BAE Said to Brief Pentagon on EADS Merger to Save Status

BAE Said to Brief Pentagon on EADS Merger to Save Secure Status
BAE Systems Inc.'s top programs in the U.S. include ship-repair contracts with the U.S. Navy and making the Army’s Bradley Fighting Vehicles. Photographer: Simon Dawson/Bloomberg

BAE Systems Plc’s U.S. unit has started briefing Pentagon officials on the company’s plan to merge with European Aeronautic Defence & Space Co. in an effort to preserve its security clearance for defense contracts, according to two people familiar with the talks.

BAE Systems Inc., the U.S. unit that has $14.4 billion in defense contracts and provides training to the Central Intelligence Agency, is trying to persuade the Pentagon to let it keep a security arrangement governing involvement by its foreign owners, the people said, speaking on condition of anonymity to discuss the private talks. It would be a step toward approval of the deal by the Committee on Foreign Investment in the U.S., or CFIUS, they said.

Winning approval from the panel is key to a merger of the European companies because BAE’s U.S. revenue was 47 percent of its $30.7 billion in sales in 2011. EADS and BAE said on Sept. 12 that they are exploring creation of an aerospace and defense combination with estimated revenue of $94 billion, exceeding Chicago-based Boeing Co.’s $76 billion in sales last year.

“One of the big questions that will be asked in the U.S. is,‘Does this transaction result in significantly greater foreign government control of the merged company?’” said Clay Lowery, a former assistant Treasury secretary who oversaw the CFIUS process under President George W. Bush and is now a consultant with Rock Creek Global Advisors LLC in Washington.

Special Agreement

Units of London-based BAE and Toulouse, France-based EADS both operate in the U.S. under “special security agreements” negotiated and overseen by the Pentagon’s Defense Security Service. Such agreements let foreign owners keep operational control of their U.S. subsidiaries, while requiring industrial security and export controls as well as active involvement of U.S. citizens with security clearances on the board of the American entity, according to the agency’s website.

Both BAE and EADS have filed paperwork to inform the Pentagon agency that the companies are in talks about a potential merger, Cindy McGovern, a spokeswoman for the Defense Security Service, said in an e-mail.

BAE and EADS also have hired law firms and lobbyists to help win approval of the merger from U.S. authorities and acceptance from Congress.

BAE has brought on Republican consultant Vin Weber, a former House member who is a partner at Mercury/Clark & Weinstock in Washington, as well as Democratic lobbyist Steve Elmendorf at Elmendorf Ryan LLC, according to BAE’s congressional filings. Both firms indicated they were hired to lobby on the proposed BAE-EADS merger.

Lawyers Retained

BAE has retained the law firm of Covington & Burling LLP in Washington, and EADS has hired Kaye Scholer LLP to represent it in the CFIUS application, according to the firms.

Under the proposed merger still being negotiated, EADS, the parent of Airbus SAS, may own 60 percent of the combined company with BAE getting the rest.

The balance would be the opposite in the U.S., where EADS’ smaller operations would be absorbed into BAE’s business, according to BAE Systems spokesman Brian Roehrkasse. The U.S. entity would continue to report through BAE’s U.K.-based holding company, according to Roehrkasse, who declined to comment on discussions with Pentagon officials.

That arrangement may help sell the merger to the Pentagon because BAE has more of a track record working on sensitive and classified matters. BAE’s top programs in the U.S. include ship-repair contracts with the U.S. Navy and making the Army’s Bradley Fighting Vehicles.

CIA Work

Under BAE’s current special security agreement it provides training to intelligence agencies, including the CIA. According to a BAE fact sheet, the company’s Intelligence & Security unit employs 7,200 people and is the largest U.S. provider of intelligence analysts to the Pentagon and intelligence agencies.

EADS, the prime contractor for the U.S. Army’s UH-72 Lakota light utility helicopter, also performs some classified work for U.S. agencies, company spokesman Guy Hicks said. When it bid against Boeing in 2010 for the U.S. Air Force’s $35 billion contract to supply refueling tankers, the company received permission under a so-called national interest determination to obtain classified briefings, Hicks said. Boeing ultimately won the contract.

