Expropriation - Investment protection and mitigating the risks

September 2010

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Introduction

International investors and lenders face the risk of expropriation of their project investments. Projects in foreign jurisdictions and in particular those in politically unstable or developing countries must be structured to ensure that there is both contractual and treaty protection to safeguard such investments.

Historically, the lack of appropriate mechanisms open to foreign investors and lenders to protect projects and the associated risks caused a restriction in the flow of international investment into certain countries. In order to overcome this difficulty, to remedy the concerns of investors and lenders and to improve the flow of investment funds, there have been an increasing number of contractual protections that have become market standard for international projects and treaty protections for investors and lenders such as bilateral and multilateral investment treaties between states.

In recent years there has been a marked increase in the number of investors and lenders that have sought compensation from states perceived by investors and lenders to have expropriated their projects. This has been in part due to the internationalisation of projects and the ability of investors and lenders to seek recourse for such expropriation through investment treaties.

This article considers the options that are available to investors and lenders at both the pre-expropriation stage and post-expropriation stage. This article focuses on international projects and the options available to investors and lenders.

What is expropriation?

In a nutshell, expropriation is the taking of a project by the state, whether for public purposes or otherwise. As case law on expropriation has developed, so the understanding of what is and what is not expropriation has become clearer. At a basic level, expropriation can be divided into direct and indirect expropriation.

Direct expropriation is where the state exercises its sovereignty over a project either on an individual basis or as part of a wider scale nationalisation programme. Generally direct expropriation is a clear action by the state that transfers title of the project from the investors to the state and as such provides clear grounds for the deprived investors to seek compensation from the state; for example following Venezuela’s expropriation of oil projects in the Orinoco Belt in 2007. In other words the investors and lenders have a specific action and point in time from which they can measure the state’s liability.

Indirect expropriation is less specific. As GC Christie surmised:

  • “a state may expropriate property, where it interferes with it, even though the state expressly disclaims any such intention, and
  • even though a state may not purport to interfere with rights to property, it may, by its actions render those rights so useless that it will be deemed to have expropriated them.”

Commentators have described indirect expropriation variously as disguised, creeping and consequential expropriation, for example the refusal to renew or the withdrawal of a licence (Tecmed v Mexico)1, undermining contractual arrangements (CME v Czech Republic)2 and termination of contracts for irrelevant reasons (Azinan v Mexico)3.

For an investor and its lenders the main issue is that there is no clear single action by the state and as such the moment from which compensation should accrue may lack definition. The investor may therefore find itself in a position where it is unclear whether it should continue to operate the non-profitable project or abandon it and try to claim that expropriation has taken place due to the state’s indirect interference. It is worth noting that not all changes to legislation or regulation by a state which are to the detriment of a project can be classified as expropriation. Non-discriminatory measures that are lawfully taken by a state, including the introduction of quotas, changes to taxation, environmental protection, labour laws and other measures may not be deemed to be expropriation despite the loss suffered by the investor and lenders and as such little or no compensation would be available to the investor and lenders in such circumstances. Such non-discriminatory measures however must be in line with international law and must not have the effect of “eviscerating” the rights of the investor (Eureko v Poland)4.

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What is the risk?

In short, the risk is that following a direct or indirect expropriation the investor is not compensated.

Investors and lenders would argue that any expropriation by the state should result in sufficient compensation from the state to ensure that the investor is in no worse a position than if the expropriation by the state had not taken place. However, from case law the general trend is for the expropriating state either to seek to justify its expropriation of the asset or project and thereby not pay any compensation, or claim that no expropriation has taken place and therefore no compensation is due, such as in Metalclad v Mexico5.

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Mitigating the risks through the investment structure

The structure that investors and lenders adopt for a project is an important way in which investors and lenders can avoid any expropriation or interference in their project by the state.

A state may be willing to provide lenders and investors with some form of sovereign or government guarantee to act as an incentive for an investment into their country. Such a sovereign guarantee may be given at the outset of a transaction, as seen in many infrastructure projects and will provide the investor and any lenders with comfort that the investment will be backed by the government and if an expropriation does take place the guarantee should ensure that the investor and lenders have direct recourse to the government for breach of contract. It is standard practice for such a guarantee to include a waiver of sovereign immunity. Sovereign guarantees are often provided in concession agreements, these typically take the form of payment guarantees; ie if the contracting state entity does not pay the investors then the government will do so. If an expropriation by the state takes place the investors and any lenders to the investment will be able to seek compensation under such a guarantee from the government.

Sovereign guarantees will often go further when investors or lenders need further incentives to invest into the project. The host state will show its commitment and support of the project through covenants in the agreement between the investors, lenders and the state, for example undertaking to implement specific legislation, the grandfathering of key legislation if applicable, making available government resources and importantly committing not to undermine the investment through adverse regulation or similar. Investors and lenders may also seek an acknowledgement from the state of the investors’ equity contribution into the project and that they are due a return on their investment. In short the investors and lenders are seeking comfort from the host state that expropriation, whether direct or indirect, will not take place and there is the maintenance of minimum investment conditions.

