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From Serial A Financing to Prohibited Transaction: First CFIUS Divestment Order Against Closed Deal by Chinese Investor

Posted by on March 7, 2020

On March 6, 2020, US imposed a divestment order against a closed deal by Chinese investor, under national security review steered by CFIUS (Committee on Foreign Investment in United States), and enforceable by the Department of Justice.  Set forth below briefs significant enforcement development, which is natural progression from the enforcement initiatives under the “whole-of-government” approach as we briefed previously.  This could become a norm against cross-border transactions that were seemingly legitimate, smoothly closed, but allegedly, at a later stage, warrant blocking due to national security concerns under the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”).

1. Executive Summary

On March 6, 2020, President Trump imposed an divestment order, which mandates full divestiture of an already closed acquisition of an US cloud-based hotel property management software developer by a Chinese public company providing integrated hotel management systems (HMS) mainly in China.  Specifically, the “prohibited transaction” concerns the acquisition of StayNTouch Inc, a private company incorporated in the State of Delaware and SaaS (Software as a Service) hotel property management systems (PMS) developer, by Beijing Shiji Information Technology Co., Ltd., a Chinese public company listed in Shenzhen and incorporated in China (“Beijing Shiji”), through its wholly owned Hong Kong subsidiary, Shiji (Hong Kong) Ltd. (“HK Shiji”) (with Beijing Shiji and HK Shiji together as “Purchaser”) (“CFIUS Divestment Order” or “this order“).

Beijing Shiji invested in StayNTouch through a 15% subscription of its Serial-A shares on January 15, 2016 , and announced it as a “completed” acquisition on September 18, 2018 (“2018 Shiji-StayNTouch Acquisition”).  The CFIUS Divestment Order represents intensifying enforcement under the “whole-of-government” approach to block, suspend, and intervene US-outbound transfer of “critical technology,” as well as foreign (Chinese) US-inbound investment involving “sensitive personal data,” as we highlighted in the previous alert.

2. Analysis

Summary below is from trade compliance and corporate counsel perspectives.

2.1 Background: Whole-of-Government Approach & Regulatory Priority

In August 2018 U.S. Congress overwhelmingly passed, and President Trump swiftly signed it into law the John McCain National Defense Authorization Act for the Fiscal Year of 2019 (“NDAA“). The Export Control Reform Act of 2018 (“ECRA”) and the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), as the integral parts of the NDAA, became law.  Under §1261(a) of NDAA, this “whole-of-government strategy legislatively targets China as follows:

“a principal priority for the United States that requires the integration of multiple elements of national power, including diplomatic, economic, intelligence, law enforcement, and military elements, to protect and strengthen national security”.

ECRA and FIRRMA expanded and strengthened the US export control and investment review regimes under CFIUS (Committee on Foreign Investment in United States) to intervene (and block) US-outbound transfer of “critical technology,” which includes nuclear facilities, and “emerging” or “foundational” technologies that are not yet on pre-existing export control lists but “are essential to the national security of the United States.”  (See Annex 1 for a list of BIS-proposed representative categories for “emerging technology.”)

Before NDAA, “covered transactions” by CFIUS limited to US-inbound, controlling foreign investment.  Under FIRRMA’s final implementing regulations, “covered transactions” extends to (a) “non-controlling” investments, either inbound or outbound, involving “Critical Technology” determined under ECRA, critical infrastructure, and sensitive personal data (“TID US Business”), (b) investment in TID US Business with “substantial interest” (>25% equity or voting interests) by a foreign party in which “a foreign government has substantial interest (>49% equity or voting interests),” and (c) real estate transactions with proximity to military/sensitive sites. Material misstatement or omission in CIFUS filings or evasion or circumvention will be enforcement focuses and subject to significant penalties.

So far, the US Government has identified “software specially designed to automate the analysis of geospatial imagery” that triggers export/CFIUS clearance.  For more details, please refer to our previous alert.

2.2 Full Divestiture Order

Under this CFIUS Divestment Order dated yesterday (March 6, 2020), President Trump finds that the parties to the 2018 Shiji-StayNTouch Acquisition “might take action that threatens to impair the national security of the United States.”  In the 2018 Shiji-StayNTouch Acquisition, StayNTouch is being integrated into the Purchaser as a fully owned subsidiary, with the founder of StayNTouch to “continue to lead the company and take an active role in Shiji Senior Management team focused on global expansion (since September 2018).” 

