The introduction of the National Security and Investment Act has had a significant impact on the processing of deals in the UK, in particular, Scottish banking transactions. In this episode, Brodies' banking and finance experts Lindsay Lee and Thomas Horton discuss:
- How and why Scottish banking transactions are impacted by the NSIA;
- How the market has responded;
- Things to be aware of when seeking Government approval; and
- How things could change in the future once the Moveable Transactions (Scotland) Bill comes into force.
More insights from our Banking & Finance team:
- Brodies LLP lawyers discuss the National Security and Investment Act and it's impact on Scottish finances.
- How new Scots law share security will benefit finance transactions in the energy sector
The information in this podcast was correct at the time of recording. The podcast and its content is for general information purposes only and should not be regarded as legal advice. This episode was recorded on 05/07/2023.
David Lee, Podcast host
David Lee hosts Podcasts by Brodies. David is an experienced journalist, writer and broadcaster and he is also the host of 'The Case Files' and 'What do I do if...' Podcasts by Brodies.
00:00:05 David Lee, Host
Hello and welcome to Podcast by Brodies.
My name is David Lee and, in this episode, we discuss the current challenges for Scottish banking transactions and a possible solution heading our way.
In January 2022, the National Security and Investment Act became law, giving the UK Government the power to scrutinize any acquisitions or investments that could harm national security and, if necessary, the power to veto those transactions. The legislation has had a significant impact on the processing of deals in the UK and one particular area that has affected is Scottish banking transactions. I'm joined today by Lindsay Lee and Thomas Horton, experts from Brodies banking and finance team, to find out more. Welcome to you both.
Lindsay, if we can just get some basics on the table first, can you just tell us what is the National Security and Investment Act?
When was it introduced and why?
00:01:08 Lindsay Lee, Senior Associate
The Act itself was introduced on the 4th of January 2022 and as you've mentioned in the introduction, it gives the UK Government new powers to screen and impose conditions and even to block corporate deals that it thinks might threaten UK national security.
In terms of why it was introduced, there's broadly two reasons. Firstly, there was a general concern over foreign investment in UK assets in key areas of the economy and infrastructure and secondly, the previous regime under the Enterprise Act gave the UK Government quite limited intervention powers on national security grounds.
So, the NSIA itself creates this tripartite regime where you've got, first of all a mandatory system where acquirers of certain shares or voting rights that exceed certain specified thresholds in companies, and other entities which are involved in specified activities in the UK in sensitive sectors - there are seventeen of those. Those acquirers have to seek advanced authorization and obtain approval from the Secretary of State.
So alongside the mandatory system, we've also got a voluntary system and that was designed to encourage parties who didn't fall within the mandatory system but who thought that their proposed acquisition might raise national security concerns. That also allows them to notify the Secretary of State.
Then the third aspect is what's called "government call-in power," and that is the power for the government to call-in for review any in-scope transaction if it has a reasonable suspicion that there is a risk to national security. Unlike similar regimes in other countries and despite what I've said about one of the concerns being around foreign investment, these provisions cover all transactions and not just those involving foreign investment.
00:03:07 David Lee, Host
Okay. And why are banking transactions such a big issue at the moment? Why does that matter?
00:03:16 Lindsay Lee, Senior Associate
Well, in the context of the NSIA, the National Security Investment Act, they arguably shouldn't be. As I've mentioned, the act is about acquisitions of control, and it was brought in to give the government powers to intervene in transactions that might pose a threat to national security and that's not really what we've got in banking transactions where the NSIA implications arise.
The main aim in a banking transaction is not for the lender or for the bank to acquire a stake in the corporates in the way that you would see in a merger or an acquisition or an investment for example. It comes about because of the way that certain types of security for the financing are taken and that brings the transactions within the scope of the act. The way that security is taken in Scotland differs from the way that it can be taken in England. So that means that we're seeing the issues arise far more often or in far more broad situations in Scottish transactions than we are in English transactions.
00:04:17 David Lee, Host
Thomas, we've heard there that banking transactions shouldn't really be part of this, but they are.
So, what is that specific connection between the act and how does it interact with banking transactions specifically?
