Foreign Direct Investment Episode 1

Fiona:
Hello, everyone. I'd like to welcome you to the first episode in this foreign direct investment series. The series will focus on updates, trends, and developments in foreign direct investment screening regimes across Europe. In 2021, we've seen foreign investment in Europe rebound strongly, and we're expecting this trend to continue. My name is Fiona Garside and I'm a Senior Expertise Lawyer in the Antitrust, Regulation and Foreign Investment team at Ashurst in London. I'm delighted to be joined today by Neil Cuninghame and Steven Vaz, who are both partners in our team. Today we'll be talking about the National Security and Investment Act, which came into force in the UK on the 4th of January 2022, and drawing on Neil and Steven's experience advising on foreign investment and merger control. Thank you both for joining me today.

Neil:
Hello.

Steven:
Good to be here.

Fiona:
So the National Security and Investment Act, or the NSI Act, has introduced a new regime, which has significantly strengthened the UK government's power to intervene in deals on the basis of national security. And this is part of a global trend that we're seeing toward enhanced scrutiny of investments. While some jurisdictions such as the United States and Australia have had foreign investment review processes for many years, other jurisdictions are just starting to introduce them and we've seen a proliferation in the last two to three years, particularly across Europe. But one thing we should highlight just at the outset about the UK's new regime is that it's not a foreign investment regime: it's a national security regime, which means it applies to both UK and foreign investors. Now, Neil, how much has actually changed under the new regime?

Neil:
Well, quite a lot has changed Fiona. What we had before was a regime under which national security issues could be assessed in the context of the merger control process, so the relevant Secretary of State could intervene in cases where they thought deals raised potential national security issues, but that actually only happened in a handful of deals each year at most. And the new regime is completely different: it introduces, in some cases, mandatory notifications which have to be notified and clearance sought prior to closing of the transaction. And on top of that, you've got a voluntary notification regime and a call-in power for the government, which allows them to call in transactions for more detailed assessment, whether or not they've been notified.

To give you an idea of the scale of it, I said that only a handful of deals each year were assessed on national security grounds under the previous regime: in its impact assessment published at the time of the bill being introduced to Parliament in November 2020, the government indicated that it expected up to 1,800 notifications per year, and that it would have detailed assessments of perhaps up to 100 or so of those. So there's going to be a vast increase in the number of deals being reviewed both at all and apparently in quite some detail.

Fiona:
So it really is a transformative change for the UK. Steven, is there anything you wanted to add just at the outset?

Steven:
I think it will be a real change in approach for buyers and sellers because previously in the UK you only had the merger control regime, which was voluntary. So bringing into place a regime that requires a clearance for the deal before it can close will affect the way in which deals are negotiated.

Fiona:
And it's also involved the establishment of effectively a new regulator within the Department for Business, Energy and Industrial Strategy as well known as the Investment Security Unit or the ISU. Are there any sectors which the ISU is likely to be particularly interested in under the mandatory regime?

Steven:
So Fiona, the mandatory regime covers 17 sectors of the economy, which the government considers are more likely to raise national security concerns. And this goes beyond the obvious sectors of defence and the military. Broadly speaking, it covers various advanced technologies, infrastructure, energy, and certain critical suppliers to the government. Now, importantly, not all activities within these sectors are caught by the mandatory regime. There are detailed criteria for each sector, which are often complex and there are aspects of the criteria that remain unclear in some respects, but helpfully it is possible to speak to the ISU to seek clarification. And I think Neil, you've done that a couple of times recently.

Neil:
Yes, that's right Steven. So in one case within the energy sector, which is one of the mandatory notification sectors, there's a category for upstream petroleum facilities. So that's things like upstream petroleum pipelines and terminals and other infrastructure. Where you're acquiring a relevant entity, which has an ownership stake, amongst other things, in one of these facilities where that facility has a throughput of more than 3 million tonnes, that's a notifiable event. And the question arose well what about in situations where these facilities, as they often are, are owned by multiple players in the oil and gas sector. How does that work? Is that ownership of one of these facilities? So we went off to the ISU and they, I might say slightly unhelpfully, gave the answer that any ownership stake is sufficient. So you have the prospect that if you're buying an entity, which in turn owns a small stake in one of these upstream petroleum facilities then that's a notifiable event.

