2015 reform of Investment Canada Act now paying dividends in form of inward foreign direct investment

As we await Q3 statistics on Canada’s inward and outward foreign direct investment (FDI), the rebounding numbers in Q1 and Q2 have represented a step in the right direction. FDI is a macroscopic measure of private investment (in contrast to portfolio investment) and includes among other types of investment, mergers and acquisitions. The rebounding comes after a 2015 Q4 that saw inward FDI dip below $5 billion for the first time since 2011, while setting a historical high of $22.4 billion earlier that year in Q2. Strong inward FDI figures from Q3 will likely strengthen Canada’s attractiveness as an opportunity for foreign investors, and would be particularly timely in light of Prime Minister Trudeau’s initiative to raise private funds for infrastructure.

In spite of the weak figures in late 2015 and early 2016, a report on global investment from A.T. Kearney from earlier this year suggests that the rebounding performance may be a sign of bigger things to come. The report cites an increasing confidence in the Canadian economy among global investors, at least in a comparative sense relative to other countries. The report ranks Canada behind only the United States and China in foreign investor confidence. Speaking in general terms, the report cites geopolitical tension as the greatest driver of bearish investor behaviour in 2015. As a consequence, the stable political climate in Canada may represent a comparative advantage and an attractive investment opportunity for foreign investment.

A more direct factor that the A.T. Kearney Report points to is the 2015 reform to the Investment Canada Act as the catalyst for the rebounding interest in the Canada economy. Prior to April 2015, investments of $369 million from World Trade Organization members were subject to a net benefit review and potentially creating a chill in the market. That threshold (among other thresholds for other types of entities) has since been increased to $600 million. Details regarding the requirements of the net benefit test may be found here. Thresholds are set to increase further to $800 million in April 2017 and then to $1 billion in April 2019, with annual adjustments going forward in relation with nominal GDP growth. While it is unlikely that investment interest in Canada will increase in proportion to the increasing threshold, this reform should nevertheless attract a steady amount of additional foreign private investment for the next several years.

The author would like to thank Peter Georgas, Articling Student, for his assistance in preparing this legal update.

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Five months after Brexit: domestic UK M&A drops to 30 year low

In the days leading up to the June 23, 2016 Brexit referendum, we discussed Brexit’s potential impact on the M&A market: Britain without the EU: how will Brexit affect dealmaking? Today, we take a look at how those predictions have held up five months after the historic vote.

Domestic UK M&A down 62%

As predicted, economic and political uncertainty has created a hostile deal environment for domestic UK M&A. According to Thomson Reuters, the value of deals between UK companies has dropped 62% since the vote to a 30-year low. A lack of large deals may be to blame – not a single domestic deal worth over US $1 billion has been announced since the vote.

A recent survey of executives by Ernst & Young (EY Survey) suggests that the slowdown may persist at least in the short term. The number of UK respondents who said that they are looking to transact in the next year has dropped from 59% to 48% since May. The respondents cited domestic political stability and currency volatility as their top concerns. Interestingly, the respondents did not cite Brexit per se as a top concern, which suggests that it is the effects of Brexit rather than the actual decision to leave the EU which concerns UK companies the most.

Inbound UK M&A down 69%

Immediately following the vote, sterling fell 11% as expected. It has since fallen even more. However, predictions that a weakened sterling could boost foreign acquisitions of UK targets have not held up. Rather, inbound UK M&A has fallen by 69% since the vote.

In addition, the EY Survey reveals that the UK has dropped out of the top five global M&A destinations for the first time in the survey’s seven year history. The majority of respondents from countries who previously favoured the UK as a gateway into Europe, including Japan, US and China, now express a negative sentiment about investing in the UK. It is apparent that the bargain M&A opportunities presented by a weakened sterling is insufficient to overcome the fundamental concerns caused by Brexit.

Clearly, the British government faces major challenges in the upcoming months and years as the UK starts to work out its future relationship with the EU. In the meantime, M&A players will continue to evaluate whether the transition can provide enough certainty and stability for a favourable deal environment.

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The growing length of M&A agreements: a response to new legal risks and market conditions?

