Within the omnibus John S. McCain National Defense Authorization Act for Fiscal Year 2019 (2019 NDAA) that the President signed into law on August 13, 2018, is the Foreign Investment Risk Review Modernization Act (FIRRMA), which significantly expands the authority of the US government to review and restrict foreign investments on national security grounds.

Most notably, FIRRMA, which moved through Congress at breakneck speed, empowers the Committee on Foreign Investment in the United States (CFIUS), a US government inter-agency committee, to review a far broader group of “covered” transactions than ever before to determine if they threaten to impair national security and, therefore, should be prohibited or suspended. The new range of transactions includes, among others, certain minority foreign investments in critical technology and critical infrastructure companies and real estate deals near ports and sensitive government installations. The new law also increases the time allowed for these reviews and makes some notifications of foreign investment mandatory (as compared to the voluntary system of years past).

FIRRMA’s expansive new coverage and rules will require new implementing regulations and allow CFIUS to create new exemptions to screen out truly benign investments that will be caught within the law’s expanded scope. Thus, there will be a lengthy rule-making process in which interested parties can participate and provide views. At this writing, the breadth of potential exemptions from these expanded FIRRMA coverages is very much an open question of critical consequence to investors.

I. The rationale for FIRRMA

It is ironic that one of the broadest expansions of US regulatory authority over business transactions in a generation, and the resulting increase in government personnel and funding to manage this stepped up foreign investment review function, was passed in record time by one of the most conservative, anti-regulation Congresses in history. This legislation was already moving at near light speed through Congress with bipartisan support when Secretary of Defense James Mattis accelerated its pace by calling for its inclusion in the 2019 NDAA.

Why the hurry? The genesis of and the rationale for FIRRMA is the serious concern in Congress over, and a desire to more closely scrutinize, a range of Chinese investments not covered by existing law that the law’s sponsors believe pose national security threats. The legislation is a counterpart to a recent determination by the US Trade Representative under Section 301 of the Trade Act of 1974 that China has adopted laws, policies and practices relating to technology transfer, intellectual property, foreign investment and innovation that are unreasonable and discriminatory, and unfairly result in the transfer of technologies and intellectual property from US companies to China.

While the Trump Administration had considered imposing special foreign investment restrictions on China under Section 301, it ultimately decided to rely on the new coverage and disciplines in FIRRMA instead.

II. The broad scope of FIRRMA’s changes beyond Chinese transactions – and when they become effective

Despite the legislation’s focus on China, FIRRMA’s reforms apply across the board to all investors in all countries unless exemptions are created.

Since FIRRMA’s provisions have different effective dates, it is useful for businesses, private equity firms and other foreign investors to focus on the changes and their implications in the order in which they will be implemented. While some new FIRRMA provisions are effective immediately, others will become effective on the earlier of either 18 days from the date of enactment or 30 days after the Staff Chair of CFIUS determines that the regulations, organizational structure, personnel and other resources necessary to administer the new provisions are in place.

A. Review timelines have been extended

This elongated time frame includes:

a) Off the clock time (30 days): the informal time that CFIUS typically takes to review draft joint voluntary notifications that parties submit in order to facilitate a determination that they are “accurate and complete,” as required to initiate the review. This phase has no mandatory time frame, but has in practice expanded to as long as 30 days or more in recent years;

b) 45-day review: the initial formal CFIUS review after a case is initiated (which has been increased from 30 to 45 days); and

c) 45-day investigation, plus 15-day extension: the full 45-day investigation, which CFIUS now has been granted authority to extend up to an additional 15 days in “extraordinary circumstances,” as defined by CFIUS in the regulations.

Of course, cases also could include the subsequent 15-day Presidential determination phase (which FIRRMA leaves intact) if they last that long. However, in practice, this phase rarely takes place because most cases conclude before this period.

FIRRMA’s extension of the initial CFIUS review period from 30 to 45 days was adopted to allow more cases to be resolved in this first stage because CFIUS staff had observed that numerous cases were resolved soon after the 30-day period ended. In 2017, more than 70% of the cases went to a full 45-day investigation, which is a significant increase from prior years.

