Investments and the impact of the UK’s new national security screening regime

In January 2022, the UK introduced a new screening regime for transactions which might raise national security concerns.

With a broad scope, the regime goes beyond M&A and can capture minority investments, asset transfers and corporate restructurings.  In this insight, we focus on the implications for scaling businesses looking for investment.

Background

The UK Government has made clear that “the UK economy thrives as a result of foreign direct investment” but states that “an open approach to investment must include appropriate safeguards to protect our national security”. 

With this in mind, the UK’s National Security and Investment Act 2021 (NSIA) has come into force. For a detailed overview of its provisions, please look at our FAQs published here.

Set out below are our particular comments from an investment perspective.

Sensitive sectors of the economy

The first thing to flag is the NSIA’s focus on 17 sensitive sectors of the UK economy.  If your business or idea involves products, services or assets (even if only at a very developmental stage) in one of these sensitive sectors, it will be vital to check whether your proposed investment or other transaction (for example, granting a technology license to a university spin-out) is a trigger event where a notification to the UK Government must be made or is recommended.

The 17 sensitive sectors are as follows:

• Advanced Materials
• Advanced Robotics
• Artificial Intelligence
• Civil Nuclear
• Communications
• Computing Hardware
• Critical Suppliers to Government
• Cryptographic Authentication
• Data Infrastructure
• Defence
• Energy
• Military and Dual-Use
• Quantum Technologies
• Satellite and Space Technologies
• Suppliers to the Emergency Services
• Synthetic Biology
• Transport

Much greater detail about what they encompass can be found in these Regulations.  Helpfully, the UK Government has also published this slightly more digestible guidance on the sectors.

Many of the above are areas where the UK is an innovation leader, with high levels of activity coming out of our universities.  For this reason, the UK Government has provided bespoke Guidance for the Higher Education and Research-Intensive Sectors.  This sets out useful examples of when the NSIA regime may apply, amongst other things, to university spin-outs and research collaborations.

It is also important to think about both the existing and potential applications of the products or services of the company being backed by the investment.  Do they have a dual-use nature i.e. both civilian and military use?  If so, they may well be caught by the regime, even if current use is purely civilian.  Particular examples include robotics, artificial intelligence, “advanced materials” and synthetic biology. 

Domestic and foreign application

Before moving on to discuss the trigger events most likely to be relevant to investments, it should be flagged that the NSIA regime applies equally to foreign and domestic investments and assets.  Even if your transaction involves only UK parties and UK assets (including shares), it can still be caught by the regime.

Trigger events

If your business operates in a sensitive sector (or if you think the investment might otherwise raise national security concerns), you must see if the proposed investment constitutes a trigger event.

Listed below are the key types of transaction caught by the regime, with a note against each confirming if they trigger a mandatory or voluntary notification:

Depending on the nature of the investment, you may be caught by one or more of the above trigger events.  For example, venture capital investments may tip the 25% shareholding threshold and transfers to university spin-outs are likely to involve “qualifying assets”.

“Qualifying assets” fall into key three areas: (i) land, (ii) tangible moveable property and (iii) “ideas, information or techniques which have industrial, commercial or other economic value”.  A detailed summary of what these capture can be found in our FAQs.  It could include:

• designs
• plans, drawings and specifications
• software
• trade secrets
• databases
• source code
• algorithms
• formulae
• land
• tangible moveable property such as laboratory equipment.

It should also be noted that, even where the target company doesn’t operate in a sensitive sector, the UK Government can still call the transaction in for review if the Secretary of State reasonably suspects:

• that a “trigger event” has occurred or is in progress; and
• that “trigger event” has given rise to or may give rise to a national security risk.

So even if neither your business nor the investor operates in a sensitive sector but there are other reasons why the investment may be of interest to the Government, a voluntary notification (or at least preliminary discussions with the Government’s Investment Security Unit) may be advisable.

Material influence

A trigger event of particular interest to investors will be that relating to “material influence” over company policy as an investor’s consent rights, reserved matter protections and board representation could lead to an investor gaining “material influence” over the target, even with a relatively small shareholding.

Where there are factors other than just an investor’s shareholding which indicate an ability to exercise material influence over policy, even shareholdings of less than 15% may attract scrutiny (although we would expect most cases of material influence to arise in the ≥15% and <25% shareholding bracket).

