Podcast - FOCI Mitigation: SSAs, SCAs and Proxy Agreements

Molly O'Casey: Welcome to the 11th episode of "Are We All Clear," the podcast on facilitating security clearances. I'm your host, Molly O’Casey, an international trade Associate with Holland & Knight’s Washington, D.C., office. Today's episode will discuss outside directors and proxy holders, their role in the NISPOM framework, and insulating a cleared company from its foreign owners, as well as practical approaches to outside directors and proxy holder selection, employment and accountability. Today's speaker is Antonia Tzinova. Antonia leads Holland & Knight’s committee on foreign investments, also known as CFIUS, and our industrial security team. Welcome back to the podcast, Antonia.

Antonia Tzinova: Hi, Molly. It's good to be back.

Molly O'Casey: Good to have you back. This episode kind of serves as a continuation of our previous episode on FOCI mitigation, FOCI being foreign ownership, control or influence. For anyone listening to this episode as a one-off, could you provide some context on FOCI?

Antonia Tzinova: Sure, it's good to provide context. Happy to. So, FOCI stands for foreign ownership, control or influence. A company that performs on classified contracts cannot be under FOCI unless FOCI is mitigated. And here — I said it three times already — FOCI mitigation is intended to prevent the foreign interest from adversely affecting the performance of classified contracts or preventing it from safeguarding classified information. As the acronym suggests, ownership is not the only way to control or influence a company. The DCSA, the regulator, looks at formal and informal arrangements that allow the foreign person control over a company with the ability to exert undue influence.

Molly O'Casey: Right. And within the FOCI context, outside directors and proxy holders come up in the context of FOCI and mitigation. Right? Can you give us a brief overview of FOCI mitigation strategies?

Antonia Tzinova: Sure. So I mean, these are spelled out specifically in the NISPOM. NISPOM stands for the National Industrial Security Program Operating Manual. And FOCI is enforced by the DCSA. I mentioned this one already. DCSA stands for Defense Counterintelligence and Security. Apologize for the soup of acronyms. So FOCI issues frequently come up during the initial facility clearance application or in the context of mergers and acquisitions. But that's not the only time. I mean, any time a company signs up for a major foreign contract and would derive a substantial amount of revenue from a foreign source, these would be things that need to be reported to the DCSA and accordingly mitigated. To mitigate control stemming out of foreign ownership, DCSA uses a set of complex mitigation structures depending on the level of ownership or the level of clearance required. Example: secret vs. top secret. There are three different agreements used: security control agreement or SCA, a special security agreement or SSA, or a proxy agreement. This is in contrast to small levels of foreign ownership or passive foreign ownership or some other form of loss of influence. For example, foreign debt, where a board resolution or special board resolution may be more appropriate. So it really depends on the mix of factors that need to be considered.

Molly O'Casey: And as discussed in our last episode, this has the potential to come up a lot and become very complex.

Antonia Tzinova: That's right. I mean, the companies that have been in this field for a while and doing it are probably well versed. DCSA is a good resource to always guide them. But for a newcomer or for a complex transaction, it's usually advisable to involve counsel.

Molly O'Casey: Brilliant. Thank you for setting the scene, Antonia. Within this context, what are outside directors and proxy holders?

Antonia Tzinova: Right. So, as we said, where we have more sizable foreign ownership, especially with voting rights in a cleared company, the foreign owners and the DCSA enter into an agreement, and it could be an SCA, an SSA or a proxy agreement. And the agreement establishes the rights and obligations of the parties. And when I say the parties, I mean the cleared company, the foreign owners and the DCSA. Outside directors and proxy holders are mechanisms that are used in these mitigation structures to negate foreign ownership and foreign control. So these are independent U.S. nationals. They're nominated by the foreign parent. But it's important to remember they are vetted and approved by the DCSA in advance so that they can serve on the company's board of directors. On one hand, they exercise the rights of the foreign owner on the board. On the other hand, they ensure that the national security interests of the U.S. are protected in all cases. These must be U.S. nationals with no prior relationship to the cleared company or the foreign owners to ensure their financial independence. And this is something that I really want to emphasize. I mean, if there has been any sort of financial involvement of this person, they will be disqualified as an outside director or a proxy voting.

Molly O'Casey: Right. Which makes sense because, I mean, money is a huge influence, right?