Paper and filesGiven the increasing size and complexity of M&A transactions, it is perhaps natural that M&A agreements would also increase in length and linguistic sophistication. In a new discussion paper, Professor John Coates of Harvard Law School examines the evidence for this hypothesis in the period from 1994 to 2014. He finds in that time frame the average M&A contract in his sample more than doubled in length and significantly increased in linguistic complexity.

Coates studies a sample of 564 public M&A agreements over the relevant time period. The sample is confined to all-cash deals over $100 Million USD in deal value, between US buyers and non-regulated US publicly held targets. He finds that these contracts grew from being on average 16,994 words in 1994 to 44,730 in 2014—an increase of 163%. He also finds that the average agreement increased in complexity from Flesch-Kincaid grade 20 (“post-graduate”) to grade 30 (“post-doctoral”).

Coates argues that the changes stem mainly from an increased appreciation of both relevant legal risks and changes in deal and financing markets and not from parties seeking to “grandstand” by adding provisions without significant content. Such provisions include sections addressing, for instance, financing conditions, reverse termination fees, specific performance, dilution, unlawful payments, and forum selection. As Coates writes, these kinds of provisions “represent rational responses by deal participants to a changed deal environment.”

In the experience of our Canadian deal lawyers, Coatess’ conclusions about the reasons for these changes tend to be borne out. We believe that the growth in length and complexity has originated in large part from the increased sophistication of our clients, who demand more complex and detailed drafting. The use of word processing and computers has no doubt made this task easier, which has also accelerated contract length.

While Coates’ sample is confined to the context of US public M&A, many of the same considerations that have tended to increase the length of M&A contracts will also apply in the context of private transactions. We also find that the Canadian market typically lags but does follow the US market. In some cases, our US clients have been surprised by the relative shortness of Canadian M&A contracts.

While it remains to be seen whether the length and complexity of M&A contracts will continue to increase at the same sharp pace, these developments reflect parties’ heightened expectations that M&A contracts will account for an increasing number of risks and potential complications.

The author would like to thank Joseph Bricker, Articling Student, for his assistance in preparing this legal update.

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President Elect and M&A: a cross roads or business as usual?

can-us-680x220The election of Donald Trump as President of the United States adds to a cascade of political events that have surprised observers and may have profound effects on global flows of people, capital, and goods.

While nothing is set in stone, Donald Trump and his administration have led us to believe that they are contemplating significant changes to areas that may, indeed, have an effect on North American M&A.

A new American protectionism?

Trump campaigned on a promise to renegotiate the North American Free Trade Agreement (NAFTA), which he has called “the single worst trade deal ever approved in [the United States of America]”. While Article 2202 of NAFTA allows for amendments to the agreement, the language in that article suggests that this can occur only if agreed upon mutually among the signatories. Nonetheless, under Article 2205, any party to the agreement can withdraw from NAFTA upon six months’ notice to the other parties, leaving the agreement in force and binding on the remaining parties.

It is uncertain how Canadian companies may be affected in either instance. However, in the event significant changes are made to NAFTA, or the agreement is abandoned altogether, the attractiveness of target companies that rely on North American free trade may be affected.

Notably, while Justin Trudeau has opened the door to renegotiating NAFTA, stating “if Americans want to talk about NAFTA, [he is] happy to talk about it”, the Globe and Mail reports that Donald Trump made no mention of NAFTA while unveiling his plans for his first 100 days in office. He did, however, express his desire to have the United States withdraw from the Trans-Pacific Partnership – another agreement Trump had campaigned vigorously against leading up to the election.

The future of mega-mergers

In cases where mergers of US companies require regulatory review, there have been some indications that a Trump administration would take a harsher line. As a candidate, Trump said he would block the mega-merger between AT&T and Time Warner. Indeed, his campaign stated that “Donald Trump will break up the new media conglomerate oligopolies that have gained enormous control over our information […] Donald Trump would never approve such a deal.” Given that the Republicans won the presidency and both houses of Congress, these plans may now become a reality.

