Lessons from the first FSR merger investigations

The Foreign Subsidy Regulation (FSR) came into force in July 2023, and the European Commission is starting to develop its substantive approach in FSR merger investigations. In this article, Lorenzo Coppi [1] shares his insights from working on two important recent cases: the first in-depth merger investigation and the first successful application by a Chinese company. He sets out his thoughts on the investigation process, and the analysis involved once an investigation has been launched.

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The views expressed in this article are the views of the authors only and do not necessarily represent the views of Compass Lexecon, its management, its subsidiaries, its affiliates, its employees or its clients.

Introduction

The Foreign Subsidy Regulation (FSR) is a new competition tool that has been in force for slightly longer than a year, and the European Commission (the “Commission”) is starting to develop its substantive approach in FSR merger investigations.[2] This article summarises our experience from advising the acquirers in two recent important cases: Emirates Telecommunications Group / PPF; [3] and Haier / CCR.[4][5]

Emirates Telecommunications Group’s acquisition of parts of PPF Telecom was the first (and to date the only) in-depth FSR merger investigation. This was an “accelerated” in-depth investigation which did not run its full course and was closed on the basis of commitments offered by the Parties.

Haier’s purchase of Carrier’s commercial refrigeration business was instead “approved” after a preliminary review.[6] This case is significant as it marks the first time a Chinese company has successfully gone through the FSR’s merger investigation process, [7] which is important as the FSR has commonly been seen as a barrier to Chinese investment, [8] even though this is not the official position of the Commission.[9]

In this article, I share insights from working on these first two cases, I organise these thoughts around the three analytical steps of an FSR merger investigation, i.e. determining:

• Step 1: Whether a foreign financial contribution is a subsidy;
• Step 2: Whether that subsidy negatively distorts competition; and
• Step 3: Whether any positive effects of the subsidy outweigh the negative effects of distorting competition (known as “the Balancing Test”).

Step 1: Is the foreign financial contribution a subsidy?

In this first step, the Commission must determine whether a foreign state’s (or a foreign state-owned entity’s) financial contribution to the acquirer can be considered a subsidy. A subsidy is present when the financial contribution confers a selective benefit to the acquirer.

A “benefit” arises when the acquirer could not have received the financial contribution on the same terms from a commercial market operator (i.e. the financial contribution is not “market conform”), [10] and that benefit is “selective” if it was not available to all companies.[11] If instead the financial contribution was market-conform (not a benefit), or available to all companies (not selective), then the financial contribution is not a subsidy.

To initiate an in-depth FSR investigation, the Commission does not need to prove conclusively the existence of a subsidy. Rather, it must show that there are “sufficient indications” that one exists.[12]

This implies that the burden of showing the presence or absence of a subsidy is as much on the Parties as it is on the Commission. Indeed, in our experience, the Commission often explicitly asks the Parties to carry out an analysis of the market conformity of different financial contributions (especially loans), and a very large part of the economic analysis in these early cases focused on whether the reported foreign financial contributions are market conform, or are in fact subsidies.

There are several types of foreign financial contributions that can constitute a subsidy, but the most common types include: loans, tax measures, grants, state guarantees, and purchase or sales of goods or services.[13] All these measures were considered by the Commission in these early cases.

Loans

In these types of cases, often the acquirer received term loans or revolving credit facilities from several banks, that include state-linked institutions but also ones not linked to a state. In the case of Emirates Telecommunications Group / PPF, the central issue was whether the loans granted by state-linked banks were offered at below-market rates; if they were, a subsidy would be present.[14]

The way to address this question is by comparing the terms of the actual loan (generally the interest rate) with a reliable benchmark of an equivalent “market rate”. In important cases, it is common for the Commission to request the Parties to provide an analysis of the economic terms of the loans and to assess whether those terms are in line with normal market conditions. Indeed, this constituted the bulk of the analysis in the cases in which our team has been involved.

