The Committee on Foreign Investment in the United States (“CFIUS”) has just implemented new rules effective February 13, 2020 under the Foreign Investment Risk Review Modernization Act (“FIRRMA”). The new regulations overhaul how CFIUS will review inbound investments into the U.S. for national security risks, and the changes have significant implications for U.S.-based investment funds.
The changes include:
- Certain non-controlling minority investments will now be subject to CFIUS scrutiny for the first time, particularly those involving advanced technologies, critical infrastructure, or significant personal data of U.S. residents;
- Certain deals now must be filed with CFIUS, particularly where foreign government ownership or certain advanced technologies are in play; and
- Important clarifications for investment funds, including when a fund’s non-U.S. limited partner interests may be subject to CFIUS review, and when a non-U.S. fund entity (such as a Cayman entity) may still be deemed a U.S. person falling outside of CFIUS’s reach.
Below we outline the key questions investment funds should be asking about their deal pipelines and fund formations. We conclude with practical advice to investment fund managers on how to comply with the new rules and, wherever possible, appropriately insulate their deals and LP arrangements from CFIUS scrutiny. The new rules are dense—clocking in at over 200 pages—and they are highly technical, but with the right focus and counsel they can be navigated to successful outcomes.
1. Is the Fund a “Foreign Person”?
CFIUS has jurisdiction over certain investments where a “foreign person” will gain control or certain rights over a U.S. business. The new rules helpfully clarify that many U.S. funds will not be counted as foreign persons, even if they invest through non-U.S. entities such as Cayman fund vehicles. In particular, the new rules confirm that an investment fund is not a foreign person, even if it is incorporated in a non-U.S. country, if either:
- The fund’s activities and investments are primarily directed, controlled, and coordinated by or on behalf of the general partner in the United States; or
- A majority of the equity interest in the fund is ultimately owned by U.S. nationals.
Importantly, while many U.S.-based investment funds will not meet the definition of a “foreign person” that would trigger CFIUS jurisdiction over the fund’s investment in a U.S. business, the fund’s limited partner roster may still subject a deal to CFIUS jurisdiction based on the rights a foreign limited partner might gain through its indirect investment in the U.S. business. Therefore, even a U.S.-based fund should consider the rights its non-U.S. limited partners will have in the U.S. business. In a competitive bidding process, a bidding U.S. fund will be at a disadvantage if it has granted its foreign limited partners rights that could trigger a CFIUS review.
2. Will a Non-U.S. Investor Gain “Control” Over a U.S. Business?
CFIUS has long had jurisdiction over transactions that could result in non-U.S. “control” of any U.S. business. CFIUS defines “control” broadly to include “the power, direct or indirect, whether or not exercised . . . to determine, direct, or decide important matters affecting an entity.” FIRRMA and the new regulations have not changed this definition, nor CFIUS’s jurisdiction over these “covered control transactions,” substantially.
This control test is not tied to a particular percentage interest in the underlying U.S. business. A limited partner could have 49 percent of a partnership, and, if the general partner has sole authority to determine, direct, and decide all important matters affecting the partnership and funds operated by the partnership, the general partner, and not the limited partner, controls the partnership and the funds. If, however, the limited partner has the authority to veto major investments proposed by the general partner and to choose the funds’ representatives on the boards of the funds’ portfolio companies, then each of the general partner and the limited partner has control over the partnership and the funds.
3. Will a Non-U.S. Investor Gain Certain Rights in a “TID” U.S. Business?
In addition to traditional covered control transactions over which CFIUS has long had jurisdiction, the new rules have added to CFIUS’s jurisdiction certain other investments by foreign investors, even if they do not confer control.
To fall within CFIUS’s jurisdiction, these “covered investments” must meet a two-prong test:
- First, the investment must be in a U.S. business that:
- Develops critical Technologies;
- Performs critical Infrastructure functions; or
- Collects or intends to collect certain sensitive personal Data of more than one million U.S. citizens
(a “TID U.S. business”).
- Second, the investment must afford a non-U.S. person:
- Access to material nonpublic technical information (which does not include purely financial information);
- Membership or observer rights on a board of directors body of the TID U.S. business; or
- Any other involvement, other than through voting of shares, in substantive decision making of the TID U.S. business regarding critical technologies, critical infrastructure, or sensitive personal data of U.S. citizens.
