In the aftermath of the Hungarian veto of the VIG/AEGON deal and the EU Commission’s decision finding a violation of its exclusive competence to assess concentrations meeting the thresholds of the Merger Regulation (EC) No 139/2004 (“EUMR”) (see our previous blog), the decision of the European Court of Justice (“ECJ”) in the Xella Magyarország case (C-106/22) brings further guidance on the application of national foreign direct investment (“FDI”) screening rules. The ECJ has found that Hungary’s veto of Xella Magyarország's acquisition of domestic quarry owner Janes és Társa constituted an illegal restriction of the freedom of establishment.

In short, the ECJ has ruled that not every indirect acquisition by non-EU investors falls into the scope of Regulation (EU) 2019/452 (“EU FDI Screening Regulation”). Unless a case involves an abusive approach or structures that circumvent the law, the ECJ interprets the term “foreign investor” within the meaning of the EU FDI Screening Regulation narrowly. Member States may not use FDI screening rules against EU investors simply because a non-EU company within their ownership chain holds a majority stake or otherwise controls them.

The only standard for the assessment of the Hungarian prohibition at issue was therefore the freedom of establishment guaranteed by the EU Treaties. According to the decision, the applicable Hungarian FDI regulations could not meet this standard, as the supply of gravel, sand and clay to the construction sector at the regional level did not affect any “fundamental interest of society”. In a rare deviation from the opinion of the Advocate General (“AG”) , the ECJ has applied a relatively strict standard and set boundaries against protectionist ambitions of Member States towards EU investors.

Background

Although the EU FDI Screening Regulation provides a framework for domestic FDI screening regimes and enhances EU-wide coordination and cooperation, there is no “one-stop shop” mechanism that would allow for a centralised decision. The screening of FDI is allowed on the grounds of public security or public order. These concepts are not new and are recognized in primary and secondary legislation:

• Art. 52(1) TFEU allows Member States to adopt restrictive measures regarding freedom of establishment, “on grounds of public policy or public security”. The same grounds are envisaged as possible justifications for a restriction of the free movement of capital contained in Art. 65(1)(b) TFEU.
• In addition, Art. 346 TFEU stipulates that Member states may take measures deemed necessary for the protection of the essential interests of national security which are connected with the production of or trade in arms, munitions and war material.
• Art. 4 of the EU FDI Screening Regulation provides for an open-ended list of factors which Member States may take into consideration when considering whether a foreign capital transaction is likely to threaten “public security” or “public order”.
• “Public security” also plays a role under the EUMR, which comes into play provided that the thresholds for filings under EU merger control rules are met. Under the EUMR, Member States are entitled to take measures to protect “legitimate interests of public security, media plurality and prudential rules or another public interest”.

Member States may use different criteria in assessing whether their actions fall into any of these categories. A vivid example of the ambiguity of public policy or public security considerations under EU rules is that public security reasons, such as securing the supply of energy, raw materials and food, are legitimate under the recently adopted EU FDI Screening Regulation (see our previous blog and update), but not under the EUMR. While EU and national regulators interpret the terms in different ways, this question has brought a lot of uncertainty to investors, together with unforeseen delays in their transactions. This has been illustrated by a series of Hungarian FDI vetoes.

The Hungarian FDI saga

Hungary currently has a double FDI screening mechanism, although the scope of the two regimes is slightly different, they both apply to EU investors without any link to third countries. This gives an extensive opportunity to Hungarian authorities to review and block transactions, which, in the case of genuine EU investors, clearly infringes fundamental principles of EU law.

A previous veto concerned the blocking of the VIG/AEGON deal (an acquisition of AEGON’s Hungarian subsidiaries by VIG, an EU investor, a company listed on the Vienna Stock Exchange) on the basis of insurance activities being included in the catalogue of activities deemed sensitive to national security. Although the veto was eventually lifted (see our previous blog), the question of what would be a legitimate reasons to block a deal is still pervasive.

The Xella Magyarország case is yet another Hungarian FDI veto underlying the increasing risks of FDI screening mechanisms undermining – or even tearing apart – M&A deals. This time, the Hungarian government prohibited the acquisition of Janes és Társa, a Hungarian company that owns a quarry, by Xella Magyarország, another Hungarian company with indirect Bermudan ownership, but ultimately owned by an Irish national. The Hungarian government considered the indirect presence of a non-EU shareholding in a domestic company active in the extraction of raw materials a threat to national security. However, in a preliminary ruling, the ECJ held that FDI screening rules cannot be used simply because a company registered in a third country exercises control over an EU investor.

Significance of the case

Both the ECJ judgment and the underlying opinion of the AG complement long-standing case law in the area of fundamental freedoms and provide further guidance on the concepts of “public order” and “public security” for prohibiting a deal under national FDI screening rules: Subjecting the acquisition of EU companies by third country investors to FDI screening is in itself already an obstacle to the exercise of the four freedoms of the internal market. National FDI screening mechanisms should be scrutinised under the Treaty rules of the internal market and should be subject to a complete proportionality review.

In general, a threat to public order and security exists when a transaction affects a set of fundamental values and interests of society. These include, in particular, internal and external security, the safeguarding of the functioning and integrity of the State and its institutions and public services, as well as the survival of the population, foreign relations, military interests and the peaceful coexistence of peoples. In addition, Member States may take into account in particular whether the acquirer is directly or indirectly controlled by the government, including other government agencies or armed forces, of a third country, including through its ownership structure or significant financial resources. It should be noted that the ECJ evaluates public security and public order restrictions on a case-by-case basis, taking into account the specific circumstances of the case and the balance between the exercise of fundamental freedoms and the legitimate interests at stake.

