Background

On 11 July 2023, the Cabinet Office published the UK Government’s second Annual Report (“Report”) containing details of how the regime established by the National Security and Investment Act (“NSIA”) is functioning in practice. The Report covers the period from 1 April 2022 to 31 March 2023 (the “reporting period”) and examines the regime’s first full year in operation – the first Annual Report covered only the initial three-month of the regime since 4 January 2022 (see our earlier update on that report here).

Since the NSIA went live last year, it has created a very expansive stand-alone regime which, for certain types of transactions, requires a mandatory notification and an obligation to pause closing until clearance has been obtained – or risk significant financial and criminal sanctions (as well as commercial consequences) for non-compliance. The day-to-day operation of the regime is conducted by the Investment Security Unit (“ISU”). During the reporting period, the ISU moved from the former Department for Business, Energy and Industrial Strategy into the Cabinet Office at the same time as other machinery of government changes announced by the Prime Minister on 7 February. As part of this move, the decision maker under the NSIA regime became the Secretary of State in the Cabinet Office, currently Oliver Dowden who is also Deputy Prime Minister. He is the fourth Secretary of State during the reporting period to be responsible for the regime.

Key takeaways from the Report

The Report sets out a variety of statistics on how the NSIA regime has been functioning during the reporting period including the number and type of notifications made, key sectors engaged by the regime and details on the origin of investment – the final point not being a requirement for publication but included as part of an “ongoing commitment to be as transparent as possible”.

Notifications

• In total, 866 notifications were made to the ISU during the reporting period. This is lower than the anticipated annual range of 1,000 to 1,830 which the ISU estimated would be received each year in its Impact Assessment published in 2020. This is, however, still a considerable number, which emphasises the significance of the regime to those investing in the UK.
• Over three quarters of notifications made were mandatory (77%), with the remainder being either voluntary (21%) or retrospective validation applications where transactions had been completed without having obtained the necessary approval (2%).
• The most common sector cited in mandatory notifications (47%) was ‘Defence’, with more than twice as many as the second most common sector; Critical Suppliers to the Government. This was followed by Data Infrastructure, Military and Dual Use and Artificial Intelligence. For voluntary notifications, Advanced Materials was the most commonly cited sector, followed by Defence – which likely reflects how broadly both sectors are defined.
• The new metric of ‘origin of investment’ indicates that the UK (nearly 60%) and the US (around 25%) accounted for the vast majority of notifications made, with China in 7^th place with below 5%. It is unclear exactly how ‘origin of investment’ has been determined for these purposes, with some individual transactions apparently having multiple origins attributed to them.
• 43 notifications were rejected by the ISU, with the most common reason being that the acquisition was notified using the wrong form (i.e. as a mandatory notification when it should have been voluntary, and vice versa).

Transactions and investments subject to in-depth scrutiny:

• A total of 65 call-in notices were issued during the reporting period; slightly below the 70 to 95 which is was estimated would be issued annually in the Impact Assessment. This represents fewer than 10% of all notifications made or reviewed during this period – indicating that the clear majority of notified transactions are cleared without issue within 30 working days. An additional 10 non-notified transactions were subject to an in-depth national security assessment.

• Notably, there is a stark difference in the call-in rate between deals notified on a mandatory and voluntary basis: following a mandatory filing, around 6% of deals were called in compared to 12% for voluntary filings, so twice as many. This may give the Government pause for thought about whether mandatory sector definitions, or the types of transactions that are caught on a mandatory basis, could be recalibrated to be more effective – including excluding internal reorganisations from the scope of mandatory notification.

• Compared to the statistics on origin of investment for notifications made, there was disproportionate emphasis on Chinese investment being subjected to in-depth scrutiny. Of the call-in notices issued, 42% of these involved acquirers associated with China compared to 32% with the UK and 20% with the US.

• The most prevalent sectors for call-in notices were Military and Dual Use (37%) followed by Defence and Advanced Materials, both at 29%.
• 11 notifications were withdrawn having been subjected to this further scrutiny, which led to ‘final notifications’ being issued to end the assessment period. Unlike final orders, final notifications are not made public.

Interventions made to address national security concerns

• During the reporting period, 15 final orders were imposed: 5 prohibition decisions (i.e. a block or unwinding order) and 10 conditional clearances.
• This gives an overall intervention rate of around 20% of transactions called in and less than 2% of all notifications made or reviewed. Although this is a relatively low intervention rate, it is significantly above the 10 or so interventions anticipated by the Impact Assessment.
• The Secretary of State is required to keep final orders under review and consider requests to vary or revoke them where there has been a material change in circumstances. During the reporting period, one final order was varied and one revoked.