There are two main ways to carry out this analysis:

• By reference to internal benchmarks (i.e. the terms of loans granted to the acquirer by commercial banks); or
• By reference to external benchmarks (i.e. the terms of debt instruments – typically bonds – provided to other companies with a similar credit profile in the relevant timeframe).

While, from an economic perspective, internal benchmarks often tend to be more appropriate (as they reflect more directly the credit profile of the acquirer), in our experience, the Commission tends to require that an analysis of external benchmarks is also carried out.

In any case, the available (internal or external) benchmarks need to be adapted to account for several differences, for instance in:

• the point in time when the loan was granted;
• the currency (and/or underlying reference rate) of the loan;
• the term or duration of the loan;
• whether the interest rate is fixed or variable;
• whether the debt instrument is a bond or a commercial loan;
• possible differences in seniority, collateralisation or structure of the loan.

In both Haier / CCR and Emirates Telecommunications / PPF, based on a very detailed analysis of internal and external benchmarks, the Commission was satisfied that the Parties had received loans from state-owned financial institutions on terms that were comparable to market rates (although in the case of Emirates Telecommunications / PPF, the Commission only came to this conclusion after the in-depth investigation).[15]

Tax measures and grants

When it comes to tax measures and grants, our experience is that the Commission has adopted a pragmatic approach and did not raise concerns over measures that had no direct nexus to the EEA (i.e. foreign regional tax breaks), that accrued to group companies that had no direct link to the acquiring entity, and/or were limited in magnitude.

State guarantees

A state guarantee implies that the state backs (insures) the debt of a company. As the debts of the company are backed by the state, lenders are then prepared to lend money to the company at lower rates than they would if their capital was provided to a borrower which did not have such guarantee. If the state does not ask for an adequate payment from that company, then such guarantee gives rise to a subsidy.

According to case law, [16] the inapplicability of normal insolvency and bankruptcy provisions can give rise to an unlimited guarantee, insofar as such exemptions imply that creditors are more likely to be repaid than in normal circumstances.

Emirates Telecommunications was exempt from the applicable bankruptcy law of the Emirates, but it was unclear whether that exemption would have made it safer or in fact riskier to lend to, and therefore on what basis the Commission could infer that Emirates Telecommunications enjoyed an unlimited guarantee.

The lesson from this is that the bar for opening an in-depth investigation (there being “sufficient indications” of a subsidy) is fairly low.

The provision or purchase of goods or services

As noted by the FSR, a subsidy can also arise if a company purchases products or services from the state or a state-owned company at below the market price, or if it sells products or services from the state or a state-owned company at above the market price.[17]

This concern was raised by the Commission in Emirates Telecommunications / PPF, where – as noted in the opening decision (the “Opening Decision”), the Commission considered contracts awarded to Emirates Telecommunications by state-owned enterprises or government departments.[18] The concern was that the company might have been selling telecom services to these public entities at inflated prices compared to what they charged private companies, and that those inflated prices constituted a subsidy.

As in the analysis of loans, here too the crux of the analysis is finding a reliable benchmark for what constitutes the “normal” market benchmark for the price of business-to-business telecom services in the UAE. These services are often bespoke and vary significantly between different contracts, hence carrying out a benchmarking analysis is very challenging.

Possibly because of this reason, the initial concern (which was always secondary to the subsidies potentially arising from the state guarantee and the loans) was not further developed during the in-depth investigation.

Step 2: Is there a negative distortion of competition?

Once a foreign subsidy is identified, the next step is to determine whether it negatively distorts competition.

The interesting point here is that the FSR introduces two requirements that do not generally feature in the analysis of distortions of competition in State aid investigations. Unlike in State aid investigations, under the FSR, the Commission must:

• demonstrate that a subsidy distorts competition (this differs from State aid investigations, where once the presence of a subsidy is established – the Commission can simply presume that it distorts competition); [19] and
• that it distorts competition in the internal market negatively – a requirement that is in Article 4 of the regulation itself.[20]

The Commission acknowledges these differences in principle. However, an important issue for FSR cases in the future will be how it conducts this analysis in practice.

