Germany further tightens transaction environment for foreign investors
On 19 December 2018, the German government passed an amendment of the German Foreign Trade Regulation (Außenwirtschaftsverordnung, "AWV") expanding the competences of the Federal Ministry for Economic Affairs and Energy (Bundesministerium für Wirtschaft und Energie, "Ministry") to review and potentially prohibit (direct or indirect) investments of Non-EU-investors in German companies. The new AWV entered into force on 29 December 2018 and marks the preliminary end of a vivid public and political debate in Germany. In particular, this debate was triggered by recent successful Sino-German transactions (e.g. Kuka, Daimler) as well as aborted investment plans of Chinese investors (e.g. 50Hertz and Leifeld, cases where the German government decided to intervene in one way or the other). However, the debate also has to be seen in the wider context of the recent strive for protectionism and Chinese investments in Germany having increased considerably over the last five years. Last, but not least, such debate in Germany is fueled by what some people refer to as "German Angst": Germans are not known for being easy going or taking a simple approach to unknown situations.
On this backdrop, the passing of the new, stricter regulations does not come as a surprise. The speed in which the international and German investment environments are being amended without simultaneously providing any of the much-needed transparency is, however, perceived as somewhat unsatisfactory from an investor's point of view. Only a couple of years ago, the German foreign investment framework was little more than an afterthought; such proceedings were only initiated in very specific cases and were no issue at all in the vast majority of international transactions. This situation recently changed, in particular in July 2017 when the ninth regulation to amend the AWV entered into force and, inter alia, brought with it:
- a notification duty for transactions in so-called "critical" business sectors as well as a definition of "critical" businesses;
- extensions of the time periods for an assessment of transactions; and
- an extension of the information obligations for the parties of the transaction (for a brief assessment of the implemented changes please see KWM on "New German Regulation on Foreign Investment Control" (July 2017)).
In addition to the amendments of the applicable legal framework, the factual environment for foreign investments in Germany also noticeably changed in recent years. Whereas in the past the relevant legal provisions existed but were in fact ignored in most transactions, it is by now a clear market practice in the context of Chinese investments to initiate a foreign investment control proceeding wherever doubts remain. Generally, this means applying for a certificate of non-objection (Unbedenklichkeitsbescheinigung) which can be obtained within 2-3 months, sometimes even less, unless the transaction is delayed due to reservations by the Ministry. This trend is also the result of signals provided from the Ministry, that it is willing to look at more transactions than before, inter alia to obtain as much knowledge as possible on foreign investments in Germany (for a more detailed assessment of the developments in the first year after the amendments to the AWV in 2017 please see KWM on "Changes to foreign investment control in Germany?" (August 2018). In numbers, this has resulted in 66 foreign investment control proceedings in 2017 and approximately 80 in 2018 (all significantly up from 41 such proceedings in 2016).
The relevant amendments of the AVW in 2018
Even though the most recent amendments of the AWV were barely 18 months old, the German government, influenced by the press, reached the conclusion that the existing legal framework was not enough to enable the Ministry to review all of the transactions of interest. This resulted in the following key amendments to the AWV:
Lowering of the threshold for investments for specific business sectors
Before 29 December 2018, a uniform threshold requiring a (direct or indirect) acquisition of at least 25 % of the voting rights of a German company applied to all kinds of foreign investments. Any acquisition of voting rights below that threshold was not reviewable. The new AWV now provides for a lower threshold of 10 % of the voting rights for certain transactions which can be defined as "critical" transactions.
The most relevant "critical" transactions are investments in German companies which:
- are active in the armaments and defense business (military business);
- operate a so-called "critical infrastructure" or specifically develop software for the operation of a critical infrastructure; or
- offer cloud-computing services.
In case of a "critical" transaction the (direct or indirect) acquisition of at least 10 % of the voting rights in the German company already triggers the right of the Ministry to review the transaction. For all other (non-critical) transactions, the old threshold of 25 % of voting rights continues to apply. The reason for lowering the relevant threshold to 10 % for certain transactions appears to be that in the opinion of the German government investments change their character from a mere financial/portfolio investment to a strategic investment once a stake of at least 10 % is acquired.
Introduction of new business qualifying as critical infrastructure
The amended AWV further introduced a new business area qualifying as a critical infrastructure. In addition to the business areas energy, water, IT and telecommunication, financial and insurance services, public health, transport and nutrition, any companies active in the sectors of media, tele media, radio broadcasting and print media are now also deemed to operate in a critical infrastructure.
