Fair and Equitable Investment Screening
Author: Dr. Bálint Kovács (University of Szeged)
Introduction
With the widespread adoption of investment screening by Western states, there is increasing evidence as to the ways in which this tool of economic security is implemented. Investment screening accommodates an important exception to open market principles: the national security imperative. The liberalisation of foreign direct investment (“FDI”) flows is now limited by strategic economic security. In this context, foreign investors face an additional reporting obligation, under the framework of national security investment screening.
That investors must be guaranteed certain procedural rights and safeguards in the process of investment screening appears as common sense, indeed essential for the rule of law. But their effective use appears rather sensitive. In this blog I briefly discuss three fundamental procedural safeguards that pose difficult questions of rule of law in the economic security context: the right of access to the file and underlying evidence, the right to be heard during the process, and the broader principle of procedural transparency.
Dealing with matters of security, in the context of investment screening, states have a wide margin of appreciation in determining threats and adopting mitigating measures (see de Kok, 2022, p. 86). Screening procedures have been described as having a ‘black box’ character (see Vranes, 2023, p. 27). The use of classified information certainly limits the extent to which screening decisions can be contested.
The cases that emerged over the past few years have contributed to a better understanding of the administrative law limits of the national security exception, and conversely, to the procedural limits of investors’ rights. Below I present two cases focusing on the mentioned procedural safeguards, and then I turn to their analysis from an international investment law perspective.
I. The Ralls Case
The United States has had much experience with investment screening through the work of the Committee on Foreign Investment in the United States (“CFIUS”). The CFIUS process for reviewing national security implications of FDI – governed by Section 721 of the Defense Production Act, as amended by the Exon-Florio Amendment in 1988 – allowed for very limited judicial scrutiny over blocking decisions. Since then, the institution evolved through further amendments and new case law.
In 2012, Ralls Corporation, an American company owned by two Chinese nationals, senior executives of the Sany Group, acquired four US companies, seeking to establish wind farms in North-Central Oregon. The investor was not obliged to seek CFIUS approval under the rules in force at the time. However, the proximity of the projects to restricted airspace and a bombing zone used by the US Navy, prompted CFIUS to initiate a post-closing review.
It subsequently issued temporary orders that prohibited construction at project sites, restricted access to these sites by Ralls Corporation personnel, and conditioned the sale of the project companies by prior government approval. The CFIUS investigation concluded with a recommendation that the US President take prohibitive action. In September 2012, the US President issued an executive order (“EO”) highlighting that Ralls’s activities constituted a credible threat to US national security, mandating divestment from the project companies within 90 days, and removal of physical structures from project sites within 14 days. Ralls challenged the decision in court.
The grounds for contesting the outcome of the CFIUS review, including the EO, was the alleged violation of the due process clause of the Fifth Amendment to the US Constitution, and equivalent provisions in the Administrative Procedure Act (“APA”). In its defence, the US government invoked 50 U.S.C. §2170, which precludes judicial review of actions and findings of the President having to do with a national security threat posed by a foreign investment. The government also argued that Ralls lacked a constitutionally protected property interest because it had acquired the project companies with the knowledge that the transaction could be subject to federal review and an order to divest.
The DC Circuit Court that heard the case in appeal decided that while 50 U.S.C. §2170 did preclude the substantive review of the US President’s determination that there was a national security threat, it did not preclude the review of the process in which the determination was made (Ralls Corporation v. CFIUS, D.C. Cir., 2014). What is more, the court did not accept the argument that Ralls’s property right interests gained under Oregon state law were contingent due to potential federal deprivation. The court recognised that Ralls had in fact gained fully vested rights that could not be extinguished without due process. This opened the case for determination of which specific procedural rights the foreign investor was entitled to under the US Constitution. The court stated that these were at least the following: “that an affected party be informed of the official action, be given access to the unclassified evidence on which the official actor relied and be afforded an opportunity to rebut that evidence” (Ralls Corporation v. CFIUS, p. 36). The court upheld previous case law based on which access to classified information can be withheld, but also underlined that the unclassified information on which a screening decision relies must be provided notice of and given access to.
