Outbound China M&A and investment – US

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From time to time, conditions come together to create the ‘Perfect Storm’. Meteorologists use this term rarely and as a benchmark to compare all subsequent weather events. The potential for outbound investment from China today points to a similar unprecedented event: a flood of investment opportunities in the US that could extend for the next several years.

When the following factors converge, they prove to be all-powerful indicators as to why Chinese companies have a unique opportunity to purchase US-based assets and companies today:

• M&A pricing multiples have retreated to far more reasonable levels than those from 2005 to mid-2008.

• Private equity competitors remain on the sidelines, hesitant to invest until the credit markets loosen.

• Numerous quality companies are overleveraged and excellent opportunities exist to obtain ownership control through recapitalisation transactions.

• The worldwide recession is finding its floor and domestic demand from China will provide a natural basis for future growth in key industries.

• The Chinese government has issued policies to encourage Chinese companies to acquire strategic assets abroad and the huge Chinese foreign currency reserve provides the war-chest for such acquisitions.

• The resurgence of the IPO market in Shanghai and Hong Kong provides a ready source of capital to consolidate and expand newly-acquired businesses.

Given the initiative to expand into the US by many Chinese companies, the following summarises some of the most important US pre-acquisition requirements of which buyers need to be aware. Understanding and appropriately addressing cross-border regulatory filings, including those related to antitrust and national security (CFIUS and export control), as well as conducting appropriate due diligence regarding bribery, money laundering, and intellectual property issues, is critical to successful dealmaking in the US.

Antitrust

Any outbound investment strategy into the US must account for US antitrust laws, including statutory filing requirements with the federal antitrust authorities for certain transactions. Generally, for transactions exceeding US$65.2 million, the parties must file notification with the antitrust agencies (the US Department of Justice and the Federal Trade Commission) under the Hart-Scott-Rodino Antitrust Act (HSR). A reportable transaction cannot close until the HSR filing is made and all applicable waiting periods have expired or have been terminated without government challenge. The purpose of the HSR notification is to enable the government to review the merger and to address any antitrust concerns before the merger closes. Nonetheless, most transactions are cleared by the antitrust authorities. It is worth noting that the agencies may, however, investigate non-reportable transactions if they believe the transaction raises competitive concerns. Ultimately, it is the federal courts that have the final word if the agencies choose to challenge any transaction.

Antitrust analysis in the US is highly developed under stated ‘Merger Guidelines’ developed by the federal antitrust authorities. The Merger Guidelines set forth specific analyses to gauge the competitive impact of a transaction on the marketplace. These analyses go beyond a brief exposition, but they normally require defining the market and determining the competitive effect on the market due to the transaction.

(i) The HSR filing and initial waiting period

In considering potential antitrust issues relating to any outbound investment, the first step the acquirer and target corporation should take is determining whether a filing will be required. If a transaction meets the filing thresholds under the HSR rules (and no exemptions apply), the parties should move promptly to gather the relevant information to be contained in the filing, as antitrust review can sometimes become the determining factor in the transaction timeline. The HSR notification form requires the parties to provide financial information, a description of the transaction, and certain documents that analyse the competitive aspects of the transaction.

The acquirer and target corporation can file the HSR notification as soon as they have a signed agreement or letter of intent. The HSR notification is confidential and its filing triggers an initial 30-day waiting period (15 days for a cash tender offer). During this period, the antitrust agencies will review the transaction to determine whether they have any substantive antitrust concerns. At the conclusion of the initial waiting period, the reviewing agency will either: (1) allow the waiting period to expire without action; or (2) issue a ‘Second Request’ for information. The parties can request early termination of the waiting period; however, they may not receive it.

(ii) The Second Request

Although infrequent, a Second Request is typically a very broad request for documents, data, and interrogatory responses. Issuance of a Second Request automatically extends the initial waiting period for an additional 30 days that begins after both parties have (or, in the case of an exchange offer, after the acquirer has) certified ‘substantial compliance’ with the Second Request. For cash tender offers, the issuance of a Second Request extends the initial waiting period for 10 days after substantial compliance. Each transaction is different, but the process can take several months to complete.

