1. Introduction: Turning Impediments into Opportunities
Canada requires that Canadians own and control certain targeted industries, including telecommunications operators, broadcasting licensees, domestic airlines and a number of cultural industries such as certain book publishing and retailing businesses. Despite complaints that these rules lead to inefficient industries, diminished competitiveness, high consumer prices and reduced investment, they nonetheless endure. Canadian politicians are reluctant to weather the political storm that they fear will follow from liberalizing these rules. In an environment where worries about the "hollowing out" of the Canadian economy have become something of a political hot-button, no politician wants to be identified with easing the way for yet another Canadian corporate mainstay to fall under foreign control.
To be clear, the Canadian ownership and control rules do not forbid foreign investment in the targeted industries. But they do make it difficult for an investor seeking to make a sizeable investment, or to consummate a merger. That said, a few determined investors have persevered, and they have found that opportunities do indeed exist – opportunities that are that much greater because the rules are complex and difficult. For example, despite Canadian ownership and control rules, American Airlines was able to buy a majority interest in a Canadian airline and operate much of its back-office activities, Goldman Sachs was able to buy a majority interest in the Canadian broadcasting business of Alliance Atlantis, US-based Loral was able to buy a majority interest in Telesat, Canada's largest communications satellite operator, and non-Canadian private equity firms were able to acquire a large majority of the equity in Air Canada.
How did they do it?
The purpose of this article is to provide some answers to that question. In doing so, we will summarize the rules that apply to the targeted industries, with particular mention of the complex and confusing "Canadian control-in-fact" requirements. We will go beyond the formal rules, however, and discuss the successful strategies that non-Canadian buyers have employed to satisfy the rules while allowing them to achieve their investment objectives.
2. The Canadian Ownership and Control Rules, and Who Enforces Them
The Canadian ownership and control rules are all structured in a similar manner. They establish formal limits on measurable factors, such as the percentage of voting shares that that non-Canadians can hold or the percentage of the board of directors that must be Canadian. These are usually straight-forward to understand and apply. But the rules also include a requirement that Canadians exercise "control-in-fact" of the enterprise – a concept that is anything but straight-forward.
The rules are enforced by several federal regulators. Although enforcement, in theory, can occur anytime, a foreign investor is most concerned at the time of a business acquisition, when regulatory scrutiny is most intense. The rules become a key input on whether to make an offer, and how to structure it.
In the following paragraphs, we will first summarize the formal, measurable rules that apply to the most relevant industries. We will assume that a corporation structure is used for the Canadian business. Other structures, such as trusts and partnerships, do come up and can be workable, but they are beyond the scope of this paper. We will then move on to tackle the concept of Canadian control-in-fact.
Section 16 of the Telecommunications Act states that a telecommunications company that owns transmission facilities (referred to as a "Canadian carrier"), such as a cellular telephone company, will only be eligible to operate in Canada if it is Canadian owned and controlled. That requirement will be satisfied if (a) at least 80% of its directors are Canadian, (b) Canadians own at least 80% of its voting shares, and (c) it is controlled-in-fact by Canadians. The term "Canadian" is defined in the Canadian Telecommunications Common Carrier Ownership and Control Regulations. A company will be considered "Canadian" if: (a) Canadians own at least 66.7% of its voting shares, and (b) it is controlled-in-fact by Canadians.
It is important to note that only voting shares are mentioned. Non-Canadians can own non- voting shares to increase their overall equity participation in the Canadian carrier. That said, some practical limits do apply before issues of non-Canadian control-in-fact start to surface – as discussed below. It is also possible for the non-voting shares to be convertible into voting shares if and when the rules permit such conversion.
The rules for telecommunications companies are enforced by two separate regulators. The Canadian Radio-television and Telecommunications Commission ("CRTC") enforces compliance under the Telecommunications Act. It does this by requiring the filing of an annual affidavit of compliance. It will also investigate Canadian ownership and control if a complaint is filed, or where it believes some review is required. The CRTC does not have jurisdiction to approve start-up or the acquisition of a Canadian carrier. That said, because the CRTC can review ownership and control at any time, it can conduct an investigation at the time of start-up or acquisition. The CRTC has been known to do so in high profile cases.
