Fact or Counterfactional? Unpacking the Crafar Controversy.

Posted on April 8, 2012
By Dr Bronwyn Howell

Justice Miller’s setting aside of the Ministerial consent given under the Overseas Investment Act 2005 for the highly contentious sale of the Crafar farms to Chinese interests (Pengxin) in the High Court in Wellington on February 3 ¹  raises more questions than it answers about the processes that must be undertaken when foreigners seek to purchase sensitive assets – including any farm land – in New Zealand. Whilst many have hailed the decision as a vindication of the stated purpose of the Overseas Investment Act 2005 (“the Act‟) “to acknowledge that it is a privilege for overseas persons to own or control sensitive New Zealand assets”, Justice Millar’s interpretation of how the current Act should be applied risks cementing in a countervailing “curse‟ on the current (New Zealand) owners of all assets of the class to which the sale to foreign interests is declined ².

If the current (New Zealand) owners cannot sell to the highest valuing individual, regardless of nationality, then the consequences for the New Zealand economy in the long run could be substantial. The necessarily lower market values eventuating for the relevant “sensitive assets‟ such as farm land will flow through to lower capital valuations. In respect of farm land, New Zealand owners risk becoming “locked in‟ to owning lower-valued businesses with consequently lower borrowing capacity which will constrain the extent to which they can fund the expansion and development necessary to remain competitive in world markets. And perhaps most importantly, the current concentration of New Zealand’s scare capital resources in relatively less productive property investments subject to highly volatile farm gate commodity receipts will also likely persist, contrary to the widely-espoused policy aspirations of substantial diversification of New Zealand’s capital stocks across the wider primary production value chain (e.g. downstream dairy production) and into other industries.

The Counterfactual Test

At the nub of Justice Miller’s finding is the “counterfactual” against which the Overseas Investment Office (OIO) is required to test the “factual” case proposed by the prospective purchasers. Justice Miller found that the OIO could not count the funds invested by prospective purchasers Pengxin to bring the dilapidated farms back into full production as a benefit of the foreign investment, because under a forward looking counterfactual, it could reasonably be expected that any (New Zealand) purchaser would have also made a similar investment. The case for the purchase to be approved must therefore rely upon the additional investments being brought to the table by Pengxin being “substantial and identifiable”.

On face value this would appear to be a reasonable expectation. The objective of an Overseas Investment Act should be to foster beneficial foreign investment and ensure that transactions that are deleterious to the national interest are prevented from proceeding. As the Act covers investment, then the criteria on which the assessment is made ought to be primarily economic in nature. Furthermore, the assessment must be forward-looking, taking into account not just the effects of the current transaction “on the table‟, but the effects of the decision made by officials on the suitability of that transaction on subsequent transactions – including the information that the decision conveys about the likelihood of future transactions of a similar nature being acceptable.

Heatley & Howell (2010)’s ³  review of the Act concurs with Justice Miller’s finding that the current OIO processes incorrectly use the status quo as the relevant counterfactual – albeit that they propose the relevant counterfactual is what will occur if the application is declined. However, they also postulate that the current OIO and Ministerial processes are further flawed because the assessments explicitly exclude from consideration the gains to the vendor of selling to a foreigner who values the asset more highly than the highest-valuing New Zealander. This results in the assessment process being based upon highly subjective criteria surrounding additional investments brought only to the current transaction (such as specific expansion plans for the business under consideration and funding peripheral activities such as scholarships and increasing public walking access) whilst ignoring the consequential benefits of newly-enriched New Zealand owners and the benefits brought to the wider New Zealand economy as a consequence (e.g. reinvesting the proceeds; alterations to market values).

Sorting Facts from Frictions

Somewhat surprisingly, therefore, Justice Miller’s decision finds that in assessing the benefits, the OIO was correct in omitting from consideration the very much higher price that Pengxin was prepared to pay for the farms than a hypothetical New Zealand purchaser (noting that at the time of the judgement, no formal offer had been received from the consortium of New Zealand purchasers who sought to have the decision of the Ministers of Land Information and Finance to approve the sale reviewed, and that the indicative price suggested to the receivers was deemed “unworthy of acknowledgement” ⁴. ]). Indeed, it was found that even though such a sum would enter the New Zealand economy as a benefit to the purchaser if the sale proceeded, it could not be considered part of the benefit assessed by the OIO as it was not part of the exclusive list of criteria which the Act specifies as economic benefits of the foreign investment.

If this adjudication is indeed correct, then current Act requires that the economic assessment of the benefits of selling farm land to foreigners must exclude from consideration what is almost certainly a very substantial economic benefit to the New Zealand economy of the transaction proceeding (given that a rational seller would not have accepted an offer from a foreigner if it was not higher than the highest New Zealand offer). The justification offered is that it was the intention of the politicians in passing the Act that simply paying more than a New Zealander is prepared to pay is not sufficient to justify the “privilege” of owning or controlling sensitive New Zealand assets.