In essence, from an economic perspective, there are two ways in which a subsidy could distort competition in the context of an acquisition, that is:

• distortions in the acquisition process – this occurs where a foreign subsidy has changed the outcome of the acquisition, because the target would not have been acquired at all, because some other firm would have acquired it instead, or – potentially – because the price paid for the target would have been different; [21] and/or
• distortions in the target's product market – this occurs where a foreign subsidy provides a competitive advantage to the company in its future operations. For instance, the subsidised entity might benefit from continued financial support, allowing it to compete more aggressively by accessing cheaper capital than its rivals can.

The Commission’s approach to the analysis of distortions of competition in Emirates Telecommunications / PPF is instructive.

In its Opening Decision, the Commission was concerned about both types of potential distortions of competition: those affecting the acquisition process, and those affecting the relevant product market post-acquisition.[22] The Commission first stated that a potential unlimited guarantee and a subsidised loan directly financing the acquisition would be presumed to distort competition (under Article 5(1)(b) and Article 5(1)(d) of the FSR, respectively), in particular because those foreign subsidies would have improved Emirates Telecommunications’ competitive position in the acquisition process. In addition, the Commission considered that the foreign subsidies would be liable to improve the competitive position of the combined entity following the acquisition, providing it with access to a cheap source of funding.

In its final decision, the Commission concluded that the foreign subsidies it identified did not negatively distort the acquisition process of PPF.[23] This is because there were no competing bidders for PPF, and Emirates Telecommunications had its own resources that were sufficient to perform the acquisition. As a result, the Commission acknowledged that Emirates Telecommunications would have acquired PPF even in the absence of the subsidies. Moreover, the Commission was satisfied that the acquisition price reflected the target's market value, so that the price paid for the target company was not inflated by the subsidies.

The Commission focussed its attention on the potential distortion to competition in the target’s product market. In particular, the Commission considered that the subsidies could help the merged entity secure better financing terms than its rivals, as a result of which it could enjoy an advantage over its competitors in terms of pursuing acquisitions, licensing spectrum, or investing in infrastructure deployment, particularly within the EU. This decision is interesting for at least three reasons.

First, it shows that the Commission is just as likely to pursue potential distortions of competition in the product market post-acquisition as it is to pursue actual distortions in the acquisition process. While distortions in the acquisition process can be objectively assessed by reference to what actually happened in the acquisition process and by reference to the price paid for the target, the potential future distortions of competition in the product market post-acquisition are, by the very fact that they have not yet taken place, more uncertain and thus more difficult to prove (or to disprove, when the Commission puts the burden of proof on the Parties by relying on the presumptions in Article 5 of the FSR).

Second, it shows that the threshold for raising “sufficient indications” of distortions of competition is quite low, as the Commission so far has been reluctant to engage in a substantive analysis of the distortions of competition in their preliminary reviews of mergers, leaving it to the in-depth investigation. While Emirates Telecommunications / PPF could have been the opportunity for a substantive analysis of distortions of competition, in practice there was no opportunity for such substantive analysis, as the Parties offered remedies which led to an “accelerated” review.

The fact that the in-depth review was accelerated is an important signal in its own right, as it shows that merging parties can accelerate the investigation by engaging in early discussions about remedies, which, in practice, creates a process akin to the Phase 1 remedies process in a merger investigation under the EUMR – a process that is not formally available under the FSR. Accelerating the process has clear benefits for the merger parties in terms of expediency, but – just as in the Phase 1 remedy process under the EUMR – accelerating the process can also carry the risk of conceding remedies that might not be strictly necessary if a full investigation is allowed to run its course, and a full assessment of the potential distortions of competition is carried out.

