infraread issue 11 | UK 16 Apr 2018 A question of balance: UK proposes measures to protect national security in the context of foreign investment

Key Points

The 17 October proposals were contained in a Green Paper¹ entitled "National Security and Infrastructure Investment Review". The proposals were split into two categories:

• "Short-term" proposals: proposed amendments to the UK merger control regime lowering the jurisdictional thresholds for review of mergers in the military and dual-use sector, and parts of the advanced technology sector; and
• "Long-term" proposals: wider reforms intended to allow for better scrutiny of transactions that may raise national security concerns. This may include a wider "call-in" power to allow the Government to scrutinise a broader range of transactions on national security grounds and/or a mandatory notification regime for foreign investment in certain parts of the economy considered critical for national security. This would include parts of the defence, civil nuclear, energy, communications and transport sectors.

On 15 March 2018, the Government confirmed that it intended to proceed with the short-term proposals and published draft legislation to bring into effect some of the proposed changes. At the same time, it published its response to the consultation (Consultation Response) and draft guidance (BEIS Draft Guidance) explaining the changes. Alongside the BEIS Draft Guidance, the Competition and Markets Authority (CMA) published its own draft guidance (CMA Draft Guidance) on its approach to competition assessments under the proposed new rules. 

It remains to be seen how the Government will take the long-term proposals forward, with a White Paper expected later this year. Changes are likely, although it is unlikely that the long-term proposals will be brought into effect before 2019.

Overview

The Green Paper emphasised that the Government wants the UK to remain among the economies most open to foreign investment, and suggested that any steps taken would be restricted to what was necessary and proportionate. It stated that no part of the economy should be automatically "off limits" to foreign investment. The Government is clearly mindful of the importance of not discouraging foreign investment at a time when the UK is expected to leave the European Union by the end of 2020 at the latest (including the transitional period).

Nevertheless, the Government considers that a better balance needs to be struck to ensure appropriate scrutiny of the potential national security impact of transactions, especially those involving investment from abroad. In this regard, the Government would be bringing the UK more into line with other developed economies which have established regimes for assessing foreign investment, such as the Committee on Foreign Investment in the US (CFIUS), the Foreign Investment Review Board (FIRB) in Australia and the Investment Canada Act.

Particular areas of concern identified in the Green Paper were the risks that the ownership or control of critical businesses or infrastructure could provide opportunities to undertake espionage or sabotage, or to exert inappropriate leverage.

If implemented, the long-term proposals would significantly increase the scope for intervention by the Government in UK infrastructure transactions. From an investor perspective, key issues will include: whether any new regime is proportionate and does not discourage foreign investment; whether it is clear (both as to its scope and the circumstances in which concerns may arise); whether it is transparent; and whether it is applied consistently and efficiently. The Government states in the Consultation Response that it has committed to implementing a transparent and proportionate regime which is wholly focused on national security.

The proposals come at a time when national security and controls over foreign investment have become an issue of greater prominence internationally. For example, on 12 March 2018, Singapore-based Broadcom's proposed acquisition of Qualcomm was blocked by President Trump on national security grounds. And in January, the sale of money transfer firm Moneygram to China's Ant Financial, the digital payments arm of Alibaba, was abandoned following failure to obtain CFIUS consent.

In the EU, the European Commission set out proposals in September 2017 for an EU-wide foreign investment screening mechanism. A key aspect of these proposals was their acceptance that national security should remain a matter of Member State competence and therefore that the Commission would not be able to impose its views on national governments (although the European Parliament has since suggested that the Commission's powers should be strengthened).

Short-term proposals

The Government is concerned that there is an unacceptable risk that transactions falling outside the scope of the existing merger control regime under the Enterprise Act 2002 (EA02) could give rise to significant national security concerns. (Further information on the existing merger control regime under the EA02 is provided in the Merger Control under the Enterprise Act 2002 box below.) The Government has highlighted that "advances in technology now mean that there are ubiquitous goods with the potential to be directed remotely should a hostile actor obtain access or control" and that this could undermine the UK's national security. Furthermore, the Government's view is that such advances have often been driven by small niche businesses, with the result that mergers involving such businesses run a real risk of raising national security concerns. The Government also notes in the BEIS Draft Guidance that computers are exponentially more powerful than in 2002 (when the EA02 was enacted) and that the UK faces greater and more complex threats than it has done historically, including cyber operations to compromise critical national infrastructure and attempts to covertly influence Government policy.

