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    How to ring-fence your way out of merger and takeover supervision in the telecom sector

    Shareholders in Telecom and IT companies considering an exit should be aware of two new legislative developments. First of all, the Ministry of Economic Affairs has published a draft bill that authorizes the Minister of Economic Affairs to block or undo any acquisition deemed a threat to national security or public order.

    This proposed bill, The Telecommunications Sector (Undesirable Control) Bill (the "Bill"), was introduced on February 9th of this year as part of a larger governmental effort to prevent unwanted (foreign) shareholders from taking control of companies considered of vital importance to Dutch society – so-called 'vital companies'. Additionally, in September 2017, the European Commission published a draft regulation that provides a framework for the screening of foreign direct investments that could potentially impact national security or public order (the "Regulation"). This Regulation contains a basic set of requirements that member states should adhere to when screening a foreign investment and authorizes the European Commission to issue a non-binding opinion.

    This article explores the challenges faced by companies in the Telecom and IT sector preparing for a takeover under the proposed Bill and Regulation and investigates whether pre-deal structuring in the form of ring-fencing can help shield these companies from unwanted government interference.

    Challenges under the new Telecommunications Act

    The Bill introduces a new chapter, titled 14a, to the already existing Telecommunications Act and gives the Minister of Economic Affairs the right to prevent a new shareholder from acquiring a controlling interest in a 'telecommunications party' if the acquisition significantly impacts the telecommunications sector and, as a result, poses a risk to national security or public order. More remarkably, the Bill empowers the Minister to force a shareholder to sell (all or part of) his controlling interest, if at a later stage, it can be shown that the initial acquisition posed a threat to national security or public order.

    The potential impact of this Bill is even more dramatic when considering how broadly it defines 'telecommunication party.' The Bill is applicable to all companies based in the Netherlands (or Dutch branches thereof), that directly or indirectly control an electronic communications network or service, a hosting service, an internet hub, data center or any other network or service designated as such by order in council. As a result, the Bill could, in theory, impact many companies.

    The Bill has been widely criticized. It has been denounced as overly complicated, criticized for its use of vague terms and thresholds and condemned for potentially infringing on two of the fundamental freedoms underpinning the European Union single market – the free movement of capital and freedom of establishment.

    Proposed Regulation European Commission

    On 14 September 2017 the European Commission published a proposed Regulation that provides a legal framework for the screening of foreign direct investments in the European Union. In its current form, the Regulation only applies to takeovers that could potentially pose a threat to national security or public order. This could be an acquisition of a company that operates in a critical infrastructure sector, such as: energy, communication or data storage or an acquisition of a company that owns or develops vital technology, such as artificial intelligence, semi-conductors, cybersecurity etc. The framework– which takes the form of a regulation with direct effect -- addresses three specific topics:  1. Screening of foreign direct investments by member states on the grounds of security or public order;  2. Cooperation between Member States and the Commission in the event a specific foreign investment in one Member States could potentially impact the security or public order in another member state; and 3. Screening by the European Commission in the event a foreign investment in a member states affects a project or program of Union interest. A remarkable feature of the proposed Regulation is that it allows the European Commission to voice its opinion on a proposed investment. Although, the opinion is non-binding we believe it will weigh heavily on the minds of politicians and will most likely not tip the scale in the (foreign) investor's favor. Our opinion is supported by the wording of the Regulation: "the Member States where the foreign direct investment is planned or has been completed shall take utmost account of the Commission's opinion."1)

    Proposed solution: Ring-fencing

    At first glance, the Bill and proposed Regulation appear to have far-reaching consequences for shareholders of companies in the Telecom and IT sector. However, if we explore an approach taken by some Dutch companies to separate activities of ‘vital’ importance to society from other company business, a possible roadmap to steer clear of governmental interference emerges. This process that separates one part of the company from the rest is a form of pre-deal structuring often referred to as ring-fencing. It has already been proven successful in other sectors considered vitally important to Dutch society. Ring-fencing can be achieved by various means. Firs off, a complete legal split can be created by dividing all companies assets between two separate legal entities. Alternatively, a lighter form of ring-fencing can be achieved by an organizational separation within one legal entity.

