Implications of New CFIUS Regulations for Fund Investments
- Under the new FIRRMA regulations taking effect in February 2020, CFIUS has jurisdiction over, and in many cases CFIUS filings will be mandatory for, noncontrolling foreign investments in U.S. businesses involved with critical technology, critical infrastructure, and sensitive personal data of U.S. citizens.
- Certain indirect foreign investments made through qualifying U.S.-managed investment funds will be disregarded if the foreign investors have limited governance and information access rights and if limited partner advisory committees or similar bodies in which foreign investors participate also have limited rights.
- These rules have important implications for U.S.-based investment funds, foreign investors in those funds, and businesses receiving offers of investment from such funds.
Recognizing the importance of investment funds to U.S. investment activity and mergers and acquisitions, and also acknowledging that fund participants may include non-U.S. investors who have no meaningful involvement in the funds’ portfolio businesses, the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), as part of its reform of the jurisdiction and processes of the Committee on Foreign Investment in the United States (CFIUS), authorized CFIUS to exempt certain indirect foreign investments via U.S.-managed investment funds from some of FIRRMA’s provisions relating to investments in U.S. businesses engaged in developing or producing critical technology, providing critical infrastructure, or collecting sensitive personal data (together, “TID Businesses”).
On January 13, 2020, CFIUS released final regulations implementing the exemptions authorized by FIRRMA. These rules, which take effect on February 13, 2020, will have important implications for the following types of parties:
- Investment funds raising funding from non-U.S. investors;
- Established investment funds with non-U.S. investors, whose funds are not fully invested;
- Non-U.S. investors in U.S. investment funds; and
- U.S. businesses receiving acquisition or investment offers from funds with non-U.S. investors.
Target Businesses for Which Fund Exemptions Are Relevant
Under the new FIRRMA regulations, many non-U.S. investments in TID Businesses will be subject to CFIUS jurisdiction and/or mandatory filings. TID Businesses include the following:
- Critical technology TID Businesses. Critical technology businesses are those involved in the production and development of (i) military technology and services subject to the International Traffic in Arms Regulations; (ii) dual-use (civilian/military) technologies that are controlled by the Export Administration Regulations for various reasons relating to national security, nonproliferation regimes, regional stability, or surreptitious listening; and (iii) emerging and foundational technologies to be designated by the Department of Commerce pursuant to FIRRMA’s sister legislation, the Export Control Reform Act of 2018 (ECRA).
- A subset of critical technology businesses includes businesses that are active in, or developing critical technology specifically for use in, one or more of 27 specified industries. The CFIUS “pilot program” established in November 2018 mandated CFIUS filings for certain foreign investments in these businesses. The pilot program expires on February 12, 2020, but has been largely replaced by provisions in the final FIRRMA regulations. CFIUS intends to issue new rules that would replace the 27-industry qualification with one based on export control licensing requirements.
- Critical infrastructure TID Businesses. Critical infrastructure businesses are those that produce, operate, or manage various forms of U.S. infrastructure listed in the FIRRMA regulations.
- Personal data TID Businesses. Personal data businesses are those that collect or maintain personally identifiable data, if (i) the businesses either target U.S. government personnel or contractors, or collect data on large numbers of individuals, and (ii) the data also falls into at least one of several qualitative categories identified in the FIRRMA regulations.
Exemptions Applicable to Indirect Investments Via U.S-Managed Funds
Under the FIRRMA regulations, certain transactions involving TID Businesses trigger CFIUS jurisdiction or mandatory CFIUS filings:
- CFIUS jurisdiction over non-controlling investments in TID Businesses. Generally, the new FIRRMA regulations give CFIUS jurisdiction over a non-controlling foreign investment in a TID Business if the investment affords the non-U.S. investor (i) access to material nonpublic technical information of the TID Business; (ii) voting or observer rights with respect to, including the right to nominate members of, the board of directors or similar governing body of the TID Business; or (iii) involvement, beyond the voting of shares, in substantive decision making by the TID Business with respect to the use, development, acquisition, or release of critical technologies; the management, operation manufacture, or supply of critical infrastructure; or the use, development, acquisition, safekeeping, or release of sensitive personal data of U.S. citizens.
- Mandatory filings for foreign government-backed investments in TID Businesses. A CFIUS filing is required for a transaction in which a foreign investor acquires a 25 percent interest in a TID Business and a single foreign government (including its subnational governments) holds a 49 percent direct or indirect interest in the investor.
- Mandatory filings for other investments in critical technology TID Businesses. A CFIUS filing is required for a transaction in which (i) the foreign investment is in a critical technology TID Business (described above) that develops or produces a critical technology as part of its activities in one or more of 27 industries listed in the regulations or develops or produces a critical technology specifically for use in at least one of those industries (even if the technology can also be used in other industries) and (ii) the transaction will afford a foreign person (w) control of the business; (x) access to material nonpublic technical information possessed by the business; (y) voting or observer rights with respect to, including the right to nominate members of, the board of directors or similar governing body of the business; or (z) other involvement, other than through voting of shares, in substantive decision making with respect to the business’s use, development, acquisition, or release of critical technology.
