Foreign investment into domestic enterprises, including but not limited to mergers, acquisitions, and takeovers, often raise concerns of national security, especially if the foreign acquirer, ultimately, will be in a position of influence to exercise great influence over the enterprise’s activities, and assets, including access to intellectual property and propriety technology.  Given these concerns, most states have gone the way of introducing broad administrative review procedures, in the form of national security review.  The ideal national security review ensures that key interests of the state - often referred to as issues of national security - are not jeopardized while introducing as little obstruction as possible to foreign investment into domestic enterprises.  Therefore, national security review needs to possess the following key attributes. Firstly, it needs to process applications within a reasonable time frame.  Secondly, the review process should not be perceived as a black box and the foreign applicant should be able to reasonably predict the outcome of this applicant with prior research and advice.  Thirdly, it should give confidence to the foreign applicant to the extent that it creates the impression that the administrative body conducting the national security review is making a conscious effort to separate politics from commerce. In this way, the security review is able to instill confidence in foreign investors.  

            This article looks at the structure of and academic criticisms on the American national security review system, which are then used in a comparative setting to the Chinese national security review system to analyze the potential strengths, weaknesses, and unique aspects of the Chinese national security review system in evolution.  This article first talks about the concept of national security in general, demonstrating the difficulties in identifying with any confidence what this concept actually means.  Then it proceeds to introduce the American national security review system, which also introduces key concepts that are used in the Chinese national security review system.  Finally, this article introduces the Chinese national security review system and the changes proposed, analyzing the similarities and differences between the Chinese and American national security systems.

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What does national security mean?

            The definition of what constitutes national security is particularly difficult to tackle.  In fact, it is expected and understood that national security has a different meaning for different stakeholders.  In the American context, this plurality of national security is entrenched into the national security review system.  The administrative agency in the United States (U.S.) that conducts national security reviews, The Committee on Foreign Investment in the United States (CFIUS), is composed of the heads of numerous directors and departments which represent both traditional areas of national security and new areas of non-traditional areas of national security[1].  During a review or investigation, each member of CFIUS is expected to apply that definition of national security that is consistent with the representative agency’s specific legislative mandate.[2]

            Historically, there were two competing approaches to national security in the U.S., where one approach supported the idea that the concept of national security should be interpreted narrowly and the other approach supported expanding the scope of national security to address new challenges.  The narrow interpretation would limit the definition of national security to the more traditional and “narrow national security controls dealt within export control measures”[3] including limitations over sales of military technologies, weapons, and minerals to rival states.  The broad interpretation supports the idea that the ‘broad industrial base issues’ should also be included in the national security review process.[4]  The question of whether a narrow interpretation of national security or a broad interpretation of national security continues in far from settled even after President Reagan’s rejection of the term “essential commerce” as an aspect of national security in the Exon-Florio Amendment (1988)[5].  It is fair to say that the congress has largely succeeded in pushing a broad interpretation with the inclusion of the concepts of ‘homeland security’ and ‘critical industries’ in the Foreign Investment and National Security Act (FINSA) of 2007.

 

What is the scope of national security?

            One way to better understand what is considered to be an issue of national security is to look at what sectors are covered within the scope of national security reviews.  The governing legislation in this area is the FINSA which uses the terms “critical infrastructure” and “critical technologies” when describing national security.[6]  These terms are subject to interpretation themselves, and in particular, the term ‘critical infrastructure’ is broadly defined to include all systems and assets, whether physical or virtual (such as intellectual property and patents), so vital to the United States that the incapacity or destruction of such systems or assets would have a debilitating impact on national security.[7]  The Homeland Security Act of 2002 presents a list of the industries that are considered critical infrastructure.[8]  According to the Homeland Security Department and Presidential Policy Directive 21, critical infrastructure includes the following 16 sectors: chemical sector; commercial facilities sector; communications sector; critical manufacturing sector; dams sector; defense industrial base sector; emergency services sector; energy sector; financial services sector; food and agriculture sector; government facilities sector; healthcare and public health sector; information technology sector; nuclear reactors, materials, and waste sector; transportation systems sector; and the water and wastewater systems sector.[9]  It is clear that in the U.S., national security is defined very broadly, which gives the CFIUS lots of flexibility (which might be sensitive to the political leanings of the time) in settling issues of national security and foreign investment.

