I. Introduction

The U.S. defense industry is expected to be under increasing financial stress over the next several years. Specifically, reduced Government spending will negatively affect defense contractors who rely primarily on Government contracts and fail to diversify their revenue base. Because some of these companies may either seek to reorganize their capital structures or file for bankruptcy in the near term, it is important for interested parties to consider national security and Government contract issues that may affect the restructuring of a U.S. defense contractor.

Although U.S. Government policies encourage investment in the United States, transactions that could result in foreign control of a "U.S. business," including a defense contractor, may involve review by the Committee on Foreign Investment in the United States ("CFIUS"). CFIUS, an inter-agency U.S. Government committee composed principally of Executive branch agencies, reviews transactions that raise national security issues. Although review is ostensibly voluntary, CFIUS may request that parties submit a transaction for review if a voluntary filing has not been made, and may initiate its own review if the parties decline to file. The President ultimately has the authority to block a transaction, or unwind it after closing, if there is credible evidence to believe that the foreign acquirer might take action that threatens to impair the national security and other provisions of law do not provide "adequate and appropriate" authority to protect the national security.

CFIUS has jurisdiction over mergers, acquisitions, or takeovers "by or with a foreign person," which could result in foreign control of a U.S. business when the transaction raises national security considerations. For purposes of CFIUS review, the U.S. business includes not only businesses organized as legal entities, but also assets that are operated as a business undertaking, even where not separately incorporated. Control exists where a foreign person has the ability to "determine, direct or decide" important business matters affecting an entity. By design, the test is not a bright-line test; instead, it is a functional definition that is quite fact-specific. While a majority ownership interest in a U.S. business generally will constitute control, in other cases control may be found where a foreign person acquires a partial ownership interest that is accompanied by significant governance rights, such as the ability to block or determine important matters. In addition, CFIUS has jurisdiction over the sale of a U.S. business by one foreign person to another, and the acquisition of one foreign company by another, where what is conveyed includes control over a U.S. business.

There is no definition of "national security" in the CFIUS statute or applicable regulations, thus affording CFIUS a fair amount of discretion in determining whether a transaction presents national security considerations. The analysis that CFIUS undertakes entails examining the threat posed by the foreign acquirer and the vulnerabilities posed by the U.S. business in light of the potential consequences for national security. While acquisition of a U.S. defense contractor engaged in national security matters would clearly warrant CFIUS review, other less obvious considerations may draw the attention of CFIUS. CFIUS review extends to transactions involving "critical infrastructure," such as bridges, telecommunications, utilities and technology, whether or not supplied to the U.S. Government. Further, a U.S. entity, even if not itself sensitive, may have facilities located near sensitive military or national security installations. Indeed, in a recent case, a Chinese-owned corporation was forced to unwind its purchase of membership interests in wind farm projects, after CFIUS initiated a review post-closing that was likely triggered by the location of the wind farms near a sensitive Navy installation.1

If a proposed transaction involves the transfer of Government contracts as assets, additional issues can be presented by the Anti-Assignment Act. Under that Act, with a few exceptions, Government contracts may not be assigned to other parties without the consent of the U.S. Government. Although the bankruptcy process generally provides mechanisms for contracts to be assumed by a reorganized debtor or assigned to a third party, the Anti-Assignment Act may prevent such Government contracts from being assumed or assigned without the consent of the U.S. Government. Governmental consent may or may not be forthcoming, and if granted, may carry conditions.

These national security and Government contract issues most commonly arise in the context of bankruptcy or restructuring transactions that propose: (i) the sale of a U.S. debtor's assets under section 363 of the Bankruptcy Code or pursuant to a chapter 11 plan of reorganization; or (ii) the assumption or assignment of a U.S. debtor's Government contracts pursuant to section 365 of the Bankruptcy Code.

II. Asset Sales

Section 363 of the Bankruptcy Code governs all sales of a debtor's assets (other than those pursuant to a plan of reorganization under section 1129) regardless of the size of the asset to be sold. This section applies both in the context of a sale of a single asset as well as a sale of substantially all of the assets of a business. Under section 363(c)(1), a debtor may sell its assets in the ordinary course of business without notice and a hearing, unless the court orders otherwise. However, if a proposed asset sale is not in the ordinary course of business, section 363(b)(1) provides that a debtor must provide notice and a hearing before such sale may be consummated.

