Defense globalization: foreign investors in U.S. corporations navigate sea of regulations.

Investment in the U.S. defense industry is attractive to European and Asian companies simply because the federal government is the largest customer in the world by an order of magnitude.

The United States spends far more on national defense and homeland security than any other nation in the world. Reasons for increased spending in the United States include the need to replace equipment used in ongoing wars, the Defense Department's initiatives to ensure the military remains a technologically superior force, the growing requirements to protect transportation, energy, communications and other critical infrastructure, and the government's desire to acquire new capabilities to protect troops in the field and citizens at home from terrorist attacks.

European and Asian companies understand that they need to have a presence in the United States in order to earn U.S. government business. Some foreign firms have concluded that the best way to compete against large, home-grown defense contractors is to buy them.

Some opportunities cannot be effectively pursued unless a U.S. subsidiary is facilitating the paperwork required to respond to a government solicitation. Other business opportunities can only be pursued with a cleared U.S. facility. Non-U.S. companies that have realized the benefits of direct investment in the United States include BAE, EADS, Airbus, Smiths, Thales and Rolls-Royce. British companies alone have invested more than $1.6 billion in acquiring U.S. defense, aerospace and homeland security companies.

The Defense Department's policy, generally, is to support the military with the best technology and equipment at the lowest price. For these and other reasons, the Defense Department will buy European or Asian items, or U.S.-made items with foreign components. As the Pentagon moves toward network-centric war-fare, some of the best and lowest-cost equipment will come from Europe and Asia.

Although members of Congress have proposed legislation that is aimed at limiting foreign participation in U.S. defense procurement, most policymakers understand that contracts with foreign firms help maintain and build relationships with allies. It would be more difficult to obtain the support of our allies in a military effort if we excluded their contractors. In addition, cooperation with other countries facilitates interoperability of forces and assets.

American companies considering selling to foreign owners should examine the application of the International Traffic in Arms Regulations (ITAR), the National Industrial Security Policy Operating Manual (NISPOM), the Committee on Foreign Investment in the United States regulations, and other trade and security laws and regulations.

Discovering government approval requirements or compliance issues late in the process will delay closing. The "due diligence" information gathering process should cover the following areas:

Export Compliance. The buyer's due diligence should include an export compliance audit. Without an audit, the buyer may unknowingly assume contingent liabilities and unasserted claims by U.S. government agencies.

Export Authorizations and Government Contracts. Due diligence should identify all export authorizations and government contracts of the target company. Special procedures exist for transferring export authorizations and government contracts in an asset sale. Further, with respect to exports governed by the ITAR, the buyer must register with the Directorate of Defense Trade Controls (DDTC) or update its registration to cover the acquired business.

Facility Security Clearances. In the course of reviewing prime and sub-government contracts, the buyer should identify those that require that the target receive access to classified information. To permit performance of the classified contracts, the target must have a facility security clearance. Buyers will want to obtain approval from the Defense Security Service for the continuation of the clearance post-closing. Failure to plan for the "foreign ownership, control or influence" resulting from the transaction will interrupt business and reduce the value of the target company.

Committee on Foreign Investment in the United States. Merger and acquisition deals are covered by regulations administered by CFIUS. Notice to CFIUS is advisable in most circumstances. CFIUS review requires due diligence of the target in the areas discussed above and in other areas, including details concerning the structure and ownership of the buyer.

Liability concerns also must be addressed. A buyer may be held responsible for violations of an acquired business even though the violation occurred prior to the buyer's acquisition of the business. While parties to a transaction may reach agreement as to those liabilities and claims that will be assumed by the buyer, DDTC and the Bureau of Industry and Security may hold the buyer directly responsible for even those liabilities and claims that the parties assigned to the seller. As a result, the buyer's only recourse may be to pursue indemnification from the seller.

In most cases, the export violations of the target company should be disclosed in the context of the acquisition. Voluntary disclosures are handled more favorably by the enforcement and compliance agencies than are directed disclosures.

In many transactions, disclosures will be directed if not done voluntarily. DDTC may require successor entities to conduct post-acquisition export compliance reviews of acquired companies and report their findings to DDTC. This practice effectively requires acquiring companies to make voluntary disclosures of pre-acquisition violations of export laws and regulations a condition of closing.

When a target company will be owned or controlled by foreign interests, the existing clearance will be suspended or revoked unless the company takes steps to negate "foreign ownership, control or influence" (FOCI) regulations to the satisfaction of the DSS. Suspension or revocation can be damaging to the target's business.

Planning is critical to avoid a prolonged disruption to the target's business. The target initially must make a proposal to DSS to negate FOCI. The NISPOM prescribes various FOCI negation arrangements. They include the voting trust, the proxy agreement, the special security agreement, the security control agreement, exclusionary board resolutions and the limited facility security clearance.

In the event that DSS accepts the company's arrangement to negate FOCI, the company must prepare the required documents, including board resolutions, a key management information statement, a certification pertaining to non-U.S. interests and a technology control plan. The company also must identify personnel for positions that require security clearances.

Because CFIUS review can delay proposed acquisitions considerably, it is vital that parties to proposed acquisitions or mergers involving non-U.S. ownership understand the powers of CFIUS and allow a minimum of 30 days for CFIUS to review the transaction before closing.

Pursuant to the Exon-Florio Amendment to the Defense Production Act of 1950, the president, following a review by CFIUS, may suspend or prohibit any non-U.S. acquisition, merger or takeover of a corporation that is determined to threaten the national security of the United States. Every transaction is potentially reviewable by CFIUS. Even transactions that appear as purely civilian may invoke a CFIUS review because of the Department of Homeland Security's interest in protecting critical infrastructure, including the transportation, energy, communications and financial industries.

CFIUS also has authority to retroactively review a transaction. If a private party or government agency were to bring "credible evidence" to CFIUS, even many years after a transaction was consummated, CFIUS could commence an investigation.

While there is no requirement that the parties to an acquisition notify CFIUS of a transaction, filing is advisable to give management and shareholders certainty that the transaction is valid and will not be challenged. CFIUS cannot investigate transactions that it previously decided did not warrant investigation. It is prudent for parties to a transaction to submit details of the transaction to CFIUS to obtain--pursuant to a 30-day review procedure--a determination that the transaction does not warrant investigation. Through this action, a non-U.S. investor can establish a "safe harbor" for the transaction and be comfortable that CFIUS will not investigate and unwind the transaction at a later date.

Investment in the U.S. defense industry is attractive, but the complexity of U.S. regulations and bureaucracy too often has the unintended consequence of serving as a protectionist measure.

George IV. Grammas is a partner at Squire, Sanders & Dempsey, in Washington, D. C. He focuses on laws and regulations governing international trade, technology transfer, government clearances and foreign participation in the U.S. defense and security industries.