Canada: Foreign State-Owned Investors Spark “National Security” Concerns

Last Updated: October 23 2007

Article by Cliff Sosnow, Eric Elvidge, Elysia Van Zeyl, Alexis Von Finckenstein, © 2007, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on International Trade, October 2007

Canada Signals its Intention to Place Restrictions on Foreign Investment

Foreign state-owned enterprises hoping to invest in Canadian industry may face an additional hurdle in the near future. In a recent address to the Vancouver Board of Trade, Minister of Industry Jim Prentice indicated that the federal government intends to revise the Investment Canada Act (ICA), citing the need to examine acquisitions by so-called state-owned enterprises and the absence of a national security review mechanism as concerns necessitating a full review of the ICA this fall.

Minister Prentice’s statements illustrate the government’s intent to strike a difficult balance between maintaining Canada’s free-market system that encourages foreign investment while protecting Canada’s industries and resources from enterprises whose objectives may not be strictly commercial.

Somewhat puzzling is the government’s simultaneous praise for Canada’s accessible investment climate and calls for tighter controls on that same investment environment. There was an explicit recognition of the numerous benefits Canada enjoys because of foreign investment, including job creation, enhanced innovation and increased productivity. Despite these benefits and the government’s position that the ICA has been working well, the Minister stated "[F]ree markets do not mean a free pass. Canada is open for business, but it’s not for sale. And like other countries around the world, it’s important that we have safeguards in place to protect our interests." He concluded that the ICA needs some updating to ensure "that we are maximizing the benefits of foreign investment for Canadians while retaining our ability to protect our national interests." Minister Prentice framed the national interest sought to be protected as "national security."

The Canadian government’s concern regarding foreign state-owned enterprises stems from the observation that certain of these enterprises fail to comply with market principles and fail to adhere to transparent corporate governance practices. In addressing these concerns, the government is considering the introduction of guidelines for foreign state-owned enterprises and a national security test to be incorporated into foreign investment reviews under the ICA.

It is not yet clear whether Minister Prentice intends to fold the new guidelines for foreign state-owned enterprises into the current "net benefit" test under the ICA, or whether it will entail new criteria. The net benefit test that is currently used during investment reviews examines the effect that the proposed investment will have on economic activity, productivity and competition in Canada, compatibility with Canadian national industrial and cultural policies, as well as the impact on employment, resource processing and Canadian export activity. On past occasions, Minister Prentice has indicated his opinion that the net benefit test is broad enough to allow him to stipulate that transactions must be transparent and comply with market principles.

The address was sparse on specifics about what a national security test might entail or when a bill will be officially introduced in Parliament. Further, it is also unclear at this point whether this national security test will fall within the scope of the current net benefit test as an amendment to the test or whether amendments will be required to the ICA to create an entirely new category of review. Minister Prentice did say that any legislative or policy changes would not apply to take-overs currently in progress.

Adding an additional layer to this complexity, in July 2007 the federal government established a review panel and charged it with the responsibility of examining the key elements of Canada’s foreign investment legislation and competition policies. The core mandate of the panel is to review the ICA and the Competition Act. Among the issues the panel will be considering are the treatment of state-owned enterprises, the possibility of a national security review clause and sectoral investment restrictions (i.e., in telecommunications, mining and resources, etc.). The panel’s report, which is scheduled to be released in June 2008, is expected to provide recommendations on how foreign investment can be used to strengthen Canadian businesses. Minister Prentice indicated that further details regarding the proposed changes to the substance of reviews under the ICA will be announced prior to the completion of the panel’s report. This urgency results from the position, as expressed by the Minister, that state-owned enterprises and national security are a high priority and need to be addressed immediately. It is unknown at this time how the panel’s examination of the same issues and the recommendations based on their examination of the issues will fit into the government’s analysis and timelines.

Amendments to the ICA: Compliance with Canada's International Trade Obligations

An examination of the net benefit test and its modifications, consideration of a national security test and the application of criteria for the review of investments by state-owned enterprises invariably raise, as Minister Prentice correctly points out, complex compliance issues regarding Canada’s international obligations under the World Trade Organization (WTO) and the North American Free Trade Agreement (NAFTA). In considering changes to the treatment of foreign state-owned enterprises under the ICA, he pledged to look carefully at the provisions in other G8 countries, as well as in Canada’s NAFTA and WTO obligations. Proposed modifications to the net benefit test as it applies to certain state-owned enterprises or the application, out of a whole cloth, of a new national security test to review foreign investments by state-owned enterprises raise compelling questions about compliance with WTO and NAFTA investment rules.

