Global M&A trends and risks
Powerful new forces shaping in the M&A landscape
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Global | Publication | September 2016
For international companies investing in energy and natural resources projects, ensuring contractual stability over the lifetime of the project is critical. Securing this stability requires careful drafting of the contract and the use of the full suite of contractual and non-contractual protections available to investors. Stabilisation clauses form part of this wider suite and, if well drafted, can provide investors with greater certainty in their dealings with host states.
International investment contracts in the extractive sector commonly provide that disputes arising under the contract are to be resolved by reference to international arbitration. This choice is largely driven by the fact that a state or state entity will generally be a party to the contract and arbitration is perceived to offer a more neutral forum for dispute resolution than state courts and better enforcement prospects. These contracts include a number of other distinctive provisions also necessitated by the fact that a state or state entity will be a party to the contract, including stabilisation clauses. International arbitration practitioners operating in this sector need to be familiar with these provisions and with their limitations.
Investors’ desire for stability is easily understood. They are entering into a long-term relationship with a sovereign state, in industries characterised by high upfront capital costs and lengthy lead times if and before revenues start to flow. They typically bear the costs of exploration and development, and also the costs of production once it commences. At this point, they can find themselves vulnerable to unilateral action by a host state, including amendments to national laws and tax provisions, as the state seeks to take a bigger bite of the cherry. Therefore, when investment contracts are negotiated, investors seek certainty that the deal struck will be honoured by the state throughout the life of the project.
Host states generally do not have the same motivations. They are looking to derive maximum benefit from their natural resources and contractual flexibility will enable them to respond to changing political, economic and social conditions – including circumstances where acreage proves more profitable than projected and the investor stands to benefit from windfall profits.
As a result, there is a tension between investors’ desire for stability and host states’ desire for flexibility which parties need to anticipate and prepare for when negotiating investment contracts.
International investors use various mechanisms to mitigate the risk of changes to an investment contract’s legal and fiscal regime. This includes the use of stabilisation clauses. These are not boilerplate clauses: their terms vary widely, including in defining the event that triggers the protection (this could be a formal change in law, or a broader change in the application of existing law) and the nature and extent of protection offered (such as monetary compensation or compensatory revision of the underlying contract).
A traditional form of stabilisation clause is the ‘freezing’ clause, which freezes the provisions of the national law applying to the contract as at the date of the contract. The validity (and therefore enforceability) of such clauses – which effectively handcuff a state – is uncertain. They are seen as impeding a state’s sovereign right to develop its own law and its sovereignty over its national resources.
More modern forms of stabilisation clause either provide for a right to reopen the contract upon occurrence of an adverse change in law or circumstances, or for a right to compensation for adverse consequences of a change to the fiscal circumstances or legal regime. As these clauses provide for an adjustment to the contractual regime, they represent a departure from the international law principle of pacta sunt servanda (‘agreements must be kept’). The aim of such clauses is to reconcile the investor’s desire for stability with the host state’s sovereignty and need for flexibility by providing a mechanism to adapt to changed circumstances. This reduces the risk of conflict and deadlock between the parties. Unlike traditional freezing clauses, it is generally accepted that modern stabilisation clauses are binding under international law. However, economic rebalancing clauses are yet to be the subject of particular arbitral or judicial scrutiny, so modern jurisprudence on the interpretation and operation of such clauses is limited.
The terms of a contract’s stabilisation provisions will differ depending on the specific clause; these are generally tailored to the parties and circumstances. There are, however, four commonly recognised categories of modern stabilisation clause.
Intangibility clauses prohibit any unilateral change to the contractual regime without the consent of all parties. The effect of this is to freeze the contract, rather than the law. In this sense, intangibility clauses can be seen as a sub-category of traditional freezing clauses.
Allocation of burden clauses shift the burden of a unilateral change in the legal or regulatory environment from the affected investor to the host state, so the host state sets off the adverse impact to the investor. These clauses are commonly used for changes to tax and customs rules.
Rebalancing of benefits – or adaptation clauses – provide for the contract to be adapted so as to rebalance the position of the parties to the original contract equilibrium.
Renegotiation clauses provide for the contract to be renegotiated either upon the occurrence of specific pre-agreed events or the occurrence of any event which was unforeseen as at the date of the contract, is outside the control of the parties and which negatively affects the economic equilibrium beyond a stated threshold. A renegotiation clause may also provide that parties are to consult on a periodic basis to consider whether the economic balance of the contract requires adjustment.
Poorly drafted stabilisation clauses may fail to have the effect sought and may even undermine the stability of the contract. Parties drafting stabilisation clauses must therefore ensure that whichever clause it chosen, all key elements are carefully defined.
Adaptation and renegotiation clauses are often the most problematic. The key elements to consider are:
In order for investors to avail themselves of the protection of a stabilisation clause (in whatever form), they must ensure that the contract includes suitable dispute resolution provisions which can be triggered in the event of a breach or a failure to reach agreement on renegotiation. International arbitration is recommended for international contracts of this kind.
Investors should also consider including complementary hardship and force majeure provisions, as these can offer additional protection.
Careful consideration should be given to the governing law of the contract. Investors must consider any domestic law limitations that might undermine the validity of the stabilisation clause. Where international law applies, a stabilisation clause will only be enforceable to the extent that it complies with norms of international law, so these too must be considered – in particular the principle of permanent sovereignty of states over natural resources and the right of the state to develop its own laws.
Finally, investors should be aware that even if held to be binding, tribunals can be reluctant to compel states to comply with stabilisation clauses. Compensation for breach is much more likely to be ordered than specific performance. In these circumstances, the legality of the state’s action will be relevant to the measure of compensation awarded. If the actions taken by the state were non-discriminatory and in the public interest (but nonetheless amounted to a breach of the stabilisation clause), compensation for fair market value will typically be used. Where, however, the state’s actions were discriminatory and/or not in the public interest, the party may be awarded actual loss together with future profits.
Contractual stabilisation clauses – whether in the form of a traditional freezing clause, a more modern rebalancing clause, or some form of hybrid – are part of a wider suite of contractual and non-contractual mechanisms which investors should consider at the outset of any natural resources project. Notwithstanding questions over enforceability, if carefully drafted, stabilisation clauses can increase the protection available to investors, and provide substantially more certainty and stability in their dealings with host states.
Nina Varumo is a freelance portrait and documentary photographer based in Stockholm. A recent project of hers Kvinnor till sjöss (‘Women at sea’) is on ongoing photo series highlighting the working life of female seafarers in order to change the stereotypical image of what and who is a seafarer.
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