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World Trade
Organization

WT/DS70/R
14 april 1999
(99-1398)
Original: English

Canada - Measures Affecting the Export of Civilian Aircraft

Report of the Panel

(Continued)


Brazil submits that EDC cannot be collecting the requisite risk premium if it is merely making the rate of inflation.

9.138 Brazil argues that, even if all EDC loans are secured, private lenders still demand a spread of at least 150 basis points above the riskless US Treasuries of identical tenor. Brazil bases this calculation on the fact that EDC provides debt financing for CRJ aircraft for 15 years or longer. Brazil asserts that the difference between the yield risk for riskless US Government 15-year securities (5.31 percent) and the yield for investment grade-rated unsecured non-rail transportation bonds (6.88 percent) is approximately 150 basis points.

9.139 Brazil also submits even if the net cost to government approach to "benefit" advocated by Canada were accepted generally, it would not be appropriate in the specific context of EDC debt financing since, in order to give the appearance of meeting its costs, EDC receives relief from the Canadian government. Brazil refers to the April 1996 Report of Canada's Standing Senate Committee on Banking, Trade and Commerce, which notes that the Canadian Government provided debt relief of $151 million to two of EDC's "problem" accounts. Brazil recalls that the Senate Report concludes that "looking at the bottom line can give a misleading impression of how EDC is faring on its loan portfolio."549

9.140 Brazil notes that, in response to a question from the Panel, Canada submitted as Business Confidential Information an EDC Standing Board Resolution of 17 June 1992, which applies to all business conducted by EDC under its corporate account, including the regional aircraft sector. Brazil notes Canada's assertion that, in accordance with this Resolution, EDC has lent above its cost of funds under its corporate account with respect to the regional aircraft sector since 1 January 1995. Brazil notes, however, that a clause in the Resolution expressly allows the EDC to derogate from the Resolution in certain circumstances. Brazil submits that a question remains whether the derogation has been applied for EDC lending in the regional aircraft sector.

9.141 Brazil also submits that, even if EDC were considered to be profitable overall, this fact tells the Panel nothing about whether EDC meets its costs on its lending activities to the regional aircraft industry. Brazil has adduced evidence with respect to one alleged instance of EDC of debt financing in the regional aircraft sector. Brazil asserts that EDC debt financing was provided for 30 Bombardier CRJs purchased by ASA Holdings, Inc. and its subsidiary, Atlantic Southeast Airlines (hereinafter referred to collectively as "ASA"), in April 1997.

9.142 Canada denies that EDC debt financing in the regional aircraft sector constitutes "subsid[ies]" within the meaning of Article 1.1 of the SCM Agreement. Canada asserts that Brazil's allegations concerning EDC are not supported by the evidence adduced.

9.143 Canada asserts that the EDC is a corporation incorporated under the laws of Canada that is wholly-owned by the Government of Canada. Canada states that EDC operates on commercial principles with the objectives of (a) supporting and developing, directly or indirectly Canada's export trade; and (b) supporting and developing, directly or indirectly Canada's capacity to engage in exports, and respond to international business opportunities.550 Canada submits that EDC is self-sustaining, and that it earns a significant net interest margin that is equal to or better than most commercial financial institutions of similar rating. Canada asserts that the commercial viability of EDC's activities should be viewed in the context of the fact that the core lending business of many major banks is "increasingly unrewarding".551 According to Canada, at 3.03 percent, EDC's net interest margin -- a better measure of performance than "return on equity" -- is better than most commercial banks of similar or better credit rating.

9.144 Canada denies Brazil's allegation that EDC provides debt financing at "concessionary" rates. Canada submits that EDC's financing activities are based on commercial pricing. According to Canada, rates for EDC financing reflect commercial benchmarks and spreads that are in accordance with commercial credit ratings -- and, where this is not available, internal EDC credit ratings in accordance with prudent commercial practices. Canada also submits that EDC's financing terms and structures are consistent with market trends and practices.

9.145 Canada states that the EDC always lends above its cost of funds, and therefore does not incur a net cost on its financing activities. Canada also states that the EDC operates on the basis of commercial principles, and therefore does not provide an advantage above and beyond the market. For these reasons, Canada argues that EDC financing does not constitute a subsidy.

