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Foreign Investors In the USA Under Suspicion

10/24/2007 | Handelsblatt
More political control for more national security

The USA heightens the scrutiny for foreign investments and thereby accelerates the dangerous race for a new protectionism

The United States Congress wants more control over foreign direct investments that could threaten national security. It is not big news that politics play a role in the regulation and surveillance of foreign investments, but the extent to which the Foreign Investment and National Security Act of 2007 (hereinafter FINSA) that came into force as of October 24, 2007, heightens the scrutiny is more than noteworthy. A short look into the development of investment control makes it more obvious.

I. A brief history of foreign investment control in the USA
Despite the traditional openness of the US to foreign investments, there is at the same time a history of governmental surveillance. Already during World War I for instance, foreigners were forbidden to hold shares in civil airlines, shipping companies and radio stations. Even today, a foreigner or foreign entity may not hold ownership of 25 % or more of a US-airline. The democratic majority in Congress rejected a Republican bill to change this law.
  1. Foundation of the Committee on Foreign Investment in the US (hereinafter CFIUS) in 1975
    In 1975, President Ford created CFIUS through an Executive Order. The purpose was to monitor the economic consequences of foreign investments in the USA. CFIUS's foundation arose out of worries about increasing politically motivated investments by the Organization of the Petroleum Exporting Countries in the USA. Simultaneously,  the sale of the Rockefeller Center to Japanese investors symbolized the economic threat by Japan. The following years saw an increasing unhappiness about CFIUS's mandate. It was unclear whether it had to focus on political or economic effects of investments. In addition, Congress complained about a lack of transparency and governmental control because the leading finance department kept all information secret.
  2. The Exon-Florio Provision of 1988
    Before Exon-Florio, the law only limited foreign investments in the areas of aviation, navy, banking, natural resources and energy. Exon-Florio was the consequence of growing concerns about increasing foreign investments. Most especially, the proposed sale of Fairchild Semiconductor Co. by Schlumberger Ltd. to the Japanese Fujitsu Corporation caused a big stir. The Department of Defense was afraid of Japanese control over an important supplier of military computer chips. Public pressure finally made the deal impossible despite then-President Ronald  Reagan's approval. In the aftermath, there was a hope to achieve a balance between the traditional openness for foreign investments and the longing for more state surveillance and presidential discretion in national security questions.

    In 1988, the Exon-Florio Provision was added to the Defense Production Act of 1950. It provided for the reconstruction of CFIUS as an independent Committee composed of 12 agencies, led by the US Department of the Treasury. It granted to the President the authority to prohibit or reverse any foreign acquisition, merger or takeover that was considered a threat to national security. The provision was meant to be a default rule for cases in which other laws protecting national security proved insufficient. CFIUS was delegated the authority to review, scrutinize and give a recommendation to the President.
  3. The Byrd Amendment of 1993: Heightened Scrutiny for governmental investors
    The Byrd Amendment obligated CFIUS to investigate all transactions in which the acquirer is controlled by or acting on behalf of a foreign government, and that result in control of a person engaged in interstate commerce that could affect the national security of the United States. Once again, the Amendment turned out to be problematic because of an unclear mandate. While CFIUS saw itself obligated only to do 30-day reviews and further 45-day investigations in its sole discretion, Congress regarded CFIUS as obligated to undertake 45-day investigation in all cases that involve government-controlled investors. FINSA finally resolved the dispute in favor of Congress.
  4. American ports in Arab hands unbearable: Congress calls for a reform of CFIUS
    After a relatively quiet period for CFIUS, the number of voluntary applications for approval of foreign investments increased significantly after September 11, 2001. Investors worried about a supposedly more restrictive attitude of the US government. Hardly anyone was willing to go through with a transaction without CFIUS's prior approval. The risk of a subsequent investigation that might lead to a reversal of the transaction and the stigma of being declared a national security risk seemed too high after 9/11. While the President, in fact, denied extremely few transactions, more and more transactions were aborted due to negative press and public pressure. In addition, the number of Mitigation Agreements rose. These obstructed, for example, governmental electronic surveillance on the investor or prohibited their access to critical technologies, all for the sake of mitigating national security risks.

    Simultaneously, Congress complained about its lacking control, too many transactions going through without an investigation and too many aborted investigations.