Fiona:
Does that mean there's no requirement for an entity to have significant activities in the sectors to be captured?

Steven:
No, there isn't. In most cases, there are no minimum turnover, asset value or market share thresholds. Put simply, if the target has activities within the mandatory sector, even if this is a really small part of its overall activities, then it will fall within the mandatory regime. And what that means practically is some quite detailed due diligence will be required. It may well need to go beyond the usual due diligence of the material contracts and parts of the business, because if a company has for example, even a single government contract which requires the company's employees to have security check level vetting, then it will fall within the critical suppliers to the government sector.

Fiona:
It's interesting to hear you both talking a little bit about how you're already seeing this play out in practice. Could you tell us a little bit more about the sectors where you've been either making notifications or raising questions since the regime came into force? Perhaps Neil, if we start with you?

Neil:
Yes, sure. Thanks Fiona. So, we do quite a lot of work in the energy space. So I've already talked a bit about upstream petroleum facilities. Another type of activity caught by the energy space is electricity generation. So the basic threshold is, where you'll require a notification is where the entity you are buying has a generating asset, so an individual generating asset with 100 megawatts of capacity. So that's a relatively large facility, but not extremely large. But one point that's worth highlighting in that context is that there's another aspect to it: another threshold where the combination of the buyer and the target have one gigawatt of generation capacity.

So one consequence of that is that any time that an entity, which already has one gigawatt of generation capacity across its various assets, buys some new generation capacity in Great Britain, it's going to be required to notify that regardless of the size of the capacity that is actually buying under the deal. And in terms of other sectors, quite a lot of queries in the transport sector. That's actually relatively narrow. So the mandatory sectors only cover larger airports as well as ports and harbours, and also on route air traffic control services. So that's a couple of the areas I've been dealing with. Steven you've obviously had others as well.

Steven:
Yes. I mean, I think at the moment there's a lot of M & A activity covering defence contractors and subcontractors, and they're clearly within scope of the mandatory regime as you would expect. And I'm also seeing deal activity in the advanced technology sectors, such as advanced robotics, artificial intelligence and computer hardware. And again, depending on the activities of the target, these types of businesses can quite often be within scope, even if the business itself is an early stage company, perhaps with very limited revenues or contracts at that stage.

Fiona:
It sounds like you're both dealing with an interesting spread of sectors. If we stay with the mandatory regime just now, not all investments in entities active in these sectors will be captured. What types of investments are actually caught?

Neil:
Well, the mandatory regime, first of all, only applies to investments in qualifying entities, which is a defined term, which meet the specified description. So those are the sorts of descriptions that we were talking about as to what's covered in the energy sector, transport sector, et cetera. One consequence of the fact it's qualifying entities is that asset deals where you're buying assets rather than a company or other form of entity, they do not need to be notified and cleared before closing, even if they're doing the sorts of activity that would require a notification if it was a corporate or an entity acquisition. It's worth noting that qualifying entity doesn't need to be incorporated in the UK, but at least typically it will have to carry on business of a specified description in the UK, for example, through a subsidiary, office, branch, or just staff in the UK carrying out the specified activities.

But if you are doing one of these specified activities, e.g. making advanced robotics in Germany, for example, and merely selling them into the UK then that shouldn't be caught by the mandatory regime. Now, another aspect of what is caught is what level of control do you need to get over an entity to be caught by the mandatory regime? And in most cases, what you're talking about is whether you are acquiring a level of either share ownership or voting rights above either 25, 50 or 75%. And so one consequence of that is that if you gradually increase your stakes in a relevant entity, you may have to make multiple notifications over time as you go over each of those gates.

Fiona:
Another important practical point about that 25% threshold is that it brings minority investors into scope of mandatory regime, even if they're essentially taking a passive shareholding. A lot of deals in these key sectors involve consortium bids involving entities such as investment funds or pension funds. How will that notification impact them?

Neil:
Well, I mean, in short it'll be a notifiable event. In a consortium bid where you are acquiring an entity, a relevant entity, which falls within one of these specified descriptions which require mandatory notification, it'll be the acquisition vehicle which in principle needs to make the notification. Obviously assuming it's acquiring more than 25% typically over the relevant entity. Often of course, these consortium bids are for 100% of the relevant entity. But as you would expect, probably, each of the investors in that consortium are relevant to the assessment process and will have to provide information as part of the notification, certainly if they hold at least 5% of the relevant acquisition vehicle. And another point on minority stakes that's worth highlighting is that it's not just those 25%, 50% and 75% thresholds, which can trigger a notification.

