LawFlash

CFIUS Says Farewell to NAICS, Hello to Export Licensing in Mandatory Declarations

June 03, 2020

The Committee on Foreign Investment in the United States’ proposed changes to the mandatory declaration program would expand the potential industries affected by the mandatory declaration requirements, but also narrow the focus to foreign persons and countries that are subject to export controls.

At the time the final regulations were published on January 17, 2020, implementing the Foreign Risk Review Modernization Act of 2018 (FIRRMA), the US Department of the Treasury’s Committee on Foreign Investment in the United States (CFIUS) indicated that it would be proposing changes to the Pilot Program’s use of the 27 North American Industry Classification System (NAICS) codes as one of the triggers for mandatory declaration requirements and would move toward a focus on exporting licensing requirements.[1] In the interim, CFIUS had essentially incorporated the Pilot Program’s mandatory declaration requirements into the final regulations with the addition of a few exceptions.

On May 21, 2020, CFIUS published its proposed changes to the mandatory declaration program and solicited comments by June 22.[2] We anticipate that following the closing of the comment period, the final regulations implementing these regulations will be published quickly and become effective for transactions not signed or closed before the effective date of the final regulations.

As detailed below, the proposed changes represent an expansion of the potential industries affected by the mandatory declaration requirements through the elimination of the 27 NAICS codes, but also a narrowing of the focus to those foreign persons and the countries where they are located that are subject to export licensing requirements.[3] If adopted, determining whether a particular covered transaction[4] or covered investment[5] is subject to a mandatory CFIUS filing will now depend on the detailed export control analysis required by the regulations. Further, this new emphasis on the applicable export controls may benefit foreign persons from countries not subject to the same level of export controls, especially those who did not benefit from the initial designation of Excepted States and Excepted Investors, which were limited to Australia, Canada, and the United Kingdom and their qualifying entities or persons. Conversely, foreign persons from countries subject to greater export controls may experience increased mandatory declaration requirements.

Proposed Rule and Required Export Control Analysis

The current mandatory declaration program requires a submission to CFIUS if a transaction is a “covered transaction” that constitutes a “covered investment” or would result in a change in control of a Technology, Infrastructure, or Data (TID) business and (1) concerns a US business that produces, designs, tests, manufactures, fabricates, or develops one or more “critical technologies” as defined under FIRRMA and the implementing regulations; and (2) the US business uses or specifically designs such technology for use in an industry categorized under one of 27 NAICS codes.

Under the current regulations, which are a carryover from the Pilot Program, the export control analysis that had to be conducted focused on whether the US business had technology controlled for export under the export control regimes referenced in the definition of “critical technology.”[6] That analysis was agnostic toward the identity of the foreign investor/purchaser but rather focused on the reach into and control over the TID US business’s technology the foreign purchaser would receive as a result of the transaction. As a result, in a non-controlling investment, the foreign person could agree not to have a board representative or observer, and agree not to have any access to “material non-public technical information” to preclude the investment from being considered a “covered investment,” even where the US business met the export control requirements. This was a popular structuring technique used when “critical technology” was present.

Now, the proposed rules change the mandatory declaration requirements to be triggered when a “US regulatory authorization” would be required for the export, reexport, transfer (in country), or retransfer of “critical technology” to a foreign person that is a party to the covered transaction, and such foreign person

  1. could directly control such TID US business as a result of the covered transaction;
  2. is directly acquiring an interest that is a covered investment in such TID US business;
  3. has a direct investment in such TID US business, the rights of such foreign person with respect to such TID US business are changing, and such change in rights could result in a covered control transaction[7] or a covered investment;
  4. is a party to any transaction, transfer, agreement, or arrangement to evade CFIUS jurisdiction or review; or
  5. individually holds, or is part of a group of foreign persons that, in the aggregate, hold, a voting interest for purposes of critical technology mandatory declarations in a foreign person described in the foregoing sections.[8]

While the proposed regulations do not modify the definition of “critical technologies,” they eliminate the requirement that the US business operate in one of the specified 27 NAICS codes. The use of NAICS codes caused concern in both industry and government, as the codes are generally broad and designed principally for census purposes and necessarily required a subjective determination that was susceptible to manipulation.

