National Security and Investment Bill (Second sitting)

Stephen Flynn Excerpts

Committee stage & Committee Debate: 2nd sitting: House of Commons
Tuesday 24th November 2020 Public Bill Committees

[The Chair]

Thank you, Dr Lenihan. There are lots of Members wanting to speak and we have limited time, so I will try to get through some quickly. I will call Stephen Flynn, Mark Garnier, then Stephen Kinnock.

[Stephen Flynn (Aberdeen South) (SNP)]

Thank you for your comprehensive and helpful answers, Dr Lenihan. I would like to divert back to some of the comments that were made about the Bill on Second Reading, particularly relating to definitions, or a lack thereof, in relation to national security. I would welcome your thoughts as to whether the Bill should or should not have a definition.

My second question relates to the scope of the Bill, which you mentioned earlier. In terms of the consultation going on, 17 sectors have been identified. The glaring omission seems to be social media, but I would appreciate your view on whether artificial intelligence would cover off social media to a level that you would be comfortable with.

Dr Lenihan: Those are both really good questions that I hoped would be asked. If national security is that which seeks to maintain the survival of the state and preserve its autonomy of action within the international system, unfortunately that means that you cannot necessarily define national security in law without binding yourself in an inflexible way. What we have seen is that most foreign direct investment regimes of this nature all refer to national security. I do not know of a single one that actually defines it or limits itself to a particular definition. I could be recalling incorrectly but I have looked at over 18 of them and I have never seen a particular definition.

What you do see in regulations is guidance as to how national security risk might be assessed or examples of what could be considered a threat to national security. US guidance is helpful on this, in terms of how they put their regulations together. Some have argued that it is too comprehensive—it is a lot to read and provides the lawyers with a lot to do—but it is useful and has meant that the process of knowing when you might be triggering concerns is easy to navigate. I really do not think that the UK wants to define it in the Bill.

There was a US Government Accountability Office report in 2008 examining the foreign direct investment restrictions in 11 countries at that time. Each was determined to have its own concept of national security but none of them actually defined it. In 2016 the OECD did a similar report after a new resurgence of changes in laws, and it looked at 17 countries including Lithuania, Korea, Mexico and Japan, and they came to the same conclusion. The OECD has quite good guidance in general on this and they have not recommended that their countries define national security risk, but they have recommended regulations to help increase transparency around what could be considered a risk.

Regarding the sectors for mandatory notification, I think that is a very good question and one that it is difficult to grapple with in many ways, because the threat is emerging and changing at the very same time that technology is emerging, changing and interacting with our society in various ways. Various countries have been trying to deal with this. In the US, a final rule was just put out in relation to non-controlling investments and situations where you have certain mandatory notifications. A pilot programme was initiated in 2018 to try to define—as your consultation will, in many ways—the proper sectors using North American industry classification system codes, instead of standard industrial classification codes as the UK regulation does.

Whatever codes you use, though, the US found that they had an incredibly high volume of mandatory notifications and were not necessarily getting to the issue that they wanted to. They have changed that under the final rule, and now mandatory notifications in that classification are going to be defined [Inaudible.] and would come under certain US export control regimes. The idea behind that is that the US is doing a review of export control regimes, which will try to get to what foundational technologies might be of concern. I think that applies to your question about social media.

Social media is of concern because of the data, and data retention, involved in most social media. As I understand it, the sectors in the Bill will be kept under constant review and can be changed and updated as needed. That is important, and it might be worth doing a pilot programme.

[The Chair]

Dr Lenihan, I was trying to squeeze two more questions in, but I think it will probably be just one.

--- Later in debate ---

[Andrew Griffith (Arundel and South Downs) (Con)]

Q It is a pleasure to serve under your chairmanship, Sir Graham.

Thank you for joining us, Mr Leiter. It is invaluable to have a practitioner’s perspective as we make legislation; that is something I would like us to do more often. I wanted to ask about your practitioner experience with respect to two things: first, the inclusion in the Bill of personal criminal sanctions and, secondly, its behavioural impact, from the point of view of attorneys and lawyers advising clients, on the likelihood of notification.

