The Situation: On July 13, 2023, the European Court of Justice ("ECJ") issued a judgment (Case C-106/22 - Xella) clarifying the conditions under which EU Member States may screen and block foreign direct investments.
The Background: Over the past few years, EU Member States have strengthened their national Foreign Direct Investment ("FDI") screening mechanisms and blocked an increasing number of transactions by non-EU investors. The ECJ's decision imposes restrictions on EU Member States on the way they design their FDI screening mechanisms as well as on the arguments they can bring forward to justify blocking decisions.
Looking Ahead: EU Member States will have to check to which extent their FDI screening mechanisms comply with the guidance issued by the ECJ. They will face uphill battles in case they want to block acquisitions of EU companies by EU-based companies only because these EU-based acquirers have non-EU shareholders. The ECJ will ensure that EU Member States only block transactions in these cases if there is a genuine and sufficiently serious threat affecting a fundamental interest of society.
In another case relating to foreign direct investment control in Hungary, the ECJ clarified the conditions under which EU Member States may screen and block foreign direct investments. The ECJ held that Regulation (EU) 2019/452 ("EU Screening Regulation") does not apply to investments performed by a EU-based company even if it is (directly or indirectly) controlled by non-EU shareholders. The freedom of establishment granted by Art. 49 of the Treaty on the Functioning of the European Union ("TFEU"), the ECJ continued, protects an EU-based company that wants to buy another EU-based company even if such EU acquirer has non-EU shareholders. According to the ECJ, any restriction of this freedom needs to be justified by legitimate reasons of public interest (inter alia to ensure security and the continuity of supply "as regards basic social needs") and must be appropriate and necessary for the protection of such interest.
While the ECJ acknowledges that Member States remain free to determine the requirements of public policy and public security, these requirements need to be interpreted strictly and their application by EU Member States is subject to the control by the EU's institutions. As regards the specific facts of the case at hand, the ECJ held that the goal to secure the supply of local construction companies with basic raw materials does not justify a blocking decision. The ECJ further concluded that the required "real and sufficient serious threat" is unlikely to exist in a case where the foreign-controlled investor already purchased 90% of the target's production capacity in the past.
In the case for which the ECJ provided its preliminary ruling, the Hungarian government blocked the indirect acquisition of a company owning a quarry used for the extraction of construction aggregates (sand, gravel, and clay) by a U.S.-based private equity firm. The quarry's production of these materials accounts for less than 1% of Hungary's production of these aggregates. Ninety percent of the quarry's production is sold to the direct acquirer, which is a wholly-owned subsidiary of a German entity. The remainder is sold to Hungarian building companies.
According to the Hungarian government, its screening act is to prevent speculative investments in companies strategic to the Hungarian economy. It justified its blocking decision with the strategic importance of the extraction and supply of aggregates and with the need to protect a secure and foreseeable supply. If the quarry were to fall into foreign hands, Hungary argued, the long-term supply of building materials would be at risk.
Given that the direct acquirer in the case at hand is a Hungarian entity controlled by a U.S.-based private equity fund, a decisive question for the legal analysis is whether this entity can rely on the freedom of establishment provided by Art. 49 TFEU to EU-based entities or (only) on the free movement of capital protected by Art. 63 TFEU, which is also enjoyed by non-EU entities. According to the ECJ, the mere fact that an EU entity has non-EU shareholders is insufficient to consider such EU entity a non-EU investor with the consequence that such entity is protected by the freedom of the establishment. As such entity constitutes a "Union company" despite its foreign owners, the ECJ held, the EU Screening Regulation does not apply.
In a second step, the ECJ confirmed that Member States are allowed to restrict foreign direct investments to protect security and public order even if they are protected by a fundamental freedom. While noting that Member States are, in general, free to determine the requirements of public policy and public security, the ECJ held that these grounds must be understood restrictively and their scope cannot be determined unilaterally by an EU Member State without control by the EU institutions. In particular, the ECJ confirmed that public policy and public security can only be relied on in case there is a genuine and sufficiently serious threat affecting a fundamental interest of society. While the ECJ acknowledges that the objective of guaranteeing security of supply of certain products and services may constitute a reason of public security and may therefore justify a restriction of a fundamental freedom, it held that the aim of ensuring security of supply of aggregates for local construction companies does not qualify as a possible basis for a blocking decision. Furthermore, the ECJ expressed doubts whether the transaction blocked by Hungary may constitute a "real and sufficiently serious threat affecting a fundamental interest of society," noting that the direct acquirer of the target purchased already 90% of the target's production capacity in the past.
The relevance of the ECJ's decision, which certainly concerns a unique fact pattern, goes far beyond the case at hand.
Firstly, the fact that the ECJ held that companies that are constituted in accordance with the law of a Member State and that have their registered office, central administration, or principal place of business within the Union are EU companies that enjoy the freedom of establishment even if such companies have non-EU shareholders has far-reaching consequences for FDI screening mechanisms of EU Member States. This is because—in case of an acquisition of a local target by a direct EU acquirer with non-EU shareholders —many of such mechanisms deem these non-EU shareholders to indirectly acquire the local target and consider themselves entitled to block the direct acquisition by the EU acquirer. A significant number of FDI screening mechanisms of EU Member States (or at least their application in practice) is therefore likely to violate EU law.
Secondly, the ECJ makes clear that Member States wishing to block transactions or to impose remedies must bring forward a legitimate aim and must ensure that any restriction is appropriate and necessary for the protection of a genuine threat to a fundamental interest of society. According to the decision, this test will be met only in limited fact patterns. Further, the decision makes equally clear that any blocking decisions by EU Member States are subject to a judicial review on the basis of EU law. The ECJ's decision therefore clearly strengthens the procedural position of acquirers in screening proceedings under national law and should facilitate legal remedies against government decisions blocking or restricting foreign direct investments.
Four Key Takeaways:
- Companies constituted in accordance with the law of a Member State and having their registered office, central administration, or principal place of business within the Union are EU companies for FDI screening mechanism purposes even if they have non-EU shareholders. Because they can rely on the freedom of establishment when acquiring other EU companies, their transactions can only be blocked in very limited fact patterns.
- FDI screening mechanisms of EU Member States as well as blocking decisions based thereon are subject to a judicial review on the basis of EU law. Any blocking decision requires a legitimate aim designed to protect against a genuine threat to a fundamental interest of society. According to the ECJ, restrictions of the right to invest in an EU undertaking need to be justified by legitimate reasons of public interest and need to be appropriate and necessary for the protection of such public interest.
- The assessment of whether there is proportionality and an acceptable justification for a given restriction is subject to judicial review on the basis of EU law.
- The ECJ's decision clearly strengthens the procedural position of acquirers in screening proceedings under national law and should facilitate legal remedies against government decisions blocking or restricting foreign direct investments.
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