In place of the NAICS code determination, the proposed rules introduce a new definition of “US regulatory authorization,” which will apply to covered change of control transactions and investments. Importantly, the proposed rules do not affect the ability of a foreign person in a non-controlling investment to give up a board seat or observer rights and access to “material non-public technical information” involving critical technologies in order to preclude subjecting the transaction to the mandatory declaration rules, and this will remain a popular structuring technique.

The proposed regulations also introduce a new concept of “voting interest for purposes of critical technology mandatory declarations” that applies to any foreign person making the direct investment. This means that parties to a transaction will need to conduct an export control analysis not only on the foreign person making the direct investment, but also on any person having a sufficient “voting interest,” which is defined as 25% or more and requires aggregation of the investment by persons acting in concert.

Interestingly, the definition of “US regulatory authorizations” uses different language for the different export control regimes without any explanation or policy rationale.[9] The proposed rule further explains that the question of whether a regulatory authorization would be required shall be determined

  1. without giving effect to any license exemption available under the ITAR or license exception available under the EAR except as described paragraph in (e)(6) of this section;[10]
  2. based on such foreign person's principal place of business (for entities) as defined in Section 800.239, or such foreign person's nationality or nationalities (for individuals) under the relevant US regulatory authorization, as applicable; and
  3. as if such foreign person is an “end user” under the applicable US regulatory authorization, as applicable.

The proposed rule does not explain or provide any strategic rationale regarding why only three EAR license exceptions are recognized. However, the US government’s recent removal of License Exception CIV[11] and institution of an affirmative licensing requirement for exports in furtherance of “military end uses” or “military end users” in China, Russia, and Venezuela[12] suggest an increased concern over the use of certain license exceptions by certain adversaries.

Further, and although the commentary and examples do not address the issue, this explanatory language in 3. above also raises the question whether the foreign person’s status for export control purposes (e.g., listing on the Entity or Denied Persons List maintained by the US Department of Commerce), in addition to its principal place business or nationality, could determine if a “US regulatory authorization” is required. In other words, if a foreign person on the Entity List were included in the relevant ownership chain with 25% or more voting interest, would “US regulatory authorization” be required? This would then bring into the mandatory declaration requirement transactions involving entities where existing investors are or become Entity List parties.

Conclusion

The proposed changes represent both an expansion of the potential industries affected by the mandatory declaration requirements through the elimination of the 27 NAICS codes but also a narrowing of the focus to those foreign persons and the countries where they are located that are subject to export controls. These changes could benefit foreign persons in jurisdictions with fewer export controls and result in increased mandatory declarations for jurisdictions with greater export controls.

The wording of the definition of “US regulatory authorization,” the exclusion of certain license exceptions, and the “voting interest” requirements will present some interpretive challenges that may be further clarified either in the final regulations or through the CFIUS implementation that follows.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Carl A. Valenstein

Washington, DC
Giovanna M. Cinelli
Kenneth J. Nunnenkamp
Ulises R. Pin
Alex S. Polonsky
Heather C. Sears
 Katelyn M. Hilferty
Christian Kozlowski



[1] Provisions Pertaining to Certain Investments in the United States by Foreign Persons, 85 Fed. Reg. 3112, 3121 (Jan. 17, 2020) (codified at 31 C.F.R. part 800).

[2] Provisions Pertaining to Certain Investments in the United States by Foreign Persons, 85 Fed. Reg. 30,893 (proposed May 21, 2020) (to be codified at 31 C.F.R. part 800).

[3] The proposed rule also makes clarifying amendments to the definition of the term “substantial interest” by clarifying that the focus is on substantial investments in general partners, managing members, or the equivalent that primarily direct, control, or coordinate the activities of that entity, but it does not otherwise modify the structure of the mandatory filing requirement. See id.