The UK Government’s assessment of whether an investor will gain the ability to materially influence policy relevant to the behaviour of the target company will be considered in the light of the Competition and Markets Authority (CMA) guidance on this issue which was produced in the context of UK merger control.  Broadly, the CMA guidance indicates that a finding of material influence may be based on:

• the investor’s ability to influence the company’s policy through exercising votes at shareholders’ meetings (in particular, any rights to veto resolutions should be considered together with any circumstances which might mean resolutions can be practically blocked by the investor);
• the investor’s ability to influence the company’s board and other shareholders whether directly or indirectly;
• the investor’s ability to step in, or to benefit from enhanced rights, in certain circumstances; and
• other arrangements, including financial arrangements or other commercial agreements with the company, which may allow the investor to materially influence policy without necessarily being able to block votes at shareholders’ meetings.

Situations where an investor’s industry expertise might lead to its advice being followed to a greater extent than its shareholding would seem to warrant, should be critically assessed.

The variety of commercial arrangements entered into by businesses makes it difficult to state categorically what will (or will not) constitute material influence for the purposes of the NSIA.  Investors will need to look at their influence over any investee company on a case-by-case basis.

Over time, we hope that the Government’s approach to “material influence” will be further clarified as submissions in this space are made and reviewed. Until then, case law in UK merger control cases can provide some guidance to the practical application of material influence.

Is a notification mandatory?

It could be.

If your investment falls within the mandatory notification regime (see table above), then the investor must submit a clearance application to the UK Government’s Investment Security Unit (ISU).  You cannot complete the investment without the ISU’s go ahead.  Doing so has serious implications, including:

• the investment being legally void;
• a fine of up to 5% of worldwide turnover or £10 million (whichever is greater) potentially being imposed on the investor; and
• potential imprisonment of up to five years for the investor (or its officers, if the breach happened with their consent, connivance or neglect).

If the investment triggers only a voluntary notification obligation (see table above), you should consider making a clearance application to the ISU. The benefit of making a voluntary submission is that, assuming your investment gets the green light, the ISU won’t then issue a “call-in” notice after completion.

If the ISU does issue a “call-in” notice and decides that a national security risk has arisen, it can impose necessary and proportionate remedies for the purpose of preventing, remedying or mitigating that risk.  What that practically means is likely to vary across the risks identified. A final order might, among other things, include provisions:

• requiring the appointment of a person to conduct or supervise certain activities
• restricting access to sensitive sites, confidential information and/or supply chains
• relating to the transfer of intellectual property
• as a last resort, requiring the investment to be unwound.

How is a notification made and what are the timings?

Please see our FAQs for more detail on this.

The NSIA regime can look backwards

It is worth noting that, unusually, the NSIA has retrospective effect which means a transaction can be called in for review by the ISU if it took place after 11 November 2020.  The ISU expects to use this power in a very limited way advising that the power was included to ensure parties did not accelerate transactions to avoid scrutiny.

However, companies looking for further investment or a potential sale may want to seek retrospective clearance from the ISU for previous transactions, to ensure its “call-in” powers cannot subsequently be exercised.  This is likely to be something investors and acquirers look at in their future due diligence.

Specific considerations for investments

• Think about the NSIA at an early stage – If a notification is to be made, this needs to be submitted as soon as possible to start the ISU’s timeline for review. The UK Government has said it will process applications as quickly as possible but in scaling businesses, where cash funding may be needed quickly, it is just not clear if this will be quick enough. Make sure to flag any urgency in your application.
• Think through all the angles – The NSIA regime can trip up transactions in many ways. Not only does it potentially capture rounds of investment but also internal restructurings (for example, share allotments to incentivise new managers) and options (not usually on grant but on exercise, so a pre-emptive clearance should be considered).
• Expect enhanced due diligence – Investors will want to understand at an early stage what the business does (or could do – applying a dual-use mindset) and where it operates. They will also want to know about any transactions taking place since 11 November 2020 which could have been trigger events under the NSIA.
• Assess the investor’s proposal – In practice, what does the investment proposal look like? What will the investor’s shareholding, consent rights, reserved matters and board representation look like? Does the investor (or it’s investor director) have status or expertise in a sector which may influence the target’s other shareholders or directors?
• Resourcing – Considering whether an NSIA notification needs to be made and submitting an application will be time-consuming. The parties will collectively need to agree how to resource this, particularly where the company has a small staff.
• Keep up-to-date – The NSIA regime is continuously evolving with new guidance being published by the UK Government. Additionally, industry specialists are pooling their knowledge and experience – for example, the BVCA has recently published The National Security and Investment Act - a guide for VC and PE firms. Over time, we expect things to become clearer from an investment perspective. It has been confirmed that investors who have a history of passive or long-term investments may indicate low or no acquirer risk. However, this doesn’t mean you shouldn’t make a notification – it simply means that once a notification is made, the ISU will review the investor’s background to assess the risk associated with it having control or influence over the company.