EU foreign subsidies regulation: another notification regime for dealmakers to become law
The European Union has a strong regime to address EU State Aid, i.e. subsidies granted by EU Member States. However there has been growing concern over recent years that forms of assistance granted by 'third' (i.e. non-EU) countries can also impact the internal market, and that legislation is required to address the loophole.
The result is the Foreign Subsidies Regulation (or 'FSR'): a new regulation seeking to combat the effects of potentially distortive subsidies granted by third countries to companies operating in the EU.
On 30 June 2022, the European Commission, European Council and European Parliament reached political agreement on the text of the FSR. The final text was approved by the European Parliament on 11 July 2022, with the next step being a full vote of the legislature in November 2022. Once the Parliament and the Council formally adopt the final regulation, it will be published in the EU's Official Journal and will enter into force 20 days after that. The obligations under the FSR are expected to take effect from mid-2023.
The Foreign Subsidies Regulation provides three routes for EU scrutiny of third country (i.e. non-EU) subsidies:
- A broad ex officio review tool, giving the Commission the power to investigate potentially distortive foreign subsidies on its own initiative.
- A mandatory, ex ante, notification regime for concentrations meeting certain financial thresholds, including a minimum level of foreign contribution received from third countries. (Note: the 'financial contribution' does not need to be directly related to the transaction in question).
- A mandatory, ex ante, requirement to notify public procurement bids where a certain level of financial contribution has been granted by third countries.
This briefing focuses on the second aspect: the requirement to notify transactions where one or more parties have received financial contributions from one or more third countries. We explore how that regime will operate, as well as some of the ambiguities created by the drafting and next steps for dealmakers active in the EU.
Under the agreed text, 'concentrations' will need to be notified to the Commission, before they are completed, where the following thresholds are met:
- One of the merging entities, the acquired undertaking or the joint venture is (i) established in the EU; and (ii) generates an aggregate turnover of at least Euro 500m in the EU; and
- All undertakings involved in the concentration were granted, in the three financial years prior to notification, combined aggregate financial contributions of more than Euro 50m from third countries.
The theory of harm underpinning the new notification regime for concentrations is intuitive: it is simply that the grant of a financial contribution to a transaction party can give an advantage to a bidder or an acquirer, not because of (for example) an inherently superior bid, but because of the mere existence of the advantage conferred by the financial contribution. Consequently, the Commission needs to be notified when a financial contribution might be of relevance to a transaction so that it can assess whether or not it is distortive in nature.
In addition, under its ex officio powers, the Commission will be able to require notification of potentially subsidised concentrations that fall below the notification thresholds (if it considers that the concentration would merit ex-ante review given its impact in the EU). The Commission will also have the power to review, on its own initiative, already implemented concentrations.
Helpfully, the concept of a 'concentration' has been lifted from the EU Merger Regulation ("EUMR"), i.e. is defined as a change of control on a lasting basis that results from the merger of two previously independent undertakings, the acquisition of control of an undertaking by another, or the creation of a full function joint venture. The concept of 'control' is also analogous to the EUMR, meaning the ability to exercise decisive influence on an undertaking.
Who is the relevant party in asset management or private equity deals?
In an alternative asset management context, although the party acquiring control might technically be a fund limited partnership or a corporate entity in a stack designed to facilitate the acquisition, we expect the party deemed to be acquiring control for the purposes of the FSR to be the private equity firm or the asset manager: partly due to the analogous position under EUMR and because, in reality, they will be the ones exercising the decisive influence.
In any event, for the purposes of calculating the thresholds, group-wide turnover is used (see 'Valuing the financial contribution' below.
Establishment in the EU?
The concept of being 'established in the EU' is not defined in the proposed FSR. It is also not a term used in the EUMR and, therefore, would benefit from additional clarity in subsequent guidance.
An equivalent term is, however, used in the EU GDPR. Recital 22 of the GDPR defines 'establishment' as the 'real exercise of activity through stable arrangements' and, as such, whilst the presence of a branch or subsidiary isn't determinative, it is considered probative. We consider it likely that 'establishment' will prove a similarly low bar for the purposes of the FSR, and may indeed be analogous to the same concept used in the GDPR.
