Liz Loxton 7 Mar 2019 06:36pm

Is the security whitepaper sensible or risky?

Is the government’s white paper on national security and investment a sensible precaution or a deterrent to investors? Liz Loxton reports
Caption: Illustration by Justyna Stasik

Against a political backdrop dominated by just one topic – Brexit – the government opened a consultation exercise mid-last year on inward investment from foreign entities and states. The Department of Business, Energy and Industrial Strategy (BEIS), released a National Security and Investment white paper in July and its initial consultation period ended in November.

The government’s stated aim is to reform the current regulation of acquisitions and investment to toughen its stance on the ability of ‘hostile actors’ to acquire or invest in sensitive technology or assets. From one perspective, this is an update of the UK’s existing takeover and investment oversight, a modernisation that would have given the officials the ability to block China’s investment in nuclear power plant Hinckley Point C, for instance.

From another, it is an example of a government over-reaching in a form that will give it extended influence across a broad range of transactions and much greater scope to investigate and intervene in run-of-the-mill deals.

Continental drift

In the foreword to the consultation, Greg Clarke MP argues that, once eventually laid before parliament and enacted, it would put the UK broadly in line with similar regimes elsewhere. In a rare example of a shared perspective on economic policy, both the US and the EU have been exploring increased investment screening.

Donald Trump’s desire to rein in China’s trade ambitions is well documented and has been partly manifested in a strengthening of the Committee on Foreign Investment in the United States (CFIUS). US Congress passed an expanded review system for CFIUS in the summer and Trump’s administration has indicated that the committee would be able to apply its powers widely, reviewing transactions involving foreign investment in businesses that design or produce technology across some 27 sectors, particularly technology and infrastructure.

“Arguably, this gives some indication that we may be moving towards the US regime of foreign investment screening, which grew from a concern around Chinese investment in technology and infrastructure assets – areas where there is perceived to be a potential threat, often from government-backed entities investing in local companies, making acquisitions or entering commercial arrangements,” says Sarah Pearce, a partner in law firm Paul Hastings. In the EU, proposals to strengthen screening mechanisms would allow member states to share information on the potential security impact of deals.

“The EU has indicated similar views (expressing concern about Chinese investment in hi-tech areas and how much information they are going to get) and the UK white paper seems to be suggesting that we’ll have our own regime,” says Pearce.

The intention behind the BEIS white paper – the desire to protect national assets and security – is a hard one to shoot down, concedes David Petrie, head of ICAEW’s Corporate Finance Faculty. However, he argues, with the legislation effectively replicating existing protections under the Enterprise Act of 2002, the government does not lack the capability to intervene in deals and transactions where a military application is apparent or where the technologies, if acquired via acquisition or joint venture, are of a sensitive nature. Indeed, ICAEW’s view is that the legislation at best will be costly and cumbersome to business and at worst might discourage investors and allow direct political intervention in takeover situations.

“It’s a piece of legislation which has received very clear messages from us, from the City of London Law Society and senior partners in leading law firms. We have serious concerns that this will be detrimental to the UK as a destination for investment,” says Petrie. In October, ICAEW convened a discussion bringing together BEIS officials with leading capital markets and corporate finance experts to encourage debate and explore the specific dangers perceived by government. “We take this very seriously; the issue needs an effective and authoritative response,” says Petrie.

John Fingleton, former director general of the Office of Fair Trading and founder of Fingleton Associates, told the Financial Times changes in the act “have enormous potential to harm the UK economy and to draw politicians into decision-making on a huge number of acquisitions and investments”. Of specific concern is the scope officials will have to look across many industry sectors and the intention to examine many more cases each year. Marc Israel, a partner with law firm White & Case, says the proposed changes look likely to cause much increased regulatory scrutiny.

“Over the last 15 years, there has been on average less than one intervention a year on national security grounds, no deal has been blocked and a number have been cleared with remedies. One of the differences here is the increase in anticipated activity. The government says it expects 200 notifications a year, 100 of which they expect to subject to more detailed analysis, with 50 resulting in some sort of remedy. We are all scratching our heads to understand which cases in the past would have resulted in a remedy under the new rules.”

This much larger regulatory apparatus will bring additional costs to the taxpayer as well as having an impact on industry, Petrie believes, in the form of delays to sale processes and lessened attractiveness. The City of London Law Society agrees and also points to specific concerns around very small transactions. The white paper does not propose an eligibility test based on turnover or share of supply, since those don’t offer an appropriate measure of whether a business is likely to pose a threat, should they be acquired by a ‘hostile actor’. The CLLS says the absence of a turnover or financial threshold test “would mean that even the most insignificant transactions would incur transactional costs”.

Hi-tech concerns

Of particular concern in this respect are hi-tech entities such as university spin-outs across a broad range of technologies, says Petrie. This is an area where the UK excels and government strategy is to develop these companies, he points out. “For this group of companies, funding could come from a wide variety of sources including sovereign wealth funds.

So the concern for advisers and market participants and these tech companies is, what view will the government take as to their investments made up to the point that this legislation comes into effect? Most businesses look to grow and develop and seek outside investment. What is their future value going to be if they are excluded from these avenues?” More broadly, commentators point out that most transactions will probably see little impact. “Ultimately, the vast majority of inward invest is unlikely to be affected by this,” says Israel.

“Companies and their advisers will do an assessment and incur a degree of cost. They may not want to notify. And many will be able to get comfortable that there isn’t any risk.” Overall, interest from ‘hostile states’ in a transaction or asset is likely to be the deciding factor when it comes to investment screening. “If you are European, US or Canadian buyers, you’re unlikely to have any difficulty. One of the terms used in the draft legislation is ‘hostile states’” he says. The potential to lessen UK plc in terms of investor attractiveness remains, however, not least because the legislation proposes post-deal remedies that would increase risk to sellers.

Currently, in the context of UK merger control, if the government finds a problem in a completed deal, a typical remedy is that the acquirer has to sell some or all of the business it has acquired. “Where this proposal is very different is that if the government finds it doesn’t like a deal, it could force the seller to take the asset back,” says Israel.

“That is one of the most alarming things in this legislation. If that power is enacted it may end up leading to seeking upfront approval by the back door as many sellers (eg private equity houses looking to exit an investment at the end of a fund’s life) might be unwilling to take the risk – however small.” With Brexit still firmly in the eye of the storm, this legislation is unlikely to be a priority, Israel points out. “It’s quite possible that we will have another government by the time these proposals are taken forward. In which case, it’s by no means certain that this will come into force any time soon. That provides plenty of time for the adviser community to lobby and raise concerns.”