(iii) Concluding an investigation

At the end of the second 30-day waiting period, the government will either (1) take no action, allowing the waiting period to terminate; or (2) sue to block the deal, typically seeking a preliminary injunction from a federal district court. In some cases, to avoid a lengthy court battle, the acquirer and target corporation will agree to divest portions of the business or to limit certain forms of conduct pursuant to a consent decree.

Antitrust review can play a key role in any sizeable transaction and should be anticipated at the outset of any proposed transaction.

National security

Under the Exon-Florio Amendment – and as amended in 2007 by the Foreign Investment and National Security Act of 2007 (FINSA) – the US President is authorised to undertake an investigation to determine the effects on ‘national security’ of mergers, acquisitions and takeovers proposed by or with foreign persons that could result in ‘control’ of persons engaged in interstate commerce of the US (a so-called ‘Covered Transaction’). The Committee on Foreign Investment in the United States (CFIUS or Committee), chaired by the Department of the Treasury, is the US Government’s inter-agency committee tasked with the Exon-Florio/FINSA review process. Other permanent members of CFIUS include the US Attorney General and the Secretaries of Homeland Security, Commerce, Defense, State and Energy – and as non-voting members, the Secretary of Labor and the Director of National Intelligence.

Other Executive departments/agencies can be added on a case by case basis as the President deems appropriate – the President has thus far designated the US Trade Representative and the Director of the Office of Science and Technology. Others designated to ‘observe, and as appropriate, participate’ include the Director of the Office of Management and Budget, Chairman of the Council of Economic Advisors, Assistant to the President for National Security Affairs, Assistant to the President for Economic Policy and Assistant to the President for Homeland Security and Counterterrorism. Generally, one agency takes the lead on a CFIUS review.

In analysing any proposed transaction, questions arise as to whether the proposed deal is a Covered Transaction that is subject to review; if so, whether ‘control’ exists; and if ‘control’ is present, whether the transaction implicates the ‘national security of the US’. Under CFIUS’s regulations, the term ‘control’ means the ‘power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine, direct, or decide important matters affecting an entity’.

Where more than one foreign person has an ownership interest in an entity, the regulations state that ‘consideration will be given to factors such as whether the foreign persons are related or have formal or informal arrangements to act in concert, whether they are agencies or instrumentalities of the national or sub-national governments of a single foreign state, and whether a given foreign person and another person that has an ownership interest in the entity are both controlled by any of the national or sub-national governments of a single foreign state’.

The term ‘national security’ is not defined under the Exon-Florio Amendment or FINSA, other than to note that the term includes issues relating to homeland security. Instead, the law provides a list of 11 illustrative factors that must be taken into consideration in assessing whether the transaction poses national security risks:

1) The potential effects on domestic production needed for projected national defense requirements;

2) The potential effects on the capability of domestic industries to meet national defense requirements, including the availability of human resources, products, technology, materials, and other supplies and services;

3) The potential effects on the control of domestic industries and commercial activity as it affects the capability and capacity of the US to meet the requirements of national security;

4) The potential effects on sales of military goods, equipment, or technology to any country (A) identified by the Secretary of State as supporting terrorism, missile proliferation or chemical and biological weapons proliferation, or (B) identified by the Secretary of Defense as posing a potential regional military threat to the interests of the US, or (C) listed as supporting nuclear proliferation;

5) The potential effects on US international and technological leadership in areas affecting US national security;

6) The potential effects on US ‘critical infrastructure’, including major energy assets; FINSA defines ‘critical infrastructure’ as ‘systems and assets, whether physical or virtual, so vital to the US that the incapacity or destruction of such systems or assets would have a debilitating impact on national security’;

7) The potential national security effects on US ‘critical technologies’;

8) Whether the transaction involves control by a foreign government;

9) Whether the subject country adheres to nonproliferation controls, cooperates with the US in counter-terrorism efforts, and whether the transaction creates a potential for transshipment or diversion of technologies with military applications;

10) The long-term projection of US requirements for sources of energy and other critical resources and material; and

11) Other factors determined to be appropriate, generally or in connection with a specific review or investigation.