What to make of the amended AWV
As stated above, the key amendment of the AWV, as enacted in December 2018, is the lowering of the threshold to at least 10 % of the voting rights for investments in German companies active in a "critical" business sector. Apart from that, in our view, the assessment of the new AWV is more about what it does not contain rather than what has been changed. The AWV still does not address certain key questions, amongst others:
Is the AWV only applicable to share deals or are other forms of acquisitions of companies also covered (e.g. asset deals or share deals concerning only preferential shares which yield no voting rights – we expect that the Ministry will opt to construe the AWV extensively)?
Does the AWV apply to investments by foreign-owned, locally operative companies, which implement their own investment decisions and where such investment decisions cannot be attributed to the foreign owner?
What are the key elements for the Ministry for its assessment of whether a transaction poses a threat to public security and public order?
Which documentation has to be prepared and provided to the Ministry in connection with a foreign investment control procedure?
Is only the initial acquisition of at least 10 %, respectively 25 %, of the voting rights relevant under the AWV or will subsequent investments exceeding such threshold trigger a (completely) new, additional process?
Is the list of critical infrastructures explicitly set out in the AWV exclusive or can the Ministry determine that other business areas also qualify as critical infrastructure (in our view, the latter is likely to be the case even though the Ministry continues to stress that mere commercial aspects will not be considered for defining critical businesses)?
While remaining ambiguous on these questions, the amendment to the AWV further refrains to take the edge of some provisions which, in our view, provide for particularly onerous burdens for foreign investors. In particular, the new AWV continues to apply to all transactions, regardless of the size and volume of the intended investment. It would have been a welcome clarification if the AWV had exempted small and maybe even some mid-size deals from its scope and the burden of an investment control procedure.
Further, the extraordinary mechanism for the attribution of voting rights from a subsidiary to a parent company remains unchanged. This attribution mechanism sets out that any voting rights owned by a "subsidiary" are fully attributed to a "parent" company. While such a contribution mechanism often exists in connection with parent-subsidiary relationships, the AWV is unique with regard to the fact of what is deemed to be a "subsidiary". While other laws and regulations predominately follow a control-principle, the AWV simply applies the thresholds set out above. As a result, in case of an acquisition of a German company active in a "critical" business, an ownership of a mere 10 % of the voting rights in a subsidiary will cause the voting rights held by such a subsidiary to be fully attributed to the parent company; the relevant threshold is 25 % in case of an acquisition of a non-critical business. In case the investment structure consists of a chain of companies (e.g. the investment structure provides for several subsidiaries in various jurisdictions to provide a tax efficient investment structure), the 10 % threshold (or respectively the 25 % threshold) will apply with regard to every link of the investment chain. As a consequence, the AWV may potentially result in a full legal attribution of voting rights to a parent company while the actual commercial ownership is diluted. This mechanism is difficult to justify vis-à-vis foreign investors. Further, it establishes onerous obligations for foreign investors even after their initial investment has been implemented, as any changes in the ownership structure post transaction which concerns a stake of 10 %, respectively 25 %, of the voting rights may potentially result in an indirect acquisition of a German company which triggers the applicability of the AWV. This establishes high demands for the monitoring of transactions by foreign investors in case the ownership structure does not remain completely stable; this also covers intra-group restructurings post transaction.
As a result, while the recent changes to the AVW serve to implement the (politically) desired effects, the new AWV from a legal and practical perspective misses the opportunity to provide for a transparent and coherent legal framework which can be easily applied to foreign investments. Consequently, the opaqueness of the entire proceedings remain – perhaps willingly – unchanged. This causes uncertainty and thus provides a very challenging investment climate for foreign investors in Germany, who may be subject to material disadvantages when compared to their European competitors, e.g. in case of an auction process. In particular, prudent investors looking for the highest level of transaction security will be likely to apply the 10 % threshold to many of their investment plans.
While it can be expected that the German government or the Ministry will pass certain Level-2 acts, potentially within the first half-year of 2019, which may provide some further clarification, it remains to be seen how helpful these additional regulations will be. Based on our recent experience in a number of proceedings and clearances under the AWV and the fact that the Ministry co-ordinates its investigation with other ministries and the intelligence services, we would not expect that these Level-2 acts will provide comprehensive transparency. Clarity may, however, be obtained for standard transactions in uncritical business sectors.
Was that it?
The two recent changes to the domestic German law will, in all likelihood, not mark the end of the changes to the local foreign investment environment. While the German government has been assessing and adapting its local law, the European Commission has also been contemplating to pass legislation for foreign investments in the European Union. In this context, a proposal for a European Directive for foreign investment control proceedings was published by the European Commission in September 2017 (COM 2017/0224) and at the end of 2018, a principal agreement on this proposal was reached. Current expectations are, that a European Directive will be passed in the spring of 2019 and that the member states will become obliged to adapt their local laws until the end of 2020. While the European proposal published in September 2017 primarily serves the purpose of collecting information and to increase transparency for foreign investments within the EU, it also considers a wider scope of transactions as critical (e.g. covering not only critical infrastructures but also critical technologies, companies responsible for securing the public with basic supplies, companies having access to or controlling sensitive information/data as well as transactions which are controlled or financed by state institutions). Thus, it can be expected that the AWV will soon be amended and extended yet again.
