How New U.S. M&A Restrictions On China Will Affect Tech Cos. - Terrorism, Homeland Security & Defence

In a regulatory blitz, the Trump administration has recently taken a series of unprecedented actions designed to further protect domestic information and communications technology, or ICT, and services from what it considers Chinese threats. These steps will constrain China’s access to the U.S. market and to U.S. technology — and some have an immediate effect.

We summarize below the implications of these new developments, and flag key takeaways for M&A professionals.

The View From Washington

The month of May saw significantly increased tensions between the U.S. and China on national security grounds, which will have a cascading economic impact.

According to President Donald Trump, foreign adversaries are increasingly creating and exploiting vulnerabilities in the U.S. ICT sectors in order to commit malicious cyber-enabled actions, including economic and industrial espionage against the United States. Trump has emphasized that maintaining an open investment climate in these sectors must be balanced by the need to protect the country against critical national security threats.

Similarly, the Trump administration recently announced China had “reneged” on its commitments to enshrine under its domestic law prohibitions on forced technology transfer and protections against intellectual property theft, both of which it believes malign U.S. companies operating in and outside China. Due to this breakdown in negotiations, instead of a trade deal, for now the U.S. and China have set a course of escalating tariff actions and other retaliatory measures.

Executive Order on Securing Information and Communications Technology and Services Supply Chain

On May 15, 2019, Trump issued an executive order that declares a national emergency with respect to foreign threats against ICT and services in the U.S. It delegates authority to the U.S. Secretary of Commerce to establish, within 150 days, a comprehensive regulatory regime to mitigate or prohibit certain transactions posing an unacceptable risk to U.S. national security or the security and safety of U.S. persons.

While the EO does not specifically target any country or companies, there is broad consensus that its focus is China and its companies, such as Huawei and ZTE.

The EO prohibits all dealings in ICT and services by any person subject to U.S. jurisdiction, or with respect to any property subject to U.S. jurisdiction, where they: (1) involve technology or services supplied by a “foreign adversary” (as to be designated by the Department of Commerce) or a party under the jurisdiction, ownership or control of such adversary; and (2) the transaction poses risk of sabotage to U.S. networks, critical infrastructure or “digital economy,” or other national security risks.

The EO defines ICT and services broadly, and includes any hardware, software or other product or service primarily intended to fulfill or enable the function of information or data processing, storage, retrieval or communication by electronic means, including transmission, storage and display.

Transactions covered by the EO include any “acquisition, importation, transfer, installation, dealing in, or use of” any ICT or services “designed, developed, manufactured, or supplied, by persons owned by, controlled by, or subject to the jurisdiction or direction of a foreign adversary.”

The U.S. Director of National Intelligence must provide the president and the secretary of commerce with an associated classified threat assessment before the end of June. The Commerce Department will use that threat assessment to draft implementing regulations that will:

Identify particular countries or persons that are “foreign adversaries” for the purposes of the EO;
Identify persons owned by, controlled by or subject to the jurisdiction or direction of foreign adversaries for the purposes of the EO;
Identify particular technologies or countries with respect to which transactions involving ICT or services warrant particular scrutiny under the EO;
Establish procedures to license transactions otherwise prohibited pursuant to the EO;
Establish criteria by which particular technologies or particular participants in the market for ICT or services may be recognized as categorically included in, or as categorically excluded from, the prohibitions established by the EO; and
Identify a mechanism and relevant factors for the negotiation of agreements to mitigate concerns raised under the EO.

Commerce Department Adds Huawei and Affiliates to Entity List

The day after Trump issued the EO, the Trump administration took direct aim at Huawei. The Commerce Department issued a final rule adding Huawei and 68 of its non-U.S. affiliates to the Bureau of Industry and Security’s “entity list,” effective as of May 16, 2019.

Within the area of international trade controls, such a designation is often referred to as the “death penalty,” as it effectively bans a company from sourcing parts and components from U.S. companies and other U.S.-origin technology worldwide, cutting them off from a critical supply chain.

Though there may be some limited exceptions forthcoming to temporarily allow certain maintenance of existing networks, a license will now be required to provide Huawei and its identified affiliates with any items subject to the export administration regulations, and it is anticipated that such license applications are likely to be denied, or at a minimum, intensely scrutinized.

FCC Denies China Mobile’s License Application

Less than a week before the EO, the Federal Communications Commission denied China Mobile USA’s application to provide telecommunications services between the United States and foreign destinations, on the grounds that national security and law enforcement risks could not be addressed through a mitigation agreement between China Mobile and the U.S. government.

Notably, this regulatory process consumed over seven years, as China Mobile filed its initial application in 2011. In 2018, after a lengthy review of the application, discussions with the applicant and consultation with the U.S. intelligence community, the Commerce Department’s National Telecommunications and Information Administration filed a recommendation on behalf of executive branch agencies to deny China Mobile’s application.

This was the first instance in which executive branch agencies (commonly known as "Team Telecom") have recommended that the FCC deny an application under Section 214 of the Communications Act of 1934 (commonly referred to as a “Section 214 application”) due to national security and law enforcement concerns.

In light of this denial, the EO, and the addition of Huawei to the entity list, Team Telecom likely will issue additional recommendations that the FCC deny pending similarly situated applications — and possibly even make recommendations to revoke existing licenses that pose similar national security concerns.

Key Takeaways

Carefully Consider Regulatory Overlap

The U.S. government’s efforts to protect the telecom sector reflect a whole-of-government approach. It is crucial to understand how and under what circumstances new rules and regulations may — or may not — interplay with existing regulatory regimes.

For example, existing (and new) export controls and the new EO regime will have significant impacts on a CFIUS risk analysis in connection with an exit or other investment transaction involving a “foreign person.”

Conduct Internal Risk Assessments Early in the Transaction Process

U.S. ICT companies should conduct risk exposure assessments, and consider whether developing new compliance policies and procedures would be warranted under these circumstances.

Notably, these are broad exposure risks that are not limited to network operators, original equipment manufacturers or more traditional major players. These risks extend to component manufacturers and IT service providers.

Risk Is Not Limited to China

While the emphasis of these latest regulatory efforts is focused on reducing risk perceived to be emanating from China, none is specifically limited to addressing Chinese risks. Thus, U.S. ICT companies also will need to consider indirect risk.

CFIUS, for example, continues to assess possible third-party risks associated with perceived dependencies on problematic commercial partners, and the potential loss of U.S. technological leadership.

Stay Alert — More Change Is Coming

Under the EO, the Commerce Department is required to publish the associated regulations to fully implement the new regime by mid-October 2019. The department is also working to publish a notice of proposed rulemaking for “emerging” technologies, and an advanced notice of proposed rulemaking for “foundational” technologies, as required under the Export Control Reform Act and the Foreign Investment Risk Review Modernization Act, or FIRRMA.

Furthermore, CFIUS is currently drafting implementing regulations for FIRRMA before its statutory deadline in February 2020, which, among other things, will expand its authority to review certain foreign minority investments in both ICT and services. Stakeholders need to prepare for a shifting regulatory landscape.

Mario Mancuso, Sanjay Mullick, Anthony Rapa and Shawn Cooley are partners and Lucille Hague is an associate at Kirkland & Ellis LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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