Ironically, however, this reform, which was designed to speed up CFIUS determinations, may in practice slow them down. US government departments and agencies that participate in CFIUS, facing competing demands on their time and resources, are likely to take the full time available for the initial review to make their decisions. Thus, the same issues CFIUS member agencies have faced at the 30-day mark are now likely to occur at the 45-day mark, with the resulting shift of these cases to full investigation.

B. Covered transactions have been expanded

At its core, FIRRMA expands the range of “covered” transactions subject to Presidential suspension or prohibition under current US law, although this expanded scope will only go into effect after 18 months or later, following a rule-making proceeding.

1. Acquisitions of real estate interests at US ports and near military and sensitive installations

FIRRMA fills a gap in CFIUS’s authority by adding the ability to review a foreign person’s purchase, lease or concession with respect to US real estate located at, or that will function as part of, an air or maritime port, or is in close proximity to a US military installation or other US government facilities or properties that are national security sensitive, or could reasonably afford a foreign person the ability to engage in intelligence collections or otherwise expose national security activities at such installations, facilities or properties. Today, CFIUS can only review acquisitions of US businesses and not properties without associated businesses.

Why the expansion? Recent cases involving Chinese acquisitions of businesses adjacent to military facilities (a wind farm near a naval weapons system training facility and a mining company with properties near a naval air station) have raised questions about whether the investments are being made for legitimate business purposes or for espionage. While CFIUS has been able to effectively deal with these transactions because they have involved the acquisition of a business, these cases have demonstrated the need to add authority for CFIUS to address purchases or leases of property near such facilities (i.e., where no US business changes hands). Similarly, since the Dubai Ports case during the George W. Bush Administration, there has been a focus on foreign persons participating in activities in or near US ports.

2. Minority foreign investments in US critical technology and critical infrastructure firms

Today, CFIUS can only review foreign acquisitions of “control” over US businesses. A centerpiece of FIRRMA is its addition of the authority to review “[a]ny other investment” that is not “passive” in nature but in a US business that

• owns, operates, manufactures, supplies or services “critical infrastructure”;
• produces, designs, test, manufactures, fabricates or develops “critical technology”; or
• maintains or collects sensitive personal data of US citizens that may be exploited in a manner that threatens national security.

In effect, the new law broadly expands the US government’s ability to suspend or prohibit minority, non-controlling acquisitions that are not passive in this select genre of companies.

What are critical technology and critical infrastructure firms? It will be up to CFIUS to define these key terms in new regulations. But Congress has laid down some markers. “Critical infrastructure” will include “systems and assets, whether physical or virtual, so vital to the United States that the incapacity or destruction of such systems or assets would have a debilitating impact on national security.” The term “critical technologies” is even broader in scope. It includes the usual categories: defense articles or services on the US Munitions List, certain dual use items on the Commerce Control List, regulated nuclear facilities, equipment and materials, and various agents and toxins subject to federal regulation.

What are emerging and foundational technologies? Notably, however, the term “critical technologies” also includes a new concept: “[e]merging and foundational technologies” controlled pursuant to the Export Control Reform Act of 2018, a companion law to FIRRMA which also is part of the 2019 NDAA. This crucial new dual use list of technologies is designed to include a wide range of new developmental technologies now largely unregulated. Based on congressional hearings and committee discussions, it is a safe bet that areas such as artificial intelligence, autonomy and advanced computing will be covered as “critical technologies.”

What “passive investments” are outside the scope of the expanded authority over minority investments? The scope of the passive investment exemption is quite narrow. To be “passive” and therefore exempt from review, an investment must not afford the foreign person any of the following: (i) access to material non-public information in the possession of a US critical infrastructure or critical technology company; (ii) membership or observer rights on the board of directors or equivalent governing body of such firms or the right to nominate an individual to such a position; or (iii) any involvement, other than through voting of shares, in substantive decision-making in the management, governance or operation of such firms. In short, passive means really passive. Any role with a US firm other than a simply financial investment, with no other rights, does not qualify for the exemption.

What about private equity and venture capital investments? The good news is that Congress has crafted a carveout for traditional private equity investments that are passive in nature and, therefore, exempt from covered minority investments. The private equity and venture capital communities, which have raised billions from foreign investors, including sovereign wealth funds, had raised concerns over expanded CFIUS authority. Historically, most of these funds structure equity purchases by foreign and other investors as limited partnerships, under which the investors have no rights to control the fund, its investment decisions, or the management of its portfolio companies and no right of access to the portfolio company’s technology or other non-public information. All control rights are generally granted only to the general partner of the fund, which typically is the senior management of the investment fund, wherever located.

