Chinese investors' guide to the US tech market

Chinese investment in the US is at an all-time high, continuing a recent trend of explosive growth driven by a surge of investments into the telecommunications, media and technology (TMT) sector as Chinese companies seek to acquire innovative technologies and access new markets and distribution channels. Chinese investors injected US$6 billion in US high-tech firms in the first quarter of 2014 alone. That figure surpasses all inbound investment from China from 2009 to 2012 combined. Those first-quarter investments were headlined by Lenovo's announced acquisitions of IBM's x86 server business (US$2.3 billion) and telecommunications equipment manufacturer Motorola (US$2.91 billion). More recently, Alibaba Group invested US$120 million in mobile game studio Kabam and a Chinese investment group has proposed a US$1.7 billion buyout of US chipmaker OmniVision.

Despite the swell of Chinese interest in the US TMT space, many prospective buyers are unfamiliar with the regulatory hurdles they are likely to encounter in such deals. In other cases, the highly publicised successes or failures of Chinese companies that have gone before them have coloured new investors' perspectives on the US regulatory framework. Perhaps the best example of the latter phenomenon is the case of the Chinese-owned Ralls Corporation, which was ordered in 2012 to divest four wind farm projects located near US military facilities on US national security grounds. Earlier this year, a US federal appeals court ruled that Ralls was not afforded due process and remanded the case for further proceedings. In the wake of that decision, many Chinese investors have asserted that the Ralls case heralds more transparency in the review process and greater openness to Chinese investment, despite the fact that the decision is not final and, in any event, it is unlikely to have a material effect on the national security review process.

A number of regulatory issues apply to acquisitions in the US TMT space as a result of foreign ownership. Each of these regimes raises potentially complex questions that will turn on the specifics of any deal, but investors can first prepare themselves by asking the right questions.

National security review

The single most significant issue facing TMT sector acquisitions by Chinese investors is likely to be evaluation of the deals for national security sensitivities by the Committee on Foreign Investment in the United States (CFIUS). Under US law, mergers, acquisitions and certain long-term leases that could result in a foreign entity controlling a US business (so-called “covered transactions”) are subject to review by CFIUS, which is composed of representatives from sixteen federal government departments and offices, led by the US Department of Treasury. CFIUS reviews covered transactions to determine: (1) whether a foreign person exercising control of the US business in question might take action that threatens US national security; and (2) if the deal were allowed to close, whether existing US law adequately protects relevant national security interests.

No transactions are required to be submitted to CFIUS for review. However, because CFIUS has the power to review, and potentially prohibit, any covered transaction on its own initiative at any time, including unwinding deals even after they have closed (as it ordered done by Ralls Corporation, subject to the case's ongoing legal process). Parties to a covered transaction may elect to submit a voluntary notice requesting CFIUS review prior to closing the deal. Such a voluntary notice triggers a 30-day review period, which CFIUS may extend for an additional 45 days in limited circumstances. If CFIUS concludes at the end of the review period (whether 30 or 75 days) that there are no unresolved national security concerns, the transaction qualifies for safe harbour under applicable law and, subject to any conditions imposed by CFIUS, the transaction may proceed without the possibility of suspension or prohibition on national security grounds. Most transactions reviewed by CFIUS are ultimately approved.

CFIUS is not required to focus on particular countries or industries when assessing the national security implications of transactions within its jurisdiction. In practice, however, certain countries and market sectors naturally invite greater scrutiny, and Chinese investments in the US TMT sector implicate a trifecta of issues that make them particularly ripe for CFIUS scrutiny:

(1) historically tense diplomatic and economic relations between the US and China;
(2) the inherent sensitivity of the assets that fall within the TMT sector, which was recently exacerbated vis-à-vis China by the US Department of Justice charging five Chinese military officials for hacking US corporations to steal trade secrets; and
(3) public awareness – and suspicion – of Chinese activity in this space resulting from heavy political and media focus, especially on the failures.

CFIUS has intervened in several announced Chinese TMT transactions in the US in recent years. For example, Huawei's proposed takeover of US telecommunications firm 3Com in 2008 and Superior Aviation Beijing's proposed acquisition of US aircraft maker Hawker Beechcraft in 2012 were both reportedly derailed by national security concerns. Even some inbound Chinese tech deals that successfully navigated national security review were only able to do so after the parties agreed to so-called mitigation agreements with CFIUS, including Lenovo's takeover of IBM's PC unit in 2005 and Wan Xiang's acquisition of the assets of bankrupt US battery maker A123 in 2013.

In light of the foregoing, although CFIUS notification is not mandatory, given the recent experience of Chinese investors in the US, any Chinese acquisition of consequence in the US will likely attract CFIUS attention. Parties should therefore carefully consider voluntarily notifying CFIUS prior to closing. This is true even in transactions that do not have obvious national security implications – but especially in TMT deals, which have long been an area of emphasis for CFIUS – because the threat of a post-closing CFIUS review and the potential for forced divestiture poses substantial risk of material loss and reputational damage to foreign investors.

Foreign ownership limitations

Tech companies are mostly free of any TMT sector-specific regulation, except for a number of media distribution and telecommunications companies. The US Federal Communications Commission (FCC) is the agency primarily responsible for regulating the telecommunications and media industries in the US. Its jurisdiction flows from its statutory authority to grant radio licenses to various telecommunications providers, broadcasters (whether radio or television) and satellite providers, among others. These licenses are the most fundamental assets of the companies that hold them, and they are also what give the FCC jurisdiction over these firms. Importantly, these licenses are also subject to foreign ownership limitations.