Given the underlying bankruptcy purpose of maximizing the value of the estate assets, section 363 sales ("363 Sales") are typically undertaken through a public auction process. As a first step in this process, the debtor generally will attempt to find a bidder to set the floor value and opening bid for the asset (a "Stalking Horse Bidder"). Once a Stalking Horse Bidder has been located and a purchase agreement agreed to (or, in the absence of a Stalking Horse Bidder, once the asset is ready to be marketed for sale), the debtor will submit a motion to approve various procedures to govern the sale process. Where a Stalking Horse Bidder is involved, such bid procedures typically include various bid protections, such as breakup fees, topping fees, expense reimbursements, minimum overbid increments, bidder qualifications, or no-shop clauses that restrict a debtor's ability to market the asset. These are included in order to frame the auction process and to compensate the Stalking Horse Bidder for the expense and risks associated with assuming such role.

As part of the bidding procedures, there will also typically be a period for the trustee (or debtor-in-possession)2 to approach other parties (whether through direct communication or through public notification) who may be interested in purchasing the asset at issue and for such parties to undertake due diligence, which period begins upon the court's approval of the bidding procedures, and a deadline by which any additional bids for the asset must be submitted. If additional bids are received, the trustee will then hold an auction for the asset at which each of the competing bidders can increase their respective bids for the asset. At the conclusion of the auction, the party submitting the highest and best bid will be selected as the winning bidder, and the trustee will seek court approval of the sale to the winning bidder.

Additionally, if the property to be sold as part of an asset sale is subject to a lien securing an allowed claim, section 363(k) permits the holder of such claim to, unless the court orders otherwise, "credit bid" at the auction, offsetting the amount of its claim against the purchase price. The right to credit bid enables a secured creditor to purchase assets without putting up any cash and retake the property when it believes that the price bid at the sale does not sufficiently reflect the value of the collateral.

Alternatively, a chapter 11 plan of reorganization can provide for a sale of a debtor's assets pursuant to section 1123(b)(4) of the Bankruptcy Code. When formulating a chapter 11 plan, the plan proponent is required to divide the various holders of claims and equity interests into different groupings or "classes." Under a plan, each holder of a claim or interest is entitled to a particular treatment on account of such claim or interest. Among other things, a plan may provide for creditors to receive cash, new or modified debt, equity in the reorganized debtor or certain rights to purchase securities in the reorganized debtor. In chapter 11 cases, it is quite common for a group of lenders or bondholders to agree to convert their debt into equity pursuant to a plan.

In bankruptcy, asset sales under section 363 or a plan of reorganization typically are conducted on an expedited basis due to a debtor's liquidity concerns and declining operational performance. Accordingly, in the context of selecting a winning bidder at an auction, a trustee will likely consider the speed and certainty with which a potential purchaser may consummate the proposed sale. In order to avoid being disadvantaged in the sale process, a foreign bidder must therefore quickly identify and manage national security issues it may face in completing the sale, including whether CFIUS review may be necessary or prudent under the circumstances of the transactions.

By law, CFIUS reviews can take 30-90 days after the filing is accepted, or longer if the parties elect to withdraw and refile. Most reviews can be completed in 30 days, but reviews of acquisitions by entities controlled by a foreign government or of critical infrastructure quite often go to full investigation, generally lasting another 45 days. For these reasons, if a transaction should be submitted to CFIUS for review, a foreign bidder is well-advised to engage with CFIUS early, and to develop a comprehensive strategy that takes into account timing considerations—both for the CFIUS process (how long the review and investigation will take) and the bankruptcy process. Such a strategy maximizes closing options, helps identify potential deal risk early on and may help the bidder address and resolve the prospect of CFIUS review, which may devalue the bid if left unresolved.

Another key issue will be to assess whether and how, in the context of multiple bidders, CFIUS can be persuaded to accept the filing and "start the clock" where it is not clear that the foreign bidder will prevail. If a foreign bidder can demonstrate that its bid will likely prevail, CFIUS may well be willing to start its review at an early stage. Therefore, a foreign investor should give strong consideration to becoming the Stalking Horse Bidder in order to increase the likelihood of early CFIUS review.

In addition, a comprehensive strategy should include a careful assessment of whether and how the transaction might require CFIUS mitigation in response to possible national security concerns. Where mitigation is likely, the foreign bidder should proactively consider strategies, including excluding certain assets from its purchase, or agreeing to enter into special security arrangements with Government entities, including proxy agreements that assign voting control to independent U.S. citizens. By addressing potential CFIUS concerns as early as possible, a foreign bidder may optimize its potential to be selected as a winning bidder by reducing perceived risks that it will not be able to consummate a transaction on time or at all.

