This article originally appeared in the March/April 2014 issue of Director Journal, a publication of the Institute of Corporate Directors (ICD). It is a follow-up to Mike’s 2013 reflection on foreign investment titled “The Unpredictable Evolution of Canadian Investment Policy: Six cautions for directors in the wake of China’s deal for Nexen“, published in the March 2013 issue of Director Journal.

Ottawa favours flexibility over predictability

Directors exploring the option of a foreign sale must be aware of the increasing complexity of political risk surrounding such deals.

Three major developments have driven a further evolution in Canada’s foreign investment policy in the year since Prime Minister Stephen Harper announced new rules governing state-owned enterprises (SOEs) and higher investment review threshold limits: the decline in Chinese investment since the CNOOC Ltd.-Nexen Inc. transaction; the use of the national security test to screen out or deter unwanted investors; and a further adjustment to Canada’s review thresholds.

The China question

The growth of Chinese foreign investment is raising public policy concerns around the globe as democratic countries try to reconcile the need to develop Chinese trade and investment relationships with the politics of working with a regime where the rule of law is secondary to party policy. As The Economist noted last year, since the 2008 global financial crisis, all countries seem to be putting up barriers to trade and foreign investment. But it is Canada, the United States and Australia who seem to have the greatest concerns about China.

According to the Bank of Montreal, Chinese SOEs currently own 10 per cent of the total reserves in Canada’s oil sands, with other SOEs accounting for an additional two per cent. Some critics of the new SOE guidelines have publically expressed concern that restricting SOE enterprises has cooled potential Chinese investment. Former Industry Minister Jim Prentice, now Vice Chair of CIBC, said in a speech last fall that large SOEs have emerged as a dominant form of international capital, especially in the energy sector, and Canada should not be intimidated by their presence.

These views may not be shared unanimously. In implementing the new SOE guidelines, the government was responding to vocal domestic concerns raised by industry, academia and NGOs, and in the media. A powerful lobby of Canadian oil interests encouraged the federal government to let the Nexen-CNOOC deal proceed, but only if restrictions on further SOE investment were implemented. Some in Canadian industry claimed to be very concerned about what they saw as the capital cost advantages SOEs have over the private sector. Others said that keeping SOE investment out makes it easier for Canadian companies to acquire properties.

A voice of reason in this debate has been Kevin Lynch, former Clerk of the Privy Council and current Vice Chair of BMO Financial Group. Lynch points out that it is not the ownership of capital that the government should be primarily concerned with, but the behaviour of capital. For example, to date, CNOOC has kept every promise it made to the Canadian government, including obtaining a listing on the TSX despite being very thinly traded. Contrast this with U.S. Steel which, after making explicit employment and operational undertakings to the federal government when it acquired Stelco, closed most operations within a year, settled a messy lawsuit with the government, and announced last fall that it was permanently closing its Canadian operations.

Meanwhile, the Chinese government is moving to address growing barriers to outbound investment by SOEs and is countering perceptions of capital cost advantages by tacking additional taxes onto SOE profits. By 2020, Chinese SOEs will be expected to hand over 30 per cent of their profits as dividends to the central government. Private-sector business will also be given greater opportunity to invest in SOEs and do business in areas dominated by them.

National security test

The government started using “national security” in earnest as a screening mechanism for foreign investment in 2013, perhaps in part because it has the added benefit of not requiring the government to provide any specific reasons for its concerns.

In a much-discussed case last fall, the government formally rejected the acquisition of the Allstream Division of Manitoba Telecom Services Inc. by the Egyptian investment group Accelero Capital Holdings. From what we can decipher from Industry Minister James Moore’s statement on the matter, the government was concerned about the national security implications of a foreign buyer operating a national fibre network that provides critical telecommunications services to the Government of Canada.

Soon after that, the government also made it clear that it was not comfortable with a possible sale of BlackBerry Ltd. to the Chinese computer-maker Lenovo Group Ltd. or any other state-influenced acquirer. What was noteworthy here is that the government opined on a potential investor before it even had the opportunity to submit an application. The upside for the government and the aspiring investor, however, was that both were able to avoid a potentially embarrassing and protracted public debate.

Expect to see—or, rather, “not see”—more of this.

Adjusting foreign investment thresholds

On a more positive note, 2013 ended with an important liberalization of the threshold level at which all investments by non-SOEs are reviewed, due to looming provisions of the Comprehensive Economic and Trade Agreement (CETA) between Canada and the EU that will affect other freetrade agreements.

As part of CETA, Canada agreed to increase the foreign ownership threshold limits for all European transactions to $1.5-billion over the two years after the agreement comes into effect. Grandfathering provisions in all of our major free-trade agreements, including NAFTA, mean our other favoured trading relationships will automatically be granted the same privileges. Significantly, however, SOE thresholds are not affected and remain fixed at $344-million.

Based on country of origin, the practical implication of this policy change is that, within a few years, the vast majority of foreign investments will be executed without a review.

A question of balance

The recent controversies surrounding foreign investment have proved embarrassing for both the government and prospective investors as the current Investment Canada review process, with its legislated timetables, can turn a foreign investment into a “competition” that media love to cover.

Companies now feel compelled to increase the types of undertakings they are making to demonstrate their commitment to the Canadian economy, and indeed to society. These often go far beyond capital and employment guarantees and now commonly include listing on the TSX, establishing regional headquarters or world product mandates, and making philanthropic donations—all in an attempt to pass a public litmus test about the benefits of foreign ownership. The contracted duration of these undertakings is also lengthening. None of this is helpful in demonstrating that Canada welcomes foreign investment.

Clearer rules may provide less risk to investors, but the government believes it is more politically vulnerable if transactions like the PotashCorp or CNOOC deals capture the attention of the public. Looking at the policy changes overall, it is apparent that any foreign transaction of significant size will continue to carry a high level of political risk if it becomes part of public discourse. This is particularly true if the transaction is by a SOE, and even more so if it is a Chinese SOE. We can also expect the continued use of the national security test to screen out unwelcome investors owing to the lack of justification required from the government.

Directors need to know that there is unlikely to be any deviation from this tactical approach to policy making as long as the current government is in power. The prime minister is clear: he wants flexibility in the rules. The question remains, however, whether there is enough predictability in the rules to entice foreign investment, particularly in the energy patch.