Decision No. 299-A-2000

May 1, 2000

May 1, 2000

IN THE MATTER OF a review by the Canadian Transportation Agency of the Canadian status of Air Canada.

File No. U 3570/99-66


BACKGROUND

The Canada Transportation Act, S.C., 1996, c. 10 (hereinafter the CTA) requires that air carriers holding domestic and certain international licences issued by the Canadian Transportation Agency (hereinafter the Agency) must be Canadian as defined in section 55 of the CTA. This is an important requirement that must be complied with at all times.

"Canadian" is defined in section 55 of the CTA as a "...Canadian citizen or a permanent resident within the meaning of the Immigration Act, a government in Canada or an agent of such a government or a corporation or other entity that is incorporated or formed under the laws of Canada or a province, that is controlled in fact by Canadians and of which at least seventy-five per cent, or such lesser percentage as the Governor in Council may by regulation specify, of the voting interests are owned and controlled by Canadians;...".

Air Canada is one of many air carriers that need to be Canadian as defined in section 55 of the CTA. The Agency notes that Air Canada purchased an aggregate of 68,750,000 of its publicly traded Common Shares and Class A Non-Voting Common Shares at a price of $16 per share (hereinafter the Air Canada Offer). In conjunction with the Air Canada Offer, Air Canada intends to acquire all of the outstanding voting and non-voting shares of Canadian Airlines Corporation. Air Canada also intends to effect a comprehensive restructuring as such relates to the affairs of Air Canada and Canadian Airlines International Limited.

In connection with the Air Canada Offer and Air Canada's other intended actions, the air carrier has entered into or is about to enter into agreements with several entities. The agreements, among other matters, are intended to provide funds for the Air Canada Offer. Significant agreements have been entered into with UAL Corporation andor its subsidiary, United Air Lines, Inc. (hereinafter UAL) and Deutsche Lufthansa AG (hereinafter Lufthansa). UAL, Lufthansa and Air Canada are three members of the Star Alliance, an alliance of several airlines formed, among other matters, to integrate their networks. Agreements have also been entered into with the Canadian Imperial Bank of Commerce (hereinafter the CIBC) and Caisse de dépôt et placement du Québec (hereinafter CDPQ).

Given the importance and magnitude of these transactions, the Agency has conducted a review of the Canadian status of Air Canada. As part of its review, the Agency has examined the transactions or intended transactions pertaining to the foregoing agreements to determine what impact, if any, such have on the Canadian status of the air carrier.

With respect to these transactions, the Agency has reviewed information and documentation that are in the public domain including Air Canada's issuer bid dated November 2, 1999. The Agency has also reviewed information and documentation including numerous agreements that have been filed with it by Air Canada on a confidential basis.

ANALYSIS AND FINDINGS

In order to be Canadian as defined in section 55 of the CTA, an air carrier such as Air Canada needs to comply with two basic requirements on an ongoing basis. Firstly, at least 75 per cent, or such lesser percentage as the Governor in Council may by regulation specify, of its voting interests need to be owned and controlled by Canadians. Within the meaning of this provision, "voting interests" mean voting shares and the votes assigned thereto. Secondly, the air carrier needs to be controlled in fact by Canadians.

Do at least 75 per cent of Air Canada's voting interests continue to be owned and controlled by Canadians?

Air Canada has a share ownership constraint system in place to ensure that the 75 per cent voting interest requirement is complied with at all times. The system has been in place for several years and has been previously reviewed by the Agency. The Agency has already determined that the system is fully satisfactory in terms of it being able to ensure ongoing compliance with this requirement.

The Air Canada Offer has resulted in the air carrier purchasing a large percentage of its publicly-traded voting interests. Air Canada's share ownership constraint system discloses that both before and after the Air Canada Offer, more than 75 per cent of its voting interests are and will be owned and controlled by Canadians. Accordingly, the Agency is satisfied that Air Canada continues to comply with this requirement.

Does Air Canada continue to be controlled in fact by Canadians?

