On 13 July 2023, in a preliminary ruling pursuant to Art. 267 TFEU, the Second Chamber of the European Court of Justice (ECJ), following a request from the Budapest High Court (Fővárosi Törvényszék) addressed the standards a prohibition under foreign direct investment review laws and regulations must meet and, in this context, also commented on the scope of Regulation (EU) 2019/452 of 19 March 2019 establishing a framework for the screening of foreign direct investments into the Union ("EU Screening Regulation"). The ECJ’s  judgment (ECJ, Judgment of 13 July 2023 - Case C-106/22) is good news for investors.

The Facts of the Case

Xella Magyarország ("Xella") is a Hungarian manufacturer of concrete construction products and part of an international group spanning numerous jurisdictions. The group's holding company is based in Bermuda. It is ultimately owned by an Irish national. Xella intends to acquire all shares in the Hungarian mining company Janes és Társa, which extracts gravel, sand and clay from a quarry in northwestern Hungary. Xella is the target company's most important customer: 90% of its production, which accounts for a regional market share of 20.77 % and a national market share of 0.52 %, is purchased by Xella to process the raw materials into sand-lime bricks.

The responsible Hungarian Minister for Innovation and Technology prohibited the acquisition under Hungary's foreign direct investment review regime arguing, among other things, that Xella was indirectly owned by a company based in Bermuda. Should Janes és Társa become indirectly owned by a foreign company, this would pose a long-term risk to the security of raw materials supply in the construction sector. The security and predictability of raw material extraction and supply, the Minister argued, are of strategic importance. Xella subsequently filed an action against the prohibition.

The Budapest High Court hearing the case suspended its proceedings and referred two questions to the ECJ for a preliminary ruling, only one of which ultimately had to be answered. With the question, the Hungarian court essentially asked the ECJ to clarify whether a domestic company which is a member of a group of companies established in several EU Member States, over which an undertaking of a third country has decisive influence, may be prohibited from acquiring ownership of another domestic company regarded as strategic, on the ground that the acquisition harms or risks harming the national interest in ensuring the security of supply to the construction sector, in particular at the local level, with respect to basic raw materials such as gravel, sand and clay.

The ECJ’s Ruling

The ECJ found that pursuant to Art. 54 TFEU Xella could rely on the freedom of establishment and that the prohibition of the acquisition at issue constituted an unjustified restriction on the freedom of establishment.

The ECJ's Findings on the Scope of Application of the EU Screening Regulation

The wording of the Budapest High Court's question, which explicitly refers to recitals 4 and 6 of the EU Screening Regulation, gave the ECJ the opportunity to address the scope of application of the EU Screening Regulation.

With the EU Screening Regulation, the EU created a cooperation mechanism in 2019, which essentially aims at ensuring coordination, cooperation, and communication amongst EU Member States in the screening of foreign direct investment, for example, to ensure that Member States inform each other, with the Commission participating, when a foreign direct investment in one Member State could affect security or public order in other Member States.

The ECJ ruled that the scope of application of the EU Screening Regulation is limited to investments in the EU “made by undertakings constituted or otherwise organised under the laws of a third country.” The EU Screening Regulation is generally not applicable to cases in which the direct acquirer is an EU company. The ownership structure of the direct acquirer is irrelevant.

The ECJ's finding on the scope of application of the EU Screening Regulation is of particular interest for M&A practice. The cooperation mechanism created by the EU Screening Regulation does not apply when the direct acquirer is an EU company. Constellations in which, for example, Chinese or U.S. investors invest in an EU company indirectly through another EU company are therefore not subject to the cooperation mechanism of the EU Screening Regulation.

In the future, foreign direct investment review proceedings in which the direct acquirer is an EU company may possibly be concluded in a faster manner since the EU cooperation mechanism would not apply. However, it is also possible that national authorities will now more frequently take the view that the investment by an EU company controlled by non-EU shareholders constitutes a circumvention of the screening mechanisms (Art. 3 (6) EU Screening Regulation) and that the EU Screening Regulation therefore applies. Especially in the case of special purpose vehicles that are established solely for the purpose of a specific investment, competent national authorities could increasingly consider this to be a circumvention in the future. This risk is likely to be lower, however, in the case of direct acquirers who engage in operational business activities.

It is also possible that the ECJ's ruling incentivizes the Commission to expand the scope of the EU Screening Regulation. Soon it would have the opportunity to do so: the EU Screening Regulation is currently being evaluated and the Commission will present a report at the end of 2023, which could also contain proposals for amending the EU Screening Regulation.

The ECJ’s Decision on the Compatibility of the Investment Prohibition with the Freedom of Establishment

According to the ECJ's findings, companies that have the nationality of an EU Member State (i.e. are established under the laws of an EU Member State and have their registered office, central administration or principal place of business within the Union) enjoy freedom of establishment irrespective of their direct or indirect shareholders’ nationality. The prohibition of an acquisition of shares based on national foreign direct investment review laws and regulations is a restriction of the freedom of establishment within the meaning of Art. 49 TFEU. However, according to Art. 52 (1) TFEU, a restriction on the freedom of establishment may be justified on grounds of public policy, public security or public health.

In its judgment, the ECJ refers to its established case law according to which purely economic grounds, such as, in particular, promotion of the national economy or its proper functioning, cannot justify restrictions on fundamental freedoms, including the freedom of establishment. However, reasons of an economic nature may constitute an overriding reason in the public interest capable of justifying a restriction of fundamental freedoms, if they pursue an objective in the public interest. Public order and security can only justify a restriction of fundamental freedoms if there is a “genuine and sufficiently serious threat” to a fundamental interest of society. In principle, the threat may also relate to security of supply.

Whether a possible threat to security of supply actually justifies the prohibition of an investment must be decided on a case-by-case basis and also depends on the sector concerned. In the past, the ECJ has already recognized the safeguarding of the supply of public services in the areas of oil, telecommunications or electricity as a reason of public security with which restrictions of fundamental freedoms can be justified. However, according to the ECJ, the situation is different in the case of the supply of basic raw materials such as gravel, sand and clay to the construction sector at the local level. A fundamental interest of society is not affected in this case. Therefore, the Hungarian Minister of Innovation and Technology's prohibition in question is not consistent with the freedom of establishment.

The fact that the ECJ reminds EU Member States in clear terms of its case law on the conditions for justifying a restriction on freedom of establishment is good news for investors. The ECJ clarifies that the grounds for prohibition of investment made directly by an EU company must meet high standards.