China-U.S. Trade Law : International Trade Lawyer & Attorney : Baker Hostetler Law Firm : Trade Remedies, Customs & Export Controls

This text is based on presentations on this subject made recently by Mr. Burke to the American Chamber of Commerce in Beijing, the American Chamber of Commece in Shanghai, and the CCH/Wolters Kluwer conference for in-house legal counsel in Beijing.

 Some Chinese Mistakenly Think They Are Unwelcome

Chinese direct investment in the United States is increasing. Last year Chinese companies doubled the amount of money they invested in the United States compared to 2009.

There are many reasons why Chinese companies would want to acquire or set up operations in the United States. Most costs of doing business in the United States, other than labor, are now cheaper than in areas of China with the advanced infrastructure that modern industrial operations need. Production in the United States often provides better access to customers; allows companies to take advantage of Buy American provisions when selling to government agencies; and enables companies to avoid trade barriers, such as antidumping or countervailing duties assessed on imports from China.

Notwithstanding these reasons for investing in the United States, many Chinese companies are hesitant to do so because of media reports on national security reviews of foreign investment that have given the impression the United States is hostile to foreign investment, or at least investment from China. The media have created the impression that Chinese companies are forced to abandon acquisitions in the United States because of political opposition and national security reviews by the Committee on Foreign Investment in the United States (“CFIUS”).

The reality is that the United States welcomes most Chinese investment. The United States has no restrictions on greenfield investment by foreigners, except for some state (non-federal) laws that limit the ability of foreign persons to purchase farmland. Thus, foreigners may create new U.S. businesses on the same basis as Americans. Recent examples of Chinese greenfield investments in the United States include Tianjin Pipe’s steel pipe mill in Texas; Suntech Power’s solar panel assembly plant in Arizona; and American Yuncheng’s gravure cylinder plant in South Carolina.

CFIUS national security reviews apply only to the acquisition of existing U.S. businesses. Even in those circumstances, only three to seven percent of foreign acquisitions each year go through the CFIUS process. Blocked acquisitions are rare; projects blocked presented unique challenges.

Chinese Transactional Failures Have Been Exceptions

A handful of Chinese acquisitions have been abandoned as a result of CFIUS review, or political opposition. However, circumstances unique to each transaction, not general hostility to Chinese investment, caused those deals to fail.

One failure was Northwest Non Ferrous International Investment Co. Ltd.’s attempted acquisition of Firstgold Corp., a gold mining company in Nevada. That acquisition was abandoned just before the end of a CFIUS review due to the expectation of an unfavorable CFIUS recommendation. Questions had been raised because of sensitive military and intelligence installations adjacent to the mines. Had those mines been located elsewhere, the acquisition likely would have sailed through the national security review.

The failed acquisitions receiving the most press attention recently include Huawei Technologies Co. Ltd.’s attempt to acquire 3Com and, more recently, assets from 3Leaf Systems. Huawei bought intellectual property rights from 3Leaf Systems, a developer of cloud computing, without filing a notification with CFIUS. CFIUS learned about the transaction and self-initiated a national security review that resulted in a recommendation that Huawei be ordered to divest.

There were several reasons why the 3Leaf transaction ended badly for Huawei. The Pentagon had serious concerns about the technology that were magnified by a lingering mistrust of Huawei following the 3Com transaction and its mishandling of the CFIUS process in the 3Leaf case. The more important reason, however, was a more general mistrust of Huawei in the U.S. Government due to allegations of close corporate connections to the People’s Liberation Army, espionage, intellectual property theft, and support for terrorist regimes (Iran, Iraq and the Taliban). These circumstances were peculiar to Huawei. The Huawei transactional failure does not indicate any general hostility to Chinese investment.