The Agency has examined numerous agreements that have been filed by Air Canada on a confidential basis. This includes the Master Financing Agreement that Air Canada has entered into with UAL and Lufthansa. The Master Financing Agreement along with other related agreements and documents disclose that UAL and Lufthansa are to provide certain funding on favourable terms to Air Canada and to guarantee a credit facility to be put in place by the air carrier. The transactions relating to these agreements have been carefully reviewed by the Agency.

Documentation discloses that Expo Investment Partnership, L.P., (hereinafter Expo) a partnership formed by UAL and Lufthansa has purchased 10,000,000 Class A Convertible Participating Non-Voting Preferred Shares, Series 1, (hereinafter the Preferred Shares) in the capital of Air Canada for a purchase price of $232,500,000.

The Preferred Shares entitle the holder thereof to receive dividends only to the extent that dividends are paid to holders of Air Canada Class A Non-Voting Shares. Each Preferred Share entitles the holder thereof to receive $25 in cash plus declared and unpaid dividends in the event of liquidation of Air Canada, in priority to the Common Shares and Class A Non-Voting Shares of Air Canada. The Preferred Shares are not redeemable by Air Canada prior to December 31, 2009, except if UAL or Lufthansa leaves the Star Alliance or materially breaches alliance agreements with Air Canada and, in either case, Air Canada terminates the alliance agreements. The Preferred Shares contain important Air Canada covenants. The holder of the Preferred Shares may retract the Preferred Shares for $25 each plus adjustments if certain events occur, which include Air Canada materially breaching alliance agreements or breaching certain covenants. The Preferred Shares are convertible at any time, in whole or in part, at the option of the holder, into Class A Non-Voting Shares or Class A Convertible Participating Non-Voting Preferred Shares, Series 2.

The Agency notes that the Preferred Shares are non-voting shares that can only be converted to shares which are also non-voting. The Agency also notes that if conversion were to occur, given the existing share capital of the air carrier, Expo would own only a relatively small economic interest in Air Canada which is less than 10 per cent. The Air Canada covenants which exist as a result of the Preferred Share issuance are in place to protect the investor. The Agency concludes that the covenants are reasonable and raise no control in fact concerns. Having examined all these matters, the Agency concludes that the issuance of the Preferred Shares do not result in Expo being able to exert control in fact over Air Canada.

Through a special-purpose entity, UAL has purchased or will shortly purchase three Airbus A330-300 aircraft which are to be leased on favourable financial terms to Air Canada. The annual lease payments which Air Canada is required to make are equal to the debt service charges on approximately U.S.$223,500,000 of third-party indebtedness. Each lease has a 25-year term, subject to early termination pursuant to customary provisions and in circumstances similar to those which would trigger retraction rights with respect to the Preferred Shares. From an operational perspective, the lease provisions appear to be standard and Air Canada will be responsible for maintenance, insurance, taxes and other customary costs. Having examined the principal lease provisions, the Agency concludes that the Airbus A330-300 aircraft lease transactions have no bearing on control in fact.

UAL and Lufthansa have severally agreed to guarantee up to $162,000,000 and $150,000,000, respectively, of Air Canada's regularly scheduled payment obligations pursuant to credit facilities to be entered into between Air Canada and financial institutions. The guarantees are to expire on December 31, 2009. The guarantees can be terminated prior to the scheduled termination in circumstances similar to those which would trigger retraction rights in respect of the Preferred Shares. Air Canada is to pay UAL and Lufthansa a commitment fee of 3/8 of 1 per cent of the commitment and a drawdown fee based on the differential between the credit ratings of Air Canada and the guarantors. Intended guarantee terms and conditions appear to be standard and reasonable. The Agency concludes that the guarantee transactions have no bearing on control in fact.