Many of the perceived difficulties in the FSR stem from the definition of 'financial contribution.' It is important to note that the concept of a 'financial contribution' is not the same as that of a 'subsidy' in a State Aid context. Indeed there is a wide difference between the two, with 'financial contribution' being a materially lower bar for the purposes of triggering a filing obligation. Unlike a subsidy, a 'financial contribution' granted by a third country does not need to be shown to 'confer a benefit' on an undertaking(s) or industry for the purposes of the notification obligation in the FSR.
The question is then, what is a financial contribution? That is answered by Article 2 of the FSR.
A financial contribution shall include:
- The transfer of funds or liabilities, such as capital injections, grants, loans, loan guarantees, fiscal incentives, setting off of operating losses, compensation for financial burdens imposed by public authorities, debt forgiveness, debt to equity swaps or rescheduling;
- The foregoing of revenue that is otherwise due, such as tax exemptions or the granting of special or exclusive rights without adequate remuneration; or
- The provision of goods or services or the purchase of goods or services.
Purchase of goods or services
The outlier in this definition is the reference to the 'purchase of goods or services' which prima facie would include contracts made between a government and a private undertaking for the purchase of goods and services and, on the face of the FSR, seemingly even if they have been negotiated on arm's length, commercial terms or were subject to a strict public procurement process. Examples might be, for example, government cleaning contracts, defence contractors, prison caterers, school stationary suppliers and other innocuous purchases of goods or services.
Such benign flows of money from governments to private companies is not the crux of the issue that the FSR seeks to address. However, as there will be cases where the Commission will want to assess any distortions from commercial contracts with third country governments (see potential examples below) this provision provides the Commission with that flexibility. It will, however, be important for guidance to be published in order to provide much needed certainty over the types of assistance that the Commission is most interested in, and whether this limb should be confined to circumstances where the purchase of goods is used as a front for, or in lieu of, other, more direct financial aid.
The inclusion of 'purchase of goods' in the definition of a financial contribution could, for example, cover the following types of circumstances.
Imagine the case of a property developer facing solvency issues, which is given a liquidity injection by a third country government purchasing its vacant property stock. This would be akin to a bailout insofar as the property would not have been purchased were it not for the undertaking's ailing financial situation. That property developer may then go on to seek to acquire a property portfolio (or, indeed, any business) in the EU.
The third country intervention should not escape the FSR regime simply because the government notionally received goods in return. Indeed the acquisition by a third country developer of a European property business would be exactly the sort of situation the FSR anticipates.
The issue at hand is that there is nothing in the text of the FSR to suggest that the scope can be limited to just these types of situations.
Loans and grants
The concept of a 'financial contribution' also includes loans and grants. This would capture, prima facie, measures taken by many governments in response to the COVID-19 pandemic (for example the Coronavirus Large Business Interruption Loan scheme in the UK that allowed businesses to borrow up to GBP 200m). Although applications for that particular loan scheme closed on 31 March 2021, the three-year reference period for measuring total financial contributions in the FSR means that those loans may be relevant for the calculation of the notification thresholds until well into 2024.
From whom can a 'financial contribution' be made?
Under Article 2 of the FSR, relevant financial contributions may be made by:
- The central government and government authorities at all other levels;
- Foreign public entities, whose actions can be attributed to the third country, taking into account elements such as the characteristics of the entity, the legal and economic environment prevailing in the State in which the entity operates including the government’s role in the economy; or
- Any private entity whose actions can be attributed to the third country taking into account all relevant circumstances.
Whereas the first of these limbs is intuitive, the second and third are currently left as potentially very widely drawn, and would benefit from increased clarity. Whilst it is understandable that the Commission would want to avoid being so prescriptive that unusual manifestations of a State fall outside the FSR, the wide scope of this definition leads to significant uncertainty over its intended perimeter.
One notable example is the inclusion in point (ii) of 'the government's role in the economy' as a relevant consideration when determining if a financial contribution has been made by a 'foreign public entity'. Although not clear, this wording could be taken to imply that a government-aligned entity in a western-aligned country (like perhaps the US or UK for example) might be able to escape scrutiny (i.e. the notification requirement under the FSR) whereas a comparable entity in countries with high levels of State control, such as Russia or China, cannot. However, the FSR is left unclear as to how these factors will objectively fall to be considered under the process of assessing the Commission's jurisdiction.