However, history suggests that merger review may, in fact, be carried out with a lighter touch, especially relative to a Democratic administration. As the Financial Times notes, President George W Bush challenged an average of 14 deals per year over his tenure, with President Bill Clinton challenging on average 32 per year. In the first six years of the Obama administration, the Department of Justice on average challenged 17 deals per year. The Financial Times observes that most advisers now expect that Trump will follow his Republican predecessors.

What do dealmakers think?

To the extent that M&A hinges on the confidence of the parties, it is worth noting what dealmakers think about a Trump victory. Survey evidence taken before the election paints a mixed picture: in March, Bloomberg reported that the M&A community (e.g., bankers, lawyers) favoured Trump over Hillary Clinton when it came to business interests, including M&A; however, in a separate, global survey taken in April by Intralinks Holdings, Inc, the overall consensus was that Trump would be bad for business and M&A.

Now that Trump has been elected, many dealmakers are expressing optimism about the deal climate that will emerge over the next four years, even if it is not the one they predicted. Trump is widely expected to bring in lower personal and corporate taxes and a less burdensome regulatory environment. In addition, many are predicting a boom for M&A in specific industries, such as pharmaceuticals.

But before Trump’s specific policy proposals become clear, uncertainty could prove a weight on deal-making. These potential changes may affect both the timing of deals—as parties may wish to keep their powder dry until the implications become clearer—and the kinds of deals that are ultimately attractive to dealmakers. Indeed, as the years after the credit crisis show, uncertainty tends to dampen the overall dollar value of M&A activity. In the days and months to come, dealmakers will need to keep their antennae up as these developments unfold. Norton Rose Fulbright’s Canadian deal lawyers are monitoring these events carefully.

This blog post is in no way intended to be partisan or to express any political views regarding President-elect Trump or his administration.

The author would like to thank Joe Bricker, Articling Student, for his assistance in preparing this legal update.

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US-Canada cross-border M&A: the effect of fluctuating exchange rates

CurrencyUncertainty has been a theme in 2016: on the heels of Brexit, Donald Trump has been named the President-elect of the United States. As a result of Trump’s surprising victory at the ballot box, financial markets and the US dollar were sent into a tailspin as this news swept the globe. Despite this drop, in little over two weeks since the US election results were determined, both the capital markets and the US dollar have rebounded and plateaued. Has the foreign exchange rate actually plateaued despite this change in government? What does this mean for the future of M&A in Canada if it has not? More specifically, if there is a large fluctuation in the exchange rate, how does this effect cross-border M&A activity between Canada and the US?

There are two schools of thought regarding a change in the exchange rate and how it affects M&A in Canada with foreign acquirers, both explored in George J. Georgopoulos’ paper. The first is that it has no effect on cross-border M&A. Although the assets are cheaper for the country whose currency is now relatively stronger, the foreign asset will continue to generate revenue in the foreign, and weaker, currency. When this revenue is brought back to the country of origin, it is subject to the same lower exchange rate, which has the effect of off-setting any of the savings realized in the initial acquisition.

The second theory, which Georgopoulos has found some traction, focuses on transferrable assets. When focusing specifically on a M&A transaction concerning high R&D intensive industries, it was found that currency depreciation in the target country increases the likelihood of an acquisition by a foreign company. Georgopoulos speculates that this is because companies in this category have assets or technology that can easily be brought back to the country of origin and utilized by the acquiror in their domestic market. Transferring assets does not expose the acquirer to the exchange rate and instead, allows them to utilize this technology to be more efficient in their home country. In support of his theory, he found that greenfield investments in this same sector were not affected by a change in the exchange rate.

Although it is anyone’s guess how a Trump administration will shape the future of international business or cross-border M&A in general, it appears that a drastic change in the exchange rate, in either direction, will only have a small effect on the M&A realm. For most industries, the incentives to engage in a foreign merger will be driven by other factors, none of which will have to do with the exchange rate.

The author would like to thank Robert Corbeil, Articling Student, for his assistance in preparing this legal update.

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M&A transactions between fintech companies and traditional banks

Financial technology (fintech) companies like Square, Wealthsimple and Mint are already having disruptive effects in their respective industries, changing the way Canadians pay for goods and services, invest their savings, and manage their finances. A recent survey shows that Canadians are becoming less dependent on traditional banks given the variety of options to self-manage their finances.

