How the additional regulatory hurdle will impact companies doing business in the EU

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Why the EU Foreign Subsidies Regulation has been introduced

The EU Foreign Subsidies Regulation (“FSR”) came into force on 12 January 2023 but the substantive provisions are not coming into force until later in 2023, allowing companies time to prepare compliance with the FSR’s obligations. The purpose of the FSR is to enable the European Commission to scrutinize financial contributions from non-EU countries and address any distortions to the internal market caused by these foreign subsidies. The FSR will impose a significant administrative burden on both foreign companies operating in the EU and EU companies.

EU State aid law already regulates subsidies granted by EU Member States. However, there have been concerns that subsidies granted by non-EU countries may also have an impact on the internal market. The existing merger control regime did not enable the European Commission to review or factor in foreign subsidies as part of its assessment of M&A activity. As a result, the FSR is introducing a new ex-ante regime which will enable the European Commission to review foreign subsidies in the context of M&A activity and public procurement procedures. In addition, the FSR will also empower the European Commission to open an ex-post investigation into any market situation where it suspects the existence of a distorting foreign subsidy.

Companies will have to master this additional regulatory hurdle on top of the already challenging tasks of effectively navigating EU merger control rules and foreign direct investment (FDI) regimes. Having to consider all three regulatory workstreams will make it increasingly complex for dealmakers to assess the viability of an envisaged transaction, ensure deal certainty and coordinate a realistic transaction time. In addition, this new regulatory layer may offer a new angle of attack for competing companies trying to convince the European Commission that a transaction should have been notified or, if notified, that it should not be cleared. Hence, specialized legal advisers should be consulted at a very early stage of a proposed transaction to thoroughly consider all three regulatory workstreams.

Before looking at how the FSR will impact M&A transactions, it is important to set out the scope of the FSR. As noted above, its purpose is to address the impact of distorting foreign subsidies on the internal market.

Taking each element in turn, what is a foreign subsidy? A foreign subsidy is a financial contribution by a non-EU Member State which confers a benefit on a company engaged in an economic activity in the internal market. Hence, the concept of a “financial contribution” under the FSR is very broad (in particular, much broader than the concept of subsidies) and has to be assessed on a case-by-case basis. These may include transferring funds, tax breaks, public support in the context of COVID-19 or the Russian war against Ukraine, the provision of loans or guarantees by the State, forgone revenue and supplying goods/services to the public sector. It remains to be seen how these contributions, which have to be calculated on an aggregated basis for all non-EU countries, can be reliably valued by companies’ tax and accounting teams.

Importantly, the contributions may be granted by a foreign public entity or authority, or also by a private entity whose actions can be attributed to the non-EU country.

A foreign subsidy will only give rise to concerns where it is “distorting”, meaning it has a (potentially) negative effect on competition by “improv[ing] the competitive position of the undertaking concerned in the internal market”. The FSR provides examples of the types of foreign subsidies which will be considered most likely to distort the internal market (e.g., an unlimited guarantee for a company’s debts) and those which are considered unlikely (e.g., in relation to natural disasters).

Finally, the European Commission will also consider whether the negative effects of the foreign subsidy are outweighed by any positive effects, such as promoting research and development. The European Commission will have broad discretion to determine what factors it considers to be relevant for this assessment. Further guidance on how the European Commission will apply this balancing test is expected in the coming months.

How will the FSR affect M&A transactions?

The FSR provides the European Commission with three new tools. Here, we are focusing on the mandatory merger notification tool. From 12 October 2023, companies will be required to notify the European Commission of foreign financial contributions in the context of M&A activity when certain thresholds are met.

What transactions need to be notified?

Companies will need to notify the European Commission of mergers (including full-function joint ventures) involving a foreign financial contribution when two cumulative thresholds are met:

  • One of the merging companies, the target, or the joint venture is established in the EU (meaning it has a subsidiary or permanent business establishment in the EU) and generates turnover of at least €500 million in the EU; and
  • All companies involved (i.e., in an acquisition, the acquirer(s) and target, in a merger, the merging companies and for a joint venture, the parent companies of the joint venture and the joint venture itself) have been granted a total of more than €50 million in foreign financial contributions in the three years prior to notification.

In contrast to the EU Merger Regulation, the focus is on EU turnover and there is no worldwide turnover threshold. This means that there may be transactions which require a filing under the FSR but do not require an EU merger control filing to be made. There is also a local nexus requirement for joint ventures, meaning it is not enough for the parent companies to have turnover in the EU.

However, transactions solely between non-EU companies that relate to the acquisition of a non-EU company may be subject to the notification obligation in light of financial contributions from third countries, provided the turnover threshold detailed above is met and the acquired company has a subsidiary in the EU.

The European Commission may also request prior notification of any transaction that does not meet the thresholds set out above, if it suspects a distorting foreign subsidy has been granted. While this is unsurprising given the recent focus on below-threshold transactions in merger control worldwide, it will create significant uncertainty. The European Commission is expected to issue further guidance on how this provision will be applied.

The European Commission estimates that around 30 mergers, acquisitions and joint ventures will be notified each year.

What we know about the notification procedure

On 6 February 2023, the European Commission published the draft Implementing Regulation for consultation which sets out the procedural framework. The draft Implementing Regulation includes a notification form which contains a table for parties to complete with a list of all
financial contributions received in the three years prior to notification. For each financial contribution, the parties will need to provide the following information: the names of the receiving and granting entities; the type and amount of the financial contribution; the date the contribution was granted; and whether the contribution was granted as a result of a tender process. In view of the burden on businesses, the Implementing Regulation only requires the table to be completed if: the individual amount of the contribution is at least €200,000 and the total amount of contributions per third country is at least €4 million per year.

