Venture investors and startups are waking up to a new reality as the U.S. government is newly empowered to scrutinize foreign investment, including into venture funds and by foreign strategic investors. We’ve written previously about the big impact the Foreign Investment Risk Review Modernization Act (FIRRMA) will have on venture capital. The Treasury Department recently made a bold gambit when it issued Pilot Program rules under FIRRMA (fact sheet here). All aspects of the startup ecosystem are wise to understand these rules and buckle up going forward.
1. Why is CFIUS doing a pilot program anyway?
FIRRMA was signed by President Trump on August 13, and its passage kicked off an up to 18-month rulemaking to define key terms, set practices, and otherwise provide clarity. But because the Trump Administration was eager to use FIRRMA’s authorities to crack down on industrial espionage by foreign governments (with an emphasis on China), the legislation gave authority to create pilot rules to the Committee on Foreign Investment in the U.S. (CFIUS), which is led by Treasury. By doing a pilot, CFIUS does not need to wait until the final rule to flex its muscle.
2. It’s called a pilot program, so does this mean the rules won’t be permanent?
The pilot rules issued last week won’t be permanent, but that’s just because they will be replaced by final rules which should be in place 18 months after FIRRMA’s enactment. The venture industry will need to live under the pilot rules for the next year or more. That will mean many open questions and uncertainty for investors, limited partners, and startups. The final rule will reflect stakeholder input and ideally offer far more detail than the pilot rules. NVCA is fully engaged in the rulemaking process, including by standing up a working group to identify and prioritize issues, and by hiring outside counsel to assist during the process.
The pilot rules go into effect immediately and create mandatory filing obligations (more on that below) for a new class of non-controlling investments that kick in November 10.
3. How will this impact me as a VC or founder?
The impact of FIRRMA’s pilot program remains to be seen but is likely to be considerable. If you are a VC with foreign LPs or co-investors or a startup considering taking foreign investment, you ought to engage counsel on compliance. The piece of the pilot rules directly applicable to the startup ecosystem is the expansion of CFIUS jurisdiction to non-controlling investments by a foreign entity into a ‘critical technology’ company if the investment has certain characteristics. Let’s unpack what that means….
Under the new regime, CFIUS is no longer limited to situations when ‘control’ of a U.S. entity passes to a foreign entity. CFIUS now has authority no matter the size of the investment or percentage ownership stake if an investment otherwise meets FIRRMA’s requirements. The regulations define ‘critical technology’ very broadly, and includes items included on various export controls lists and to-be-determined “emerging and foundational technologies.” (See §801.204). Suffice it to say this covers a lot of venture-backed startups.
The foreign person investment can be direct into a company or indirect through a fund and must have certain characteristics to be a “pilot program covered investment” that gives rise to a CFIUS filing (See §801.209). The investment must afford the foreign person:
- Access to any material nonpublic technical information in the possession of the U.S. business;
- Membership or observer rights on the board of directors or equivalent governing body of the U.S. business (or right to nominate an individual to a position on the board or equivalent governing body of the U.S. business); or
- Any involvement, other than through voting of shares, in substantive decisionmaking of the U.S. business regarding the use, development, acquisition, or release of critical technology.
If the investment hits any of these prongs, and the underlying company works with critical technologies, then CFIUS has jurisdiction. If in addition the underlying company is in one of the 27 target industries in §801.212 and Appendix A) then mandatory declaration may be required. Generally, these mandatory declarations must be made at least 45 days before the expected completion date of the transaction.
So what is “material nonpublic technical information” anyway? The pilot program rules repeat what the statute has to say about the definition of “material nonpublic technical information”, i.e. it is not available in the public domain, and is necessary to design, fabricate, develop, test, produce, or manufacture critical technologies, including processes, techniques, or methods. Importantly, the rules and statute tell us that “material nonpublic technical information” does not include financial information regarding the performance of an entity, such as that provided by GPs to LPs on a quarterly basis. This definition unfortunately does not speak for itself and during the duration of the pilot program venture investors will need to ensure they’re on the safe side of the street when it comes to information provided to LPs or to foreign strategics.
Another must-understand section is special requirements for foreign LP participation on a Limited Partner Advisory Committee. Policymakers had a curiosity about LPACs and included a section in FIRRMA called Special Clarification for Investment Funds that dealt specifically with LPACs. The corollary to that statutory section is §801.304 of the pilot rules (“Treatment of certain investment fund investments”). This section provides a test to determine whether a foreign LP on an LPAC is a pilot program covered transaction. The test gets at questions like whether the foreign LP can control the fund via the LPAC or glean sensitive information because of LPAC membership. If you have a foreign LP on your LPAC then you will want to get to know §801.304. The example scenarios Treasury provides in §801.304 are helpful to understand how this section operates.
4. What should venture investors be doing?
Right now, venture investors should be assessing how FIRRMA (and particularly the pilot rules) affects their business and consulting counsel.
If you have foreign LPs, you will need to evaluate what type of information you share with these LPs. The most common tripping point is likely to be whether any information you share is “material nonpublic technical information.” As discussed above, the statute and regulation give us a little insight about what this is (necessary to design, develop, etc. critical technologies) and is not (financial information), but many questions will arise given the ambiguity of the term.
If you are or have foreign co-investors, you will need to evaluate what information or rights pass to the investor due to the investment in a critical technology startup. Receipt of a board seat or board observer status is a cut-and-dry case, and investors will need to decide going forward whether the right is worth the trouble of CFIUS. Access to “material nonpublic technical information” or “substantive decisionmaking” about the business is less clear, but investors will still need to decide whether these rights are essential enough to warrant the time, burden, and cost of the CFIUS process.
NVCA will remain engaged on FIRRMA and its rules on your behalf. We see our role as simultaneously advocating for fair and workable foreign investment rules and educating the industry on how your world will be impacted.
5. How can I better educate myself on this and other national security topics?
The best way to do that is by joining NVCA’s first ever Emerging Technology Meets National Security conference in Washington, DC on November 14. FIRRMA, CFIUS, and the new pilot rules will be a big topic of conversation. You will hear from Heath Tarbert, the head of CFIUS who will lead implementation efforts, and a panel of CFIUS experts at government agencies. You will also hear from venture leaders like Ted Schlein of Kleiner Perkins, Ray Rothrock of RedSeal, Bedy Yang of 500 Startups, and many more. This is your chance to have a front row seat for critical developments that will impact our industry for years to come. Register here.
Jeff Farrah served as General Counsel at NVCA, where he advocates before Congress, the White House, and agencies for pro-entrepreneurship policies and leads in-house legal matters for the association. He loves working at the intersection of venture, public policy, and the law. Jeff served as Treasurer of VenturePAC, the political action committee of NVCA.