Coordinating investment screening across the US, Japan, and Korea #JapanFinance

Sarah Bauerle Danzman:
There are currently two paths toward a U.S. outbound investment regulation. First, the Biden administration issued an executive order that instructs the Treasury Department to develop regulations to restrict certain kinds of outbound investment to China, specifically non-passive investment in advanced semiconductors, quantum computing, and artificial intelligence (AI) systems with military applications. Treasury collected two rounds of comments on draft rules and is expected to release the final regulations soon, though likely not before the U.S. presidential election. Second, some members of Congress have been attempting to pass a similar statutory requirement. These efforts have evolved over time from a proposed case-by-case review of outbound investment to a sectorally scoped prohibition regime. These legislative gambits have so far not been able to pass both chambers of Congress, partially because Representative Patrick McHenry, the current chair of the House Financial Services Committee, has been strongly opposed to a sectoral-based outbound regulation. Additionally, Representative Andy Barr has circulated a competing legislative proposal that would use list-based financial sanctions—rather than sectoral restrictions—to address outbound investment in Chinese companies with ties to the Chinese military.

These measures’ general policy objective is to prevent the Chinese government from benefitting from cutting-edge dual-use technologies such as advanced semiconductors, forms of AI that have military applications, and quantum computing. The worry is that U.S. corporations investing their research and development resources in China create national security risks that any innovations developed on Chinese soil will be transferred to the Chinese Communist Party. Similarly, U.S. venture capital firms that invest in Chinese high-technology products bring legitimacy and the necessary managerial know-how to scale from start-up to commercialization. The U.S. government wants to prevent U.S. venture investors from helping the Chinese build a tech ecosystem that would augment Chinese military and surveillance capabilities.

While U.S. allies have been more willing to go along with the United States on regulatory issues such as inbound investment review and export controls, robust outbound investment restrictions in Japan and South Korea are unlikely. First, these firms need to expand abroad to stay globally competitive, and they cannot rely on large internal markets. Second, neither country has a venture capital market approaching the size of the United States.

Sarah Bauerle Danzman:
Japan and South Korea both have investment screening regimes that developed within the context of both countries’ more state-guided approach to late development. Consequently, both have rather substantial reporting requirements in comparison to the United States. For example, Japan’s 2019 amendment of its Foreign Exchange and Foreign Trade Act expanded reporting requirements for foreign investors in covered sectors/assets to include transactions as small as 1% of outstanding shares. South Korea’s foreign investment rules also require substantial reporting, including mandatory registration even for portfolio investments in the country. South Korea’s investment climate is more generally protected than Japan’s; several sectors—especially those comprising critical infrastructure—still have blanket equity restrictions on foreign ownership. Korea pairs this selectively restrictive investment climate with proactive promotion of foreign investment in priority sectors. Indeed, its investment screening apparatus is housed in the Ministry of Trade, Industry, and Energy, which also has a mandate of attracting beneficial investments.

While Japan and Korea have, in many regards, more reporting requirements than the United States, their regimes are also characterized by a much more targeted focus on high technology leakage and security-critical supply chains. The Committee on Foreign Investment in the United States (CFIUS) is a cross-sectoral mechanism that can review any cross-border acquisition regardless of the business activities of the U.S. target. In contrast, Japan and South Korea have sector-based review authorities, meaning that only sectors that are deemed strategically important are reviewable. In the case of South Korea, the Act on Prevention of Divulgence and Protection of Industrial Technology also creates a process through which the government can review foreign acquisitions of Korean firms that possess a designated “national core technology.”

Of the limited information on case review that is publicly available, it is widely understood that CFIUS operates much more assertively than the Japanese or South Korean screens. For instance, the United States enters into letters of agreement with transaction parties that bind acquirers to making specific and often costly changes to their operations in order to address national security concerns that CFIUS has identified. Japan, in contrast, does not actively engage in such mitigation negotiations. Instead, filing data seems to suggest that the Japanese Ministry of Finance provides guidance to investors about how they would need to change their operations or deal structure to mitigate security concerns, after which investors either make the recommended changes or abandon the transaction.

Sarah Bauerle Danzman:
At a minimum, allies and partners should be clear about the procedures through which they will review economic transactions for possible intervention as well as the criteria through which they evaluate investment deals for potential security concerns. Every country, and indeed every administration within those countries, will have slightly different definitions of what economic security entails and will accept different amounts of risk, since blocking transactions can have important and substantial negative economic consequences. The fact that Korea’s investment screening authority is housed in the same ministry tasked with attracting investment, for example, provides context for why Korea may be more willing to accept some risk if the economic benefits are high enough.

It is much harder, however, to commit to developing common standards for review or to share classified information. The U.S. Foreign Investment Risk Review Modernization Act allows the U.S. government to share some transaction-level information with allies when necessary. The confidentiality of the CFIUS procedure limits the extent to which the public can independently verify internal procedures, but it is my understanding and experience that information sharing is usually done sparingly.

Sarah Bauerle Danzman:
The Nippon Steel case is controversial. President Joe Biden has stated publicly several times that he does not support the deal, and Vice President Kamala Harris as well as former President Donald Trump—both of whom are running for president—have taken the same position. But, it is unclear how this transaction would create an unmitigable national security risk, especially since Japan is a strong U.S. treaty ally. This raises concerns that CFIUS has become politicized, and is—at least in this case—no longer evaluating cases on rigorous, fact-based, national security criteria. Indeed, Japan’s new prime minister, Shigeru Ishiba, raised this precise concern when he was running for office, stating that a U.S. decision to prohibit the acquisition could “undermine the trust of its [the United States’] allies.”

In my mind, there are two key takeaways. First, firms—even from allied nations—will need to be much more attuned to political sensitivities arising from electoral cycles as they manage their deal flow. Gone are the days when major cross-border acquisitions could be assumed to go through without political controversy. Second, governments should not reach for national security justifications to solve politically sensitive problems. Doing so only undermines trust in the impartiality of national-security-focused regulations and reviews. This is why having clear criteria for how governments conceptualize and evaluate risk, as discussed above, is so important. It allows governments to assess whether decisions were made in keeping with review criteria or if the review process was manipulated to produce a politically expedient outcome. There may sometimes be instances in which political calculations are so overwhelming as to make a transaction infeasible, but governments need to develop authorities and processes to address these issues on their own terms rather than by shoehorning the policy analysis into one of economic and national security.