In our latest review we reflect on some notable developments and trends in UK corporate and commercial law:
Foreign Direct Investment: A review of the UK’s National Security Regime
Technology: A review of the recent EU Artificial Intelligence legislation M&A: The role of W&I Insurance in transactions
Economic Crime: A summary of the key features of the Economic Crime and Corporate Transparency Act 2023
Corporate Finance: A review of the government’s proposals for reform of the UK Prospectus Regime
Capital Markets: A summary of the UK government’s proposals for reform of the UK Listing Regime
If you would like to discuss anything arising from this briefing please get in touch.
Foreign Direct Investment: Review of the UK National Security Regime
Background
In November the UK government launched a review of the National Security and Investment Act 2021 (NSIA). The NSIA came into force in January 2022 establishing an independent regime for the scrutiny of transactions on national security grounds. In many respects the legislation was a case of catch-up by the UK and part of its response to the perceived threat of hostile actors controlling critical UK businesses and infrastructure. However the scope of the regime attracted concern from the outset – the significant broadening of the government’s intervention powers jarring with its wider declared aims to reduce regulatory burden and encourage investment.
As anticipated the new regime has seen a significant increase in notifications of transactions. Whilst the government has largely dealt with these expeditiously, anecdotal evidence indicates that businesses and advisors find the regime opaque and excessively broad often capturing unproblematic transactions (in the first full year more than 90% of transactions were cleared unconditionally). The ensuing delay and uncertainty is considered by many to be a material factor in the slowdown in UK M&A.
Regime
To recap the principal features of the regime:
Mandatory notification of transactions involving any one or more of the 17 prescribed “sensitive” sectors. A voluntary notification process applies in all other cases.
“Transactions” is a broad concept capturing much more than M&A deals (e.g. equity investments, joint ventures, land transactions and security arrangements).
Notifiable transactions which are not notified are void.
Heavy financial sanctions and criminal liability for non-compliance.
Extensive government “call-in” powers to review transactions at any stage.
No safe harbours.
Extra-territorial effect – provided the transaction has sufficient UK nexus, the application of the legislation does not require the target or any of the transaction principals to be registered UK entities.
Review (Call for Evidence)
The review’s over-arching objective is to assess how the NSIA regime can be “narrowed and refined” while maintaining its core objective of protecting national security. The areas where the government has called for evidence include:
Changes to the scope of the 17 specified sensitive sectors. Defence triggered nearly 50% of all mandatory notifications in the latest audited year to 31 March 2023 - indicating that that sector is drawn too wide. The government is also considering the inclusion of 2 new sectors and reviewing whether any activities falling within the 17 sectors are unlikely to create national security risk. In addition, feedback is requested concerning the potential narrowing of the regime’s application to Artificial Intelligence; and whether activities captured by the existing definition could be removed on the basis that they do not pose a national security risk.
Limiting the application of the mandatory regime to intra-group transactions. This has been a particular issue where ultimate ownership remains unchanged.
Changes to process and forms. The government is looking to improve notification and assessment processes to improve transparency. At present there is limited opportunity for contact once a notification is submitted.
Exemptions to mandatory notifications. At present there are none.
Conclusions
Government pronouncements accompanying the launch of the review were welcome, in particular the stated desire to hone the regime and make it more business-friendly. The review should improve certainty in the notification process and in turn the confidence of investors in the UK as an investment destination. That said businesses will be well advised to track the review’s outcomes not least as certain of the amendments floated by government may result in significant changes to both the regime’s operation and application.
The Call for Evidence closes on 15 January 2024.
Technology: EU reaches consensus on landmark AI legislation
After an extensive 36-hour negotiation, EU policymakers have successfully reached an agreement on the EU Artificial Intelligence Act (Act). Although the first draft of the Act was published in 2021, it struggled to keep up with the rapid technological advancements within artificial intelligence (AI). Notably, the original draft of the Act made no mention of general purpose AI models like ChatGPT.
The Act aims to set a global benchmark for AI regulation. It adopts a risk-based approach whereby the categorisation of an AI system under the Act will determine whether any obligations under the Act will apply.
Key aspects
The Act provides a list of prohibited uses of AI. For example, it sets strict restrictions on the use of facial recognition technology except for law enforcement under limited exceptions. Furthermore, the Act explicitly prohibits the use of AI for social scoring and the exploitation of vulnerable people.
