Arnold & Porter has been monitoring developments in our nation’s capital over the past few months. This week’s report follows.

House Ways and Means Committee addresses political activities of tax-exempts. On Wednesday, the Committee marked up several pieces of legislation that would impact the political activities of tax-exempt organizations. During the markup, Chair Jason Smith (R-MO) and Republican lawmakers underscored the importance of increasing transparency into the financial practices of tax-exempt organizations, foreign influence in U.S. elections, and ensuring that tax-exempt organizations are upholding the public interest commitments that justify their tax-exempt status. Committee Democrats highlighted their efforts to advance campaign finance reform and promote voter turnout.

The markup advanced legislation, including (i) H.R. 8290, an act requiring tax-exempt organizations to publicly disclose grants made to foreign organizations, (ii) H.R. 8314, which would penalize tax-exempt organizations for making political contributions after receiving donations from foreign entities, including revocation of tax-exempt status for repeat violations, (iii) H.R. 8291, the End Zuckerbucks Act, which would prevent tax-exempt organizations from providing funding to support election administration, and (iv) H.R. 8293, which would require tax-exempt organizations to disclose information about contributions from foreign sources. Plans for House consideration are unclear and obstacles can be expected in the Senate.

Donor-advised funds under scrutiny. Highlighting the potential reputational risks of controversial donor-advised fund grantmaking decisions, House Ways and Means Committee Chair Jason Smith (R-MO) sent a letter on May 6 to the Chamber of Commerce criticizing its foundation for accepting $12 million in funding from the Tides Foundation, a “left-leaning” political organization. Chair Smith argued the Tide Foundation’s work contradicts the Chamber’s mission and implied the Chamber may not be acting to fulfill the purpose that justifies its tax-exempt status. The letter includes a number of questions and requests a response by May 20. Last week, the IRS held a two-day hearing featuring over 40 stakeholders on proposed regulations for donor-advised funds. Stakeholders submitted more than 200 comments on the proposed rules.

China Updates

House farm bill includes ag land reporting requirements. Ahead of a May 23 committee markup, House Agriculture Committee Chairman Glenn Thompson (R-PA) issued a summary of a draft farm bill, which is expected to be released today. Provisions include reforms to reporting requirements for tracking agricultural land owned by entities with ties to China, Iran, North Korea, Russia, and any other countries identified as potential threats. Additionally, a Government Accountability Office report in January recommended the Department of Agriculture coordinate with other agencies to provide public data on foreign investments. (RFG thanks Arnold & Porter for contributing this story.)

White House announces new measures on Chinese imports. On Tuesday, President Biden announced an increase in tariffs on goods made in China. Electric vehicles will bear the heaviest burden, with tariff rates of 100%. Semiconductors, solar cells, and needles and syringes will face 50% tariffs, and steel and aluminum products, batteries, battery components and parts, critical minerals, ship-to-shore cranes, and personal protective equipment such as face masks, respirators, and gloves will face a 25% tariff rate. China’s Commerce Ministry said that Beijing would “take all necessary actions to defend its own interests.”

The administration also announced it is adding 26 Chinese textile companies to the Uyghur Forced Labor Prevention Act Entity List because they source their cotton from the Xinjiang region where the Uyghur minority are being exploited through forced labor.

With respect to trade, a chart prepared by the St. Louis Fed illustrates the growth and decline of Chinese imports in the U.S., and the Bank also discusses the impact of decoupling on American manufacturing.

China cuts off access to live trading data. China has blocked access to real-time trading information concerning foreign investors’ activities in mainland stocks, says The Financial Times. To stem volatility and reduce speculation in the market, China also intends to curb the release of live data on “southbound” trading of Hong Kong stocks by mainland investors.

CFIUS Regs May Create Investment Opportunities

Recent U.S. regulatory developments surrounding Mubadala Investment Company’s planned majority acquisition of Fortress Investment Group may herald the arrival of a new avenue for U.S. institutional investors to access attractive co-investment opportunities via strategic relationships with non-U.S. investors.

