TaPP Insights: Investment Screening

The centrepiece of the current regime of investment screening in the UK is the UK National Security and Investment Act 2021 (the NSI Act).

History

The UK’s new regime is the culmination of several years of discussion on the UK’s approach to national security matters, including a White Paper in 2018. The NSI Act commenced fully on 4 January 2022, with a retrospective effect, applying to acquisitions that took place from the time the legislation was introduced to Parliament (i.e. 12 November 2020). A new infrastructure surrounding the Act included the establishment of a new team in the Cabinet Office, the Investment Security Unit (ISU). The ISU is responsible for the implementation and operation of the NSI Act. The government has also issued detailed secondary regulations, for example on the key sectors of the economy affected by the investment screening, as well as publishing Market Guidance Notes to clarify the process, an annual report in July 2023, and a Call for Evidence on the functioning, scope and performance of the NSI regime so far. Throughout the process, the government has heavily emphasised that the purpose of the NSI Act is to give businesses the “confidence and consistency to thrive” [Ministerial Foreword], that the UK continues to welcome investments, and that screening is entirely national security related (that is, not to be used on the basis other public interest or economic grounds).

Scope and substantive provisions

The NSI Act introduces a requirement for mandatory notification of investments made in one of the 17 key sectors, including military and dual use, energy, advanced materials, computer hardware, and research, among others. Notably, the obligation to notify is “country agnostic”, applying equally to both domestic and foreign acquirers, [2] and does not distinguish between private and state-controlled entities (relevant in relation to concerns over China and its model of state capitalism). The legislation sets no minimal threshold based on turnover or asset value but requires notification within any of the 17 sectors.

The government learns of transactions either through its own market monitoring, or through two notification routes within the Act: mandatory and voluntary. Notification is mandatory where there is acquisition of control (principally about the certain sizes of shareholding or voting rights), and if the acquirer fails to seek clearance, the transaction is void in law, with potential civil and criminal penalties. While acquisition of assets does not trigger the mandatory notification, the government may demand an assessment if there is reasonable suspicion of a risk to national security. In such cases, the government can issue interim orders, such as mandating that the target remains separate from the acquirer, to prevent any actions that could impede its investigation. Besides property, assets can also include “ideas, information or techniques which have industrial, commercial or other economic value” – e.g. trade secrets or software. Notably, the scope is quite wide: a foreign-based asset will also be a qualifying asset if it is used in connection with activities carried on in the UK, or the supply of goods or services to persons in the UK. Following this review, the government may either approve the transaction, impose conditions to mitigate national security risks, or in cases where national security concerns are identified, block or reverse the transaction.

Impact

The NSI Act has been in effect for three years, and the first NSI Annual Report, published 2023, provides a rich source of information on the sectors which are most affected – in terms of mandatory notifications, voluntary notifications, call-ins and final orders:

• In the NSI Act’s first year of operation, the government received 671 mandatory and 180 voluntary notifications. It issued 14 final orders, comprising of 5 prohibitions and 9 conditional clearance decisions. Government has subsequently issued a further two conditional clearance decisions. (However, 95% of notifications which were processed in the period were accepted (806 of 849)).
• Of the 17 sectors, the most affected are military and dual use, defence, communications, energy, advanced materials and computing hardware. Interestingly, the Act’s effect on higher education institutions – indeed “academic research” is the fourth largest source of voluntary notifications, with over 15%.
• The remedies imposed to date fall broadly within three categories: “information safeguards” (to protect sensitive information and technology from unauthorised access); “capability preservation” remedies (to preserve UK-based manufacturing and R&D operations); and “security” remedies (to retain British citizens/nationals in leadership positions, especially in companies active in the military and dual-use sector).
• To date, all prohibition decisions have involved Chinese (4 in 5) and Russian (1 in 5) parties; and 3 out of 5 prohibited transactions concerned the semiconductor industry.

Despite the general consensus that the NSI Act is sweeping and far-reaching, some commentators have expressed concerns that it does not adequately address the fast pace of changing economic threats. Issues identified by the House of Commons Business and Trade Sub-Committee on NSI include:

• The lack of definition of “national security”;
• The volume of cases, given that over 800 notifications were received to date (although this falls short of government projections, suggesting capacity is not overstretched);
• A lack of sufficient parliamentary oversight as the relevant Sub-Committee cannot receive certain types of sensitive information that it would require to carry out its role effectively; [3]
• Inconsistency of approach with international allies (especially on topics such as media freedom, cybersecurity, critical supply chains, biosecurity, and critical materials).

The current phase of EU investment screening policy was initiated with the establishment of an EU-wide Investment Screening Framework (ISF)(Regulation 2019/452). The launch of this regulation aimed to address the concerns raised primarily by Chinese and Russian investors targeting strategic sectors in the EU.

However, commentators and scholars note a significant shortcoming; namely, that national security remains the competence of member states, limiting the Commission’s ability to propose effective coordination.

As part of a wider package on economic security, new proposals for the revision of the Investment Screening Framework are emerging. The third report from the European Commission on the Screening of Foreign Direct Investments into the Union includes consultations, surveys, and semi-structured interviews to evaluate the performance of the ISF over the last three years, focusing on its impact and efficiency. The proposals draw on the findings of the report evaluating the effectiveness and impact of the FDI screening across the EU over the last 3 years. Among the identified deficiencies and shortcomings revealed by the Commission’s stakeholder consultation and OECD study is the central issue is that not all EU members screen effectively or at all. For example, 22.7% of foreign acquisitions and 20% of greenfield projects were in member states without a fully applicable investment screening mechanism (non-screening member states). Approximately 42% of the average FDI stock can be accounted for by non-screening Member states. Most acquisitions by Russian investors went to non-screening member states. While the EU can exercise some forms of pressure, the decentralised nature of coordination is an impediment to proper enforcement and to addressing sectors and programmes broadly and strategically.