Antonia Tzinova: I mean, the ability to generate revenue, whether as a person or as a company, it's a motivating factor. Yes. That's why it's important.

Molly O'Casey: Right. That's an interesting sharing of power between the foreign owner and DCSA. The foreign parent nominates them, but ultimately they have to meet DCSA's approval, which makes sense. As the outside director says, proxy holders kind of wear two hats, so to speak, in that they're both the board member and the protector of U.S. national security interests. How do foreign investors select a person to serve as an outside director or proxy holder?

Antonia Tzinova: There is no set rule, or there is no, like, official registry where you can go and select a person. The only requirement is that these are U.S. nationals with no prior relationship to the cleared company or the foreign owners. They must be cleared or eligible for clearance at the level of the company. But given the broad authority that they have, as we'll discuss in a moment, they should also be trustworthy, business-savvy, knowledgeable. I mean, the foreign investor is kind of handing over control over the company to these people. And they should not be just like, somebody who's eligible. They should also be able to manage a business. We, as outside counsel, maintain a roster of individuals who have expressed an interest to serve as an outside director, a proxy holder. These are typically former government officials, retired Army personnel. We're talking, you know, maybe at the level of general or in the government, you know, a director or somebody who's been in an influential or like high-level office with the government. So they understand the process, but they also have a proven record with the U.S. government and also have some managerial experience and ambition enough to be able to run something. So when we're assisting a client to set up an SSA or proxy board, we may recommend people from our roster. Obviously, there are many ways to identify someone. The one thing that's important is that both the foreign parent and DCSA, if you're comfortable with the nominated person, because they will be in effect running the company.

Molly O'Casey: Yeah, that's quite a specific set of skills. I imagine we have a very interesting list of people.

Antonia Tzinova: Well, yeah, and we update it from time to time based on experiences, but it's a relatively small world. There are currently about 170-176 companies that are under such a form of mitigation, so people know each other. We kind of get referrals this way.

Molly O'Casey: We discussed this notion of the two hats that outside directors and proxy holders wear. Could you tell us more about their exercise of rights for the foreign owner on the board, which we can kind of consider the first half that they wear?

Antonia Tzinova: Sure. So to start off with a general setup in the business world, the shareholders of any company typically appoint the members of the board, and then the board appoints the officers of the company, the senior officers, senior management, who then run the company. The board members act in a typical business context. Act at the shareholders' leisure, so to speak. And in a typical business context, they can be removed by the shareholders with or without cause. Their primary goal is to protect the financial interest of the shareholders, and they run the company in line with the shareholders' vision and goals. When we talk about a cleared company and in the case of an outside director or proxy holder, they must protect the financial interest of the company, but they are more independent in their decisions of how to achieve this: who to hire, who to promote. In the case of the proxy agreement, the proxy holders are the ones deciding on pretty much everything except for disposing of the company. So independence is a key distinctive factor when we are comparing general business to a cleared company and the FOCI mitigation.

Molly O'Casey: So that's the more traditional corporate aspect of that role. Which brings us to their second hat. How do outside directors and proxy holders protect the national security interests of the U.S.?

Antonia Tzinova: Right. So under the NISPOM, and the modification agreement, whichever form that is, the proxy holders or the outside directors, they have a lot of authority to act as independent directors of the board. They are the ones who oversee any matters relating to the company's classified contracts, like hiring employees, staffing, establishing security policies and procedures. They are cleared at the level of the company, and at least some must be present at any board meeting for the board to constitute a quorum, for the board to make any decisions. And under these agreements, there is a special committee of the board called the government security committee or GSC. The outside directors or the proxy holders are members of the GSC, and through the GSC, they handle all matters related to safeguarding classified information.

Molly O'Casey: Ooh, GSC, a new acronym. How exciting.

Antonia Tzinova: That's right.

Molly O'Casey: So we've got the outside directors and proxy holders who are members of the GSC, which sounds like it's sort of its own thing within the board. Who else is on the board? Are there other members of the board? How should we be conceptualizing them as we consider FOCI mitigation?