    In the Energy sector the vital processes of national transportation and the distribution of electricity are protected by ring-fencing. Tennet Holding B.V. is the operator of the national electricity grid and, as such, is responsible for dividing electricity among local distribution networks. Within the Tennet Group, the activities involving grid management are separated from other non-vital activities and are placed under government supervision to guarantee the proper distribution of electricity.   A recent example in which the government pushed for ring-fencing in the context of a merger was Fox-IT. Fox-IT Holding B.V., which had been commissioned by the Ministry of Defense to encrypt state secrets, was purchased in 2015 by the British NCC Group. Once the Ministry caught wind of the merger, they feared that state secrets might fall into the wrong hands. In an attempt to prevent this from happening, they demanded, as one of the conditions for continuing to work together, that:

    • Fox-IT and all its subsidiaries remain governed by Dutch law;
    • all current and future contracts related to encryption for the Ministry of Defense, be performed by a separate legal entity – Fox-Crypto B.V.;   
    • Fox-Crypto B.V. not be permitted to dissolve, merge, divest, sell its shares, appoint new directors or change its articles of association without prior approval of the Ministry of Defense;
    • the Ministry of Defense have a right of first refusal in the event Fox-IT sells its shares;
    • Fox-IT Holding B.V. guarantees that all commitments under current agreements with the Ministry of Defense are honored;
    • management and other key employees of Fox-Crypto B.V. hold the Dutch nationality; and
    • the IT-system of Fox-Crypto B.V. be separated from the other IT-systems.

    The Tennet and Fox-IT examples reveal what shareholders of vital companies should take into consideration when structuring an acquisition and/ or exit. Shareholders must carefully analyze and dissect the vital part of the company from the non-vital part. Any agreements relating to the separation should be incorporated in the articles of association or in a separate shareholders' agreement. Moreover, all standing agreements with clients and suppliers should be allocated to the right legal entity and all shared services, such as IT, should be separated.

    Carve-out

    As previously mentioned, ring-fencing is most successful when a seller separates non vital activities from vital activities and transfers the latter to a separate legal entity. This type of pre-deal structuring bears a strong resemblance to a carve-out. A carve-out is a transaction where a company segregates a portion of its business and sells it to a third party or floats it through an initial public offering. Carve-outs are usually structured as asset-deals, share deals, legal divestures or a combination of the three. When considering a carve-out deal careful preparation and planning are paramount. The complex and intricate transaction structure raises a number of unique legal issues not normally present in more typical whole business M&A transactions. Because certain parts of the target's business are inextricably linked to the seller's remaining business, extensive due diligence is required to analyze the viability of the asset(s) on a stand-alone basis. Major challenges for a carve-out in the Telecom and IT sector are employees and IP/IT. The carved-out business often shares IP assets and services, including IT services, with the seller and other subsidiaries and/or affiliates. Due diligence is required to identify the assets that should be transferred to the buyer and those that should remain with the seller. This due diligence should focus on (registered and unregistered) IP ownership (i.e. confirmation on ownership of and rights to assign IP and review of licenses and change of control issues), third party IP entitlements (review of licenses), IP disputes and IT assets (review of proprietary and licensed software and other IT assets). Once due diligence is completed parties need to decide whether the seller licenses IP assets to the buyer and/ or provides IT services to the buyer after the completion for either a transitional period or on a long-term basis. Usually, this requires drafting limited trademark license agreements and obtaining consent from third party licensors. A crucial structuring tool in these matters is a transitional service agreement ("TSA") which ensures that the seller continues to provides infrastructure support, such as IT and HR, after closing. Important components of these TSAs are finance/accounting, legal, tax, call center/customer services, website access and IT (including access to software and support services). In the event the carve-out is structured as an asset deal employment issues become very important. If the asset deal qualifies as a "transfer of undertaking", obligations under existing employment contracts will automatically be transferred to the new employer. In that case, the acquirer is, in principle, responsible for the carve-out entity's pension plan and arrears in premium payment. We recommend conducting due diligence focused on all terms and conditions that could result in an employment issue and negotiating terms that leave employment risks dating from the past with seller. 

    Conclusion

    Companies in the Telecom and IT sector with plans to sell all or part of their business face uncertain times. As demonstrated by these new legislative developments, the protection of vital companies - especially in the Telecom and IT sector – remains a top priority in the Hague and Brussels. 

    However, as this article attempts to show, shareholders need not panic. A proven solution might be within reach. Examples from other companies in sectors deemed vitally important to Dutch society show that ring-fencing can both help companies avoid unwanted interference from government authorities and increase the chance of a transaction's success. By using the same legal framework as required for a carve-out transaction, we believe shareholders can ring-fence their way out of governmental merger and takeover supervision.

    1) Article 9.5, Regulation of the European Parliament and of the Council establishing a framework for the screening of foreign direct investments into the European Union 2017/0224 (COD)