[4] The term “covered transaction” means any of the following:

  1. A covered control transaction.
  2. A covered investment.
  3. A change in the rights that a foreign person has with respect to a US business in which the foreign person has an investment, if that change could result in a covered control transaction or a covered investment.
  4. Any other transaction, transfer, agreement, or arrangement, the structure of which is designed or intended to evade or circumvent the application of Section 721. 31 C.F.R. § 800.213.

[5] The term “covered investment” means an investment, direct or indirect, by a foreign person other than an excepted investor, in an unaffiliated TID US business that is proposed or pending on or after February 13, 2020, and that

  1. Is not a covered control transaction; and
  2. Affords the foreign person
    1. access to any material nonpublic technical information in the possession of the TID US business;
    2. membership or observer rights on, or the right to nominate an individual to a position on, the board of directors or equivalent governing body of the TID US business; or
    3. any involvement, other than through voting of shares, in substantive decisionmaking of the TID US business regarding
      1. the use, development, acquisition, safekeeping, or release of sensitive personal data of US citizens maintained or collected by the TID US business;
      2. the use, development, acquisition, or release of critical technologies; or
      3. the management, operation, manufacture, or supply of covered investment critical infrastructure.
  3. Notwithstanding paragraphs (a) and (b) of this section, no investment involving an air carrier, as defined in 49 U.S.C. 40102(a)(2), that holds a certificate issued under 49 U.S.C. 41102 shall be a covered investment. Id. at § 800.211.

[6] The term “critical technologies” means any of the following:

  1. Defense articles or defense services included on the United States Munitions List set forth in the International Traffic in Arms Regulations (ITAR);
  2. Items included on the Commerce Control List set forth in Supplement No. 1 to part 774 of the Export Administration Regulations (EAR), and controlled

    (1)   pursuant to multilateral regimes, including for reasons relating to national security, chemical and biological weapons proliferation, nuclear nonproliferation, or missile technology; or

    (2)   for reasons relating to regional stability or surreptitious listening;

  3. Specially designed and prepared nuclear equipment, parts and components, materials, software, and technology covered by 10 C.F.R. part 810 (Part 810);
  4. Nuclear facilities, equipment, and material covered by 10 C.F.R. part 110 (Part 110);
  5. Select agents and toxins covered by 7 C.F.R. part 331, 9 C.F.R. part 121, or 42 C.F.R. part 73; and
  6. Emerging and foundational technologies controlled under Section 1758 of the Export Control Reform Act of 2018 (50 U.S.C. 4817). Id. at § 800.215.

[7] The term “covered control transaction” means any transaction that is proposed or pending after August 23, 1988, by or with any foreign person that could result in foreign control of any US business, including such a transaction carried out through a joint venture. Id. at § 800.210.

[8] Provisions Pertaining to Certain Investments in the United States by Foreign Persons, 85 Fed. Reg. at 30,898.

[9] The term “US regulatory authorization” means any of the following:

  1. A license or other approval issued by the Department of State under the ITAR.
  2. A license from the Department of Commerce under the EAR.
  3. A specific or general authorization from the Department of Energy under the regulations governing assistance to foreign atomic energy activities at Part 810 other than the general authorization described in 10 C.F.R. 810.6(a).
  4. A specific license from the Nuclear Regulatory Commission under the regulations governing the export or import of nuclear equipment and material at Part 110. Provisions Pertaining to Certain Investments in the United States by Foreign Persons, 85 Fed. Reg. at 30,898.

[10] 15 C.F.R. §§ 740.13 (Technology and software – unrestricted (TSU)), 740.17(b) (Encryption commodities, software, and technology (ENC)), and 740.20(c)(1) (Strategic Trade Authorization (STA)).

[11] Elimination of License Exception Civil End Users (CIV), 85 Fed. Reg. 23,470 (Apr. 28, 2020) (to be codified at 15 C.F.R. part 740).

[12] Expansion of Export, Reexport, and Transfer (in-Country) Controls for Military End Use or Military End Users in the People’s Republic of China, Russia, or Venezuela, 85 Fed. Reg. 23,459 (Apr. 28, 2020) (to be codified at 15 C.F.R. part 744).