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Foreign Acquisitions of Defense Contractors: How to Address National Security Concerns

As consolidation in the defense industry and globalization of the economy continue, there has been an increase in acquisitions, mergers, and investments involving foreign entities and U. S. companies. These transactions often require the parties to navigate their way through the sometimes rough waters of the Exon-Florio Amendment to the Defense Production Act and the Defense Security Service (“DSS”) regulations concerning “foreign ownership, control or influence” (“FOCI”).

The Exon-Florio Amendment authorizes the Executive branch to review, investigate, and potentially, suspend or prohibit the acquisition by foreign entities of U.S. companies. Exon-Florio is administered by the Committee on Foreign Investment in the United States (“CFIUS”), an interagency group chaired by the Treasury Department. CFIUS review is almost always initiated by a voluntary filing by the parties to the transaction.

In practice, the most complicated cases are those involving a U.S. acquisition target or merger partner that possesses clearances to handle classified national security information and thus is subject to the National Industrial Security Program, administered by the DSS. Generally, a company must be granted a “facility security clearance,” and certain of its personnel (usually including its board of directors and key officers) must receive “personnel security clearances” before the company may handle classified information.

Facility security clearances may be granted to companies under FOCI only in certain narrowly defined circumstances after the holder of the clearance or the applicant has demonstrated to the satisfaction of the DSS that the FOCI has been mitigated. Among the factors regarded as indicative of FOCI are foreign beneficial ownership of five percent or more of a cleared company’s securities, indebtedness to foreign interests (including banks or companies organized outside the United States), a foreign interest’s ability to appoint or elect directors or other management personnel and the registration of five percent or more of a public corporation’s shares in “street names” (thereby giving rise to doubt about the identity of the actual owners of the shares). Although the industrial security regulations refer to beneficial ownership, DSS officials are usually more concerned with the ability to direct the affairs of a corporation or partnership than with who captures the economic benefits of the company’s activities.

Any change in control at a cleared facility, including the transfer of shares or other interests equivalent to five percent of the cleared company’s equity, must be reported in advance to the DSS. (It should be noted that where a U.S. company acquires a foreign entity, but uses stock instead of cash as consideration, foreigners may hold large amounts of stock in the domestic company even though the foreign entity is the target, not the buyer). Cleared contractors must continually update reports to the DSS on their ownership status and are subject to periodic DSS inspections of their books and records.

Companies undergoing a change in control or receiving significant foreign investment can take steps to insulate their classified operations from their foreign owners. Among other things, directors — especially directors of parent companies — can be insulated from access to classified information and decision-making about classified projects. In some cases, the DSS requires that the cleared company or its parent appoint trustees or a proxy board made up of U.S. citizens (usually retired military or civilian defense personnel) eligible for high level clearances, cede to that group the daily management of the cleared company and thereafter be excluded from most information about the company’s activities other than basic intracorporate financial data.

Execution of such proxy or voting trust arrangements can be time consuming, requiring substantial negotiation with the DSS. Integration of engineering operations within the constraints of proxy agreements and other arrangements established to protect U.S.-origin data and technology from unauthorized foreign access or use is often one of the most challenging aspects of these transactions. Companies should carefully consider their strategies for addressing these issues as soon as they begin pursuing an opportunity for foreign acquisition, merger or investment.

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