Thus, even minority investments may trigger CFIUS jurisdiction if they come with certain informational or governance rights in a TID U.S. business. Notably, however, CFIUS has carved out from these new covered investment rules those deals where the only non-U.S. investors are from the closely allied countries of Australia, the United Kingdom, and Canada, and have clean compliance records as verified by CFIUS.
4. Does the Investment Fall Within the Investment Fund Safe Harbor?
The CFIUS final regulations provide a specific safe harbor from CFIUS jurisdiction for U.S.-controlled investment funds that might fall under the “covered investment” definition due to their foreign limited partners. Non-U.S. limited partner participation in an investment fund will not qualify as a “covered investment” in a U.S. business where:
- The fund is managed exclusively by a general partner (or equivalent);
- The general partner is a U.S. person (and, where a mandatory critical technology filing is at issue, exclusively controlled by U.S. nationals);
- The non-U.S. limited partner does not have and, with respect to any non-U.S. limited partner on an advisory board, the advisory board does not have, the ability to approve, disapprove, or control (except as relates to waivers of potential conflicts of interest):
- Investment decisions of the investment fund, or
- Decisions made by the general partner related to entities in which the fund is invested;
- The non-U.S. limited partner does not have the ability to unilaterally dismiss, prevent the dismissal of, select, or determine the compensation of the general partner;
- The non-U.S. limited partner does not have access to material nonpublic technical information; and
- The investment does not afford the non-U.S. limited partner any “covered investment” rights over any TID U.S. business (access to material non-public technical information, board or observer rights, or involvement in substantive decision making regarding critical technologies, critical infrastructure, or sensitive personal data).
5. Is a CFIUS Filing Mandatory?
For the first time, FIRRMA and the final regulations impose mandatory filing rules in certain transactions. This mandatory regime puts an additional CFIUS compliance burden on non-U.S. investors, and funds with non-U.S. limited partners.
The mandatory filings fall into two categories:
- For funds, deals where (1) the general partner of a fund is owned 49% or more by state-owned entities from the same non-U.S. country, and (2) the fund acquires a 25% or greater interest in a TID U.S. business.
- Deals involving an investment in a TID U.S. business that develops critical technologies used in 27 industries specified by CFIUS (including certain aircraft manufacturing, computer manufacturing, guided missile and space vehicle manufacturing, military vehicle manufacturing, chemical manufacturing, research and development in nanotechnology or biotechnology, and a number of other sectors).
6. How Can Investment Funds Structure Investments and Limited Partner Rights to Avoid Engaging in Covered Control Transactions and Covered Investments?
The new CFIUS rules can cause issues for investment funds if they are not careful in forming their limited partnership agreements and structuring their deals and diligence. U.S. investment funds should:
- Ensure non-U.S. investors do not have the ability or right to veto or otherwise control the fund’s or the general partner’s investment decisions, even through negative rights or rights requiring a unanimous vote of the limited partners.
- Limit the rights of non-U.S. investors over the general partner, including regarding the dismissal, selection, and compensation of the general partner.
- Ensure non-U.S. investors do not have the ability to sit on, observe, or appoint a director to, the board of directors of U.S. portfolio companies.
- Restrict any non-U.S. investor board membership to membership on a limited partner advisory committee that may provide industry expertise to, but does not make investment decisions for, the fund or portfolio companies.
- Restrict the information of TID U.S. businesses provided to non-U.S. investors to only financial information to ensure non-U.S. investors do not gain access to material nonpublic technical information.
Following these recommendations requires front-end vigilance. Fund managers should:
- Consider CFIUS implications when establishing the rights of limited partners in any new funds and assess the rights granted to non-U.S. limited partners and co-investors.
- Consider amending fund governance documents, including limited partner agreements, to restrict limited partner rights.
- Evaluate whether non-U.S. investors in the fund cause the fund to be a non-U.S. person under CFIUS regulations.
- Provide the general partner the ability to exclude non-U.S. limited partners from a proposed investment due to CFIUS concerns.
- Involve CFIUS counsel early in the pre-investment process to understand and limit the CFIUS implications of the transaction and to permit time for a CFIUS review, if mandatory or advisable.
- Use creative investment structures and vehicles to limit non-U.S. limited partners’ rights over and access to portfolio companies.
The new CFIUS regulations are highly complex and technical. And in some ways, they are as burdensome as they first appear. But they also provide significant clarity as to CFIUS’s new rules of the road, and that is welcome. Dealmakers that can understand the rules, and align to them, will have an advantage over the competition and the ability to pursue their deals quickly and decisively.