FINAL REPORT OF THE PANEL UNDER CHAPTER 18 OF THE CANADA-UNITED STATES FREE TRADE AGREEMENT

5.44 Following Puerto Rico's exclusion of imports at the end of 1991, the Panel has no information on bilateral discussion of an equivalency determination or other means of reopening the Puerto Rico market until July 1992, except for Canada, Québec and Lactel's efforts to have the Puerto Rico market reopened by the findings of an Administrative Hearing. During July-September 1992, correspondence between the Canadian Trade Minister and the Acting U.S. Trade Representative indicated scope for a possibly mutually acceptable equivalency study. However, Canada's lack of confidence in an expeditious equivalency determination that would re-open the Puerto Rico UHT milk market to Lactel (even if the determinations were favourable to Canada) led to the convening of this Panel.

5.45 The central issue in these events with respect to U.S. obligations under 708.2(a) is whether, with Puerto Rico's closing of its market to Lactel since December 31, 1991, the United States failed to prevent the introduction of a government standard that constituted an arbitrary, unjustifiable or disguised restriction on trade. Exclusion from the market obviously restricts trade, so the question is whether the exclusion is arbitrary, unjustifiable, or disguised. The exclusion is not disguised. Nor, in view of the extended discussions and proceedings during 1991, the explanations offered in the U.S. letters, and the six-month extension of Lactel's license between July 1 and December 31, 1991, can the exclusion be viewed as arbitrary. The issue remaining is whether the exclusion is justifiable.

5.46 Canada alleges that the Puerto Rico measures were unjustifiable because there were several other less trade-restrictive means of attaining the same objective such as sending FDA inspectors to Québec to rate Lactel's UHT milk, certifying Canadians to carry out the ratings, agreeing to an equivalence study or inspecting each shipment. That other less trade-restrictive means existed is clear to the Panel. What is less clear again is the significance to be attached to this fact. In the absence of an equivalency study, the choice of any one of these other means does not necessarily offer the same level of protection as the PMO. Thus, it appears to the Panel that the existence of less trade-restrictive means cannot be used to support the argument that the Puerto Rico measures are unjustifiable until an equivalency study has taken place. Unfortunately, the terms of reference for such an equivalency study, much less the study itself, were never agreed upon.

5.47 Did the United States fail in its obligation by permitting Québec's UHT milk to be excluded from sale in Puerto Rico before an equivalency study had been completed? Closing the market in the midst of an equivalency study, or of discussion of the terms of reference for such a study, is disturbing because one party could, by delaying a refusal to agree to terms of reference, exclude imports from the other party indefinitely. On the other hand, if Article 708.2(a) were taken as requiring that imports be permitted until an equivalency study had been concluded, then the exporting party could, by delaying or refusing to agree on terms of reference, retain access to the market indefinitely without having to meet the new standard or establish equivalency.

5.48 Whether the United States met its obligations must then turn on the facts of the case. Did the United States follow a path that would expeditiously lead to an equivalency determination? The documents available to the Panel raise questions about the behaviour of the United States in this respect. Puerto Rico and United States officials on several occasions stated seemingly non-negotiable positions that would not permit establishment of equivalency in the sense of ''having the same effect'' that the FTA calls for. FDA and Puerto Rico officials raised objections to an equivalency study on grounds of cost and applicability to only one company in Canada - United States (as opposed to two-way) trade that are irrelevant to 708.2(a) obligations. Most troubling is that these considerations were cited many months after bilateral discussions on equivalency had begun, indeed in the letter of December 31, 1991 in which the Governor of Puerto Rico excluded importation of UHT milk from Québec.

5.49 On the other hand, the Panel is aware of difficulties caused by the fact that Puerto Rico's genuine health and safety concerns had to be reconciled with obligations under the FTA in a most complicated and unprecedented fashion. United States and Puerto Rico officials made statements that indicated a willingness to find ways for Lactel to retain its license to sell UHT milk in Puerto Rico. Bilateral discussions of equivalency in fact occurred on three separate occasions in 1991, beginning on March 6, 1991. The documentation reveals that these meetings and other exchanges between Canadian, United States and Puerto Rico officials were protracted, incoherent and nonproductive; the Panel does not have evidence, nor did Canada allege, that the unproductive nature of the discussions was due to bad faith on the part of the United States.

5.50 In the circumstances, while the United States' handling of this matter was far from exemplary for the reasons given in paragraph 5.48, the Panel cannot find that the United States' exclusion of UHT milk from Québec is a clear violation of Article 708.2(a). In reaching this conclusion, the Panel is mindful of the fact that the determination of the terms of reference and the conduct of an equivalency study is inherently a consensual process which can neither be imposed nor conducted unilaterally. Under the FTA the Parties must cooperate and work together.¹²²

(iii) Schedule 11 of Annex 708.1

5.51 Canada has raised a last argument based on Article 708. It argues that the requirements by Puerto Rico that ratings be carried out by an FDA-certified officer runs counter to the FTA obligation "to work towards equivalent inspections systems for dairy products" found in Schedule 11 of Annex 708.1. The Panel considers that this provision, like Article 708.1, does not go beyond a "best efforts" obligation. It stresses the importance of developing equivalent inspection systems but does not fix a time limit for doing so. What is involved is essentially a process that the Parties accept to set in motion. An essential part of this process was the recognition by the United States of the applicability of the definition of equivalence of Article 711. However, considering the nature of the obligation assumed by the Parties in Schedule 11 and the facts of the present case, the Panel is not ready to say that the United States has acted in a manner inconsistent with Schedule 11 of Annex 708.1.

