Using Carve-Outs to Limit CFIUS Exposure*
Carve-outs are used to facilitate transactions in a variety of regulatory and commercial contexts. When it comes to carve-outs undertaken in the context of the Committee on Foreign Investment in the United States (CFIUS), the term “carve-out” can have two meanings, depending on whether — with apologies to William Shakespeare — the carve-out is achieved by the parties or is thrust upon them by CFIUS.
The latter situation comes up in the context of CFIUS mitigation, when a particular asset or subsidiary is separated from the target business so CFIUS can place conditions on, or perhaps seek to block, foreign ownership of that business. The ongoing CFIUS case concerning the U.S. business of TikTok is a fairly recent example. Another widely reported example from a few years back is CFIUS’s carve-out of the Hotel del Coronado from the 2016 acquisition by Anbang Insurance from Blackstone of a 16-property hotel portfolio. Once the Hotel del Coronado was carved out of the deal, Anbang was permitted to acquire the other 15 properties.
Today, and perhaps more frequently, “carve-out” has also come to mean a precautionary approach to foreign investment and other regulatory reviews. In this context, a carve-out involves the exclusion of certain subsidiaries, assets, and operations from the scope of a transaction in order to avoid local regulatory reviews that could adversely affect deal certainty, timing, and/or conditions. For CFIUS purposes, the point of a carve-out is to exclude anything that could qualify the target as a “U.S. business,” since CFIUS jurisdiction is limited to certain foreign investments in U.S. businesses.
Perhaps the most public example of a carve-out was the 2017 acquisition by Canyon Bridge Capital, a private equity fund backed by Chinese government funds, of Imagination Technologies, a UK-based developer of computer processors. Earlier in 2017, President Trump, on the advice of CFIUS, had blocked Canyon Bridge’s proposed acquisition of Lattice Semiconductor. To avoid a similar outcome with the acquisition of Imagination, the target separated its U.S. subsidiary MIPS and sold it to a U.S.-based venture capital fund. As a result, CFIUS no longer had jurisdiction over the Canyon Bridge-Imagination transaction.
More recently, CFIUS reviewed and subsequently threatened to seek a Presidential order blocking the proposed merger of Magnachip Semiconductor Corporation — a U.S.-listed Delaware corporation with its effective headquarters and all of its manufacturing facilities in South Korea — with an affiliate of China-based Wise Road Capital. As discussed in more detail in our post of 14 September, we do not know whether Magnachip had actually tried to effect a precautionary carve-out, but Magnachip had recently closed its California facility used for administration, sales, and R&D functions, and said it had no employees, tangible assets or IT systems located in the United States at the time the transaction was signed.
Because the vast majority of CFIUS cases (other than some internal reorganizations) involve both a buyer and seller of interests in a U.S. business, the motivations for avoiding CFIUS review may be different for each party. Buyers may be concerned with whether CFIUS will let them generate the desired strategic and financial synergies from a transaction. Sellers, on the other hand, are often concerned with removing any regulatory hurdles that could interfere with closing, though they may also be conflicted about the use of a carve-out to do so. A carve-out will usually reduce the consideration to be received by the seller, unless the U.S. portion of the business contributes little to its overall value or an alternative buyer with better CFIUS prospects can be found.
Are carve-outs legal?
The CFIUS regulations explicitly allow CFIUS to assert jurisdiction over any transaction or arrangement “the structure of which is designed or intended to evade or circumvent the application” of the law governing CFIUS. The key word here is “evade,” because it brings to mind the difference under U.S. tax law between tax “evasion” and tax “avoidance.” In the CFIUS context, “evasion” and “circumvention” are more likely interpreted as the intent of the parties to transfer the substance of the U.S. business to a foreign investor while disguising the form of the transaction so it appears to be outside CFIUS’s jurisdiction. On the other hand, “avoidance” is the restructuring of a transaction so that it either does not involve a U.S. business or so that the rights the foreign person will gain with respect to the U.S. business will not reach the threshold for CFIUS jurisdiction.
As an example of evasion and circumvention, the CFIUS regulations describe the use of a U.S. intermediary, using funds provided by an undisclosed foreign party, to acquire interests in a U.S. business on behalf of the foreign party. A more subtle form of evasion not described in the regulations is when various formal and informal arrangements regarding U.S. facilities, assets, and personnel give a foreign party the benefits of owning a U.S. business. If CFIUS has a substantive interest in a transaction, it is likely to look through the form of these transactions and assert jurisdiction, taking the separate transactions together as a foreign acquisition of a U.S. business.
Are carve-outs effective?
Carve-outs are often inherently difficult for multinational companies that have centralized certain functions in specific countries. In those situations, it is harder to peel apart the different functions along national lines while retaining value in the other countries.
Even when the target business can be separated cleanly by country, it is getting harder for investors in multinational companies to focus on assets in countries that lack robust foreign investment review processes. This is especially true for targets located in OECD countries, because more and more of those nations have initiated or strengthened their foreign investment regimes either to protect against opportunistic foreign acquisitions of local businesses with pandemic-depressed valuations or for broader national security or national interest purposes.
What are the keys to successful carve-outs?
Parties should first consider what they hope to gain from the transaction. Some of those goals may not be achievable if the parties execute an effective carve-out at the cost of valuable synergies. Parties also need a realistic game plan for dealing with the carved-out U.S. business, with a clear understanding of whether it will be retained by the seller, sold to a third party, or wound down.
Most problems with carve-outs arise from situations when the parties want to “have their cake and eat it too.” The acquirer may start by saying it has no interest in the U.S. business, but then decide that it wants to keep certain U.S. personnel, assets, or contracts. There is a lot of grey area here - but if CFIUS wants to look at a transaction, every instance in which the hard line between the U.S. business and other countries is blurred gives CFIUS another potential jurisdictional hook.