The second regulator that can exercise jurisdiction is the federal Ministry of Industry (also known as "Industry Canada") pursuant to regulations under the Radiocommunication Act. Industry Canada's jurisdiction extends to telecommunications companies that operate using wireless communications, such as cellular telephone companies. It applies virtually the same rules as under the Telecommunications Act.
Industry Canada manages the radio spectrum and, in that capacity, it issues licences to Canadian carriers that operate using the radio spectrum – referred to as "radiocommunication carriers". Invariably, Industry Canada will vet applications for compliance at the time of licence issuance, for example, following a spectrum auction. In addition, those licences usually require reporting to Industry Canada of events that could bear on Canadian ownership and control, such as a takeover. Thus, Industry Canada approval becomes an important prerequisite to a non-Canadian's decision to invest in a Canadian wireless company.
With very limited exceptions, neither the CRTC nor Industry Canada have issued public decisions, with reasons, for their actions in allowing or declining investments based on Canadian ownership and control of telecommunications companies. The most notable exception was the CRTC's decision in the 1996 refinancing of Unitel Communications, a decision which came very soon after the Canadian ownership and control rules were implemented and which may be of limited relevance today. As a result, neither regulator has provided much in the way of concrete guidance on how it interprets and applies these rules.
The Canadian ownership and control rules for broadcasting companies (including cable television companies) are implemented by means of a direction issued from the Canadian Government to the CRTC pursuant to the Broadcasting Act, called the "Direction to the CRTC (Ineligibility of Non-Canadians)"2 (the "Direction"). The Direction stipulates that the CRTC cannot issue, amend or renew a broadcasting licence where the applicant is non-Canadian.
The Direction defines "Canadian" in a manner that has many similarities to the telecommunications statutes, but there are important differences as well. In the case of a licensee that is a corporation, (a) at least 80% of its directors must be Canadian, (b) Canadians must own at least 80% of its voting shares, and (c) the CEO must be Canadian. The CRTC must also be satisfied that the licensee is not controlled-in-fact by non-Canadians. Where the licensee is a subsidiary of another corporation, Canadians must directly or indirectly own more than 66.7% of the voting shares of the parent corporation. As well, in certain circumstances, measures must be in place to ensure that the parent corporation cannot exercise any influence over programming decisions by the subsidiary-licensee.
In contrast to the situation with telecommunications companies, the CRTC has issued many decisions commenting on ownership and control of broadcasting companies. These can be viewed on the CRTC website at www.crtc.gc.ca 3
The Canada Transportation Act establishes Canadian ownership and control rules for the licensing of certain categories of air transportation service provider, most notably domestic airline companies. A company will satisfy the requirements if it is "Canadian", that is: (a) at least 75% of its voting interests are held by Canadians,4 and (b) it is controlled-in-fact by Canadians. Unlike the communications statutes, the Canada Transportation Act does not provide any more comprehensive definition of the term "Canadian".
The Canada Transportation Agency monitors and enforces the Canadian ownership and control rules for airlines. A handful of decisions appear on the Agency website at www.cta-otc.gc.ca
d. Cultural Industries
The Investment Canada Act allows the Canadian government to screen foreign investment to determine if it is of "net benefit" to Canada. Foreign direct acquisitions of Canadian businesses with assets that exceed C$312 million,5 for most industries, and C$5 million, for certain sensitive sectors of the economy, must endure a "review" by one of the two government departments that deal with such matters. Often the review will lead to undertakings relating to employment and future investment and other commitments considered beneficial to Canada. Only very rarely will an acquisition be turned down.6
The sensitive sectors has recently been reduced to only include cultural businesses: the publication, distribution or sale of books, magazines or newspapers or music in print or machine readable form; and the production, distribution, sale or exhibition of films or video recordings, and audio or video music recordings.
With certain cultural industries, the government has issued policy guidelines that make it very difficult, if not impossible, for a foreign acquisition to pass scrutiny. These extra-sensitive sectors include film distribution, book publishing, distribution and sale, and magazine publishing.