There's another category of control, which is where an entity acquires voting rights, which enable it to secure or prevent the passage of any class of resolution. Now that sounds quite broad, but actually on the basis of the legislation and the government guidance, it seems relatively clear that the mandatory regime only applies if veto rights, for example, of the sort that you see in consortium agreements or shareholder agreements extend to most, or all decisions, not only certain specific things, which is of course what you normally see in shareholder agreements, but that's one to just be aware of.

Fiona:
So I guess as the government said in its impact assessment, it is going to be a significant number of deals that will be caught by the mandatory regime. Steven, is there any way you can close those deals without waiting for clearance?

Steven:
Unfortunately there isn't, because any deal that's subject to the mandatory regime that's closed before clearance will be void. And obviously that will concern buyers and sellers, as well as any third parties that are providing finance for the deal. The buyer also faces additional risks if it closes a mandatory deal without clearance: these include fines of up to £10 million or 5% of the buyer's global turnover, if that's higher, and also potential criminal liability with individuals being able to be imprisoned for up to five years. But I think helpfully for listeners that are involved in auction processes, it is usually the target's activity that triggers a mandatory filing requirement and that does mean that all bidders will be in substantially the same position in terms of whether or not they have to obtain a clearance.

Fiona:
Thanks, Steven. So far we've been talking about the mandatory regime, but Neil, you mentioned at the beginning that deals in any sector can actually be called in for review, regardless of whether or not they've been notified. What conditions need to be met before the government could call a transaction outside the mandatory regime in for review?

Neil:
Yeah. I mean, you're right. That the call in regime is very broad in scope and acquisition of control, as defined, over any qualifying entity which can just basically be an entity with some UK nexus is sufficient. And in this context, trigger events are defined more broadly than just the types of control we were talking about earlier in the context of the mandatory regime: so, for example, the 25, 50 and 75% thresholds. So there's an extra category of control for the voluntary and call-in regimes, which is the acquisition of material influence over an entity. Now that's a lower threshold than the other types of control. The concept is taken from UK merger control. It's a relatively nebulous concept and what the competition authority which applies that in the merger control context says in its guidance is that's unlikely to be relevant for shareholdings of less than 15%, but it doesn't rule that out. And it will take into account factors such as the right to appoint directors, particular industry expertise, and the relative shareholdings of the other directors in deciding whether there is an acquisition which allows the entity to materially influence the commercial policy of the entity. So it's important that is thought about as well in the context of the voluntary or call-in regime though, rather than the mandatory regime.

Fiona:
And the call-in power also applies to asset deals, which are obviously entirely outside the mandatory regime. I know the government's indicated that they're less likely to intervene in an asset deal, but in what circumstances might a deal be called in?

Neil:
Well, firstly, you have to meet the requirements for a qualifying asset or an acquisition of a qualifying asset, but that's defined pretty broadly and includes land, property, ideas or information with economic value (so you might be talking about things like trade secrets, algorithms, software, for example). And again, an acquisition of control of a qualifying asset is defined pretty broadly. It's simply the acquisition of a right or interest in relation to the asset that enables the person to use the asset or direct or control its use to a greater extent than before. So you're going to need to assess, that's a pretty low threshold. You're going to need to assess whether that acquisition of a relevant asset may raise national security issues and therefore be of interest to the government.

Fiona:
It's a very broad call-in power indeed then. Another point that we should highlight is that the government can actually call transactions in for up to five years after the deal closes.

Neil:
Yes, that's right, which is obviously quite a long period. And so that raises the prospect that they could call in a deal four and a half years later and at that stage impose remedies on the buyer. Now, of course, that won't happen very often, if at all. But that prospect is there. It's worth noting that that retrospective call-in period can be reduced to six months by making sure the Secretary of State, or the ISU effectively, is aware of the deal. And of course, if you're worried about the risk of a call-in, you can mitigate that risk or indeed remove that risk by making a voluntary application for clearance. Alternatively, you can seek some form of informal guidance for the ISU to try to get some form of comfort that the transaction isn't going to be of interest to the ISU from a national security perspective.