The Mubadala/Fortress Investment Group transaction. According to news reports, in May 2023, Mubadala Investment Company, an Abu Dhabi sovereign wealth fund, agreed to a transaction with Softbank that would lead to Mubadala holding 70% of U.S.-based Fortress equity, with Fortress management holding the other 30%. However, since that time, Mubadala entered into discussions with several potential co-investors—including a university, Brazil’s BTG Pactual, and certain U.S. pension funds—in an apparent effort to reduce Mubadala’s expected equity stake in Fortress. The impetus for these changes is widely believed to be Mubadala’s desire to address concerns raised by the U.S. Committee on Foreign Investment in the United States (CFIUS) about the transactions.

In May 2024, following lengthy negotiations, CFIUS cleared the transaction without the addition of any co-investors. However, Mubadala reportedly was required to make important concessions, including waiving day-to-day control of Fortress, and committing to keep U.S. technology and data in the United States. Although CFIUS ultimately approved the transaction without a U.S. institutional co-investor, the fact that the parties and CFIUS considered such an arrangement a feasible mitigation option is a new development in the CFIUS space that is worthy of close attention going forward.

CFIUS and the Foreign Investment Risk Review Modernization Act. CFIUS has the power to block or unwind certain deals that could harm national security—a category of transactions that has expanded significantly with the passage of the Foreign Investment Risk Review Modernization Act (FIRRMA) in August 2018. In the event CFIUS identifies a national security risk relating to a particular transaction, CFIUS will coordinate with the parties to mitigate such risk. Mitigation can take many forms, and does not necessarily impede the applicable foreign buyer’s ability to receive the economic benefit of its investment. Often, mitigation involves limitations on access and influence by the foreign buyer. Such limitations may include establishing a board composed of U.S. persons or another U.S.-based governing body to manage the day-to-day operations of a business. If CFIUS determines that no unmitigated national security issues will result from a transaction, it typically issues a “safe harbor” letter assuring the transaction will not be blocked or unwound.

The passage of FIRRMA has particularly enhanced CFIUS resources and authority over deals involving companies that are deemed “TID U.S. Businesses,” which comprise a subset of U.S. companies that deal in critical or sensitive technologies, infrastructure, or personal data (TID). For example, in 2018, CFIUS blocked Ant Financial, an Alibaba affiliate, from buying MoneyGram. In 2019, a post-acquisition CFIUS review forced iCarbonX, a Chinese company, to conduct a fire sale of its stake in PatientsLikeMe, a healthcare platform. Finally, in March 2020, at CFIUS’ recommendation, President Trump issued an executive order requiring Chinese company Beijing Shiji Information Technology Co., Ltd. to divest all interest in the assets and operations of StayNTouch, a U.S. hotel reservation data platform.

Implications for institutional investors. The growing range of deals requiring scrutiny due to FIRRMA, coupled with the recent developments concerning Mubadala’s purchase of Fortress, suggest that we are entering a regulatory environment in which U.S. institutional investors can play an increasingly important role in helping foreign parties to invest in U.S. companies. Large tax-exempt U.S. institutional investors may be particularly well-suited for this purpose due to their reputation as being passive, long-term, and risk-avoidant. Such investors are often likely to be regarded as trusted stewards of a foreign buyer’s U.S. asset, making such buyers more comfortable relinquishing control to a third party. At the same time, CFIUS may look more favorably on a transaction in which reputable tax-exempt investors serve as a perceived buffer to protect U.S. national security concerns from risk of foreign access, such as with the Fortress acquisition by Softbank prior to the adoption of FIRRMA, and the broader set of TID U.S. businesses under the FIRRMA regime. Given the added value they bring to the transaction, U.S. tax-exempt investors could be positioned to participate in such investment opportunities more frequently, and with more favorable terms, than other investors (such as financial businesses, which tend to take a more active and aggressive role with respect to their holdings). Accordingly, we may see an increase in U.S. tax-exempt investors partnering with foreign buyers of U.S. businesses.