In addition, companies will be required to disclose due diligence reports and provide detailed information about the bidding process (if applicable). This may give rise to practical difficulties as bidders are unlikely to be aware of all the details required in the notification, such as details of other bidders, how many letters of intent were received and which bidders withdrew at what stage.

Companies are encouraged to engage in prenotification discussions with the European Commission. This is likely to be of even greater importance early on in the regime to enable the parties to receive guidance from the European Commission on the level of detail required in order for the notification to be considered to be complete. During the pre-notification discussions, notifying parties may also request waivers if certain information is not available.

Helpfully, the formal review procedure is consistent with the EU merger control regime. First, the review timetable is identical under the two regimes. The European Commission will have an initial review period of 25 working days and, if the European Commission opens an in-depth review, it will have an additional 90 working days to complete its review. The in-depth review may be extended by 15 working days if commitments are offered. Second, as with the EU merger control regime, a deal cannot be closed before the European Commission has completed its review because a standstill obligation applies. Third, at the end of the review the European Commission will issue a decision that does not object to the transaction, makes commitments binding or prohibits the transaction.

However, the consistent timetables do not necessarily mean that the reviews will run concurrently, particularly as pre-notification discussions may vary in length. This will be a complicating factor when negotiating the deal timetable and longstop dates.

Potential penalties

Companies risk significant fines for failing to comply with the FSR’s requirements. In particular, the European Commission will have the power to impose fines of up to 10% of the parties’ combined worldwide turnover for failing to notify a relevant transaction; completing the transaction without receiving approval (i.e., breaching the standstill obligation) and failing to comply with a European Commission decision. In addition, failing to comply with a European Commission investigation may result in fines of up to 1% of the total turnover of the company concerned. There is also a risk of daily fines for ongoing breaches. In addition, similar to its competition law enforcement powers, the European Commission can conduct investigations including compulsory information requests and inspections and – if it identifies distorting foreign subsidies – can prohibit transactions, impose exclusions from the tender or impose remedies or accept commitments.

How should companies be preparing?

The FSR will come into force gradually throughout 2023 but it is important that companies start to prepare now. Companies will need to put in place processes to collect, process and report the information required to complete notifications. To minimize the burden, companies should consider what existing systems could be leveraged.

Companies should also begin their risk assessments now. First, companies need to identify and quantify financial contributions granted by non-EU countries over the previous three years. Second, companies (together with their legal advisers) should determine whether these financial contributions confer a benefit on a company active in the internal market and are considered to be “foreign subsidies” as a result. Third, if there are any foreign subsidies, companies (again, together with their legal advisers) need to assess whether the foreign subsidies could be considered to be “distorting”. This preliminary assessment should include consideration of the purpose of the contribution, the relevant product/market, the nature and amount of the subsidy, and the overall market position and evolution of the company. Finally, companies should consider the possible positive effects of the subsidy, which arguably may outweigh the distorting effect: for example, if it promotes research and development or environmental protection.

Practically, it will take time to compile the necessary information and ensure that all financial contributions granted by any third country have been identified. Consequently, companies should start this rather complex analysis now and take an iterative approach to their risk assessments as further guidance is released. Companies should be aiming at developing and maintaining an up-to-date internal database that enables them to easily identify all relevant financial contributions from at least 12 October 2020, regardless of size, before the new notification requirement comes into force in October 2023. In addition, an effective system should be developed to continuously track and record all financial contributions in the future.

Both the extent of the information required about foreign financial contributions, as well as the assessment of their potential to distort competition, will require input from various international specialists from different functions, such as Finance, Tax, Legal, Commercial.

Undertaking these comprehensive risk assessments will ensure that companies are prepared for the notification requirements coming into force on 12 October 2023. The FSR will not apply to M&A activity where the agreement was concluded, the public bid was announced or a controlling interest was acquired before 12 July 2023.

However, it is important to note that the merger notification requirement requires companies to consider financial contributions received in the three previous years. Much of this information will already be available to companies, so the administrative burden will be eased by starting to collate the information now.

In addition, companies should consider how they will factor the FSR obligations into their due diligence procedures. As noted above, companies will be required to disclose due diligence reports as part of the notification process. It will also be crucial to ensure that information about any foreign financial contributions received by the target is received at an appropriate stage to determine whether the notification thresholds are met.

An additional difficulty will be that some of the information on the sale process that has to be provided will be sensitive data that only the seller will have access to. This includes inter alia the number of candidate buyers contacted by the seller, the number of candidates interested in the transaction, candidate buyers who have withdrawn from the project and at what stage of the process, the contact details of all companies that have expressed an interest, etc.

Companies should also engage with legal advisers about how deal documents may need to be adapted to reflect the FSR. This will include consideration of warranties, disclosures, conditions precedent, long-stop dates and deal timetables.

Conclusion: further guidance to come

The FSR will increase the administrative burden of M&A activity because it creates an additional filing requirement for certain transactions. Existing merger controls (both at EU and national level) and foreign direct investment controls will continue to apply in parallel. While it is helpful that the review period is consistent with the EU merger control regime, this does not change the fact that companies will face an increased administrative burden in preparing notifications, because different information will be required both to assess whether a notification is required and in the notification itself (if relevant).

As set out above, companies should already be thinking about how to prepare their internal systems and deal documents to ensure they are ready for when the FSR comes into force in the second half of 2023.

The consultation on the Implementing Regulation closed on 6 March 2023. In addition to the final version of the Implementing Regulation, we expect the European Commission to issue further guidance in the next few months. Companies will need to follow these developments and take an iterative approach to their risk assessments.

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