The CFIUS review process is entirely voluntary, although the Committee has the authority to compel a review if the parties to a transaction decide not to submit the deal for review. If a review is in order, CFIUS’s regulations set forth a detailed set of approximately 50 questions that must be answered, thereby forming the basis of the parties’ notice of the proposed foreign acquisition to CFIUS. The Committee has 30 days after receiving and accepting a notice of a proposed transaction to determine whether a full investigation is warranted. If it is not, a letter concluding review is issued to the parties to the transaction. Most transactions are concluded within the initial 30 day period. When CFIUS is unable to conclude its preliminary review during 30 days, a party may voluntarily withdraw and resubmit, thereby restarting the 30 day process.

If, during the initial review, CFIUS determines that: (1) the transaction threatens to impair US national security and the threat has not yet been mitigated; (2) the lead agency recommends an investigation and CFIUS concurs; (3) the transaction would result in foreign government control; or (4) the transaction would result in the control of any US critical infrastructure that could impair US national security and the threat has not yet been mitigated, then CFIUS must conduct and complete within 45 days an investigation of the transaction. Once the 45-day period expires, the transaction mandatorily goes to the President’s desk for final action within 15 days.

Subject to making certain ‘findings’, the President is authorised to take such action as he considers appropriate to suspend or prohibit any transaction. Or, in the case of a transaction that has already been consummated, order divestment of assets so as not to impair US national security. Notwithstanding this power, the President has rarely invoked this authority. Failure to notify CFIUS does not preclude future investigation and transactions that are not reviewed potentially remain permanently open to scrutiny.

FINSA greatly expanded the scope of the Exon-Florio process and, undoubtedly, the broad sweep of FINSA imposes new concerns on industries previously believed to be unaffected by the Exon-Florio process. Moreover, the Exon-Florio/FINSA process is increasingly politicised and businesses may expect more thorough CFIUS reviews, and greater scrutiny by Congress. More deals likely will be subject to CFIUS review due to a broadened concept of ‘national security’ to include homeland security and critical infrastructure. While it is the policy of the US to welcome foreign investment, foreign investors are well advised to carefully assess whether a filing is in order.

Bribery

One of the many consequences of the Watergate scandal in the early 1970s was the discovery of a widespread practice by US companies of bribing foreign government officials in return for their assistance in obtaining or retaining government business or obtaining other favourable government treatment. In a subsequent investigation, the SEC found that these payments – many of them made by issuers required to file audited financial statements – had been paid through ‘off-the-books’ accounts or were otherwise improperly recorded in the companies’ books and records. As a result of the SEC’s investigation – and a number of scandals involving US companies bribing officials of allied governments during the height of the Cold War – the US Congress enacted the Foreign Corrupt Practices Act (FCPA) in 1977, acting to restore the integrity of the American business system and to protect the national security of the US.

For many years, the US was the only country to implement and actively enforce measures to prohibit its citizens and businesses from bribing foreign officials. For over 20 years, no country followed the US lead in prohibiting foreign bribery. Finally, in the late 1990s, persistent US efforts paid off with the signing and subsequent ratification of a number of international agreements requiring signatories to enact laws similar to the FCPA. The most prominent and rigorous of these agreements was the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. In 1998, the FCPA was amended to more closely reflect the requirements of the OECD Convention, although the basic prohibitions of the FCPA remained largely the same.