Antonia Tzinova: Good one. So let's start with the difference between an outside director and a proxy holder. And then I'll address your other question. As you know, we have different mitigation structures. We mentioned them a couple of times already, SCA and SSA and a proxy agreement. These are the three major ones. The SCA and the SSA call for outside directors. This is to distinguish the outside director from the inside director. So here we have a new figure, if you will, while in each case the foreign owner nominates them. I mean, both the outside and the inside directors, the SCA must vet and approve the outside directors before they take their positions on the board. The inside directors do not need to be vetted by DCSA, so in that sense, they are true representatives of the foreign owner on the board. Consequently, the inside director cannot be corrected, even if they're a U.S. national. So in a company of the SCA or an SSA, you have a mix of outside and inside directors in what are called an office of directors. These are cleared senior officers in the company that can also serve as directors. One important rule about outside directors is that they always outnumber the inside directors. So you typically see three outside directors and one or two inside directors. Now, taking this to the proxy agreement, when it comes to a proxy agreement, which is the strictest form of mitigation, where the foreign parent is literally a passive investor in the company, they are three independent, cleared U.S. nationals that have been vetted and approved by the SCA before they step into the shoes of the foreign shareholder. And once they do, they act as the owners. They act as members of the board. The proxy holders exercise all prerogatives of ownership with complete freedom to act independently from the foreign stockholders, including full responsibility for the voting stock and for exercising all management prerogatives. And there are very limited exceptions to that. As I mentioned earlier, the proxy holders must obtain approval from the foreign shareholder for the sale or disposal of the company or a substantial part of its assets, and that's about it. And in the proxy agreement they're no inside directors. So the proxy holders have full responsibility of overseeing management of the company. It is this ability of the outside directors and proxy holders to act independently from the foreign owners that ensures they guard the national security interests of the U.S. board, as we discussed earlier. But to come full circle to your initial question, yes, and in addition to the outside directors or proxy holders, there are other members of the board. And so we can have inside directors in the case of SSA, or we can have cleared officers, directors. These, the senior management that are cleared and can also serve on the board, and you can have them under either scenario.

Molly O'Casey: So basically for SSAs and SCAs, we have outside directors, and by directors and office directors. The outside director plays a direct role in, as the name suggests, FOCI mitigation. And the inside director is a traditional foreign owner on the board, whereas the officer director is like any senior officer of a company, but they've obtained a security clearance from DCSA and can serve as directors.

Antonia Tzinova: That is correct.

Molly O'Casey: Then for proxy agreements, we have proxy holders, and the proxy holders step into the shoes of the owners and have minimal limitations on what they can do. So they basically just you know…

Antonia Tzinova: Praise the world.

Molly O'Casey: Yeah. I was trying to think of a good analogy, and I couldn't come up with one.

Antonia Tzinova: But that is the case. They really have that much authority over the company.

Molly O'Casey: Who do outside directors and proxy holders report to? Is this DCSA or the foreign parent?

Antonia Tzinova: So good one, the outside directors and proxy holders owe a fiduciary duty to the company. I mean, they must protect the business and the foreign shareholders' investment and financial interest in the company, and they cannot run amok and kind of lose the value of the foreign investor at the same time, as we spoke. They must act independently from the foreign parents so that they can protect the national interest of the U.S. and safeguard the classified information in the possession of the company. I mean, these are cleared individuals, and anybody who's cleared owes allegiance and has to follow certain protocols in order to be able to maintain their personnel clearance. And so this kind of duality, if you will, may sometimes create tension with the foreign parent, as the foreign parent has very little visibility into the running of the company. And that's why it is very important that there is a clear line of communication between the outside directors of proxy holders and the foreign parent. It's a trust relationship, so it is important for both sides to create the right environment for the trust to be built. And just one example from this is — like, based on what acting outside directors have communicated and have shared as a good practice — is like after every board meeting or after every meeting of the GSC, the Government Security Committee of the board, you know, the outside directors invite the foreign parent, maybe over Zoom on a short go or in-person meeting and just provide a briefing. This briefing is at the very high level, obviously intended to inform the parent without disclosing any classified information or somehow adversely affecting the ability of the company to protect classified information. But the willingness of the GSC to communicate regularly with the foreign parent establishes trust. And this is where, again, I said it's important for people who serve in those positions to have some business savvy because, you know, they need to make decisions, business decisions of the company that they may not be able to report to the foreign parent.