            Another angle to look at the scope of the national security review is to look at who is subject to national security review.  More recently, the main concern of the U.S. national security review system has been focused on the activities of sovereign wealth funds, wholly or partially state-owned enterprises, and persons who act as agents of foreign governments.   The 1992 ‘Byrd Amendment’ to the Exon-Florio statute introduced two new conditions that can trigger a CFIUS investigation on foreign transactions.  CFIUS is required to investigate proposed mergers, acquisitions, or takeovers where (1) the acquirer is controlled by or acting on behalf of a foreign government; and (2) the acquisition results in control of a person engaged in interstate commerce in the United States that could affect the national security of the United States.[10] 

            The final amendments to the contemporary CFIUS process were introduced through the Foreign Investment and National Security Act of 2007 (FINSA).  The new law requires CFIUS to review all covered foreign investment transactions to determine (1) whether a transaction threatens to impair national security; (2) the foreign entity is controlled by a foreign government, or (3) the transaction would result in the control of any ‘critical infrastructure that could impair national security.”[11] During the risk assessment process, CFIUS considers the following three issues: (1) What threat is posed by foreign investment in terms of intent and capabilities; (2) What aspects of the business activity pose vulnerabilities to national security; and (3) what the national security consequences are if vulnerabilities are exploited?[12]  The concept of a ‘covered’ foreign investment is closely related to the amount of control the foreign investor would acquire over the American business and is further investigated in the following section.

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American National Security Review System

            In 1988, Congress approved the Exon-Florio amendment to the Defense Production Act, which formalized the president’s powers to block proposed or pending foreign investment transactions and specified the process through which foreign investments are reviewed.   According to the amendment to the Defense Act, the President and the CFIUS are both authorized to unilaterally initiate a review of any (a) ‘covered transaction’; or reinitiate a review of a transaction that has previously been reviewed or investigated if (b) any party to the transaction submitted false or misleading material or if (c) any party to the transaction or the entity resulting from consummation of the transaction intentionally materially breaches a mitigation agreement or condition.[13]  When a security review is initiated (either voluntarily submitted by the president, or unilaterally initiated by the president or CFIUS), CFIUS has 45 days to complete its investigations[14].  In certain cases, an additional investigation might be required, which should also be completed within an additional 45 days[15]. Finally, as was mentioned before, CFIUS is an administrative body, not a legislative body.  It reports directly to the President of the U.S., and the President has the unique power to veto a proposed foreign investment[16].  There are a number of key terms that need to be clarified to understand the Exon-Florio Amendment and the CFIUS national security review mechanism.

 

‘Covered Transactions’ and ‘Control’ of U.S. Enterprises by Foreign Agents

            The Exon-Florio amendment defines ‘covered transactions’ as “any merger, acquisition, or takeover that is proposed or pending after August 23, 1988, by or with any foreign person which could result in foreign control of any person engaged in interstate commerce in the United States”.  The Treasury Department regulations bring further clarification to which transactions are covered in 31 CFR 800.  31 CFR 800 provides a list of seven conditions that describe which transactions are not ‘covered’ and therefore not subject to investigation.  Broadly speaking, a transaction is not ‘covered’ if it does not result in the control of a U.S. enterprise by a foreign agent, if the investment is solely for the purpose of investment, or the acquisition is the result of an ordinary course of business such as through a contract of insurance[17].

 

            Control: The Treasury Department regulation 31 CFR 800 provides guidance on the concept of ‘control’.  Unless the investment is solely for the purpose of passive investment (without a plan or intention to exercise control)[18] whether a foreign investment grants control is decided on a case by case basis.  Even the acquisition of a minor portion of the shares can constitute control.  As a rule of thumb, a transaction where the ownership of more than 10% of the shares of the voting securities of the firm would be by a foreign agent can be subject to a national security review. [19] Common elements of control include important matters such as:​​​​​​​

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1.  The sale, lease, mortgage, pledge, or other transfer of any of the tangible or intangible principal assets of the entity, whether or not in the ordinary course of business;

    

2. The reorganization, merger, or dissolution of the entity;

3. The closing, relocation, or substantial alteration of the production, operational, or research and development facilities of the entity;

4. Major expenditures or investments, issuances of equity or debt, or dividend payments by the entity, or approval of the operating budget of the entity;

5. The selection of new business lines or ventures that the entity will pursue;

6. The entry into, termination, or non-fulfillment by the entity of significant contracts;

7. The policies or procedures of the entity governing the treatment of non-public technical, financial, or other proprietary information of the entity;

8. The appointment or dismissal of officers or senior managers;

9. The appointment or dismissal of employees with access to sensitive technology or classified U.S. Government information; or

10. The amendment of the Articles of Incorporation, constituent agreement, or other organizational documents of the entity with respect to the matters described in paragraphs (a)(1) through (9) of this section.

