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Travers Smith's Alternative Insights: Balancing national security and national interest

Travers Smith's Alternative Insights: Balancing national security and national interest

Originally published 12 March 2021

Update

The National Security and Investment Act ("NSI Act") received royal assent on 29 April 2021, and the Government recently announced that the new regime will come into force on 4 January 2022.

As anticipated in our original Alternative Insights briefing on the new national security regime below, unlike other foreign investment regimes, the NSI Act will not be limited to acquisitions made by foreign investors. Therefore, despite criticism from commentators, it will also capture acquisitions by UK acquirers and those from "friendly" countries. A significant number of UK deals will need to be analysed to establish the risk of being scrutinised and in certain instances will need to be conditional on national security clearance (or potentially risk facing criminal and/or civil penalties).

Notably, transactions with lengthy gap periods, which sign before the regime comes into force but only complete once it is in force (i.e. from 4 January 2022 onwards), will potentially be caught by the new regime, and consideration should therefore be given to whether a mandatory notification (and therefore suspensory condition to the transaction agreement) will be required. Transactions which complete between 12 November 2020 and 3 January 2022 (inclusive), may also be subject to "call-in" by the Government, in light of certain aspects of the NSI Act applying retrospectively.

For further information on the NSI Act, including the final "control" thresholds, revised definitions of the 17 mandatory sectors and other key details for investors to be aware of, please see our briefing The UK's National Security and Investment Act 2021: what you need to know.

Overview

A regular briefing for the alternative asset management industry. 

In recent years, governments around the world have been reviewing their powers to scrutinise and intervene in transactions that affect national security. It is not easy to get the balance right. On the one hand, the instinct of policy-makers is to require a wide range of transactions to be notifiable in advance, or reviewable after the event, and to take sweeping powers to prevent deals, or to order them to be unwound. On the other hand, for governments that want to encourage foreign investment in crucial sectors of the economy, such a heavy-handed approach will be counterproductive. Uncertain, expensive and time-consuming hurdles to investment and M&A activity are likely to have a chilling effect on inward investment, and may persuade entrepreneurs to locate innovative businesses elsewhere.

The UK government is currently grappling with exactly this dilemma. When it launched its National Security and Investment Bill in November last year, it provoked an avalanche of criticism.  Most commentators did not disagree with the policy intent – they recognised that the UK's existing powers to call in transactions need to be beefed up – but there were serious concerns that the proposed powers were too broad. These concerns are the subject of ongoing discussion – evident from debates in the House of Lords this week. Among other things, businesses are concerned that the regime will not be limited to acquisitions made by foreign investors and, therefore, unlike other foreign investment regimes, will also capture acquisitions by UK acquirers and those from "friendly" countries. 

The British Private Equity and Venture Capital Association (BVCA) was among those who responded to the consultation by pointing out that, as initially proposed, the new rules could delay and increase the cost of deals to such an extent "that they will reduce the appeal of the UK as a base for international early-stage innovators". Alternative asset managers contemplating acquisitions or disposals were similarly concerned about unnecessary hurdles for deals when national security was clearly not in issue. The BVCA response recounted the (unfortunate) experience of the recently reformed US rules and urged the government to learn the lessons.

Despite continuing to hold the line on many points, the government did make it plain last week that it has heard some of the concerns.  Its response to the consultation sets out revised definitions for the 17 sectors (including defence, energy and transport) that would be within the mandatory notification regime envisaged by the Bill and, on the whole, these have been narrowed in response to industry feedback. Moreover, the government says that it intends to refine the definitions further in discussion with stakeholders. 

These 17 definitions are crucial because they identify the types of transactions that could be subject to mandatory pre-deal scrutiny and approval on grounds of national security by a new regulator, the Investment Security Unit. The new law will require prior notification of a deal that involves an acquisition of "control" of an entity in one of the designated sectors – and an acquisition of "control" could occur when a party has only 15% of the shares or votes (a threshold which is itself another key area of ongoing debate). Criminal penalties can apply when a deal is not notified, so parties will necessarily be conservative in their assessment, making it even more crucial that the definitions are as narrow, and as clear, as possible. The government's initial proposals were widely thought not to satisfy either of these requirements.

...The new law will require prior notification of a deal that involves an acquisition of "control" of an entity in one of the designated sectors – and an acquisition of "control" could occur when a party has only 15% of the shares or votes (a threshold which is itself another key area of ongoing debate)....

The latest proposals attempt to remedy that – and certainly seem more reasonable in their scope. For example, the definition of "artificial intelligence" as a sector has been narrowed, and, significantly, now says more clearly that companies that purchase products or licenses in relation to AI (for use, but not for further development) are not covered by the definition. The number of companies within the "data infrastructure" sector has been narrowed considerably, while retail energy suppliers are now expressly excluded (something the government says was always its policy intent). Other sectors, though, have not been narrowed in scope – for example, "defence" continues to include contractors and sub-contractors who provide government cleaning or hospitality services.

No doubt further work will be needed to further define these mandatory sectors, but there is at least a willingness from government to work with stakeholders and a recognition of the dangers of an overly-inclusive approach – something that was also recognised by the House of Lords.

These proposals are expected to become law in the coming months, and the regime is expected to be fully operational by the end of 2021.  Investors will continue to work through them, and the voluntary notification regime that will sit alongside, together with the more extensive "call-in" power that will enable the regulator to assess deals which have already been consummated – including, potentially, deals completed since 12 November 2020, the day after the draft rules were first published. 

Whatever the outcome of the ongoing discussions, one thing is already clear: many more UK deals will need to be conditional on a national security clearance, and more analysis will be needed during the due diligence phase of a deal to establish the risk that a deal could be subject to scrutiny after it is concluded. On the other hand, the longer-term effect on the UK's attractiveness as a destination for foreign investment will not become clear for some time. 


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TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS

A series of regular briefings for the alternative asset management industry.