9.146 Canada notes Brazil's general argument that EDC attempts to satisfy "the seemingly endless appetite of Canadian exporters for financial support", Canada asserts that Brazil has selectively quoted from the relevant source materials. Canada states that Brazil omits a connecting sentence that substantially qualifies the passage. Canada notes that the full paragraph from which Brazil quoted states:

"It will be hard to maintain the pace of 1995 and earlier, but EDC has a lot of growing to do before it begins to satisfy the seemingly endless appetite of Canadian exporters for financial support and advice. However, EDC cannot nor should not strive to be the solution for all the challenges faced by Canadian exporters. EDC complements the banks and other financial intermediaries, but cannot substitute for them." [emphasis added by Canada]

9.147 Canada asserts that, by saying that EDC cannot substitute for banks and other financial institutions, the Chairman and the President of the EDC were acknowledging that EDC should not try to satisfy the "endless appetite of Canadian exporters." Canada concludes that, contrary to Brazil's conclusion from the misquoted passages, EDC manifestly does not attempt to satisfy the "endless appetite of Canadian exporters".

9.148 Canada also notes Brazil's reliance on the statement in the Chairman and President's Message that EDC's "goal is to help absorb the risk on behalf of Canadian exporters, beyond what is possible by other financial intermediaries". Canada notes that Brazil relies on this statement to support its argument that "no private financial institution or investor would provide this degree of financing on concessionary terms." Canada states that the full text from which this statement is extracted reads:

In addition to the shift from sovereign to commercial loans, the complexity, scale and duration of financing are changing, and thereby changing the risks associated with insuring and financing Canadian exports.

To reinforce its capacity to manage these changing risks, EDC has established a new Financial Services Office and procedures for evaluating loan portfolios on an industry, geographic, and individual transaction basis. Our goal is to help absorb risk on behalf of Canadian exporters, beyond what is possible by other financial intermediaries, by diversifying the Corporation's business both on a country and sectoral basis. We are determined to achieve this goal through growth in both emerging and established markets. [emphasis added by Canada]

9.149 Canada submits that, contrary to Brazil's assertion, the passage, when quoted in full, does not support the proposition that EDC enters into financing on concessionary terms. Canada asserts that the sentence quoted by Brazil is concerned with portfolio diversification by the EDC, which Canada considers to be an elementary and prudent market activity, which has nothing to do with whether EDC financing confers a benefit.

9.150 Canada asserts that the statement by Mr. Labbé, a former EDC President to the effect that "EDC's financing support gives Canadian exporters an edge when they bid on overseas projects" is not evidence that EDC finances below market. Canada asserts that earlier in the same article, Mr. Labbé is quoted as stating that:

What we bring to the table is a wide variety of financial solutions and insurance support, as well as extensive market and sectoral expertise... We have teams dedicated to different market sectors such as information technology and industrial equipment so that we understand your business as well as you do.

9.151 Canada argues that, taken in context, the "edge" that EDC's financing support gives Canadian exporters derives from their knowledge of the various export markets, from their expertise in "complex and tightly negotiated financing arrangements" and from their awareness that a "few basis points in interest rates can make or break the deal". Canada adduces evidence to demonstrate that this sort of knowledge and expertise is something that almost all financial institutions trumpet in their promotional literature.

9.152 With regard to Mr. Labbé's statement before the Canadian Parliament that EDC's goal is to avoid losing money by "making at least the rate of inflation", and his acknowledgement that the rate of inflation would be below the return "that would be required to survive in the private sector", Canada asserts that net interest margin is a better measure of performance than return on equity in the context of EDC debt financing. Canada defines net interest margin as the difference between gross interest income and gross interest expense on all interest bearing assets, divided by the value of interest bearing assets. Thus, Canada asserts that net interest margin is a useful measure of how well a financial institution's assets are performing. Canada asserts that EDC's net interest margin is better than most commercial banks of similar or better credit rating. Although Canada concedes that EDC does not pay corporate income tax, and does not normally pay a dividend, Canada asserts that these facts are not relevant for the net interest margin comparison because the net interest margin is calculated before tax and before dividends are paid. Canada asserts that whether or not a financial institution pays corporate income taxes or dividends does not affect its cost of funds, or the risk margin charged. Canada notes Brazil's argument that, even if all EDC loans are secured, private lenders still demand a spread of at least 150 basis points above the riskless US Treasuries of identical tenor. Canada notes, however, that Brazil's argument is based on the difference between the yield for riskless US Government securities (5.31 percent) and the yield for investment grade-rated unsecured non-rail transportation bonds (6.88 percent). Canada submits that the yield on unsecured bonds does not support an argument regarding secured lending.