There is also a supply chain responsibility on foundation models. Providers of general purposes AI models, such as ChatGPT, may be required to provide information to downstream economic providers with necessary information to comply with the Act. Such models are also subject to disclosure requirements whereby it needs to disclose detailed information surrounding training data used (including copyrights) and technical documentation.
Public bodies and private entities providing essential public services, who deploy high risk AI systems are required to conduct a Fundamental Rights Impact Assessment (FRIA). Comprehensive details of what the FRIA entails are yet to be published.
Timeline
While it is a success that an agreement has been reached on the Act, it is important to note that it is not the final text as it has not yet been passed. Most aspects of the Act will not take effect until 12 to 24 months (save for the prohibitions on banned AI which will come into force after 6 months). Meanwhile, companies can proactively consider the Act to gauge whether they fall within its scope and determine the potential applicability of the associated obligations under the Act.
Other relevant legislation
It is crucial to recognise that the Act is only one of the many laws being introduced in the EU within the digital sector. Other proposed and enacted laws include the AI Liability Directive, Digital Markets Act, Digital Services Act and Data Act, to name a few.
Having said that, it is imperative for companies to consider the extensive range of both proposed and enacted laws to ensure compliance. This could eventually lead companies to spend more on regulatory compliance rather than on the deployment of AI technology. Nevertheless, ensuring compliance is important, given that hefty fines, potentially reaching up to 35 million Euros or 7% of global turnover, could be imposed for violations of the Act.
Relevance to UK companies
While the UK has adopted a pro-innovation approach whereby it relies on cross-sectorial principles rather than regulation, an Artificial Intelligence (Regulation) Bill has been introduced in Parliament. Time will tell whether this represents the first step in the UK’s journey towards regulating AI.
Notwithstanding the UK’s contrasting approach, the Act has a wide territorial reach. In essence, the Act will apply to anyone who places AI systems on the EU market or putting them into service regardless of where they are based. Consequently, UK companies that deploy systems within the EU or offer them on the EU Market will be subject to the Act. Hence, it is equally important for UK companies to take the Act into consideration.
M&A: W&I Insurance
W&I insurance has been a part of the UK and international M&A marketplace for many years. Initially viewed as expensive and suitable only for larger transactions, the product has evolved and now plays a significant role in a wide variety of transaction types and sizes. It forms part of a wide suite of M&A insurance products from litigation to title insurance and special tax liability insurance.
This article takes a brief look at W&I, its development and current trends.
W&I insurance covers financial loss arising from a breach of warranty in a share purchase agreement. There are essentially 2 types of policy - depending on whether the policy is taken out by the buyer or the seller. Originally conceived as a “sell-side” product (where the buyer claims against the seller who in turn looks to the insurer for coverage), today the vast majority of policies are taken out by buyers. In a “buy-side” policy the buyer claims directly against the insurer which effectively steps into the shoes of the seller with the intention of providing back-to-back cover with the position agreed in the share purchase agreement (SPA).
Advantages
From the seller’s perspective W&I usually facilitates a cleaner exit while the buyer sees the policy as affording better protection in enforcing warranty claims e.g. avoiding any seller- related solvency risk. W&I is particularly useful in transactions where:
The seller is not prepared to provide warranties (e.g. a private equity seller)
There will be an on-going post-completion commercial relationship between the parties
There is a significant divide between the parties in the warranty coverage sought and offered
A bidder in an auction process wishes to offer the seller reduced warranty exposure
A buyer can negotiate an extended coverage period beyond the warranty limitation period agreed with the seller.
Exclusions
It is important to remember that certain matters will be excluded from coverage including:
Known risks identified during the due diligence process - W&I insurance protects against unknown risks (see below)
Fraud or misrepresentation
Environmental matters
Certain specific liabilities e.g. defective products, money laundering, bribery and corruption
Consequential losses
Forward-looking warranties
Aspects not covered by due diligence
While many will be industry standard, the exact scope of the exclusions and limitations will be the result of negotiations between the insurer and the insured party. A buyer should ensure that the insurer does not exclude risks which are material to the transaction.
