CFIUS 2.0: Investment Funds and Other Stakeholders Await Full, Revamped Regulations

FIRRMA mandates full implementation of its provisions by early next year, but CFIUS actually began the process of transitioning to this “CFIUS 2.0” framework last fall by implementing a pilot program on critical technologies. 

Pilot Program – Context and Outputs

In FIRRMA, Congress authorized CFIUS to conduct pilot programs using its new authorities and, in so doing, the authors of this law had two specific intentions. They had concluded that there were substantial holes in the jurisdiction of CFIUS that needed to be plugged as soon as possible for the sake of national security, particularly in the area of critical technologies. In addition, the authors of FIRRMA had realized the sheer complexity of the new functions they were asking CFIUS to execute under FIRRMA and recognized value in allowing CFIUS to “test drive” some of these new authorities, collecting data along the way to inform the arduous and painstaking process of drafting the full regulations.

The sole pilot program took effect last October and has already been the subject of much public scrutiny and commentary, but it remains to be seen what data and lessons CFIUS will glean from it. Reportedly, the volume of declarations that have been submitted to CFIUS has been less than expected (dozens of filings, instead of hundreds). There are likely several different reasons for that result, but this data point could lead CFIUS to scope its jurisdiction more broadly than it otherwise would have (within the left and right limits provided by FIRRMA).

Will Key Jurisdictional Terms Be Re-Defined Under CFIUS 2.0?

Once FIRRMA is fully implemented, the breadth of CFIUS’s new jurisdiction will depend on how several key terms are defined and scoped in the new regulations. First and foremost among those is “foreign person,” which will remain central to CFIUS’s “covered transaction analysis” (through which it decides whether a particular transaction falls within its jurisdiction). For the pilot program, CFIUS defaulted to its legacy definition of “foreign person,” which is somewhat ambiguous and had generated confusion even prior to the enactment of FIRRMA, particularly for investment funds that indirectly invest in U.S. companies. Under that definition, a foreign person is defined to include “any foreign national, foreign government, or foreign entity”, as well as “[a]ny entity over which control is exercised or exercisable by a foreign national, foreign government, or foreign entity.”

In the past, CFIUS has used the latter prong of this highly flexible definition to assert jurisdiction, concluding that U.S.-managed investment funds that are under foreign “control” are therefore foreign persons. And, the legacy regulations broadly define control as “the power, direct or indirect, whether or not exercised … to determine, direct, or decide important matters affecting an entity.” This sprawling definition has resulted in questions by U.S.-managed investment funds over what types of rights foreign limited partners (LPs) may hold without making the entire fund a foreign person in the eyes of CFIUS.

That very term – “control” – may itself be on the table for broadening as rulemakers draft the CFIUS 2.0 regulations, despite the fact that it has been a stable, bedrock concept in the CFIUS regulations for years. CFIUS is likely looking for ways to make it harder for certain foreign investors, particularly those from China or other foreign adversary nations, to evade its newly expanded jurisdiction, so this is another aspect worth monitoring.

The term “foreign entity” has also been central to the pilot program jurisdiction, because it is another avenue through which a fund can constitute a foreign person. For the pilot program, CFIUS likewise defaulted to its legacy definition of foreign entity: any entity organized under foreign law, “if either its principal place of business is outside the United States or its equity securities are primarily traded on one or more foreign exchanges.” The legacy regulations do provide one exception to this rule: an entity is not a foreign entity if it “demonstrates that a majority of the equity interest in such entity is ultimately owned by U.S. nationals.” Yet, historically this exception has been narrowly construed by CFIUS and difficult to satisfy. What’s more, as CFIUS drafts the forthcoming regulations, it may further constrict this exception to make it more difficult to circumvent its jurisdiction through creative structuring.

Under the current regulations, for investment funds that are organized under foreign law, this essentially means that most that are based offshore will be considered a foreign entity by CFIUS, while most of those that are based in the U.S. will not. Of course, that would not be the end of the analysis, since any fund that CFIUS considers to be under foreign control would itself be a foreign person.

With regard to the forthcoming CFIUS 2.0 regulations, CFIUS has thus far not offered many hints as to how the terms foreign person, foreign entity, or control may evolve. Nonetheless, for funds that are based offshore or that have foreign LPs, these aspects of implementation are being watched closely. For example, in comments submitted last year regarding the pilot program, key stakeholders such as the National Venture Capital Association, the American Investment Council, and the U.S. Chamber of Commerce sought clarification on many of these same points. 

CFIUS Provides Limited, Informal Guidance Regarding Investments “By or Through” Investment Funds

In June of this year, the Treasury Department (in its capacity as chair of CFIUS) provided informal guidance that is relevant to investment funds, posting online some new Frequently Asked Questions about the Pilot Program. Treasury shed light on a handful of issues, including whether certain indirect investments made by a foreign LP—who is a member of the fund’s LP advisory board or committee (LPAB/LPAC) — automatically fall within CFIUS’s jurisdiction. Its guidance was that being a member of the LPAB/LPAC does not “in and of itself” bring the transaction within CFIUS’s jurisdiction, and that additional analysis would be needed to consider whether the investment could either result in foreign control of the target company or afford the foreign LP any of the rights that would trigger CFIUS’ pilot program jurisdiction (over non-controlling, non-passive investments), including:

1. Access to “material nonpublic technical information;”
2. Board membership or observer status (or the right to nominate someone to the board); or
3. Involvement in certain “substantive decisionmaking” pertaining to the target company’s technology. 

Treasury also clarified that, even where a foreign investor’s indirect investment through a fund would not by itself be subject to CFIUS jurisdiction, a direct investment by that same foreign person might be.

This update from Treasury provides some additional guidance to U.S.-managed funds on what types of relationships with foreign LPs could cause CFIUS to consider the fund to be a “foreign person.” CFIUS is likely to continue this same approach, or some variation of it, in its forthcoming CFIUS 2.0 regulations. Thus, it is useful for funds to both review their existing limited partnership agreements to ensure they reflect Treasury’s new guidance and also stand ready for further regulatory developments. Interested stakeholders should prepare to provide substantive input on the draft regulations through the notice-and-comment process, which will occur sometime between now and the end of the year. Stakeholders are likely to be given at least 30 days to provide comments to CFIUS, once the draft is released.

Conclusion

As CFIUS continues drafting the final implementing regulations for FIRRMA, investment funds and other stakeholders are watching and waiting. Stakeholders can expect the CFIUS rulemakers to strive for bright-line rules wherever possible, in contrast to the flexible and sometimes open-ended language of FIRRMA itself. The CFIUS 2.0 regulations may well take the form of an entirely new regulatory structure, versus a modest update to the legacy regulations. And, if past is prologue, these regulations might not be updated for over a decade once they are put in place.

Disclaimer: This article is not intended as legal advice, nor should it be considered as such. It is for general information purposes only.