Canadian-controlled buyers need not be worried about the Investment Canada Act. This begs the question of what is a "Canadian" in this context. The Act answers this question by setting forth various presumptions and tests for assessing the Canadian-ness of an acquirer. Generally, an entity will be considered Canadian if a majority of its voting interest are held by Canadians. However, in the case of cultural industries in particular, the Government can look beyond the ownership of voting interests and assess if non-Canadians control-in-fact the entity. As it is the cultural industries, notably the extra-sensitive cultural industries, where the risk of rejection is the greatest, that proper structuring of an acquisition to achieve Canadian control can substantially ameliorate this risk.
As can be seen in the foregoing, when foreign acquisitions occur in the telecommunications, broadcasting, airline and cultural sectors, control-in-fact by Canadians can become an important issue in determining if the investment can go ahead. How does a regulator determine who is in the position to control-in-fact a company? The answer starts with the explanation given in 1993 by the National Transportation Agency (as it then was) when it assessed the investment by the parent of American Airlines in Canadian Airlines, where it made the following oft-quoted statement:7
There is no one standard definition of control in fact but generally, it can be viewed as the ongoing power or ability, whether exercised or not, to determine or decide the strategic decision-making activities of an enterprise. It also can be viewed as the ability to manage and run the day-to-day operations of an enterprise. Minority shareholders and their designated directors normally have the ability to influence a company as do others such as bankers and employees. The influence, which can be exercised either positively or negatively by way of veto rights, needs to be dominant or determining, however, for it to translate into control in fact.
Thus the key points to examine are who determines either strategic direction or day to day operations. This sounds straight-forward, but the experience is that it is anything but. An investment, and the resulting relationship among the various investors and the target being invested in, is usually a hand-crafted work with many points of potential or actual influence by the various stakeholders. Deciding which are important, and which are not, and the balance between influences, typically leads to a prolonged and careful examination by the relevant regulator.
Foreign investors who wish to make sizeable investments quite naturally want as much ownership and control as the law allows. If they cannot hold 100% ownership and control, they may well be satisfied with substantial ownership and sufficient influence in order to protect their investment. Although there is no precise formula for determining when influence crosses over the line to become dominant or determining, to use the language of the National Transportation Agency, experience shows that some factors are more important than others. These are discussed below.
4. Important Control-In-Fact Factors and How to Use Them
a. Ownership Limits
All the ownership tests refer to maximum numbers of voting shares (or other voting interests). However, no specific limits are imposed on non-voting shares or other forms of equity participation. A foreign investor can therefore obtain a greater equity participation in a Canadian target than the ownership tests would suggest. Indeed, this is commonly done.
That said, regulators become concerned if the overall equity held by non-Canadians becomes too large. Where Canadians have too small an economic stake in an entity, and non-Canadians too large a stake, regulators simply do not believe that Canadians will hold control. As the National Transportation Agency commented in 1993:8
The Agency finds that as the economic interest of a shareholder, as reflected in ownership of voting and non-voting shares, increases above 25 per cent, such shareholdings become of increased importance in determining where control in fact lies. The greater the economic interest, the greater the likelihood that the owner of that economic interest will be able to exercise control in fact. This matter becomes of major importance as the economic interest reaches and exceeds 50 per cent.
In more recent decisions, the CRTC has allowed substantial foreign equity participation in Alliance Atlantis9 (65% -- 2007), Fundy Cable10 (62% -- 1998) and Persona11 (65% -- 2004). Moreover, in 2007, Industry Canada permitted a non-Canadian to acquire 64% of the equity in Telesat Canada.12 All of these cases involved a single foreign investor, and either one or a small number of Canadian investors.