Retention
Insurers typically require that the parties accept a certain portion of the risk, and this is reflected in the policy retention (also known as the deductible, excess or attachment point). This is the threshold at which the insurer will become liable under the policy and below which it is generally not liable. It effectively performs the same function as the de minimis basket in a SPA. The buyer should ensure that that basket is disregarded in the policy to ensure there is no double hurdle for making a claim. The buyer should also ensure that this excess matches not just the materiality thresholds in the warranty limitations but also those applicable in due diligence reports and the compilation of the seller’s data room.
Insurers will commonly seek a policy retention of between 0.25% and 0.5% of the transaction’s enterprise value.
Seller Knowledge/ Buyer Knowledge
It is common for a seller to qualify a warranty by reference to its awareness and the SPA definition of “awareness” will be of material interest to an insurer. In particular that the concept assumes a degree of enquiry has been made on the seller’s part.
Insurers will be unwilling to provide coverage against circumstances within the buyer’s knowledge. It follows that a buyer is unable to bring a claim against the insurer in relation to a matter discovered in due diligence or disclosed by the seller.
Due Diligence
W&I is not a substitute for a proper due diligence exercise and warranty negotiation. As a rule, “red flag” (exceptions-only) format reports will be acceptable. Any indications that the parties are placing undue reliance on the policy will raise concerns for the insurers as will any seller disclosure exercise which is anything other than thorough and an SPA which is unbalanced.
Process
Typically a term sheet is requested from a broker early in the process giving time to achieve the desired coverage. Selected insurers will be given access to the principal transaction documents following which non-binding indications of interest will be submitted specifying the terms and conditions of coverage. The selected insurer will be granted access to any data room and due diligence reports following which the insurer and insured negotiate the coverage and premium.
Timescale and Costs
The process of finalising an insurance policy takes typically 2 to 3 weeks. However, much depends on the status of the transaction at the time the insurer’s lawyers become involved, the information provided to the insurer and the quality of the data room, due diligence exercise (scope and materiality), disclosure letter and SPA warranties and indemnities. The premium for a W&I policy commonly varies between 1% and 1.6% of the amount of the insurance. This will be influenced by the insurer’s perceived risk taking into account those factors referred to above.
Bringing a claim
A claim notice under the policy will not differ materially from a typical breach of warranty notice under an SPA; however, insurers will expect that the insured notifies as soon as reasonably practicable after discovering a circumstance that could give rise to a loss under the policy. The buyer (insured) should ensure that it complies with the policy’s specific notification requirements; there is little downside to reporting a potential breach to the insurer.
Trends
Whilst the use of W&I insurance on larger private equity transactions has been commonplace for many years, insurers are taking an increasing interest in smaller - sub
£10m - transactions previously considered uneconomic. The launch of technology streamlining and standardising the insurance process will help maintain interest amongst insurers for smaller deals.
In the context of the seller’s cap under the SPA warranties, historically insurers were keen to ensure that the seller had some “skin in the game”. However, nil recourse structures have become commonplace meaning the seller’s liability under the warranties is limited to £1. This may mean that an uninsured gap emerges in the buyer’s protection and it will be a matter of negotiation between the parties whether the seller should be liable for that gap.
Evidence indicates that the most common notified claims relate to financial statements, tax assessments, compliance with laws and material contracts.
W&I has proved largely resilient to the recent downturn in UK M&A activity due in part to the security it represents to counterparties. It is clear that the product will continue to evolve and play an increasing role across the UK M&A landscape.
Economic Crime
The Economic Crime and Corporate Transparency Act 2023 received Royal Assent on 26 October 2023 (ECCTA). The corresponding Bill was published in September 2022 as the second part of a legislative package aimed at preventing abuse of UK corporate structures and tackling economic crime. It was preceded by The Economic Crime (Transparency and Enforcement) Act 2022 which provided for the creation of a register of overseas entities and requirements for overseas entities owning UK property to apply for registration.
The ECCTA creates new responsibilities for all new and existing company directors, persons with significant control and any person filing on a company’s behalf.
The headline changes include:
Companies House reform: the initiation of the most significant reform of Companies House in its history seeing it adopt a more proactive gate keeper role as a key part of the UK’s economic crime prevention infrastructure. Amongst other things Companies House will be empowered to query filings, request further evidence, reject any filings and remove material from the register more swiftly. Filing of accounts will be electronic only in due course.
Identity Verification: New requirements will be introduced for all new and existing company directors, LLP members, ‘persons with significant control’ (PSCs) and those persons responsible for filing information with Companies House. Failure to verify ID will be a criminal offence and/or incur a civil penalty. Companies House will only accept filings from individuals whose ID has been verified.
