How FIRRMA Impacts U.S. Private Equity Funds
The Situation: The Foreign Investment Risk Review Modernization Act ("FIRRMA") clarifies when U.S. private equity funds with foreign limited partners are not considered foreign for purposes of the Committee on Foreign Investment in the United States ("CFIUS") and expands the reach of CFIUS to include noncontrolling investments.
The Result: U.S. private equity funds need to consider whether their fund structures could cause them to be foreign persons for CFIUS purposes generally and also understand how FIRRMA expands the jurisdiction of CFIUS to include certain types of noncontrolling investments.
Looking Ahead: U.S. private equity firms should: (i) carefully consider CFIUS issues when establishing new funds to understand whether rights of foreign limited partners trigger CFIUS jurisdiction; (ii) confirm whether investments by their funds in U.S. critical technology companies trigger a mandatory CFIUS notification requirement; and (iii) monitor additional efforts to implement the various other provisions of FIRRMA.
Last year, the president signed FIRRMA into law, clarifying how CFIUS will treat investments made by private equity funds subject to future regulations, and simultaneously expanding CFIUS' jurisdiction to encompass noncontrolling investments in "critical infrastructure" and "critical technology" companies, as well as companies that maintain or collect sensitive data of U.S. citizens (collectively "Sensitive U.S. Businesses"). This expanded jurisdiction will have a significant impact on foreign investors generally, as well as U.S. private equity funds with foreign general or limited partners.
U.S. Private Equity Funds with Foreign Capital
Under FIRRMA, U.S. private equity funds with foreign limited partners will not be considered foreign if certain conditions are met. To not be considered foreign, and thus outside the jurisdiction of CFIUS:
- A fund with foreign limited partners must be managed exclusively by a general partner, managing member, or equivalent that is not a foreign person;
- An advisory board or committee on which a foreign person participates may not have the ability to approve, disapprove, or otherwise control: (i) investment decisions of the fund or (ii) decisions made by the general partner, managing member, or equivalent related to entities in which the fund is invested;
- The foreign person may not otherwise have the ability to control the fund, including the authority to: (i) approve, disapprove, or otherwise control investment decisions of the fund; (ii) approve, disapprove, or otherwise control decisions made by the general partner, managing member, or equivalent related to entities in which the fund is invested; or (iii) unilaterally dismiss, prevent the dismissal of, select, or determine the compensation of the general partner, managing member, or equivalent; and
- The foreign person may not have access to material nonpublic technical information.
When considering whether the foreign limited partner otherwise has the ability to control the fund, FIRRMA expressly states that a waiver of a potential conflict of interest, a waiver of an allocation limitation, or a similar activity, applicable to a transaction pursuant to the terms of an agreement governing an investment fund, would not be considered to constitute control of investment decisions of the fund or decisions relating to entities in which the fund is invested.
In our recent experience, some of the standard limited partner rights included in limited partnership agreements may be considered to go beyond these waiver-type rights. CFIUS could consider such rights as providing a foreign limited partner with control of investment decisions of the fund or decisions relating to entities in which the fund is invested. Unfortunately, CFIUS has not yet issued regulations clarifying this provision of FIRRMA. As such, it is currently unclear how CFIUS will interpret the provision and whether standard limited partner rights will be treated as waiver-type rights.
Under FIRRMA, the term "material nonpublic technical information" means information that: (i) provides knowledge, know-how, or understanding, not available in the public domain, of the design, location, or operation of critical infrastructure; or (ii) is not available in the public domain and is necessary to design, fabricate, develop, test, produce, or manufacture critical technologies, including processes, techniques, or methods. It does not include financial information regarding the performance of a U.S. business.
Further, even if the above conditions are technically met, funds with only one or a few significant foreign limited partners may find themselves subject to CFIUS' jurisdiction when there are negative rights or rights requiring a unanimous vote by the limited partners. Under these circumstances, CFIUS may find that the limited partner controls the investing fund or general partner, even if the rights are not exercised.
Indirect Noncontrolling Investments by Foreign Persons
FIRRMA also provides CFIUS with jurisdiction over noncontrolling investments in Sensitive U.S. Businesses. An indirect investment by a foreign limited partner in a Sensitive U.S. Business through an investment fund is subject to CFIUS jurisdiction if the fund is foreign (either because of a foreign general partner or foreign limited partner whose rights are not restricted, as described above), or if the foreign limited partner obtains:
- Access to any material nonpublic technical information in the possession of the U.S. business;
- Membership or observer rights on the board of directors or equivalent governing body of the U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body; or
- Any involvement, other than through voting of shares, in substantive decision-making of the U.S. business regarding: (i) the use, development, acquisition, safekeeping, or release of sensitive personal data of U.S. citizens maintained or collected by the U.S. business; (ii) the use, development acquisition, or release of critical technologies; or (iii) the management, operation, manufacture, or supply of critical infrastructure.
While CFIUS has not yet implemented the provisions of FIRRMA relating to investments in certain types of Sensitive U.S. Businesses (i.e., "critical infrastructure" companies and companies that maintain or collect sensitive data of U.S. citizens), effective November 10, 2018, CFIUS began reviewing certain noncontrolling investments in "critical technology companies" through implementation of a mandatory pilot program that we previously described here and here, respectively. The pilot program adopts the rules described above for noncontrolling covered transactions. We expect that these rules also will be included in regulations implementing the review of investments into the other types of Sensitive U.S. Businesses.
With the above in mind, U.S. private equity funds that have foreign general or limited partners should evaluate the impact that such a structure could have on U.S. investments by the fund, including investments in Sensitive U.S. Businesses, in particular. In addition, U.S. private equity firms that are establishing new investment funds that will involve foreign capital should carefully consider how the fund is organized and the rights, if any, that foreign limited partners will obtain.
One final note: The list of noncontrolling rights provided above is, and will be, relevant not only for evaluating whether investments in Sensitive U.S. Businesses by foreign persons could be subject to the jurisdiction of CFIUS, but also for providing some insight into what types of rights CFIUS considers to be passive for purposes of evaluating whether a foreign investor is obtaining control over U.S. businesses that are not Sensitive U.S. Businesses.
Three Key Takeaways
- U.S. private equity funds need to understand CFIUS' expanded jurisdiction and consider whether their fund structures could cause the funds to be foreign persons for CFIUS purposes.
- Investment funds must evaluate if they are a foreign person for purposes of CFIUS when investing in the United States because certain investments require a mandatory notification to CFIUS before closing.
- Parties should consider involving counsel early in the drafting of investment documents to understand the CFIUS implications of how funds are structured.
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