As a short-term measure, the Government therefore intends lowering the existing jurisdictional thresholds under the EA02² in two sectors:

• the military and dual-use sector – covering the design and production of military items and "dual-use" items;³ and 
• companies whose business involves certain activities relating to computer processing units (CPUs) or quantum-based technology including quantum computing and quantum communications techniques. Among other things, it is understood that the provisions relating to CPUs are intended to deal with concerns that non-detectable "back doors" might be incorporated into them.

In these two sectors, the Secretary of State would be able to intervene (and potentially prohibit the merger) on national security grounds if any of the following apply:

• the UK turnover of the target exceeds £1 million (reduced from the standard £70 million); or
•  the merged entity will create or enhance a UK share of supply of 25 per cent or more (i.e. the existing "share of supply test"); or
• the target has an existing UK share of supply of 25 per cent or more (this would remove the need for an increase in market share).

The draft legislation published on 15 March 2018 provides significantly greater clarity than the Green Paper as to the scope of activities to be covered by the expanded provisions, although some uncertainties remain. The scope of activities comprises:

(a) businesses which develop or produce "restricted goods", or hold certain types of information relating to such restricted goods. Restricted goods are goods, software or information the export or transfer of which is controlled under specified export control legislation, namely schedules 2 and 3 to the Export Control Order 2008, the schedule to the Export of Radioactive Sources (Control) Order 2006 and Annex I to EU Council Regulation No. 428/2009 (which relates to dual-use items). These provisions are intended to cover both military and dual-use items;

(b) owning, creating or supplying intellectual property relating to computer processing units and certain related items, as well as designing, maintaining or providing support for the secure provisioning or management of "roots of trust" for CPUs and computer code which provides low level control for CPUs. Roots of trust are defined to mean hardware, firmware or software components which are inherently trusted to perform critical security functions, and include cryptographic key material that can identify a device or verify a digital signature; and

(c) research into, developing or producing anything designed for use in, or supplying services employing, various forms of quantum technology, specifically quantum computing or simulation, quantum imaging, sensing, timing or navigation, quantum communications and quantum resistant cryptography. The BEIS Draft Guidance notes that quantum technology has the potential to break currently secure computer and telecommunications systems and could give military vehicles and weapons substantial additional abilities.

The BEIS Draft Guidance suggests that businesses (and those considering buying them) ought generally to be aware of whether they fall within the scope of the extended powers. However, it also indicates that they may approach the Government for (non-binding) guidance if they are unclear on whether they, in fact, do so.

If the Secretary of State were to intervene under the expanded powers, the existing public interest process under the EA02 would be followed. Thus, he or she would become the final decision-maker on whether the deal should be cleared or prohibited, provided he or she continued to believe that the public interest consideration remained relevant (although the Secretary of State must accept the advice of the CMA on competition issues, and the European Commission remains the decision-maker on competition issues in EUMR cases).

An impact assessment published as part of the Consultation Response contains a Government estimate that between 5 and 29 new transactions per year would be brought within the scope of UK merger control by the intended changes. Of these, the Government estimates that it would issue an intervention notice on national security grounds in one to six cases per year. Given that the Government has only intervened on national security grounds in seven transactions in the last fifteen years (equating to 0.5 interventions per year) under the existing EA02 provisions, this is perhaps a surprisingly large number. 

The Government also highlights research produced on its behalf by Economic Insight, which has found that clear and predictable national security regimes with transparent and objective criteria are not seen as significant barriers to foreign investment. The Government has therefore concluded that the potential impact of the proposed changes on foreign investment into the UK will be very limited.

The way in which the Government has chosen to implement the changes means that the new regime would technically allow the Secretary of State to intervene on any of the specified public interest grounds in any deal where the target is active in the specified sectors and the new, lower thresholds are met. However, the Government makes the reasonable point that it cannot foresee any circumstances in which transactions involving firms in the specified sectors would give rise to media plurality or financial stability concerns. National security should, therefore, be the only potentially relevant consideration.

Of perhaps more relevance in practice is the fact that the reduced thresholds also apply to the CMA's powers to conduct competition assessments. However, the CMA Draft Guidance published on 15 March 2018 states that it does not expect the changes to bring about a material change in its approach. In this regard, the CMA notes that mergers between competitors which might raise competition concerns would typically already qualify for assessment under the existing "share of supply" test (which does not require the target to be of any particular size). The CMA recognises that the new rules could broaden the circumstances in which it has power to intervene where the parties are not competitors, but are active in related markets. Currently, such transactions would only be caught where the target has UK turnover exceeding £70 million. Under the new rules, in the specified sectors, such deals could be reviewed where the target had turnover exceeding £1 million (and potentially even less). The CMA states that most mergers between non-competitors are benign from a competition perspective and that it is not aware of any such cases that it would have wanted to examine historically but did not have the power to do so. Therefore, it does not envisage a material change in its approach. Of course, this does not rule out the possibility of additional deals being subject to detailed competition assessments where they would not have been caught by the existing rules.

