By Jinsong Zhang, Wei Kao, Zhengyi Pan King & Wood Mallesons‘ Finance & Capital Markets group
On September 13, 2017, U.S. President Donald Trump issued an executive order blocking a Chinese-backed private equity firm headquartered in Palo Alto, California, Canyon Bridge Capital Partners Inc. (“Canyon Bridge”), from buying a Hillsboro, Oregon-based chipmaker, Lattice Semiconductor Corporation (“Lattice”), for $1.3 billion, sending a signal that the U.S. will oppose China-related takeover deals that particularly involve in the high-tech sector.
This is the second blocked Chinese connected acquisition in the semiconductor industry within a year, and was only the fourth time within the last thirty years that a U.S. President vetoed a transaction based on national security grounds. [1]Interestingly, although transactions blocked by the U.S. President are rare, all of the four blocked deals are China related.
This decision came amid growing scrutiny on Chinese investments and some lawmakers are calling Washington to toughen its rules governing foreign investment. The Lattice/Canyon Bridge case reflects the significant changes in the current political environment in Washington toward China related investments. Therefore, it is becoming more important for the Chinese investors, especially those backed by the Chinese government, to understand and carefully analyze the CFIUS review process before making investment decisions.
Overview of Committee on Foreign Investment in the United States (CFIUS) Review Process
The U.S. government controls foreign investment in the U.S. primarily through an interagency committee called CFIUS. CFIUS, comprised of nine Cabinet members, two ex officio members and other members appointed by the President, is chaired by the Secretary of Treasury Department. CFIUS is authorized to review transactions that could result in control of a U.S. business by a foreign person (“Covered Transactions”), in order to determine the effect of such transactions on the national security of the United States.
The CFIUS review process could take several months to complete. Generally, the parties are recommended to first conduct pre-consultation with CFIUS by submitting a draft notice prior to the formal filing, and then follow by a jointly formal voluntary notice of the proposed deal. The staff will do a first review and determine whether to proceed. After the case is successfully circulated to all CFIUS members, a 30-day initial review period begins. If CFIUS identifies potential national security concerns associated with the transaction, a 45-day subsequent investigation may be initiated. CFIUS may also refer a transaction to the President for decision, and the President will announce a decision within 15 days of the completion of the investigation. If CFIUS determines that more time is required for it to complete its review, CFIUS may ask the parties to withdraw and refile the application so that they can recalculate the review period.
CFIUS primarily focuses its review on two key points. The first key point is whether the target company will be “controlled by a foreign person”, especially controlled by a foreign government, after the transaction. Under the CFIUS regulations, “control” does not exist where a foreign person acquires 10% or less of a U.S. business for “passive investment.”[2]Any transaction that amounts greater than 10% shares of the target company or not for passive investment is outside of such safe-harbor and may meet the threshold for “control”. Recent cases have shown that Chinese State-backed entities, regardless of how the entity structure would be organized, would be an obvious red flag and receive heavy scrutiny.
The second key point is whether the target company is in the business involving “national security”. Generally, industries such as information security, national defense, telecommunications, aerospace, transportation, military appliance, energy are sensitive sectors that would trigger national security concerns. However, in the last few years, besides the traditional sensitive industries, industries that involve leading-edge technology such as artificial intelligence, semiconductor, and big data analytic have also been drawing enhanced scrutiny by CFIUS. Furthermore, CFIUS is also becoming increasingly alarmed to acquisitions that grant foreign investors access to personal data of U.S. residents.
As a result of such expended scope, several high-profile transactions involving Chinese investors were halted due to “national security” concern, including the Aixtron transaction which was blocked by President Obama (semiconductor); Royal Philips’s sale of a controlling interest in its Lumileds business to a Chinese purchaser which was blocked by CFIUS (LED products); Fairchild Semiconductor rejected a Chinese acquisition offer due to CFIUS risk (semiconductor); HNA Group’s proposed acquisition of Global Eagle Entertainment Inc. fails to obtain CFIUS approval (inflight entertainment and connectivity products); and T.C.L. Industries Holdings abandoned the proposed purchase of Inseego Corp (telecommunication). These cases are either withdrawn by the applicant or rejected by CFIUS.
The Lattice/Canyon Bridge Transaction
The target, Lattice Semiconductor Corporation, an Oregon company, is a publicly traded semiconductor company that manufactures programmable logic devices which can be used by customers for specific uses such as vehicles, computers, and mobile phones. Lattice started seeking potential acquirers in February 2016, and on April 8, 2016 China Reform Fund Management Co (“CRFM”) approached Lattice for a potential takeover bid. After the parties reached a preliminary understanding, instead of a direct investment, CRFM decided to establish a new private equity buyout fund, Canyon Bridge Capital Partners, Inc. with China Venture Capital Fund (“CVCF”), a subsidiary of CRFM, as its sole limited partner.
On November 3, 2016, this $1.3 billion deal was announced. The parties jointly filed with CFIUS on December 28, 2016 for the first time. Approximately one month after the proposed acquisition was announced, a bipartisan group of 22 members of the U.S. House of Representatives submitted a letter to then U.S. Secretary of the Treasury Jack Lew objecting to the proposed transaction, asserting that “the deal could disrupt the U.S. military supply chain and possibly lead to a reliance on foreign-sourced technologies for many critical U.S. Defense Department programs.” In a September 1, 2017 filing with the U.S. Securities and Exchange Commission, Lattice announced that the parties had been unable to resolve certain concerns expressed by CFIUS regarding the proposed acquisition. According to public reports, CFIUS submitted a package of information to President Trump and recommended that the President block the proposed acquisition.
