John P. Carlin, Nicholas J. Spiliotes, Charles C. Comey, Robert S. Litt, Joseph A. Benkert, Panagiotis C. Bayz, Charles L. Capito III, and Amy S. Josselyn
Life Sciences + Healthcare and National Security, CFIUS, Sanctions + Export Controls
As many life sciences companies and investors are aware, the U.S. Department of the Treasury (“Treasury”) recently announced a new “pilot program” for the Committee on Foreign Investment in the United States (“CFIUS”) effective November 10, 2018. The pilot program implements certain provisions of the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), which brought sweeping change to CFIUS’s authority to conduct national security reviews of foreign acquisitions of and investments in U.S. businesses in high-technology fields.
What companies and investors may not yet fully appreciate, however, is the scrutiny that the new CFIUS pilot program brings to foreign investors that focus on research and development in pharmaceuticals and biotechnology, as well as to the U.S. businesses active in these sectors that seek to raise such financing. This Client Alert addresses issues that life sciences companies and investors should be considering in light of these new requirements.
Key takeaways for life sciences companies and investors include:
What is the CFIUS pilot program, and how does it relate to life sciences companies?
The new regulations issued by Treasury establish the CFIUS pilot program effective November 10, 2018. Under the pilot program, CFIUS may now review certain non-controlling investments in “pilot program U.S. businesses” that produce, design, test, manufacture, fabricate, or develop “critical technologies” used in connection with, or designed specifically for, one of 27 pilot program industries.
Notably, “Research and Development in Biotechnology” (NAICS Code 541714) is among the identified pilot program industries. According to the 2017 NAICS Manual, this industry includes businesses engaged in “the study of the use of microorganisms and cellular and biomolecular processes to develop or alter living or non-living materials” that “may result in development of new biotechnology . . . processes or in prototypes of new or genetically-altered products that may be reproduced, utilized, or implemented by various industries.”
Given the broadly worded scope of the “Research and Development in Biotechnology” industry, it is possible that many U.S. life sciences companies could be deemed to be involved in a “CFIUS pilot program industry.” Accordingly, investors and companies will need to examine whether (i) the company’s products and technologies constitute “critical technologies” and (ii) the additional terms of the financing place it within the scope of the CFIUS pilot program.
What are “critical technologies” in the life sciences industry?
Under the pilot program, critical technologies include, among others:
A life sciences company must classify its products, or submit a classification request to the U.S. government, to determine whether an item is controlled under the ITAR or the applicable requirements of the EAR. For EAR items, the company must also analyze the reason for the item’s control to determine whether it falls under the CFIUS pilot program requirements.
The Department of Commerce is preparing to publish proposed regulations covering “emerging and foundational technologies” as mandated by the ECRA. The list of such technologies will likely include biomaterials, biopharmaceuticals, and new vaccines and drugs that have been the subject of recent nation-state economic espionage efforts from groups in Russia, China, and Iran. Because the Chinese government’s “Made in China 2025” plan also focuses on high-performance medical equipment, such devices may also be included on the forthcoming list.
Which types of life sciences investments will CFIUS be able to review?
Prior to FIRRMA, CFIUS’s review was limited to transactions that could result in foreign control of the U.S. business. FIRRMA expands CFIUS jurisdiction to include certain non-controlling investments in U.S. businesses involved with critical technology, critical infrastructure, or sensitive personal data of U.S. citizens, subject to regulations to be published to implement these changes The CFIUS pilot program implements a portion of these FIRMMA changes related to critical technology. It expands CFIUS review jurisdiction to include “pilot program investments,” or non-controlling investments in pilot program U.S. businesses that afford the foreign investor any of the following rights:
Life sciences companies and investors should be aware that future Treasury regulations will implement FIRRMA changes to cover foreign investments in a U.S. business that maintains or collects sensitive personal data of U.S. citizens, if the investment provides the foreign person board membership or observer rights, or involvement in substantive decision-making regarding the sensitive personal data held by the business. Data that may be collected or held by life sciences companies, including genomic or health data, is likely to be included in such regulations. Indeed, CFIUS as a matter of current policy is already closely scrutinizing transactions involving the collection and storage of personally identifiable information of U.S. citizens.
Are there additional considerations for investment funds?
The pilot program regulations clarify for investment funds how the participation of foreign persons as limited partners (or equivalents) in the fund will impact pilot program jurisdiction. Generally, CFIUS will not have jurisdiction to review an investment by a fund in a U.S. business, based solely on the participation by a foreign limited partner on the advisory board or committee of a fund, if the fund (i) is managed exclusively by a general partner or equivalent that is not the foreign person; (ii) the advisory board or committee does not approve investment decisions, or the general partner’s decisions regarding investee companies; (iii) the foreign person does not otherwise have the ability to control the fund; and (iv) the foreign person does not have access to material nonpublic technical information of investee companies as a result of its participation on the advisory board or committee.