The implications of this judgement are not trivial. Nor are they independent of the issue of the relevant counterfactual against which the application must be assessed. If one considers the act of foreign investment as a means of improving the financial state of the economy into which the investment is made, then it appears naïve to discount what is almost surely the most substantial economic gain – the price premium paid by the foreigner – from consideration in the assessment of the “substantial and identifiable benefits‟ to New Zealand of the transaction proceeding. They are substantial, and indeed identifiable, as a firm offer is already on the table (as opposed to a hypothetical bid that might never eventuate).

Consequently, they should enter into the “factual” assessment. If they are not part of the “factual”, then the inability for them to enter the local economy if the transaction is declined should be considered as part of the counterfactual. That is, the correct counterfactual is not “what would happen if a hypothetical New Zealander bought the farms”, but “what will occur if the currently-proposed transaction is prevented”.

Intervention under the Act to prevent a sale negotiated between two willing parties from proceeding is not costless. If there is a “price” to be paid for the “privilege‟ of a foreigner owning or controlling “sensitive” New Zealand assets, then there must also be a corresponding “value” placed on the ongoing New Zealand ownership or control of the self-same assets. However, rather than being a “privilege”, it is a “curse” – as it translates as the profit foregone by the (New Zealand) vendors when the transaction is overruled. In effect, intervention under the OIO is the uncompensated “taking” of the right a New Zealand owner has to freely decide to whom the property can be sold ⁵.

If there were valid economic reasons for preventing the transaction, then the economic gain to New Zealand from intervening would be greater than the loss incurred by the owner, and compensation could in principle or in fact be paid to the affected party and the national economy would still be better off than if the transaction had proceeded (as occurs when, for example, land is acquired under the Public Works Act for roading or electricity developments). A comprehensive economic cost-benefit analysis would identify if such circumstances actually prevail. However, if the reason for intervention is not economically motivated (for example, intervention arises from a popular political perception that New Zealand ownership of farm land is desirable in itself and should be maintained at any cost) and no compensation is paid (as indeed there is no pool from which it can be paid if there is no economic benefit arising), then the individual New Zealand owners bear the costs directly. They, and by extension, the New Zealand economy in total are poorer, albeit that many people favouring ongoing New Zealand ownership of the assets are happier as a consequence.

Costing the Curse

So if Justice Miller’s interpretation is upheld, then what are the possible consequences of intervening in the Pengxin transaction? On a short-run analysis, if the OIO finds that the additional peripheral “economic benefits” ⁶  over and above what a hypothetical New Zealander would pay renders the Pengxin (or another foreign) proposal unable to meet the test of “substantial and identifiable”, the Crafar receivers now have an asset which can only be sold to New Zealanders. Whereas the rival consortium suggested a price that was “not worthy of acknowledgement” in an open market against a higher-valuing foreign bidder, without competition from foreign purchasers the price offered by New Zealanders post-refusal will likely be even lower than the pre-Pengxin one⁷. Both the Crafar family and their creditors will be in a very much worse financial position than if the Pengxin sale went ahead.

In the long run, however, there will also be a “knock-on effect” in the dairy farm property market. Regardless of whether a local offer for the Crafar farms is accepted, the signal to the farm property market is that dairy farm sales to foreigners are now highly unlikely to be acceptable. The market value of all such farms will now fall as prospective buyers and sellers take account of the new information. Whilst this may be good news for those New Zealanders wishing to buy a farm, it is bad news for those currently owning them. As farms are businesses, a fall in market value translates to fall in the capital value of all farm businesses – all of which is borne by the (New Zealand) equity owners (given that the outstanding debts of these businesses will not alter as market values fall).

All New Zealand farmers are now poorer as a consequence of the refusal. Some may now be in the position of having debts that exceed the new lower capital value of the business, and like the Crafars, be forced into receivership. It cannot be discounted that this will set in train yet another round of declining market values for farm businesses. Even farmers without debt overhang will be affected, as their ability to borrow to fund new developments is correspondingly constrained. This will likely have the effect of restricting the pace of on-farm productivity improvements in New Zealand, relative to other countries where there are more liberal approaches to foreign farm ownership. This would not bode well for the competitiveness of New Zealand’s main exporting businesses.

Going Forward or Looking Back?

Even if there is not a substantial fall in the market values of farms (as some might argue that the current rate of foreign purchase is so small that turning down one or two sales will have negligible effect on the market value of farms), the foregoing analysis shines some light on the conundrum of why, after thirty years of policies aimed at diversifying New Zealand’s economy away from reliance upon commodity returns for primary produce, our predominant export-focused business investments are in property – and noticeably, farm land.

