The economic case against the net benefit test

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Appeared in the Financial Post

The recent decision by the federal government to block a proposed takeover of Progress Energy Resources by Petronas, a Malaysian state-owned company, increases the likelihood of a rejection of the pending acquisition of Nexen by CNOOC, a Chinese state-owned oil company. It also follows the federal government’s action denying the takeover of Potash Corporation by BHP, a privately owned Australian company.  These developments justify reconsideration of whether the net benefit test used by the Canadian government to assess foreign takeovers of Canadian companies makes economic sense.

Since Petronas is a state-owned enterprise (SOE), as is CNOOC, the economic issues raised by their proposed acquisitions are more complicated than in cases when the foreign investor is privately owned, as is BHP. Nevertheless, the basic economic arguments against making government approval of foreign takeovers of Canadian companies conditional on a net benefit test are similar and compelling, regardless of the ownership status of the foreign investor.

The market for corporate assets is global. Hence, would-be acquirers of Canadian companies compete against other foreign and domestic investors.  Global competition in the market for corporate control generally ensures that the price paid for a successful acquisition reflects the long-run expected profitability of the corporate assets acquired when they are used efficiently.  Indeed, for private investors, it is the expectation of being able to improve the efficiency and profitability of takeover targets that justifies outbidding other investors for the assets in question.

When capital markets are competitive, the use of a net benefits test is unlikely to enhance the gains realized by Canadians from foreign takeovers of domestic companies. One might argue that the Canadian government can use its review process to leverage implicitly higher prices for domestic assets by “requiring” foreign investors to agree to specific undertakings as a condition of government approval. For example, a foreign investor might be required to increase domestic head office employment or expand production in Canada to show a net benefit to the Canadian economy. But if competition obliges the foreign investor to pay close to the maximum price it will pay for an acquisition, any effort by the government to elicit such undertakings will merely cause the foreign investor to abandon the takeover.

Alternatively, the foreign investor will reduce its bid price for the takeover target by the amount of the “implicit tax” imposed by the net benefit test. Since government transfers of income and wealth impose a variety of economic costs, application of the net benefit test will reduce, rather than increase, the economic gains to the Canadian economy from foreign investments.

This economic criticism of the net benefit test seems less compelling when the foreign investor is an SOE.  One presumptive reason is that SOEs aren’t profit-maximizers.  Hence, it cannot be assumed that they outbid other investors for Canadian assets because they anticipate being the most efficient users of those assets.  Indeed, they may initiate acquisitions to promote home government objectives which are inconsistent with efficient use of Canadian assets.  For example, SOEs may acquire Canadian oil companies to sell oil to home country consumers, even when Canadian energy prices are higher than prices they receive in their home countries.   But if an acquiring SOE subsidizes home country consumers by exporting its oil at below-world prices, the cost of the subsidy will be borne by stakeholder groups in the home country and not by Canadians.

Another prominent complaint about SOEs is their lack of accounting and managerial transparency. This gives rise to concern that Canadian investors, lenders, employees and others doing business in Canada with the SOE will be treated opportunistically by the SOE. For example, minority domestic investors may be victimized by the SOE funneling profits earned in Canada back to the parent company. However, if domestic stakeholders anticipate opportunism, they will take actions to protect themselves such as domestic lenders demanding more collateral from SOE borrowers than from private borrowers or managers working for SOEs preferring cash bonuses relative to stock options, and so forth.

In sum, the economic case against the net benefit test rests on the notion that competitive markets typically produce better economic outcomes than government regulators. This notion is especially plausible when market participants are relatively sophisticated investors, lenders and managers.

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