• Traditional funds are exempt. Congress has made it clear that these investments will be treated as passive, even when the foreign person investing in the fund has membership on a fund advisory board or committee, provided that the fund’s general partner, managing member or the equivalent is not a foreign person; the advisory board or committee has no authority to approve, disapprove or control investment decisions of the fund; and the foreign investor has no control over the fund.
   
• Novel fund structures are not exempt. In recent years, a range of fund structures have afforded Chinese investors, sovereign wealth investors and other foreign investors greater rights to participate in investment decisions of a fund and the governance of the fund’s portfolio of companies. In contrast to traditional equity funds, these types of new investment structures are not exempt primarily because of a concern by Congress that they are designed to afford control rights to foreign investors while avoiding CFIUS jurisdiction.

3. The potential for broad “country” exemptions from the new coverage of real estate and minority investments.

While FIRRMA’s large-scale expansion of covered transactions plainly was designed with China in mind, it is difficult to identify a compelling national security rationale for applying this new regulatory authority across the board to US friends and allies and all other countries. For one thing, there is no indication that the types of issues the US Trade Representative found with respect to Chinese investment practices apply to other countries. There is no sustained course of conduct by other countries to engage in pernicious investment practices, such as a pattern of acquiring dual use capabilities on a large scale to foster increased military capabilities, the use of opaque or hidden equity investments in start-ups, and the like.

In any event, supporters of FIRRMA have long pointed to a provision in earlier forms of the bill that afforded CFIUS the authority to create, by regulation, a “white list” of designated countries whose transactions would be exempt based on a number of criteria, including the existence of a US mutual defense treaty with that country, that country’s process for reviewing foreign investments on national security grounds, and similar factors.

However, at the end of the legislative process, this explicit, country-based carveout provision was eliminated in favor of a vague provision called “Country Specification,” which allows CFIUS to create exemptions for “certain categories of foreign persons.” Congress only specifies that CFIUS shall take into account how a foreign person “is connected to a foreign country or foreign government, and whether the connection may affect the national security of the United States.”

This ambiguous formulation may have been intended to comply with the World Trade Organization’s (WTO) non-discrimination rules, which would make country-based distinctions more problematic, although presumably in this situation they could be justified under the WTO’s “essential security” exemption. Hence, at this writing, CFIUS’s intentions are not known on this matter – a key question for western investors from NATO and other friendly countries.

On the one hand, the broad expansion of covered transactions creates an incentive for CFIUS to adopt some meaningful exemptions – whether country based or otherwise – to avoid being deluged with declarations and filings and also limit the potentially chilling effect of FIRRMA on US participation in the global flow of emerging and foundational technologies. On the other hand, the history of CFIUS reflects a strong reluctance to establish broad exemptions of classes of countries or companies from its scope. In order to maintain the flexibility to address future transactions that could arise that might adversely affect national security, a prudent approach makes sense. Since CFIUS operates by consensus, it may be difficult to find full support in CFIUS for broad exemptions.

4. New export controls on joint ventures and other transactions involving the transfer of emerging and foundational technologies

Under pressure from the business community, Congress eliminated an expansive and controversial proposal from FIRRMA that would have afforded CFIUS the right to review a US critical technology company’s contributions of both intellectual property and associated support to a foreign person through any collaborative arrangements such as joint ventures.

Specifically, the Export Control Reform Act of 2018, the companion law to FIRRMA, creates a new and robust inter-agency process to identify emerging and foundational technologies “essential” to national security that are not already covered by existing US export controls and establishes, subject to certain exemptions, appropriate export licensing requirements over such technologies.

The challenge for the inter-agency community is how closely to regulate emerging and foundational dual use technologies, such as artificial intelligence and autonomy, when there are real questions about how, if at all, their dissemination can be meaningfully controlled in a globalized economy. A number of them are digital in nature and are inherently intangible, which renders them difficult to control. Likewise, numerous key technologies are already subject to broad global diffusion. They are ubiquitous in nature because high-tech innovators all around the globe are focused on and investing heavily in these areas.