Corporate Directors: The regulations have been tightened significantly restricting the use of corporate directors. The changes will apply to existing and new companies. A corporate director will be required to be a legal entity with legal personality and each of its directors will have to be natural persons whose ID has been verified.
Company registers: The legislation will abolish the requirement for a company to maintain registers of secretaries, directors, directors’ residential addresses and persons with significant control. The requirement to keep a register of members will be retained. Companies will also be required to provide Companies House with a one-off full shareholder list updated annually as part of the confirmation statement process.
Limited Partnerships: The legislation includes long anticipated reform to the UK limited partnership regime. LPs remain widely used and attractive in a number of contexts in particular as private fund vehicles. However the mis-use of these structures in a number of recent scandals has drawn attention to their light filing requirements and opaques nature. The reforms will mean improved transparency with increased disclosure of information both on registration and on an ongoing basis.
Company administration: A number of changes are to be implemented with the intention of reducing compliance burdens and improving the quality of the register’s information. Changes include revisions to the company names regime and the requirement for companies to provide the registrar with an email address.
Failure to prevent fraud: A new strict liability corporate offence is introduced of failure to prevent fraud where a company does not have reasonable fraud prevention procedures in place. The Act also refines the ‘identification doctrine’ - where companies can be held criminally liable for the acts of their officers or employees if they represent the company’s ‘directing mind and will’ - such that their actions can be attributed to the company concerned.
The changes to the UK corporate regime are significant. The provisions of the ECCTA will come into force at a later date to allow companies and Companies House time to prepare for implementation.
The government plans to consult on guidance on “reasonable procedures” and it is not anticipated that the new failure to prevent fraud offence will be in force before 2025. Many of the changes concerning company administration will come into effect next year.
UK Prospectus Regime
Background
The UK prospectus regime is the body of law and rules which require the production of a prospectus in certain circumstances. These are broadly when a company offers shares to the public and the admission of a company’s shares to trading on a regulated market (an IPO). In the absence of a prospectus, unless an exemption applies, the making of such an offer or request is a criminal offence. A prospectus is a vital source of information for investors and responsibility for its accuracy rests with the company and its directors. Criminal liability may be incurred where the prospectus is inaccurate or misleading.
Current Position
The current UK prospectus regime is derived substantially from the EU law in force immediately prior to Brexit and which was on-shored as part of the UK’s withdrawal agreement. Authority and responsibility for the UK regime sits with HM Treasury and the Financial Conduct Authority (FCA).
Proposals
The government published proposed reforms to the regime in March 2022. Following extensive consultation the final draft Public Offers and Admissions to Trading Regulations 2023 (the “Regulations”) were published in late November 2023. The Regulations create the framework for a new UK prospectus regime. The objective is a more agile regime with increased responsibility delegated to the FCA. The Regulations will separate the regulation of admission of securities to trading on a UK regulated market from the regulation of public offers of securities.
Key Features
Some of the key features of the Regulations include:
Public Offers: A key change is the removal of the requirement for a prospectus for public offers. Instead, the Regulations will make it unlawful for a person to offer relevant securities to the public in the UK unless an exemption applies. Most of the existing exemptions will be retained e.g. an offer addressed to fewer than 150 persons in the UK (excluding qualified investors) and offers of shares already admitted to trading on a regulated market or primary multi-lateral trading facility (“MTF”). New exemptions include offers to existing shareholders and offers made by means of a “regulated platform” (see below).
Admission to trading on a regulated market: A prospectus will remain a feature of this part of the regime. The FCA will be delegated responsibility for determining whether a prospectus is required and its form and content.
Admission to trading on an MTF: Currently, admissions to MTFs (e.g. AIM and AQSE Growth Market) are regulated by the MTF operator's own rules. An MTF is typically regulated by the exchange or firm through which it operates, subject to FCA oversight. Under the Regulations the FCA will have power to make rules admitting securities to an MTF and to set continuing obligations. AIM and AQSE Growth Market are likely to be primary MTFs. The likelihood is that an MTF admission prospectus will be required where shares are admitted to trading on an MTF.