Pending any wider reforms under the long-term proposals (see below), the existing merger control regime will continue to apply in all other sectors (for further details refer to the Merger Control under the Enterprise Act 2002 box above).  

It should be noted that the intended expanded regime is not premised on there being any foreign investment element: the powers would apply equally to UK acquirers and to non-UK ones. However, the BEIS Draft Guidance states that foreign investment is more likely to raise national security concerns than domestic investment since foreign investors may be controlled or influenced by hostile state actors (albeit the Government reiterates that the vast majority of foreign investment poses no national security concerns).

What will be the impact for merging parties?

While notification will remain voluntary if the new thresholds are met (pending any introduction of a mandatory regime – see below), the Secretary of State (and, indeed, the CMA) could choose to review the transaction if it was not notified, and therefore parties to transactions caught by the new provisions will need to carry out an assessment of whether national security (or competition) concerns may arise, and may consider notifying in order to maintain greater control over the review timetable.

What happens next?

As noted above, on 15 March 2018 the Government published its response to the Green Paper consultation, alongside draft legislation and draft guidance. The draft legislation which has been introduced to Parliament covers changes to the "share of supply" test and the definitions of the relevant sectors caught by the expanded regime. A separate draft statutory instrument relating to the revised turnover test is expected to be introduced shortly. Assuming Parliamentary approval is granted, all the changes will be introduced at the same time. The Government has stated that the new rules will not have retrospective application and this is clear from the draft legislation.

Long-term proposals: Wider reforms to foreign investment control

The Green Paper also put forward a range of longer-term proposals which are intended to make more substantive changes to the way in which the national security implications of foreign investment are scrutinised. It is possible that only some of the proposals will ultimately be implemented.

Expanded voluntary regime with greater "call-in" powers

The Green Paper proposed an expanded "call-in" power modelled on that contained in the EA02 which would allow it to scrutinise a broader range of transactions for national security concerns, while maintaining a voluntary notification regime. As with the short-term proposals considered above, this regime would in principle apply to both foreign and domestic investors.

Under the proposals, the Secretary of State would be able to make a special "national security intervention" at any time within a three-month "call-in" window following completion, where he/she reasonably believed that national security risks were raised by the acquisition of "significant influence or control" over any UK business entity by any investor. The Green Paper proposes that significant influence or control would cover:

• an acquisition of more than 25 per cent of a company's shares or votes; or
• "any other transaction that gives (directly or indirectly) significant influence or control". 

The Government has indicated that it will provide guidance as to what this second threshold might mean, suggesting it may draw on the guidance on the meaning of "significant influence or control" in the context of the Register of People with Significant Control under the Companies Act 2006. Among other things, the Government has said that it wants to make sure it can assess transactions where an investor would obtain unrestricted access to sensitive sites or data.

The Government is also considering whether any such expanded call-in power should be extended to cover the following (neither of which is caught by the existing EA02 regime): 

• new projects, in particular where these are expected to develop into businesses whose activities may have significant national security implications, such as a new nuclear power station; and/or
•  sales of bare assets, such as machinery or intellectual property.

If a transaction were to be called in under this expanded power, the Secretary of State's review process would be separate from any competition review process.

Mandatory notification regime for certain foreign investment

The Government is also considering a mandatory notification regime for foreign investment into the provision of "essential functions". The Green Paper does not discuss how "foreignness" would be determined, and this will need to be addressed at the next stage of the consultation process. It is notable that many infrastructure investor groups with significant UK investments are not UK-based.

Such a mandatory notification regime could potentially be extended to cover:

• new projects;
• specific businesses or assets (the Government envisages publishing a list of affected businesses and assets, except when this would give rise to clear national security threats); and/or
• land in proximity to national security sensitive sites; for example, where there is a risk of espionage or sabotage.

The Government proposes that a mandatory regime would only cover companies:

• which undertake "essential functions" that the Government views as being critical to ensuring the UK's national security; or
• where existing licensing or regulatory regimes are insufficient to protect national security.

