Chinese investment in the United States is an important source of funds, and an attractive exit alternative, for many U.S. businesses. Under the Obama Administration, more than 90 percent of U.S.-China deals were clearing CFIUS. Since the Trump Administration took office, the clearance rate has fallen to under 60 percent. CFIUS does not make full data available, but our dataset is available here.
Whatever the precise clearance rate may be, there is no doubt investment from China faces significant new hurdles under the Trump regime. Legislation passed by Congress in August 2018, the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), will impose even harsher restrictions on certain types of investments, from certain countries, in certain technologies. FIRRMA will not be fully effective until comprehensive regulations are issued, potentially in 2019 and no later than February 2020, but a pilot program that goes effective in November this year gives a hint of difficulties to come.
Still, business must go on. The United States and China are the two largest single economies in the world. California alone is the world’s fifth largest economy. Suppressing trade between these economies for any length of time, in today’s globalized economy, simply is not possible. Companies will find a way, as they always do, to advance their business objectives within whatever constraints are imposed by those in political power—not by evading new restrictions, but by finding a way to get business done without tripping over the rules.
This paper will summarize some of the techniques increasingly being used to comply with U.S. restrictions on foreign investment while at the same time advancing the business objectives of the parties. The discussion below is necessarily general, and counsel should be consulted in all cases before implementing any business arrangement.
CFIUS Clearance Is Still Possible
U.S.-China deals can still be cleared through CFIUS. Statistically, more than half of China deals have cleared CFIUS even under the Trump Administration. The clearance rate is higher still if deals that really stood little chance of succeeding are left out of the calculation—in other words, the clearance rate is still good for deals that are not obviously non-starters, where the parties are transparent and willing to work with the regulators.
Several recent successful deals make this clear. In May 2018, CFIUS cleared a Chinese investment in Origene Technologies, a pharma company. In June, CFIUS cleared the acquisition by China Oceanwide Holdings Group of Genworth, despite concerns about Chinese access to sensitive personal financial and other information held by the U.S. target; the solution was to segregate sensitive data and agree to protections against leakage. In July, CFIUS cleared the acquisition of Orient Overseas International, even though the target assets included part of the Port of Long Beach, clearly a national security-sensitive location. There, the solution again involved “third party mitigation,” separating the Chinese buyer from control over the sensitive asset(s) or information while still allowing the commercial deal to proceed. In November, CFIUS cleared a very large investment by Harbin Pharmaceuticals in the U.S. public company GNC Inc. During that same period, five deals failed but two of them were by HNA Group, which recently has been negatively received by CFIUS because of concerns over the Chinese party’s transparency. The lesson from the last six months: the right deals, handled the right way, are still clearing.
Additionally, it is still a reasonable business decision, in appropriate circumstances, to not make a voluntary filing with CFIUS. The new pilot program under FIRRMA (see our blog post here) makes filings mandatory for certain investments, in certain listed sectors, where critical technology is involved. But there are many sectors of the U.S. economy where Chinese investment is still welcome that do not raise obvious national security concerns, and in those cases, parties can reasonably decide to forgo a voluntary filing.
Safe Harbor is Still Available in Most Cases
There is still a safe harbor for equity investments of less than 10 percent, as long as the investor receives only customary minority protections and does not have a board seat or observer rights. Subsequent investments are aggregated, and multiple investors who are, or might be thought to be acting in concert would also be aggregated. Many PRC investors still find safe harbor investments attractive, either for financial reasons or to support a strategic relationship with a U.S. party. From the U.S. companies’ point of view, assembling a group of independent foreign investors (that is, investors not connected with each other or from the same home country), each of whom would hold less than 10 percent and none of whom, individually or collectively, have a board seat or observer rights, can still permit access to PRC investment funds.
A CFIUS pilot program under FIRRMA cuts back on the safe harbor somewhat. The pilot program makes a filing mandatory even where the foreign person acquires less than a 10 percent stake, if the investor has access to material non-public information, receives a board seat or observer rights, or has some involvement in substantive decision-making. However, the pilot program applies only where the U.S. business is in one of the identified sectors and works with critical technology.
Debt is Do-able
CFIUS historically applied to acquisitions and other investments where the foreign person acquired a degree of “control” over a U.S. business. Admittedly, CFIUS takes a broad view of what constitutes “control.” With the new pilot program, control is not necessarily required, but there must still be some form of an equity investment.
But debt—and in some cases convertible debt—often does not carry the types of governance rights that trigger CFIUS jurisdiction. The recent use of debt by Orient Hontai Capital in a transaction with the U.S. technology company Applovin permitted the parties to close the deal even though they tried, repeatedly and unsuccessfully, to clear an equity investment through CFIUS.