The presence of U.S. institutional investor capital may also facilitate CFIUS approval of a transaction by virtue of diluting the foreign investor’s equity interest. If the aggregate dilution by third-party investors reduces an equity interest below 50%, a large shareholder might still be considered to have “control” as defined by CFIUS; however, the reduced equity and voting interest would likely provide CFIUS some measure of comfort that the U.S. business has sufficient protections. Even if the dilution by a U.S. institutional co-investor does not reduce a foreign person’s equity interest below 50%, the reduction may be contractually sufficient to eliminate any voting threshold requirements in the purchase agreement that the foreign person might otherwise have been able to exercise unilaterally.

Very few upsides come without potential downsides. For example, U.S. institutional investors may have to disclose to the U.S. government detailed information about their management and holdings that extend beyond what is required under their existing regulatory requirements. While the U.S. government does keep this information confidential, it is only natural that some investors may be wary of making such disclosures. Moreover, being party to a transaction undergoing CFIUS review can be burdensome, requiring investments of both time and money in an endeavor that may not be successful. Although CFIUS approves most transactions, ultimately there is no guarantee a transaction will not be blocked. Also, to facilitate a transaction, U.S. institutional investors may be called upon to play an active role in overseeing and implementing CFIUS mitigation requirements concerning the portfolio company on a going-forward basis.

Conclusion. U.S. institutional investors—particularly those that are tax-exempt—seem poised to become valuable partners to foreign companies that require CFIUS approval across an increasingly broad scope of acquisitions and investments. While such partnerships ultimately were not a factor in obtaining CFIUS approval of the Mubadala transaction, the fact that they were considered worthy of serious consideration as a mitigating factor may incentivize non-U.S. investors to consider from the outset a deal structure that has one or more U.S. tax-exempt institutional co-investors in place prior to engaging with CFIUS to seek approval of a given transaction. This forward-looking mindset could considerably help smooth a CFIUS review and facilitate more rapid clearance (rather than spending a year negotiating risk mitigation with CFIUS, as seen in the Mubadala/Fortress transaction). Accordingly, in the coming years, U.S. tax-exempt institutional investors that foster close relationships with active foreign investors may have a growing number of opportunities to co-invest in exclusive transactions on favorable terms. U.S. investors who would like to consider pursuing such opportunities would be well advised to work closely with experienced CFIUS attorneys who can advise them on how to avoid potential pitfalls, while enhancing their ability to access attractive investment opportunities.

Investments: Defense, Growth Equity & Pot

Pitfalls and incentives in defense investing. Investors in the defense and security sectors will be affected by the administration’s “carrots and sticks” approach to U.S. foreign policy objectives. Proskauer explains where the government’s restriction and incentivizing efforts are focused.

Growth equity growing as an asset class. McDermott Will & Emery says that investors are increasingly drawn to growth equity as a distinct asset class. Growth equity sits in the space between venture-stage start-ups and established businesses generally favored by traditional private equity. Rather than getting in on the ground floor where the risk is greatest, growth equity investors get in on the second or third floors, often providing the first source of institutional capital and the initial expansion efforts for the business. The firm says the key to successful equity investment, where a founder or pre-investment management team often retains overall control of the business, is to align incentives and expectations from the start.

Pot to become profitable? On April 30, the DOJ submitted a formal proposal to the White House to reclassify marijuana from a Schedule I controlled substance to a less-dangerous Schedule III controlled substance, and to formally recognize its medical use—a move that would potentially lessen the tax burden on cannabis companies. Because of their current Schedule I designation, cannabis companies are prohibited under Section 280E of the Internal Revenue code from deducting certain business expenses such as rent, payroll, advertising, and various other expenses, effectively subjecting them to tax on their gross income. This often results in an effective tax rate of 70% or more. The redesignation would mean that many more cannabis companies would be profitable. At present, fewer than 25% of them are in the black.

The Wall Street Journal notes that cannabis will remain illegal on the federal level. Therefore, companies selling cannabis still will not be able to do business with banks and credit card companies, won’t be allowed to transport products across state lines, and can’t be traded on U.S. stock exchanges. Ahead of a May 23 committee markup, House Agriculture Committee Chairman Glenn Thompson (R-PA) issued a summary of a draft farm bill which, as we said earlier, is expected to be released today. The House bill does not address cannabis and hemp policies, which the Chairman expects to be “one of the more interesting debates” during the markup. See RFG’s earlier write-up about the cannabis industry.