Michael Leiter: Let me answer that with two points. First, there is clearly an educational process when such a new regime comes into place for bankers, attorneys and business people. This regime will take some time for them to understand as well, but I think that the UK, like the US—I have already drawn some distinctions about the risk of reducing investment in both countries—remains overall one of the most attractive places to invest in the world. One of the reasons it is so attractive is that it has a strong rule of law and courts system, and clear legislation. In that regard, those who would come and invest in the UK very much understand the need to comply with these regulations, and criminal and civil penalties.

What we have seen in the United States is an appreciation, even if there was some initial shock at the scope of the review and what might be considered a national security concern, and a very robust understanding that we at the Bar and our clients have developed about the importance of these reviews and compliance with the legal regime that applies. I do not see any likelihood of, or reason for, the same not taking hold in the UK. I find that my clients are quite appreciative of the counsel we give them, whether it is related to the US or a UK foreign investment. Overall, I think that the concern tends be less about personal criminal liability, although such concern undoubtedly inspires some, and more about the ability to continue to have good, strong, open relations with regulators in the country in which business is being done. That is critical.

The second piece I would commend you on, which is much better than the US system, is that the Bill provides for a very full and complete review by your courts. That is quite positive, especially with the change that will have to be implemented by the Government. The fact that there is an ability to turn to the courts for review is central and important. As you may know, that is not nearly equivalent in the United States. The ability to pursue remedies in the courts in the context of CFIUS is actually quite narrow. On behalf of my clients, and for improvement of the system, I am quite jealous of your approach on this front.

[Stephen Flynn]

Q Thank you for your comprehensive answers, Mr Leiter. I am afraid that I have crossed out many of the questions that I had because your answers have been so comprehensive. To go back a couple of steps, you have referenced the structure and understanding of the regulations, and the challenges posed by that, as well as the understandable challenges posed by the creation of a new body to oversee the call-in process. That, understandably, will take time to implement. Do you think that lag and uncertainty might put off investors? On a similar line, in terms of the timeframe for call-in, there is the five-year retrospective, the six months for the Secretary of State to act, and the potential for up to 75 days or more to act. Is any of that likely to put off investors?

Michael Leiter: I will take those in reverse order. You are absolutely right: the timing is often central to much of what goes on in the world of mergers and acquisitions. With respect to the effective five-year look-back with six months of notification, that is not dissimilar to what we have in the United States. It serves a very useful purpose in that it certainly incentivises parties to file voluntarily.

To the extent that one includes a voluntary notification regime, I think that it is very important to have some period of look-back. I do not have a strong view whether that should be four or five years, but I do think that look-back is important in a voluntary regime. Of course, in CFIUS, there is no statute of limitations at all, but in reality, we rarely see CFIUS going back more than one year, at most two or three. Again, I think that if everything were mandatory, this would not be required, because to the extent that one has a voluntary regime, it is perfectly reasonable to give the Government an opportunity to look back. Doing so also provides an important incentive for parties, because they will often calculate the likelihood of the Government coming and knocking on their door one or two years down the line. I think that a general approach makes sense.

With respect to the specific timeline for the reviews, your Bill mirrors not perfectly, but closely, the CFIUS approach. In most cases, that timeline works relatively well, but there are a few exceptions. First, in public company mergers and acquisitions, this is no problem. The period between signing and closing tends to be quite long, so the idea of 75 days is not problematic. Similarly, whenever you have a matter where there is a competition review, which of course encompasses many things—on our side, Antitrust and Hart-Scott-Rodino, and in the UK and EU there are separate regimes—that 75 day-period seems to fit relatively well, provides sufficient time for the Government do their review, and will not be problematic.

The place where I think this is more problematic—I apologise that I cannot recall the Member who asked the question—is in smaller-scale, early-stage venture investments. That is where deals can go signed to close within hours or days, and having that longer period could be quite disruptive. In that sense, to the extent that one is concerned with early-stage technology investment, these timelines can be problematic, and finding a window to get through that quickly is quite important.