Regulated platforms: The government's policy is that companies remain able to offer securities to the public without admitting them to a securities market. As noted above, prospectuses will no longer be required for public offers; as such, the current requirement for an FCA-approved prospectus for offers over €8m will be removed. Instead, there will be an exemption from the public offer prohibition for an offer of relevant securities made by means of a regulated platform. Companies will need to rely on this exemption when a public offer exceeds £5m and is not otherwise exempt from the public offer prohibition. Operating an electronic system for public offers of relevant securities (e.g. a crowd funding platform) will become a regulated activity under the new regime.
Prospectus: In terms of the overall standard of preparation of a prospectus, the overarching requirement for a prospectus to contain “necessary information” will be retained but the FCA will be given power to make rules on the detailed disclosure requirements. The liability regime applicable to forward-looking statements included in a prospectus (estimates, opinions, projections etc.) will be reformed. Broadly, a different liability threshold (based on fraud or recklessness) will apply to such statements while the existing negligence-based threshold will apply otherwise. This change is intended to encourage the inclusion of forward-looking information - identified by the Hill UK listing review as an important issue for investors.
Timeline
Much of the detail is expected to be set out in new FCA rules. The FCA plans to consult on those rules during the summer of 2024, with the new UK Prospectus Regime expected to take effect in 2025 at the earliest.
UK Listing Regime
Background
The UK listing regime is the body of law and regulations which apply to companies with shares admitted to listing on the Official List. These derive significantly from EU law previously adopted by the UK while it was an EU member.
The Official List is maintained by the FCA and is divided into 2 tiers – premium and standard. Issuers listed on the premium segment are subject to more onerous requirements.
With few exceptions, admission to the Official List itself requires that a company’s shares are admitted to trading on a regulated market (e.g. the London Stock Exchange Main Market and AQSE Main Market). It follows that a listing must take place in parallel with an admission of shares to trading on a regulated market.
A company which is “listed” is subject to the Listing Rules published by the FCA. These specify minimum requirements for listing and continuing obligations of issuers. Those obligations are in addition to any requirements of the applicable market on which the company’s shares are traded and the disclosure, transparency and governance rules which form part of the FCA’s handbook.
Proposals
The Financial Conduct Authority has announced proposals to overhaul the UK’s listing regime. These follow the UK Listing Review conducted by Lord Hill and published in 2021 which itself was driven by Brexit and part of the government’s plan to boost the UK as a destination for IPOs and to help innovative companies raise finance.
The proposals follow a series of discussion papers and consultations published by the FCA. The reforms came at the end of year which saw increased pressure on the UK capital markets and reflect the global competition facing London as a global financial centre. Their objective is to increase the appeal of the UK markets to international businesses by simplifying the listing process and relaxing certain continuing obligations whilst moving toward a more disclosure-based regime and increased responsibility for sponsors.
Key Features
The proposals include:
Simplifying the listing regime by creating a single listing category for commercial companies (replacing the existing premium and standard segments). The complexity and burden of the proposed eligibility requirements sit between the existing premium and standard listing categories. Existing premium listed companies will migrate automatically to the new commercial category and standard listed companies to a new transition category subject to the existing standard listing continuing obligations.
A 10% free float requirement (shares in public hands) both at IPO and as a continuing obligation.
Enhanced notification of certain significant transactions - e.g. related party and Class 1 transactions - rather than shareholder approval.
Continuation of the existing premium control and independence regime meaning that controlling shareholder relationship agreements will remain mandatory.
A new category for special purpose vehicles (SPACs) and other shell companies.
A new listing rules and sourcebook structure intended to be more accessible and less complex.
Relaxation of requirements for historical financial information, minimum track record or a working capital statement. This is consistent with the desire to attract earlier stage businesses. (However, the new prospectus regulations will still require an IPO issuer to include historic financial information and a working capital statement in its prospectus and the FCA will expect sponsors to consider whether there is a reasonable basis for an issuer to include such a statement.)
Dual class share structures will be permitted as well as enhanced voting rights permissible in favour of specified persons with no mandated sunset provisions.
A modified sponsor regime including the sponsor’s role (on and post IPO), criteria for approval as a sponsor and sponsor supervision.
The proposals tread a delicate line between improving the attraction of the UK markets to international businesses, protecting the market’s integrity and maintaining the confidence of investors. The reforms place increased emphasis on disclosure and an onus on investors to carry out due diligence.
Timeline
The consultation period will be open until 22 March 2024 (16 February for the sponsor proposals) and the FCA expects the new regime to be implemented in 2024 H2.
