With President Trump’s signing of the Foreign Investment Risk Review Modernization Act (“FIRRMA”) on August 13, 2018, private equity sponsors and investors will need to pay closer attention to review by the Committee of Foreign Investment in the United States (“CFIUS”) of foreign equity investment in the United States.

Given these developments, whether investments are made directly, or indirectly through a general fund, separate account or co-invest vehicle, sponsors that are themselves foreign—or have foreign LPs—should consider whether a CFIUS filing should—or must—be made.

CFIUS and Controlling Investments

When a foreign person’s acquisition of control of a U.S. business might raise national security concerns, parties to the transaction have often chosen to file a notice with CFIUS to obtain U.S. Government review and approval of the transaction. Among the many factors that may raise such concerns are U.S. businesses that have government contracts, are the sole or a dominant source or supply of an important product, operate critical infrastructure, develop or manufacture critical technology, collect sensitive personal information, or are proximate to U.S. ports or military installations.

Historically, an equity investment would only be considered a “covered transaction”—and, therefore, within CFIUS’s jurisdiction—if the foreign person acquired “control” of a “U.S. business.” “Control” means the power to determine important matters affecting an entity, including by having voting control, positive or negative control of a board decision, or influence afforded by a dominant economic stake—and is not limited to holding a majority of the voting equity.

FIRRMA changes none of that. In three circumstances, the sponsor should continue to consider whether a notice should be filed with CFIUS if a general partner (“GP”) or a fund acquires control of a U.S. business that raises national security implications:

Until FIRRMA, in a typical PE structure, a U.S. or offshore fund with a U.S. GP that U.S. persons ultimately control, notwithstanding one or more foreign LPs, seldom triggered CFIUS issues. That is because no foreign LP “controlled” the U.S. business directly or indirectly. Even where the U.S. fund acquires a controlling interest in the business, an individual LP usually does not have any direct or indirect control over the portfolio company. Nor does it usually have any means of exercising control over the GP absent special governance rights (e.g., the unilateral right to terminate the GP). Nonetheless, both prior to FIRRMA and now, economic leverage—where a foreign LP has a dominant equity position in a fund—could be considered as providing that LP with the means of exercising control over a U.S. GP.

FIRRMA’s Expansion to Non-Controlling “Other Investments”

Sponsors and LPs will now need to pay attention to noncontrolling equity investments in certain types of U.S. businesses because FIRRMA expands the scope of CFIUS’s jurisdiction to “other investments”—of any size—by a foreign person in three categories of U.S. businesses:

1. A business that owns, operates, manufactures, supplies or services “critical infrastructure”—that is, systems or assets whose incapacity or destruction would have debilitating impact on national security
2. A business operating in an area of “critical technology.”
3. A business that maintains or collects sensitive personal data of U.S. citizens that may be exploited in a manner that threatens national security.

Importantly, however, an “other investment” will be a “covered transaction” if and only if the foreign person acquires at least one of the following “trigger rights” in connection with its investment:

1. Access to material nonpublic technical information in the possession of the U.S. business.
2. A seat on the board of the U.S. business, including as an observer, or the right to nominate a director.
3. Substantive decision-making authority (other than through voting of shares) with respect to the critical infrastructure, critical technologies or sensitive personal data aspects of the U.S. business.

This expansion of FIRRMA to “other investments” comes into effect on the earlier of 18 months after the date of enactment of FIRRMA (i.e., February 2020) or CFIUS’s issuance of implementing regulations (the “FIRRMA delayed effective date”). For PE sponsors, that a noncontrolling investment by a foreign person in one of the three categories of business may be a “covered transaction” only if one of these “trigger rights” is present has important implications both for direct investments and for indirect foreign investments by an LP through a fund. These are described further below.

Separately, FIRRMA also expands the definition of “covered transaction” to include the acquisition by foreign persons of private or public U.S. real estate, by purchase or lease, that is or is located within an airport or maritime port, is in close proximity to a U.S. military installation or is otherwise sensitive to national security or that would facilitate intelligence gathering by the foreign person or expose national security activities to foreign surveillance. This expansion to real estate investments, which includes a statutoril -based exception for real estate in urbanized areas, also will come into effect on the FIRRMA-delayed effective date. The expansion has been of interest to REITs and developers of nearby projects, who may be focused on the nationality of their tenants.

Notably, with respect to the expansion of “covered transaction” to “other investments” and certain real estate transactions, one provision of FIRRMA contemplates that the implementing regulations will further define the term “foreign person.” Ultimately, therefore, the expansion may be limited to “certain categories” of foreign persons, taking into account how the foreign person is connected to a foreign country or a foreign government and whether that connection may affect U.S. national security. The regulations could provide that foreign persons from certain countries that are close U.S. allies might not be subject to the full range of FIRRMA’s expansion of “covered transaction.”

