any informational issues

and get the filing in good shape so that when the case is formally accepted, it can be processed much more quickly.

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Strategic Considerations: CFIUS Mitigation • CFIUS has broad authority to impose mitigation measures on parties (even where they do not

agree) based upon a risk-based analysis where the national security risk “arises” from the covered transaction.

• CFIUS considers whether mitigation is feasible before referring a transaction to the President.

• It is critical to consider potential CFIUS mitigation when negotiating a deal. Fully understand the target’s business and whether it has sensitive/unique technology or is in an area of

significant concern to the U.S. Government. Assess potential sensitivities regarding the buyer, e.g., foreign government ownership. Determine whether the target has facilities located in close proximity to sensitive U.S. assets.

• CFIUS mitigation can be standalone or in addition to other mitigation arrangements under separate authorities such as the NISPOM or Team Telecom.

• CFIUS mitigation can address specific issues such as supply chain concerns, external concerns such as close proximity to sensitive U.S. assets, or broader governance issues.

• Although more likely than a Presidential block, mitigation can undermine the rationale for the deal and even require that certain assets be divested.

• Buyers should negotiate purchase agreement provisions providing protection against unfavorable CFIUS mitigation.

• The lead agency(ies) monitors mitigation measures on behalf of the Committee.

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