The inter-agency community thus faces the trade-off between limiting its regulations to high-end applications of these technologies that clearly have a nexus to defense, or broadening its coverage to a wider range of key technologies and, in the process, creating barriers to US cooperation with other western innovators and countries in these emerging fields, potentially to the detriment of US war fighters.

Broader licensing disclosure requirements for joint ventures and collaborative arrangements. Notably, the proposed legislation authorizes the Commerce Department to require applicants for the export of such technologies for use by joint ventures or other collaborative arrangements to identify not only the foreign person participating in the arrangement, but also any foreign person with significant ownership interest in the foreign person. The requirement for identifying foreign ownership is an apparent effort to ensure transparency with respect to joint ventures and collaborative arrangements in allied countries that might involve ownership from China or other countries of concern.

5. Cats and dogs: circumventions and bankruptcies

Finally, FIRRMA affords CFIUS new authority over any other transaction or arrangement in which the structure is designed or intended to circumvent the application of Exon-Florio authority. CFIUS also will have authority over the transfer of certain assets pursuant to bankruptcy proceedings or other defaults. These new authorities will become effective now without a delay for implementing regulations.

C. Short-form declarations

In FIRRMA, Congress also created a new type of short-form CFIUS filing, known as a declaration, to be used for several purposes.

Optional declaration. First, in an effort to short-cut the current CFIUS process for some transactions, FIRRMA authorizes CFIUS to establish, by regulation, a process whereby parties in any covered transaction will have the option to submit a short-form declaration (generally not to exceed five pages) with basic information about the transaction instead of a full and detailed written notice. CFIUS then must decide, within 30 days of receipt, whether to: (1) request that the parties file a full notification; (2) initiate a unilateral review of the transaction; or (3) complete the action and clear the transaction.

Participants in foreign investment transactions will have to decide whether to use this abbreviated process and weigh the benefits of an early decision based on a short filing versus simply doing nothing or filing a traditional and more complete notification. If the transaction is so benign that it can be cleared in this manner, the question is whether it makes sense to make a filing in the first place in order to obtain deal certainty. The dilemma is that if the parties guess wrong, and cannot get a clearance in 30 days, then they may face a yet longer process – the initial 30-day declaration stage plus the time and cost of preparing a full joint notification and participating in the full CFIUS review process.

Mandatory declaration for certain foreign government investments. FIRRMA also requires CFIUS to establish, by regulation, a mandatory declaration, subject to exceptions and waivers, to be developed for covered acquisitions of a substantial interest in a US business involved in critical infrastructure or critical technology, or that maintains or collects sensitive personal data in which a foreign government has, directly or indirectly, a substantial interest. The meaning of the term “substantial interest” remains to be seen and, along with waivers and exceptions, will be developed by regulation, but it explicitly will exclude less than a 10% voting interest.

The mandatory declaration provision has the potential to include a wide range of transactions, including investments by sovereign wealth funds. There is, however, a carve out for foreign government investments in investment funds that meet certain specified criteria, including when the fund is managed exclusively by a general partner or the equivalent that is not a foreign person.

D. Filing fees

In a departure from current law and practice, FIRRMA authorizes CFIUS to impose a filing fee, to be specified in the regulations and to the extent appropriated for by Congress, which cannot exceed the lesser of 1% of the value of the transaction, or $300,000, adjusted annually for inflation. While this fee will necessarily take some time to put into place, it will change the CFIUS benefit/cost/risk process for potential foreign buyers. In the future, they will need to take into account the filing cost, in addition to other expenses and risks, in deciding whether to participate in the CFIUS process.

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The key question is whether FIRRMA’s expanded authority to evaluate and restrict problematic foreign acquisitions makes sense given the potential chilling effect on US participation in the flow of global innovation in emerging and foundational technologies, which is increasingly collaborative in nature. It is a subject for debate whether and to what extent FIRRMA’s broad expansion of US authority to restrict foreign investment will, in fact, advance US national security.

What is not debatable, however, is that parties seeking to structure foreign acquisitions of US businesses need to carefully consider whether to participate in the upcoming regulatory process in order to further shape and limit FIRRMA’s application to their business activities and to consider the implications of this expanded coverage for their particular transactions on a case-by-case basis.

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