We can, however, say with some certainty that sovereign wealth funds are intended to be caught by the FSR. Indeed, in the impact assessment accompanying the proposed FSR, the Commission gave the example of the acquisition of Pirelli, which was partially funded by the Chinese Silk Road Fund as a government investment fund.
There are other types of entity that may be analogous to sovereign wealth funds and therefore also caught. Take the example of a government aligned pension provider. If the provider is considered to fall within the second limb above (i.e. a foreign public entity) then, consequently, professional advisors to that provider could theoretically be deemed to be in receipt of 'financial contributions' by virtue of providing services to them.
The current, widely drawn approach to the scope of providers of financial contributions caught by the FSR may raise questions in a classic asset manager context. For example:
- If a third country government aligned pension provider or sovereign wealth fund (or several such entities) invests money with an asset manager, it is plausible (though unclear) that the investment itself may constitute a financial contribution. If that is the case, then each subsequent material acquisition that the asset manager seeks to make in the EU could arguably trigger the need to notify under the regime.
- If a third country government aligned pension provider or sovereign wealth fund (or several such entities) invests, say, Euro 850m with an asset manager, assuming a 2% annual charge, the fund or pension provider would likely pay circa. Euro 50m in fees to the asset manager over a three-year period. These fees may amount to a 'purchase of services' for the purposes of the FSR which may constitute a financial contribution. Therefore, it is plausible (though unclear) that such fees would need to be taken into account when measuring the value of financial contribution received by the asset manager.
Both of these examples create the possibility of a far reaching and burdensome obligation on the alternative asset management industry to monitor its position against the financial thresholds and to notify its EU investments.
Although the financial threshold is relatively simple – Euro 50m over the preceding three year period - there is no standard or recognised accounting concept that aligns with the notion of a 'financial contribution' as it appears in the FSR. Therefore, the process of gathering and interpreting the required data should be given careful consideration.
The provisions on aggregation at Article 22 FSR also pull the group of the entity in receipt of the financial contribution into the calculation. On a practical note, this poses particular issues for asset managers with controlling stakes in large numbers of portfolio companies. The group-wide aggregation gives rise to a scenario where, if an asset manager has a portfolio company with third country government contracts worth over Euro 50m, any material acquisition by the manager from that moment forwards would satisfy the financial contribution limb of the threshold.
In addition, as currently defined, the Euro 50m threshold applies to all undertakings involved in the concentration. That leaves scope for the Commission to include financial contributions to the target, as well as to the acquirer, in the threshold calculation. (Plus, as noted above, all of the financial contributions do not need to come from the same third country).
From a policy perspective, such an approach appears to lack clear purpose. For example, if a US headquartered target is established in the EU (through e.g. a subsidiary) and has received financial contributions from the US – those contributions would be aggregated with any financial contributions that the acquiring group has received e.g. from China.
It also leaves open the possibility that an acquirer with absolutely no links to foreign financial contributions, must notify its deal to the Commission because the target has received the requisite level of foreign financial contributions. The theory that a financial contribution given to an EU-established target, which is then acquired by a purchaser that has not been in receipt of any third country assistance, could pose distortive effects in the internal market is difficult to justify.
The process of notification and review under the FSR won't come as a surprise to deal-makers with experience of merger control notifications to the European Commission.
Once the financial thresholds are met, the deal must be notified to the Commission, and a standstill obligation applies – therefore the deal cannot close before the Commission has completed its review.
Analogous to the merger control regime under the EUMR, the Commission has a period of 25 working days to conduct the initial (Phase I) review. If the Commission has sufficient indications of the existence of a foreign subsidy distorting the internal market, it can open an in-depth (Phase II) investigation lasting 90 working days, extendable by a further 15 where the undertakings concerned offer commitments.
Once the financial thresholds are met (on the basis of turnover and the financial contribution) the Commission will then assess whether that financial contribution results in a distortive foreign subsidy. (Unlike State Aid granted by a Member State, foreign subsidies are not automatically prohibited).
For the Commission to take redressive measures or accept commitments there must be a foreign subsidy (i.e. a financial contribution, provided directly or indirectly by a third country, conferring a benefit, and limited to one or more undertakings or industries) with an actual or potential distortive effect on the internal EU market. The Commission will weigh any positive effects (re: the development of the relevant subsidised economic activity on the internal market, as well as broader positive effects in relation to relevant EU policy objectives) against the negative effects of a foreign subsidy.