- As noted above, CFIUS intends to issue new regulations that would mandate filings for other investments in critical technology TID businesses based on export control licensing requirements rather than activities in one or more of the 27 industries.
The FIRRMA regulations exempt certain indirect foreign investment via U.S.-managed funds from these provisions. As a first step for an exemption to apply, the fund must meet certain qualifications:
- Investment company. The fund must qualify as an “investment company” as defined in the Investment Company Act of 1940, as amended, or as an entity that would be an investment company but for one of the listed exclusions (see 15 U.S.C. § 80a-3).
- General partner qualifications. The fund must be managed by a general partner, managing member, or equivalent. In the case of mandatory filings for foreign government-backed investments as described above, the manager cannot be a “foreign person” as defined in the FIRRMA regulations. In the case of other investments in critical technology TID Businesses, as described above, the general partner or equivalent either (i) cannot be a foreign person or (ii) must ultimately be controlled exclusively by U.S. nationals (i.e., U.S. citizens or individuals who were born in certain U.S. possessions, but not U.S. permanent residents).
- Principal place of business of general partner. Comments on the draft regulations noted that many investment funds have general partners that are non-U.S. entities, even though the people actually managing the funds’ investments are located within the United States. In response, CFIUS has included within the new FIRRMA regulations an interim rule defining the principal place of business of a fund as the primary location in which the fund’s activities and investments are primarily directed, controlled, or coordinated by or on behalf of the general partner, managing member, or equivalent.
Since CFIUS’s definition of “foreign person,” as applied to an entity, indirectly relies on the principal place of the entity, this definition addresses the comments regarding offshore general partners, with one important proviso: If the general partner has previously told any U.S. or foreign government (including subnational governments) that its principal place of business, headquarters, or equivalent is outside the United States, the non-U.S. location will be treated by CFIUS as the principal place of business unless the general partner can demonstrate that the principal place of business has subsequently been relocated to the United States.
CFIUS is welcoming public comment on this interim rule; the comment period will remain open for a 30-day period ending February 18, 2020.
- Limited partner advisory committee with limited powers. Foreign participation in a fund’s limited partner advisory committee (LPAC) or similar body will not disqualify the fund or the foreign investor from FIRRMA’s exemptions if both of the following conditions is met:
- The fund’s LPAC or similar body does not have any of the following powers:
> Approval, disapproval, or any other control over investment decisions by the fund;
> Approval, disapproval, or any other control over decisions by the fund’s general partner or equivalent with respect to the fund’s portfolio companies;
> Unilateral power to dismiss, prevent the dismissal of, select, or determine the compensation of the general partner or equivalent.
> Participation on the fund’s LPAC or similar body would not afford the foreign investor access to material nonpublic technical information.
- Limits on governance and information rights of indirect foreign investors. In addition to qualifications applicable to the fund in general, the exemption does not apply if the investment, though indirect, would afford the foreign investor any of the rights, as described above, that give CFIUS jurisdiction over non-controlling direct investments in TID Businesses.
Implications for U.S.-Managed Funds and Foreign Investors
The exemptions described above provide opportunities and challenges for various parties involved in investments in TID Businesses:
- Investment funds raising funding from non-U.S. investors need to consider whether they qualify for these exemptions, which could give the funds a competitive advantage when bidding for deals with TID Businesses against other parties that CFIUS might treat as foreign investors. U.S. funds should therefore consider whether their fund agreements, along with any side letters and co‑investment arrangements, qualify for CFIUS exemptions or might be disqualifying.
- Established investment funds with non-U.S. investors, whose funds are not fully invested, should undertake a similar analysis.While it may be difficult to revisit previously signed fund documentation, established funds should still consider whether they qualify for CFIUS exemptions for future portfolio investments.
- Non-U.S. investors in U.S. investment funds, if they wish to take advantage of the exemptions offered by the FIRRMA regulations, must consider whether CFIUS’s qualifying restrictions on governance and information access rights will be acceptable. For some non-U.S. investors, seeking to qualify for the CFIUS exemptions may require a significant change in past policies and practices.
- TID Businesses receiving acquisition or investment offers from U.S.-managed funds should assess, as part of their diligence efforts, whether those funds qualify for the FIRRMA regulations’ exemptions.Due to greater deal certainty and lower timing risk, TID Businesses are likely to favor acquisition or investment offers from investment funds that qualify for CFIUS exemptions as compared to investment funds that do not qualify for CFIUS exemptions.
The FIRRMA regulations as a whole, and the regulations applicable to fund investments in TID Businesses in particular, are lengthy, detailed, nuanced, and in the case of a key definition (as described above), not yet final. Given the complexity of the new rules and their implications for investments in and by U.S.-managed funds, parties pursuing such investments are encouraged to seek experienced counsel for assistance. Please e-mail one of the contacts to the right if you have any questions or concerns.