The Green Paper suggests including certain specific activities within the following sectors: civil nuclear, defence, energy, communications and transport, as well as businesses involved in the manufacture of military and dual-use items and advanced technology (as per the short-term proposals outlined above), and possibly the government and emergency services sectors. 

Annex C to the Green Paper sets out the proposed "essential functions". The identified activities are quite broad in both the energy and communications sectors, for example, and appear to include (among others) all energy network companies (including interconnectors as well as transmission and distribution companies), large-scale power generation, large energy suppliers, providers of infrastructure for voice and data networks with more than one million end users and any operator of a submarine cable. Proposed coverage in the transport sector would be narrower, comprising statutory harbour authorities with a 5 per cent share of UK traffic, airports classified as dominant (i.e. Heathrow and Gatwick) and the provision of en route air traffic control services. In some cases, the scope of precisely what would be covered is also unclear.

The same threshold of "significant influence or control" would apply as in the potential wider call-in power considered above.  Clarity on how this threshold would be applied would be essential in a mandatory regime.

Failure to comply with any new mandatory notification regime would be punishable by sanctions, which could potentially include criminal offences, financial penalties and/or director disqualification. Any package of wider reforms would also be accompanied by additional powers to request information from companies.

If the Government decides to introduce a mandatory notification regime, it seems likely that it also envisages a wider call-in power operating alongside it, which would not be limited to the specified "essential functions". 

It is proposed that the Secretary of State would have the same powers as under the existing public interest mergers regime, namely: (1) to clear the deal unconditionally; (2) to impose conditions; or (3) to prohibit the deal altogether. In cases where a deal had completed prior to the national security assessment (in the context of a voluntary notification regime), the Secretary of State could potentially "unwind" a deal if this were considered necessary to protect national security.

The Government envisages a "clear, short time frame" for review, but no further detail is provided. The envisaged decision-making process, including which bodies/government departments would be involved, is not discussed in the Green Paper, although the Government's current intention seems to be that final decisions would reside with a Secretary of State rather than any specialist body.

Affected parties would be able to seek judicial review of the Secretary of State's decision.

How is this different from the existing regime?

Particularly if a mandatory regime is introduced, this would involve a significant change. As noted above, under EA02, the Government has only intervened on national security grounds in seven transactions in fifteen years. The Green Paper estimates that a mandatory regime covering the identified essential functions would involve "fewer than 100" transactions per year.  

As noted above, investments in new projects are not covered by the current merger control regime, nor are transfers of "bare assets", specific businesses, or land.

What would be the impact for merging parties?

The Green Paper recognises that an expanded call-in power would increase uncertainty for businesses. However, it emphasises that the Government would only intend using the new powers in a small number of cases, and that it could provide informal advice to businesses about whether it had national security concerns about particular proposed investments.

Any mandatory notification regime would clearly impose an increased burden on foreign investors into affected businesses, and would be likely to catch a significant number of transactions which do not, in practice, raise any national security concerns. However, a mandatory regime might provide greater certainty of application, at least in the short term. Although the Government has indicated that it would seek to grant rapid approval in "no issues" cases, a mandatory regime would inevitably have an impact on deal timetables and create additional work for the parties. However, in some cases at least, particularly at the outset while investors adjust to the new regime, the same is likely to be true of a "call-in" regime. Some infrastructure investors are known to prefer a mandatory regime with clear notification criteria to the uncertainty of a call-in regime. 

The increased involvement of politicians in merger control (whether under an expanded call-in power or a mandatory notification regime) is also likely to increase uncertainty and, depending on how the system works, could also give rise to transparency concerns. However, the Green Paper (and the Consultation Response and BEIS Draft Guidance relating to the short-term proposals) certainly suggests that the Government wishes to have a regime that is as transparent and certain as practicable, so as not to risk discouraging foreign investment. 

What happens next?

The consultation on the wider reforms closed on 9 January 2018. The Government is expected to issue a more detailed White Paper on its long-term proposals during 2018, and it is unlikely that these proposals will be brought into effect before 2019.

1. See here for a copy of the Green Paper. A Green Paper is a term used in the UK to denote a Government consultation seeking views on proposals the Government is considering where those proposals are at a formative stage. Green Papers are often followed by White Papers, which set out more developed proposals, often including draft legislation.
2. See the "Merger Control under the Enterprise Act 2002" box for further information on jurisdictional thresholds.
3. "Dual-use" refers to products which have both military and civilian uses.