Bloomberg Law - October 30, 2020
U.S. government agencies are increasing scrutiny of the supply chain of companies developing hypersonic technologies used in military aircraft and missiles amid escalating tensions with China and Russia. Lowenstein Sandler LLP attorneys offer guidance on how companies and their counsel can take proactive steps to successfully complete transactions amid CFIUS and other national security reviews and regulations.
National security experts know that countries hostile to U.S. interests are taking advantage of our country’s current health and economic challenges by finding ways to invest in critical technologies, including hypersonics, which can travel at more than five times the speed of sound.
U.S. companies engaged throughout the hypersonic technology supply chain must be vigilant about both their supply chain vulnerabilities and beneficial ownership of foreign investors to prepare for, or mitigate, U.S. government scrutiny, including review and potential intervention by the Committee on Foreign Investment in the U.S. (CFIUS).
As a critical technology vital to future warfighting capabilities, nation-states are aggressively pursuing hypersonics. Both China and Russia have been touting their growing capabilities in hypersonic technology, which is the science behind missiles that travel in excess of Mach 5 and can quickly change trajectory mid-flight.
The U.S. government worries that these countries may take advantage of “a lull in U.S. modernization” to improve their capabilities in this area, perhaps even through surreptitious means.
The increase in demand for hypersonic technology components does not come only from abroad. According to a May article in Design and Development Today, as recently as 2017 the Pentagon spent about $800 million on hypersonic weapon programs, rising to $3.4 billion in 2020. The administration’s 2021 budget request seeks $3.6 billion.
While most investment in hypersonic technology is defense-related, venture capital investment has exceeded $300 million over the last five years, including in support of commercial ventures.
Despite market demand, smaller suppliers of defense technology are struggling to keep up as their supply chains are affected by the Covid-19 pandemic and an increasingly tense U.S.-China trade war. This issue has been especially acute for hypersonics: Many of the companies involved in this technology tend to be smaller and could be more vulnerable to the economic effects of the pandemic and trade restrictions.
Agencies Are Increasing Supply Chain Scrutiny
The effects of the pandemic and trade conflict with China come on the heels of increasing U.S. government restrictions on the use of Chinese products, based on concerns that China could infiltrate the U.S. defense industry by embedding its technology in U.S. defense equipment. As a result, the Defense Department is increasingly focused on the origin of components used in weapons systems.
Many defense contracting supply chains are global and have deep roots in China. Pentagon officials have declared the need to make sure that foreign nations cannot cut off U.S. companies’ access to vital materials or buy their way into the defense-industrial base.
As part of this effort, agencies have increased their scrutiny of the supply chain to include even small companies developing components that could be incorporated into hypersonic technologies. In February, the then-acting secretary of the Navy underscored the supply chain’s vulnerabilities, stating that it’s “not so much the top tier suppliers, but it’s the second and third tier suppliers that have a lot of vulnerabilities that we’ve discovered.”
A recent analysis of the hypersonic supply chain noted that “the risk of supply chain infiltration by foreign adversaries to hypersonic technology exists at deeper levels than are typically visible” by the Defense Department and prime contractors.
To address these vulnerabilities, the Defense Department has implemented rules restricting the use of some Chinese equipment and is considering increased cybersecurity requirements. Pending legislation incentivizes companies to source materials domestically.
Be Proactive to Mitigate Foreign Investment Concerns
On the foreign investment side, CFIUS has long scrutinized foreign acquisitions of U.S. companies that present national security concerns. In February, new regulations expanded CFIUS authority to cover non-controlling transactions involving foreign investors. Parties are now required to submit a declaration to CFIUS for review of a transaction if the U.S. business must obtain a U.S. regulatory authorization to export its critical technology to the foreign party involved in the transaction.
U.S. companies involved in hypersonic-related technology must be proactive about mitigating potential CFIUS concerns. Manufacturers and suppliers should seek counsel to conduct proper due diligence and CFIUS analysis ahead of any potential foreign investment transactions, especially those involving Chinese and Russian investment.
Affected companies and investors should consider filing a notice with CFIUS to obtain a safe harbor ruling that CFIUS does not object to the transaction. Parties choosing not to file for review remain vulnerable to unilateral CFIUS review, as there is no limit on when CFIUS can review a transaction.
Obtaining a safe harbor ensures that CFIUS will not later review the filing and impose penalties; force the foreign party to divest from the U.S. business; or require the parties to adhere to conditions mitigating specific national security concerns.
Due to disruptions caused by the pandemic, trade conflicts, and growing U.S. national security restrictions, companies involved in hypersonic technology should examine whether vulnerabilities exist within their supply chains, and, if so, whether alternatives are available.
Companies should also perform thorough due diligence on all foreign investment, including identification of beneficial ownership, and determine whether the company’s technology requires an export license.
Be sure that your counsel can:
- Identify any national security implications;
- Conduct export classification reviews;
- Raise alternative supply chain opportunities;
- Explore applicable exemptions; and
- Craft deal documents to position your company to successfully complete transactions while facing CFIUS and other national security obligations.
Reprinted with permission from the October 30, 2020, issue of Bloomberg Law. © 2020 The Bureau of National Affairs, Inc. All Rights Reserved.