Fed Says IAs Should “Know” Their Customers

On May 13, the SEC and FinCEN published a joint notice of proposed rulemaking (Joint NPRM) that would, among other things, require investment advisers to maintain reasonable procedures to verify the identities of their customers. The Joint NPRM is the outgrowth of an earlier proposed rule by FinCEN that would incorporate certain investment advisers into the definition of “financial institution” under the Bank Secrecy Act (BSA), thus requiring them to adopt AML and CFT requirements pursuant to the BSA, as well as SAR filing obligations. As such, it is a necessary component of bringing adviser AML programs to the level of other “financial institutions.” (See our prior story on the earlier proposal.) The Joint NPRM and FinCEN’s earlier proposal only apply to a subset of investment advisers, including registered investment advisers and exempt reporting advisers.

The Joint NPRM defines the term “customer” as a person “who opens a new account with an investment adviser.” Thus, if a nonprofit opens an account with a covered investment adviser, the nonprofit would be the customer and would most likely provide its legal name, date of formation, addresses, and tax ID number. If a private fund opens an account with an investment adviser, the fund is the customer. In these circumstances, the investment adviser would collect the identifying information of the fund itself, not that of those invested in the fund. However, an investment adviser would be required to obtain information about individuals with authority or control over the account, if this is consistent with the adviser’s risk assessment which must “enable an investment adviser to form a reasonable belief that it knows the true identity of each customer.” Information concerning individuals involved with legal entities should be necessary only if the investment adviser is unable to verify the legal entity’s identity using the standard verification methods set forth in the proposed rule.

In practice, many investment advisers already maintain AML/CFT programs or records, particularly if licensed as banks, registered as broker-dealers, or having advised mutual funds. Nonetheless, the Joint NPRM and earlier proposal would provide a mechanism for the SEC to examine investment advisers, pursuant to the BSA.

Events Contracts Face Proposed Ban

The CFTC has issued a new Notice of Proposed Rulemaking to specify events contracts that are prohibited because they are “contrary to the public interest.” Bloomberg notes that controversial binary options have been of increasing interest to Wall Street and have been used to legally bet on monetary policy, lunar landings, and music awards. Trading platform Kalshi’s effort to list contracts on the 2022 Congressional elections unleashed a “firestorm,” as did a request from another exchange to allow betting on NFL games.

The CFTC release explains that event contracts involving “gaming,” war, terrorism, assassination, and activity that is illegal under federal or state law “are, as a category, contrary to the public interest and therefore may not be listed for trading or accepted for clearing on or through a CFTC-registered entity.” The agency defines gaming in detail, and provides several examples, including staking something of value on a political contest, an awards contest, or a game in which athletes compete.

It is unclear whether there is sufficient time for the proposed rules to be adopted before the U.S. elections this year or the start of the next NFL season. Moreover, Kalshi and PredictIt have both sued the CFTC over this matter.

PE: Healthcare, Antitrust & Retail Investors

Three takeaways for healthcare. Frost Brown Todd notes that PE healthcare deals are receiving more scrutiny from antitrust authorities. It says:

However, in an upbeat note for PE firms, a U.S. district judge on Monday ruled that the FTC had failed to show how Welsh Carson, a minority investor in the roll-up acquisitions underlying the case before the court, had violated the antitrust laws.

Cheerleader settlement. Varsity Spirit, its current owner Bain Capital, and prior owner Charlesbank Capital are participating in an $82 million settlement for alleged violations of various antitrust laws.

Increased costs for pets. Fortune speculates on whether PE firms are to blame for the increased costs of vet services.

Healthcare and others facing more False Claim Act proceedings. The DOJ has reported collecting more than $2.68 billion from 543 settlements and judgments under the False Claims Act in 2023—the highest number of settlements and judgments in a single year. The False Claims Act imposes treble damages and penalties on those who knowingly and falsely claim money from the United States, or knowingly fail to pay money owed to the United States. As in past years, healthcare fraud accounted for the greatest percentage of recoveries.