           

            Furthermore, the Foreign Investment Risk Review Modernization Act has further specified that the following kinds of investments are also covered[20]:

1. A purchase, lease, or concession by or to a foreign person of real estate located in proximity to sensitive government facilities

2. “Other investments”[21] in certain U.S. businesses that afford a foreign person access to material, nonpublic, technical information in the possession of the U.S. business, membership on the board of directors, or other decision-making rights, apart from through the voting of shares

3. Any change in a foreign investor’s rights resulting in foreign control of a U.S. business or an “other investment in certain U.S. businesses

4. Any other transaction, transfer, agreement, or arrangement designed to circumvent CFIUS jurisdiction.      

           

             What 31 CFR 800 demonstrates is that ‘control’ is defined very broadly for the purpose of limiting the immediate and future effects of foreign acquisition on all aspects of the American business that accepts foreign investment.  Articles (a), (b), (c), and (j) of the legislation protect the structural composition of the investee; articles (d), (e), and (f) protect the decision making autonomy of the investee; and articles (g), (h), and (i) protect the technology and human capital of the investee.  Looking at these restrictions, it is clear that the purpose of the American national security review is to limit, to the utmost extent, the ability of the foreign investor to impact the investee in any real manner.  In effect, under the American national review system, the only acceptable gain the foreign investor should have from its investment is monetary profit. FIRRMA is likely to bring many more foreign investments in the U.S. under CFIUS investigations with the introduction of the catch-all phrase listed above.

 

Chinese National Security Review System

            The history of a national security review in China began in 2006.  In 2006, MOFCOM released the Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors, which called for notification and review of inbound mergers and acquisition transactions that might have an impact on national economic security[22].   In this early stage, it is already possible to point out the similarities between the American national security review system and the nascent Chinese national security review system.  According to article 12 of the MOFCOM 2006 regulation, a review is required if the transaction (1) results in actual control, (2) involves key industries, (3) has factors imposing or possibly imposing material impact on the economic security of the state; and (4) results in transfer of actual control in a domestic enterprise which owns any well-known trademarks of Chinese historical brands.[23] The Anti-Monopoly Law of 2008 further affirms that a foreign agent’s request for the merger and acquisition of domestic enterprises may be subject to a national security review, in addition to the anti-monopoly review.[24] 

            However, the regulations that provide the specifics of the national security review system were not introduced until 2011.  In February 2011, the State Council issued the Notice on Establishment of a Security Review System for Acquisition of Domestic Enterprises by Foreign Investors.[25]   The notification provides clarifications on the questions of process, which transactions are subject to review, and the concept of control.  According to the notification, the national security review panel is jointly headed by the State Council and MOFCOM.  The national security review first begins with a general review that lasts 30 days beginning on the day of application.  If the general review finds that the proposed transaction does not impact national security, the process ends.  If the review panel finds that there might be legitimate national security concerns, a special review is initiated.  The special review should be completed in 65 days.  If all members of the panel agree on a certain opinion, then the panel is authorized to take steps to decide whether the proposed activity should be permitted or denied.  If the panel fails to reach a unanimous decision, it will automatically submit all findings to the State Council.  There is no guidance on how long the review of this report at the State Council may take[26]. 

            The 2011 notification suggests the following transactions are covered under the national security review procedure : (1) transactions that would affect national defense, productivity and supply capabilities, transactions that would affect the operational stability of the PRC economy, (2) transactions that would affect social order, and (3) transactions that would affect the research and development capacity of China’s technologies key to national security. 

            It is also important to understand the meaning of ‘control’ within the scope of China’s national security review system.  According to the notification, (1) control includes situations where (foreign investors own more than 50% of the shares; (2) a foreign investor owns less than 50% of the shares but has sufficient voting rights to exert a material influence of the shareholders vote and resolutions of the board of directors; and (3) foreign investors otherwise gain actual control of management decisions, human resources, or technologies[27].  However, China’s national security review system seems to be on the verge of a big overhaul.  In 2015, MOFCOM released the draft articles on a new Foreign Investment Law.  The draft articles propose a significant expansion of the national security review system.  In particular, there is a concerted effort to clarify which sectors are covered under the national security review system, as well as which kinds of transactions can be subject to security review.

