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Inside China: Navigating Cfius

This year could provide greater insight into the inner workings of US national security review, a process that has proved particularly problematic for Chinese buyers

This year could provide greater insight into the inner workings of US national security review, a process that has proved particularly problematic for Chinese buyers

Chinese investment into the US has been growing and may see a significant leap in 2016. Last year volumes reached $15.7 billion, according a note published by the Rhodium Group, up 30% from 2014. In just the first two months of this year, according to Thomson Reuters Chinese acquirers have announced 22 deals in the US, worth a combined $23 billion. It's a massive increase over 2015, which saw 88 deals worth $13 billion, and 88 deals for $7 billion in 2014.

Against this backdrop, the obscure operations of the Committee on Foreign Investment in the United States (Cfius) looms large. Official data shows that from 2005 to 2014, the number of Cfius investigations have consistently increased, despite fluctuations in foreign investment. Notably, in 2012, China surpassed the UK to become the most reviewed home country of foreign acquirers (with 23 transactions investigated). It is likely to hold on to that position for the time being.

Cfius reviews

Cfius describes itself as an interagency committee that serves the US president in overseeing the national security implications of inbound foreign investment. Established in 1975, it now consists of 16 heads of different government branches and is chaired by the Secretary of the Treasury. In addition to the permanent members, the president may appoint, from time to time, temporary members to the committee.

The Committee has authority to review and investigate proposed mergers, acquisitions and takeovers, in which:

  • the acquirer is controlled by or acting on behalf of a foreign government; and
  • the acquisition results in control of an US enterprise that could affect the national security.

These authorisations are vaguely worded, and can be subject to broad interpretations.

Parties to a covered transaction are supposed to file a voluntary notice to Cfius, which initiates the review process. The review process commences with a 30 day review period, during which Cfius determines whether an investigation is warranted. If so, there is a 45 day investigation period, during which Cfius determines whether to recommend the president to suspend or prohibit the transaction. If it recommends a suspension, there is a 15 day period for the president to determine whether to suspend or prohibit the transaction. In addition, parties may conduct informal communications with Cfius and seek unofficial determinations before filing a notice. Parties may also voluntarily withdraw from the process and terminate the underlying transaction at any stage during the process. Although submitting to Cfius review is supposedly voluntary, Cfius has the authority to initiate review of a covered transaction and may do so retrospectively.


"Chinese buyers are now expected to pay a Cfius premium"


It is important to note that Cfius does not have the authority to prohibit or suspend a covered transaction; that authority resides with the president, only. But, a Cfius objection, or even a decision to investigate, casts such negativity around a potential transaction that it often compels the parties to voluntarily withdraw. Of the 1320 transactions reviewed by Cfius between 2005 and 2014, 435 were investigated, 151 ended in voluntary withdrawal, and three went up to the president. Of those that went all the way, only one transaction was blocked by presidential decision. This was in relation to a proposed acquisition by Ralls Corporation, a US company affiliated with a Chinese state-owned company.

For Chinese companies subject to Cfius review in publically known transactions, 'controlled' by a foreign government doesn't usually trigger any questions. Most of them are either state-owned enterprises (SOEs) or otherwise affiliated with SOEs. Since foreign government control of an acquirer is one of the three categories that would generally subject a transaction to the 45-day Cfius investigation following the initial review, transactions involving Chinese SOEs will almost certainly encounter delays and uncertainties.

The concept of 'national security', however, is much harder to quantify. In its reports Cfius lists a number of non-exclusive factors to be considered in deciding whether to block a deal. These include: ensuring the domestic capability and capacity necessary to fulfill national defence requirements; the transaction's impact on US technological leadership in an area affecting national security; the potential effects on US critical infrastructure, critical technologies and long-term US energy needs; whether the transaction involves an acquirer that is controlled by a foreign government; whether the home country of the acquirer adheres to US policy on non-proliferation and export control requirements; and the existence of government contracts relevant to national security. The ambiguity in whether or how a national security review should be conducted is further aggravated by the confidentiality requirement imposed on the information and documents reviewed. Cfius does not disclose to the public whether a notice has been filed or any decision or result that comes off any filing. It is understandable that some level of ambiguity is purposefully placed there to provide necessary flexibility for evolving national security concepts, so that Cfius can always stay on top of new industries and technologies, and novel project structuring. However, such ambiguity leaves much guess work for transaction parties and does not afford the predictability that multi-billion deals require. In addition, Chinese acquirers have to cope with this ambiguity in the context of the dynamic US politics and US-China relations.

Prominent cases

Cfius was relatively unknown to Chinese investors until 2005, but since then, it has become to be viewed as a roadblock to investment into the US. In recent years, China originated acquisitions dominate the list of Cfius-thwarted deals, both in number and volume.

CNOOC – Unocal

In August 2005, the China National Offshore Oil Company (CNOOC) dropped its $18.5 billion bid for Unocal Oil Company, citing political pressure as the main reason. Subsequently, the Unocal board recommended to its shareholders a competing offer from Chevron that was valued at approximately $17.7 billion. CNOOC is a majority-owned company of the state (and an SOE), and the bid raised congressional concern about foreign control of US energy resource and harm to national security. Cfius's involvement in this transaction was less than direct, for its review did not actually ever start. By conditioning its review upon Unocal's acceptance of the bid, Cfius effectively put CNOOC's proposal in limbo. Since this transaction would have to be examined by Cfius, and potentially, the president, the proposal came with risks of delay and uncertainty that would be hard for the Unocal board and shareholders to swallow. It is quite understandable that CNOOC complained that the political environment had made it difficult to accurately assess its chances of success, creating a level of uncertainty that presented an unacceptable risk to its ability to secure this transaction.

