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WASHINGTON/LONDON (Reuters) - To win approval for their planned $45 billion merger, EADS and BAE systems must persuade Washington to let a pan-European behemoth control some of the most sensitive U.S. defense contracts, without triggering a political backlash.
Defense industry experts say it should not be difficult for Washington to protect its security interests in allowing the deal to go ahead, but the politics could become complicated if Boeing and other competitors lobby against the deal.
"The security issue can be dealt with if the deal is structured properly," said Loren Thompson, chief operating officer of the Virginia-based Lexington Institute think tank.
"The only way this deal can be blocked in the U.S. is if opponents demagogue the issues of security."
The merger must first be cleared by European officials, and the companies and shareholders must agree terms, but U.S. approval would eventually be necessary as well.
BAE is British in origin, but increasingly it has become a trans-Atlantic firm, easily the biggest foreign company in the U.S. defense sector. The U.S. military is its biggest customer and accounts for nearly half of its global revenue.
Its U.S. defense operations are precisely what would make it such an attractive partner for EADS, the Franco-German maker of Airbus civilian jetliners.
Under a complicated Special Security Arrangement (SSA) with the U.S. government, BAE's U.S. defense businesses are kept under separate management and run by Americans, allowing it to bid for and work on contracts involving top secret technology.
Theoretically, there is little reason why those safeguards could not remain in place after a merger with EADS.
But politically, it may be one thing for Washington to allow defense deals with a private sector contractor from Britain - its main battlefield ally in Iraq and Afghanistan - and another thing entirely for it to cooperate so closely with a European giant, partially controlled by the French state.
Opposition in Congress could be sparked quickly, given long-simmering mistrust of France and concerns about European trade subsidies, said an executive for one of the biggest U.S. weapons makers who asked not to be identified while speaking about the deal between the European firms.
"This could get inflamed pretty quickly. After all, this is the House of Representatives that banned 'French' fries," the executive said, referring to a period of difficult relations between Washington and Paris, when France opposed the Iraq war and the congressional cafeteria began serving "freedom fries".
Some experts compared the political risks surrounding the merger to those of Dubai-based ports operator DP World, whose plans to manage operations at U.S. port terminals were derailed in 2006 by sudden bipartisan opposition in Congress.
Opposition could come from Boeing, which is EADS's rival in the civil aviation sector. Boeing has so far not launched a lobbying effort over the proposed merger, but has said it would examine it closely and expects the government to as well.
U.S. officials have been tight-lipped thus far, saying only that they will carefully review the terms, if and when BAE and EADS submit a proposal.
Sources close to the negotiations say initial talks with senior Pentagon officials revealed no major dealbreakers, despite some news reports highlighting possible concerns.
BAE's Special Security Arrangement, which limits senior management jobs at its U.S. division to Americans, has particularly wide-ranging terms, allowing it to win work on sensitive U.S. projects such as the F-35 fighter jet and cybersecurity, as well as with various intelligence agencies.
EADS also has a U.S. unit with an SSA for secret Pentagon work, but its activities are much more limited. Senior sources at BAE say they are hoping their security arrangement could be extended to the U.S. operations of the combined group.
"BAE's SSA is very good and gives it a lot of access," said a source close to BAE who asked for anonymity because he was not authorized to discuss the deal publicly. "For the merger to happen, BAE wants its SSA preserved. BAE does not want ... any impediments to its ability to do what it does in the U.S."
Former U.S. government officials say the current structure will be reviewed closely to rule out access by foreign governments, and may well be tweaked in some form.
"BAE is saying everything would remain the same ... but (the Department of Defense) looks at who is the ultimate owner and whether a foreign government has the right to control you in any manner," said one former U.S. national security official.
BAE will have to use its political and economic clout in Washington - and possibly make some concessions - to get a green light for the deal. Its lobbyists began blanketing Capitol Hill within hours after news of the merger surfaced, seeking to assure key lawmakers that the merger would not harm America's sensitive defense projects, according to industry sources.
Sean O'Keefe, the former Navy Secretary and Pentagon budget chief who heads EADS's U.S. unit is also making the rounds, as are other Americans with the company.
Once a deal is announced, it must be approved by a body called the Committee on Foreign Investment in the U.S. (CFIUS), which is headed by the U.S. Treasury and includes the Pentagon, State Department and other government agencies.
That process, which is conducted behind firmly closed doors, could take weeks or months and may well stretch into 2013, said former officials, predicting that Congress could start to air its concerns once a formal proposal was on the table.
"That's when the politics will start heating up," said the executive from the large U.S. arms firm. He said most U.S. companies don't feel threatened by the deal, given EADS's tiny presence, but could be irritated by the Pentagon allowing two European companies to merge when they have discouraged similar moves by U.S. firms.
One senior industry executive familiar with the deal agreed that the politics could become a "wild card", noting that the Dubai Ports situation showed how quickly the tide could turn against a deal in Washington.
Even if the political environment turns hostile, President Barack Obama's administration might find it difficult to block the deal, given the involvement of key allies, and his own repeated calls for cooperation with allies on defense.
"If the British, German, French and Spanish governments appeal directly to Obama to approve the deal ... it's hard to see how he could turn them down," said an executive at another large U.S. defense contractor. "There's just not enough business to go around."
BAE's U.S. work in land vehicles and ship repair is not expected to raise security concerns. But it could be a different story for Sanders, a Nashua, New Hampshire company that makes sensitive aircraft protection and surveillance equipment. BAE's SSA was shaped when it acquired the unit from Lockheed in 2000.
The U.S. unit of BAE is run by American CEO Linda Hudson, who previously worked for General Dynamics and is widely respected in the industry. Most of the U.S. division's board members are also American, although the parent company's British CEO and finance director also sit on the board.
After the merger, that may not be enough to satisfy Washington, said Espirito Santo defense analyst Ed Stacey.
"The U.S. will want a stiffer firewall around some sensitive projects," he said, noting that while the current board of BAE's U.S. unit was selected by the company but vetted by the Pentagon, the U.S. unit of the combined company might have to accept a board installed by the Pentagon.
"BAE may also be ordered to divest a few of its best U.S. assets, which would damage the logic of doing a deal."
BAE insists that it does not expect to have to divest any of its U.S. operations - the very units that make the deal so attractive to EADS - but privately executives say certain other concessions such as the board makeup may be acceptable.
Editing by Peter Graff