According to the OECD, discrepancies and disparities between EU member states have led to the phenomenon of simultaneous oversharing and underscreening, of non-risky and risky sectors respectively. This is because the Commission exerted pressure on smaller member states to establish their own investment screening mechanisms, resulting in many essentially replicating the EU framework within their own regimes, as seen in countries like Romania, Ireland, and Sweden. The scope of these mechanisms can vary significantly, with larger member states often having more detailed criteria to determine when screening is necessary and smaller member states adopting a broader, catch-all approach, and this has translated to inconsistency in practice.

As in the UK, the Commission found that resolving gaps in coverage in the EU may require addressing the definition 0f FDI for screening purposes. Currently, the scope of the Regulation (covering transactions that fallunder its definition of ‘foreign direct investment’) excludes certain important transactions and transaction types. The problem is the definition of ‘foreign investor’ in the Regulation, which means that the cooperation mechanism underpinning the EU FDI screening regulation cannot be used for investments by non-EU investors if these investors invest via an entity set up in the EU, even though the public order or security implications of such transactions can be the same as in scenarios where the foreign investor directly invests from abroad., which is the case in 31% of acquisitions and 28.2% of greenfield investments on average from 2019Q1-2023Q2, and there are limits to governments invoking economic security arguments.

In a first test case before the Court of Justice of the European Union (CJEU), the Hungarian court in Budapest sought guidance on whether a Hungarian law, allowing the Minister of Innovation and Technology to block certain investment acquisitions was compliant with the EU FDI Screening Regulation and with EU law in general. The case involved Xella Magyarorszag Kft., a Hungarian with a parent company established in Germany, but with indirect shareholders in Luxembourg and Bermuda, seeking to acquire shares in the Target company (a gravel, sand, and clay extraction company). The Minister argued that longer term risk would be posed to the security ofsupply of raw materials to the construction sector, given indirect Bermudan ownership. However, the CJEUconcluded that the acquisition did not pose a “genuine and sufficiently serious threat to a fundamental interestto society”, and while requirements for public policy, public security, or public health as grounds for restrictionsmay be determined by the Member States, nevertheless derogations must not be misapplied to serve purelyeconomic ends.

Future developments

Given these issues with the 2019 Framework, the Commission is exploring new definitions and parameters. A key issue remains in how to delimit the concept of a national security risk territorially. That is, what should be the authority of a member state government to address investment bids if the risks are to another EU member state? And should it be able to block investment on another country’s behalf? With regards to the scope of application, the European Commission is trapped in a paradox, at pains to stress that it is not deterring investors but still working to enhance security.

Of course, investment screening is just one part of a wide array of economic security agenda initiatives undertaken by the EU. For instance, the Commission has been raising concerns and advocating for potential screening for investment subsidies from home (EU) governments, aiming to identify instances of unfair competition. In early 2024, the EU launched a probe into its first case involving Foreign Investment Subsidies
Regulation, in which a Chinese state-owned train manufacturer (CRRC Qingdao Sifang Locomotive Co. Ltd) bid EUR 610 million in a public procurement procedure of 10 electric trains by Bulgaria’s Ministry of Transport and Communications. The CRRC bid was significantly lower than competitors (e.g. the Spanish company Talgo), raising concerns that EUR 2 billion of Chinese state subsidies were unfairly distorting the market. [4]

Shifts in geopolitics are ushering in changes in investment screening regimes, representing what can be seen as a transition from the politics of investment screening to the geopolitics of investment screening.

A changing landscape

Previously, attention was primarily focused on the impact on domestic economic capabilities, with politicians expressing concerns about the location of value-added activities, as seen in cases like AstraZeneca/Pfizer (2014) or GKN/Melrose (2016). Questions regarding international mergers and acquisitions such as these often revolved around the future of economically and politically valuable activities such as research and development (R&D), sparking political anxieties.

However, over the past five to six years, there has been a significant shift towards heightened and geopolitically acute concerns about subversion, largely driven by China. While investors routinely factor investment screening into their due diligence, their concerns now also include future reputational and commercial risks of triggering concerns among national security services. Investors are increasingly wary of national investment security bureaucracies scrutinizing whether an asset is vulnerable to subversion (in the UK, this was exemplified by Designated Vendor Direction related to Huawei in October 2022).

Targeted concerns

The shift that has been seen is driven both by general concerns about rising geopolitical competition but also by the perceived risk stemming from Chinese laws, specifically the 2017 National Intelligence Law of the PRC (NIL), Article 7 of which mandates that any Chinese organisations and citizens must cooperate with national intelligence efforts in accordance with Chinese national security interests. In this context, the kinds of remedies that a government might have applied or accepted from an investor – structural remedies; control tests; senior management commitments or undertakings – are of relatively limited use, because the risk is not simply strategic direction, domicile, or the relocation of economic activity but the scope for corporate espionage ordisruptive activities by an investor.

The risk of subversion encompasses a range of threats, including industrial espionage or disruptive activities. This is especially acute where an acquired firm holds valuable knowledge assets that could be stolen or is integrated in any way into sensitive infrastructure or systems. At present, the most acute sensitivities are around advanced technologies and technologies that interface with critical infrastructure, but this picture is likely to evolve.

This dynamic is driving the trend of “internal decoupling,” prompting companies to implement internal structural remedies, such as segregating Chinese and non-Chinese operations, to mitigate potential risks. Investors are often acting pre-emptively to insulate themselves from subversion risk. This is creating a feedback loop in which suspicions on all sides are elevated by attempts to manage perceived geopolitical risk.