Ralls and wind farms

In March 2012, Ralls – a US corporation – acquired a number of wind farms. Following the consummation of the acquisition, it came to the knowledge of Cfius that Ralls is owned by executives of Sany Group, a Chinese SOE, and that some of the wind farms located in the state of Oregon were situated close to a restricted airspace for drone testing. As a result, Cfius notified Ralls and conducted a retrospective review of the transaction. Following the initial 30-day review, Cfius decided that further investigation was warranted and interim mitigation measures were necessary to protect national security. Pursuant to those orders, Ralls was required to cease all construction and operations at the project site, remove all stockpiled or stored items from the site, and cease all access to the site. In September 2012, based on reports and recommendations of Cfius, President Obama issued an executive order requiring Ralls to divest the Oregon project within 90 days, and to remove all physical installations it had constructed within 14 days since there was credible evidence that the acquisition threatened to impair US national security.

In response, Ralls filed a lawsuit in the district courts in Washington, DC. The court allowed Ralls' due process claim to proceed, but ruled that the president's action is within his authority. Ralls appealed to the Court of Appeals which, in July 2014, issued an unexpected ruling concluding that President Obama's order, requiring Ralls Corporation to divest itself of assets already acquired, deprived the company of its property interests without due process of law in violation of the US Constitution. The court explained that due process requires, at the least, that an affected party be informed of the official action, be given access to the unclassified evidence on which the official actor relied and be afforded an opportunity to rebut that evidence. Accordingly, Cfius was ordered to disclose unclassified evidence and reevaluate the transaction. However, in October 2015, before the order was fully complied with, Ralls and Cfius were reported to have reached settlement. Although the terms of the settlement were not publically disclosed, it is understood that Ralls will still have to dispose of the wind farms, albeit to an acquirer previously objected to by Cfius.

The court ruling in Ralls should reduce the opacity of the Cfius process for foreign parties and provide some enhanced procedural protections. However, any procedural changes made by Cfius are unlikely to affect the outcome of its review. While significant in theoretical discussions, several factors are likely to limit the practical impact of the DC Circuit's decision. First, the ruling pertains to procedural matters only, the substance of decisions made by Cfius and the president remains beyond reach. Second, in order to claim due process protection over property rights, the parties would have to first close the deal, which wouldn't be the case in most covered transactions. Third, the mere risk of Cfius review or investigation would break up a deal. In addition, Cfius became even more proactive following its review of Ralls, expanding the scope of review to greenfield investments and transactions to which parties are all foreign.

Lumileds

In January 2016, Dutch company Philips announced it was terminating a $2.8 billion deal to sell its Lumileds lighting business to a consortium led by Chinese venture-capital firm GSR Ventures. Although neither party is American, the deal attracted Cfius objection because Lumileds has a large portfolio of US patents for LEDs [light emitting diode] lighting, and a sizable presence in the US through manufacturing and research-and-development facilities in San Jose, California. It is also reported that the Lumileds business might possess know-how of advanced microchips that could have military use.

FairChild

In February 2016, Fairchild Semiconductor announced that to avoid 'an unacceptable level of risk for failure to obtain Cfius approval', it was declining a $2.6 billion takeover bid from China Resources Microelectronics and Hua Capital Management. Instead, it would accept a lower bid from ON Semiconductors, despite the Chinese offer of a $108 million break-up fee should Cfius blocks the deal.

Western Digital

Inside China
Inside China, written by FenXun Partners’ Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye.

Yang is a specialist in China’s financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Liu’s practice focuses primarily on the asset management industry, and has previously worked as an associate at Skadden Arps Slate Meagher & Flom in New York.

That same month, China SOE Tsinghua Unisplendour abandoned a $3.8 billion deal to acquire a 15% interest in Western Digital due to pending Cfius review. The parties, at one time, believed that if structured as a minority investment the deal wouldn't be subject to review by Cfius. But it collapsed when Cfius's intention to conduct a review became clear.

Based on these precedents, Chinese buyers are now expected to pay a Cfius premium, bidding higher than others to account for the possibility that the deal won't ultimately close. On the back end, more exuberant break-up fees may be needed for the purpose of inducing a target to go through a potentially arduous process or forgo alternative bids. Structurally, divestment of sensitive assets, cession of post-acquisition board seat or management rights, or alteration of existing contracts may need to be swallowed for the purpose of avoiding Cfius review or complying with its conditions. Many Chinese buyers, including privately-owned companies, perceive a competitive disadvantage created by these factors.

2016 is shaping up to be an active year for Cfius. There is already anxiety and expectation surrounding a number of high-profile transactions, including China National Chemical Corporation's $43 billion proposed takeover of the Swiss agrotech company Syngenta, Chongqing Casin Enterprise Group's proposed acquisition of the Chicago Stock Exchange for an undisclosed amount, which already raised attention in Congress, and Haier's proposed acquisition of GE's appliance business for $5.4 billion. With this amount of dealflow and public attention, perhaps more of Cfius's thinking will be revealed over the course of this year.

By FenXun Partners' Sue Liu in Beijing

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