Under U.K. takeover rules, EADS and BAE must submit a formal merger proposal by Oct. 10 or seek an extension of the deadline.

CFIUS Approval

After getting informal approval from the Pentagon for a special security agreement to continue to work on defense and intelligence contracts and after the parent companies have reached agreement, the companies would make an application for CFIUS approval, the people familiar with the process said.

CFIUS, an interagency committee that reviews the national security implications of foreign investment in the U.S., would have 75 days to accept or reject the application.

The panel is headed by Treasury Secretary Timothy Geithner, and among its 16 members are the heads of the departments of Defense, Justice, Homeland Security, Commerce, State, and Energy. Established by President Gerald Ford in 1975, CFIUS recommendations are enforced by the president.

The U.S. review will have to decide “whether existing special security agreements they set up with BAE still work, or do they need to move them toward what are called proxy agreements or even to a sale of specific assets?” Lowery said.

Proxy Agreement

That’s an outcome BAE and EADS are trying to avoid because a proxy agreement requires the foreign owners of a U.S. subsidiary to surrender control to a board of three U.S. citizens with security clearances. The proxy board exercises full operational control of the subsidiary, including the right to sell or dissolve the company, according to the Pentagon’s website. Foreign owners are entitled only to get financial information and repatriation of revenue and dividends.

“EADS currently could not operate the same kind of sensitive businesses that BAE does in the U.S. without a proxy,” said Ivan Schlager, who heads the CFIUS practice for Skadden, Arps, Slate, Meagher & Flom LLP in Washington.

In the U.K., Parliament’s defense committee has said one issue it will review is whether the merger would affect BAE’s relationship with the U.S., “including the development of the Joint Strike Fighter and continuing access to U.S. technology.” BAE is a subcontractor to Lockheed Corp. on the F-35 fighter, the Pentagon’s costliest weapon.

Shareholder Stakes

The U.K. holds a so-called single golden share in BAE Systems, giving it the power to thwart a takeover, and it would maintain that stake in the merged entity. EADS and BAE also have promised a similar stake to France and Germany in the hope that it will prompt the governments to give up their current holding structure in EADS.

French and German interests each hold 22.16 percent in EADS. The French and German governments are in talks over whether to accept a reduction. France’s share would drop to 9 percent under the proposed merger.

U.S. trust in BAE’s U.S. subsidiary was demonstrated in February 2011, when it was permitted to acquire three units from L-1 Identity Solutions Inc. L-1 sold the operations as a prelude to a merger with Paris-based Safran SA.

The three units provide security and intelligence consulting, intelligence analysis as well as training and technology development for U.S. intelligence agencies including the CIA, according to BAE.

BAE doesn’t expect to be asked to divest those units under a merger with EADS, one of the people familiar with the Pentagon talks said.

Political Pressure

Even if CFIUS raises no concerns about a merger, foreign mergers and acquisitions sometimes come under political pressure in Washington, according to Chad Sweet, chief executive officer of the Chertoff Group, a Washington-based consulting firm.

In 2005, state-controlled Chinese oil company Cnooc Ltd. made an $18.5 billion bid for U.S. oil producer Unocal Corp and later withdrew the offer in the face of opposition from U.S. lawmakers. In 2006, Dubai Ports World, a state-owned company in the United Arab Emirates, acquired commercial operations at six U.S. ports when it bought a U.K.-based company. While CFIUS approved the deal, Dubai Ports sold the operations after U.S. lawmakers objected to the foreign ownership.

“In the case of BAE-EADS, bigger issues are likely to be at play,” said Sweet, who formerly served as the chief of staff at the Department of Homeland Security. Chertoff Group co-founder Michael Chertoff is chairman of of BAE’s U.S. unit.

A continuing dispute between the U.S. and the European Union over government subsidies to Boeing and Airbus may put pressure on U.S. lawmakers to oppose the deal, Sweet said.

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