UK: Prudence Or Protectionism?

Enhanced UK powers to scrutinise mergers on grounds of national security

The UK government is to introduce enhanced powers to scrutinise mergers on grounds of national security and is considering further, more substantial such powers. This briefing looks at what these changes are likely to mean and whether they represent a move towards a more protectionist approach.

In October 2017, the UK government consulted on two sets of proposals designed to broaden its powers to scrutinise mergers on grounds of national security. In March 2018, it announced that it has decided to implement the first set of proposals; the second set (the longer term reforms) is still being considered.

• Short term reforms: these reforms will allow scrutiny, on national security grounds, of acquisitions of advanced technology and military/dual use technology businesses where the annual UK turnover of the target is over £1 million or it has a 25% share of supply. The changes are subject to Parliamentary approval but are expected to be introduced later this year and could be in force by the summer.
• Potential longer term reforms: these potential changes are likely to take longer to reach the statute book and would give the government significantly broader powers to intervene in mergers on national security grounds, particularly in relation to businesses considered to be relevant to the UK's critical national infrastructure. One option would involve mandatory notifications of certain transactions, which would be a significant change in approach as compared with the status quo.

Background to the reforms

What is the current position?

The UK government already has some powers to scrutinise mergers on grounds of national security - but only where the following conditions are met:

• as with any merger, where the target business has annual UK turnover of over £70 million or the merger would result in the creation (or the increase) of a share of supply of 25% in the UK; or
• the merger does not meet the thresholds in the first bullet but involves a current or former defence contractor who has (or had) access to confidential defence-related information and at least one of the merging parties carries on business in the UK.

In both these cases, the Secretary of State for Business, Energy and Industrial Strategy (the "Business Secretary") can "call in" the merger, enabling him or her to take the final decision on whether it should be allowed to proceed. Such "call-ins" are rare. However, it is not uncommon for the Ministry of Defence to take an alternative, non-statutory approach to address any national security concerns it has by using its position as a key customer of defence contractors to secure voluntary undertakings.

Why does the UK government think it needs new powers?

The UK government argues that its existing powers to scrutinise mergers on national security grounds (see above) are not broad enough. In the short term, a particular concern is that the current regime does not allow adequate scrutiny of the fast-moving technology sector.

Take the example of a small company which has developed promising new technology with potential defence or security applications. The acquisition of the company would not meet the UK merger control thresholds because its turnover is well below £70 million - and it is being acquired by a company which is not a competitor (so there would be no increase in its share of supply as a result of the transaction). Unless that company is already a supplier to the UK's defence or security services, then currently the Business Secretary would not be able to "call in" the transaction.

A key longer term concern for the government is that the concept of a "merger" in the existing regime is too narrow to allow scrutiny of some transactions with potential national security implications. An example would be if a company sold the intellectual property in technology that it had developed with defence or security applications – it is unlikely that the bare assets on their own (i.e. without staff, or customer contracts, etc.) would be regarded as an "enterprise" for UK merger control purposes, and therefore the current UK regime would not apply.

Is the drive for new powers connected with Brexit?

The government's push to amend the law in this area does not appear to be connected with (or dependent on) the UK leaving the EU. EU Member States already have the ability under the EU Merger Regulation to apply national rules to mergers based on "public security" grounds (among others). This is an exception to the usual "one stop shop" rule for mergers meeting the EU Merger Regulation jurisdictional thresholds.

That said, a number of countries have been taking steps to broaden the scope of their powers to scrutinise mergers on national security grounds – see below under the heading "The wider international context".

The short term changes

Overview

For certain advanced technology and military/dual use businesses (see below for explanation), the UK merger control regime will apply where the business in question has:

• turnover of over £1 million (as opposed to the normal £70 million threshold); or
• a share of supply of 25% or more (as opposed to the normal test where a 25% share of supply must be created or increased by the merger, i.e. there must be some overlap with the acquiring party).

This will enable the Business Secretary to "call in" any such transactions raising national security concerns, just as he/she is currently able to do in relation to transactions meeting the existing thresholds for UK merger control (see above). In theory, these businesses will also be potentially at risk of scrutiny on competition grounds by the UK Competition and Markets Authority (CMA). However, the CMA has indicated that it considers it "very unlikely... that it will need to initiate investigations on competition grounds" into these transactions.

Which businesses will be caught by the short term changes?

The definitions of the businesses which will be caught by the changes are complex and specific advice should be sought if you are concerned that your business may be affected by these changes, which are expected to take effect later this year (possibly by the summer). In summary, the new rules will apply to businesses involved in:

• Military technology: in most cases, these businesses should not be difficult to identify, as they will generally be suppliers of products with obvious defence applications, such as automatic weapons.
• Dual-use technology: this means technology that could have both civilian and defence applications. The export of dual use technology is subject to a licensing regime and relevant products are identified in the government's Strategic Export Control Lists (SECLs). As a result, businesses which export their products outside the EU should be aware of whether they are considered to be suppliers of dual use technology.
  
  However, although the legislation defines this category by reference to the SECLs, not all the products listed will be caught by the amended merger control regime; in particular, items on the EU and UK Human Rights export control lists are not covered, as they are not considered to raise national security concerns.
• Intellectual property in computer processing units: this covers businesses which own, create or supply intellectual property relating to a particular type of hardware, namely computer processing units (CPUs).
  
