U.S. Foreign Investment Update for October 2020: CFIUS, Team Telecom, and DCSA
The past month has been an active one for the various authorities responsible for U.S. foreign investment reviews, even without considering the widely publicized presidential order requiring the divestment of Musical.ly, the U.S. predecessor of the popular video sharing application TikTok.
To start, one of the thresholds for mandatory pre-closing filings of critical technology transactions is changing at CFIUS, and short-form declarations are currently being cleared at a much higher rate than in 2019. Not to be outdone, the Federal Communication Commission has issued new rules governing “Team Telecom” national security reviews of international telecommunications licenses. Additionally, National Interest Determinations are no longer required for certain cleared contractors subject to Special Security Agreements with the Defense Counterintelligence and Security Agency.
Our note outlines these changes and their implications for cross-border investment.
CFIUS: New Threshold for Mandatory Filings for Critical Technology Investments
On September 15, 2020, CFIUS issued a new rule revising one of the thresholds for non-U.S. investments in “critical technology” businesses for which pre-closing filings will be required:
- As before, the first prong of the mandatory filing test is that the investment target be a U.S. business that “[p]roduces, tests, manufactures, fabricates, or develops one or more critical technologies.” “Critical technologies” is defined as (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 (EAR) for various reasons relating to national security, non-proliferation regimes, regional stability, or surreptitious listening; (iii) other items subject to US export controls as nuclear materials, facilities, or equipment or as select agents and toxins; and (iii) “emerging and foundational technologies” designated by the Department of Commerce pursuant to the Export Control Reform Act of 2018.
- The second prong of the mandatory filing test remains intact. The non-U.S. investment must result in the investor receiving one of the following rights with respect to the U.S. critical technology business: (i) control of the business; (ii) access (even if not used) to any material non-public technical information in the business’s possession; (iii) voting or observer rights with respect to the board of directors or similar governing body of the business; or (iv) any involvement, other than through the voting of shares, in substantive decision making with respect to the business’s use, development, acquisition, or release of critical technology.
- The new regulation changes the third prong of the mandatory filing test. As anticipated in our January 2020 note regarding CFIUS’s mandatory filing regime, the new rule no longer considers whether the U.S. business develops or produces critical technology either as part of its own activities in one of 27 listed industries or specifically for use by others in one of those industries. Instead, the new test is whether an export license or similar authorization would be required for (i) the non-U.S. investor receiving the governance or information access rights described above, or (ii) anyone directly or indirectly holding a 25 percent or greater voting interest in the non-U.S. investor (or its general partner or equivalent manager, if the investor is managed by such an entity).
- The relevant country for determining export license requirements is based on the principal place of business (if an entity) or nationality (if an individual) of the non-U.S. investor or its 25 percent owner.
- Exceptions from export licensing requirements are generally not considered as part of this test, except for EAR exceptions for (i) certain types of operating and mass market software, (ii) certain encryption technologies, and (iii) transfers under Strategic Trade Authorizations for software exports to certain listed countries.
The new rule will create winners and losers. For those investors CFIUS would view as benign, certain transactions will no longer be subject to mandatory pre-closing filings just because the target was involved in a sensitive industry. On the other hand, investors from countries subject to heavier export licensing requirements will be subject to more required filings.
The new threshold also increases the level of diligence required by parties to assess whether a pre-closing CFIUS filing is required. Not only do the parties have to know whether the U.S. business develops or produces critical technologies, they also need to know whether export licenses would be required for the non-U.S. investor or its owners. This analysis can be particularly challenging for early-stage U.S. businesses with immature export compliance programs. It may also present issues for non-U.S. investors that are less accustomed to dealing with export controls or their application to the investors’ owners.
The new regulation takes effect on October 15, 2020, but parties should note that the 27-industry test has not been eliminated entirely. For critical technology investments that were signed and closed prior to October 15, the 27-industry test will still be a factor in determining whether a pre-closing CFIUS filing was required. If a required pre-closing filing was not submitted, CFIUS can impose a civil penalty up to 100 percent of the value of the transaction.
CFIUS: 2/3 Clearance Rate for Short-Form Declarations
During an October 2 presentation hosted by the Center for Strategic and International Studies, Thomas Feddo, who as Assistant Secretary of the Treasury for Investment Security leads CFIUS, reported that CFIUS is currently clearing approximately two-thirds of the transactions for which the parties are filing short-form declarations. This is a substantial increase from the previously reported 37 percent clearance rate for mandatory pre-closing declarations that were filed in 2019 under CFIUS’s pilot program for investments in critical technology businesses.
Feddo ascribed the increased clearance rate to (i) greater efficiency within CFIUS and (ii) a “positive feedback loop.” As anticipated in our July 2020 client note, parties and their CFIUS advisors are becoming more discerning. They are submitting short-form declarations for transactions that are less inherently risky, while submitting full notices for transactions that will involve greater, and lengthier, CFIUS scrutiny. The ability to submit declarations for lower-risk transactions has been facilitated by the February 2020 CFIUS regulations, which permit the use of declarations in lieu of full notices for voluntary CFIUS filings involving any type of business.