In the 2004 restructuring of Air Canada, the Canadian Transportation Agency (the new name for the National Transportation Agency) found Canadian control-in-fact where "a large majority of [the Air Canada holding company's] economic interest will likely be held by non-Canadians when the [restructuring] proceedings terminate." Some commentators calculated that non-Canadians held as much of 85% of the shares in the reorganized Air Canada at that time, although this has not been publicly verified by the regulator.13
Although a non-Canadian equity participation level of up to 65% does not seem to generate concerns, it is not easy to know how high the foreign equity participation can go before regulatory resistance will become significant. Much will depend on the individual facts. For example, a single non-Canadian investor is probably more troublesome than a large number of unrelated foreign investors, given the difficulty by multiple investors in concentrating their individual influence into control. Indeed, in the case of a public company, it is unlikely that regulators would have concerns about a large number of small non-Canadian shareholders owning non-voting shares, even if the total equity held by non-Canadians reaches 90% or more. There is simply no realistic ability of any single small non-Canadian shareholder, or all of them in the aggregate, to meaningfully influence the company and its direction such as to trigger Canadian control-in-fact concerns.
b. Canadian partnering
Given the limits on voting and non-voting equity that a non-Canadian investor can hold, a foreign investor that wishes to acquire a Canadian company will need to find one or more Canadian partners. Sometimes a Canadian strategic partner can be found; in other cases, a financial partner will be selected. Although it might be thought that Canadian regulators would prefer, from a Canadian control perspective, a Canadian strategic partner rather than a financial partner, this is not evident from the decisions that have been issued in recent years. Both the Persona and Telesat cases referred to above involved Canadian financial institutions teaming with knowledgeable non-Canadian investors to acquire Canadian targets.
Large Canadian pension funds in particular have capitalized on the opportunity arising from such investments. They have partnered with non-Canadian investors to acquire Telesat, to found Ciel Satellite, and to acquire BCE, Canada's largest telecommunications and broadcasting conglomerate. The later, which was approved in 2008 but ultimately failed to close, would have been one of the largest private equity acquisitions ever undertaken in any country.
c. Board of Directors
The board of directors is responsible for the management of the business and affairs of a company. As such, it is a key locus of control. A control-in-fact examination looks closely at the composition of the board of directors, and the rights of various shareholders to determine the composition of the board.
In some cases, a statute will dictate the composition of the board. For example, the Telecommunications Act requires that at least 80% of the board of directors of a facilities-based Canadian carrier must be resident Canadians. In other cases, the statute is silent. In such circumstances, the general rule is that a majority of the directors should be Canadians. Moreover, non-Canadian shareholders should not be in the position of appointing a majority of the directors, regardless of their nationality.
In a closely held company, a non-Canadian investor may accept that it can only appoint a minority of the directors, but there may be some resistance to the Canadian shareholder appointing a majority of the directors, especially where the Canadian holds a minority equity interest. In such cases, appointing independent directors will often satisfy the requirements of the investors, and the regulators. To be independent, a director would have no current or historical relationship to either investor such that he or she could be beholden to the investor and thus subject to its influence.
d. Minority protection rights
Canadian regulators accept that non-Canadian investors are entitled to protect their investment through restraints (vetoes) on certain decisions, without amounting to control-in-fact. Typically, these restraints appear in a shareholders agreement among the investors in a closely held company. Regulators spend a great deal of time and effort understanding the nature of these minority protection rights and their bearing on control-in-fact. Indeed, this is usually the most onerous part of a Canadian control-in-fact review.
The types of minority protection rights, whether reserved to non-Canadian investors or their appointees on the board, that commonly raise few if any issues with regulators include the following:
- Changes in organizational documents;
- Issuance of shares to third parties;
- Material change in the company's business;
- Initiating insolvency or liquidation proceedings;
- Sales of a business unit beyond a certain size;
- Acquisitions beyond a certain size; and
- Incurring indebtedness beyond a certain size.
By contrast, certain types of minority protection rights are likely to trigger control-in-fact concerns as they can potentially address the core direction of the enterprise. Regulators are very reluctant to accept arguments that a non-Canadian will not be in control where the non-Canadian can exercise veto rights for the following (even where a Canadian may also exercise the same veto rights):
- Appointment, remuneration and tenure of the chief executive officer;
- Approval of the annual business or capital plan.
e. Exiting a Business Relationship
In any business relationship, a great deal of time is devoted to determining the mechanism for ending a business relationship. Over the years, creative lawyers have developed a wide variety of such mechanisms. Typically, these do not raise control-in-fact issues. Regulators accept that the exit can be triggered by either the Canadian or non-Canadian interests.