Fiona:
Thanks Neil, given this very broad call in power, Steven, is there any way of knowing or assessing how likely it is that your deal will be called in?

Steven:
I think Fiona, that's going to be the critical question for anyone who's buying assets or businesses in the UK that are not subject to the mandatory regime. Now, the government's published a statement which sets out the way in which they expect to exercise their call-in powers and essentially a deal is at risk of call in if there's a reasonable risk that it may give rise to a national security concern. Now, the government has not defined exactly how it's going to assess national security because clearly that in itself is a very sensitive question and therefore the government will have a very flexible approach, but its overall framework will be to consider three factors. The first of these is target risk. So that really is looking at what does the target do and is the target's activity such that it could give rise to a risk to national security?

I think target risk is going to be greater where the target is involved in one of these 17 specified key sectors or in closely related sectors of the economy. The second factor is control risk, and that is just simply the amount of control that is being acquired over the target. Clearly, the more control that's being acquired the higher the level of risk. But the most important to the three factors is really acquirer risk and that's looking at who is buying the asset and whether that purchaser has any characteristics that suggest a risk to national security, taking into account its ultimate owners, it's management and perhaps any links it has to entities that are seen as being hostile to UK.

Fiona:
I think acquirer risk is likely to be of great interest to listeners so perhaps we can explore that in a little bit more detail. There's a lot of foreign investment into the UK, particularly by state-owned enterprises and pension funds overseas and they'll want to understand exactly how the regime will apply to them. The Secretary of State has said that he doesn't expect these entities, state-owned enterprises or other entities affiliated with foreign states to be inherently more likely to pose a risk to national security. But is there any other comfort that we can offer to these sorts of investors?

Steven:
Well, I think the first form of comfort is really what the government's been saying throughout the introduction of this legislation: this is not a foreign investment act. It is very much aimed only at national security and the government very much welcomes foreign investment into the UK economy and wants that to continue. So the Act is not about economic protectionism. So taking that into account, the statement I referred to earlier says that where a purchaser has a history of passive or long-term investments that in itself may indicate a very low level of acquirer risk and that should be good news for most long term investors.

I think, as you say, entities that are affiliated with foreign states are not inherently considered to be more likely to give rise to a national security concern, but there is a requirement on the form to provide information on any links to state ownership or any politically exposed persons that are part of the management of the purchaser. And it's likely the government will have more questions where the ultimate purchaser is a state-owned enterprise, particularly if there are links to a state that is considered to be hostile to the UK.

Fiona:
Once you've taken into account those three factors and you think there is a risk that your deal might be called in for that detailed national security assessment. Is there any way of trying to get ahead of this?

Steven:
Well, there are a number of options, which I think Neil mentioned briefly earlier. You can speak to the ISU informally before the deal is closed to seek their guidance as to whether they are likely to have concerns and therefore whether they are likely to call in the transaction. That form of informal engagement could include a briefing paper that explains the reasons why the parties are not intending to notify the transaction. However, if there are greater national security concerns or if the buyer wants complete comfort that the deal will not be called in after it's closed, then there is an option to make a voluntary notification and obtain a formal decision from the ISU. The one benefit of a voluntary notification as compared to a mandatory notification is that the parties are able to close the deal while the government's investigating. But of course that puts the buyer at risk if remedies are imposed. So there'll be a need to consider whether that is appropriate in each particular case.

Neil:
And it's worth noting that you can get that informal guidance in the context of the mandatory regime, as well as the voluntary regime. So for example, in an auction context, there may be various bidders who are competing to acquire a relevant entity and both the seller and the various potential buyers may have an interest in getting comfort from the ISU that they're unlikely to raise any issues. And we've certainly seen that on various auction processes in the lead up to the new regime coming into play. So there are various options to consider about getting comfort or guidance from the ISU beyond simply making a notification.

Fiona:
Thanks, Neil. And speaking of engagement with the ISU, our team's already been working on several deals and engaging directly with the ISU. What have we learned about the assessment process so far?

Neil:
Well, in terms of the process itself, there's an initial review period of 30 working days from the time when a notification is accepted. So broadly speaking, six weeks. The government has indicated that somebody else will be cleared more quickly than that and we'll come back to that. And the vast majority of cases are expected to be dealt with in this initial 30 working day period. In those cases where a more detailed assessment is called for, the deal is "called in" is the formal term that they use, whether or not there's been a notification. And when that happens, then there's initially a further period of 30 working days and that is then extendable by the government if they think they need more time for a further 45 working days. So you've got that initial six week period, then another six weeks then potentially another nine weeks plus holidays.