A paradigm example was China National Offshore Oil Corporation's (CNOOC) effort to take over the Californian oil company Unocal. CNOOC's offer was much higher than the competitors' and CFIUS did not investigate, but still CNOOC had to abort the transaction when Republicans and Democrats unanimously opposed the deal in Congress because of national security concerns. After the Chinese retracted from the deal, the American Energy-Giant Chevron won the bidding contest with a much lower offer.

An even bigger Congressional uproar followed the takeover of Peninsular & Oriental Steam Navigation Company (P&O), whose subsidiary controlled operations in several US ports, by DP World, a firm owned by the Emirate of Dubai. The deal was closed after a mere 30-day review by CFIUS. Despite security issues, P&O avoided a further 45-day investigation with a simple reassurance letter. Congress' patience was at an end.  It considered ports such critical gates where goods, as well as people, could be smuggled in, that they could not be left in foreign control and especially not to Arabs without a more thorough investigation.  Since Congress had no power to reverse the deal, it enacted a law that made its practical implementation impossible and demanded more Congressional control over CFIUS. DP World had to sell its shares to an American competitor.  The affair thus started the reform process leading up to FINSA.

II. Amendments to CFIUS legal basis, leadership and structure through FINSA
CFIUS is no longer based on an Executive Order, but on the Defense Production Act amended by Exon-Florio and FINSA.

The chair is still the Treasury Department, which has to designate a lead agency for every review. In addition to the Secretaries of Homeland Security, Commerce, Defense, State and the Attorney General, who remain members, FINSA appoints the Secretaries of Energy and Labor (ex-officio) and the Director of National Intelligence (ex-officio) as new members. Further, the President can still appoint the heads of any other executive department, agency or office for a transaction review. Similarly, the chair of the lead agency can consult any other agency.

III. Report to CFIUS generally still voluntary, review process similar after FINSA
Usually, an initial 30-day review is triggered when both parties voluntarily report a proposed transaction and in most cases, it ends with a binding governmental approval of the transaction. If CFIUS determines that there are security risks that cannot be eliminated through a Mitigation Agreement, a 45-day investigation follows. Thereafter, CFIUS gives a non-binding recommendation to the President, who decides within 15 days whether to approve of the transaction. The Attorney General is responsible for the judicial implementation of the decision. The parties have no right to a judicial review and cannot withdraw their application once the process begins. Since FINSA, the 45-day investigation is mandatory for all cases with governmental involvement and highly recommended if critical infrastructures are at issue.

IV. New Factors to be considered by CFIUS
The reform adds seven factors to the currently existing five factors. CFIUS has to consider:

(1) whether the transaction has a security-related impact on critical infrastructure in the United States;
(2) the potential effects on United States critical infrastructure, including major energy assets;
(3) the potential effects on United States critical technologies;
(4) whether the transaction is a foreign government-controlled transaction;
(5) in those cases involving a government-controlled transaction, a review of (A) the adherence of the foreign country to nonproliferation control regimes, (B) the foreign country's record on cooperating in counter-terrorism efforts, (C) the potential for trans-shipment or diversion of technologies with military applications;
(6) the long-term projection of the United States requirements for sources of energy and other critical resources and materials; and
(7) other factors as the President or the Committee determine to be appropriate.

V. The five old factors to be considered by CFIUS remain
CFIUS still has to consider:

(1) domestic production needed for projected national defense requirements;
(2) the capability and capacity of domestic industries to meet national defense requirements, including the availability of human resources, products, technology, materials, and other supplies and services;
(3) the control of domestic industries and commercial activity by foreign citizens as it affects the capability and capacity of the U.S. to meet the requirements of national security;
(4) the potential effects of the transactions on the sales of military goods, equipment, or technology to a country that supports terrorism or proliferates missile technology or chemical and biological weapons; and
(5) the potential effects of the transaction on U.S. technological leadership in areas affecting U.S. national security.