That said, some exit provision can raise problems. For example, a non-Canadian would not be able trigger a shotgun buy-sell provision in a shareholder agreement, such that the non-Canadian would end up with all of the shares. Doing so would violate the ownership limits. But the non-Canadian would be permitted to trigger such a provision where another Canadian ends up buying the shares of the exiting Canadian, and the drafting reflects such an approach
Another related area of concern can arise where the non-Canadian attempts to dictate to whom a Canadian can transfer its shares upon exit. Regulators often view this as a mechanism for the non-Canadian to exercise excessive influence over the Canadian shareholder, and thus contrary to the Canadian control-in-fact rules. Sometimes, parties can achieve half-measures that will be acceptable, such as a restriction on the non-Canadian selling to a particular named company.
Parties should be wary of exit provision that so substantially undermine the interests of the Canadian investor as to bestow a great deal of influence and leverage on the non-Canadian. For example, a provision which, upon termination of a shareholders agreement, allows a non-Canadian to terminate a valuable trade-mark or technology agreement on very short notice would, in effect, prevent the Canadian from exiting except on terms acceptable to the non-Canadian – a circumstance that regulators might well find troubling on control-in-fact grounds.
5. To Conclude
Canadian ownership and control rules are a fact of business life in Canada. Although they prevent non-Canadian investors from carrying on business in an unfettered way, there is still much scope for non-Canadian investors to realize many, if not most, of their investment objectives. Indeed, very prominent non-Canadian companies have successfully navigated these rules to make quite sizeable investments. The key is to appreciate that the rules do permit a degree of flexibility, and that this flexibility can often be applied in a productive manner.
3. Many of the decisions are summarized in: Grant Buchanan and Lorne Salzman, Revisiting Canadian Ownership and Control of Canadian Communications Companies, April 2008, prepared for the Fourteenth Biennial National Communications Law Conference Sponsored by the Law Society of Upper Canada and the Canadian Bar Association, and available at http://www.mccarthy.ca/article_detail.aspx?id=3960
4. In 2009, the Act was amended to permit the government to reduce this number by regulation so that 51% or more of the voting interest need be held by Canadians. The government has also announced that this threshold change will be implemented with respect to EU investors.
5. Amendments to be implemented in 2009 will change the calculation from a test based on book value of assets of the target to a test based on the "enterprise value" of the target, and new threshold levels will be set. These will increase over 6 years to a level of C$1 billion, and then adjusted thereafter with the size of the economy.
6. The Investment Canada Act, and its application, has been criticized, most recently by the Competition Policy Review Panel, as overreaching and lacking clarity, among other deficiencies. See Compete to Win, the final report of the Competition Policy Review Panel, 2008, pg. 35, which can be found at http://www.ic.gc.ca/epic/site/cprp-gepmc.nsf/en/home
7. Decision No. 297-A-1993 (In the Matter of the review by the National Transportation Agency of the proposed acquisition of an interest in Canadian Airlines International Ltd. carrying on business under the firm name and style of Canadian Airlines International or Canadian by Aurora Investments, Inc., a wholly-owned subsidiary of AMR Corporation), 27 May 1993
8. Ibid. In that case, the Agency observed that the non-Canadian interest could rise to 56%, but nonetheless approved the transaction.
9. Broadcasting Decision CRTC 2007-429, 20 December 2007
10. CRTC Letter of Authority A98-0061, 14 May 1998
11. Broadcasting Decision CRTC 2004-284, 21 July 2004
12. See Telesat Canada press release at http://www.telesat.ca/news/releases/2006/06-13-e.asp
13. See McFetridge, D.G., The Role of Sectoral Ownership Restrictions, a research paper prepared for the Competition Policy Review Panel, March, 2008, p. 10.