Third, so far, the Commission seems not to have had the opportunity to consider the requirement in Article 4 of the FSR that the potential distortions of competition would negatively affect competition in the relevant market. This wording of Article 4 departs from the wording of Article 107 TFEU and thus the traditional approach to State aid, where a distortion of competition does not need to have negative effects, and where implicitly it is considered that any distortion – by the very fact that it distorts the market – would be negative, a point that is not supported in economics (where, for instance, a distortion of competition that would allow entry and reduce the market power of the incumbents would distort competition in a positive as opposed to a negative way).[24]

It remains to be seen whether in future cases the Commission will be true to the language of the FSR and try to determine the negative effects of the distortions of competition, or whether it will fall back on the familiar State aid approach and simply assume that any distortion would be negative by definition.

Step 3: The Balancing Test

In theory, even when the Commission finds a foreign subsidy to distort competition negatively, its work will not be done. The analysis under the FSR entails a third and a final step: the Balancing Test. In this step, the Commission must consider whether the positive effects of the subsidy outweigh the negative effects of distorting competition to determine whether, on balance, the subsidy harms consumers or the European economy.

From an economic perspective, the Balancing Test asks a fundamental question about the role of the state in the economy: can the subsidy result in a better overall outcome for the market than competition alone would achieve? This question arises in ad hoc State aid cases (i.e. those that do not fall neatly under any of the existing State aid guidelines) and provides the rationale that underpins the various State aid guidelines. Thus, the FSR in principle requires one to perform a fundamental economic test of the effects of the subsidy.

In practice, to our knowledge, no FSR merger case has so far made it to step three. The Commission concluded that Haier had not received a subsidy, and Emirates Telecommunications offered remedies early in the in-depth investigation, which made a full balancing exercise unnecessary. However, should the Commission take a decision after a full in-depth investigation in the future, it will have to carry out a Balancing Test and show that, on balance, the subsidy harms competition and consumers in the internal market.

In the case of Emirates Telecommunications it would have been interesting to determine whether one of the distortions of competition explicitly found by the Commission, namely the fact that the subsidy could “have engaged in investments, for instance in spectrum auctions or in the deployment of infrastructure [emphasis added]” [25] would have been considered to be harmful.

In my view, it is far from clear why a subsidy that leads to an increase in investment in telecommunications infrastructure should be considered (i) to be a negative distortion of competition; and/or (ii) to fail the Balancing Test.

In fact, investment in telecommunications infrastructure would, I believe, pass the Balancing Test, as it directly promotes broad EU policy goals.

In particular, the EU’s Digital Decade Programme for 2030 aims to achieve gigabit connectivity for all EU households and full 5G coverage in all populated areas by 2030. According to the Commission, “achieving these goals will require substantial investments from the private sector”, [26] and the Commission has identified investment needs of more than €200 billion across the EU noting that the “attractiveness of advanced digital networks by private investors is of crucial importance for the future of connectivity”, [27] especially in regions like Central and Eastern Europe where 5G investment is lagging.

Indeed, the Guidelines on State aid for broadband networks explain that private investment in broadband networks (both fixed and mobile) may be expected to be sub-optimal, and therefore allow State aid in support of broadband networks.[28]

It is therefore unclear to me why a potential increase in investments in telecom infrastructure as a result of the acquisition should not have been considered, on balance, to be positive and in line with community interests. In fact, a remedy that requires “a prohibition of any financing from the EIA and e& to PPF's activities in the EU internal market, subject to certain exceptions concerning non-EU activities and ‘emergency funding’”, [29] insofar as it reduces investments in telecommunication infrastructure is probably not in the community interest.

It seems to me that permitting EU taxpayers’ money to be spent on broadband networks through State aid, but then simultaneously using the FSR to prevent foreign taxpayers’ money to finance the same investments may be a negative unintended consequence of the FSR.

In any case, the experience here emphasises that, if in future the Commission seeks to enforce against a merger under the FSR, the Balancing Test will be an important and necessary stage where economic analysis should play a crucial role.

