The EU Foreign Subsidies Regulation: New wide-reaching powers for the European Commission in M&A transactions

Scrutiny of foreign subsidies in Europe

The European Union’s Foreign Subsidies Regulation (FSR) entered into force on 12 January 2023 and creates a regime aimed at combating distortions of competition on the EU internal market caused by foreign subsidies. It imposes mandatory notification and approval requirements for acquisitions of businesses with significant EU operations and large EU public tenders and gives the European Commission (EC) the power to launch ex officio investigations. Since 12 October 2023, the notification obligations are fully applicable.

Companies that are active in the EU (or plan to invest in the EU or participate in EU public tenders) and that have received “financial contributions” from non-EU countries need to put in place systems for gathering the information required for FSR. Some companies also need to consider how to manage cost allocation, transfer pricing and governance issues, and prepare explanations as to why foreign financial contributions (FFCs) that are subsidies are unlikely to distort competition in the EU. As the FFC concept is very broad and all such benefits received from an ex-EU State are caught, collecting and preparing FSR filings is time consuming. To avoid delaying transactions, any company potentially active in larger M&A transactions having an effect in Europe should start their preparation well before it expects to be signing any deal.

By early December 2023, the EC had already entered into pre-notification discussions for 38 concentrations - significantly more than anticipated - with eight notified and four approved. The EC’s reviews to date have focused on ownership and governance structures, direct financing of concentrations, and links between limited partners in private equity funds and foreign states. 

What are foreign financial contributions?

The FSR covers any form of direct or indirect contribution from non-EU governments or public or private entity attributable to a third country. Such a contribution may be distortive where it confers a benefit not normally available to a company in the EU, and that benefit is specific to one or more companies or industries as opposed to all companies.

The FFC concept is extremely broad, including direct grants, interest-free or low-interest loans, tax incentives (such as exemptions/reductions), state-funded R&D, government contracts (regardless of size, whether they qualify as “subsidies” or whether they have any connection to the EU), and grants of special or exclusive rights without adequate remuneration.

The EC’s investigative tools

Mandatory pre-notification for M&A transactions

Companies engaging in M&A activity that triggers the following thresholds are required to submit a Form FS-CO and await EC approval:

1. Turnover threshold
   The turnover of the target (in case of acquisitions), the JV (for creation of a JV), or one of the parties (for mergers) in the EU was at least €500 million in the last financial year; and
2. Financial contribution threshold
   The undertakings concerned (the acquirer and the target, the merging entities, or the JV and its parents) were granted, by non-EU governments or State-owned entities, “financial contributions” of more than €50 million in the three years prior to the conclusion of the agreement, the announcement of the public bid or the acquisition of a controlling interest.

An FFC has to be notified only if (i) the amount of the specific contribution equals or exceeds €1 million and (ii) it belongs to one of the categories of foreign subsidies considered to be most likely to be distortive (i.e., rescue and restructuring subsidies, unlimited State guarantees, certain types of export financing or subsidies directly facilitating a concentration).

FFCs that do not fall into these categories, only need to be reported in an aggregated summary table. Only those third countries where the estimated aggregate amount of all financial contributions granted in the three years prior to the triggering transaction is at least €45 million need to be reported.

The IR provides a list of FFCs that do not need to be included in the summary table (and which do not count towards the €45 million total), including, for example, contributions below €1 million, contracts for goods and services concluded on market terms (except financial services), and certain general tax measures. Despite these exceptions, the burden on notifying companies is material. Companies must, for instance, still go through the potentially complex process of determining whether counterparties are attributable to third-country governments.

The FSR notification process and timetable are similar to the EU Merger Regulation process, with an initial 25 working day review period followed by an in-depth 90 working day review period (with a possible extension by 15 working days if commitments are offered) from the date of formal notification. Notifiable transactions must be approved by the EC before they can close, creating a standstill obligation.

As a result, companies contemplating M&A transactions may need to obtain FSR clearance alongside merger control and foreign direct investment approvals.

Other Investigations

The EC can also conduct ex officio investigations into potentially distortive foreign subsidies. Its extensive ex officio powers permit it to investigate support granted by third countries to companies up to 10 years prior to the investigation (but not more than five years prior to the application of the FSR).

