Increased number of national security reviews, divestiture orders in fiscal 2016-2017

10 January 2018

The Investment Review Division published its annual report on the administration of the Investment Canada Act for the fiscal year ended March 31, 2017. The report contains information on the Canadian government's use of the Act's national security review powers, among other things. This is the second annual report in which the government has released information on the use of these powers, and the first since the government published national security review guidelines in December 2016 and since annual public reporting on the use of the national security review powers became a legal obligation in June 2017.

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In 2016-2017, five national security reviews were conducted (one of which was a re-review of a previous review that was judicially challenged). Three of these reviews resulted in divestiture orders. Two resulted in the transaction being permitted subject to non-public conditions. No transactions were blocked prior to closing, and no reviews concluded with the foreign investor being permitted to own the target Canadian business condition-free.

As a result, in our view, fiscal 2016-2017 saw a comparatively high number of national security reviews and divestiture orders. To put that into context, between 2009, when the national security review powers were added to the Act, and the end of fiscal 2015-2016, a total of eight national security reviews were conducted, two of which resulted in divestiture orders (three others were blocked before closing and one was abandoned by the parties).

Background

In 2009, the Canadian government introduced broad national security review powers under the Act. These powers enable the government to review any investment in a Canadian business by a non-Canadian. The potential outcomes of such a review are:

  • the investment is allowed to proceed, with or without conditions;
  • closing of the investment is prohibited; or
  • the non-Canadian is required to divest the Canadian business if closing has already occurred.

The government did not originally provide any guidance as to the factors that could trigger a national security review or influence its outcome. This degree of opaqueness resulted in significant criticism from stakeholders. Among other things, it made it difficult for potential investors to assess, before incurring significant pursuit costs, the national security review risks associated with a transaction.

In the summer of 2016, the government released, for the first time, some high level information on the use of the national security review powers, including the number of reviews that had been conducted, broken down by year, and their outcomes (see our August 2016 MarketCaps for more information). In December 2016, the government released Guidelines on the National Security Review of Investments under the Investment Canada Act (see our January 2017 MarketCaps for more information). Included in the guidelines is a non-exhaustive list of factors the government will consider in assessing national security risk, as well as guidance on filing notifications under the Act. Among other things, the guidelines encourage investors to file their notification form at least 45 days before the planned closing date for the investment, particularly where any of the risk factors listed in the guidelines are present. The rationale behind this is that if the government has not initiated the national security review process within 45 days from receiving a notification form, then it no longer has a right to do so and the investor can close with confidence that it will not subsequently face a potential divestiture order on national security grounds.

Key Facts and Insights

Summarized below are the number of national security reviews that have occurred and their outcomes, broken down by year, since the national security review powers were added to Act in 2009.

Year 2012-13 2013-14 2014-15 2015-16 2016-17

Number of Reviews

2

1

4

1

5*

Outcomes**

1 Blocked

 

1 Transaction Aborted by Parties

1 Blocked

1 Divestiture Required

 

1 Blocked

 

2 Non-public Conditions Imposed

1 Divestiture Required

3 Divestitures Required

 

2 Non-public Conditions Imposed

* One review was pursuant to a court order. Although not specified in the annual report, this would have been the O-Net Communications/ITF Technologies transaction, which was the subject of a great deal of media attention and controversy. The (former Conservative) government ordered Chinese controlled O-Net Communications to divest Montreal based ITF Technologies. O-Net Communications sought judicial review. The (current Liberal) government agreed to do a new review, the result of which was that O-Net Communications was permitted to continue to own ITF Technologies subject to non-public conditions.

** The outcome may have occurred in a different fiscal year but relates to a review that commenced in the identified fiscal year.

These facts support the following observations:

  • When considered in the context of all transactions that could have been reviewed under the national security powers, the percentage that have actually been reviewed is negligible, less than 0.25%. 5,208 transactions have been brought to the Canadian government's attention through the submission of a notification form or (normal course, non-national security) review form since the national security review powers were enacted. It bears mentioning that 5,208 transactions is an artificially low denominator for the calculation because it only covers control level acquisitions. The national security review powers can be applied to the acquisition of any interest in a Canadian business, including non-control level acquisitions. Statistics on non-control level acquisitions are not available.
  • If a national security review is conducted, there is a good chance that the result will be catastrophic to the transaction.
    • In eight of the twelve transactions that have been reviewed the foreign investor was not permitted to own the target Canadian business - either the transaction was blocked pre-closing, the parties aborted it during the review, or post-closing divestiture was required.
    • In four of the twelve transactions the foreign investor was permitted to own the target Canadian business subject to non-public conditions.
      • Please note that because O-Net/ITF was reviewed twice, there have been 13 reviews of 12 transactions, and one of the five "divestiture required" outcomes set out in the table above was converted to a "non-public conditions imposed" outcome.
    • Allowing a transaction to proceed, condition free, after a national security review is an option that is available to the government, but based on the information in the annual reports, this has never happened.
    • We acknowledge that the review of 12 transactions is a small sample size and that it is therefore important to not overstate the significance of any apparent patterns or trends. At the same time, a recurring theme does seem fairly clear. Zero of the transactions that have been reviewed have been permitted to close unencumbered. Some kind of a remedy was considered necessary in every case. In two thirds of the reviews, the outcome was catastrophic to the transaction. In the other third, conditions were imposed.

It also bears mentioning that the 2016-2017 report contains an incrementally higher degree of information than the 2015-2016 report. In addition to reporting on the number of reviews conducted in the year and their outcomes, the report identifies the number of notices of potential national security review that were issued and their outcomes (a notice of potential review affords the government additional time to decide whether to conduct a full review), and identifies the risk factors that influenced the review/no review decisions and the outcomes of the reviews that were conducted.

Four notices of potential national security review were issued in fiscal 2016-2017. In two of those transactions, the government decided that a full review was not necessary and took no further action. In the other two, a full review was conducted and resulted in either a divesture order or the imposition of conditions. Statistics on notices of potential review in previous years are not available.

The report indicates that, of the risk factors identified in the national security review guidelines, the following most commonly influenced the decision to conduct a review and the outcome of the review:

  • the potential for transfer of sensitive dual-use technology or know-how outside of Canada;
  • the potential to negatively impact the supply of critical services to Canadians or the government; and
  • the potential to enable foreign surveillance or espionage.

Other influential risk factors, which are also outlined in the guidelines, were the potential for injury to Canada's defence capabilities; the potential for injury to Canada's international interests; and the potential of the investment to involve or facilitate organized crime.

The report also indicates that the decision of whether to conduct a review and its outcome is influenced by a "consideration of the application of other domestic legal frameworks which protect against threats to national security and apply to both Canadian and non-Canadian controlled businesses." Although the report does not provide examples, plausible examples include a Foreign Ownership, Control or Influence review by the Canadian Industrial Security Directorate or a change of control review by a provincial or federal energy regulator.

Finally, like the 2015-2016 report, in the cases where a national security review was conducted the 2016-2017 report does not identify the industries in which the relevant Canadian businesses operated, the countries of origin of the relevant foreign investors, or whether the relevant foreign investors were state-owned enterprises. The report states that "the information herein is published in accordance with confidentiality and privileged information requirements and the need to safeguard national security." However, considering that approximately five pages of the report that relate to non-national security review matters are devoted to breaking down investments by economic sector and country of origin, it is at least conceivable that another factor may have motivated the government's decision to not disclose this information, even in a highly aggregated form, in relation to national security reviews. Specifically, concerns about the potential impact on diplomatic relations with the relevant countries may have been a factor, particularly if this information may have revealed that investors from one country or a small group of countries have been the subject of a disproportionately high number of reviews. For example, fragments of information about four of the national security reviews that have been conducted have become public, and two of them involved Chinese investors, and news reports have suggested that Canada's national security review regime has become an area of contention in relations between Canada and China.

The 2015-2016 and 2016-2017 reports may not disclose as much information about the use of the national security review powers as some stakeholders would have liked. Nevertheless, between these reports, the national security review guidelines and the fragments of information that have become public about some national security reviews, foreign investors now have a good sense as to what factors may give rise to national security concerns, when they should file their notification forms at least 45 days before the planned closing date, and when they should engage with the Investment Review Division at an early stage in their transaction planning. Given the number of post-closing divestiture orders that have been issued, where the risk factors identified in the guidelines are present it is particularly important that foreign investors insist on submitting their notification form at least 45 days before closing (possibly over the objections of sellers, who may prefer that a buyer wait until after closing when the risk of a post-closing review and divestiture order would, in the absence of any indemnification or unwinding provisions negotiated into the purchase agreement, be solely the buyer's problem).


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