Team Telecom: FCC Approves New Rules Clarifying the National Security Review Process
Applications to the Federal Communications Commission (FCC) for licenses are subject to a public interest review by the FCC. As part of its public interest review of applications for new or transferred licenses to provide international carrier services, undersea cable landing stations, and satellite base stations, if the applicant has 10 percent foreign ownership, the FCC refers the application for a national security review led by the Departments of Justice, Homeland Security, and Defense, a group informally known as “Team Telecom.” Team Telecom would solicit information from the applicant, but unlike CFIUS, had no official process for conducting its reviews or completing them within a certain period of time. In one notable instance, the national security review took seven years.
In June 2016, the FCC issued a notice of proposed rulemaking (NPRM) to address these shortcomings, but no action was taken until April 2020, when President Trump issued an executive order creating the Committee for the Assessment of Foreign Participation in the United States Telecommunications Services Sector. As discussed in our April 7 client note, the executive order formally established the new Committee (which in the absence of a succinct acronym, we expect will continue to be called Team Telecom) comprising the original three members, advised by other government agencies with relevant expertise and equities. The executive order also called for Team Telecom to complete its “initial review” of applications within 120 days, followed by a 90-day “secondary assessment” when necessary. In response to the executive order, the FCC reopened the docket from the 2016 NPRM and asked for public comments on both the original proposal as well as implementation of the executive order.
After considering the public comments, the FCC met on September 30 and adopted new rules governing Team Telecom referrals and reviews. Key elements of the new rules include:
- Identifying low-risk transactions that will not be referred to Team Telecom. These include (i) applicants that are ultimately owned by US persons but are held indirectly through non-US intermediaries, (ii) applicants that are already subject to FCC/Team Telecom mitigation agreements and for whom there has not been a material change in foreign ownership; and (iii) applicants who have been cleared without mitigation by the FCC and Team Telecom in the past 18 months and for whom there has not been a material change in foreign ownership.
- Requiring applications (other than those exempt from referral to Team Telecom) to be accompanied or preceded by responses to standard Team Telecom questions regarding the applicant and the subject business. Within the next 90 days, the FCC’s International Bureau is expected to circulate draft questions for public comment and then make the final questions available to the public on the FCC website. In the meantime, we expect applicants to continue to respond to the triage questions currently asked by Team Telecom.
- Applicants will certify in advance that they will comply with the Communications Assistance for Law Enforcement Act and related lawful intercept rules and orders, make communications and communications records accessible to U.S. law enforcement authorities, identify a U.S. point of contact for lawful intercept requests and service of process, update the FCC on significant changes while the application is pending, and acknowledge that any license granted by the FCC can be revoked for failure to satisfy any conditions placed on the license. The FCC expects these advance certifications to obviate the historic need to seek these standard undertakings from applicants later in the process, allowing license applications to be approved more quickly.
- Implementing the 120/90-day Team Telecom timeline required by the April 2020 executive order.
Except for the Team Telecom questionnaire, these new Team Telecom rules will take effect 30 days after publication in the Federal Register (which has not happened as of this writing). Once the new rules are in force, applicants should have a greater understanding of what to expect in terms of their obligations and the government’s when a Team Telecom review is required.
DCSA: National Interest Determinations No Longer Required for Certain SSA-Mitigated Entities
Among its various responsibilities, the Defense Counterintelligence and Security Agency (DCSA) oversees contractors that require access to classified or other sensitive information to support national security-related activities. For cleared contractors that are subject to foreign ownership, control, or influence (FOCI), DCSA implements mitigation mechanisms in accordance with the National Industrial Security Program Operating Manual (NISPOM). The choice of mitigation mechanism under NISPOM depends on the degree of FOCI over the contractor and the sensitivity of the information to which the contractor requires access.
If a non-U.S. investor is effectively acquiring control of a contractor with access to “proscribed information” (including Top Secret and other particularly sensitive information categories), the mitigation options available to DCSA are either a proxy agreement, voting trust, or special security agreement (SSA). Under either a proxy agreement or voting trust, which are structured differently but have the same practical effect, independent, DCSA-approved, and cleared U.S. citizens effectively hold all of the ownership rights of the investor and manage the business on its behalf. Under an SSA, an investor can have board representation and participate in management of the business on matters not involving access to classified or other proscribed information.
Since most investors would prefer to participate in the management of a business they just bought, the SSA would seem to be the preferred FOCI mitigation option, but this was not always the case: A contractor subject to SSA mitigation also required the government to issue a National Interest Determination (NID) before the contractor could participate in new programs or contracts requiring access to proscribed information. The preparation of NIDs is coordinated by DCSA with other U.S. government agencies with security responsibilities; because the interagency process could take months, the NID requirement was viewed as competitively disadvantageous for SSA-mitigated entities. Contractors mitigated under a proxy agreement or voting trust, however, did not require NIDs because the proxies or trustees fully insulated the contractors from FOCI.
Pursuant to section 842 of the FY2019 National Defense Authorization Act, however, NIDs are no longer required as of October 1, 2020, for SSA-mitigated contractors whose foreign parents are from Australia, Canada, or the United Kingdom (the same countries currently designated as “excepted countries” for CFIUS purposes). This is an important development for investors from these countries in U.S. contractors; although the investors must still qualify for FOCI mitigation using an SSA, qualified investors will have greater involvement in management and insight into operations and performance without also limiting the contractors’ involvement in projects requiring access to proscribed information.