United States: Recent Activity in Chinese Transactions Subject to CFIUS Review: Does the Equation Change for Chinese Investors?

Chinese investment in US companies continues at an increasing rate. By the third week of February 2016, Chinese companies had announced more than $80 billion of new proposed transactions. These did not include pending transactions that carried over from 2015. Many of these acquisitions are in high technology sectors, following through on publicly announced Chinese government plans to achieve greater self-sufficiency or to increase world-wide market share in those industries. Chinese organizations' bids for significant US businesses and assets has resulted in much public discussion regarding their review by the Committee on Foreign Investment in the United States (CFIUS), the legislatively established body which reviews proposed inbound foreign direct investment (FDI) transactions for national security concerns. In 2012, China displaced the UK as the country with the most transactions reviewed by CFIUS, and CFIUS annual reports show that since 2012, the Committee has reviewed more Chinese transactions than from any other country.

The increase in CFIUS reviews of Chinese transactions results from a number of factors, including: the large overall increase in Chinese investments in the US; Chinese interest in sensitive US technologies and assets; and, most significantly, from a desire by the acquiring entities to obtain the certainty provided by a CFIUS clearance. China, and Chinese organizations, are vigorously pursuing strategic acquisitions, investments and agreements in the US in a broad range of business sectors. While many of these business sectors do not raise potential national security concerns, a number do. Chinese offers in manufacturing, high-tech and natural resources have raised a number of potential national security concerns, including those relating to critical infrastructure, supply chain security and defense procurement. The sensitive nature of even a small part of a business can trigger CFIUS interest, and the participation of a Chinese organization in a transaction involving such assets virtually compels a national security review. Finally, Chinese reticence to consummate an investment without CFIUS review is understandable given the increasing number of transactions involving Chinese organizations that run into difficulties obtaining CFIUS clearance, a number of which were not submitted for CFIUS review prior to closing, only to find that CFIUS objections led to divestiture or the imposition of mitigation that changed the transaction.

In most circumstances, CFIUS approval divests the Committee of jurisdiction and therefore provides the only means for the acquiring entity to obtain certainty with respect to a transaction. Unless a transaction is submitted for review by CFIUS, and approval is given, the transaction can be unwound (whether in whole or part) post-closing if CFIUS undertakes a review at a later time, and identifies national security concerns. Moreover, if a transaction subject to CFIUS review is not notified to the Committee, CFIUS can request a filing at any point, pre- or post-closing, and thereby potentially interfere with or adversely affect the transaction closing schedule (if the request occurs pre-closing) or the transaction itself. The fact that a number of proposed and consummated Chinese transactions reviewed by CFIUS have resulted in divestiture orders or agreements only serves to heighten both the business and cultural sensitivity in China to the risks posed by CFIUS. Thus, both Chinese investors and US sellers are determining that CFIUS approval should be sought for a wide variety of Chinese transactions, and this trend is likely to continue.

CFIUS recently released its annual report for Calendar Year 2014, which showed the number of Chinese transactions reviewed by CFIUS remained in the low 20s, although the percentage of the CFIUS workload consumed by Chinese transactions actually declined five percent because of a rise in the overall number of submissions. The continued increase in proposed Chinese investments in US companies that produce essential and sometimes sensitive technologies means that CFIUS will continue to play a prominent role in these deals. And while some transactions will be abandoned because of an inability to address CFIUS concerns, many more will be approved after CFIUS review, both with and without mitigation requirements. It is therefore essential that parties, analysts and even the press understand the difference between deals that raise difficult or unsolvable national security concerns and those that do not occur for other reasons, whether or not related to CFIUS.

Recent press coverage concerning proposed Chinese acquisitions of US companies that raised or could have raised national security issues has focused more attention on the role that CFIUS plays, which can occur at all stages of the transaction. These events demonstrate that, for transactions where national security concerns may exist, the need for CFIUS review can influence the parties when they are weighing competing offers; in valuations; when drafting essential deal terms like breakup fees and termination rights; and when structuring (or re-structuring) exactly which assets or business will be sold. Acquisition decisions must account for actual or potential national security considerations and the parties' understanding of those issues can be affected by a range of factors from their appetite for risk to their public image. Deals fall apart for myriad reasons, and even when the underlying reason relates to national security, the root cause is not automatically CFIUS, though the specter of CFIUS undoubtedly plays its part.