At the same time, financings in the fintech sector have ramped up over the last five years. $7.4 billion was raised by venture-backed fintech firms in the first six months of 2016. As discussed in a previous blog post, there is some speculation that a wave of M&A may be on the horizon for fintech. A recent Mergermarket report (the Report) sheds light on the dynamics of M&A transactions in the fintech sector with, specifically, traditional banks.

The Report, which was conducted in the United States, found that there is optimism about the partnerships that can be forged by fintech companies and regional and community banks. Banks, in particular, are eager to embrace new technologies. Using financial technology gives banks the ability to improve their online services, decrease costs, and reach new customer bases. In fact, 81% of banks surveyed as part of the Report were already working with fintech companies, usually in the form of a formal partnership or joint venture.

On the flip side, the Report revealed that fintech companies and banks have a different view on how important it is to partner with each other. Whereas the majority of bank respondents viewed working with fintech companies as essential or very important, there was sentiment among many fintech firms that fintech can thrive without working with banks. Many fintech respondents envisioned the banking industry in ten years’ time as consisting of just a few large banks with fintech servicing all other niches.

The Report makes a few key conclusions. First, banks are eager to work with fintech companies and fintech companies can benefit from bank partnerships (which may bolster fledgling reputations and scale up customer bases). Second, data security and system integration remain perennial issues. Third, the risks involved with getting a fintech’s systems to communicate with a bank’s existing technology can pose barriers to partnership. Last, conducting due diligence, obtaining regulatory approvals and maintaining regulatory compliance are weighty considerations for companies looking to merge or acquire a fintech company.

There are some important differentiating factors in the Canadian market which may impact the Report’s application to Canada. Unlike the United States, Canada’s financial institution landscape is dominated by a handful of large established banks which, to a certain extent, have the ability to keep up with or emulate financial innovations using in-house resources. As well, the regulatory landscape, already complex in the United States, is notoriously more rigorous in Canada. A potential result may be a chilling effect for transactions with American fintech companies unused to the harsh Canadian environment.

Whether through M&A transactions with banks, via partnerships and joint ventures with established players in the banking industry, or by a company’s internal operations’ initiatives, fintech companies are going to continue to have a significant impact on the way Canadians bank.

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The new trend of M&A in the media industry

On October 22, 2016, AT&T Inc. (AT&T), the second-largest U.S. wireless provider, and Time Warner Inc. (Time Warner), one of the world’s largest producers of TV shows and movies and the owner of HBO and CNN, announced an agreement whereby AT&T intends to acquire Time Warner for $85.4 billion. After the announcement, share prices of other media companies, including Discovery Communications Inc. and AMC Networks Inc., rose immediately. While the AT&T / Time Warner deal remains subject to regulatory scrutiny, analysts predict that the potential deal may kick-off of another round of industry consolidation, where more combinations of content and distribution may be observed.

One may wonder what triggers the surging interests in the M&A between content providers and distributors? The most popular explanation is that technology development has changed the way people enjoy media products. Media firms have seen more and more of their younger audience cutting their cable cords and switching to mobile devices. Meanwhile, acquiring content allows distribution companies to diversify their revenue. As summarized by Julius Genachowski, the former U.S. Federal Communications Commission Chairman and a partner at the Carlyle Group, the current M&A trend in media industry “reflect[s] [a] landscape that’s changing dramatically from wired to wireless with big changes in consumption of video particularly among millennials.”

This argument is challenged by Professor Bharat Anand in his recent article published online in the Harvard Business Review. Professor Anand raised an interesting question: if the incentives behind the M&A between content providers and distributors are to gain access to wireless channels for the former and to diversify revenue sources for the latter, why do they not simply enter into contractual agreements rather than strike an expensive merger deal? In other words, what is the real synergy in the merger?