The FCPA consists of four provisions – three prohibiting bribery and one requiring accurate books and records and internal controls – that apply only to ‘issuers’, whether US or foreign, i.e. those companies whose securities are traded on the US stock exchanges. Significantly, due to its origin as a proposal by the SEC, the FCPA provides for both civil and criminal enforcement. The SEC has the sole authority to bring a civil case against ‘issuers’, as well as their officers, directors, employees, and agents, and stockholders acting on the issuer’s behalf. For all other companies and individuals – foreign or domestic – the Department of Justice (DOJ) has authority to bring a civil enforcement action. Finally, as with any criminal statute, the DOJ has the sole authority to bring a criminal case, and it may do so against any entity or individual subject to the FCPA’s prohibitions.

Similar to the domestic bribery statute, the FCPA’s anti-bribery provisions prohibit direct or indirect payments of money or ‘anything of value’ to a foreign official in order to obtain or retain business. The basic elements of a violation of the anti-bribery provisions are as follows:

• To act corruptly;

• In furtherance of an offer, payment, promise to pay, or authorisation of the payment of any money, or offer, gift, promise to give, or authorisation of the giving of anything of value;

• To any foreign official, foreign political party, political party official or candidate for public office;

• For the purpose of influencing any act or decision in an official capacity; inducing an act or omission to act in violation of official duty; inducing the use of influence to affect an act of the government or an instrumentality of the government;

• In order to assist the payer in obtaining or retaining business for or with, or directing business to, any person or securing any improper advantage.

The anti-bribery provisions apply to ‘issuers’, ‘domestic concerns’, and foreign persons acting within the US. The term ‘issuer’ is defined as any company subject to the registration or reporting requirements of the Securities Exchange Act of 1934 as amended (the 1934 Act). Issuers may also be foreign companies, including a foreign company with American Depository Receipts (ADRs), which are registered pursuant to Section 12 or required to file reports under Section 15(d) of the 1934 Act. In general, publicly-held companies with securities or ADRs listed on securities exchanges in the US are issuers subject to the anti-bribery provisions. The FCPA further applies to all officers, directors, employees, or agents of an ‘issuer’, regardless of nationality.

A ‘domestic concern’ is any US person or business entity other than an ‘issuer’, including US citizens working for foreign concerns. The salient feature of the domestic concern is the nexus with the US. Under the definition of ‘domestic concern’, as adopted in 1977, a subsidiary corporation which was organised under the laws of the US, or a subsidiary corporation that had its principal place of business in the US, would be subject to the anti-bribery provisions of the FCPA. Domestic concerns employed or retained by foreign entities and foreign subsidiaries are also within the purview of the anti-bribery prohibitions. An individual’s or business entity’s status as a domestic concern does not change with location or with employment relationships.

The original 1977 statute explicitly excluded foreign corporations, including subsidiaries of US companies, from direct coverage unless they qualified as ‘issuers’ in their own right. Further, although the 1977 statute provided for criminal liability over all officers, directors, and stockholders acting on behalf of an issuer or a domestic concern, regardless of nationality, it appeared to limit liability over foreign employees and agents to civil liability alone. Although the DOJ seemed to share this view, it has recently embraced a different interpretation and, in criminal cases arising from an investigation of pre-1998 conduct, charged two foreign nationals with having acted as agents of domestic concerns. In 1998, Congress explicitly extended the scope of the FCPA to include ‘foreign persons’. In the amended statute, ‘foreign persons’ are defined to include companies or persons that do not otherwise qualify as issuers or domestic concerns, that do something in the US in furtherance of an unlawful payment to a foreign official.

The 1998 amendments also explicitly expanded criminal liability to foreign nationals who were employees and agents of issuers and domestic concerns. The DOJ has utilised this expanded scope and brought charges against foreign nationals who, it alleged, acted as agents of a domestic concern.

In summary, the DOJ and the SEC have a variety of statutory options at their disposal when it comes to charging foreign corporations who satisfy some form of jurisdictional requirement. They may be charged in a criminal case as a ‘foreign person’. If their securities are traded in the US through ADRs, the entity may be charged in either a civil case by the SEC or a criminal case by the DOJ as an ‘issuer’. Finally, the entity may also be charged as an ‘agent’ of either an issuer or a domestic concern.