Three recent high-profile transactions—GO Scale's proposed acquisition of Royal Philips Lumileds business unit; China Resources Microelectronics and Hua Capital Management's proposed acquisition of Fairchild Semiconductor; and Tsinghua's Unisplendour Corp.'s proposed investment in Western Digital Corp.—highlight the different ways that CFIUS can or cannot influence a deal outcome. These transactions received substantial news coverage that addressed purported reasons for their failure—each of which ended for very different reasons. Nonetheless, that coverage leaves the reader with the impression that CFIUS acted to "block" all three transactions. This is not the case, however, and only one (the GO Scale/Philips transaction) actually ended because of unresolved national security concerns after CFIUS completed a national security review. The other two transactions ended when the parties decided that, in their opinion, potential national security concerns or efforts to resolve those concerns, made CFIUS approval unlikely. These are critical distinctions because, based on publicly available information, it is unclear whether CFIUS would have blocked these deals or required mitigation that would have led to their abandonment.

We examine each transaction briefly below to highlight why the published assessments of CFIUS' impact has been incomplete. Overgeneralization or exaggerated conclusions about these events has unfortunate real world implications. The perception that CFIUS is blocking numerous Chinese transactions has heightened the perceived risks involved in transacting with Chinese companies. As US companies weigh offers from Chinese companies, they seek higher premiums on the purchase price, greater escrows, and substantial reverse breakup fees as the means to hedge that perceived risk. While the risks are certainly greater for proposed sales of high technology or sensitive technologies to Chinese buyers, evaluation of that risk depends upon not just information, but also an accurate understanding of the motivations for why parties close deals or walk away.

Philips Lumileds

GO Scale's proposed acquisition of the Philips Lumileds business is the only transaction of the three recently in the news where CFIUS completed its national security review. The deal involved a $3.3 billion sale by Royal Philips NV of approximately 80 percent of Philips' LED division, Lumileds, to GO Scale Capital, a consortium of investors comprised of GSR Ventures, Oak Investment Partners, Asia Pacific Resource Development, and Nanchang Industrial Group. The sale was announced in April 2015, and submitted for CFIUS review. In the fall of 2015, the companies indicated that "unforeseen" CFIUS objections had arisen, but expressed hope that the Committee's concerns could be addressed through "reasonable steps"—language which suggests that the parties attempted to negotiate an acceptable mitigation agreement with CFIUS. By late January 2016, however, the parties announced that they were terminating their transaction because, "despite extensive efforts" to mitigate CFIUS's concerns, "regulatory clearance" had not been obtained. Essentially, assuming mitigation was available, it was not acceptable to the transacting parties. In these situations, CFIUS informs the parties that if the transaction is not terminated, the Committee will recommend that the President block the deal.

It is fair to characterize this transaction as one "blocked" by CFIUS. Certainly, as originally proposed by the parties, CFIUS was not prepared to approve the transaction and whatever mitigation was required to obtain approval was deemed unacceptable to the parties. Thus, had the parties desired, they could have requested that CFIUS complete its action and formally recommend that the President block the transaction. This rarely occurs, however. The more typical scenario is that which happened here: the parties acknowledge the CFIUS position, withdraw their notice (thus terminating the CFIUS statutory requirement for a recommendation to the President) and terminate the transaction. Occasionally, parties may return with a different deal in an attempt to win CFIUS approval, but in most cases that reach this point, this ends the matter, as it apparently did here.

Western Digital

In September 2015, Unisplendor Corp. (Unis), a business unit of Tsinghua Holdings, which itself is a business affiliate of Tsinghua University, one of China's top universities, and Western Digital Corp., a well-known US manufacturer of computer and information storage solutions, agreed to a $3.775 billion equity investment by Unis in Western Digital. Unlike the Philips Lumileds transaction, where the parties readily acknowledged CFIUS jurisdiction, the parties in the Western Digital transaction took an aggressive stance towards CFIUS, asserting in the transaction documents and public statements that they did not believe the investment was a "covered" transaction, despite the fact that the investment came with board representation and would make a Chinese entity the largest Western Digital shareholder. While the CFIUS test for jurisdiction is "control," the Committee has adopted a fairly broad notion of what constitutes control, and has asserted jurisdiction in many cases where even less indicia of control existed. Despite this history, the parties built their investment expectations around the highly unlikely scenario that CFIUS would agree that this investment did not result in control and was therefore not a "covered" transaction.