Professor Anand thinks that the value of the merger can be explained by the term complement. Complement is a concept in economics which refers to a product or service that, when cheap and widely available, can benefit the company’s core product. For example, ornaments are a complement to Christmas trees, as cheap ornaments can boost Christmas tree sales. Professor Anand argues that content is an increasingly important component for tech companies, which provides new methods to attract users. For instance, the new video services on Amazon helps bring in more consumers to the online stores. The live videos and instant articles from traditional publishers on Facebook provide users another reason to go on Facebook besides sharing photos with friends.

Professor Anand noted that Amazon is an e-commerce provider and Facebook is a social networking provider and neither is a distributor. Thus, the trend in media industry should not be labeled as “combination of distribution and content”. The bigger picture, or the “real battle” in his own words, is businesses competing on networks and connections, where content is not the core but serves as a critical complement.

Therefore, if content is the king for distributors, as phrased by many analysts, then complement is the emperor for connectors. Investing in the complement by acquiring the content, which is much cheaper than buying the entire media powerhouse, reveals the new trend of M&A in the media industry.

The author would like to thank Jaray Zhao, Articling Student, for her assistance in preparing this legal update.

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M&A considerations for resource issuers: Canada’s Extractive Sector Transparency Measures Act

Canada’s Extractive Sector Transparency Measures Act (ESTMA, or the Act) came into force on June 1, 2015. The Act imposes disclosure obligations on certain Canadian businesses engaged in the commercial development of oil, gas or minerals with respect to payments made to domestic and foreign governmental bodies. As we previously noted, Canadian businesses subject to the Act are currently required to collect information on the payments they make, and the first ESTMA-compliant reports will be due to Natural Resources Canada by May 30, 2017 (for organizations with a December 31 financial year end).

Resource companies currently negotiating acquisitions as purchasers should be mindful of this legislation and ensure that appropriate provisions are included in the purchase agreement so they are able to comply with the Act and so they do not inherit any reporting obligations they cannot satisfy.

For instance, if a reporting entity under the Act (the Purchaser) acquires another company (the Target) by way of a share purchase, the Purchaser will be required to include disclosure in its ESTMA report with respect to payments made by the Target during the portion of the Purchaser’s financial year prior to the acquisition. This because the Act requires disclosure of payments made by entities controlled by reporting entities under the Act, regardless of whether or not the controlled entities are reporting entities themselves under the Act.

As a result, Purchasers may wish to include a representation and warranty that no payments were made to any domestic or foreign governmental body by the Target during that financial year, other than as disclosed in a disclosure schedule listing all the payments required to be disclosed under the Act. Furthermore, it would be prudent to include a representation that the Target has not structured any payments with the intention of avoiding the requirement to report those payments in accordance with the Act. Purchasers will also want to obtain comfort that the Target has complied with the Act in all respects, including filing its ESTMA reports. In certain circumstances, it may also be worth considering a specific indemnity with respect to non-compliance with ESTMA in favour of the Purchaser.

In the situation where assets are being purchased, rather than shares, there is generally less concern for inherited reporting obligations as these obligations and any liabilities associated with them remain with the seller of the assets. Note, however, that each transaction should be carefully considered in light of its particular circumstances and ESTMA-related provisions in purchase agreements should be drafted accordingly.

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Canada’s first post-BEPS tax treaty: implementing the new treaty shopping proposals

Last November, we told you about the new treaty shopping rules proposed by the Organisation for Economic Co-operation and Development (OECD) as part of the final report on Action 6 of the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan).

The main proposal in Action 6 was the amendment of the OECD model tax treaty to include “limitation on benefit” provisions. Two types of provisions were proposed: (i) specific provisions (LoB provisions) that limit the availability of treaty benefits to individuals, corporations, and other organizations that meet specific criteria that are intended to establish that business is actually carried on in a contracting state, and (ii) general provisions, (principal purpose provisions) that limit the availability of treaty benefits when one of the principal purposes of a transaction is to gain access to treaty benefits.

Both approaches have disadvantages. LoB provisions prevent an entity from accessing treaty benefits only if the specific criteria are not met, even where the only reason for the transaction is to access treaty benefits. Principal purpose provisions do not depend on any specific criteria, and instead rely on the interpretation of an entity’s “principal purpose”; as a result, the availability of treaty benefits may be uncertain to business and governments alike. In order to minimize the impact of these contrasting disadvantages, Action 6 recommends the inclusion of both provisions in tax treaties.