Consequently, a CFIUS process must give the affected party an “opportunity to present evidence to CFIUS and to interact with it”, in direct reaction to (or, by tailoring its submission to) the expressed concerns, and to “rebut the factual premises underlying the President’s action” (Ralls Corporation v. CFIUS, p. 37). The court made clear, however, that this did not mean that “the President must, in the future, disclose his thinking on sensitive questions related to national security in reviewing a covered transaction.” What is more, because the President acts through CFIUS, “[a]dequate process at the CFIUS stage (…) would also satisfy the President’s due process obligation” (Ralls Corporation v. CFIUS, p. 38).
The ruling is highly significant as it separates classified information from unclassified information, and provides that the latter must be revealed to the investor so that it may effectively exercise its procedural rights. It underlines the significance of interacting with the particular unclassified information that is relied upon in the screening procedure. The mere opportunity to present information to the reviewing authority, a general right of submission, without the possibility of responding to the particulars of the unclassified information the authority relied upon, is procedurally insufficient. An opportunity must be provided to rebut specific factual premises on which the review decision relies. In effect, this ameliorates the black box character of the review to the extent that unclassified information is relied upon in the CFIUS process. Conversely, such a decision may also prove to be an incentive on the side of the state for the use of more classified information further limiting disclosure.
Under the fair and equitable treatment (“FET”) standard, arbitrary conduct by governmental agencies is prohibited, and fairness in administrative and judicial proceedings must be ensured. This is principally interpreted in a procedural sense. The withholding of evidence, or failing to properly hear a case, may constitute violations. Evidently, violations need to be measured to the wide margin of appreciation screening mechanisms afford the state, especially in light of the classified information utilised in these processes. The Ralls case is a seminal example of the conflict between national security interests and procedural due process, and how the state may be in violation of investors’ rights. The case underscores the importance of giving access to information during screening proceedings allowing for a tailored rebuttal of facts, while preserving the classified nature of national security information. Without the opportunity to respond to the evidence, the court found Ralls’s due process rights were violated.
In international investment law there is a high threshold for proving denial of justice as a violation of the FET standard. However, a case similar to Ralls would make for an argument that would be difficult to ignore (see Manchester Securities v. Poland, para. 498). If the state relies completely on classified intelligence, the entire screening process may become unreviewable, making the effectiveness of judicial scrutiny questionable under international legal standards. In such cases, proving that there is malicious overclassification may also prove a viable avenue of redress.
II. The Toshiba Case
The 2021 Toshiba case in Japan presents a different set of challenges, where informal state influence comes to the fore. In essence, the Japanese screening authority was used as a tool for informal pressure and in order to obstruct the exercise of shareholder rights. It is a case in which the lack of clear procedural boundaries allowed for directed state intervention in corporate governance under the guise of national security and to the detriment of foreign investors.
Japan’s investment screening regime is governed by the Foreign Exchange and Foreign Trade Act (“FEFTA”), which was significantly amended in 2017 and 2019 to address rising concerns about the leakage of sensitive technologies and the protection of critical infrastructure. The 2019 amendments were particularly impactful, lowering the threshold for mandatory prior notification of stock acquisitions in core sectors – such as telecommunications, semiconductors, nuclear power, aerospace, and weapons – from 10% to just 1%. The amendments also introduced requirements for foreign investors to submit prior notification for certain shareholder activities, such as voting for the appointment of themselves or their associates as directors, or tabling important business proposals (see Ishikawa, 2020, p. 83). In effect, this meant that the authorities exercising powers under the FEFTA – the Ministry of Economy, Trade and Industry (“METI”) and the Ministry of Finance (“MOF”) – gained broad supervision powers of foreign shareholder behaviour within Japanese public companies.
In the 2010s, the management of Toshiba, an electronics company, made a number of risky decisions which prompted several crises at the company level (see also Aronson, 2022, pp. 91-119, for an excellent review of the details of the various difficulties Toshiba faced at that time). The solution for these crises was to issue shares and bring in new investors, which momentarily saved the company. But the new shareholders were less patient with the company’s management, preferring the sale of the company rather than its restructuring (Aronson, 2022, p. 101). Activist shareholders moved to challenge the existing board by appointing five directors. This would have given the foreign activist shareholders a majority. The move ultimately failed, but it is the set of reasons behind its failure that brought much attention to the screening regime in Japan.
