On Friday, the Committee on Foreign Investment in the United States (CFIUS) issued its final regulations governing national security reviews of foreign investments in U.S. businesses. These regulations formally implement amendments adopted by the Foreign Investment and National Security Act of 2007 (FINSA) to the Exon-Florio Amendment to the Defense Production Act of 1950.
Almost a year ago, when CFIUS was still in the process of drafting the regulations, ACT released a paper on the importance of not unnecessarily restricting US-bound FDI flows during a time of sharply reduced domestic credit availability.
We pointed out that, thanks to the sub-prime mortgage disaster, it has become much harder for small and medium-sized IT firms to raise capital to develop new products, jeopardizing America's position as the most innovative and most economically successful country in the world.
FDI flows are therefore, we concluded, more important than ever and while attention should be paid to their security implications, the CFIUS review process should not be made into an arena for political wrangling.
Since then, things on the economic front have become… a lot worse.
Thanks to the subprime crisis infecting the rest of the financial system, investment banks have faltered, Fannie and Freddie have been taken over by the government, and even insurance giant AIG has received a cash infusion from the Fed.
What’s most disastrous for small IT firms, banks have increasingly turned away businesses and slashed credit lines. And the chances of getting VC money don’t look much better: In the second quarter of 2008, quarterly venture capital investment in U.S. companies slipped below the $7 billion mark for the first time in 18 months – a 12% drop compared to the same quarter last year.
Even SBA loans, to which entrepreneurs traditionally turn when they can’t get conventional loans, have dried up substantially. The SBA reported last week that loan volumes made under its flagship 7(a) loan program fell 30% in the fiscal year ended Sept. 30. And in October, overall SBA loan volumes were 50% lower than in October 2007, due mainly to sharp drops in the SBA Express loan program that makes smaller loans, said Eric Zarnikow, head of the SBA's Office of Capital Access.
In short, a lot of small IT firms – along with many other SMEs – find it increasingly hard to get access to capital. And since even big companies are feeling the credit crunch, tech startups are also finding it much harder to get acquired.
Yet, when foreign investors come knocking, the U.S. often seems less than happy to invite them in. Remember the outcry that Belgian-Brazilian beverage giant InBev’s proposed (and by now completed) acquisition of U.S. brewing company Anheuser-Busch caused? The outrage about InBev’s plans had nothing to do with vital security interests. Instead, it was driven by, as one newspaper article put it, “concern … that another American icon would be taken over by foreign interests.”
(Of course, Europeans are just as prone to these sentiments as Americans. To name just one example: France, which has long been known for its policy of protecting “national champions,” recently founded a sovereign wealth fund to shield French firms from foreign takeover at this time of crisis.)
While it is understandable to want to protect companies that have a lot of sentimental as well as economic value for their home country, it is not a rational thing to do when companies are struggling to get money to start new ventures, invest, and make acquisitions.
It is therefore laudable that in the statements accompanying the final regulations published on Friday, CFIUS notes that it “will continue its practice of focusing narrowly on genuine national security concerns alone, not broader economic or other national interests.”
However, in practice it may be very difficult for CFIUS to distinguish between economic interests and national security interests.
The regulations also aim to provide some guidance with respect to two other threshold issues: whether the transaction involves the acquisition of “control” or “critical infrastructure.”
The regulations define “control” in functional terms as having the “power, direct or indirect, […] to determine, direct, or decide important matters affecting an entity.” Thus, it is possible that a less than 10% investment may result in a holding of control; similarly, a greater than 10% investment may, depending on the specific facts, not be deemed to constitute control. Whether “control” exists in a particular transaction will depend on the specific rights to be held by the foreign entity.
Critical infrastructure is defined in the regulations as “a system or asset, whether physical or virtual, so vital to the United States that the incapacity or destruction of the particular system or asset of the entity over which control is acquired pursuant to that covered transaction would have a debilitating impact on national security.” Given this broad definition, many types of transactions may be deemed to involve critical infrastructure.
The definitions of “control” and of “critical infrastructure” (as well as the lack of a definition of “national security”) introduce elements of uncertainty into the CFIUS review process which may counteract the final regulations’ stated goal of “[strengthening] the CFIUS process in a manner that reaffirms America's longstanding policy of openness to investment, consistent with the protection of our national security.”
In particular, the effect of FINSA and the final regulations is likely to be that a greater number of transactions will be notified to CFIUS, and such transactions, in particular those involving foreign government interests and critical infrastructure, will be subject to enhanced scrutiny.
It is therefore vital for CFIUS to make sure that the review process is fair, consistent and transparent, and only prohibits those transactions which can clearly be expected to have a detrimental effect on national security. The CFIUS review process should not be allowed to be made into a political tool that can be used as a carrot or a stick to achieve economic or foreign policy objectives. It should also not be seen as an instrument for pleasing certain constituencies and garnering electoral votes.
Otherwise, the U.S. runs a danger of stifling foreign investment right at a time when, for many companies, it’s FDI or die.