The implications of each type treaty shopping provision are significant for businesses that are looking to find a tax-efficient way to enter the Canadian market. On September 23, 2016, Canada entered into a new tax treaty with Israel (the Canada-Israel Treaty), Canada’s first treaty since the final report on Action 6 of the BEPS Action Plan. The text of the Canada-Israel Treaty provides important insight into Canada’s approach to treaty-shopping in the post-BEPS Action Plan environment.

Significantly, the Canada-Israel treaty does not include any LoB provisions as recommended by Action 6. Rather, the Canada-Israel treaty includes principal purpose provisions that deny the availability of treaty benefits with respect to dividends, interest, royalties, and capital gains if “one of the main purposes” of a transaction is to gain the benefit of the provisions relating to dividends, interests, royalties, or capital gains, respectively.

Similar principal purpose provisions have appeared in every tax treaty that Canada has entered into since 2010. In other words, Canada has not used its first opportunity to change its approach to treaty negotiation in light of Action 6 of the BEPS Action Plan. Instead, Canada has continued to insist on principal purpose provisions in an attempt to deny treaty benefits to entities that lack sufficient connections to Canada, while not insisting on LoB provisions that provide greater certainty as to the availability of treaty benefits.

Canada may yet alter its approach. However, the Canada-Israel Treaty is our first look at how Canada will look to combat treaty shopping. So far, Canada has chosen to take a broad approach that has the potential to create tremendous uncertainty for business looking for the most tax-efficient way to expand into Canada.

In addition, and simultaneous to ongoing treaty negotiations, the Government of Canada committed in its 2016 Budget to the development of a multilateral instrument to implement treaty-related recommendations in the BEPS Action Plan. Businesses must continue to consider what treaty shopping provisions are in place and what their implications will be as Canada enters into new tax treaties and renegotiates existing ones, as well as the potential impacts of the yet-to-be-completed multilateral instrument.

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Merging of digital and physical worlds: impact on M&A in non-digital industries

Strategy& of PwC published Mergercast “Digital Deals – A New Frontier” (Episode 56) in July 2016, which discusses the growing rationale for digital deal-making and post-deal challenges. Particularly, this podcast identifies that digital deals accounted for nearly 32% of all transactions in 2015, up by 20% since 2011, indicating the growing appetite for digital M&A. Many companies operating in traditional industries are looking to enter into or enhance their digital capabilities by identifying digital targets, particularly hardware, software, IT service and Internet companies. Digital deal growth is most notable in non-digital industries, such as automotive, retail and wholesale, aerospace, defense, and hospitality.

Focusing on retail and wholesale specifically, a Deloitte publication predicts that growing e-commerce and declines in foot traffic require retail-based companies to find innovative opportunities to digitize a once traditional business model. To identify a suitable target, the purchaser must strategically consider whether it plans to add analytic capabilities to an existing business or to create true versions of digital products or services. In the case of retailers, Deloitte suggests in another publication that incorporating analytics on weather, labour and staffing, store layouts, CRM data, real-time location and websites are necessary for the purposes of long-term planning. To that end, it is expected that we will see an increased blending of online and offline value offerings by physical retailers. Strategy& further indicates that purchasers may also seek targets which can digitalize their value chain, a less obvious-to-consumer alternative to incorporate the benefits of digital targets. For example, companies such as Amazon.com, Inc. have changed the landscape of retail and wholesale, by significantly improving the traditional model through its digital platform and analytic capabilities. In all cases, completing a digital deal is less about driving synergies than a traditional deal and more about gaining access to the advantages of digitizing a business.

Despite the many benefits of digitalizing businesses, identifying and integrating a target are key considerations for purchasers. Strategy& suggests that many targets are grassroots in nature, often operating out of garages and university dorm rooms. The nature of the digital industry increases the challenges associated with deal valuation and integration, emphasizing the importance of a well-structured deal to fully capture its advantages.

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