Conclusions

These cases were the amongst the first where the Commission has conducted a substantive analysis of a merger under the FSR, and the Commission’s approach will no doubt continue to evolve over time. Nevertheless, some lessons already emerge:

• The bar required to open an in-depth investigation – “sufficient indications” of a distortive subsidy – is low. Whilst to date there has been only one in-depth merger investigation, this may have more to do with the Commission taking a pragmatic approach to early cases than to the threshold for an in-depth investigation being particularly high. In fact, an in-depth investigation can be opened whenever a potential subsidy is present, without an explicit early screen for whether the potential subsidy would result in a distortion of competition. This, combined with the fact that a subsidy may potential arise from many different types of direct and indirect financial contributions, means that many mergers are potential candidates for in-depth review. This could lead to more mergers being reviewed under the FSR than initially expected, once the Commission’s approach has been more fully developed and its capacity to review cases has expanded.
• The bulk of the substantive analysis in preliminary reviews is on establishing whether a financial contribution, especially loans, confers a benefit. Given that the Commission tends not to engage in a detailed analysis of the potential distortions of competition in the preliminary review stage, leaving it for the in-depth review phase, the bulk of the substantive analysis in preliminary reviews is on the market conformity of the various financial contributions. The Commission seems to have adopted a pragmatic approach to dealing with tax advantages and grants, focussing much more intensely on loans and potential guarantees.
• The approach to assessing distortions of competition is still at an early stage. Another implication of the fact that the Commission tends not to engage in a detailed analysis of the potential distortions of competition in the preliminary review stage is that there is still no blueprint for such analysis. It is clear that the Commission will consider both distortions of competition both in the acquisition process and in the product market in which the target operates, but it still remains an open question how such distortions should be identified and – importantly – how one would determine whether they negatively affect the market.
• State aid precedents are the Commission’s security blanket. Quite understandably, the Commission tends to fall back on State aid precedents and practice. However, in certain areas the FSR requires some adjustments, as some of the precedents developed with regard to European markets and companies may not automatically translate to companies from other regions of the world. Moreover, the FSR requires the Commission to (i) demonstrate that a subsidy would negatively distort competition; and (ii) engage in a Balancing Test. These analyses are not in practice routinely carried out in State aid cases, so at some point the Commission will find it necessary to engage in somewhat novel analysis.
• The accelerated in-depth review is akin to Phase 1 remedies process. The Emirates Telecommunications case signals that parties can accelerate the in-depth investigation by engaging in early discussions about remedies. This in practice creates almost a “Phase 1 remedies process”, which is not formally available in FSR reviews. As it is also the case in Phase 1 remedies cases under the EUMR, in an accelerated process parties would have to put forward remedies before a full analysis of whether remedies are strictly necessary has been concluded, which may lead to wider remedies.
• Some remedies may not be in the best interest of European consumers. Especially if remedies are designed before a detailed analysis of the distortions of competition and before the full Balancing Test analysis has been carried out, it is possible that remedies may prevent companies from making investments that would benefit European consumers. The requirement that Emirates Telecommunications does not finance PPF’s investments in broadband networks may be one such case.
• The Haier / CCR decision may be a signal that the FSR is not an insurmountable hurdle for Chinese companies. As noted in the introduction to this article, to our knowledge Haier’s acquisition of Carrier’s commercial refrigeration business is the first time that a Chinese company has successfully navigated an FSR merger review. This – together with the fact that the first in-depth merger investigation did not involve a Chinese company – may be taken as a policy signal from the Commission that the FSR is not an insurmountable hurdle for Chinese companies. Interestingly, just a few months before the Commission’s approval of the CCR acquisition, the executive board of Finnish heating company Purmo recommended shareholders to accept a competing acquisition offer over Haier’s higher offer, due to “uncertainties” regarding Haier’s ability to obtain EU foreign-subsidy approval for its bid.

While the Commission’s analysis of mergers under the FSR is likely to evolve over time, our first-hand experience of these initial investigations suggests that there are already the first signs of an initial approach to the analysis.

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References