This article was originally published in the Director Journal, a publication of the Institute of Corporate Directors March, 2013

Six cautions for directors in the wake of China’s deal for Nexen

Directors in Canadian-owned companies need to be aware of the political risk associated with the sale of their firms. One of the more surprising developments in the Harper government during its seven years in power is the evolution of its stance on foreign direct investment (FDI). In opposition, the conservatives had mostly advocated a policy of minimal restriction on FDI, but the more nuanced demands of governing tested this policy early. The federal government has been adjusting its policy ever since – which increases the importance of political risk as a board of directors consideration.

Early in its first minority mandate, the government was challenged by two major deals: the acquisitions of Inco by Brazilian-owned Vale and of Falconbridge by Swiss-based Xstrata. In response, Prime Minister Stephen Harper launched the Competition Policy Review Panel, chaired by L. R. Wilson, to review Canada’s competition and foreign investment policies. The Wilson Report’s central recommendation on investment was a “reverse onus” test, eliminating the so-called “net benefit” test in the Investment Canada Act and putting the onus on government to prove why an acquisition should not be concluded. Wilson had no doubt observed that the existing approval process, with its legislated (and lengthy) review timetables, could force governments to bow to public opinion and media pressure on commercial transactions that they ought to leave to the marketplace to decide.

Tellingly, Wilson’s recommendation was never adopted. With the 2008 global economic meltdown, foreign investors began to reconsider many of the promises, or “undertakings,” they had made to Investment Canada to secure foreign investment approval. U.S. Steel Corp., which had acquired Stelco in 2007, closed its Canadian steel production, in complete disregard for the company’s promises, but kept its U.S. facilities open. The government successfully sued U.S. Steel, having concluded that Canada needed to play by much tougher rules when it came to enforcing the contractual commitments of foreign investors. More generally, it came to the realization that it could not take an entirely “free market” view on foreign investment.

In summer 2010, the Anglo-Australian mining giant BHP Billiton made an unsolicited offer for Potash Corp. of Saskatchewan (PCS), promising to establish its global potash headquarters in Canada, relocate its entire Canadian operation to Saskatchewan, spend billions to develop the largest potash mine in the world on the Jansen site, and use the management expertise of PCS to help with the process. initially, the offer was positively received by federal decision makers, but it soon grew to be a political liability. While most PCS shareholders were already outside Canada, the centre-right government of Saskatchewan quickly rode to the “rescue” of Potash, citing myriad concerns, from the loss of tax revenue to the lack of dependability of foreign investment undertakings.

At a time when every vote counted to Harper’s minority government, Saskatchewan was able to marshal enough political opposition to give the federal government pause. More neutral observers noted that the resources themselves were not actually being sold, but remained provincially owned and regulated. But the federal government was not going to spend any political capital explaining this to the public when the political momentum was with “the crowd.” Rejecting the application, despite unprecedented economic and other commitments, became the expedient decision.

Most recently, the acquisition of Nexen Inc. by the China National Offshore Oil Corp. (CNOOC) has created a whole new test around foreign investment by raising the stakes over state-owned enterprises (SOE) controlling a significant part of our economy.

CNOOC had studied the BHP Billiton case well. It came with a friendly deal for Nexen, premium-priced for shareholders and with significant commitments to the Canadian government, including the full retention of Nexen employees and management, establishment of a North American headquarters, and a public listing on the TS X – a significant concession designed clearly to meet SOE guidelines introduced in 2008. The transaction was also the first major investment by a Chinese company since Prime Minister Harper travelled to China in February 2012 to announce that Canada was “open for business.”

As time went on, the federal government’s support for the Nexen deal began to erode. Ultimately, however, the government allowed the deal to proceed – grudgingly – because it met its legislative and SOE tests.

Total Chinese investment in the oil sands now exceeds 10% of production, and total SOE investment, including the OECD-based Statoil and Total, exceeds 20%, prompting the prime minister’s now-famous remark when announcing that the CNOOC deal had been approved: “To be blunt, Canadians have not spent years reducing the ownership of sectors of the economy by our own governments, only to see them bought and controlled by foreign governments instead.” The government then announced it would restrict further SOE investment in the strategically important oil sands, except under “extraordinary circumstances.”

Much speculation has gone into what “extraordinary” means, with critics trying to anticipate the loopholes. But this misses the point. What is really significant is that the oil sands, like potash, are now at least informally designated as a strategically important asset.

The CNOOC/Nexen transaction only affected 3% of oil sands output and has no strategic significance affecting production, but the concern was more for the precedent it set for possible future acquisitions of larger Canadian companies such as Encana, Canadian Natural Resources or Suncor.

So what lessons can directors of Canadian-owned companies learn from this unpredictable evolution in Canadian investment policy?

First, each transaction must be assessed as a separate event. The Investment Canada Act sets out some specific criteria that can offer guidance, but there are no clear rules on whether these transactions will be approved. That is not necessarily a bad thing. Retaining some flexibility is important for government because it is impossible to anticipate all the implications of future transactions. That said, the process has become very political, and companies investing in Canada must manage on that basis.

Second, don’t be confused by the Harper government’s “Conservative Party” label. This is not a government driven by ideology. As the prime minister has said, “Practical government rarely permits such simplicity.” The Harper government is highly attuned to public opinion and will not turn a blind eye to a foreign acquisition if the deal could have an impact on the government’s popularity. Some sort of risk mitigation for the government’s own interests will likely be required for any potentially controversial transaction.

Third, the government is increasingly defining its economic policy in terms of the national interest, and all of its actions need to be seen in light of whether they enhance the country’s wealth and power. If an acquisition were to seriously erode the national interest in a particular industry sector, expect the government to be skeptical.

Fourth, no major takeover can expect to be approved without significant attention to the provinces. Beyond the Potash example, support from Alberta helped CNOOC in Ottawa, while opposition from Quebec short-circuited any formal application from North Carolina-based Lowe’s last year when it was contemplating a hostile offer for the Montreal-based RONA hardware chain.

Fifth, any acquisition of a significant brand or operation that is likely to gain public attention could well trigger a policy backlash. This risk exists whether the acquirer is private or governmentowned. But it certainly increases with the amount of government ownership in an SOE, along with the size of the investment target and the diversity of its shareholder base.

Finally, there is no replacement for being prepared. Political-risk transactions need to be assessed well in advance of any announcement. Government-relations and communications strategies need to be planned and prepared for decision makers, media and stakeholders. In the past, many lawyers would recommend holding concessions to the end in order to negotiate from a position of strength; today, key commitments to satisfy governments or regulators should be developed ahead of time and in all probability announced as soon as public communications commence in order to mitigate potential political fallout.

Canada will continue to be an open economy and encourage foreign investment. As the prime minister himself said after the BHP decision, “No one should doubt this government’s policy… that, generally speaking, foreign investment is in the interests of the Canadian economy.” That said, the days of Canada being “open for business” are over, when control of significant Canadian companies is at stake. In these uncertain economic times, the current government’s assessment of its own interests and the Canadian national interest will be the norm going forward. Foreign investors, as well as directors, would be wise to study the evolution in Canada’s investment policy and to do a formal political-risk assessment before entering into talks with a Canadian target company.