  The aim here appears to be to capture businesses which own or develop the components which effectively act as the "brain" of a computing device. Software is not covered by this definition except for "the instruction set architecture for CPUs" and/or "computer code that provides low level control for CPUs".
• Roots of trust in CPUs: this covers businesses which design, maintain or provide support for the secure provisioning and management of roots of trust in CPUs (and/or the computer code that provides low level control for such CPUs). "Roots of trust" are "hardware, firmware or software components that are inherently trusted to perform critical security functions." The concept includes "cryptographic key material bound to a device that can identify the device or verify a digital signature to authenticate a remote entity."
• Quantum technology: this covers businesses involved in quantum computing or simulation, quantum imaging, sensing or time navigation, quantum communications or quantum-resistant cryptography. Whilst quantum technology is (at present) a highly specialised field, most businesses within that sector are likely to be caught; in addition to firms that undertake research or develop/produce anything designed for use in such quantum technologies, the definition also encompasses firms that supply services using such quantum technologies.

The longer term changes

Overview

As regards the longer term, the government is consulting on two potential options to broaden its powers to scrutinise mergers on grounds of national security (which would be in addition to the short term changes outlined above):

• The first option would be to further expand the existing "call-in" power to situations that do not necessarily amount to a relevant merger (as currently defined in the UK's merger control regime).
• The second option would involve a mandatory notification regime for businesses engaged in certain activities regarded as having national security implications.

The proposed expanded "call-in" power

The proposed expansion of the current "call-in" power in respect of national security matters would likely include "any... transaction that gives (directly or indirectly) significant influence or control over [that] company or over its assets or businesses in the UK". This could include the sale of bare assets, together with new projects that do not involve currently functioning enterprises (but could be reasonably expected to become businesses whose activities may have national security implications). As such, it would involve a significant expansion of the concept of "enterprise" in current UK merger control legislation, the transfer of which is currently required in order for the merger control regime to apply.

However, as regards the concept of "significant influence or control", it would appear that the government has in mind a higher control threshold than the concept of "material influence" which currently applies to transactions which do amount to the transfer of an enterprise under the existing UK merger control regime. For example, in relation to share purchases, "significant influence or control" is likely to be defined as the acquisition of more than 25% of a company's shares or votes.

The proposed mandatory notification regime

The second proposal would involve a mandatory notification regime, applying to businesses:

• "which undertake, or are crucial to the undertaking of, the essential functions which the government views as critical to...the national security of the UK;" and
• where foreign ownership or control could pose a risk to the national security of the UK which there is no other reasonable means of mitigating (e.g. through licence conditions of the kind currently imposed by sectoral regulators, etc.).

There would be criminal sanctions for failure to notify. The proposed scope of "essential functions" is outlined in the box opposite.

There may also be a power for the government to designate certain businesses or assets as subject to the regime, even though they do not actually provide an "essential function" themselves. For example, in addition to the actual operator of a nuclear power station, the government might also designate any key suppliers to that business and/or owners of assets which are necessary for nuclear power generation on that site. The consultation paper also suggests that plots of land close to national security-sensitive sites could be designated as subject to the regime where there was considered to be a risk of e.g. espionage or sabotage.

Prudent safeguards or creeping protectionism?

There is certainly potential for these proposals to be perceived as a sign of the UK adopting a more protectionist approach – indeed, the Prime Minister may have contributed to that impression in 2016, when (referring to Pfizer's 2014 bid for AstraZeneca), she said that "a proper industrial strategy wouldn't automatically stop the sale of British firms to foreign ones, but it should be capable of stepping in to defend a sector that is as important as pharmaceuticals is to Britain." However, unless the concept of "national security" were to be broadened very considerably beyond the scope of the current proposals, it is difficult to see how the UK government could successfully use such powers to "defend" a business such as AstraZeneca (or Cadbury, which was mentioned in the same speech) against acquisition by a foreign owner.

The wider international context

These proposals are probably better viewed in the context of a wider trend to broaden the scope of national security scrutiny powers internationally. For example, as the government points out, authorities in many other developed Western economies (including the US, Australia, France, Germany and Canada) are able to scrutinise mergers on grounds of national security and often have broader scope to do so than the UK. In response to pressure from some Member States, the European Commission has also recently tabled proposals for an EU-wide framework for screening of foreign direct investment. This involves certain harmonisation and coordination of EU Member State regimes, as well as provision for screening by the European Commission on the grounds of security or public order in certain cases.

This is not to say that businesses/investors can afford to be entirely relaxed about the UK proposals. In particular, experience from the US suggests that legislation of this type can potentially have a serious impact on acquisitions of assets which might, at first sight, appear relatively uncontroversial.

The US experience

In the US, the CFIUS regime allows certain acquisitions by "foreign persons" to be scrutinised on national security grounds. An example of the potentially wide-ranging impact of such legislation is a recent situation where Chinese investors were forced to divest their interest in a wind farm close to a naval weapons training facility in Oregon. CFIUS has also been used to block a Chinese-owned firm taking over an equipment supplier to the semi-conductor industry. Whilst such cases are relatively rare, there is some evidence that an increasing number of transactions relating to the US are being abandoned in the face of security concerns.

Practical implications

In the past, national security concerns have only arisen in a limited number of cases and have usually been addressed by limited undertakings, e.g. to keep a certain number of UK nationals with security clearance on the board. However, if the reforms outlined above are pursued, more transactions will face the additional procedural hurdle of addressing security concerns, which is likely to, at the least, have material implications for transaction timing and costs – and may, in a small number of cases, result in the transaction being blocked. It is also worth noting that, where merging parties are unsure as to how to proceed, the government has indicated that it may be able to provide "informal guidance" (but it remains to be seen how useful this procedure will be in practice).

The longer term changes: what happens next

The government has yet to publish its response to the consultation on the longer term proposals and could decide to change its approach. However, given the wider international trend towards increased scrutiny of transactions on national security grounds, in our view it is unlikely to abandon the proposed reforms altogether.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.