• Of the 15 final orders imposed:

  • Over half had a link to China (with 4 of the 5 prohibition decisions involving China in some way). Transactions involving UK and US investment were also subject to intervention with 4 reported as originating in the UK and 3 in the US (although it is unclear from the statistics whether these transactions also involved a Chinese angle).

  • The most prevalent sectors were Military and Dual Use and Communications (both receiving 4 final orders) and Energy, Defence, Computing Hardware and Advanced Materials (each receiving 3 final orders), although it is important to note there may be some overlap as more than one sector can be relevant for any given transaction.
• On average, the Government took 27-28 working days to decide to call in an acquisition, and 81 working days to issue a final order.
• Interestingly, there were no explicit details on potential sanctions and the status of non-compliance with the regime, although there is a statement that no criminal prosecutions had been “concluded” during the reporting period, which indicates there may be at least one prosecution in train.

Observations on the past year

The Report confirms that the initial entry points to the regime, in broad terms, remain country agnostic, and the ‘origin of investment’ statistics help underline that there is a broad church of investors interacting with the regime. In particular, the highest proportion of investment resulting in mandatory notifications originates in the UK, followed by other G7 allies, roughly in line with the levels of incoming foreign investment over the past year or so from these countries.

However, the most striking statistic is that, despite ranking 7^th on the list of investment origin for notifications made in the Report (and not even featuring in the top 10 for inward investment to the UK, based on June 2023 UK Government figures), Chinese investment accounted for nearly half of all call-in notices and over half of all final orders. There may be a number of reasons for this, including that the specific sectors into which Chinese investments are made are those which are of the most sensitive nature and the perceived risk posed by China. Indeed, Oliver Dowden stated in an interview published concurrently with the Report that “China represents the largest state-based threat to economic security… So it’s not a surprise that we should look carefully at Chinese transactions. But equally, we look across the board”.

Whilst a number of sectors have so far been prominent, there has been a notable focus on the Military and Dual Use and Defence sectors in respect of both call-in notices and final orders, with several final orders relating to the semiconductor industry in particular. Although Critical Suppliers to the Government and Data Infrastructure ranked in the top five sectors for mandatory notifications, neither of these were in the top five sectors for which call-in notices were issued. This may either suggest these were less of a focus for the ISU during the reporting period, or otherwise that the sector definitions are broadly construed and somewhat vague in practice, resulting in potentially unnecessary notifications being made.

Overall, the pragmatic and flexible approach which the UK Government has taken to its investment screening decisions under the Act has been welcomed, as the ISU has imposed a creative range of structural and behavioural remedies on transactions where possible, rather than simply blocking them, and this has facilitated the clearance with conditions of 10 of the 15 transactions in which final orders were imposed.

Whilst the nature of the national security issues being looked at by the ISU, and certain gaps in issued guidance have led to uncertainty regarding review outcomes, Oliver Dowden has made commitments in 2023 towards greater transparency of the regime. A Memorandum of Understanding was reached in April this year setting out a procedure for parliamentary scrutiny of the ISU’s processes by the BEIS Committee. Further, the ISU has more recently held roundtables with businesses and other stakeholders, including Hogan Lovells, to discuss and understand concerns and provide clarity on what to expect from the notification and review process. The ISU has also recently updated its Market Guidance to provide more detail on certain aspects of the notification procedure.

Finally, while the pace of final orders being issued under the regime picked up markedly in the latter half of 2022 (with 14 of the 15 final orders being issued in the second half of 2022), we saw a sharp fall in the level of enforcement activity in the first half of 2023. Only one final order was issued in the first quarter (a conditional clearance of an acquisition of a UK engineering company by a US private equity firm, on which a commitment was imposed to maintain continuity of supply to the Ministry of Defence) and one in the second quarter, which fell outside of the reporting period (a conditional clearance of a licence acquisition by a Canadian company in relation to assets with potential military capabilities).

Looking forward

The regime is now starting to get into its stride, and businesses and other stakeholders are gaining a better understanding of how it works in practice. However, aspects of the regime are still opaque and its scope remains very broad. Further guidance and clarity on how certain sectors are being interpreted by the ISU in practice – particularly for sectors triggering high numbers of notifications but much lower levels of scrutiny and intervention – would be welcomed. This will help give businesses greater certainty and avoid situations of unnecessary precautionary filings being made, delaying investment into the UK.