Broadened Scope of Critical Technologies and the Mandatory Declaration

For sponsors of funds that target technology businesses, FIRRMA and its implementing regulations may be of concern because they substantially expand the scope of what is considered to be a “critical technology”. Before FIRRMA, the definition of a “critical technology” has been limited, principally to a defense article subject to weapons control, a technology that was export controlled pursuant to multilateral regimes (due to national security or an anti-proliferation regime) or for reasons of regional stability or surreptitious listening, nuclear equipment or technology, or a select agent or toxin.

FIRRMA considerably expands “critical technology” to include “emerging or foundational technologies,” which are to be identified through U.S. inter-governmental agency processes. The Department of Commerce has now launched such a process to identify potential “emerging technologies.” In November, the Department issued an Advance Notice of Proposed Rulemaking (“ANPRM”) that identifies 14 proposed categories of such technologies, including biotechnology, artificial intelligence, advanced computing, additive manufacturing, quantum information, logistics technology and robotics, each of which has numerous subcategories. The public comments filed in response to the ANPRM address the definition of “emerging technologies,” the criteria for determining whether an emerging technology is important to U.S. national security, and how applying export controls to emerging technologies might affect U.S. technological leadership. Many of the commentating parties advocated for a narrower definition of “emerging technology.” The next step is for the Department to develop rules that would propose to classify particular technologies as “emerging” (i.e., “critical”) for CFIUS purposes.

For sponsors making investments that are “covered transactions,” FIRRMA also effected some important changes in the CFIUS review process. Until FIRRMA, CFIUS’s review of a “covered transaction” began with the seller and buyer jointly filing a voluntary notice. A section of FIRRMA establishes an additional, shorter-form declaration process for commencing CFIUS review; however, except for the Pilot Program (addressed below), that provision only comes into effect on the FIRRMA-delayed effective date. In some cases, the filing of declarations will be voluntary, but, in other cases, it is now or will be mandatory.

CFIUS launched a Pilot Program on November 10, 2018 that requires the filing of a declaration with CFIUS if the foreign person is making either a controlling investment or an “other investment” in a “pilot program U.S. business,” which is a business that produces, designs, tests, manufactures, fabricates or develops a “critical technology” that is used or is designed for use in a set of 27 identified industries; once the ANPRM process runs its course, and emerging technologies are defined, declarations will need to be filed for foreign investments in businesses that engage in those activities involving such technologies if they are used in those industries. The identified industries include research and development in biotechnology, nanotechnology, semiconductor and related device manufacturing and electronic computer manufacturing.

Sponsors with LPs in which foreign governments have an interest, including state-owned entities or sovereign wealth funds, also will want to pay heed to CFIUS’s implementing regulations. When issued, the regulations will make declarations mandatory for any “other investment” (described above) by which the foreign investor will acquire a direct or indirect “substantial interest” in the U.S. business, where a foreign government entity itself has a “substantial interest” in that foreign person. The regulations defining “substantial interest” have yet to be promulgated, but they are expected to include means by which a foreign government could influence the actions of the foreign person. Voting interests of less than 10 percent will not be considered a “substantial interest.”

Affected fund sponsors need to know when to make filings with CFIUS and how to reconcile deal and CFIUS review timetables. FIRRMA prescribes a period of up to 90 days—and, potentially, longer—for CFIUS’s review of notices. The new declaration process contemplates that the declarations themselves will be shorter and are subject to shorter, fixed timelines. Sponsors should note that if a declaration is to be filed, whether on a mandatory basis, under the Pilot Program, or eventually on a voluntary basis, the parties to the transaction must file it no later than 45 days before the closing of the investment. CFIUS must respond to the declaration within 30 days of filing. Fund sponsors should keep in mind, however, that CFIUS may not necessarily approve the transaction subject to the declaration. CFIUS could conclude that it cannot take any no action on the basis of the declaration, request that the parties file a full-blown notice or initiate a review of the transaction. Even as short as these deadlines are, they may present challenges to sellers or buyers to “covered transactions” that, for competitive or other reasons, needs to proceed swiftly.