Molly O'Casey: Right. And this is a duality that we already discussed in the selection process that's kind of present throughout this role. You highlighted that it's important that the outside director and proxy holder not have received payments or have a relationship with the company prior to selection, which I think raises an interesting question of once they have been instated, how does compensation work?

Antonia Tzinova: Right. So on one hand, the outside directors or proxy holders decide on compensation matters for all employees of the company, including the senior officers, like presidents, etc. But their own compensation has to be negotiated with the foreign parent at the start. I mean, before they take the position. And this is similar to, you know, negotiations with any other board member of a company. But why it's important to negotiate in advance is because the foreign parent should not use compensation as a mechanism to exert undue influence. And so usually, there is a compensation agreement in place that spells out the initial salary, you know, and increases what they're conditioned on. Any agreed-to-do-business targets, not the company, should reach for certain increases to be effectuated. So it's important that these things be well thought through in advance so that the foreign parent, as I said, can't exert influence over the outside director or proxy holder once they take over. And that kind of preserves the independence of the company and comports with the DCSA and the NISPOM requirement to run the company free of all control, free of control from the foreign parent.

Molly O'Casey: Right. The "C" in FOCI.

Antonia Tzinova: Yes, that's right.

Molly O'Casey: I think this raises another interesting potential point of influence, which is can the foreign parents remove the outside director or proxy holder?

Antonia Tzinova: Only for cause and only after consultation and approval by the DCSA. What does "for cause" mean for those who are not lawyers out there? There has to be some reason, such as a violation of commitments or a duty. That then becomes the basis for the parents to request that the DCSA approves the removal. In a general setup outside the regular business world, shareholders can remove a director for no cause, which means they can basically decide today to say, "OK, that said, thank you for your service." This cannot happen in the case of an outside director or proxy holder, except in very rare circumstances. This means without approval and prior notification. So, in very rare circumstances, when actions by the outside director or proxy holder threaten to have a serious negative impact on the business, the foreign parent can remove them on the spot and notify the DCSA immediately. But this is done really to protect the business. It's not something that happens every day. And, as I said, in all cases, it's for cause and with prior notification to the DCSA, with this exception. As a consequence, even if the company is no longer involved in classified work or no longer owned by a foreign person, which is the basis to establish a proxy board or have outside directors, the shareholders or the new owners, like U.S. owners, cannot just dismantle the proxy board or remove the outside directors. They must seek approval from the DCSA before they can remove them. And sometimes, this is known to take close to a year.

Molly O'Casey: Right. So potentially a nasty surprise in the mergers and acquisitions world.

Antonia Tzinova: That's right. You know in advance that you have to do that, but you may not have considered that you may need to carry these people for another few months.

Molly O'Casey: That we split FOCI into multiple episodes demonstrates that this is an involved process. Proxy agreements especially seem pretty intense. If a shareholder cedes so much power to the outside directors and proxy holders, what motivates foreign companies to invest in cleared U.S. companies.

Antonia Tzinova: Good one. So being able to work on classified contracts for the U.S. government is a very good business, very lucrative, and it's usually worth the investment. And that is why every major foreign defense contractor has some form of investment in the U.S. and in cleared companies, too. We're talking about all the big names out there. And at the end of the day, they do it because it's good business.

Molly O'Casey: Alrighty. Thank you for coming on, Antonia.

Antonia Tzinova: Of course. Thanks for having me.

Molly O'Casey: This area is full of acronyms. This week we had FOCI or Foreign Ownership, Control or Influence, FCL, Facility Security Clearance, NISPOM, National Industrial Security Program Operating Manual, DCSA, Defense Counterintelligence and Security Agency, SSA, Special Security Agreements, SCA, Security Control Agreements, and a new one, GSC, Government Security Committee. So each episode we ask our speaker to explain an acronym that featured in the episode with wrong answers only. Antonia, would you like to choose an acronym?

Antonia Tzinova: Sure, I'll go with SSA, and my meaning as singular security awareness. I recognize that there are many legal structures and mechanisms in the classified world that are not found in general business. And if you want to enter this world, you will need to become familiar with different aspects of industrial security so that you can run smooth operations.

Molly O'Casey: Thank you for adding to our awareness.

Antonia Tzinova: Absolutely.

Molly O'Casey: I hope everyone has a great week.