When must the parties notify CFIUS of a life sciences investment, and what are the penalties for noncompliance?
Parties to a transaction that (i) could result in foreign control of a pilot program U.S. business or (ii) is a pilot program investment (as defined above) must submit to CFIUS either an abbreviated “declaration” at least 45 days before closing the transaction or a full CFIUS notice. Declarations, as opposed to full CFIUS notices, are intended to be no more than five pages and must generally describe the parties and the transaction. On or before the 30th day after CFIUS accepts the declaration, it must take one of the following actions: (i) request that the parties submit a full CFIUS notice; (ii) inform the parties that CFIUS is not able to complete action based on the declaration and that the parties may voluntarily submit a full CFIUS notice to obtain clearance; (iii) initiate a unilateral review of the transaction; or (iv) notify the parties that CFIUS has cleared the transaction.
A party to a transaction that is subject to the pilot program’s mandatory reporting requirements that fails to comply with these requirements could be liable to the U.S. government for a civil penalty of up to the value of the transaction. This potential for substantial penalties further highlights the need for companies and investors alike to carefully consider the U.S. business’s products and technology, as well as the circumstances of the transaction, to determine whether it falls within the pilot program’s scope.
If the parties to a transaction submit to a full CFIUS review, or if CFIUS initiates a unilateral review, CFIUS could require that the parties implement certain measures to mitigate national security risks as a condition of CFIUS clearance of the transaction. Such mitigation measures could include, for example, (i) limits on the foreign investor’s governance rights (e.g., board representation); (ii) limits on the foreign investor’s access to the U.S. business’s facilities and information; (iii) requirements that the U.S. business adopt a security plan; and (iv) ongoing compliance monitoring and reporting obligations to the U.S. government. In cases where CFIUS determines that national security risks associated with the transaction cannot be mitigated, CFIUS can recommend that the President block the transaction or unwind a transaction that has already been completed.
What are the likely impacts of the CFIUS pilot program on foreign investments in U.S. life sciences businesses?
The new CFIUS rules come at time when foreign investment, particularly from China, has been contributing to a significant increase in life science funding for U.S. companies. According to PitchBook, the number of U.S. life sciences financing transactions that included an investor from China went from single digits before 2013, to 37 in 2017, to 51 through the first nine months of 2018, representing approximately 11% of all life sciences venture financing transactions in the most recent period. In terms of dollars, Chinese investors participated in financing rounds worth over $3.75 billion through the first nine months of 2018, or over a third of the value of all such transactions.
This increase in Chinese investment in U.S. life sciences companies is driven by a number of factors, including the Made in China 2025 campaign. The growth of the Chinese middle class also has increased the focus of Chinese investors on life sciences companies developing therapies to treat the Chinese population. Recent Chinese investments have also been driven by an increase in valuations of Chinese life science companies, which has made U.S. valuations attractive by comparison, and recognition that the United States is still a leading source of innovation in biotechnology.
These forces are likely to continue in the coming years. We do not expect a wholesale retreat from the U.S. market by Chinese investors absent significant additional U.S. government action. More likely, investors and companies will find ways to work through the new requirements, and these adjustments will represent the “new normal” that well-advised investors will accept and deal with, including filing CFIUS declarations where required and notifications where it makes sense to do so.
Transactions with a mix of U.S. and foreign investors, for example, may be structured with multiple closings to allow investors not subject to CFIUS reporting requirements to close before those that are, with appropriate contingency plans in case a foreign investor is not able to complete a transaction. Transactions may also be structured to permit a foreign investor to close with passive rights, with additional rights upon CFIUS clearance. Parties may also want to revisit customary information rights, board memberships, and board observer rights to preempt national security concerns and expedite CFIUS clearance. Experienced counsel can help companies and investors efficiently navigate the new requirements and achieve financing and longer-term strategic objectives.
 The impact of FIRRMA on foreign investors and U.S. companies was the subject of a previous Client Alert in August 2018. The new CFIUS pilot program was explained in further detail in a second Client Alert published earlier this month.
 These 27 pilot program industries are defined by North American Industry Classification System (“NAICS”) Code and are detailed in our previous Client Alert.
 Critical technologies also include defense items controlled under the International Traffic in Arms Regulations (“ITAR”), nuclear equipment, materials, and technology controlled under regulations pertaining to assistance to foreign atomic energy activities and the export and import of nuclear equipment and material.
 “Control” in this context includes majority and “dominant minority” investments that give the foreign investor the power to determine, direct, or decide important matters affecting a U.S. business. This jurisdiction generally excludes passive investments of less than 10 percent of the U.S. business’s outstanding voting securities that only provide the foreign investor certain non-operational minority shareholder protections listed in the CFIUS regulations.
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