In recent remarks, Deputy Assistant Attorney General Brian M. Boynton said the DOJ will focus on cybersecurity, pandemic fraud, healthcare fraud, and the potential role of private equity investors in the conduct of healthcare entities. Lowenstein Sandler urges potential investors to be especially punctilious with due diligence—the DOJ has taken the position that a failure to correct diligence issues is enough to hold an investor liable under the FCA.

ELTIF 2.0: wider PE access to individual investors. A Pitchbook piece expresses optimism that—thanks to the updated European Long-Term Investment Funds regulation (ELTIF 2.0)—investment in private equity funds will soon become accessible to individual, non-institutional European customers. (Agreements are still needed between the European Commission and the European Securities and Markets Authority regarding standards for redemptions and liquidity management tools.) RFG thinks this “good news” warrants a high degree of skepticism: the growing inclusion of individuals in private funds can easily lead to private funds being regulated more like mutual funds.

Cybersecurity Reminders

New Reg S-P rules. The SEC released amendments expanding the scope of Regulation S-P, which governs the treatment of nonpublic personal information by registered advisers and certain other financial institutions. Rule details are available here; a fact sheet is here.

Implementing a common cybersecurity platform across the portfolio. Troutman Pepper observes that as cyberattacks increase, PE firms are changing their cybersecurity strategies. Historically, portfolio companies developed their own cybersecurity protocols. Now, however, PE firms are more likely to work collaboratively with their portfolio companies to identify needs, remediate risk, and drive consistent reporting and solutions across the portfolio.

Baby, you can wipe my car. The FTC’s Office of Technology reminds consumers that data collected by newer cars includes biometric, telematic, geolocation, video, and other personal information that could potentially be used for nefarious purposes and pose a national security risk if provided to malign actors. The agency recommends wiping your car’s data before selling it and provides guidance on how to do so.

Cyberthreat mitigation for nonprofits. The U.S. Cybersecurity and Infrastructure Security Agency, along with international counterparts, offers guidance to help those with limited resources mitigate cyberthreats.

Maryland new data privacy law includes nonprofits. The Maryland legislature passed a data protection bill covering entities that have personal data of (i) at least 35,000 consumers, or (ii) 10,000 consumers and derive more than 20% of gross revenue from its sale. The law covers more businesses and strengthens the privacy protections beyond the models previously seen in other states. For example, Maryland does not exempt nonprofits or institutions of higher education, and it does not contain an entity-level exemption for HIPAA-covered entities.

Articles of Interest

PCAOB adopts new standards. The Public Company Accounting Oversight Board adopted two new auditor standards: General Responsibilities of the Auditor in Conducting an Audit and A Firm’s System of Quality Control. The new standards and related amendments will take effect for audits of financial statements for fiscal years beginning on or after December 15, 2024.

Senate releases AI roadmap. Akin describes a “roadmap” for AI regulation released by the Senate on Wednesday.

Fee variation. A Journal of Finance white paper (Harvard Law summary here) on fee variation in private equity sampled 2,400 funds raised between 1990 and 2019 and determined that:

(i) most private funds employ a fee structure where some LPs pay higher fees than others, (ii) factors dictating the use of multiple fee tiers include the asset class (venture capital funds are more likely to use a single fee tier), the associated law firm, and the level of demand for the fund (high-demand funds are less likely to offer fee concessions), and (iii) some LPs consistently pay lower fees either due to their “size and sophistication,” or simply negotiation skills and relationships with GPs. The authors support streamlining LPA negotiations.

BEPS impact on IA, fund and portfolio company finances. Managers need to evaluate the impact of the BEPS 2.0 project Pillar Two rules on financial statements, fund structures and investment choices, says EY, even if the U.S. does not adopt the rules.

NYSE halts trades for reverse stock splits. The New York Stock Exchange amended Rule 123D to halt trading on the day before a reverse stock split. This NYSE rule, effective May 11, parallels a similar NASDAQ rule. Morgan Lewis explains that market participants have requested this change because various errors may occur and go unnoticed. For example, a broker may sell more shares than a customer has in its accounts, leading to a short position.

FDI updates. Dechert released a report discussing how governments are expanding the concept of national security to trigger more foreign direct investment reviews.

RFG Weekly Roundup – May 17, 2024 |

The View From Washington: Nonprofits