The Legal Framework And Its Operation: CFIUS And FINSA

Congress enacted the Foreign Investment National Security Act Of 2007 (“FINSA”) on July 26, 2007 in reaction to Dubai Ports World and other controversies to improve accountability and transparency in the CFIUS process. FINSA provides that the President may “suspend or prohibit any covered transaction” whenever the President finds credible evidence “that the foreign interest exercising control might take action that threatens to impair the national security.” However, the purpose of FINSA set out in the preamble to the legislation is “[t]o ensure national security while promoting foreign investment ....” Thus, FINSA reinforces that, notwithstanding the need to protect national security, promoting foreign investment in the United States remains the policy of the U.S. Government. The following statistics on CFIUS reviews in the three years (2008 to 2010) since FINSA became law demonstrates that this law is not an impediment to the vast majority of foreign acquisitions of U.S. business:

•      National security reviews                                                                                313
•      Extended investigations                                                                                    83
•      Voluntary withdrawals (most re-filed and subsequently cleared)             42
•      Cases submitted to the President                                                                    0

To be governed by FINSA a transaction must be a covered transaction, which means that the transaction must involve a foreign person obtaining control over an existing US business. A covered transaction can be blocked only if it would impair national security and that impairment cannot be remedied through some other means.

FINSA defines “covered transaction” to mean “mergers, acquisitions, or takeovers . . . by or with foreign persons which could result in foreign control of persons engaged in interstate commerce in the United States.” It only covers transactions involving an existing US business. As noted previously, greenfield investments, such as the Tianjin Pipe project in Texas, are not covered. It covers an acquisition of one foreign company by another if control of a U.S. business were to change.

The regulations implementing FINSA, which the Treasury Department published for CFIUS, define “control” as:

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 . . . .

A ten percent passive investment in a U.S. company generally would not be enough to meet this definition of control. However, contractual arrangements that give a foreigner control of important matters can cause a transaction in which the foreign entity does not obtain any equity to be a “covered transaction.”

CFIUS’s implementing regulations define “foreign person” to be “(a) Any foreign national, foreign government, or foreign entity; or (b) Any entity over which control is exercised or exercisable by a foreign national, foreign government, or foreign entity.” This definition includes US subsidiaries of foreign companies.

Neither FINSA, nor the implementing regulations, defines “national security.” Consequently CFIUS has broad discretion to define national security on a case-by-case basis. Other provisions in FINSA, the implementing regulations, the legislative history and CFIUS’s subsequent actions indicate the following key areas in which national security concerns are likely to arise:

1. Defense industries, which would include companies that provide “defense articles” or “defense services” that are subject to heightened export controls under the International Traffic in Arms Regulations (“ITAR”) and the defense industrial base, which provides products needed for making military items;
2. Proximity to critical government facilities, as shown in the Firstgold case;
3. Critical infrastructure, defined in the implementing regulations as “a system or asset, whether physical or virtual, so vital to the United States that the incapacity or destruction of the particular system or asset . . . would have a debilitating impact on national security.” The company’s system or assets have to be big enough to make a difference under this definition.
4. Critical technologies, which would include (a) items controlled under the ITAR, (b) items controlled under Export Administration Regulations for national security, chemical and biological weapons proliferation, nuclear proliferation or missile proliferation reasons (probably only if the item needed a license to be exported to the acquiring company’s home country), (c) items controlled under the Export and Import of Nuclear Equipment and Materials Regulations, and (d) items controlled under the Export and Import of Select Agents and Toxins Regulations (threats to plant, animal or human health);
5. Energy and other critical resources, including essential raw materials for defense industries and critical infrastructure.

FINSA requires heightened review of proposed transactions in which a foreign government would obtain control of a U.S. business. There is a presumption that transactions by foreign governments or entities controlled by foreign governments receive an additional 45-day extended investigation beyond the initial 30-day review under which CFIUS clears most transactions. This presumption can be waived if the Treasury Secretary and the head of the other agency designated as the lead for the particular CFIUS review “jointly determine . . . that the transaction will not impair the national security of the United States.”

When a transaction is considered to be foreign government-controlled, FINSA requires CFIUS to consider the adherence of the country to non-proliferation control regimes, the U.S. relationship with the country, specifically on cooperation with counter-terrorism efforts, and the potential for diversion of technologies with military applications.

Conclusion

The United States is open to investment, but potential investors do need to pay attention to legitimate national security concerns. For the vast majority of foreign investors, including investors from China, the CFIUS review process is not an impediment. Greenfield investments do not require a CFIUS review. Most cross-border mergers and acquisitions do not require a CFIUS review. Most CFIUS reviews clear the transaction within 30 days. Only a handful of transactions have been abandoned as a result of national security concerns.