(f) Non-violation Nullification and Impairment

5.52 The Panel was asked in the terms of reference to consider:

The Panel has carefully considered this matter and is of the view that this is indeed the case.

5.53 Canada argues that, if the Panel does not find violations of the GATT or the FTA, there has nevertheless been non-violation nullification and impairment of the benefits which it could legitimately expect in respect of UHT milk sales in the Puerto Rico market under the FTA and the GATT. Canada alleges that the exclusion of UHT milk from Québec, as a result of the interpretation of the PMO, has nullified and impaired Canada's reasonable expectations under the FTA.

5.54 The applicable provisions of the FTA are Articles 1801:1 and 2011. These Articles state:

5.55 Both Parties trace the concept of "non-violation" nullification and impairment to Article XXIII:1 of the GATT, an article which has been invoked in a number of important

GATT disputes.¹²³

5.56 It is clear that the origin of Article 2011 of the FTA is to be found in GATT Article XXIII. However, there are two differences from the other instances in the FTA which reaffirm or incorporate by reference the GATT. In the first case, Article 2011 does not specifically mention the GATT. Secondly, Article 2011 explicitly links nullification and impairment with the reasonable expectations of the parties under the FTA. The absence of a specific reference to the GATT does not seem to be significant, since the GATT so permeates the structure of the FTA. However, the Panel is of the view that the reference to "...any benefit reasonably expected to accrue..." appears to give special importance to that criterion or condition. GATT panel reports have suggested other conditions for nullification and impairment, but the specific reference to the reasonable expectations of the parties in the language of Article 2011 gives that test a special place in the context of the FTA.

5.57 The Panel therefore considered whether any benefit Canada could reasonably have expected to enjoy under the FTA was nullified and impaired. The United States asserted that Canada must have been aware that Puerto Rico would eventually adopt the PMO as part of a general move to upgrade the standard of milk production in its territory. With respect to the adoption of the PMO itself, the Panel is in full agreement with the United States' position. Given the place of the PMO in the regulation of milk production throughout the United States, it was virtually inevitable that Puerto Rico would seek to align itself to the general American standard at some point.

5.58 The issue, however, relates not so much to the adoption of the PMO itself, as to the manner of its application and interpretation in Puerto Rico with respect to UHT milk from Québec. In this regard the Panel considers that Canada's reasonable expectations under the FTA were indeed upset and to this extent, Canada has suffered nullification and impairment of the benefits which it could reasonably expect. These expectations flow from both the history of the product and from the FTA.

5.59 The Panel makes no judgment of the product but notes the following facts. Québec UHT milk is a product which is consumed in Québec and elsewhere in Canada and in the world; it was consumed in Puerto Rico for 14 years; the UHT process followed under Québec law is regulated by measures which mirror the U.S. Low-Acid Canned Food Regulations.¹²⁴ Finally, UHT milk from Québec has been purchased by the U.S. Army for consumption in military bases in Puerto Rico over a long period of time up to March 2, 1993.

5.60 In the view of the Panel, consideration of the issue of non-violation nullification and impairment should take into account the general expectations to which the FTA gives rise. The FTA is a wide-ranging free trade agreement which governs virtually all of the trade between the United States and Canada. It subjects this trade to new rules which go further than the already extensive rules of the GATT. It deals with matters, including standards, which are not specifically dealt with by the GATT, and subjects them to new and more effective forms of discipline, including dispute resolution. The FTA contains a general chapter on standards and also contains more specific provisions on standards for agricultural products in Chapter 7. It specifically provides for the definition of "equivalence" of agricultural product standards in Article 711 as "having the same effect". In light of these provisions, the Panel is of the view that Canada had a reasonable expectation that a product like UHT milk would not be excluded from the market in the United States, as a result of the adoption of a new standard, if it could be shown that the product was being produced in Canada under standards having the same effect as the new United States' standard.