New Zealand is unusual in that its Overseas Investment Act is concentrated almost exclusively upon controlling the sale of very small blocks of rural land (sale to foreigners of all farm land and any rural land in excess of 5 hectares is subject to the Act, whereas sales to foreigners of assets without land are not even subject to an economic analysis – only a “good character‟ test is applied to the purchaser). It is also unusual in that the Department of Land Information, not a department with an economic focus and experience in undertaking cost-benefit analyses (such as The Treasury or Ministry of Economic Development), is responsible for its administration.

These observations are best explained by the fact that the current Act is the consequence of the amalgamation of the original Overseas Investment Act 1973 established in order to liberalise the ownership of financial institutions, and the foreign purchase provisions of the Land Settlement Promotion and Land Acquisition Act 1952 (repealed in 1995). Consequently, the current Act has “grandfathered” into it a number of restrictive farm land controls, many of which originate from the 1880s economic and social vision of New Zealand as an agrarian utopia populated by small-holding farmers. These policies were directed as much against the aggregation of farm land under common ownership as against sale to foreign interests. For example, intending purchasers of lots larger than five acres were required to sign a declaration that they did not already own farm land. If they did already own farm land, they were subject to an assessment of whether the acquisition could be deemed “excessive” – that is, would create a holding that was more than sufficient to support an individual farmer and his immediate dependents “in a reasonable standard of comfort”. The consequence was the entrenchment of the concept of the “family farm”. Until 1961, the government required all owners of farm land to be living on the land and actively farming it, effectively ruling out all “absentee owners‟, regardless of whether they were domiciled in New Zealand or overseas. This reinforced the concept of farm land ownership and farm business ownership being inextricably tied together, even though there is no legal or practical reason why those arrangements should always prevail.

The historic approach to the regulation of farm ownership has had substantial legacy effects on the industry. Whilst many controls were relaxed in the 1970s and 1980s in order to enable aggregation of farms to access the economies of scale necessary for modern farming, the culture of New Zealand family farm ownership prevails in both the urban public consciousness and rural economic reality ⁸. If, as has been claimed by many, the existing Act has been successful in preserving this artefact by precluding sales to foreign interests, then it is likely that there has already been some depressing of local farm market values. This could explain the relatively low levels of existing foreign ownership of New Zealand farms. However, if this is the case, then it has likely occurred at the expense of the diversification of the New Zealand economy away from over-exposure to investments in rural (farm) property.

If much of New Zealand’s productive capital is tied up in farm land ownership, and the Act and social mores derived from past times bias against the sale of these assets to foreigners, then despite many policy intentions to the contrary, the ability to change the investment mix in the economy is also very limited. It may be that current land-owning farmers would like to free up capital from land ownership in order to invest in other industries (e.g. dairy processing), but a tight interpretation of the Overseas Investment Act has been if not preventing them, at least discouraging them from sharing the risks of highly volatile commodity farm gate receipts with overseas investors at the same time as it has been limiting their ability to further diversify by investing in industries with complementary business cycles. Indeed there is some evidence to suggest that some foreign investment in the dairy industry may have been structured so that New Zealanders retain land ownership and foreigners control downstream processing in order to avoid scrutiny under the Overseas Investment Act. If, as is often claimed, the benefits of value-added to agricultural products comes from downstream processing investments, it may well be that the “countervailing curse” that comes as the cost of denying some foreigners the “privilege” of owning and controlling farm land has already made itself felt.

Future Proofing

Justice Miller’s judgement has sent the Crafar farms sale decision back to the OIO for reconsideration. But this is not the end of the saga. He found one process error that requires consideration, but has also unveiled another issue that is potentially more significant. It is not at all clear that the Act does in fact preclude the profits to New Zealand vendors entering into consideration. Regulation 28(g)(i) requires consideration of “whether New Zealand’s economic interests will be adequately promoted by the overseas investment, including, for example, matters such as any or all of the following …(iv) whether New Zealand’s key economic capacity is or will be improved”. If approving the bid helps maintain farm property values at a higher level and frees New Zealand capital for reinvestment, then this must enter into the factual. If turning down the bid harms property values, then this too must enter into the consideration of the counterfactual, as suggested by Heatley and Howell in their analysis.

The foregoing analysis indicates that the use of a forward-looking counterfactual opens up a whole range of new factors that must be taken into account in the event of the bid being declined. If farm land really is too sensitive to be owned by foreigners, then it begs the question of why it is subject to an Overseas Investment Act in the first place, and whether it might not be more transparent and less distorting if it was specifically excluded from such transactions. However, answering this question begs a reasoned debate about why farm land should be considered so differently from other business assets. Importantly, this debate must address whether the current owners of farm land assets should be expected to pay the price for others’ preferences about their ownership or whether the exercise of such public preferences via legislative instruments should be constrained by the obligation to compensate the losers. Not least, it begs more research of the extent to which views about the ownership of different assets may be harming, and not helping, New Zealand’s long-term economic prospects. Importantly, the focus must be on the future, and not on the past.