The Communications Act of 1934, as amended, places limits (and in some cases, outright bans) on the ability of foreign entities to hold, or to invest in companies that hold, broadcast licenses. There are essentially three levels of restrictions:

1. Foreign governments (and their representatives) are absolutely prohibited from themselves being US radio licensees, and other foreign entities and individuals are prohibited from holding specified categories of licenses, such as broadcast and common carrier (i.e. telecommunications) licenses.
2. There is a strict 20% aggregate limit on direct foreign ownership of the specified types of licenses.
3. There is a 25% aggregate limit on indirect (i.e. through a holding company or other corporate structure) foreign ownership of companies holding the specified types of licenses. However, the FCC may waive this restriction – and permit up to 100% indirect foreign ownership – unless it finds that such increased foreign ownership would not serve the public interest. Because Chinese investments in US companies are generally done through intermediate subsidiaries, most foreign ownership analyses fall under this category.

Calculating the percentage of foreign ownership that will result from a transaction is often a complicated, fact-specific process. However, in evaluating the level of foreign ownership that will result from a transaction, the FCC generally considers all equity or voting interests – not just stock, but alternative mechanisms of ownership and control as well – that will be held by all foreign entities or individuals. The review includes all relevant equity and voting interests up the vertical ownership chain. There are, however, structuring mechanisms that can be used to insulate foreign-owned interests, in whole or in part, from the calculation.

The FCC calculates equity and voting interests separately, and if the aggregate foreign equity interests or voting interests exceed the 25% threshold, the transaction cannot be consummated until the FCC makes an affirmative finding that the transaction is in the public interest. The parties must submit a petition for declaratory ruling containing detailed information about how the transaction serves the public interest, along with the standard application for authorisation to transfer the license(s) (which is required for all transactions involving such a transfer). Once the application and petition are deemed to be complete, both documents will be subject to public notice and interested parties will have an opportunity to comment on the transaction. At the same time, the FCC will coordinate with federal agencies and executive departments to evaluate any national security, law enforcement and foreign or trade policy implications of the deal. The FCC may also request additional information or documents or take similar steps to ensure a thorough record. Upon conclusion of its review, the FCC will issue a written order approving (with or without conditions) or denying the increased foreign investment.

Over the past few years, the trend at the FCC has increasingly been in favour of removing barriers to, if not outright promoting, foreign investment in regulated licensees. In June 2013, the FCC issued an order that streamlined the foreign ownership review process for certain types of licenses by reducing review thresholds and the amount and types of information that were required to be submitted to the FCC. Then, in November 2013, it issued a declaratory ruling clarifying that it is willing to consider permitting investment above the 25% threshold in US broadcasters. These actions indicate greater openness to foreign investment in the media and telecommunications markets.

Export restrictions

The US government prohibits the export of certain technological products and information without a license. Exports of defence-related technologies are governed by the US Department of State's International Traffic in Arms Regulations (ITAR), while dual-use technologies – those that may have both civilian and military applications – are governed by the US Department of Commerce's Export Administration Regulations (EAR). In either case, licenses for export to China are strictly limited, or with respect to defines-related technologies, often prohibited altogether.

Under both the ITAR and the EAR, the concept of export is defined extremely broadly. It covers virtually any form of transfer of covered products or information to foreign nationals, anywhere in the world. As a result, seemingly innocuous (and completely standard) activities in an acquisition, such as discussing the assets of the target company on a conference call that includes foreign nationals or making covered materials available in a due diligence data room that is accessible to foreign nationals, could potentially violate these regulations. Violations can carry potentially significant civil and criminal penalties.

While the idea that Chinese companies are only buying US TMT companies to bring their IP back to China is likely overstated, it is not altogether incorrect. For many Chinese purchasers, the real value of an acquisition of a US TMT company is the opportunity to integrate the target company's know-how and technology into the investor's Chinese or global operations. However, where the target company's technology is covered by the ITAR or the EAR, the acquisition may become more complex and there may be limitations on (or outright prohibitions against) the investor's ability to transfer technology outside of the US – or even to foreign nationals inside the US.

Chinese investors should attempt to determine which of the target company's technologies, if any, may be subject to the ITAR or the EAR as early as possible in a potential acquisition scenario. This may require collaboration with the seller. If any are covered by those regulations, the acquisition process will likely become more complicated, with licenses required for even basic due diligence activities (not to mention high-level discussions among executives). Moreover, Chinese investors should consider whether any potential limitations these regulations could place on the target's operations post-acquisition would ultimately undermine the value of the deal.

Balancing complex considerations

Chinese FDI is expected to continue its meteoric increase from the current level (approximately US$500 billion to date) to as much as US$2 trillion by 2020. A significant share of that investment will likely go to building global capabilities in the TMT space. The US legal system's protection of intellectual and other property rights provides strong incentives for Chinese firms to invest in US companies to develop technologies that may otherwise not be sufficiently protected under Chinese law.

There have been conflicting signals among regulators regarding how the US government is likely to react to this massive and growing influx of Chinese investors. On one hand, the FCC appears to have signalled openness to increased foreign investment in telecom and media entities. On the other hand, regulation of exports to China remains extremely restrictive (and is likely to remain so for the foreseeable future) and CFIUS will almost certainly increase its focus on deals involving Chinese investments in US TMT businesses. These considerations will be complicated by the intense public and political scrutiny of any significant Chinese acquisitions in this space.

In light of this reality, Chinese investors considering acquisitions in the US TMT space should plan ahead. They must determine the best structure for the investment and grasp regulatory compliance as early as possible in the process of exploring a potential deal. They should also consult with government and public relations advisors to help them navigate the political and media complexities that come with Chinese investors' entry into the US market.


Louise Gong, Beijing and New York, and Aaron Bartell, Washington DC, Chadbourne & Parke