Beijing Shiji initially invested through equity participation subscribing 15% of the Serial-A shares of StayNTouch on January 15, 2016, followed with capital increase in 2017, and full equity acquisition by September 14, 2019, with purchase price of RMB241,239,612.43 ($34.81 million).

Upon closing of this acquisition on September 13, 2019, StayNTouch booked net loss of RMB11.3million ($1.6 million). StayNTouch has served 429 hotels and provides innovative, cloud-based mobile hotel management solution. Beijing Shiji claims that StayNTouch is an innvavative company “user-friendly to not only those already with local HMS, but also those hotels interested in upgrading into cloud-based HMS.”  According to Beijing Shiji’s statement, it is a market leader in China handling RMB 5trillion revenues by hotels through its management software, and that all of the major state-owned banks in China use its direct settlement for hotel payments, with strategy to upgrade into a global, cloud-based hotel management system leader.

17 months after the closing, the CFIUS Divestment Order intervenes, declares it as a “prohibited transaction,” and further mandates full divestiture, within 120 days after the date of this order, including:

  • (1) 100% equity interest in StayNtouch;
  • (2) StayNTouch’s assets, intellectual property, technology, data (including customer data managed and stored by StayNTouch), personnel, and customer contracts; and
  • (3) any operations developed, held, or controlled, whether directly or indirectly, by StayNTouch at the time of, or since, its acquisition.

The CFIUS Divestment Order further authorizes the Attorney General to “take any steps necessary to enforce this order.”  It requires the Purchaser (and its subsidiaries or affiliates) shall, among other standstill/restituting requirements:

  • (i)  refrain from accessing hotel guest data through StayNTouch, “immediately from the date of this order until such time as the divestment has been completed, and verified to the satisfaction of CFIUS,”
  •  (ii)  ensure that controls are in place to prevent any such data access, until divestment completed and verified to the satisfaction of CFIUS, not later than 7 days after the date of this order,
  • (iii)  ensure, together with StayNTouch, to permit access by enforcement officials to all premises and facilities of StayNTouch located in the United States, for purposes of verifying compliance with this order, within 90 days after the certification of a CFIUS-satisfactory divestment, to
    • (a) inspect and copy any relevant books, ledgers, accounts, correspondence, memoranda, and other records and documents in the possession or under the control of the Purchaser or StayNTouch;
    • (b) inspect or audit any information systems, networks, hardware, software, data, communications, or property in the possession or under the control of the Purchaser or StayNTouch, and
    • (c) interview officers, employees, or agents of the Purchaser or StayNTouch.

3. Outlook

The CFIUS Divestment Order represents intensifying enforcement that targets US-inbound investment by privately owned Chinese buyers, through their Hong Kong or other overseas subsidiaries in traditionally tax-efficient jurisdictions, under the “whole-of-government” approach.

US authorities will no longer limit to suspend or block new transactions.  Rather, this CFIUS Divestment Order indicates that US authorities will intervene into “old” ones to restitute “prohibited transactions,” even after their consummation, so long as CFIUS and the President determine, in the President’s judgment, justifiable national security threat exists in a covered transaction upon creditable evidence.

Such divestment in the past had been rare, but becomes a new reality. In this case, it involves a target company in US providing foreign access to “sensitive personal data” captured under FIRMMA, and a Chinese Purchaser with significance businesses with Chinese state-owned enterprises (SOEs) and domestic market position. 

This regulatory development is an important alert to not only those making US-inbound investment, but also those having “(US-outbound/China-inbound) joint venture, joint development agreement, or similar collaborative arrangement.” Notably, those intending to make early stage investment (often non-controlling) must factor in, at deal screening stage, and throughout deal lifecycle (from due diligence to post-closing integration), the implications from CFIUS Divestment Order. When Beijing Shiji made Serial-A investment into a startup with significant clientele like StayNTouch in 2016, such transaction fell outside CFIUS. NDAA has revamped the CFIUS process and expanded its jurisdiction, capturing such non-controlling investment as “covered transaction.” 