 

Improvements in the 2015 Draft

            In many ways, the expansion of the list of critical and covered sectors is a welcome development for improving transparency and predictability.  In the 2011 notification, the critical and covered sectors consisted of mergers and acquisitions that affect: (1) national security with regards to the ability to manufacture products vital to national defense, the ability to provide national services, relevant equipment and facilities, (2) the stable operation of the national economy, (3) the basic order of social life, and (4) the research and development capacity of key technologies related to national security. [28] One of the main criticisms to the 2011 communication was that the list was worded too broadly and that it was impossible to discern whether investment in the sectors that are generally considered to be highly relevant to national security, such as telecommunication, financial services, and energy, was covered by the national security review mechanism.[29] These sectors, and many more, are explicitly listed in the notes on draft article 57[30], bringing clarity to the Chinese concept of national security, and providing guidance to potential investors into the Chinese market.  Furthermore, the coverage of the type of foreign investments also expanded.  The 2011 notice only covers mergers and acquisitions; however, the draft articles clarify this question by specifying greenfield investments, medium and long financing, exploration and exploitation of natural resources, operation and construction of infrastructure,  acquiring real property rights, and obtaining control of domestic enterprises through various means.[31]  Furthermore, draft articles 64 and 73 clarify that the decisions of the security review are final and cannot be challenged through legal procedures.[32]

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Chinese and U.S. Foreign Investment National Security Review Systems Compared 

            One major issue common to both national security review systems is the question of what constitutes a national security threat.  Historically, the U.S. has adopted a very broad understanding of national security, and the recent trends (such as FIRRMA) suggest that a broad and abstract application of national security is to continue.  Furthermore, the comprehensive list provided in the homeland security website and amendments to the Defense Production Act introduced via FIRRMA suggest that if the political will is there, virtually any investment can be seen as a national security threat.  As for the Chinese side, 2011 communication is criticized by many for being too vague.  The 2015 draft, if adopted, will greatly improve on this issue.  However, national security is inherently a vague concept, the definition of which could change, based on the pressing political concerns of the time.  One way to improve on this problem would be to empower domestic courts, rather than administrative bodies, to handle disputes that could arise from national security disputes.  However, both jurisdictions handle national security reviews as an executive function and the room for the judiciary to second guess the executive is slim in either country.

            The second issue includes predictability and transparency.  The CFIUS national security review is an extremely secretive process.  Under the Exon-Florio statute, all information or documentary material filed under the provision may not be made public unless requested by administrative or judicial actions.[33]  Members of Congress and their staff members are held accountable for the information they request access to and expected to keep it confidential.[34]  CFIUS presents annual reports to the chairman and ranking member of each committee of the House and the Senate, but these reports are not public either.[35]  CFIUS is so secretive that it is difficult for the public to know the complete caseload of the Committee’s work to date.  For the most part, information on individual transactions that have been reviewed by CFIUS has come from announcements made by the companies involved in the transaction.[36]  This is problematic because it becomes very difficult for foreign investors and their U.S. partners to predict what national security issues could be raised regarding an investment proposal.  Similarly, it is difficult to deny allegations that the national security review process is very politicized when virtually all information on the works of CFIUS is hidden from the public eye.  Similar criticisms are likely to arise in the Chinese national security review system unless robust and transparent information disclosure measures are introduced.

            An additional difficulty that might hamper predictability and transparency in the Chinese system is the decentralized structure of the prospective Chinese national security review system. Article53 of the draft gives local MOFCOMs the power to make judgments as to whether or not transactions are “covered transactions” during pre-approval screenings.[37]  This is potentially problematic.  Local MOFCOM branches may not have the manpower or information capacity to properly handle the pre-investigation of investments with potential national security implications.  Furthermore, this might result in the fragmentation of the implementation of the national security review system.  It is well known that Chinese provinces fiercely compete with each other to attract investments to promote the development of local economies.  This can result in lowering the standards of national security during the pre-approval screening to facilitate the investment process in some provinces, and over-zealous pursuit of national security goals in others.

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                                                                                   REFERENCES:

 

[1] U.S. Department of the Treasury, Composition of CFIUS, https://www.trasury.gov/resource-ccenter/international/foreign-

                    investment/Pages/cfius-members.aspx.

[2] James K. Jackson, The Exon-Florio National Security Test for Foreign Investment  (2010) CRS Report RL 33312.

[3] Michael V. Seitzinger, Foreign Investment in the United States: Major Federal Statutory Restrictions (2013) CRS Report RL 33103.

