Five Key Points on FDI Screening in the EU Defence Sector

By James Marshall, Laurie-Anne Grelier and Romain Girard 

The war in Ukraine, and other recent geopolitical conflicts, have underscored the need for EU-based defence capabilities to scale up to face these challenges.  Several EU initiatives which have sought to stimulate investment are starting to bear fruit, as the European Defence Agency recently reported record high defence spendings in the EU (€350bn for 2024, a 19% increase to 2023). Political support for the sector has been demonstrated by Commission President Von Der Leyen proclaiming “a new era for European Defence and Security” in her latest State of the European Union address.

In this context, understanding the regulatory framework applicable to investments in the EU defence sector is proving increasingly important. Foreign direct investment (“FDI”) screening regimes represent one of the most important regulatory checks to clear for investors.

This blog post reviews five key points for investors to consider when making investments in the defence sector, given the current geopolitical context.

I. Stricter jurisdictional triggers

Many EU Member States’ FDI regimes have specific, and generally stricter, rules for the defence sector. There are three features which contrast with the general rules applicable to other sectors:

• More investors caught: Specifically, non-domestic investors (and sometimes even domestic investors) are more likely to be caught by the FDI regimes. Germany’s FDI regime, for example, extends its screening to non-German investors where the target is active in the defence sectors, whereas its FDI rules relevant to all other sectors only cover investments by non-EU investors.
• More investments caught: Low shareholdings (typically 10%, or even less as low as 3% in Italy) and indirect investments in defence-sector targets (e.g. of a non-domestic entity with a domestic subsidiary) are more likely to be in scope. For example, Hungary triggers on indirect investments of at least 10% in the defence sector (whereas it otherwise typically applies only to direct investments).
• Separate reviewing authority: Investors in defence targets may have to make a separate (and sometimes additional) filing with the Ministry of Defence specifically (e.g. in Spain), as opposed to the Ministry of Economy for the general regime.

II. Unequal jurisdictional triggers

Whilst there are some relatively clear-cut lines to determine what characterizes a defence activity that falls within scope of an FDI regime (e.g. Tier 1 OEMs manufacturing military equipment), the assessment can become a lot more complex depending on how far up the supply chain a target is located. In turn, this is important because not all EU FDI regimes define “defence” the same way, which results in uneven jurisdictional triggers:

• Sensitive contracts: Some regimes require the target to have contracts with sensitive customers (e.g. military customers or Tier 1 OEMs) and go further and require the contracting party to be a local entity of the target (e.g. France).
• Sensitive supplies: Some regimes capture suppliers of goods on the EU’s common military and/or dual-use lists, regardless of the contractual position or whether the goods are in fact used for military/defence applications (e.g. Spain). To further complicate the matter, EU Member States’ FDI regimes diverge on which “list” they use as a reference point: the older EU regulation of dual-use products (e.g. France), the newer EU regulation (e.g. Ireland), or a mixture of EU regulation and their own domestic regulation (e.g. Germany).
• Sensitive activities: Some regimes capture only specific activities taking place locally (typically manufacturing, research, and development activities) (e.g. Germany or France), while others will capture any “activity” (which can be read to include export supplies into the country) (e.g. Belgium or Italy). Not all regimes define what “activities” are considered to be sensitive, which (given the often-sparse guidance to the contrary) can lead to a counterintuitive interpretation that non-sensitive products or services (e.g. janitorial/catering services to (e.g.) Tier 1 OEMs) are “sensitive activities” for FDI purposes.
• Sensitive access: Some regimes will capture targets with access to sensitive facilities (e.g. military installation) or their IT infrastructure, regardless of the products or services supplied (e.g. Germany). Similarly, having certain security clearances can suffice to automatically trigger a regime (e.g. Norway).

Consequently, investors must tailor their due diligence to both the target’s local presence in a given jurisdiction, but also potentially its customer base.