Implications of FIRRMA for Direct Investing

For a fund sponsor, the key takeaway of FIRRMA’s expansion is that a foreign person’s minority equity investment (whether by the GP, a partner or investment professional of the GP or one of the fund’s LPs) in certain categories of U.S. businesses may, depending both on the business and whether one of the trigger rights is present, qualify as a “covered transaction.” With respect to the three categories of U.S. business described above, the foreign person may be either (i) a foreign LP investing in a fund through a co-invest arrangement, (ii) a GP that itself is foreign or is a U.S. entity but is controlled by a foreign person or (iii) a foreign individual (such as one of the sponsor’s investment professionals) who is investing through the GP. The trigger right may be present if the foreign investor (including an otherwise passive foreign LP) has rights of access to material nonpublic technical information. That may be the case if the U.S. business is not public, and the foreign person receives sensitive technical information about the manufacturing or development of a critical technology. A trigger right may also be present if an investment professional of the sponsor who invests through the GP or a fund sits on the board of a portfolio company that is within one of the three categories. In such cases, a voluntary filing with CFIUS may be warranted once the implementing regulations are issued; alternatively, if the U.S. business is subject to the Pilot Program, the filing of a declaration, depending on the nature and use of the critical technology by the business, may be mandatory.

Implications of FIRRMA for Fund Investing

Importantly, for PE sponsors with foreign LPs, the effect of the expansion of CFIUS review described above can be substantially mitigated as to those LPs by a new, FIRRMA-provided “investment fund safe harbor”: the safe harbor entirely excludes from the definition of a “covered transaction” – and, therefore, from the purview of CFIUS – a passive investment made by a foreign LP through a qualifying investment fund. (The safe harbor is in effect for the Pilot Program and will be more generally in effect for other “other investments” by the FIRRMA delayed effective date.) To qualify for this safe harbor:

1. The fund must be under the control of a GP who is not a foreign person.
2. If the foreign LP sits on an LP advisory committee, the committee must not have the ability to approve, disapprove or control the fund’s investment decisions; decisions made by the general partner regarding the fund’s portfolio companies; or the hiring, firing, selection or compensation of the GP. (The committee may, however, opine on a waiver of a conflict of interest or allocation limitations.)
3. The LP may not have access to material nonpublic technical information as a result of participating on the LP advisory committee.

FIRRMA does not have much effect on funds that operate through U.S. GPs that are ultimately controlled by U.S. persons and where the persons investing through the GP are not foreign. As was the case before FIRRMA, that an individual LP is a foreign person should not warrant a filing with CFIUS because the LP ordinarily is passive – it does not have control over the GP or the portfolio company – assuming that the LP does not have any trigger rights. (CFIUS looks at whether an individual foreign person has control. Thus, even if a fund has multiple foreign LPs or if those foreign LPs in the aggregate hold the lion’s share of the equity, this does not change this conclusion unless the LPs are acting in concert.)

If a GP of a fund has a foreign LP with a dominant economic stake (even if not a majority of the total equity of the fund LPs), or if a foreign LP invests through a single managed account, however, the sponsor may want to consider more carefully whether to make a CFIUS filing. In such cases, that LP might be seen as having economic leverage, and, hence, some measure of control over the U.S. GP – possibly rendering that U.S. GP a “foreign person.”

Fund sponsors should note that a foreign LP’s noncontrolling, indirect investment in a U.S. business through the fund will not necessarily mean that the transaction is an “other investment.” That is so because, under the usual investment fund structure, an LP typically does not acquire one of the three trigger rights described above. That would be true with respect to the Pilot Program businesses or, more broadly, any other business that is developing an “emerging technology” (as will be specified by the Department of Commerce) or as to any of the categories of U.S. business discussed above.

In addition, many investments made by a foreign LP through a general investment fund will presumably fall within the investment fund safe harbor. To ensure that safe harbor treatment is both available and not jeopardized, the fund sponsor may wish to tailor the rights of an LP advisory committee and foreign LPs to the statutory terms of the safe harbor. Those more circumscribed rights are likely to be consistent with common practice and LPs’ expectations. Both to preserve safe harbor eligibility and to preclude a foreign LP’s interest in the fund from being considered an “other investment,” the sponsor will want to retain the right to limit the flow of any portfolio company’s sensitive information to any foreign LP. The sponsor also may wish to preserve for itself the right to take such steps over the life of the fund as may be necessary to minimize the risk that foreign LPs’ indirect investments in portfolio companies may trigger CFIUS review.

That an investment is made by a foreign fund-of-fund investor typically would not constitute a “covered transaction.” The top-tier fund generally would not acquire one of the three trigger rights that would make its investment an “other investment.” Moreover, if the underlying fund is managed by a U.S. GP, the statutory investment fund safe harbor, subject to implementing regulations, should ordinarily be available.

Key Conclusions