Over the last few years, there has been an increase in arbitration cases in the resources sector arising from the direct expropriation of property and assets into state ownership as well as the indirect expropriation through regulatory and fiscal measures such as increased taxation or restrictions on imports and exports.
Arbitration against states is generally only a last resort, with the stakes being high. The recently published arbitral award in Khan Resources v The Government of Mongolia (PCA Case No. 2011-09) is a good example of investment treaty mechanisms in action.
Khan Resources had entered into a joint venture with a Russian state-owned company and a Mongolian state-owned company in order to develop a uranium exploration and extraction project in Dornod, Mongolia. In 1998, the joint venture company obtained mining and exploration licences for the project.
In August 2009, Mongolia enacted provisions that provided for Mongolia to take ownership, without compensation, of no less than 51% of stake of joint companies where exploration of uranium reserves had been conducted with state budget. Khan Resources’ mining and exploration licences were subsequently suspended and ultimately cancelled. Khan Resources claimed that these actions were intended to exclude them from the project and to allow the formation of a new Mongolian-Russian joint venture.
In January 2011, Khan Resources commenced an arbitration against Mongolia alleging, amongst other things, a breach by Mongolia of its obligations to protect investors under its Foreign Investment Law and Article 10 of the Energy Charter Treaty 1994. Khan Resources sought more than US$326m including interest.
In March 2015, a Tribunal constituted under the UNCITRAL rules found that:
- Khan Resources’ rights in the licences were protected as “foreign investment” under the Mongolian Foreign Investment Law.
- Khan Resources were substantially deprived of their investment by the suspension and subsequent cancellation of the licences.
- The invalidation of licences was not lawful.
The Tribunal concluded that the Government of Mongolia breached their obligations under the Foreign Investment Law of Mongolia and that this breach constituted a breach of Article 10(1), the so-called “umbrella” clause in the Energy Charter Treaty.
Methodologies for Determining Quantum
Both parties accepted that the amount of compensation should be determined by the fair market value of the investment as at the agreed valuation date immediately prior to the expropriation in 2009. However, they disagreed on the most appropriate methodology to be used to assess the fair market value of the investment and called expert accountants to give evidence. The tribunal was presented with three methodologies:
Discounted Cash Flow (“DCF”) (advocated by Khan Resources). This method takes the cash flow generated in the future and discounts it to derive a present value. In this case, this involved calculating the reserves in the mine and using the future price for uranium to estimate the mine’s future earnings. This resulted in a fair market valuation of US$264.8m.
Market Comparables (also advocated by Khan Resources). This method estimates a valuation based on the market capitalisation of comparable companies or transactions. This resulted in a fair market valuation of US$245m.
Market Capitalisation or Quoted Market Price (“QMP”) approach (advocated by Mongolia). This values the investment by reference to the share price in the company at the valuation date. The relevant claimant was essentially a single-project company so the market capitalisation of that company should reflect the value of the investment. This would have resulted in a fair market valuation of between US$13.4m and US$16.6m.
The Tribunal concluded that none of these methodologies was satisfactory in this case. The DCF method may have been appropriate for a mine with proven reserves but, in this case, there were too many additional factors and uncertainties. The difficulty of finding truly comparable companies or transactions made the Market Comparables method unattractive. The QMP approach was rejected due to concerns that it produced a valuation that was lower than assessments of the value of the project in 2009.
Having discounted these methods, the Tribunal was left with various offers made between 2005 and 2010 to buy shares in the project. The Tribunal concluded that an offer made in February 2010, adjusted to take account of the impact of Mongolia’s actions, was the best way to estimate the fair value of the investment in July 2009 taking into account the challenges and uncertainties Khan Resources would have faced in realising the value of the reserves. This resulted in a valuation of US$80m and the Tribunal awarded this sum.
The Tribunal followed recent practice amongst ICSID tribunals and awarded interest on damages at a commercially reasonable borrowing rate over the relevant period (in this case LIBOR plus 2%) compounded annually from 1 July 2009 until the date of payment of the award. It rejected claims for interest based on Mongolia’s own borrowing rate, being 7.14%.
This case is of interest because:
- It is a timely reminder that investors facing expropriation have recourse.
- It confirms the benefits of structuring investments from the outset so as to take advantage of treaty protection; while Khan Resources is listed in Toronto, the relevant claimant was incorporated in the Netherlands which (unlike Canada) is a member of the Energy Charter Treaty with Mongolia.
- The award demonstrates some of the limitations of the traditional methodologies involved in assessing compensation, the Tribunal preferring to rely on evidence of actual offers.
- As part of the legal costs awarded Mongolia was ordered to pay the Claimants for a substantial ‘success fee’ they had agreed to pay their lawyers.
It is understood that Mongolia may intend to challenge the award. Foreign investors in the resources sector and beyond will no doubt watch Mongolia’s response with interest.