III. Impact of target activities on substantive review

The substantive considerations will vary depending on the scale of the target and its importance to the national defence of their home EU Member State. This bears out in three particular areas:

• Security of supply: Generally, arguments that a transaction does not result in security of supply concerns are easier to evidence for smaller players, provided they are not themselves a sole supplier into a critical project (e.g. with a unique technological input). Conversely, suppliers providing NATO-certified items that can be easily obtained from other NATO suppliers will typically not raise as many issues.
• Maintenance of R&D efforts: Where a target is an established local player, it may have benefited from significant government funding related to sensitive national projects over the years. Investments in these players will therefore more likely involve remedies or commitments surrounding these projects, which could take the form of continued (or even increased) R&D expenditure and guarantees surrounding continuity of the research, potential routine on-site monitoring, etc.
• Domestic strategy on national security: Investors should also diligence whether their target – whilst not currently being a “national champion” – is being positioned to become one by virtue of its innovative technology, and/or the amount of government funding it has received. This could be the case where the technology remains in early-stage development but shows high growth potential, specifically for the defence sector. Authorities may be less willing to unconditionally approve a transaction involving a national champion (or a potential national champion) by their foreign competitors, out of concern that national capabilities will be diminished at the profit of foreign competition.

IV. Impact of investor nexus on substantive review

For the defence sector, FDI authorities will typically be particularly sensitive to the existing capabilities and geographical footprint of the investor. For example:

• Transaction-related exposure to extraneous trade controls restrictions: Authorities will be concerned with whether a non-EU foreign investor acquiring an EU target will expose that EU target to the buyer’s home jurisdiction export controls, which could make it harder for the target to continue to supply its existing customers. For example, the United States International Traffic in Arms Regulations (“ITAR”, part of the US export control regime) can have such an impact on EU targets because they apply globally to a group of companies, including its EU subsidiaries if they exist. Given that the US export control interests are not always aligned with the EU’s, an EU target that becomes subject to ITAR due to a foreign investment could result in key components or technologies becoming subject to a third country’s export control legislation. Managing such interactions and interdependencies with foreign regulations requires carefully balanced mitigation plans.
• Government-mandated information sharing: Authorities will scrutinize whether a foreign investor can be forced by its home jurisdiction to hand over information of its foreign subsidiaries. This could result in a foreign government piercing the corporate veil and gaining access to sensitive technology currently being developed or manufactured in the EU. Screening authorities will seek to understand what physical and virtual barriers are or can be put in place to protect the EU target’s sensitive information. These may involve separate boards, firewalls, or even golden shares to ensure no undue interference takes place.
• Ties or supplies to hostile nations: Authorities will assess whether buyers have problematic or sensitive supplies. For example, if an investor supplies arms to customers or countries that are hostile to the country screening the investment, the screening authority may block the investment owing to perceived negative impact on public security, or at least apply in-depth scrutiny and request more invasive remedies.

V. Reputation and relationships matter

Investors with an established reputation in the jurisdiction where an FDI screening review takes place may face lower scrutiny compared to new or lesser-known investors. This can result in less onerous – or no – remedies being required. Leveraging an investor’s positive reputation requires a careful mix of advocacy and factual evidence. For example where an investor already (i) holds contracts relating to sensitive in-country technology and has a good track record of compliance with the applicable regulations regarding treatment of classified information, (ii) has senior personnel and staff within with similar degree of clearance as the target, or (iii) demonstrates existing capabilities to create and maintain virtual and physical barriers, it would likely prove better positioned for a favourable outcome and getting its investment through.

Conversely, a purely financial investor with no track record in the defence sector and limited exposure to the relevant jurisdiction might face greater scepticism and scrutiny from the reviewing authorities. This could in turn translate into more burdensome commitments to obtain clearance, as well as a longer clearance timeline.

The abovementioned factors become especially relevant when acquisitions are organized through a tender process.

Conclusion: Strategic Actions for Investors

Investors in the EU defence sector can consider the following actions to facilitate the FDI assessment and review of their proposed investments:

1. FDI Regimes as They Apply to Defence Sector Demand Thorough Due Diligence: Delve deeply into the regulatory environment, mapping out defence definitions and jurisdiction-specific challenges, including broader definitions of “foreign investor” and investment types.
2. Evaluate Security of Supply and National Champion Status: Analyse whether your investment involves a national champion or is critical to national security.
3. Assess Investor’s Government Nexus: Investigate how relations with foreign governments might impact your investment, especially regarding export control laws. Consider geopolitical macro dynamics and the potential extraneous political interferences.
4. Leverage Reputation and Relationships: Build trusted relationships and a positive reputation with local authorities.