M&A due diligence must ensure trade compliance perspective be in place and when appropriate, drive the deal screening and/or the determination of the scope and timing of such due diligence.  This is because, without prioritized efforts to identify if there exist sensitive dual-use technologies, or concerns with respect to U.S. critical infrastructure or sensitive personal data, the money might go into drain, like this case.  At the project side, innovative companies must build capacity to effectively monitor the upcoming further enforcement to divest transactions already closed, and conduct counter due diligence of their prospective investors as well.

In terms of reputation damages in such case, it would be difficult to estimate at this point.  Nevertheless, informed deal makers must be wary of collateral damages from such divestment order, and re-evaluate the adequacy of seemingly well-drafted deal documentation, from break-up fees and/or conditions precedent inclusive of regulatory clearance.

It’s critical to engage experienced compliance counsels with objectivity to examine and evaluate your vulnerabilities/deficiencies, structure and execute transactions properly and compliantly.

Please feel free to let us know if you have any questions.

Sincerely,

Yi Wang

P.S.: Below is the Chinese Summary:

如下为中文概要：美国政府于昨日（2020年3月6日）正式以总统令宣布一桩已于2018年9月交割完毕的中资在美全资收购为违法并要求立即剥离。该交易对价3400万美元，在交易交割两年后，CFIUS（美国外国投资委员会）认定为国家安全审查下的禁止性交易。经美国总统批准下令，CFIUS要求收购方立即剥离已收购的标的股权及资产，涉及敏感个人信息的采集(酒店管理软件和服务系统)，并指令美国司法部执行该禁令，并对标的企业在美国境内资产进行调查，直至令美国外国投资委员会满意的剥离完成（“CFIUS剥离禁令”）。

       该CFIUS剥离禁令涉及领域为酒店服务管理信息系统领域，标的企业StayNTouch Inc为酒店管理信息系统云端解决方案美国初创企业，已服务近500家美国和国际酒店（“StayNTouch”或“标的企业”）；收购方北京中长石基信息技术股份有限公司及其香港全资子公司（“石基”），为工农中建交在酒店网银结算通道共同的供应商；交易始于2016年石基对StayNTouch的A轮融资，历时近两年直至2018年9月完成对标的企业的全资收购。

       与以往先例不同（美国国家安全审查在2018年8月之前限于对构成控制的外资收购事先防范与救济），在2018年8月美国CFIUS与出口管制立法重大变革后，美国政府在该案件采取事后救济的执法手段，CFIUS认为，尽管该交易已经交割完成，但美国监管部门认为存在可信的证据表明该交易相关方“可能将采取行动”威胁美国国家安全，从而以宣布交易为禁止交易，并使用全部剥离的深度干预手腕，防止并切断外国当事方“接触敏感个人信息。”

       同样为国家安全审查视野下的技术出境美国（除了本案中的收购，也包括常见的在华直接投资/合资项目）以及关键技术相关的数据、人员往来，亦将成为下一步管制与执法的优先领域，未来此类执法将有先例可循。相关企业需要未雨绸缪，在贸易管制与投资审查体系的视野下，从事创业投资在内的投资/融资方应加强有针对的项目筛选与尽调，减少投资损失并合规运作（该被禁止的交易为现金收购3400万美元，由此带来的声誉损失目前难以估量） 。初创企业也需要加强自身合规与风控的能力建设，有效审慎反向尽调潜在投资方以及合作方及其资金和产业背景，及时有效防范引入创业投资后的贸易/投资管制方面的风险。

About the author: Yi Wang, trade and business attorney with public and private sector experience to tackle with regulatory/business challenges. He was one of the two defense counsels to MOFCOM in first Sino-US WTO dispute on semiconductors in 04′, and thereafter, counseled and managed cross-border transactions, regulatory clearance for transactions and trade/FCPA litigation at leading law firms in US/China from 02′ to 14′, and further served with GE Plastics/SABIC from 14′ to 17′. From 17′ to present, he is co-founder of Mind Realizing Law advising international businesses and institutions in operational excellence and private equity transactions with robust anti-corruption / trade compliance perspectives.