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Emerging Trends: Credit Issues Facing Defense Contracting Sector

May 5, 2014

Kaye Scholer’s National Security, Government Contracts & Regulatory Compliance and Bankruptcy & Restructuring Departments recently hosted two client events concerning “Credit Issues Facing the Defense Contracting Sector in a Period of Fiscal Uncertainty” that featured guest speakers from the Department of Defense. Both seminars were co-hosted with Loughlin Management Partners + Company and featured two panels discussing important factors to consider when faced with a turnaround situation involving a defense/government contractor, key criteria for successfully turning around and restructuring a defense/government contractor in an environment of significant budget cuts and reduced demand for services, and other related topics.

Kaye Scholer Partners Farhad Jalinous and Ronald Henry served on the first panel at both events alongside representatives from Loughlin, Aaron Kibbey and Marty Young. Partner Michael Messersmith joined them for the Washington, DC event, moderated by John Hillen of private equity firm LLR Partners, while Partner Mark Liscio participated in the seminar in New York, moderated by Admiral William O. Studeman, USN (Ret). The second panel at both events featured two representatives from the US Department of Defense: Elana Broitman, Deputy Assistant Secretary of Defense Manufacturing and Industrial Base Policy, and Ben Richardson, Chief of the Foreign Ownership, Control or Influence Operations Division of the Defense Security Service. The seminars were attended by guests from the government, banks, consulting groups, aerospace and defense companies, and investment management groups.

For this Emerging Trends feature, Partner Farhad Jalinous discussed some of the top level issues and trends presented at this event.

Q. What was the one lesson you hoped that participants would take away?

A. Perhaps the most key point to take away from the conference is the need to be aware of and plan for national security regulatory considerations early in the process. These are issues that even some in the industry may not be aware of—and even with awareness, all the various implications and requirements are not always intuitive.

In most cases, with proper planning, the Committee on Foreign Investment in the United States (CFIUS) and foreign ownership, control or influence (FOCI) mitigation processes should not prove problematic to a given path forward (e.g., distressed sale, debt-to-equity conversion). If companies do not actively address these points, however, there can be delays and unnecessary hurdles that can impact closing or, potentially, the ability of the distressed company to maintain an active facility security clearance, which is typically essential for the company to succeed. The government speakers at the conference also repeatedly emphasized that they are there to help companies and encouraged contractors to engage with them. This can be a very important and valuable part of the process that should also be addressed as part of strategic planning.

Q. In terms of defense/government contractors and crisis management, what are the most urgent issues you've seen?  How do you successfully navigate these issues?

A. Typically, the most urgent issues from a national security perspective are assessing the nature of the distressed company’s business (e.g., the nature and extent of its classified work) and determining what the post-closing ownership structure will look like from a foreign ownership and control perspective. Particularly in debt-to-equity conversions, there can be complicated ownership structures among funds that will hold significant positions in the distressed company following closing. It is important to have a clear understanding of these issues so that the parties can present the post-closing ownership structure to the Defense Security Service (DSS) (i.e., the branch of the Department of Defense that administers the National Industrial Security Program, including the FOCI program) and, if necessary, develop a FOCI-mitigation proposal to ensure that the distressed company’s security clearances will remain valid.

The ownership structure is also important to assess whether a CFIUS filing will be necessary, which should be done as early as possible within the process to account for the time needed to complete the CFIUS review process (e.g., the initial review period takes 30 calendar days and about 40% of CFIUS reviews move into an additional 45-calendar-day investigation).

Q. Given the amount of leverage on a number of defense contractors who are either stressed or distressed,  various parties expect an increasing number of debt-for-equity conversions to occur over the next twelve months. We are all aware of the regulations governing defense contributions. What regulations will be impacted by a debt-for-equity conversion?

A. From a national security perspective, there are three primary regulatory areas that could be implicated: CFIUS, FOCI and export controls.

CFIUS conducts national security reviews of transactions that could result in a foreign person having control over a US business. “Control” is defined and interpreted broadly under the CFIUS regulations, so even a foreign lender or investor acquiring a minority interest in a company could be subject to CFIUS jurisdiction. While CFIUS approves most transactions without additional conditions, CFIUS can—and in certain cases does—require mitigation measures in order for a transaction to proceed. Additionally, as noted above, most CFIUS cases take between 30 and 75 calendar days to complete the formal review process—and that is after the parties have prepared the information for the filing and gone through a draft “prefiling” stage that typically lasts a week. Accordingly, from both substantive and timing perspectives, it is critical to consider and plan for CFIUS issues as early as possible in the process.

With respect to distressed companies holding facility security clearances and performing on classified contracts, it is necessary to assess the post-closing ownership structure to determine whether any FOCI mitigation will be necessary. Generally speaking, companies under FOCI are not eligible to obtain or maintain facility security clearances unless their FOCI is appropriately mitigated. A FOCI mitigation requirement can be triggered by as little as a foreign entity holding, directly or indirectly, a five percent interest in the cleared company. For example, it is not uncommon for hedge funds or private equity groups—even those that are organized and controlled in the United States—to require some degree of FOCI mitigation to address foreign funds (e.g., foreign-organized limited partnerships) involved directly or indirectly in the transaction. Even if FOCI mitigation is ultimately unnecessary, the cleared company will need to notify DSS about the changes in its ownership structure as well as other relevant changes, such as to key management personnel.

If a distressed company is engaged in export-controlled activities, which can be the case even if the company does not engage in exports, a foreign entity obtaining an ownership interest (or in some cases even just conducting due diligence activities) can raise export compliance issues. It is critical to understand the distressed company’s business from an export-control perspective to ensure compliance throughout the process. Depending upon the nature of the transactions, regulatory filings related to export compliance may also be necessary.

 

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