Another way that lenders and investors can get comfortable with the project is to ensure that the accounts of the project company are kept offshore. Where there are currency restrictions in the host state, (often the case in developing countries) there will be a need to provide the project with special dispensation to allow revenues to be sent offshore. By having the accounts offshore in a “friendly” jurisdiction, the lenders and investors to the project can take comfort that they will be able to enforce their security over the offshore accounts if necessary.

It is increasingly common for lenders and investors to seek Export Credit Agency (ECA) support for their project. Typically an ECA will provide the lenders with a guarantee or insurance policy for 85 per cent of value of the export contract in the project. The ECA will charge a premium for providing such a guarantee or insurance policy, the cost of this premium is often dependent upon the risk, particularly political risk, associated with the host state. Another option is for the sponsors to seek a commercial insurance policy to cover any potential expropriation of the project.

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Bilateral investment treaties

In addition to the above, the project lenders and investors can ensure from the outset that the project falls within the scope of a Bilateral Investment Treaty (BIT) or a Multilateral Investment Treaty such as the North American Free Trade Association (NAFTA) or the Energy Charter Treaty (ECT).

A BIT entered into between two states to protect “investments” made by a national of either of the states into the other. It also aims to provide a level of legal protection to the investor. Many BITs contain broadly similar protections.

To qualify for protection under a BIT, there must be an “investor” with an “investment” located in the host state. A dispute would qualify for protection under a BIT if it is between the investor and the host state. Each BIT contains the definition of an “investor” and an “investment”.

International arbitration is usually the neutral forum used to resolve disputes. However, a number of treaties provide for arbitration under the International Centre for the Settlement of Investment Disputes (ICSID). This is addressed in further detail below.

The protections commonly found in BITs are:

  • right to fair and equitable treatment;
  • right to “national treatment”;6
  • right to most favoured-nation-treatment;
  • right to compensation for civil disturbance etc.;
  • protection against expropriation and nationalisation;
  • right to repatriate profits and property;
  • protection against breach of contractual obligations/“umbrella clauses”; and
  • dispute resolution/enforcing rights/arbitration.

In any investment decision, the existence and status of a BIT is an important factor. The protection afforded by BITs is extra-contractual, and so will apply to an investment contract even if not expressly referred to. The host state’s signature of the BIT is sufficiently binding for it to apply to the investment contract.

The importance of BITs continues to grow. In fact, the total number of BITs rose to 2,676 by the end of 2008. Despite the intense BIT negotiating activity of some countries, over the last four years, there has been no change in the ranking of the top ten signatory countries of BITs7.

Figure 1: Top ten total signatories of BITs up to end 2008
Figure 1: Top ten total signatories of BITs up to end 2008

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Source: UNCTAD (www.unctad.org.iia)

The growing number of BITs signed suggests that states value these treaties as having a tangible effect. However, some commentators submit that an issue may arise given the arguable inequality of bargaining power between developing countries that wish to promote foreign investment, and developed countries that wish to protect their investors8. Either way, these are important protections for an investor who is looking to invest in a higher risk jurisdiction.

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Multilateral Investment Treaties (MITS)

MITs are similar to BITs. An example of a MIT is NAFTA. NAFTA covers many issues such as environment, mobility of persons, agriculture and importantly investment. Other MITs are less detailed and deal with a more general investment programme between states such as the ECT.

The objective of the ECT is, amongst other things, to protect and promote foreign investments in the energy sector in member countries. On the one hand the treaty is explicit in confirming national sovereignty over energy resources, ie each member country is free to decide how, and to what extent, its national and sovereign energy resources will be developed, and also the extent to which its energy sector will be opened to foreign investments. On the other hand, there is a requirement that rules on the exploration, development and acquisition of resources are publicly available, non-discriminatory and transparent9.

Disputes under the ECT can either be settled by:

  • arbitration between parties to the ECT on the interpretation or application of the treaty;
  • dispute settlement mechanisms under art 26 which provides for various options for investors to take host governments to international arbitration;
  • a specialised conciliation procedure;
  • a mechanism for settling trade disputes between member countries (provided that at least one of them is not a World Trade Organization member); and
  • bilateral and multilateral non-binding consultation mechanisms for disputes arising out of competition or environmental issues10.

The ECT came into force in April 1998, and commentators have described its success since that date11. It is difficult to assess the impact of the ECT since only 22 disputes have been brought under it to date. The issue of the recent dispute between Yukos and the Russian government has seen Russia move towards withdrawal from the ECT, which was never ratified by Russia but which has also seen the permanent Court of Arbitration in the Hague decide that Russia is bound by the treaty. It is pertinent to note that 15 out of the 22 reported ECT disputes are under the International Centre for the Settlement of Investment Disputes (ICSID)12.

