China and CFIUS: Regulatory risks

No official reason was given for the regulatory decision that led to Procon Mining & Tunnelling - which is controlled by China National Machinery Industry Corporation - unwinding its acquisition of Canada-based Lincoln Mining in 2013. The unofficial explanation was that one of Lincoln's facilities was too close to Fallon Naval Air Station in Nevada, home to the US Navy's TOPGUN flight school.

This investment would receive the prize for most bizarre (alleged) grounds for rejection by the Committee on Foreign Investment in the United States (CFIUS), but TOPGUN is said to have thwarted two other Chinese M&A transactions.

While it seems odd that Procon didn't approach the regulators prior to the deal closing and seek a compromise solution, the company might not have realized it needed to do so. Lincoln is Canadian by incorporation - so it on the surface it could appear beyond CFIUS' purview - but its principal mining operations are in the US and any change in ultimate ownership must be signed off by the authorities.

Procon's misfortune underlines the importance of good advice when dealing with a regulator that reviews the national security implications of foreign investments in companies with US operations, has the power of veto, yet is under no obligation to explain its decisions publicly. With Chinese outbound M&A at record levels - and Sino-US political relations bedeviled by issues ranging from territorial sovereignty to state-sponsored electronic espionage - perhaps it has never been more important.

According to its annual report to Congress on activities from the 2014 calendar year, CFIUS reviewed 147 filings, up 50% year-on-year and not far off the all time high of 155 from 2008. China accounted for 24 of the filings, more than any other country, retaining a position it first occupied in 2012.

CFIUS has already made an impact on several China transaction in 2016. In January, Go Scale Capital - a private equity firm sponsored by GSR Ventures and Oak Investment Partners - terminated its deal to buy a majority stake in Philips' LED components and automotive lighting unit due to "unforeseen concerns" from the regulator. Both companies made their case "under the principles of openness and fairness," with Go Scale stressing is commercial and market-oriented interests, but to no avail.

The wasted process has cost Philips time and a bit of money; and the company will no doubt be more wary when it puts the asset up for auction once again. Such considerations were likely uppermost in the minds of board members at Fairchild Semiconductor International when they rejected a take-private bid from China Resources Microelectronics and Hua Capital in February. The board said the risk of rejection by CFIUS was too great, regardless of the buyer consortium's offer to pay a $108 million break fee if approval was not forthcoming.

The following week, China's Tsinghua Unigroup scrapped its plan to invest in US-based disk drive manufacturer Western Digital after CFIUS decided to launch a review of the transaction.

When CFIUS said in its annual report that there may be a coordinated strategy among foreign governments or companies to acquire US firms involved in the development of critical technologies, it might have been referring to semiconductors. Unigroup has made no secret of its desire to become a major player in the sector and has launched several aggressive bids for assets around the world. It is unclear whether the company really expects to be successful in some of these situations or is just testing the water as part of a longer-term strategy.

What this probably has done is heighten the sensitivity around all Chinese outbound deals targeting the US. The majority of these transactions will get through, but prospective investors would be advised to ensure they have covered all the bases - to the point of identifying areas in which they might have to appease the regulator and mitigate security concerns. The last thing companies want is to see the crown jewel of an outbound strategy torn from their grasp by a retrospective ruling.

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• Topics
• Greater China
• North America
• Regulation
• Buyouts
• USA
• Outbound investment
• M&A