Finally, with respect to the timing of implementation and the time that it will take to get up to speed, I think it is important to have this effectively phased. I know I have said this several times, but I think this is a rather seismic shift in the UK’s approach to review of investment. I am not saying it is a bad shift. I think it is a shift that is consistent with the United States and other allies in Europe, and Australia. I think it is going in the right direction, but it is very significant, so having some opportunity to make sure that both the private sector and the public sector are ready for that and understand the rules—that the sectors are defined in a clear way and that parties understand, especially in the realm of having criminal penalties—I think it is particularly important to do that.

I think there are probably ways, to the extent you are worried about a risk during that interim period that things are not being reviewed, of addressing that as well, with the look-back provision, or initially implementing things in a narrower or separate sense, but I would be a bit careful about not having some transition period, which allows, again, both the public and private sectors to adjust to this very significant change.

[Stephen Flynn]

Q Obviously, the consultation in relation to the 17 sectors, which was mentioned earlier by a colleague, is going to run beyond the end of the Bill—perhaps, I imagine, of its being implemented. The Government may well just get it through the House, but were that to happen the consultation would still be ongoing, so, again, I am sorry to try to pin you down on this, but do you think that would create a level of uncertainty that investors simply would not be comfortable with, and that they might well look elsewhere unless the Government were clear about having a system in place that makes things more flexible for business?

I am sorry to flip back again, but on smaller-scale early-stage ventures, we said this could be an issue, and again, I am sorry to pin you down: could it, or will it, be an issue? Where would you lean in that regard? Will we find that investors seek to go elsewhere with this a little bit more, where the timing is a little easier?

Michael Leiter: I think it will be an issue unless you are confident that small-scale, early-stage investors can have their transactions quickly reviewed within roughly 30 to 45 days. If it is longer than that, that will make the investment climate, I think, worse than other competing markets. I think that could have an impact.

On your first point, let’s face it, business always likes predictability, so you always want certainty, but deal makers have to understand risk and understand some uncertainty. That is inherent. I will say, it is not that the US has done this remotely perfectly. The US announced almost two years ago now that it was going to further define foundational and emerging technology that would then be subject to different levels of review under CFIUS. Here we are, almost two years later, and we still do not have that. The fact is that there has been uncertainty, and there will be uncertainty on your side as well. Having those definitions clarified as quickly as possible is good.

Do I think that a lack of clarity for three, four or five months about these sectors will suddenly stop investment in the UK? No. I don’t want to exaggerate it to that degree. You can try to pin me down, but the fact is this is all a matter of balancing, and there is no clear answer about when people will stop or start investing. More clarity is better. The faster there is clarity, the better, and to some extent, a lack of clarity will push people to look at other markets.

[Stephen Kinnock (Aberavon) (Lab)]

Q It is a pleasure to serve under your chairmanship, Sir Graham, and thank you very much, Mr Leiter, for your insightful evidence. I was wondering about the acquirer definitions, which are an important part of the equation, and the extent to which the legal structure and ownership base of the acquirer should play a role and, perhaps, be more clearly defined in the Bill, in terms, also, of what the triggers are for the screening process. If the acquirer is a state-owned enterprise or a state-backed investment vehicle, should that trigger a, for want of a better word, tougher or more robust screening process? If so, what might that look like in practice, and do other regimes contain that differentiation between a private sector acquirer and a state-backed acquirer?

Michael Leiter: Thank you for the question. The answer is that many regimes do draw such a distinction, which is generally a good thing, but there is an exception to that as well. This is important on two points, one of which I have already raised so I will not belabour. Understanding the ownership structure of private equity to understand how the Bill will or will not handle limited partners who are managed by a general partner at a fund is very important. That is a significant amount of investment, and clarity on that point is critical.

In the United States, for example, foreign limited partners in US private equity are fundamentally, overall, not considered for CFIUS. For foreign private equity investing in the United States, foreign limited partners are considered. Again, that is broad brush, but that is fundamentally how it works. With respect to sovereign wealth funds or state-controlled investments, there is a perfectly good argument that yes, the standard of review might be a bit more rigorous. In the United States, the way that works is that if a foreign Government-controlled entity invests in what is known as a TID business—one that that deals with critical technology, critical infrastructure or sensitive data—in the United States, and if they own more than 25% equity, that is a mandatory filing. So, it is increasing the likelihood of a mandatory filing if you are controlled by a partner.