So that's, 21 working weeks, which is potentially quite a long time, but obviously that only happens in a small number of deals, relatively small number of deals, which the ISU is considering. It's worth noting that the time periods can be extended even further through voluntary extensions or any time the ISU ask some questions when you get into one of more of these detailed assessment periods that actually stops the clock and it doesn't restart until the questions have been answered effectively. So you've got potentially long processes. However, the vast majority of deals should be being dealt with pretty quickly.

In terms of how you make a filing, it's made through an online portal, and you're going to need to fill in various boxes in that portal, providing information on things like: the shareholders or affiliates of the acquirer; as you would expect the activities of the target; how it falls within the mandatory regime, if relevant; one question is about whether it's been a supplier to the UK government in key areas in the last five years; and obviously you have to tell them about the control threshold being met. I mean, in terms of practically how it's working, it seems to be working fairly well. As you said though, it's only been in place for a few weeks. One good point, is that notifications seem to be accepted pretty quickly, in a matter of days, and appropriate cases are actually being cleared very quickly as well. And Steven, I think you've got one particular example to highlight.

Steven:
Yes, that's right. We were involved in a deal which was in one of the mandatory sectors and we knew it was going to close just a few days after the Act came into force on the 4th of January. So by engaging with the ISU towards the end of last year and providing information, we were able to get into a position where the filing could be made on a Friday. It was accepted the following Tuesday as being complete and then within two days, the ISU cleared the transaction. Now the circumstances of that case are not typical, but it does show that the ISU is able to clear deals quickly where it's already considered that there are no material national security issues.

Fiona:
That's really great to hear the process is working smoothly so far and that we've already got clearances coming through. When the government does reach decisions, Steven, is there any publication of the information that parties have provided or that final decision?

Steven:
So that's a question we're getting quite a lot from clients actually, because the nature of these activities are often highly sensitive. And in some cases, the work that the target does itself with the government may be subject to confidentiality and security clearance obligations. But the process itself is a highly confidential process. The information provided as part of the notification will not be made public. It will simply be used by the government to reach its assessment. And where are no issues, what we're seeing is there's a standard one page clearance letter that's being granted at the end of the process. Decisions that are reached even in a more in-depth investigation will not be published. And really the only time that third parties will be aware of a process is where remedies are imposed. In those cases, the Secretary of State is required to publish the final order, or at least notice that a final order has been reached, a summary of the order and a summary of reasons for it, but confidential and restricted information will not be provided even in those circumstances.

Fiona:
And speaking of remedies, we said that we don't expect the government to impose remedies very often. How often do we anticipate remedies and what sort of remedies do we think might be imposed?

Steven:
So in the impact assessment, the government stated that it only expects to impose remedies in a handful of cases, perhaps 10 a year, but the government does have a wide power to impose a range of remedies. And if we look at the way in which defence mergers were looked at under the previous regime and also the approach in other jurisdictions, we think remedies are likely to include one of the following three elements. The first is some form of condition on access to information, or to sensitive facilities, perhaps requiring that access is only granted to individuals with appropriate UK security clearances. The second is conditions requiring certain facilities or staff to be maintained within the UK, if there is a concern that essential services are likely to be offshored in some way. And then the third is where there are serious national security concerns, the government does have the ability to prohibit the transaction from closing or, if the transaction has already closed, it can require that transaction to be unwound. But I would emphasise that those sorts of prohibitions are expected to be extremely rare.

Fiona:
Neil, Steven, thank you both for that interesting overview of the new regime and your experiences advising on it so far.

Neil:
My pleasure. Thank you.

Steven:
Thank you.

Fiona:
The regime will clearly have an impact on a large number of transactions, even if the number of detailed assessments is relatively small. We'll be watching with interest over the next few months to see how the regime develops and in particular, the types of deals which the government scrutinises in more detail. If you're interested in reading more about the National Security Investment Act, then we have a Quickguide available in the legal update section on our website and in the show notes to this episode, as well as several other briefings on the Act and its background. Thank you for listening.

Speaker 4:
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