00:04:34 Thomas Horton, Associate
Yeah, as both you and Lindsay have said there, it shouldn't really impact on banking transactions, but we are seeing it starting to impact across quite a range of financing transactions and the documentation that's used in financing transactions.
I think with a particular focus on undertakings or representations and warranties that are in facility or loan documentation, particularly in the space of acquisition finance, and then also seeing impacts in relation to security documents themselves in terms of the finance documents, the loan documents…what we're starting to see really is funders looking for representations and warranties to be included in loan documentation whereby the borrower or their group of companies are confirming that there doesn't need to be any notification to or approval from the Secretary of State in relation to the wider transaction.
So not just the financing but the wider transaction as a whole and this is, particularly prevalent in acquisition finance, but we're also seeing it across energy finance, infrastructure finance and other different areas.
We're also seeing undertakings in those loan documents whereby if there is some need to engage with NSIA approvals, that it's done within a certain time frame. So, often few business days after the end of the potential time scales in which the application will be approved. I think Lindsay might touch on that a little bit little bit later on, and obviously if a representation or warranty is breached or undertaking is not satisfied, then that will often be an event of default under the loan documentation. It's one that's really key for borrowers to get right, otherwise they could immediately be in default on their loan facilities from a security perspective.
The act is really biting in relation to share security, and where there could argued that there has been an acquisition that's taken place. And after a bit of initial ambiguity and uncertainty in the market, the government actually clarified the position to make it clear that share security is expressly caught by the act, which, as Lindsay mentioned earlier on, seems a little bit at odds with the supposed aim with the legislation.
00:06:59 David Lee, Host
Lindsay touched on this a little bit, Thomas, but why is it particularly a challenge in Scotland? What is it that's different about Scotland that's making this issue particularly challenging for people doing deals?
00:07:16 Thomas Horton, Associate
I think you're right, it's a particular challenge in Scotland.
I think I should just say first off that it doesn't just affect Scottish deals, it's probably just having a greater impact in Scotland compared to elsewhere. But that's really down to a concept of English law which isn't replicated in Scott's law, and that's of equitable security.
So just as a quick refresher, in English law you can take an equitable security or a legal security. The equitable security gives you an equitable contractual right, whereas the legal security gives you an absolute legal right. Frankly, you want legal security because it's better security, but Scott's law actually doesn't recognise that concept of equitable security.
So, in order to have effective fixed security in Scotland, the funder needs to be able to take possession of the assets which is being charged to competently grant security. And without it, parties can enter into a contractual arrangement that binds the grantor, but it would not amount to an effective security, and it wouldn't bind any future liquidator of the company.
So that's obviously why funders are keen to get full legal security in Scotland as opposed to equitable security. What that means in terms of practice is that in order to have effective Scotts law share security, there needs to be a formal transfer of shares from the charge, or to the funder, or the funders nominee. That, of course, would fall under the definition of an acquisition for the purposes of the act, because ownership of shares is transferred from one entity to another.
That's in contrast to the English position where, more often than not, English law share security is via an equitable security. So that first aspect where there's no formal transfer of ownership of the shares, no acquisition in a vertical means and no need to really engage with the NSIA approvals. But I think I should caveat that by saying that on enforcement of that English equitable share security, there would be a transfer of shares and so the necessary approvals would be required at that stage - at the enforcement stage.
I think another key point to flag as well, it's not just in taking the security that borrowers and funders alike need to be live to the NSIA and it's implications, but they would also need to be aware of it in relation to the release of share security or release e of Scottish share security. Because just as there has been a transfer of ownership of shares from the charge or to the funder in taking the security, there's then obviously another transfer on release from the funder back to the charger and so the approvals will be needed at that stage as well.
00:10:12 David Lee, Host
Lindsay, this is clearly a complex area, so let's talk a little bit about banks, and lenders in particular.
Why is it such a priority for banks and lenders, and what are the implications of them actually ignoring the terms of the act?
00:10:35 Lindsay Lee, Senior Associate
So, if a bank or lender is advancing funding to a borrower and as part of the arrangements, they're going to take the share security over a Scottish entity which falls within one of the specified sectors, they're going to need to get the Secretary of State's approval before they can take that security, before they can complete it.