Several commercial or alliance agreements between Air Canada and UAL and Air Canada and Lufthansa have been in place for some time. These agreements deal with such matters as code-sharing arrangements, marketing co-operation, slot exchanges and frequent flyer point plan participation. Amendments have been made to the alliance agreements which extend their terms and which include exclusivity provisions. The alliance agreements cannot normally be terminated prior to December 31, 2009 and contain liquidated damages provisions in case of breaches to the agreements. These agreements have been filed with the Agency on a confidential basis.

The Agency has carefully examined the amended alliance agreements between Air Canada and UAL and Air Canada and Lufthansa. The Agency finds that the agreements contain standard provisions that alliance partners enter into when dealing with such matters as code-sharing, marketing co-operation, slot exchanges and frequent flyer point plan participation. The agreements are reciprocal in nature and the Agency concludes that they have no control in fact implications.

Air Canada and CIBC have entered into an amending agreement which modifies the credit card agreement previously entered into between the parties. The agreement deals with the issuance of credit cards by CIBC which entitle cardholders to receive membership in Air Canada's frequent flyer program and to earn mileage points. The amending agreement extends the arrangement from December 31, 2001 until December 31, 2009 and provides, among other matters, that CIBC pay to Air Canada a one-time additional service fee of $200,000,000. Additionally, the amending agreement provides that Air Canada issue to CIBC up to 4,700,000 warrants for Class A Non-Voting Shares in Air Canada. Of the $200,000,000, $190,000,000 has been applied to the extension of the credit card agreement to December 31, 2009 and $10,000,000 has been applied to the issuance of the warrants. The warrants expire in October 2004 and are convertible into one Class A Non-Voting Share at $24. The Agency has carefully examined these transactions and concludes that they have been entered into on normal commercial terms with no control in fact implications.

Air Canada has entered into an agreement with CDPQ whereby CDPQ agrees to purchase from Air Canada and Air Canada agrees to issue and sell up to $300,000,000 of subordinated convertible debentures. In December of 1999, Air Canada issued $150,000,000 in convertible subordinated debentures. The debentures have an annual interest rate of 7.25 per cent, payable quarterly. The debentures have several other important terms and conditions including the right of CDPQ at any time to convert the debentures, in whole or in part, into Common Shares or Class A Non-Voting Shares of Air Canada at a conversion price of $16, which equals 6.25 shares per $100 principal amount of convertible subordinated debentures. Air Canada can force conversion into Common Shares or Class A Non-Voting Shares at any time following the seventh anniversary of the issue if the weighted average closing price of the shares of Air Canada for the 20 trading days prior to the date of the redemption provides the holder an internal rate of return of at least 12 per cent for the period commencing from the date of issuance and ending on the redemption date. The debentures mature in December 2009. Having examined this transaction, the Agency is of the view that it has no control in fact implications.

The Agency has examined the motive of UAL and Lufthansa in providing funds to Air Canada. The Agency concludes that the motive of UAL and Lufthansa for these transactions is not to control Air Canada but to keep the air carrier in the Star Alliance.

CONCLUSION

Having examined all of the confidential and public Canadian ownership and control in fact evidence, both individually and collectively, the Agency concludes that the Air Canada Offer and related transactions, including transactions with Lufthansa and UAL, do not result in control in fact being exercised over the affairs of Air Canada by non-Canadians. Air Canada continues to be controlled in fact by the shareholders who own its publicly traded Common Shares and by the directors who are appointed by those shareholders. Air Canada also continues to administer an adequate share ownership constraint system which ensures that at all times at least 75 per cent of the voting shares are held by Canadians. These shares carry the majority of votes which can be exercised at shareholders meetings. The Agency has also examined how Air Canada's Board of Directors is constituted and notes that the large majority of directors are Canadian.

For all of the above reasons, the Agency concludes that Air Canada continues to be Canadian as defined in section 55 of the CTA.

The Agency has requested and Air Canada has agreed to file copies of certain agreements dealing with the Air Canada Offer and related transactions which have not yet been finalized as of the date of this Decision but in respect of which the principal terms and conditions have been disclosed to the Agency. The Agency will review the agreements upon receipt to ensure that they are consistent with evidence already filed by Air Canada.

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