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ICSID

ICSID is an institution that administers and provides facilities for the conciliation and arbitration of international commercial disputes between states and nationals of other member states. It was created pursuant to the 1965 Washington Convention on Settlement of Investment Disputes between states and nationals of other states (ICSID Convention). It is available only in respect of disputes to which a state is a party to the convention. A list of states which has acceded to the convention can be found at the ICSID website13. It is important to note that the primary purpose of ICSID is to promote foreign investment by providing facilities for conciliation and arbitration of international investment disputes.

ICSID arbitration can arise in two ways either contractually (where the investor state contracts contain an express reference to ICSID for their dispute resolution) or outside the contract (where arbitrations arise from indirect consent to ICSID arbitration contained in either the host states national investment legislation or a bilateral or multilateral treaty). Interestingly, 75 per cent of ICSID arbitrations have been brought under the latter category.

The advantages of ICSID arbitration include the following:

  • arbitration proceedings are administered by the World Bank;
  • it is a neutral and self contained system;
  • it is transparent; and
  • it has clear and reasonable legal cost schedules.

However, it is imperative for investors to remember to include a waiver from sovereign immunity clause in their contracts in order to bring a claim against a state entity - mere reference to ICSID arbitration will not be sufficient.

The essential criteria for ICSID arbitration is that:

  • parties must have consented to it in writing;
  • the dispute must be between a contracting state and a national of another contracting state; and
  • the dispute must be a contractual legal dispute arising directly out of an investment.

Although recourse to ICSID is voluntary, once the parties have given their consent to it, they cannot unilaterally withdraw their consent.

In relation to the recognition and enforcement of ICSID awards, each contracting state to the ICSID Convention:

  • will automatically recognise the award as binding;
  • will enforce the pecuniary obligations imposed by the award within its territories as if it were a final judgment of a court in that state; and
  • may enforce an award though its federal courts, providing that such courts treat the award as if it were a final judgment14.

A failure by a contracting state to enforce an ICSID award is a clear breach of its international treaty obligations. Similarly, and perhaps more crucially, a lack of enforcement may have implications for the state’s World Bank membership. This provides a valuable incentive for states to comply, and thereby offers a notable protection for investors.

It is therefore easy to understand why the importance of ICSID has significantly increased in today’s world. This is evident from the fact that today ICSID has 156 signatories15 and statistically there are already 167 ICSID cases which have concluded,16 with 127 pending17.

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Conclusion

It is never too early for investors and lenders to a project to start to plan ways to protect a project from expropriation. Investors and lenders need to adopt an integrated structure that will take account of the protection available and afforded by international law, treaties and conventions. Wherever possible, investors and lenders should seek appropriate assurances from the state where the project will be located. In addition to this, the investors and lenders should factor into any investment model the threat of expropriation and structure their project accordingly.


Footnotes
  1. ICSID Case No ARB (AF)/00/2.
  2. UNCITRAL, Partial Award 13 September 2001.
  3. ICSID Case No ARB (AF)/97/2 (Robert Azinian and Others v United Mexican States).
  4. RG 2006/1542/A Brussels CA.
  5. ICSID Case No ARB (AF) /97/1.
  6. This “national treatment” standard requires a host state to treat foreign investments no less favourably than the investments of its own nationals and companies (Asian Agricultural Products v Sri Lanka (1991) (ICSID Case number ARB/87/3).
  7. Recent Developments in International Investment Agreements (2008 – June 2009) – UNCTAD/WEB/DIAE/IA/2009/8.
  8. The International Law on Foreign Investment M Sornarajah (2007).
  9. www.encharter.org
  10. http://www.encharter.org/index.php?id=269&L=1%2F%2F%2F%5C%5C.
  11. Clarisse Ribeiro “Investment Arbitration and the Energy Charter Treaty” (2006).
  12. http://www.encharter.org/index.php?id=213&L=1%2F%2F%2F%5C%5C.
  13. http://icsid.worldbank.org/ICSID/FrontServlet?requestType=ICSIDDocRH&actionVal=Contractingstates&ReqFrom=Main.
  14. Non-pecuniary awards will have to be enforced by other means such as the New York Convention.
  15. It has been ratified by 144 , see http://icsid.worldbank.org/ICSID/FrontServlet?requestType=ICSIDDocRH&actionVal=Contractingstates&ReqFrom=Main.
  16. http://icsid.worldbank.org/ICSID/FrontServlet?requestType=GenCaseDtlsRH&actionVal=ListConcluded.
  17. http://icsid.worldbank.org/ICSID/FrontServlet?requestType=GenCaseDtlsRH&actionVal=ListPending.

This article first appeared in the June 2010 edition (Volume 25 - No.6) of the Butterworths Journal of International Banking and Financial Law.

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