Both the DOJ and the SEC have been very aggressive over the years in prosecuting those who violate the FCPA. Fines can be in the millions of dollars and companies may be forced to disgorge its ill gotten gains, lose US export privileges, and face debarment from US Government contracting. In addition, individuals may be subject to imprisonment. Foreign companies exploring investment opportunities in the US, those seeking to tap US capital markets by listing ADRs, and foreign nationals – among others – need to pay close attention to the FCPA, as well as the anti-bribery laws of the other nations in which they do business.

Money laundering

In response to the attacks on the US on September 11 2001, the US Government adopted the sweeping US Patriot Act (Patriot Act). Among other things, the Patriot Act was drafted with the specific intent to bolster the ability of government regulators to prevent and detect money laundering generally and more particularly with respect to the financing of terrorism. It was meant to strengthen, but not replace, laws already in force. This included the Bank Secrecy Act of 1970 and the Money Laundering Control Act of 1986.

Most notably, the Patriot Act significantly widened the anti-money laundering regulatory framework in the US by broadening the definition of ‘financial institutions’. The rules regulating ‘financial institutions’ now encompass: US depository institutions (all banks, trust companies and thrift institutions); US agencies and branches of foreign banks; private banks; investment banks; brokers and dealers in securities and commodities; futures commission merchants; commodity trading advisers; registered commodity pool operators and mutual and offshore funds; investment companies (irrespective of the requirement to register under the Investment Company Act of 1940); insurance companies; loan and finance companies; credit unions; credit card issuers and operators; issuers and redeemers of travelers’ checks; money orders or similar instruments; as well as individuals involved in real estate closings or settlements, among others.

The Patriot Act requires ‘financial institutions’ to institute minimum standards for the verification of the identity and legitimacy of clients. It also requires enhanced due diligence on certain accounts involving foreign persons, expands requirements for private banks and correspondent accounts, requires brokers, dealers and investment advisers to report suspicious activities, prohibits correspondent accounts for shell banks, and regulates the use of so-called ‘concentration accounts’. The Patriot Act requires institutions to designate a compliance officer, conduct ongoing employee training and ensure a viable independent audit function. In addition, it creates new violations that could trigger the application of money laundering laws, compels the production of documents located outside the US and expands asset forfeiture provisions.

As to account due diligence, financial institutions must now, among other things, verify customers’ names against government issued lists of known or suspected terrorists or terrorist organisations. This can be done quite easily online. Further, the Patriot Act requires that financial institutions establish due diligence policies and controls on foreign private banking and correspondent accounts. To deter abuse of such accounts, due diligence measures must include verification of whether the customer is a senior foreign politician, as well as the source of funds deposited into such account and the account’s purpose. Financial institutions must also review the activity in a private banking account to ensure that transactions align with the information obtained about the client. The financial institution is required to file a ‘suspicious activity report’ with the US Government when it suspects money laundering. Finally, where a senior foreign political figure is the nominal or beneficial owner of a private banking account, there must be enhanced review of the account and reports must be made of transactions that may involve the proceeds of foreign corruption.

Congress has also passed other laws that strengthen the penalties against money laundering. These include the forfeiture of assets both in the US and abroad for money laundering infractions. The US regulatory regime over financial institutions has only strengthened, and foreign investors need familiarity with the precise rules governing their respective financial institutions.

Intellectual property

A potential investor considering investing in a US corporation must also consider potential issues relating to intellectual property (IP). This includes patents and patent applications, trade marks and trade mark applications, and copyrights and copyright applications. These issues include: (1) determining the full scope and structure of the target corporation’s ownership of IP; (2) obtaining and recording security interests over the target corporation’s IP in the event of a loan to the target corporation; (3) ensuring continued permitted use of IP used by the target corporation (and the possibility of third party consents being required but not obtainable in the event of assignment, licensing, sublicensing, change of control, or bankruptcy); and (4) exposure to liability for third party IP infringement claims, including any indemnification given to the target corporation’s licensees and sublicensees, as well as any indemnification received from third party licensors.