The years-long disagreement between the new (foreign) shareholders and Toshiba management culminated in the above-described situation, prompting company management to move to protect its position. For this purpose, management sought the assistance of METI officials to counter the influence of activist shareholders (Aronson, 2022, pp. 109-112). Allegations included METI pressuring large foreign shareholders to vote in favour of management, but also the improper counting of votes (Aronson, 2022, p. 102). These were investigated by an independent committee, which confirmed the allegations, noting that the national security interests of the Japanese government vis-à-vis certain projects of Toshiba had prompted it to collude with Toshiba management to suppress certain votes (Investigation Report, 2021, pp. 68-69; Aronson, 2022, p. 103; the company replied in the Notice Regarding Company’s Response to the Investigation Report, 2021). Despite the Japanese government’s reluctance, the company was ultimately taken private by “a group of Japanese investors led by state-backed Japan Investment Corp (“JIC”) (see Tewari, 2023).
As the Investigation Report into the matter noted, the amendments to the FEFTA sought to protect national security interests (Investigation Report, 2021, p. 109). But the Act was used by the METI as a means to contact Toshiba shareholders to lodge consultations with them individually to ensure compliance with the Act itself. In turn, as the Investigation Report reveals, Toshiba management contacted the METI to obtain its support for influencing shareholders’ votes, effectively „working in unison” for that purpose (Investigation Report, 2021, pp. 134-135). It was revealed that the METI had exerted undue pressure on certain foreign shareholders with the purpose of preventing them from voting against the management’s position. FEFTA investigations were floated offensively, with potential to affect investors’ reputation (Investigation Report, 2021, p. 102). The investigators concluded that the 2020 AGM was “not fairly managed” and that the coordination between Toshiba and METI was aimed at suppressing the legitimate exercise of shareholder rights (Investigation Report, 2021, p. 136). The coordination between Toshiba and METI was done informally, and left affected shareholders without any recourse.
The use by company management of regulatory authorities raises serious questions around management ethics, but also around fairness and transparency for foreign investors. The corporate interest of company management was transfigured into national security interest, severely affecting the rights of shareholders. Such informal collusion resulted in violation of substantive and procedural rights, the remedy for which was transparency. It is clear that the screening process was not used in an impartial way, but to effect a certain kind of protectionism.
In this case the affected investors may argue that the state’s measures were unreasonable or arbitrary, as the state intervened in a matter that should have been resolved at the company level. This may constitute a breach of FET. The state also intervened in a discriminatory manner, as only foreign activist shareholders were subjected to this treatment. Furthermore, the informal manner in which the state chose to conduct its influencing campaign violated the procedural rights of the affected investors. Finally, the state’s intervention to supress voting rights violated the rights of the investors to manage, operate, and benefit from their investment.
III. Scrutiny under International Investment Law
Scholars have previously argued that investor-state dispute settlement may be used as an avenue of redress for investors affected by investment screening. In this context, the discussion on non-precluded measures clauses and the justiciability of national security measures is noteworthy (see Gáspár-Szilágyi, 2024, pp. 195-220). In both of the presented cases it is not the alleged national security interest that was contested, but the way in which it was exercised. Such state involvement constitutes clear political risk that may be compensable under international investment law. Both cases present an ex post use of a screening mechanism. In the Ralls case, the order to unwind the investment may be argued along the lines of expropriation. In the Toshiba case, an argument can be drawn up on discriminatory limitations affecting the rights of foreign investors.
Beyond the details of the above cases, the clash between investment screening and international investment law seems inevitable. International investment agreements (“IIAs”), but also national laws for the promotion of investment, apply the logic of liberalisation of investment flows. Cases such as these two, demonstrate that the use of investment screening may be motivated by economic protectionism, which challenges the very purpose of IIAs.