[4] CRS Report RL 33103.

[5] CRS Report RL 33312.

[6] Ibid.

[7] 50 U.S.C. Appendix §2170(a)(6).

[8] James K. Jackson, The Committee on Foreign Investment in the United States (CFIUS) (2018) CRS Report RL 33388.

[9] Homeland Security, Critical Infrastructure Sectors, https://www.dhs.gov/cisa/critical-infrastructure-sectors website.

[10] CRS Report RL 33388

[11] CRS Report RL 33312

[12] Ibid.

[13] 50 U.S.C. Appendix §2170, https://www.law.cornell.edu/uscode/html/uscode50a/usc_sec_50a_00002170----000-.html.

[14] U.S. Department of the Treasury, Process Overview – Voluntary Notice, www.treasury.gov/resource-center/international/foreign- 

                          investment/Pages/cfius-overview.aspx.

[15] Ibid.

[16] Section 721 of the Defense Production Act of 1950, 50 USC APP. 2170 (as amended by the Foreign Investment and National Security Act

                          of 2007), www.treasury.gov/resource-center/international/foreign-investment/Documents/Section-721-Amend.pdf.

[17] James K. Jackson, The Exon-Florio National Security Test for Foreign Investment  (2010) CRS Report RL 33312.

[18] 31 CFR 800.223; 31 CFR 800.302(b)

[19] CRS Report RL 33312

[20] Summary of the Foreign Investment Risk Review Modernization Act of 2018. Website: www.treasury.gov/resource-

                          center/international/Documents/Summary-of-FIRRMA.pdf.

[21] For a detailed explanation of what “other investments” are see: The Foreign Investment Risk Review Modernization Act (FIRRMA) of 2018

                          Section 721(a)(4)(iii), https://home.treasury.gov/sites/default/files/2018-08/The-Foreign-Investment-Risk-Review-Modernization-

                          Act-of-2018-FIRRMA_0.pdf.

[22] Qingxiu Bu, China’s National Security Review: a tit-for-tat response?, https://www.tandfonline.com/doi/pdf/10.5235/LFMR6.5.343?

                           needAccess=true.

[23] Ministry of Commerce Peoples Republic of China, Regulations on Foreign Investment and Acquisition of Domestic Enterprises (2006),

                           http://www.mofcom.gov.cn/aarticle/b/c/200608/20060802839585.html.

[24] Qingxiu Bu, China’s National Security Review: a tit-for-tat response?

[25] General Office of the State Council of Peoples Republic of China, Notice on Establishment of a Security Review System for Acquisition of

                           Domestic Enterprises by Foreign Investors (2011),  http://www.mofcom.gov.cn/article/b/f/201102/20110207403117.shtml.

[26] General Office of the State Council of Peoples Republic of China, Notice on Establishment of a Security Review System for Acquisition of                               Domestic Enterprises by Foreign Investors (2011).

[27] General Office of the State Council of Peoples Republic of China, Notice on Establishment of a Security Review System for Acquisition of

                            Domestic Enterprises by Foreign Investors (2011).

[28] General Office of the State Council of Peoples Republic of China, Notice on Establishment of a Security Review System for Acquisition of

                            Domestic Enterprises by Foreign Investors (2011).

[29] Nanshen Sun, Di Hu, Foreign Investment National Security Review System’s Legal Reform and Recommendations for improvement, 17

                             Journal of Shanghai University of Finance and Economics 82, http://www.cnki.com.cn/Article/CJFDTotal-

                             SCJB201504009.htm.

[30] Meichen Liu, The New Chinese Foreign Investment Law and Its Implication on Foreign Investors (2018) Northwestern Journal of

                             International Law & Business; See also the draft articles at http://tfs.mofcom.gov.cn/article/as/201501/20150100871010.shtml.

[31] Nanshen Sun, Di Hu, Foreign Investment National Security Review System’s Legal Reform and Recommendations for improvement, 17

                             Journal of Shanghai University of Finance and Economics 82.

[32] Nanshen Sun, Di Hu, Foreign Investment National Security Review System’s Legal Reform and Recommendations for improvement, 17

                             Journal of Shanghai University of Finance and Economics 82.

[33] 50 U.S.C. Appendix Sec. 2170(c)

[34] CRS Report RL 33312

[35] CRS Report RL 33312

[36] CRS Report RL 33312

[37] Meichen Liu, The New Chinese Foreign Investment Law and Its Implication on Foreign Investors, 38 Northwestern JILB 285, 301 (2018).