Thus, an investor might make a convertible debt investment in a U.S. business, with conversion to equity only permitted upon clearance by CFIUS and any other regulators. The economics of the debt could mirror an equity investment, so that the investor would participate in a subsequent IPO or other exit to the same extent it would have if it held equity. Of course, the investor could not require control rights at the level of the U.S. business—but when coupled with a PRC joint venture or other commercial relationship, the overall business relationship could satisfy the business needs of the parties.
Foreign Joint Ventures
CFIUS applies to acquisitions or investments in U.S. businesses. CFIUS does not apply to a foreign person’s acquisition of an interest in—or even a degree of control over—a non-US business. In the right situations, this can be used to advance the business objectives of the parties without implicating U.S. foreign investment restrictions. See our paper on this topic here.
For example, a U.S. technology company might see China as a key part of its international expansion, and investment by a Chinese partner or financial sponsor as essential to that goal. The U.S. company could form a joint venture outside of the U.S. to focus on Chinese operations, or even more broadly on Asia or international operations, together with the foreign investor. As long as the relationship did not effectively give the foreign investor control over the U.S. business or unreasonable access to national security sensitive technology, the structure would not be subject to CFIUS review.
A recent transaction, for example, involved the formation of a joint venture in China together with a strategic PRC partner. The PRC party injected significant cash into the PRC joint venture and received significant control rights at that level. PRC and Asian operations were expected to become a large part of the combined operations of the U.S. company over time. The PRC investor also made a convertible debt investment at the U.S. parent level and received warrants, but no control rights. The parties made the reasonable business judgment that none of the transactions were “covered transactions” for CFIUS purposes.
Warrants and Options
It is a reasonable position to say CFIUS does not apply to conditional rights given to a foreign person. In other words, the issuance of warrants or options to acquire equity of a U.S. business, as long as they do not carry any control indicia and are not exercisable without CFIUS approval, should not be a covered transaction. This may not be a satisfactory permanent solution for a foreign investor, but it could permit the investor to acquire a position—perhaps a blocking position vis-à-vis other foreign suitors—and participate in an exit. This tool may be useful in a situation, for example, where the parties’ objective is to seek a listing or an exit after taking in a facilitating investment from a foreign person.
Licenses and Other Commercial Arrangements
At least for now, most technology licenses and other commercial arrangements are not captured by CFIUS. The parties should be careful that the commercial arrangement does not give the foreign party any control or influence over the U.S. business, and if there is sensitive technology involved, especially export-controlled technology, this may not be a viable approach. However, in many cases the parties’ desire to exploit international expansion opportunities, and to obtain financing for that expansion, can be satisfied by using licensing, joint development, marketing, or other commercial tie-ups, perhaps coupled with debt financing at the U.S. level or equity financing outside the U.S. and limited to the non-U.S. business.
CFIUS does not apply to greenfield investments—that is, investments in the United States that do not involve the acquisition of all or part of an existing U.S. business. This is the classic “build or buy” choice companies face all the time. A foreign investor does not have to clear CFIUS in order to establish a U.S. subsidiary, rent or buy space, hire a workforce, license in technology, establish market channels, and build a successful operation in North America. Of course, investors should not “tease the bear”—setting up a new factory next door to a national security facility, for example, might not be the wisest choice of locations.
US-Controlled VC and PE Funds
The Trump Administration cannot change the fact that capital is international, and there is a great deal of capital outside of the United States. Large amounts of sophisticated capital are available in China. The question is how to deploy it into the U.S.—and how to permit U.S. growth companies to access that capital.
A private equity or venture capital fund controlled by foreign parties is clearly a “foreign person” for CFIUS purposes. However, a fund which is controlled by U.S. persons (typically through a general partner entity itself owned and controlled by U.S. persons) is not a foreign person even if all the limited partners are foreign—as long as the LPs cannot control the fund. Again, control is broadly construed by CFIUS to mean more than just control over investment decisions, but other aspects of the fund as well, such as the ability to remove the general partner or determine compensation. Such a fund could deploy PRC money into U.S. investments, for example, without triggering CFIUS review. Of course, the better part of valor will be to avoid highly sensitive investments and to respect legitimate U.S. policy concerns about specific sources of funds.
Not every foreign investor and not every fund manager will find an arrangement like this workable. But a sophisticated foreign investor might be willing to invest through a fund managed by a long-time U.S. partner or a fund manager with a long-standing reputation. At a minimum it means that foreign capital should not give up on the U.S.; it only needs to find the right channel.
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The political environment in the United States is changing fast, not least in the area of foreign investment and international trade. But business is agile, and like the legendary King Canute, no party in power can forever hold back the tide of global investment. As long as the fundamental business imperative remains—and it can hardly disappear, between the first, second and fifth largest economies in the world—the companies that succeed will be the ones that find their way through the regulations and keep expanding.
For additional information, contact Tom Shoesmith, China Practice, at [email protected].