By Andrea Shalal-Esa
WASHINGTON (Reuters) - BAE Systems insists there is "no magic number" for French and German government shares in a possible merger with EADS, but U.S. experts say anything over 10 percent could ruin the chances of winning approval from U.S. regulators.
Britain has told France and Germany repeatedly that their respective holdings in the merged firm should not exceed 10 percent, according to several sources familiar with the process.
BAE and the British government want to keep government shareholdings and rights in the proposed merger as low as possible, concerned that larger stakes could unravel the deal.
U.S. experts say stakes of 9.9 percent and lower have been viewed as generally "benign" in the past, which should allow the combined company to keep working on sensitive U.S. military and intelligence projects without Washington demanding divestitures or creation of a more restrictive proxy board.
Either of those two conditions would prompt BAE to abandon the merger talks, according to BAE executives.
British Defense Minister Philip Hammond told BBC radio on Sunday that Britain would block the $45 billion merger if certain conditions were not met, including a requirement that neither Germany or France could have a stake large enough to allow them to control the combined firm.
"That has been a BAE red line from the day one," one adviser to BAE told Reuters. "If the Department of Defense forces us to cross a point where there's going to be a divestiture or a proxy or something like that, that's the end of the transaction."
Britain and BAE also want France and Germany to agree to lock in the new ownership structure, averting future changes that could increase the governments' shares. Any changes in the ownership structure would also trigger a fresh U.S. review.
U.S. KEEPS CLOSE TABS ON FOREIGN STAKES
The U.S. government addresses foreign ownership or control of U.S. companies through a review by the Committee on Foreign Investment in the United States (CFIUS), and a separate look by the Pentagon's Defense Security Service.
BAE and EADS have hired outside counsel to shepherd the deal through the U.S. process, and both companies have been in close touch with Pentagon officials about the complex negotiations that would create the world's largest aerospace company.
U.S. officials say they must see the proposed ownership structure before launching a detailed evaluation.
Sources close to the process say no showstoppers have come up in the companies' preliminary talks with the Pentagon, but that could change if France and Germany get stakes and rights that are seen as giving them control over the company.
U.S. law deliberately avoids spelling out an exact definition of "control," leaving that up to the interpretation of the Pentagon and other U.S. agencies, which weigh factors such as voting interests; any special shares or contractual arrangements; who has control over board appointments; approval over major expenditures; and even who funds workers' pensions.
U.S. experts say a holding of 9.9 percent or less would put the foreign governments on the same footing as any investor with deep pockets buying shares on the open market.
That could help persuade Pentagon officials to agree to wrap EADS' U.S. operations into BAE's existing special security agreement (SSA), rather than imposing a more onerous proxy agreement, which would sharply limit the parent company's insight into U.S. work, or insisting on divestments, they said.
BAE officials also want to reduce the "interlock" between the management and board of the combined company and a planned UK-based holding company that would have its own robust security agreement with the British government.
The companies' current plan is for that UK holding company to oversee the U.S. unit, which would effectively put another layer between it and the parent company, further limiting an possible control by the government shareholders.
BAE,EADS BOTH GOT HIGH MARKS FOR U.S. SECURITY
Both BAE and EADS get high marks from the Pentagon for compliance with their existing special security agreements. Details of the agreements are classified and closely guarded, but such deals include specific procedures that prevent the foreign entity from controlling the U.S. company's operations.
In BAE's case, only two non-Americans -- Chief Executive Ian King and the parent company's finance director -- serve on the board of BAE Systems Inc, which has nine independent, Pentagon-approved directors, versus just five inside company officials.
The board is chaired by Michael Chertoff, the former U.S. Homeland Security secretary and includes a Who's Who of former senior U.S. military and intelligence officials, including Richard Kerr, the former deputy director of the CIA.
Among other measures, special security pacts require all communications with the parent company to be logged, and visits by officials from the parent company to be approved in advance.
If BAE and EADS are able to work out a deal with European governments, they will initiate what could be weeks of detailed talks with the Pentagon about expanding BAE's current security deal and whether it needs to be modified.
Once those details were largely agreed, the companies would ask for a CFIUS review, a 30-day process that can be extended for 45 days if required.
Ivan Schlager, who heads the CFIUS practice of Skadden, Arps, Slate, Meagher & Flohm, said other U.S. defense firms were watching the process closely since it would give a firm that gets big government subsidies easier access to the U.S. market.
Schlager said the Pentagon was in listening mode now, but there was a chance that concerns about French and German government interests could cause it to insist on an even more restrictive proxy agreement for certain BAE businesses.
One unit that could come in the cross-hairs is Sanders, a maker of sensitive aircraft protection and surveillance equipment, which BAE acquired from Lockheed in 2000.
Jacques Gansler, who served as the Pentagon's chief weapons buyer at that time, faced tough questions from some U.S. lawmakers who were angry that the Pentagon was allowing a British company access to sensitive U.S. weapons technologies.
Gansler, who serves on the board of three companies operating under SSA agreements with the Pentagon, said he still believes it was the right decision to allow BAE to buy Sanders.
He said he expected the BAE-EADS merger to ultimately win approval as well because it would create a sixth large prime contractor to bid on U.S. military contracts.
"In this case, you're not losing a competitor, you're actually strengthening one," he said, noting that the Sanders deal had also cemented already strong military ties between Britain and the United States.
(Additional reporting by Tim Hepher in Paris; Editing by Bernard Orr)