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This blog posted an article titled “Setting The Record Straight: The U.S. Is Open For Chinese Business; Don't Worry Too Much About National Security Reviews” on December 12, 2009. Two weeks later Northwest Non Ferrous International Investment Co., Ltd. (“Northwest”) dropped its plans to acquire a Nevada mining company because a national security review under the Foreign Investment National Security Act “FINSA” was coming to an unfavorable conclusion. We do not stand corrected.

The rejection of the Northwest acquisition was based on unique facts and not because of opposition to Chinese investment generally. Chinese companies should not let this case dissuade them from acquiring companies and otherwise investing in the United States.

Northwest proposed to acquire control over a mining company, Firstgold Corp., all of whose operations are adjacent to Naval Air Station Fallon, the U.S. Navy’s premier tactical air warfare training center. The Navy opposed a company owned by the Chinese Government having control of property from which its most sensitive training activities might be monitored. Also in that area are other security and military assets so sensitive that the U.S. Government treats even their identities as classified information.

Due to the sensitive nature of the government installations, any acquisition by a foreign company, including companies based in NATO countries, would have raised national security concerns. Whether China created more concern is entirely speculative and ultimately unknowable. However, Chinese companies should not view the CFIUS result in this case as based on an objection focused on China, but rather as based on the serious national security concerns it definitely presented regardless of the foreign country. FINSA requires CFIUS to consider whether the acquiring company is state-owned. However, given the serious national security concerns raised by the location of Firstgold’s facilities, the result likely would have been the same even had the acquirer been a private company.

Northwest’s lawyers have described extraordinary but failed efforts to make the acquisition compatible with national security concerns. Their memorandum to Northwest, published on the New York Times website, reports that the Committee on Foreign Investment in the United States (“CFIUS”) looked closely at all kinds of scenarios to mitigate the national security concerns, but concluded that none of them would be feasible because all four of Firstgold’s properties are located adjacent to Naval Air Station Fallon or other military sensitive locations.

The lawyers’ report demonstrates that CFIUS’ goal is not to block investments. Instead, CFIUS seeks to mitigate national security concerns. The exceptional facts in this case are that all of the operations to be acquired raised concerns. When national security is at issue, it usually affects some part of the deal and can be mitigated. Here, all of the deal was implicated; mitigation (such as spinning off some part of the deal while preserving the essential economic value) apparently was impossible.

Northwest acted wisely in this case, seeking a CFIUS review before investing because of uncertainties about national security. Reportedly, Firstgold did not want to request CFIUS review. Northwest could have invested, only to have CFIUS recommend and the President of the United States undo the deal, not because of animus toward Chinese investment, but because of the serious implications for national security.

It is important not to misinterpret the Northwest case. It proves the utility and wisdom of early CFIUS review, not an objection to Chinese investment. Notwithstanding CFIUS’ rejection of Northwest’s proposed acquisition of Firstgold, the United States remains one of the economies most open in the world to foreign investment, including from China.
 

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Chinese and other foreign companies considering investments in the United States often are confused about the degree to which the United States is open to foreign investment. They hear terms such as CFIUS, Exon-Florio and FINSA and claims that the United States is now hostile to foreign investment, especially from China and the Middle East.

The reality is that the United States remains one of the economies most open in the world to foreign investment. When it comes to greenfield investments creating new businesses in the United States, foreigners are as free to invest as domestic concerns. The United States does have procedures for reviewing foreign acquisitions of existing businesses under the Foreign Investment National Security Act of 2007 (“FINSA”), conducted by the inter-agency Committee on Foreign Investment in the United States (“CFIUS”), presided over by the U.S. Treasury Department. However, as the Treasury Department noted when it published its CFIUS guidance, “CFIUS focuses solely on any genuine national security concerns raised by a covered transaction, not on other national interests.”

Notwithstanding today’s difficult economic climate and the confusion over national security reviews of foreign investment, Chinese companies obviously remain interested in acquiring U.S. companies. For example, on October 23, 2009 BGP Inc., a subsidiary of China National Petroleum Corporation, agreed to a joint venture with ION Geophysical Corporation, a Houston, Texas based company specializing in seismic products used in oil and gas exploration. According to ION’s press release, the transaction, which would result in the Chinese company owning 16.66% of ION, is contingent upon obtaining clearance of the transaction from CFIUS. This proposed acquisition is likely to face an exhaustive and extended CFIUS review because it is in a particularly sensitive sector, energy, and the ultimate acquirer is a Chinese state-owned enterprise. Although CFIUS may require some conditions designed to mitigate national security concerns, the transaction probably will be approved.

