Expropriation risk for foreign investors is on the rise due to a confluence of factors, such as resource nationalism, the energy transition from fossil fuels to clean energy, and a sustained rise in populism and nationalist sentiment, globally. How to respond to and mitigate that risk is an increasingly pressing concern for foreign investors.
Having a playbook ready when red flags first begin to appear can make the difference between preserving a company’s value – and protecting its people – and losing everything.
What is expropriation?
Expropriation is the taking of private property by a government acting in its sovereign capacity. In some circumstances, and subject to important conditions and limitations, states have the right to expropriate. Expropriation can be direct or indirect. Direct expropriation occurs when the state seizes title or ownership of the asset. Indirect expropriation can occur when the state deprives the investor of the substantial value of its investment.
ationalisation is a form of direct expropriation and involves a state-owned entity or the state itself directly taking control of the asset. Regulatory changes, such as an increase in tax, the imposition of a new tax, or the suspension of a license for a project may lead to an indirect expropriation.
Lawful expropriation must generally be for a public purpose, non-discriminatory and accompanied by fair and prompt compensation.
All states have powers to legislate for the public good. A state may invoke its legislative, regulatory or police powers as justification for a measure that is said to be expropriatory. The debate in such instances tends to centre on the nature and purpose of the state’s action — did the measures constitute a taking without prompt, adequate and effective compensation (thus, an illegal expropriation) or were they a legitimate exercise of the state’s powers in a time of economic crisis, or otherwise measures taken within the proper scope of governmental discretion, and potentially not an expropriation at all?
What is driving the rise in expropriation risk?
Many governments in countries with large natural reserves in commodities that are high in demand, such as oil, copper and lithium, are seeking to increase revenues for the state directly or indirectly through state-owned companies by squeezing out foreign investors and changing the legal landscape to rebalance the economics of the investment. Many states are also reasserting control over natural resources in order to fight climate change and inequality concerns. This trend is particularly visible in the Americas.
In Mexico, President López Obrador, elected on a populist platform in 2018, immediately stopped all oil auctions following his election and recently awarded control of the country’s biggest oil discoveries to state-owned Pemex. Last year, Mexico also cancelled fuel import permits held by Pemex competitors on the basis of alleged corruption, a strategy deployed by Mexico to reduce private sector investment and boost Pemex’s revenues.
Chile’s newly elected president, Gabriel Boric, has pledged to end the country's neoliberal economic model and to introduce significant reforms to its mining sector, such as creating a new state company for lithium extraction and increasing royalties paid by extraction companies. In parallel to Boric’s assumption of the presidency this year, a new constitution is being drafted that is expected to focus on greater protection for the environment.
Similarly, in Peru, Pedro Castillo, who won Peru’s 2021 presidential election on the slogan “no more poor people in a rich country”, has promised to re-write the country’s constitution with the aim of addressing inequality, including the express aim to retain in Peru 70 percent of profits generated within the country, with only 30 percent allowed to go to private investors.
How can foreign investors manage expropriation risk?
Expropriations can threaten the very existence of a company.
At times the company’s people can also be at direct risk. The playbook for how to manage expropriation risk almost invariably begins with local engagement and ends, where local engagement fails to produce a satisfactory outcome, with international recourse. While the detailed strategy will vary according to the specific circumstances facing a foreign investor, the following basic protective steps can assist in preserving an investor’s rights.
As highlighted above, the political and economic climate in a host country can change rapidly. Beyond the initial due diligence conducted prior to making an investment and any commitments secured in the nature of legal stability or other similar guarantees, it is critical to monitor changes in political leadership, economic conditions and government policies to identify patterns emerging that may pose a threat to the investment and people on the ground.
Clear channels of communication internally, especially where investments are held through intermediary companies and/or joint venture vehicles, are also critical to ensure that information is circulated and escalated to the right people charged with assessing risk and, in the case of public companies, making material disclosures at appropriate intervals.
It is important, even in the face of increasing hostility, to develop and maintain open channels of communication with local authorities, either directly or through trusted interlocutors, such as local counsel, government affairs professionals or diplomats, particularly if people and evidence are at risk. Documenting the source of any such hostility, and any connection to the state, contemporaneously with the occurrence of acts of hostility is important to ensure that attribution can be made out in any claim and can, in some instances, serve in itself as a deterrent against escalation.
Identifying and preserving key records in respect of the investment outside of the jurisdiction is important to ensure the availability of documentary evidence in support of claims brought either locally or before an international tribunal. This entails both diligent record keeping of licenses, agreements and other pertinent documents as well as regularly backing up any in-country servers to a server outside of the host country to insulate, in extreme cases, against the seizure or destruction of evidence by the state.
Where an expropriation has occurred or is in progress, obtaining advice from competent local counsel is critically important
to understand the legal status and implications of the measures taken, as well as any available avenues of recourse locally. Local counsel are also often a first line resource to connect with local leaders and facilitate dialogue where possible to achieve an understanding, a renegotiation or mutually agreeable resolution of a formal dispute.
In parallel to retaining local counsel, it is also advisable to retain competent international counsel at an early stage to advise on the foreign investors’ options to have the dispute with the state resolved in a neutral forum, and in accordance with international standards. This is likely to entail a review of the main investment or project agreements as well as any applicable investment treaties that provide for international arbitration as a dispute resolution path.
Where the investor has political risk insurance, the policy must be carefully reviewed to determine whether expropriation risk is covered and, if so, to ensure that any notices and notice periods are respected. Typically, a company must be able to show that the loss was a result of the government’s conduct, rather than the company’s own violation of a local law. Additionally, most political risk policies require that the triggering event or conduct by the government of the country remain in effect for a certain period of time before a loss is covered.
Resource nationalism has always been a source of expropriation risk for foreign investors, but the energy transition, the shift to a greener global economy and the resurgence of populism and nationalism all bring new risks. Foreign investors need to remain diligent during the course of their investment. Taking the above steps will not necessarily prevent an expropriation, but it will help position the investor to preserve its rights.