There are a few points to take out of that, and the first is timing the clearance process itself has to be factored into the transaction structure and timely. Now, although most of those applications are turned around within 30 working days, the Secretary of State can take up to 105 working days to approve the share security, so that is going to have to be factored into the deal time frame.
Secondly, the clearance application process itself is a fairly large information gathering exercise. Quite time consuming. You need information about the target company, structure charts of before and after the acquisition, details of shareholdings above 5% in the acquirer - the bank or the lender - have to be disclosed, which you know if we're looking at a PNC Bank that can be a fairly large disclosure exercise in itself.
Then thirdly, are the consequences of not making the application for clearance. If a mandatory notification isn't made before the share security is taken and completed, then that transfer - so that security itself - will be void and of no legal effect. And that leads the bank or the lender without their share security and puts them in a risky position. You can seek retrospective validation for a notification that you ought to have notified but even if you get the clearance at that stage, you can still be subject to a fine for not having made it in due course, in the proper way.
That brings me lastly on to the point about sanctions. There are criminal and civil penalties for completing a transaction without getting clearance and the sanctions are draconian. For noncompliance you've got fines of up to 5% of worldwide turnover or £10 million, whichever is the greater, and there's also the potential for imprisonment of up to five years. So really quite significant implications of not getting a clearance when you should have.
00:12:52 David Lee, Host
Okay, yeah, they are quite draconian as you say, and a lot of it was this was implicit in what you just said there, Lindsay, but what is the practical impact of all this having on transactions?
00:13:06 Lindsay Lee, Senior Associate
What we're seeing is that lenders are either relying on their other aspects of their security package, most commonly the floating charge alone, or the floating charge plus unperfected share security.
On the rarer occasions where the lender wants to take perfected share security and you have to get clearance then a decision has got to be made as to whether to seek that clearance in advance of the funding being advanced, in advance of the deal completing, or whether the lender will just take an unperfected security initially, and then have a condition subsequent that they will get Secretary of State or they will seek Secretary of State approval afterwards.
Now in that latter scenario, the risk is that the lender simply doesn't have fixed security. If there's an insolvency in the period from the granting of the security and the approval being obtained and the security being perfected, the risk there lies with the lender or the bank, and of course fixed security places a lender in a much stronger position on the insolvency of the borrower.
There is, of course, a further risk that approval isn't obtained - Secretary of State approval isn't obtained - but where you've got a UK bank as lender or a funder, that's in our view a lower risk.
00:14:29 David Lee, Host
Okay. Thanks very much.
Thomas, earlier on seventeen sensitive sectors were mentioned. Anyone who is doing business listening to this podcast will think this is a complex area. Is this going to affect me? So, what are those business sectors that are particularly affected by these issues?
00:14:48 Thomas Horton, Associate
They cover a broad range of areas and sectors which I think the government have made a decision they see as being key. So that's covering things like infrastructure, energy, critical supplies to the government, critical supplies to emergency services… and so to be honest with you, I think when you're starting off any process it's quite a complex area. To be frank, I think that borrowers, funders, companies, all alike need to really be live to the implications of that.
Lindsay mentioned the potential penalties should a notification or managed notification not be made. I think the one that sticks in my head from a banking or perspective is the potential percentage of turnover fine, and if we're dealing with PLCs here, that's obviously has the opportunity to be vast sums of money.
So, I think really you need to be careful because there's also a bit of uncertainty as to what exactly would fall into one of the seventeen sectors. For example, I was recently involved in a transaction where we were funding the acquisition of a company that runs several local pharmacies all around Scotland. In the end, what we had to do was interrogate the facts of the company, consider their backgrounds and whether their business activities might fall into one of the sectors. For example, could it fall into critical suppliers to government given this is prescriptions from General Practitioners from doctors? Or would it fall into suppliers to emergency services?
There's just that uncertainty right now that we're not really sure. And in that case, after quite a lot of deliberation, it was decided that the business wouldn't fall into those sectors. In terms of my work, I do energy and infrastructure finance, and so one of the key sectors that I'm coming across is the energy sector and also in relation to telecoms transactions, that would probably fall within the communications and data infrastructure sectors. I think a particularly key one actually that we're starting to see is in relation to oil and gas exploration in the in the North Sea, and with the lifetime of those oil and gas projects there's potentially a very difficult problem coming down the line in terms of once those facilities reach term or they're refinanced - because as we talked about before, release of an existing share security would also trigger the need for notification and approval - it's really of critical importance. Certainly with me working in in energy and infrastructure finance, that's always the first question that comes across my mind when a new transaction comes through is, has the borrower has the funder considered whether or not there might be an NSIA approval process that needs to be carried out?