9.153 Furthermore, Canada rejects Brazil's argument that EDC's net interest margin is insufficient to cover the ratio of non-performing loans in its portfolio. Canada argues that the net interest margin already takes non-performing loans into account.552 Thus, any further deduction from the net interest margin to cover the cost of funding non-performing loans would constitute double-counting.

9.154 With regard to EDC's non-performing loan ratio, Canada acknowledges that, overall, EDC's non-performing loans comprise 14.4 percent of gross loans receivable. Canada also acknowledges that, overall, 57.6 percent of EDC's performing loans are classified as below investment grade. Canada asserts, however, that EDC loans in the aircraft sector are secured against the asset, thereby improving the rating of the credit. Canada asserts whether or not a loan is secured or unsecured loan has an impact on the credit risk. Canada submits that, after considering the value of such security, 91 percent of EDC's aircraft portfolio is investment grade or higher. Thus, Canada denies that EDC is engaged in high risk lending in the regional aircraft sector, as alleged by Brazil.

9.155 Canada notes Brazil's argument that EDC's allowances for loan losses as a percentage of total loans is 13.2 percent, compared with one or two percent fore major Canadian banks and the US industry average. Canada asserts that EDC allowances for loan losses are set to ensure that EDC's total portfolio maintains an equivalent rating of at least AA. Canada asserts that it is more important to consider how much is lost on the portfolio, and whether adequate provision has been made for such loss. In this regard, Canada submits that EDC's write-offs against provision have never exceeded 0.15 percent of gross loans receivable over the past eight years. Over the same period, Canada asserts that none of the Canadian commercial banks had write-offs of less than 0.21 percent, and which in one case was as high as 1.52 percent. Canada also refers to material adduced by Brazil indicating that, according to the US Federal Deposit Insurance Corporation, net write-offs of the US banking industry amounted to 0.63 percent of average loans in 1997, down from a peak of 1.59 percent in 1991. Canada concludes therefore that EDC's write-offs against provisions are more conservative than any of these other institutions. In addition, Canada refers to a letter form Canada's Auditor General contained in EDC's 1997 Annual Report , which confirms that the EDC financial statements are presented in accordance with Generally Accepted Accounting Principles ("GAAP"). Canada asserts that essential elements of GAAP are the criteria applied, and that it consistently applies those criteria, when valuing and writing-off loans.

9.156 Canada notes Brazil's reference to "Cdn $151 million in direct government relief to EDC for two of its 'problem' accounts."553 Canada asserts that this amount was paid to EDC as indemnification for the forgiveness of the sovereign debts of Poland and Egypt by the EDC in accordance with instructions from the Government of Canada resulting from Canada's international commitments through the Paris Club. Canada asserts that the relevant sovereign debts were unrelated to the civil aircraft sector.

9.157 In response to a question from the Panel, Canada submitted as Business Confidential Information an EDC Standing Board Resolution of 17 June 1992, which applies to all business conducted by EDC under its corporate account, including the regional aircraft sector. Canada asserts that, in accordance with this Resolution, EDC has lent above its cost of funds under its corporate account with respect to the regional aircraft sector since 1 January 1995.

(ii) Evaluation by the Panel

9.158 In examining Brazil's claim against EDC debt financing, we recall that the Appellate Body stated in EC - Hormones that:

"[t]he initial burden lies on the complaining party, which must establish a prima facie case of inconsistency with a particular provision of the SPS Agreement on the part of the defending party, or more precisely, of its SPS measure or measures complained about. When that prima facie case is made, the burden of proof moves to the defending party, which must in turn counter or refute the claimed inconsistency."

9.159 Thus, in order for Brazil's claim against EDC debt financing in the Canadian regional aircraft sector to succeed, a prima facie case must be made that EDC debt financing in the Canadian regional aircraft sector constitutes a "subsidy" within the meaning of Article 1 of the SCM Agreement. In particular, there must be a prima facie case that a "financial contribution" by a government or public body confers a "benefit".