Using such a standard makes sense. Right now, I do not believe the Bill provides many opportunities for that. You are already saying that, in the 17 sectors, all will be mandatory and there is no de minimis threshold. From that perspective, whether you are a sovereign wealth fund or not, it will be mandatory in a large scale of matters. You could of course say, with a dollar threshold such as you have now, that in the voluntary sector, if it was a state-sponsored entity, that would also be mandatory. I think there is some sense to that, but I would move slowly on that because, as I have noted several times, you are going to have a relatively high number of mandatory filings in the first place.

There is a second important piece to this, though, about whether you actually want to change it for Government-controlled entities. That is, especially in the case of China, but other countries as well, the distinction between state controlled and not state controlled is becoming less and less. Again, in some western democracies, it is quite clear whether it is a state-controlled entity, but to the extent a foreign Government can influence a private sector actor, that distinction starts to fade away, at least partially. Under your regime, it is not clear to me, other than expanding some voluntary into mandatory, how that will apply, and I think, to some extent, the distinction is losing some of its fineness.

--- Later in debate ---

[Nadhim Zahawi]

Q Mr Petrie, you will understand better than most that businesses will want to ensure information is being treated sensitively in any transaction. I want to capture your view of the closed material procedure for judicial review under the Bill and what you think of it in terms of that sensitivity of information.

David Petrie: I think a quasi-judicial review is really important and a part of the process, and then, if necessary, there is judicial review. I think the question cuts back to how many times that is likely to happen. We have to step back a little bit and recognise that that would be a situation where the parties to the transaction are challenging the Secretary of State’s decision as to whether or not this is in the interests of national security.

I would assume that if the sellers are British companies, they will probably have received what they feel are adequate assurances that it is okay to sell to an overseas acquirer, but the Secretary of State takes a different view, presumably based on evidence provided by our national security services. Ultimately, if there is a compelling body of evidence to suggest that a transaction should be modified or adjusted or, in extremis, blocked, it would be quite an unreasonable group of shareholders to disagree with that if the if the Secretary of State was applying the test as set out in the Bill, and indeed in the guidance note, that intervention is to be limited only to matters where the national security of this country is at threat.

That is quite different from the national interest. It is tempting—or possible, rather—in this debate to get sucked into questions about what we should and should not be doing in this country. That is not what this is about. The Government have been very clear to the investment community, and to British business more generally, about the purpose of this legislation. That is why, although markets and investors recognise that it will take a certain amount of time and effort to comply with a mandatory regime—the Government have been very clear about their purpose in introducing that—the market is generally favourably disposed towards it. We can see that it is unfortunately necessary in these modern times.

[Stephen Flynn]

Q Thank you, Mr Petrie, for your answers so far. I just have a couple of straightforward points for you to address. We discussed the timeframe in earlier sessions, in relation to the five years of retrospectivity, the six-month call-in and the potential 75 days. Do you have any concerns about the impact that that might have on potential investors into the UK? On a similar note, in terms of the fact that there will potentially be in excess of 1,800 notifications annually, an entirely new body will have to be set up, possibly working across Departments and involving the security agencies. A lot of detail will need to be put behind that, and again, that will take time. Do you think any of that will cause any uncertainty among investors and perhaps lead them to look elsewhere?

David Petrie: Perhaps I could deal with the second part of your question first, if I may, on the potential number of notifications that the new legislation is going to necessitate. The first point I make about that is that this new investment security unit will need to be very well resourced. A thousand notifications a year is four a day; I am just testing it for reasonableness, as accountants are inclined to do. That is quite a lot of inquiries. I note from the paperwork that the budget allocated to the new unit is between £3.7 million and £10.4 million. I do not know and cannot comment yet as to whether that is likely to be adequate. What I can say is that the impact statement also suggests that of those 1,000 or so transactions which are going to be subject to mandatory notification, only 70 to 95—the numbers set out in the impact statement—are likely to be called in for further review by the Secretary of State, where a very detailed analysis of those businesses and the potential target is going to be necessary.