00:18:08 David Lee, Host
Okay, that's great. That's really helpful. So, you've talked there about specific sectors.
What about the kind of transactions that we're talking about here? We talked quite a bit about share security. Are there any other types of transactions that are particularly affected by the act?
00:18:26 Thomas Horton, Associate
I think it's fair to say that share security is the most prevalent in terms of it being an acquisition falling under the act, but you're also right to note there are some other transactions, other securities which have the potential to be caught by the act.
So, I think while there has been a lot of focus on share security there, it also covers entities which don't have a share capital. In those sorts of cases, the trigger events might be linked to the holding of rights to a share of the relevant percentage of capital or profits of the entity. So that means other types of security that could be caught are assignation of partnership interests and that would also be covered by the act.
00:19:16 David Lee, Host
Okay and we've identified there’s an issue here, so how has the market responded? What's been the market's approach?
00:19:29 Thomas Horton, Associate
I would say in a word, the market approach has been very cautious.
Particularly initially with both borrowers and funders being quite wary of the potential implications of the act and also the uncertainties around what falls under it.
Lindsay mentioned one of the outcomes has been quite a lot of funders have decided to take unperfected share security in relation to Scottish companies or taking an equitable share security in relation to English companies and then relying on underlying security packages elsewhere - so underlying floating security fixed security elsewhere. Lindsay mentioned the pitfalls in that approach, as taking an unprotected share security can open up security holders - so funders - to hardening period issues. That's revolving around the period in which the security could be challengeable to other creditors, and so the lenders are then having to sometimes, reluctantly, forgo a Scottish share security at all because the flip side of that solution to taking on perfective share security, then perfecting it down the line, is being very switched-on in terms of enforcement strategy.
To get around that hardening period issue some funders are now really keen to engage with the process and are then going through the process and seeking the necessary approvals. We actually had a transaction that completed quite recently where the funder ultimately decided that they did want to take perfected share security and so we were actually able to see the process firsthand.
I think it's quite fair to say it's quite an involved process, firstly because I think there is a perception right or wrong that those potentially reviewing the applications are very, very knowledgeable in relation to standard acquisitions, but perhaps not quite as up to speed in relation to share security and the issues that we've discussed already. But I think secondly, another reason it's quite an involved process is just the volume of information that needs to be gathered about the acquirer and the company whose shares are being transferred.
For example, requiring information on every shareholder above 5% of shares in the company, and one of the initial sticking points we had in relation to the application was the structure chart with which we sent in with the application, and how the funder should be shown on that structure chart. The response that we had back was that we needed to show the funder on the structure chart given they were going to be the sole shareholder in the in the company, but that's at odds really with kind of the perceived market practice - in Scotland anyway - that's in these sorts of scenarios where share security is taken. A funder isn't shown on a structure chart for because things like voting rights, dividend rights aren't transferred on taking security, only on enforcement.
There's an argument there they don't need to be on the structure chart, and what actually ended up happening in that scenario sounds like a simple fix, but what we did was include the funder on the structure chart at the request of the of the government, but then instead of a bold complete line it was a dotted line that came from the funder to the company. But then also on the structure chart, we made very clear that the funder was only shown as the sole shareholder by virtue of there being share security and that they held no dividend or voting rights.
I think one final point I wanted to touch on was in terms of the timing of it, Lindsay mentioned the potential time scales but in the example, we had recently, it was framed as that no further action required letter that was received was almost bang on the 30 business days' time scale that we were quoted. I think it was received on maybe day 27 or 28 of the 30-business day period. I think again, really worth noting that those that were reviewing the application were very engaged and very responsive and certainly, whenever we were reverting with answers to the queries we were hearing back within a day two maximum.
I would say as well, prior to the actual finding of the of the application, the investment security units were very helpful in responding to initial queries in order to aid the completion.