The Commission will deem a distortion on the internal market to exist where a foreign subsidy is liable to improve the competitive position of an undertaking in the internal market and where, in doing so, it actually or potentially negatively affects competition on the internal market.
Whether there is a distortion on the internal market shall be determined on the basis of indicators (which could be thought of as 'soft factors'), which may include, in particular, the following:
(a) the amount of the subsidy;
(b) the nature of the subsidy;
(c) the situation of the undertaking, including its size and the markets or sectors concerned;
(d) the level and evolution of economic activity of the undertaking on the internal market;
(e) the purpose and conditions attached to the foreign subsidy as well as its use on the internal market.
However, the FSR also sets out a list of categories of foreign subsidy that are most likely to distort the internal market.
These categories (which could be thought of as 'hard factors') include:
(a) a foreign subsidy granted to an ailing undertaking, that is to say which will likely go out of business in the short or medium term in the absence of any subsidy, unless there is a restructuring plan that is capable of leading to the long-term viability of that undertaking and includes a significant own contribution by the undertaking;
(b) a foreign subsidy in the form of an unlimited guarantee for debts or liabilities of the undertaking, that is to say without any limitation as to the amount or the duration of such guarantee;
(c) an export financing measure that is not in line with the OECD Arrangement on officially supported export credits;
(d) a foreign subsidy directly facilitating a concentration;
(e) a foreign subsidy enabling an undertaking to submit an unduly advantageous tender, on the basis of which the undertaking could be awarded the contract.
The Commission has, however, a wide discretion to take into account any other factors that it considers relevant, and this is yet another example of an area where supplementary guidelines and concrete examples would be welcome.
If the Commission finds that the subsidy does (actually or potentially) distort, it will have the power to take a range of redressive measures or accept commitments: which may be structural or behavioural measures, divestments, or repayment of the subsidy with interest. If the distortion is found to be so substantial that it cannot be remedied by such measures, the Commission may require a concentration (if it has already been implemented) to be dissolved.
No equivalence regime
In the midst of the EU-wide negotiations over the scope of the FSR, it had been suggested1 (by the Committee on International Trade Rapporteur, Christophe Hansen MEP) that a form of equivalence provision should be introduced, whereby subsidies from third countries with an equivalent subsidy control mechanism to that in place at the EU level would be presumed unlikely to be distortive. Whilst this intervention was welcomed by commentators in the UK and further afield, the suggestion failed to make it into the final text of the FSR.
The FSR is here to stay. The increasing prominence of sovereign wealth funds across the globe, as well as the expansive overseas investment strategies of some overseas nations has raised alarm bells within the EU over recent years. The agreed text of the FSR reflects a strong EU-wide legislative and Parliamentary will to close the lacuna over foreign distortions to the EU's internal markets.
Whilst in many respects the thresholds for mandatory notification are clear, there remain important uncertainties about the precise scope of the FSR and the way in which it will be applied in practice by the Commission. Increased guidance on several areas, as raised in this briefing, would be welcome in advance of the FSR coming into force.
From an asset management and private equity standpoint, foreign assistance given to one portfolio company could trigger an obligation to file all EU deals going forward (even where the given deal does not involve any degree of foreign assistance). As always, the devil is in the detail (and a Euro 500m turnover threshold also applies), but such investors will need to have clear insight as to their entire portfolios in order to assess their exposure under the FSR.
All 'non-EU' financial contributions are caught for the purposes of the thresholds. Whilst there have been calls for an equivalence regime (which may have covered the UK's new Subsidy Control Act), this has not made it through to the final text. As things stand, financial contributions from the UK (or e.g. US, Commonwealth etc.) would therefore count towards the financial thresholds, triggering notification obligations, in the same way as those granted by countries that are not aligned with Western democracies. However, there are many hooks in the documentation to suggest that the substantive assessment of whether there exists a distortive subsidy is designed to take account of the specific countries and political regimes in question. Nevertheless, the filing burden remains.
In the coming months, all investors should consider creating detailed records of any non-EU financial contributions received by their portfolio or other group companies/investments over the past three years in order to assess their likely exposure to filing obligations under the FSR (regardless of whether those future deals involve companies that have received foreign assistance or not).
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