The EC can also request an ad hoc notification of transactions that do not meet the thresholds, if it suspects that the companies concerned were granted foreign subsidies in the three years prior to the transaction.

The EC’s enforcement powers

If a company breaches the standstill obligation by closing without clearance (or failing to notify), the EC may impose a fine of up to 10% of aggregate turnover in the preceding financial year. The EC also has powers to impose fines of up to 1% of global turnover and periodic penalty payments of up to 5% of the average daily aggregate turnover for each working day of delay, if companies supply incorrect, incomplete or misleading information.

The EC has the discretion to impose a wide range of remedies to address distortive subsidies, including (i) a commitment / redressive measure decision; or (ii) a decision prohibiting a concentration. Redressive measures and commitments can be structural (for example, requiring a company to unwind an acquisition, divest assets or reduce capacity or market presence), or behavioural (such as requiring a company to offer access to or licence infrastructure on FRAND conditions, publicise R&D results, repay foreign subsidies with interest or adapt governance structures).

Impact on M&A transaction

Given the standstill obligation for notifiable transactions, M&A transaction documentation (including share or asset purchase or similar agreements) will need to include a condition precedent for the FSR notification and approval, alongside information and cooperation requirements, and provisions dealing with potential remedies and other risk allocation issues.

Because an FSR review will consider FFCs that are not specifically connected to the transaction that has triggered the review, the EC may conclude that remedies required differ from the remedies that might be necessary to address lessening of competition resulting from the transaction itself. Consequently, parties may need to consider requirements in the SPA for offering and/or accepting remedies as part of the FSR review that differ from those relating to the merger control review. So-called “hell or high water” clauses that are often introduced by sellers in controlled auctions to increase deal certainty (a purchaser will need to accept any remedies that may be required to get clearance from the relevant authorities) will have to be considered by purchasers in the context of the potential for broader remedies (for example requirements to repay distortive loans or to dispose of assets acquired before the transaction at hand).

M&A transactions that are subject to the FSR notification requirement are highly likely to also require merger control and potentially foreign direct investment approvals. However, although the formal timelines for FSR clearance are similar to those of the EU Merger Regulation, parties cannot count on these processes to fully run in parallel. The focus of the EC in pre-notification will be different, such that the formal “clocks” will potentially start to run at different times, resulting in different timelines for the formal reviews. Parties will need to factor this into deal timing.

As the FSR creates an additional layer of uncertainty as to whether a deal can ultimately be completed (whether conditionally or unconditionally), parties should also consider the FSR in the context of potential break fees.

Apart from the impact of the FSR on the transaction itself, the FSR will need to be part of due diligence on, and representations & warranties and disclosure schedules relating to, the target (covering information recording systems and compliance with the FSR), not least to enable potential acquirers to understand the risk of remedies relating to FFCs already received by the target that might be found to be distortive subsidies. 

Practical considerations

Companies need to implement systems for the collection of group-wide information relating to relevant contracts, grants of exclusive rights, tax incentives on a global basis. Given that information going back three calendar years is required, this process will take time, making it inadvisable to wait until considering a notifiable transaction.

The design of such systems should minimize the burden on business, legal and compliance teams, including by leveraging existing contract management systems, grant tracking and other financial systems. One approach is to develop a system that automatically pulls in relevant information already available in existing systems to populate a template that is sent (partially populated) to relevant business, financial and legal teams for completion. This could be done by developing queries for existing databases and populating a new database with data from relevant sources.

It may also be efficient to collect information beyond the minimum needed to identify and quantify a potential FFC, to reduce the risk of significant follow-up requests. For example, a contract generating revenues likely to be an FFC would be unlikely to be a foreign subsidy if it was awarded through a competitive, transparent and non-discriminatory tender. Noting that award process in the template would reduce the need for follow up.

Together with our legal-tech team we have developed a solution to streamline information collection in a manner that minimises the burden.

In addition to gathering the data described above, it is advisable to determine whether FFCs were received on market conditions and at arms’ length, and to develop the evidence and argumentation to demonstrate that they could not be distorting the internal market.