All in all, I think really the market is learning as we go along with the process, but I think a really critical thing is to note the investment security unit are at least being as helpful as they can in order to hopefully streamline the process as more and more applications are made.
00:25:08 David Lee, Host
Thomas has outlined quite a lot of challenges there, quite a lot of complexity. What about solutions?
What might a solution in this area look like, and what role might the Moveable Transactions (Scotland) bill play in that?
00:25:31 Lindsay Lee, Senior Associate
Yeah, I think we have got light at the end of the tunnel here. I think we are expecting many of the issues that are specific to Scots law to fall away, but we're going to have to wait just a little bit longer for that to happen.
You mentioned the Moveable Transactions (Scotland) bill, that's now an act which is great news, and it's a major new piece of legislation. It's going to affect how banks and lenders can take security over moveable or tangible assets, and that act itself creates a new form of security, that will allow banks and lenders to create security by registration in a new statutory register and without the transfer of ownership. But because of legislative competence issues, the new security as it's currently drafted, doesn't extend to shares or the equivalent to shares in Scottish companies but it will as and when an order is made by the UK Government.
The act itself is expected to come into force next year and the expectation is also that the UK Government's order will dovetail with that timing wise. The net effect should be that the new security can be used to take security over shares in a Scottish company without the need to transfer ownership in the shares itself and instead, lenders will just have to register the security document. When that happens, we are going to see a major change in the way that share security can be taken in Scotland, and the position in Scotland will be much closer to that to what it is in England.
So, the taking of the share security and its release won't trigger a mandatory notification, but also the enforcement, if that involves an acquisition of control, whether by shareholding or voting rights, will require the notification still.
00:27:22 David Lee, Host
You mentioned light at the end of the tunnel there, Lindsay, is that light quite bright or is it still quite dim at the moment?
00:27:32 Lindsay Lee, Senior Associate
We're optimistic, but I think we're looking - fingers crossed - at summer of next year before the legislation comes in. But the order by the UK Government is quite complex piece of work. So, we just have to watch this space.
00:27:47 David Lee, Host
And a very key question finally, Thomas, what is your advice to clients who might find themselves caught up in this very complex web?
00:27:58 Thomas Horton, Associate
It would be to consider the act at the outset of any and all transactions, I think particularly given the implications of getting it wrong. When a deal comes across my desk and share security is mentioned in the term sheet, the first protocol in my head is always - have the funder and borrower considered the NSIA? And certainly in the energy and infrastructure work that I'm involved in, we're operating on the basis that the NSIA act does apply unless the borrower can prove to us it doesn't. And your reasons why it wouldn't, for example, suppose in the energy context, the companies where the generation of power of electricity, of energy from the asset falls below the thresholds which the government has set, or it doesn't fall within sector XYZ for a particular reason.
I mentioned the pharmacy one ultimately decided it didn't fall within critical suppliers to government or emergency services given that the scale of what was happening there, then I think thereafter where an application is made or decided, it might have to be made.
I think it's really crucial that when you're making the application to provide as much information as possible, almost provide too much information. The reason for that is to hopefully bring down the number of potential queries or responses required from the ISU and to keep that to a minimum of the time scales we mentioned before. I think key thing to note is that the initial 30 business days clock doesn't start until the ISU have no further queries on the application, and then they'll go away and review it and provide their decision. A key piece of advice would be to remember that the ISU were happy to answer your initial queries and there are definitely a resource to be used and to be taken advantage of.
The final thing, and maybe the key point to take away is to be mindful that their process takes time. The potential 30 business days and the opportunity for a further 45 further 30, so potentially up to 105 business days in extraordinary circumstances.
I would build that into your completion timeline because it's really not a process to be rushed. I think particularly given the implications of getting it wrong and not making an application where one does need to be made.
00:30:46 David Lee, Host
Lindsay, understanding that this is a legal podcast by Scotland's largest law firm, it sounds like it genuinely is important to get legal advice at the very early stages in what is a very complex area.
00:31:00 Lindsay Lee, Senior Associate
I mean, we've talked through the consequences of not getting it right. We've talked about the complexities of the transactions, it's an area where advice should be sought.
00:31:11 David Lee, Host
Thank you very much to Lindsay and thank you to Thomas for your terrific insights today on this important, very complex and challenging topic.
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