New CFIUS powers target foreign investors

Foreign investors in U.S. private equity, real estate and venture capital deals are facing new regulations that could impact the terms, timing and even viability of those investments.

Earlier this month, the Treasury Department unveiled new regulations for how the federal government reviews foreign investment in the U.S. The rules, which take effect Feb. 13, were mandated by the bipartisan Foreign Investment Risk Review Modernization Act of 2018 that expanded the ability of the interagency Committee on Foreign Investment in the United States, or CFIUS, to review transactions based on the degree of control of a foreign investor or government.

The primary focus of a CFIUS review will be transactions involving critical technology and infrastructure or operations that collect sensitive personal data on U.S. citizens and the degree of foreign control of those arrangements. Critical infrastructure sectors include telecommunications, utilities, energy and transportation.

But CFIUS officials, who represent several key agencies including the Department of Defense and Department of Commerce, also gained the authority to reject certain investments that are not passive but don't rise to the level of control, and to scrutinize real estate transactions near sensitive government facilities such as military sites.

"It is really a significant expansion. Now, even non-controlling interests may be subject to CFIUS review," said Jeremy Zucker, co-chair of Dechert LLP's international trade and government regulation practice in Washington. "Investors need to think carefully about CFIUS risk early in the process and perform a transaction-specific analysis," he said.

Representatives for investor groups and investment firms were relieved to see some changes and clarifications in the final rules that "go a long way to ensuring that the new regulations will not frustrate passive foreign investment in the U.S.," said Jason Mulvihill, chief operating officer and general counsel of the private equity advocacy group American Investment Council in Washington.

Since limited partners are typically passive investors, their investments would not fall under the new "covered investments" criteria for CFIUS review, unless critical technologies are involved or a foreign government acquires a substantial interest in them.

One of the biggest changes was exempting investors from Australia, Canada and the U.K. from mandatory disclosure to CFIUS, unless there is a question of possible foreign control of a U.S. business. That is a much shorter list than expected by many industry observers, who remain hopeful that more countries will be added in the future, particularly those that put comparable foreign investment screening processes in place.

"Having the initial exempted countries list included now, rather than later, provided some significant protection for Australian, Canadian and U.K. LPs invested in U.S. funds," said Chris Hayes, senior policy counsel at the Institutional Limited Partners Association, Washington.

Foreign investors seeking exempted investor status will also have to meet other criteria related to the degree of board and voting authority, ownership levels and other limits to how much control they can have over a particular transaction.

Another welcome change was an interim rule defining "principal place of business" that lets CFIUS officials focus on what they call the "nerve centers" of businesses seeking to invest in U.S. companies. That "extremely important" clarification will be helpful for private equity firms with funds established in foreign jurisdictions such as the Cayman Islands or Luxembourg. "It provides additional clarity that as long as you satisfy the requirements of the definition, your funds should not be foreign entities for CFIUS purposes," said Mr. Mulvihill.

One concern raised by the Institutional Limited Partners Association, which has roughly 40% of 530 members from outside the U.S., was whether the issue of a foreign investor's control could infringe on the ability of limited partners to serve on a fund's advisory committee. The final rules make clear that a foreign limited partner can participate on an advisory committee without triggering CFIUS review as long as the partner's rights and access to information and fund decision-makers are constrained, Mr. Hayes said. But definitions of "substantial interest" when it comes to voting control or a foreign government's role will be trickier, and "it is going to be more challenging with co-investments and direct investments. You have a higher percentage ownership so it is not included in the investment fund safe harbor. There is a limit to where the regulations can go," he added.

The direct investment side is likely to be affected the most, said Jeff Farrah, general counsel of the National Venture Capital Association in Washington. All limited partners "should get used to seeing new language and a possible change in relationships. … LPs are going to see more situations where (general partners) are going to use new and different terms … and it might mean they are not going to get access to some information" that could trigger a CFIUS filing, said Mr. Farrah.

The NVCA is working on model language to help guide limited partners through the CFIUS changes when structuring deals.

One option foreign investors and their American fund managers have is to ask CFIUS for a safe harbor letter by filing a voluntary disclosure of investments that don't involve critical sectors and sizable foreign ownership. Seeking a safe harbor "allows parties to manage the transaction risk," said John Beahn, a partner with Shearman & Sterling LLP in Washington who advises foreign investors on CFIUS. "The big question for the voluntary filing is, how is CFIUS going to review it, especially when it comes to parsing the level of a foreign investor's control. Now that they have this authority, how are they going to use it?"

Another option for foreign limited partners to consider is dialing back their level of control. "That's something we have been advising our clients for a while. FIRRMA was the culmination of many years of concerns being expressed," Mr. Zucker of Dechert said.

The safe-harbor route does not address concerns about timing, even with the promise of a 30-day response from CFIUS. Richard Matheny III, a partner in Goodwin Procter LLP's Washington office who advises many investment clients focused on technology and life sciences, said that particularly for investors in startup companies, "it's hard for them to accept the time delay and uncertainty created by the CFIUS process. A lot of them are going to have become comfortable accepting more risk."

Limited partners will have to make sure they understand who the other partners are and how the fund is structured, said Jeremy Swan, managing principal of CohnReznick LLP and leader of its M&A practice.

"It's more work for everybody. The seller really needs to understand the buyer and the buyer in the form of the private equity firm needs to really understand the other owners, the LP base and potential co-investors. It's another checklist that needs to be added to that diligence list. I still don't think there is enough awareness of this across the private equity and LP base to really understand what this entails," Mr. Swan said.

Still to come are details on the filing fees that CFIUS is authorized to charge to review a notified transaction, up to 1% of the value or $300,000, whichever is less.

There is also the question of whether CFIUS officials have enough bandwidth to handle their expanded jurisdiction without frustrating foreign investors. As the Canada Pension Plan Investment Board, Toronto, noted in an October letter to a top Treasury official, CFIUS review had already ramped up, with five CPPIB investments reviewed in the past year alone and a total of 16 since 2008, none of which were deemed national security risks. With 31.6% of C$409.5 billion ($313.7 billion) invested in the U.S. as of June 2019, "CPPIB hopes that its investments in the U.S. can continue to grow," it said.

Legal experts credit CFIUS officials for trying to make the final rules as workable as possible, and striking a balance between a national security mandate and foreign investment. Still, said Mr. Zucker, "any time the rules take hundreds of pages to explain, some frustrations will remain."