Congress passed FINSA in 2007 following controversies over the China National Offshore Oil Corporation’s attempted acquisition in 2005 of Unocal, a U.S. energy company, and Dubai Ports World’s acquisition in 2006 of a British company that managed several major seaports in the United States. These controversies focused congressional attention on CFIUS; the earlier Exon-Florio procedures for review of foreign acquisitions; potential harm to U.S. national security that could arise from foreign control of energy, infrastructure and critical technologies; and on investments by state-owned entities. The public debate over these cases and a new law, however, was not one-sided and the Administration convinced Congress to balance national security concerns with the need for the United States to remain open to foreign investment. FINSA, legislated on July 26, 2007, is not a barrier to foreign investment, but a balance of investment with national security.

FINSA covers any transaction that “could result in control of a U.S. business by a foreign person.” It covers transactions that could result in the switch of control from one foreign person to another. However, it does not cover greenfield investments or a strictly real estate transaction. Control over an existing U.S. business must be at stake. “Control” is defined very broadly. Thus, even the acquisition of a relatively small minority stake in a company could be covered by FINSA.

FINSA does not pose a significant barrier to the vast majority of foreign acquisitions of U.S. businesses because, although all such acquisitions are covered transactions, the President’s authority under FINSA to suspend or prohibit a covered transaction can be exercised only when the President finds that “the foreign interest exercising control might take action that threatens to impair the national security.” Neither the statute, nor its implementing regulations, defines “national security” and Congress intended CFIUS to interpret that term broadly to include, among other things, energy, critical materials, critical technologies, homeland security and infrastructure. Nonetheless, where there is no plausible connection between the business conducted by the U.S. company to be acquired and national security, FINSA will not be an issue.

Whenever a transaction covered by FINSA might affect national security, FINSA provides a review process whereby the parties to the transaction can seek clearance from CFIUS before they have invested a great deal. A CFIUS review is not mandatory, but companies generally seek one whenever there is a possibility that the transaction could be considered to affect national security. Once a transaction has been cleared by CFIUS, it cannot subsequently be challenged under FINSA unless one of the parties to the transaction submits false or misleading material information.

Companies take advantage of the CFIUS safe harbor – the preclearance -- by submitting a voluntary notice of a proposed transaction providing the detailed and extensive information that CFIUS’ regulations require for such notices. The filing of the notice commences a 30 day initial review process. Most transactions are cleared within this initial 30 day period.

When any of the CFIUS member agencies have unresolved national security concerns with a proposed transaction, a formal 45 day investigation begins. The parties typically resolve transactions that go through this second stage by agreeing with the government to mitigate the agencies’ national security concerns.

Mitigation agreements can involve modifications to the transaction, certain limitations on the new foreign owner’s exercise of control, or extra protections for critical technologies or facilities. A very small number of transactions pose national security concerns that cannot be mitigated successfully. Those transactions usually are abandoned before the completion of the CFIUS process. It is rare for CFIUS to complete its review with a recommendation to the President that a transaction be blocked.

The United States remains committed to an open investment environment, treating foreign investors on an equal footing with their domestic competition. It was for this reason that Congress set the initial CFIUS review deadline at 30 days, to coincide with the 30 day antitrust review period for mergers and acquisitions. The expanded view of national security mandated by FINSA does mean that CFIUS national security reviews are a crucial part of transactions involving foreign investment, but it is no more onerous than an antitrust examination.

Most important for success in a CFIUS review is understanding in advance the concerns of CFIUS member agencies, creative thinking about how to demonstrate that those concerns are not threatened, and where perceived threat may be reasonable, creative proposal to mitigate them. In most cases early attention to the CFIUS process and to the legitimate concerns of the member agencies, Congress, and the public, can ensure smooth and timely proceedings that result in CFIUS clearance without restrictions, or on terms that preserve the value of the transaction for all parties.

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