VI. Mitigation Agreements
Mitigation agreements are used to make a transaction approvable by reducing the threat to national security. They contain obligations like the imposition of independent board members or the condition that the production remains in the United States. Before FINSA, they had no statutory basis.   Now there are clear procedures. CFIUS is required to designate a lead agency that must provide a risk-based analysis before negotiating, imposing and enforcing an agreement. If a party breaches the agreement, the process can be reopened. In addition, if a notification of a transaction is withdrawn before CFIUS can complete any review or investigation, the measure grants the Committee the authority to take a number of actions. In particular, the Committee could develop (1) interim protections to address specific concerns about the transaction pending a resubmission of a notice by the parties; (2) specific time frames for re-submitting the notice; and (3) a process for tracking any actions taken by any party to the transaction.

VII. New reporting requirements
FINSA requires CFIUS to report annually to Congress on any reviews or investigations that it conducts. Each report must include information on the nature of the business activities of the parties involved in a transaction, on the status of the procedure, and on any withdrawal from the process, roll call votes by the Committee, extension of time for any investigation, and any presidential decision or action taken under the Exon-Florio provision. The report also must include information on the countries from which the investments originated, on the status of the investments of companies that withdrew notices and the types of security arrangements and conditions CFIUS used to mitigate national security concerns, as well as a detailed discussion of all perceived adverse effects of investment transactions on the national security or critical infrastructure of the United States. Relative to critical technologies, CFIUS must evaluate any credible evidence of a coordinated strategy by one or more countries or companies to acquire U.S. companies involved in research, development, or production of critical technologies in which the United States is a leading producer. Further, it must produce an evaluation of possible industrial espionage activities by foreign governments against private U.S. companies.

In addition, the Secretaries of the Treasury, State and Commerce must conduct a study on investment in critical infrastructure and industries affecting national security by: (1) foreign governments, entities controlled by or acting on behalf of a foreign government, or entities of foreign countries which comply with any boycott of Israel; (2) foreign governments, entities controlled by or acting on behalf of a foreign government, or entities of foreign countries which do not ban organizations designated by the Secretary of State as foreign terrorist organizations.

During every 30-day review, the Director of National Intelligence is obligated to prepare a report on national security risks.

Finally, FINSA requires the Inspector General of the Department of the Treasury to investigate any failure of CFIUS to comply with requirements for reporting that were imposed prior to the passage of this measure and to report the findings of this report to the Congress. It also limits the President's authorities to delegate decisions lower than to Deputy Secretary level.

VIII. Unofficial preparatory negotiations are common practice
Unofficial preparatory negotiations with CFIUS prior to an official application have become a common practice for two reasons. First, to avoid negative publicity, and second, to allow CFIUS more than 30 days for its review process.

According to an unspecified source, CFIUS has received more than 1,500 notifications since 1988, but conducted a full investigation only in 25 of these cases. In 13 of these 25 cases, a party withdrew the transaction upon notice that CFIUS would conduct a full review. The President prohibited only one of the twelve remaining cases. Since 1990, nearly half of the transactions CFIUS investigated were terminated by the firms involved, because the firms decided to withdraw from the transaction rather than face a negative determination by CFIUS.

History shows that the mere news about a CFIUS investigation can cause the parties' stock to crash. This happened to the US firm in 2000 Verico, Inc. after the attempted acquisition by NTT Communications from Japan, which CFIUS investigated. Its stock fell despite CFIUS's recommendation to then- U.S. President Clinton to approve the transaction.

IX. FINSA's Consequences
  1. More industrial branches affected
    Transactions in more industrial branches will be subject to a review because of the new, very broadly defined terms infrastructure, technology and energy. So far, CFIUS has scrutinized only ten percent of foreign investments and, according to Robert M. Kimmit, Deputy Secretary of the Treasury, approved the vast majority. In the future, the notification of CFIUS might become a standard procedure for most foreign investments. In cases where the parties are uncertain whether their planned transaction falls under one of the categories, they may want to use a voluntary notice in order to get certainty and avoid unpleasant subsequent questioning about national security. Hopefully, the new guidelines that CFIUS must issue by April 2008 will provide more clarity.
  2. Process more political
    The political aspect will have more impact on a transaction than the requirements, the time and the bureaucracy. The new reporting requirements and the higher level staffing of CFIUS increase the danger that every transaction will end in a political debate. In bidding situations, sellers might ask a premium from competitors with higher security risks. Losses on the stock exchange because of intimidated investors are still imaginable. The political watchdog will put pressure on CFIUS, which might in return increase the pressure on the parties to a transaction during its investigation in order to prove its diligence to Congress. The pressure will express itself in more questions, details, 45-day investigations and probably more and stricter mitigation agreements.

