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CFIUS to take closer look at foreign ownership

Judith Alison Lee said other countries that don’t have the same restrictions might draw more investment at the expense of U.S. interests.

Some fear pilot program might dampen appetite for investment in U.S.

The Committee on Foreign Investment in the United States is in the early stages of an 18-month pilot program of broader jurisdiction to review foreign investment in U.S. businesses that could present national security risks.

But while sources say the heightened scrutiny is warranted, some fear an expanded CFIUS could hurt foreign investment in the U.S.

"A lot of foreign investors are going to look to put their money elsewhere than the United States because of this," said Richard L. Matheny, a partner and head of global trade at Goodwin Procter LLP in Washington. "I know that that's happening."

As of mid-December, there were 265 private equity deals backed by foreign investors in the U.S. in 2018, reaching a total of $81.6 billion, according to data from London-based alternative investment research firm Preqin. That's up from 253 such deals and $68.3 billion in 2017. Over the last decade, the peak year in terms of dollars for foreign investor-backed private equity deals was 2015 when 231 deals were completed for a total of $122.5 billion.

Judith Alison Lee, a Washington-based partner and co-chair of the Gibson Dunn's international trade practice group, said it's too early to know if foreign investment will fall, but it's possible.

"If people think it's too onerous and it's too expensive and risky to make a U.S. investment, there are other countries around the world that don't have the same types of requirements," she said.

The pilot program's impact on foreign investment will likely become more clear in the first half of 2019, Ms. Lee said.

The Foreign Investment Risk Review Modernization Act of 2018 garnered bipartisan support in Congress and was signed into law in August. Prior to the foreign investment legislation, CFIUS could only review transactions that would result in a foreign person exercising "control" over a U.S. business. While the bar for "control" was low, Mr. Matheny said foreign investments that would not exceed roughly 15% of the voting interest in a U.S. business and conferred no board representation or other special rights were usually considered outside of CFIUS' jurisdiction, irrespective of the nature of the U.S. business.

Following the foreign investment legislation, a pilot program launched on Nov. 10 that grants CFIUS the ability to review certain non-control foreign investments in U.S. businesses that both engage with certain "critical technologies" and operate in or develop products for one or more of 27 specifically identified U.S. industries.

The reason for the legislation was chiefly China, Ms. Lee said. "The main impetus was the aggressiveness of the Chinese companies in their investments in the U.S.," she said. "Congress was worried that these (transactions) were not being adequately reviewed for national security implications."

Admonishing China

Government agencies and officials, including President Donald Trump, have admonished Chinese companies for stealing the intellectual property of U.S. companies and the personal information of U.S. citizens.

CFIUS is an interagency committee chaired by the Treasury secretary and includes representatives from 16 U.S. departments and agencies, including Defense, State, Commerce and Homeland Security. Its current policy chair, Heath P. Tarbert, will soon be nominated by the White House to lead the Commodity Futures Trading Commission.

Under the pilot program, if the foreign investor does not control the company, cannot appoint a board seat, has no hand in the company's decision-making, and has no access to non-public technical information about the U.S. business' "critical technology," not including financial information about the company's performance, the investment will not face additional CFIUS scrutiny.

Parties are required to notify CFIUS of all transactions that fall within the pilot program's scope. If a required declaration is not filed, CFIUS could assess a fine against the parties up to the amount of the value of the transaction itself, he added.

"Nobody wants to delay their investment in U.S. business to go through some regulatory proceeding that's going to take time and introduces uncertainty to the investment," Mr. Matheny said.

When asked how private equity investors have reacted to an expanded CFIUS, Mr. Matheny said: "It's like the seven stages of grief. A lot of setting their hair on fire, angst, confusion, concern."

U.S.-based incentive

Investors want to legally avoid CFIUS, if possible, Ms. Lee said. Legal fees mount quickly and a new filing fee will be implemented in the future under FIRRMA. Bringing uncertainty to the process, the committee will decide if a given transaction can go through or if some sort of mitigation is needed. "If they can avoid CFIUS, everyone wants to avoid CFIUS," Ms. Lee said.

With the passage of FIRRMA, there's great motivation to have an investment fund treated as a U.S. fund, which would not be subject to CFIUS review. Those funds can have foreign limited partners, but require a U.S. general partner or investment manager making all the decisions, Ms. Lee noted.

"The incentives are massive to be treated as a U.S. fund," Ms. Lee said. "So foreign investors in these private equity funds ... they're going to have to live with less control over the fund, less access to information and less access proprietary data. If they can live with that then it's going to make life a lot easier for the fund itself."

Ms. Lee expects to see a big uptick in funds with foreign LPs that set up shop in the U.S.

Jason Mulvihill, general counsel for the American Investment Council, a Washington advocacy group for the private equity industry, said there are several areas in the pilot program where additional clarification would be helpful, like the definition of "foreign entity" and "U.S. business."

In crafting the legislation, lawmakers were clear they did not want to meddle with traditional passive foreign investment into U.S.-controlled PE funds, Mr. Mulvihill said. "Instead, CFIUS was going to try and focus on other areas that were important to national security and we appreciate that," he said.

The pilot program is likely to run through early 2020, by which time CFIUS will issue final regulations based on the foreign investment legislation.

No problems for some

Chris Hayes, director of industry affairs for the Institutional Limited Partners Association in Washington, which represents more than 500 institutions worldwide with a collective $2 trillion in private equity assets, said the pilot program won't affect foreign limited partners investing in the U.S. through a fund vehicle, as long as the LPs aren't getting access to material non-public technical information.

On the other hand, Jeff Farrah, general counsel of the National Venture Capital Association, Washington, said in a blog post that the pilot program's impact is likely to be considerable on venture capital firms and implored VCs to evaluate the type of information they share with foreign LPs.

"The most common tripping point is likely to be whether any information you share is 'material non-public technical information,' " he wrote.