These further requirements will need to be taken into account when structuring a foreign investment in Germany in the future. The fact that the AWV was not already amended in all respects in line with these proposals is, potentially, down to the fact that such a comprehensive restriction of the free movement of capital in the European Union was deemed to require a European initiative and not individual actions of the member states.
Our view and outlook for foreign investments in Germany
The environment for foreign investments in Germany has just become a little more challenging and – to the detriment of foreign investors – still lacks a sufficient level of transparency. While the overall purpose of the AWV is understandable in the current political climate, the applicable constitutional principles in Germany generally require that any law passed only provides for the limitations and burdens which are required and appropriate to reach its purpose. With this in mind, the new AWV could well have provided for some much-needed clarity and exemptions, e.g. for the benefit of smaller investments. The resulting uncertainty relating to the regulatory framework will likely reduce foreign investors' appetites for investments. This effect stands in stark contrast to the Chinese-German bilateral agreement on the Encouragement and Reciprocal Protection of Investment which was entered into on 1 December 2003 in order to encourage and protect the foreign investments of their respective citizens in the other country.
In spite of the above, foreign investors may take some comfort in the fact that even under the new legal regime the vast majority of foreign investments by Chinese investors are still feasible and that – as of today – the Ministry has yet to prohibit any transaction based on the AWV, a fact that the Ministry and the German government continue to stress in connection with the claim, that Germany remains a liberal country which welcomes foreign investments to the furthest extent possible. However, it is also becoming clearer and clearer that the German government is willing to intervene in the free market to protect key industries and – if the European Directive is passed as planned – any foreign investment may not only be screened with regard to local interests but also with regard to the interests of other member states and of the European Union.
Therefore, a prudent and timely analysis of the foreign investment control situation should form an integral part of any plans to acquire a German company. Additionally, foreign investors have to accept that they face an additional procedural layer which they should discuss with a potential seller in due time in order to be able to keep their offers competitive. Recent developments will likely mean that sellers will increasingly ask for appropriate protection from the risks which are related to the potential failure of the foreign investment control procedure, mostly in form of long stop dates and indemnification claims/penalty payments.
Furthermore, the approval of investments, which affect a critical business, may potentially only be granted following additional negotiations with the Ministry. Such negotiations may result in a public law contract entered into by the parties of the transaction as well as the Ministry. Such public law contracts can potentially contain certain additional undertakings of the investor with regard to the target company, restrict certain future activities, grant authorities certain inspection rights or set out guidelines for the administration of shareholder rights. In order to secure compliance with these provisions the public law contract may further set out penalty payment obligations or comparable legal consequences.
While at first glance burdensome and, again, potentially having a discouraging effect, essentially these are procedural items which should remain manageable. Therefore, we continue to believe that a prudent preparation of a transaction and a clear and concise communication plan vis-à-vis the sellers and the Ministry will enable foreign investors to implement the clear majority of their investment plans as intended and within an acceptable time period. The investors should, in particular, also seek to use the process to describe the positive impacts of the transaction, e.g. provide a clear and realistic business plan setting out a sustainable growth of the target in Germany and/or the retainment or expansion of the local work-force, as this will shed a positive light on the transaction. In addition, the communication strategy should be aligned with the seller/target in due time and as much documentation for the foreign investment control process as possible should be prepared before signing of the transaction so that the process can be initiated immediately after (or in certain cases even shortly before) signing.
With regard to the preparation of this process, we currently still recommend focusing on the items that we addressed in our article in August 2018 KWM on "Changes to foreign investment control in Germany?", at least until the Ministry has issued the Level-2 acts to specify its documentation requirements. However, it can be expected that the Ministry will continue to ask further questions tailor-made for each specific transaction in excess to such Level-2 acts, so that utilizing experience from past deals will prove to be a key factor to enable a quick and smooth process.
The authors are based in KWM's Frankfurt office and regularly handle Sino-German transactions, including – beyond M&A, tax and financing aspects, dealing with German foreign investment control items as well as CFIUS aspects of Sino-German transactions. King & Wood Mallesons is dealing with foreign investment control all over the world, for a brief assessment on the UK development see the KWM analysis "UK Merger Control: national security controls on foreign investment continue to widen" (July 2018).