In the recent In re A123 Systems, Inc. bankruptcy case, Wanxiang America Corp. ("Wanxiang") – a corporation owned by a Chinese parent entity – became the successful bidder for the U.S. debtor's assets.3 In orchestrating its purchase, Wanxiang arranged to sell certain potentially sensitive assets to a U.S. company while retaining the debtor's core business. The sale was thus structured in a manner that would not delay the bankruptcy process, but which also addressed potential CFIUS concerns. Through careful planning, Wanxiang was able to navigate CFIUS review expeditiously without jeopardizing its bid.

However, In re Chateaugay Corp. highlights the pitfalls a foreign bidder for a U.S. debtor's assets may face without carefully planning for CFIUS review.4 In Chateaugay, a corporation majority-owned by the French government and a U.S. entity jointly submitted the highest bid for the assets of U.S. debtor LTV's Aircraft and Missiles Division. Apparently underestimating the difficulty and delay associated with the CFIUS review process, the French company offered to pay a $20 million "reverse break-up fee" in the event that it failed to obtain the requisite security approvals. The Department of Defense rejected the French company's proposed special security agreement and insisted that it enter into a voting trust. After the French company abandoned its CFIUS application and ultimately failed to obtain the necessary security approvals to consummate the sale, the court held that the French company had the burden of obtaining security approval for the sale and was therefore required to pay the "reverse break-up fee" to the debtor.

III. Government Contracts

In addition to the CFIUS considerations discussed above, where a U.S. Government contractor pursues a sale of its assets in bankruptcy, generally such sale will be accompanied by the assignment of key contracts and leases to the purchaser. As a U.S. contractor's principle assets often include its Government contracts, the key issues a foreign purchaser (or any purchaser) must consider include (i) valuing the contractor's Government contracts; (ii) determining whether such contracts may be terminated or devalued by the U.S. Government; and (iii) establishing whether such contracts may be assumed and/or assigned without the consent of the Government. As to this latter consideration, depending on the jurisdiction, the interaction of section 365(c) of the Bankruptcy Code and the Anti-Assignment Act may prohibit a trustee not only from assigning certain prepetition Government contracts, but from merely assuming them as well, without the Government's consent.

Section 365(a) of the Bankruptcy Code permits a trustee to assume or reject its executory contracts or unexpired leases. In other words, a trustee may choose whether to continue to perform under contracts or leases that require continued performance by both parties thereto. However, the trustee's right to assume its executory contracts and unexpired leases is subject to limitations under section 365(c)(1). Section 365(c)(1) provides:

The [debtor] may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment . . . .5

As noted, the Anti-Assignment Act provides that "[t]he party to whom the Federal Government gives a contract or order may not transfer the contract or order, or any interest in the contract or order, to another party."6 Courts have held, however, that the Act does not apply to certain types of transfers, including those transfers occurring "by operation of law."7

It is not surprising that the assignment of a Government contract is subject to the Anti-Assignment Act.8 However, due to the interrelationship of section 365(c)(1) of the Bankruptcy Code and the Anti-Assignment Act, depending on the jurisdiction in which a U.S. defense contractor files for bankruptcy protection, such contractor may also be prevented from assuming its own Government contracts without Government consent.

In deciding whether a trustee can assume a contract under section 365(c)(1), courts apply one of two tests, depending on the applicable jurisdiction: the "hypothetical test" or the "actual test".9 The "hypothetical test" bars assumption of the executory contract if applicable law would prohibit assignment of such contract.10 The approach applying the "actual test" bars assumption only when the trustee actually intends to assign the executory contract and applicable law prohibits such an assignment.11

Applying the "hypothetical test", courts find support for barring a debtor from assumption of Government contracts by the text of section 365(c)(1), which disjunctively prohibits assumption or assignment if applicable nonbankruptcy law allows the contract counter-party to refuse performance by an entity that is not the debtor or debtor-in-possession.12 In other words, if a debtor would be prohibited from assignment of a contract without consent of the Government pursuant to the Anti-Assignment Act, the debtor-in-possession is likewise prohibited from assuming that same contract by the operation of section 365(c)(1) of the Bankruptcy Code.