In the Xella Magyarország case, the ECJ identified the freedom of establishment as the fundamental freedom applicable and ruled that its restriction cannot be justified by the objective of ensuring the security of supply to the construction sector for basic raw materials, namely gravel, sand and clay, given the justification invoked does not concern a “fundamental interest of society” as is the case with the security of supply to the petroleum, telecom and energy sectors.

Previous ECJ case law

Indeed, justifications relating to the supply of petroleum, energy products and gas, as well as the security of telecommunications are the ones that have been invoked for restricting fundamental freedoms:

• The ECJ has previously held that the objective of guaranteeing the security of supply of such products or services in the event of a crisis, on the territory of a Member State, may constitute a public security reason and, therefore, possibly justify an obstacle to the free movement of capital (C-244/11 and C-463/00). For example, in Commission v. Italy (Golden Share) (C-326/07) the ECJ acknowledged as an effective justification, falling under the express derogations of Art. 65(1), the need to secure the minimum supply of energy resources, as well as the continuity of public service and national defence. Tax-related justifications have been also successfully invoked. Such examples constitute the judgment in A (C-101/5), where the ECJ accepted as a justification the need to guarantee the effectiveness of fiscal supervision, as well as the judgment in Zheng (C-190/17) acknowledging the need to combat money laundering. 
• In the Church of Scientology case (C-54/99), the ECJ made clear that the derogations of Art. 65(1) should be strictly interpreted, so that their scope could not be determined unilaterally by each Member State, without any control by the EU institutions. Strict interpretation meant that ”public security” and ”public order” could be relied on only if there was “a genuine and sufficiently serious threat to a fundamental interest of society”. This was also reiterated in the Xella Magyarország judgment (C-106/22) where the ECJ reminded that the objective linked to security of supply may be relied on only if there is a genuine and sufficiently serious threat to a fundamental interest of society. Mere economic considerations or the desire to protect certain economic operators are not regarded as sufficient justifications. That was held in Commission v. Portugal (C-367/98), where Portugal invoked the need to safeguard national financial interests to justify its golden share rules and the ECJ ruled that general financial interests cannot constitute adequate justification.

In any event according to long-standing case law derogations from the fundamental freedoms are subject to the principle of proportionality.

• Full proportionality entails an assessment in three steps: (i) Each FDI screening decision should be suitable to achieve a legitimate aim, (ii) should not go beyond what is necessary, and (iii) should not disproportionately restrict the applicable fundamental freedom. Executing national authorities are also bound to provide reasons for the adoption of any blocking measures. As the ECJ has found that no objective justification can be invoked in the Xella Magyarország case, conducting a proportionality assessment was not necessary.

• It should be highlighted that the proportionality can be assessed differently in cases involving non-EU countries compared to intra-EU cases. The distinction arises from the fact that the EU’s internal market rules, including the free movement of capital, primarily apply to movements within the EU and the EEA. When assessing restrictions on the free movement of capital within the EU/EEA, the ECJ generally applies the strict three-pronged proportionality test. However, when it comes to third country cases, the ECJ has recognised that Member States have more extensive discretion to impose restrictions based on public order or other legitimate reasons. In these cases, the ECJ applies a more deferential standard of review, taking into account the specific circumstances and the need for the protection of legitimate interests, such as national security, public order, or the prevention of financial crime.
• For example, in Gabalfrisa (C-367/98), a case involving restrictions imposed by Spain on capital movements from other EU Member States to protect the solvency of domestic insurance companies, the ECJ applied a strict proportionality test and ruled that the restrictions were not justified, as they disproportionately hindered the free movement of capital without achieving the intended objective. In contrast, in Eurofood IFSC Ltd (C-384/04), a case concerning an Irish legislation that restricted capital movements with countries outside the EU to combat money laundering and the financing of terrorism, the ECJ acknowledged broader leeway to Member States in terms of imposing restrictions on third countries and held that the restriction was justified.

Key takeaways

Overall, the Xella Magyarország judgment brings good news to investors in terms of prohibiting Member States from using national screening rules against EU-based investors with ultimate parent companies in third countries. The judgment builds on consistent case law on the free movement of capital and is a reminder that even in the field of FDI, Member States cannot overlook principles of EU law.

In the outset, it can be observed that the regulatory landscape in the field of M&A is becoming all the more burdensome for companies. Member States have significantly tightened or even for the first time introduced FDI regimes in recent years. The adoption of the EU FDI Screening Regulation has resulted in the further proliferation and tightening of national FDI screening regimes. At the same time, the Commission has also changed its Art. 22 referral policy under EU competition rules and will potentially review deals that do not meet EUMR or even national thresholds. Following the entry into force of the EU Foreign Subsidies Regulation (“FSR”) on 12 July 2023 (see our blog), companies now also have to identify funds received from third countries. This means that deals may need to be notified for merger control, FDI and FSR.

To stay on top of the latest developments in FDI screening, visit our Global Legal Guide, which provides insight into and comparison of FDI screening regimes in 20+ key jurisdictions in the Americas, Asia-Pacific, and EMEA. A summary of key features plus a detailed Q&A provide a roadmap for navigating the FDI regimes in these jurisdictions.

Authored by Akos Kovach, Stefan Kirwitzke, and Philipp Reckers. Louiza Papadopoulou, a trainee in our Brussels office, contributed to this article.