    The best way to deal with the new process will be early preparations and confidential negotiations with CFIUS and even with key members of Congress.   In other words, lobby work. Otherwise, what is left is the hope that the new stricter law will create more confidence in CFIUS and thus calm Congress down.
  3. Dubai Stock Exchange's investment in NASDAQ Stock Market: First test for new law
    The recently closed deal, in which Dubai stock exchange bought 19 percent of NASDAQ's shares, will be a first test for FINSA. President Bush already announced that the new law will be applied and the deal will be thoroughly scrutinized, though it was closed before FINSA came into force. Rumors have it that a lot of lobbyism took place in advance, which would explain the unexcited or positive echo of the deal.  New York City Mayor Michael  R. Bloomberg applauded it as "good news for New York and the nation", but warned, "Like all such deals, this one should undergo all the appropriate scrutiny, but I hope that that discussion does not devolve into the kinds of demagogic attacks that could cost Americans jobs and threaten New York's place as the financial capital of the world."  Congressman Barney Frank, Democrat of Massachusetts and chairperson of the Financial Service Committee, summarized the difference to the Dubai ports transaction on point.  "In the ports deal, the concern was smuggling something or someone dangerous into ports. What are we talking about here – smuggling someone onto a stock exchange?" The more critical New York State Senator Charles E. Schumer (Democrat) asked whether the Dubai Stock exchange is involved in the financing of terrorists and if it is prudent to give foreign governments an influence over a US stock exchange and therewith the potential to disturb the market. In his opinion, the US should be careful of investments made in critical infrastructure, financial exchanges, and utilities vital to the operation of the country. This is exactly the crucial issue that CFIUS has to solve in this transaction: Is a stock exchange a critical infrastructure under FINSA?
  4. Reactions abroad
    Other countries with no comparable protection against foreign investments fear falling behind on the issue. In Germany, for instance, Minister-President of Hesse Roland Koch is afraid that the new economic superpowers will "regard Germans as fools" and Chancellor Andrea Merkel is considering a European investment control mechanism and warns not to be naïve.

    The worries arise from state-owned funds that exist in China, Russia, some Gulf States and other nations that became rich through the sale of goods and natural resources. According to an estimate by Morgan Stanley, the new economic powers hold more than 2,500 billion US Dollars in funds ready to invest abroad. Often, the underlying incentive is the acquisition of know-how and patents. The protection strategies differ.  In France, the government protects its so-called "national champions" in eleven industry branches from foreign takeover. Spain limits the voting rights of investors in its energy companies to 3 percent.  Investments in China are almost exclusively possible in partnerships with Chinese firms. The partnership agreements usually provide for training of the Chinese employees and often result in a buy-out of the investor's technology.

    In countries like Germany, where so far only the defense industry is protected, the ideas vary from copying CFIUS or the French system to so-called "golden shares," that give the holder veto power over foreign investments, or so-called "white knights," which are national investment funds supported by the state that take over available shares in key industries to block foreign investors.  As everywhere, the primary concern is the balance between protecting national security on one hand, and a welcoming reputation for investors on the other. The latest draft for a new law in Germany grants the government the power to prohibit any foreign investment of more than 25 percent within four weeks of a voluntary notification of the transaction.  In case the government gets knowledge of a secret investment of 25 percent or more, it can reverse the transaction within three to twelve months (the exact period remains to be debated). Similar to the US law, the main criteria is national security. This is very vague, but different from the US, since a rejected investor shall be able to appeal a decision in court.


Original essay, "Investoren unter Generalverdacht: Die USA verscharfen ab morgen ihre Kontrolle von Auslandsinvestitionen und beschleunigen den gefahrlichen Wettlauf hin zue einem neuen Protektionismus," published in German in the October 23, 2007 issue of Handelsblatt.  English translation by Phillips Nizer LLP - Copyright 2007.  Reproduction in part or whole is strictly prohibited without the express written consent of Phillips Nizer LLP.  This information is provided as a public service to highlight matters of current interest and does not imply an attorney-client relationship.  It is not intended to constitute a full review of any subject matter, nor is it a substitute for obtaining specific legal advice from competent, independent counsel.