However, applying the "actual test", adopted by a majority of lower courts, a trustee may assume a contract as long as the trustee does not actually attempt to assign it.13 This approach allows a trustee to assume a contract so long as the entity assuming the contract is essentially the same entity whose performance is required under the contract.14 Courts following the "actual test" in circumstances implicating the Anti-Assignment Act note that this approach conforms with the purpose of the Anti-Assignment Act by only prohibiting "assumption or assignment in the same situations which 41 U.S.C. § 15 was designed to address—cases in which the Government would be forced to deal with an entirely new entity."15 A debtor-in-possession is "not 'an entity other than the debtor or debtor in possession,' and so could always assume the contract."16 However, if the debtor-in-possession were to attempt to assign such contract to a different entity, it would be prevented from doing so via the operation of section 365(c)(1) and the Anti-Assignment Act.17

Accordingly, if a Government contractor attempts to restructure its capital structure in a jurisdiction applying the "hypothetical test," it may be barred from assuming its valuable Government contracts, even if it does not attempt to assign such contracts to a third party. A Government contractor (or any company with key Government contracts) contemplating a restructuring through the bankruptcy process must therefore be careful to consider the jurisdiction in which it files for bankruptcy protection, as its decision to file in a jurisdiction applying the "hypothetical test" to assumptions of executory contracts may have adverse consequences to such contractor's ability to assume its key contracts.


1. See Ralls Corp. v. Comm. on Foreign Inv. in the United States, __ F. Supp. __, 2013 WL 5565499 (D.C.D.C. Oct. 9, 2013). The Ralls case is discussed in more detail in a Stroock Special Bulletin. See Christopher R. Brewster, Foreign Investors Skip Government Review at Their Peril: U.S. District Court Dismisses Challenge to President's Authority, Stroock Special Bulletin (Oct. 21, 2013), https://www.stroock.com/SiteFiles/Pub1407.pdf.

2. As used in the Bankruptcy Code, the term "trustee" generally includes the "debtor-in-possession." 11 U.S.C. §1107(a). Accordingly, when the term "trustee" is used in this article, it should be read to include debtor-in-possession.

3. See generally In re B456 Sys., Inc. (f/k/a A123 Sys., Inc.), Case No. 12-12859 (KJC) (Bankr. D. Del. 2013). Additionally, in the recent In re Fisker Automotive Holdings, Inc. bankruptcy case, Wanxiang was selected as the winning bidder at an auction for the sale of the U.S. debtor's assets. See In re Fisker Auto. Holdings, Inc., Case No. 13-13087 (KG) (Bankr. D. Del. Feb. 14, 2014) (ECF No. 628).

4. See LTV Aerospace & Def. Co. v. Thomson-CSF, S.A. (In re Chateaugay Corp.), 198 B.R. 848 (S.D.N.Y. 1996).

5. 11 U.S.C. § 365(c)(1).

6. 41 U.S.C. § 6305(a).

7. See, e.g., Thompson v. Comm'r,205 F.2d 73, 76 (3d Cir. 1953); see also FAR 42.1204(b) (providing that novation agreements, pursuant to which the Government consents to a transfer of contracts, are not necessary for a change of ownership as a result of a stock purchase).

8. See In re W. Elecs. Inc., 852 F.2d 79, 83 (3d Cir. 1988) ("[A]ssignment of a contract calling for the production of military equipment is precisely what Congress intended to prevent when it prohibited assignments in [the Anti-Assignment Act].").

9. See United States v. TechDyn Sys. Corp. (In re TechDyn Sys. Corp.), 235 B.R. 857, 860-61 (Bankr. E.D. Va. 1999).

10. See Cinicola v. Scharffenberger, 248 F.3d 110, 126 n.19 (3d Cir. 2001) (discussing the "hypothetical test"). The "hypothetical test" has been accepted by the Third, Ninth and Eleventh Circuits. See In re TechDyn Systems Corp., 235 B.R. at 860 (listing courts that have applied the "hypothetical test").

11. See Summit Inv. & Dev. Corp. v. Leroux, 69 F.3d 608, 619 (1st Cir. 1995).

12. In re TechDyn Sys. Corp., 235 B.R. at 861; see In re W. Elecs. Inc., 852 F.2d at 83 (noting that if a debtor is foreclosed from assigning an executory contract to another defense contractor under the Anti-Assignment Act, the debtor is also barred from assuming such executory contract).

13. In re TechDyn Sys. Corp., 235 B.R. at 861 (listing courts that have applied the "actual test").

14. See In re Hartec Enters., Inc., 117 B.R. 865, 872 (Bankr. W.D. Tex. 1990), vacated by settlement, 130 B.R. 929 (W.D. Tex. 1991).

15. Id.

16. Id. at 872-73.

17. See id.

For More Information

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Chris Griner
Christopher R. Brewster
Gregory Jaeger
Anne W. Salladin

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Kristopher M. Hansen
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