Although Lattice stated in their disclosure that they have proposed a mitigation proposal with a scope that was the single most comprehensive ever proposed for a foreign transaction in the semiconductor industry, an agreement was unable to be reached with CFIUS, and President Trump accepted CFIUS’s recommendation to block this deal by claiming that the acquisition of Lattice presented national security concerns for reasons including (1) the potential transfer of intellectual property to the foreign acquirer; (2) the Chinese government’s role in supporting the transaction (source of funds); (3) the importance of semiconductor supply chain integrity to the U.S. government; and (4) the use of Lattice products by the U.S. government.
Key Takeaways of the Lattice/Canyon Bridge Deal
One of the main issues arising in the Lattice/Canyon Bridge Deal is the CRFM’s strong connection with the Chinese government. In particular, CRFM owns businesses with military applications and also invested in other sensitive industries in line with Chinese government’s military and economic agendas. Realizing this tie could be potentially problematic, CRFM designed a complex transaction structure by establishing a U.S. based private equity fund, Canyon Bridge, and engaging two U.S. nationals as its general partner to oversee the fund. With this deal structure, CRFM hope to show that the purchaser, Canyon Bridge, is a US based entity and is operated by US based general partner and CRFM, as the limited partner, is only acting as a passive investor with limited operational rights. Despite this effort, CFIUS is still unconvinced and found this transaction structure to be a Cover Transaction and ultimately determined that because the funding of Canyon Bridge is solely raised from a limited partner with strong Chinese government backing, the Chinese government’s support of this transaction cannot be overlooked hence it presented unresolvable national security concerns. This shows that no matter how the purchaser designing the deal structure, CFIUS will eventually trace back to the ultimate controller and its affiliates to determine whether the target company will be controlled by a foreign person after completion. The outcome may have been different if Canyon Bridge can bring forth a more diversified group of investors as its limited partners to dilute the role and funding ratio of CRFM.
The following graph shows the deal structure and Canyon Bridge’s connection with Chinese Government. CRFM operates as an investment holding company, and provides management acquisition, merger, recapitalization and other services through its subsidiaries. CRFM invests in selected industries related to national security and the economy, and is called China’s “investment arm” by Bloomberg news. According to Reuters, one of CRFM’ subsidiaries is China Aerospace Science & Tech Corporation (“CASC”), a state-owned enterprise group originated from the Fifth Academy of the Ministry of National Defense. Many famous brands such as Shenzhou and Long March are owned by CASC. All these factors are being considered by CFIUS during its review and ultimately led to the determination that there is a significant “Chinese government’s role in supporting the transaction”.
Going Forward
U.S. President Donald Trump has seen publicly criticizing China’s economic policies in numerous occasions. Under Trump’s administration, the Lattice decision shown that the U.S. government is committed to carefully scrutinizing prospective transactions that would result in a Chinese investor acquiring control of a U.S. business in key technology sector. As mentioned above, in recent years, the CFIUS review process has resulted in the blocking—or abandonment—of numerous high profiled cases involving Chinese investors, a trend that may further escalate under the Trump Administration.
As the Lattice decision has demonstrated, it’s substance over form that matters the most, meaning neither a “limited partner” nor a U.S. private equity buyout fund managed by U.S. citizens could fall into a safe harbor. No matter how complex the deal structure is organized, Chinese State-backed investors cannot circumvent, and will be subject to, heightened scrutiny by CFIUS. CFIUS will look carefully into each equity holder’s contribution to the acquisition, their rights and obligations in controlling the target company, the identity of the ultimate controller and its affiliates and source of funds.
In addition, attention should be paid to certain sensitive industries that relate to U.S. national security, including but not limited to: information security, national defense, telecommunications, aerospace, transportation, military appliance and energy. Newly developed areas, such as artificial intelligence, semiconductor, and big data analytics are also drawing heightened review by CFIUS.
Furthermore, the length of the CFIUS review process should also be taken into account. As stated above, the process should take between 30 and 75 days, depending on whether CFIUS determines that a 45-day follow-up investigation is warranted. However, this time frame does not account for the time required to gather the detailed information that must be included in the parties’ joint voluntary notice. In addition, as illustrated by recent cases, CFIUS can, and increasingly does, request that parties to a Covered Transaction refile their request for pre-clearance, which effectively restarts the 75-day clock. As a result, it can be difficult to predict the time and costs (e.g., legal costs; management distraction) associated with obtaining CFIUS pre-clearance with any certainty. For this Lattice transaction, CFIUS requested the parties to refile their request for pre-clearance two times. As a result, the CFIUS review process for such transaction stretched over 9 months, which can present a variety of commercial and practical challenges.
The Timeline of the Lattice/Canyon Bridge Deal
Finally, it should be noted that CFIUS is confined by the legal framework that lessen unfounded hostility to new China investments and the fact that most of the Chinese investment deals are indeed approved by CFIUS without issues. Going forward, CFIUS’s increasingly expansive view of U.S. national security will require prospective foreign investors to think broadly (and creatively) regarding potential national security implications of the contemplated investments and acquisitions. However, Chinese investors should not be deterred by fear of opposition from the CFIUS or U.S. government when making decisions in future investments in the U.S.
[1]The other three transactions are: In 1990, President George H.W. Bush blocked a Chinese-based company from acquiring MAMCO Manufacturing Inc., a manufacturer of aircraft components; in 2012, President Obama ordered Chinese-owned Ralls Corporation to unwind its acquisition of a wind farm near a Navy base in Oregon; in 2016, President Obama issued an order prohibiting the proposed $710 million acquisition of Aixtron GE, a German-based technology company, by Grand Chip Investment GmbH (GCI), a German subsidiary of Fujian Grand Chip Investment Fund LP of China. In addition, there are a number of deals involving Chinese investors who voluntarily withdraw CFIUS application after running into roadblocks in the CFIUS process.
[2]31 C.F.R. § 800.302(b)