As, I hope, has been echoed by other witnesses, it is going to be extremely important that this new unit can engage in meaningful pre-consultation with market participants—with British companies, finance directors, and investors and their advisers—so that they can get a pretty clear steer at an early stage as to whether or not this is likely to be subject to further review. If the unit operates in a way where it can give unequivocal guidance to market participants at an early stage and is open to dialogue—I understand from discussions with the Minister that this is the way the unit is being asked to operate—that would be extremely helpful.

I would say that that is about process, certainly, but I think it is also about culture. It has to be a balance, which is well achieved by the Takeover Panel, for example, in this country. You do not tend to approach the Takeover Panel unless you are well-informed and have done your homework—"Don’t bother us with stuff you ought to know” is the unwritten rule. But at the right time and place, I think it is important that there is an opportunity for market participants to be able to engage in a dialogue. The guideline where we put this “Don’t bother us with stuff you ought to know” question is going to shift. At the moment, we really do not know a lot about the way the Government are going to look at certain transactions. We do know which sectors and operating activities are in scope, but, again, we are not quite sure at what stage it will be right to consult and try and get clear guidance. This process will evolve.

I note that the Bill includes provision for the new unit to issue an annual report as to the number of transactions called in and the sectors they are in. That will be extremely helpful for market participants. An issue here, I think, is potentially asymmetry of information. In order to resolve potential asymmetry of information amongst the investment and advisory community, it would be very helpful that the unit is well resourced and able to engage in meaningful pre-consultation, but, by way of a third recommendation, it would also be extremely useful if it was able to issue meaningful market guidance notes, similar to the notes that accompany the takeover code. That would again be extremely helpful so that we can understand. It would help the market to be better informed. If, for example, the unit is receiving a lot of notifications that are not correctly filled in or with important details as to ownership missing, then it would helpful to have guidance notes as to what we can do to make sure this process works with more certainty, speed, clarity and transparency—these are the things financial markets need to see—to help us with that, beyond what has already been issued, which is very helpful, I have to say. As the market evolves, that would be extremely helpful.

[Mark Garnier]

Q May I follow on from that question about the resources? There is talk about 1,800 companies coming forward and voluntarily disclosing that this transaction is going on, but I am just as interested in what happens with those companies that do not disclose this? I am not for a moment suggesting that there are a huge number of dishonest actors involved in the corporate finance market, but given the fact that the threshold was reduced to £1 million a year under the recent review, there are an awful lot of small businesses with turnover of about £1 million a year that are not very well resourced for their corporate governance functions and that could easily miss the requirement to disclose, should a transaction come through that is enticing for the shareholders, who are presumably offered the same as the directors. Are you confident that the Government have in place sufficient resources to be able to police the whole sector, to make sure that we are not missing out on a number of transactions that are going through? Even if we do, are we getting in there quick enough to make sure that the intellectual damage is not done by the time we have found out what is going on?

David Petrie: That is a very difficult question. We will find out—that is the answer to that. I think businesses working in sectors where there is a real threat to national security know that. They know that they are involved in weapons design or designing software that could have a dual use. In advising companies over the years, I have found that no one knows better than the company directors about the value of their assets and their business, both from a market perspective and to competitors or others seeking to gain access to their technology.

The Bill has been in discussion for some years now, and the advisory community is well aware of its existence and of the Government’s desire to put this legislation on the statute book, so I do not think there will be many corporate finance advisers for whom the Bill emerging last week was a surprise. I am very sympathetic to the points made about small companies falling under the provisions of the Bill, but I hope that it will be possible for them to complete what, in the first instance, is a five-page questionnaire—when completed, it could run to 20 pages or more—at a relatively low cost.

To my earlier point, I hope they are able to engage in formal and meaningful dialogue with the unit at the earliest possible opportunity by saying, “This is what we do, and this is what we are worried about.” They have to say, “We’re concerned about this. These are the people from whom we are hoping to attract investment to take the business to the next stage. How do you feel about our business, and how do you feel about the people we are talking to? How does the Government feel about xyz corporation?” I think that kind of steer would help remove a great deal of uncertainty from the circumstances that you have set out.