The transaction documents reflected a unique perspective as well, allowing for termination if CFIUS concluded that the transaction was covered, rather than the usual terms that allow for termination if CFIUS blocks the transaction or insists on unacceptable mitigation terms. After submitting their initial arguments to CFIUS in the fall of 2015, the parties withdrew their first notice to allow further negotiation with the Committee regarding the question of CFIUS jurisdiction. The public record does not indicate whether the parties revised their agreement or simply advanced arguments, but ultimately, they re-submitted their notice, in late January 2016, again arguing that their transaction was not "covered." Here, too, the public pronouncements by Western Digital muddied the waters somewhat. While a CFIUS Notice, by law and regulation, starts a 30-day "review" period, Western Digital's regulatory filing, and the subsequent reporting surrounding it, were unclear whether the parties submitted the actual CFIUS Notice, or made some other submission reiterating their arguments that the transaction was not "covered." CFIUS does not provide advisory opinions, even as to whether a transaction is covered, and therefore it is much more likely that the parties submitted their Notice, and began the initial 30-day review period. This is an important distinction because, once the required Notice is filed, the CFIUS process calls for a 30-day review followed, if necessary, by a 45-day investigation. While CFIUS can conclude at the end of the 30-day review period that a transaction is not covered, it does not generally issue any documentation stating that a transaction is "covered." If that occurred in this case, it would be a rare event, worthy of note.

Regardless of the exact posture, in late February, to the surprise of few in the CFIUS legal community, CFIUS extended its review into an investigation. This confirms that it treated the parties' late January submission as a formal Notice, and that it began its normal statutory review in late January. According to the press reports that followed, the parties terminated the investment at this point, concluding that this constituted a finding by CFIUS that the transaction was covered.

In context then, the Western Digital/Unis transaction was hardly "blocked" by CFIUS. Instead, CFIUS simply decided that the transaction met the regulatory requirements and that the Committee therefore could, in fact, exercise jurisdiction over the proposed transaction. Given the controls disclosed in the publicly released documents, it seems unlikely that CFIUS would have blocked the Unis investment. CFIUS has approved other, similar investments and rarely requires substantial mitigation for this level of involvement, unless Unis had other rights not revealed by these documents.

The termination clause in the Western Digital transaction is atypical of those that are used to address CFIUS concerns in transactions. Clearly the parties had different reasons for deciding that the investment should not occur if CFIUS simply had jurisdiction. Likely, those reasons related to Western Digital's simultaneous play for SanDisk. Shortly after announcing the Unis investment, Western Digital announced a proposed merger with SanDisk. A Western Digital company found to be under Chinese "control" due to the Unis investment would mean that the SanDisk merger would also be subject to CFIUS review. Whether for timing reasons, technology reasons, or otherwise, it seems that the parties agreed that they did not want to subject the Western Digital/SanDisk merger to CFIUS review as well. To eliminate CFIUS jurisdiction for this downstream event, the parties needed to be able to terminate the Unis investment if CFIUS concluded even that it had jurisdiction.

Fairchild

The proposed acquisition of Fairchild Semiconductor International Inc. by China Resources Microelectronics Ltd. and Hua Capital Management Co., Ltd. (CRM) represents yet another permutation. This transaction was never even submitted to CFIUS. Instead, the Fairchild board rejected the CRM offer, citing regulatory risk. According to published reports, Fairchild determined that the CRM-proposed reverse termination fee of $108 million did not "adequately justify risking the company stockholder premium present in the ON Semiconductor [a competing bidder] transaction." Interestingly, Fairchild publicly welcomed a revised bid from CRM, which apparently was not forthcoming. Id. Though news reports resounded with talk of the "chilling" effect of CFIUS, the publicly available information suggests that this was primarily an economic decision by Fairchild, though clearly influenced by, among other things, the perception that CFIUS approval was uncertain.

The Fairchild board apparently considered CFIUS rejection a significant enough risk that it sought increased protections against a CFIUS decision to block the deal. The premium offered by the Chinese entities did not provide enough economic benefit for the board to find it in its shareholders' interest to discard the alternative offer from ON Semiconductor, whose offer preceded that from CRM. Thus, while the specter of CFIUS played a role in the Fairchild board's decision, we will never know whether, in fact, CFIUS would have objected to CRM's purchase, or what conditions, if any, would have been placed upon the transaction by CFIUS. It seems overly dramatic to assert that CFIUS caused the deal to fall apart when in fact it was the parties' risk profiles.

The Fairchild deal does highlight, however, that the possibility of a CFIUS rejection or CFIUS mitigation requirements that affect the economic value of a transaction can play a role in determining the overall economic value of a proposed deal. Boards weighing bids from Chinese suitors must factor into their overall assessment of a Chinese offer the potential for CFIUS action, up to and including blocking a deal. Similarly, Chinese entities must factor into their valuations the increased costs of perceived risks if CFIUS action is possible or likely, based on the nature of the US business involved in the transaction.


Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.

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