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

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
Katelyn M. Hilferty
Christian Kozlowski