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18 July 2023
Authors: Sinziana Ianc, Elisha Kemp, Christoph Barth, Neil Hoolihan
The Court of Justice of the European Union (CJEU) has ruled that Hungary’s decision to block a transaction under its foreign investment screening rules breaches the freedom of establishment, and that Member States cannot always – without sufficient justification – restrict investments by an EU company on the grounds that it is controlled by a non-EU entity.
It does not come as a surprise that Hungary’s broad foreign investment screening rules have been found yet again to conflict with EU law. However, this is the first time the EU’s top court has considered the scope of the EU’s FDI Screening Regulation and has been explicit in reminding Member States of the high burden placed on them where the freedom of establishment granted by EU law is at issue. This judgment is therefore likely to have an impact on other Member States with similar foreign investment screening rules, as well as on how the EU’s FDI Screening Regulation is applied by Member States going forward.
Xella Magyarország (Xella) is a Hungarian company with a German direct parent company and a Luxembourg “grandparent” company which in turn is owned by a company based in Bermuda. Xella is ultimately owned by an Irish national. The Hungarian government blocked Xella from acquiring quarry owner Janes és Társa (also a Hungarian company). The foreign investment veto was based on the reasoning that allowing a company with indirect Bermudan ownership to take control of a company active in the extraction of construction aggregates – sand, gravel, and clay – would pose a longer term risk to the security of supply of raw materials at local level in Hungary.
Xella challenged the veto in the Budapest High Court, relying on its freedom of establishment in the EU and pointing out that it is ultimately owned by an Irish national. The Budapest High Court referred questions on the compatibility of Hungarian law with the EU’s FDI Screening Regulation to the CJEU for a preliminary ruling.
The Court’s Second Chamber found that the company could indeed rely on its EU freedom of establishment and that such freedom had been unjustifiably restricted by the foreign investment veto.
The Court found, first, that the EU FDI Screening Regulation only allows Member States to enact legislation screening investments by companies “constituted or otherwise organised under the laws of a third country” and not by companies from EU countries. In this respect, the Court agreed with the pleadings of the European Commission but disagreed with Advocate General Ćapeta. In an opinion published earlier this year, the Advocate General had concluded that national legislation can allow for the screening of an EU-based company if a third country has “effective participation” in the management or control of that company.
According to the Court, Hungary had not acted within the scope of the FDI Screening Regulation, as it was screening investments by companies established in the EU. The Second Chamber then explained that, in line with an earlier Grand Chamber judgment, the status as an EU company is based on the location of the registered office and the legal order under which the company is incorporated, and not on the nationality of its shareholders.
According to the Court, the Hungary-based Xella-entity was therefore to be considered an EU company, able to rely on its freedom of establishment. This finding is remarkable in itself, since Xella is a Hungarian company already established in Hungary and the EU fundamental freedoms do not apply in purely national contexts. In this respect, the Court had noted, however, that the situation at hand was not purely internal, given the “cross-border ownership structure” of Xella.
Second, the Court found that Xella was “seriously” restricted in its freedom of establishment because the security of supply to the construction sector (namely, extracting gravel, sand and clay), “in particular at [the] local level”, does not constitute a “fundamental interest of society” capable of justifying a restriction (unlike ensuring the supply of petroleum, telecoms and energy).
The Court of Justice ruled that the freedom of establishment must be interpreted as “precluding a foreign investment mechanism” that prohibits investment by a company from an EU Member State (even where a non-EU entity exercises decisive influence) on the grounds of national interest concerns relating to the security of supply in the construction sector at the local level. This ruling is fairly specific and aimed at providing guidance to the Budapest High Court on the validity of the specific foreign investment veto.
However, the CJEU spends a considerable portion of the judgment discussing the scope of the EU FDI Screening Regulation more generally, and ultimately finds that its scope is “limited to investments in the European Union made by undertakings constituted or otherwise organised under the laws of a third country” – and that this does not extend to EU companies with foreign ownership.
This means in essence that – going forward – the scope of the EU FDI Screening Regulation is clearly limited to direct investments by investors from third countries, including where such investments are made through e.g. pure acquisition structures which do not engage in business activities. Consequently, investments that are made by e.g. an EU-based portfolio company of a private equity investor or even by EU-based companies controlled by a Chinese investor, are no longer in scope of the EU FDI Screening Regulation provided that the EU-based companies have a stand-alone business, and that the transaction structure has not been chosen as a means of “circumvention” – a concept that has been applied rather narrowly but may now grow in relevance when assessing FI cases. While this approach is generally clear from the recitals of the EU FDI Screening Regulation, most EU Member State regulators have disregarded this restriction to “direct” (as opposed to “indirect”) foreign investment in the past few years.
The judgment could have wider-reaching implications for any other FDI regimes which seek to curtail investment by EU companies controlled by non-EU entities – potentially reducing their scope of application to sectors which constitute a “fundamental interest to society” within the meaning of the EU case law (and not as freely determined by the Member States) or to “artificial arrangements” which attempt to circumvent the filtering mechanism (as per Article 3(6) of the EU FDI Screening Regulation).
Notably, where Member States screen investments by EU-based (but foreign controlled) companies, the Court reminds Member States of the established and strict requirements stemming from its case law. Member States are generally free to determine the requirements of public law and public security which can constitute a justification to restrictions of the freedom of establishment. However, such derogations from an EU fundamental freedom must be interpreted narrowly and are subject to scrutiny by the CJEU. Consequently, a “genuine and sufficiently serious threat to a fundamental interest of society” must be established by the relevant Member State’s laws. Such fundamental interest can be the objective of guaranteeing the security of supply of essential products such as petroleum, telecoms, and energy, but it raises the question whether the broad list of relevant activities stemming from the EU FDI Screening Regulation as well as the catalogues enacted by all relevant EU Member States meet this strict requirement.
The Xella-judgment might well lay the groundwork for the CJEU’s future case law on FDI screening. It remains to be seen if and how the EU Member States and institutions will react to this ruling – particularly whether it will cause them to more clearly explain the substantive concerns behind any adverse decision.
Watch this space…