The first step is to determine the full scope and structure of the target corporation’s ownership of IP. This is done by obtaining a full schedule identifying any and all IP owned by the target corporation (including its subsidiaries and affiliates) that remains in force (i.e. not expired or otherwise revoked or cancelled) in any country, and to identify the corporate entities which own such IP. This will reveal whether the target corporation has adopted an IP holding company structure – whereby a single entity has title to all the IP and licenses back the IP to the target corporation’s operating units – or whether IP ownership is scattered across different operating units.

If the investment is in the form of a loan to the company, the target corporation should pledge its IP as collateral for the loan to the potential investor. This can be done by entering into a security agreement that grants a security interest over IP in all countries where IP is owned, and record this security interest with the relevant recording offices in the relevant countries – such as the national patent and trade mark or industrial property offices and/or registers of movable property. Note that for IP located in countries with federal systems, such as Canada, it may be necessary to record these security interests on the provincial or state level as well as on the federal/national level (for example, Quebec Register of Movable Property). Furthermore, as part of the IP due diligence process, one should conduct IP lien/ownership searches in the relevant countries to make sure there is not another lienholder out there with superior rights over the IP, and that the target corporation actually owns the IP as represented. Realise also that recording IP liens across a large number of countries can be very expensive.

It is important for a potential investor to determine and review the full extent of any IP licenses – either to the target corporation or by the target corporation – because one cannot assume that the potential investor or the target corporation itself can continue to use the IP it is using after the proposed investment or control transaction. For example, the target corporation may have existing contractual restrictions prohibiting licensing key IP to the investor if the target corporation previously entered into exclusive license agreements or agreements with non-compete provisions. Consent of a third party to any assignment, license, or sublicense of IP to the investor (or in the event of a change of control of the target corporation in favour of the acquirer) may be required if IP was developed with a third party (whether in a joint venture or otherwise, and whether or not the third party has formal co-ownership of the IP) or if IP used by the company is not owned by the company but only licensed from a third party licensor.

Furthermore, unless the license agreement provides otherwise, a third party licensor may have the right to terminate a licensee upon transfer, or if the licensee enters into bankruptcy. Since such third party consents may not be obtainable or bankruptcy may not be avoidable, careful attention should be given to whether use of any such IP is indeed required to carry out the investor’s and the company’s business plan going forward – and prior to making any investment in the company. Where the company licenses or sublicenses IP to third parties, the investor must also consider the royalty flow from such licenses or sublicenses and the need to continue to service such licenses.

Potential exposure to IP infringement liability should also be explored. For example, an investor should obtain information about whether the target corporation has competent freedom-to-operate opinions regarding the technology it uses. The investor must evaluate those opinions and/or obtain competent freedom-to-operate opinions if the target corporation does not have them already. An investor should also investigate whether the company is already involved in, or is potentially involved in, any IP disputes with third parties – and analyse the merit of any such IP disputes. Such a review should also consider whether the target corporation may be liable for treble damages for willful patent infringement. Finally, an investor should evaluate the target corporation’s license agreements and any provisions by which the target corporation has indemnified third party licensees or sublicensees for IP infringement, or which indemnify the target corporation for IP infringement in the event of third party claims.

The US – a logical landscape

The US regulatory landscape, albeit extensive, is actually quite logical and transparent. Consequently, with the right level of planning and knowledgeable advisers, it does not generally impose significant burdens on most transactions. As the economies of the US and the world recover from the recent recession, the opportunities for significant value creation through strategic acquisitions in the US are available for companies that thoughtfully assess target strategic investment opportunities, carefully diligence the target companies, and execute their acquisition strategies.

The authors would like to thank their colleagues, partners Ron Hopkinson (Private Equity), Christopher Hughes (Intellectual Property), Charles (Rick) Rule (Antitrust), and Dale Turza (Bribery, National Security, Money Laundering) for their contributions to, and associate David Cohen for his assistance in preparing, this article.