5.61 The provisions of the FTA on standards reflect a carefully negotiated compromise which respects the sovereign prerogatives of both states with respect to agricultural standards, but which tempers the exercise of these prerogatives with rules and procedures designed to avoid and resolve disagreements and facilitate trade. Previous Panels have reasoned that the FTA should receive a broad interpretation which takes into account the economic purposes of the Agreement¹²⁵ - in the words of a recent Extraordinary Challenge Committee, "entailing integration of two separate trading communities." ¹²⁶ In the view of the Panel, Canada could reasonably expect the USA not to close the market during the course of negotiations on the matter of equivalency, in the circumstances that prevailed with respect to UHT milk from Québec. Nor would it be appropriate to lay responsibility at the door of Puerto Rico alone. Under the FTA the actions of the Puerto Rico authorities are imputable to the United States. In the view of the Panel, the decision to close the market during the course of negotiations concerning the equivalency of standards governing the production of UHT milk in Québec with the PMO, nullified and impaired benefits which Canada could reasonably expect under the FTA. This is not to say that a Party to the FTA is automatically obliged to conduct an equivalency study prior to applying a new agricultural standard to a product of the other Party. It may well be that in many cases the facts will speak for themselves and justify the immediate application of the new standard. However, in the present case, the facts on equivalency were far from clear and therefore bilateral discussions should have continued in order to reach the appropriate determination.

5.62 In these circumstances, the Panel believes that Canada did have a reasonable expectation that an equivalency study would be undertaken, and that, in the midst of a difficult negotiation concerned with reaching an acceptable method of determining the equivalence of Québec's UHT milk production standards to those of the PMO, the authorities of Puerto Rico would not unilaterally close their market to UHT milk from Québec before the issue had been resolved between the Parties on the basis of the FTA.

5.63 For these reasons, the Panel is of the view that the United States has nullified and impaired the benefits which Canada could reasonably expect to derive from the FTA.

6. Determinations

6. Accordingly, the Panel DETERMINES that:

7. Recommendations

The Panel makes the following recommendations:

7.1. In view of the fact that Canada suffered nullification and impairment of benefits as a result of the decision by Puerto Rico to close its market while negotiations were still continuing, an expeditious and conclusive equivalency study, as proposed in the Katz letter of September 25, 1992, should be conducted without delay in order to determine as rapidly as possible whether UHT milk is produced in Québec under conditions having the same effect as those set out in the PMO. All elements of the study should be completed within a reasonable time, within two months if possible. If the Canadian standards are found to have the same effect as the PMO, UHT milk from Québec should be re-admitted forthwith and permitted to be sold in the market in Puerto Rico.

7.2. In order to ensure that commercial relations between Canada and United States with respect to the sale of UHT milk produced in Québec and sold in Puerto Rico be placed upon a stable basis in the long term, it is recommended that procedures for the continued applicability of the conclusions of the equivalency study recommended in para. 7.1, be adopted by the Parties in a reasonable and timely fashion. The Panel recommends that the Parties begin preparation of these procedures as soon as the results of the equivalency study are known.

7.3 The costs of the equivalency study and of the implementation of the procedures should be borne by both Parties. The costs of work undertaken in the United States, should be borne by the United States. The costs of the work undertaken in Canada should be borne by Canada.

SIGNED IN THE ORIGINAL BY:

June 3, 1993

____________________

ARMAND DE MESTRAL

____________________

BRUCE GARDNER

____________________

IVAN BERNIER

____________________

JOSEPH GREENWALD

____________________

FRANK PETRIE

¹²² Following his view, expressed in note 116 that there is not a hard, binding obligation in article 708.2(a), one Panelist does not agree with the argumentation in paragraphs 5.37 - 5.50. While accepting the conclusion that there is no clear violation of article 708.2(a) by the United States, this Panelist considers the discussion regarding an arbitrary, unjustifiable or disguised restriction on bilateral trade not applicable. If the evidence were clearer regarding the intent of the Parties with respect to the obligation involved in the second part of Article 708.2(a) a different analysis of measures ''...that would constitute an arbitrary unjustifiable or disguised restriction on bilateral trade'' would, in this Panelist's view, be required.

¹²³ GATT, BISD 37S/86; see also The Australian Subsidy on Ammonium Sulphate, Report of the Panel, GATT/CP.4/39, April 3, 1950 (GATT BISD vol.2 188). Japan - Trade in Semi-Conductors, GATT BISD 35S/116; U.S.A. Restrictions on the Importation of Sugar and Sugar-Containing Products Applied Under the 1955 Waiver, GATT BISD 37S/228; or Japan - Nullification or Impairment of the Benefits Accruing to the EEC Under the General Agreement and Impediment to the Attainment of GATT Objectives, GATT doc. L/5479 (1983); Uruguayan Recourse to Article XXIII, GATT BISD 11S/95; Treatment by Germany of Imports of Sardines, BISD 1S/53; and EEC Tariff Treatment on Imports of Citrus Products from Certain Countries in the Mediterranean Region, Report of the Panel, L/5778, paras 4.21 & 4.22

¹²⁴ 21 CFR 113.

¹²⁵ In the Matter of: Article 304 the Definition of Direct Cost of Processing,Final Report of the Panel, June 8, 1992, USA-92-1807-01, paras 80,81,82; In the Matter of: The Interpretation of and Canada's Compliance with Article 701.3 with respect to Durum Wheat Sales,Final Report of the Panel, February 8, 1993, CDA-92-1807-01, para. 18.

¹²⁶ Extraordinary Challenge Committee -In the Matter of :Live Swine from Canada, Decision of April 8, 1993, EEC-93-1904-01 USA, p.8