9.160 We are in no doubt that EDC debt financing in the Canadian regional aircraft sector constitutes a "financial contribution" within the meaning of Article 1.1(a) of the SCM Agreement, since it constitutes a "direct transfer of funds". Similarly, we are in no doubt that the EDC constitutes a relevant "public body". Canada has not disputed that EDC debt financing constitutes "financial contributions" by a "public body".

9.161 Brazil's claim that EDC debt financing confers the requisite "benefit" is essentially based on statements by EDC officials, an analysis of EDC's financial performance, and the EDC debt financing granted to ASA. In analysing Brazil's claim, we recall that a "benefit" is conferred within the meaning of Article 1.1(b) of the SCM Agreement when a financial contribution is provided on terms that are more advantageous than those that would have been available to the recipient on the market.554

Statements by EDC officials

9.162 Brazil refers to a statement concerning EDC's alleged attempt to satisfy "the seemingly endless appetite of Canadian exporters for financial support" through a variety of financial and risk absorption services. Canada has demonstrated, however, that the statement in full expressly provides that "EDC cannot nor should not strive to be the solution for all the challenges faced by Canadian exporters." In context, therefore, we consider that the statement adduced by Brazil does not support a conclusion that EDC attempts to satisfy "the seemingly endless appetite of Canadian exporters for financial support" through the provision of subsidized debt financing.

9.163 Brazil also refers to a statement by Mr. Labbé, a former EDC President, that "EDC's financing support gives Canadian exporters an edge when they bid on overseas projects." Brazil notes that this statement was made in the context of references to financing packages supporting export sales, and suggests that the "edge" in question is an edge in financing terms. However, Canada has demonstrated that the statement was also made in the context of references to "market and sectoral expertise", suggesting that the relevant "edge" is the ability of EDC officials to assemble better structured financial packages on the basis of their knowledge and expertise. Given the possibility for divergent contextual interpretations of Mr. Labbé's reference to the "edge" provided by EDC debt financing, this statement provides no firm guidance as to whether EDC provides exporters with an "edge" through subsidization.

9.164 Brazil also refers to a statement in the EDC Chairman and President's Message that EDC's "goal is to help absorb the risk on behalf of Canadian exporters, beyond what is possible by other financial intermediaries." Brazil relies on this statement to argue that "no private financial institution or investor would provide this degree of financing on concessionary terms." Canada has demonstrated, however, that when taken in full, this statement does not establish that EDC engages in subsidized debt financing. Rather, it simply demonstrates that EDC engages in portfolio diversification.

9.165 In addition, Brazil has relied on Mr. Labbé's statement before the Canadian Parliament that EDC's goal is to avoid losing money by "making at least the rate of inflation", and Mr. Labbé's acknowledgement that the rate of inflation would be below the return on equity "that would be required to survive in the private sector." In response, Canada asserts that return on equity is not an appropriate measure of EDC's performance, and that a more appropriate measure of performance is EDC's net interest margin. We note that Brazil does not expressly disagree with Canada's assertion that net interest margin is a better measure of EDC's debt financing performance than return on equity. Indeed, Brazil itself referred to EDC's net interest margin as a relevant economic indicator in its first written submission to the Panel. In our view, net interest margin is a more appropriate measure of performance than return on equity in the context of debt financing. We consider that return on equity is a more appropriate measure of performance in the investment sector, where equity shares are held by the investor. For the above reasons, we do not accept Brazil's argument that Mr. Labbé's statement concerning EDC's return on equity necessarily demonstrates that EDC engages in subsidized debt financing.

To continue with EDC's financial performance


549 See para. 6.7 above.

550 Export Development Act, Section 10.

551 "The trials of megabanks", The Economist, October 31, 1998, 23 at 23.

552 Canada asserted that "when a loan becomes non-performing, all financial institutions, including the EDC, cease to recognize interest income on that non-performing loan. However, all financial institutions continue to carry the interest expense of that non-performing loan. In other words, the gross interest income is the interest income on performing loans, but interest expense is the cost of funding all loans in the portfolio, performing and non-performing" (see para. 6.34 above).

553 See para. 6.7 above.

554 See para. 9.120 above