Under the NAFTA (and indeed under the WTO), Canada has agreed to provide equal treatment to investors from NAFTA countries with certain specific exceptions. Using NAFTA as an example, Article 1102 requires each NAFTA country to place all NAFTA investors on an even playing field with regards to the establishment, acquisition, expansion, management, conduct, operation, and sale or other disposition of investments (the "national treatment" standard). Investors from Mexico and the United States, for example, are to be treated no less favourably than Canadian investors acquiring existing Canadian businesses or establishing new businesses in Canada. Although the goals of a policy that limits investments to entities that show transparency, demonstrate good governance practices and operate according to free-market principles are laudable, placing limits on the ability of state-owned enterprises to invest in Canadian businesses may raise legitimate trade law compliance issues given the obligations Canada has undertaken with respect to its North American neighbours (and countries under the WTO).

The issue of compliance with international trade law obligations is particularly germane regarding the net benefit test and the national security review question. Non-conforming measures (i.e., measures that are otherwise inconsistent with international obligations) that existed at the time the NAFTA came into effect may remain in force; however, laws cannot be amended to become less consistent with NAFTA rules, including the investment rules under NAFTA Article 1102. Canada’s schedule under Annex I of the NAFTA outlines Canada’s reservations regarding national treatment. Canada has reserved the discretion to review foreign investments further to the net benefit test of the ICA that rise beyond specified monetary thresholds and that affect Canada’s cultural heritage or national identity. It is not clear whether the application of new guidelines to certain foreign state-owned enterprises would increase the level of inconsistency of the net benefit test.

Similarly, a national security test currently exists under the NAFTA and it applies to all NAFTA rules including the national treatment standard in Article 1102. Canada, as expressed in Article 2102, has the ability to take non-conforming actions that are necessary for the protection of national security interests. The national security exception in the NAFTA generally addresses concerns relating to the international traffic in arms and ammunition, the non-proliferation of nuclear weapons and measures that must be taken for national security in times of war or international conflict. It is uncertain whether the Minister’s proposed imposition of a national security test under the ICA is consistent with the way the national security exception is cast in the NAFTA. If it is not, then questions arise as to whether a new test applicable to ICA reviews is NAFTA (and WTO) consistent.

Prudence suggests that foreign general counsel and CEOs diligently examine the new tests to ensure that amendments to the ICA are consistent with Canada’s international trade obligations.

Impact on Investment Review Process for Foreign Investors

Apart from the trade law implications and assuming the proposed amendments are NAFTA and WTO compliant, the adoption of new rules designed to address concerns related to investors owned or controlled by a foreign state and national security interests will have a measurable impact on the investment review process for foreign investors.

Currently, the acquisition of control of a Canadian business, and the establishment of a new Canadian business, by a non-Canadian are subject to the ICA. Transactions that do not exceed prescribed monetary thresholds are subject to a simple notification requirement. Where the monetary thresholds are exceeded (or where the proposed investment falls within a prescribed business activity related to Canada’s cultural heritage or national identity), the proposed investment is subject to a substantive review.

A reviewable transaction may not be completed unless the relevant Minister is satisfied, in part based upon negotiated undertakings provided by the investor, that the investment is likely to be of net benefit to Canada. As earlier indicated, the ICA requires the Minister, in determining net benefit, to take into account a number of specific factors. At the moment, these factors do not address either state-owned or controlled investors or national security interests.

As earlier noted, it is not clear from the public announcements made to date by Minister Prentice how the ICA might be amended to deal with a proposed investor that is owned or controlled by a foreign state. Minister Prentice highlighted the government’s interest in ensuring that such investors operate under the same standards as any other commercial enterprise operating in Canada, "including those related to transparency, good governance practices and whether they operate according to free market principles." One can easily imagine that such standards might well constitute the subject matter of new forms of undertakings beyond the scope of those that the Minister has traditionally required in connection with the approval of a proposed transaction.

Similarly, regarding Minister Prentice’s comments on national security interests in an amended ICA, it will be very important that any test ultimately enacted indeed be explicit. The previous federal government also proposed changes to the ICA legislation to permit the review of a proposed investment based on national security concerns. However, that proposed legislation (which was never enacted) rightly attracted criticism on the basis that the term "national security" was not defined. As a result, the proposals not only could potentially have been very broad in application, they could also have allowed significant government discretion.

Regardless of how these proposed new rules might ultimately be drafted, it is almost certain that the practical impact on the investment review process for foreign investors will be more delay and negotiation. Even under the current regime, it is often difficult to obtain the Minister’s approval before the expiration of the initial waiting period of up to 45 days set out in the ICA. As a result, the initial waiting period often is extended. In future, if new rules dealing with state-owned or controlled investors and national security interests are in fact adopted, it is likely that negotiations with government officials will simply take longer, and involve a more extensive set of undertakings, before the Minister ultimately makes his "net benefit" determination.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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