Using Commercial Tools and International Law to Protect Investments in Emerging Markets
As Australian and other Western resource companies increasingly look to invest in emerging markets, particularly in Africa, managing political risk is becoming more important to their business. Argentina’s recent expropriation of most of Repsol’s interest in Yacimientos Petroliferos Fiscales SA. (YPF), has brought these risks back into sharp focus.
Indeed, resource nationalism is an increasingly common feature of the global resources market as emerging market governments take a more strategic approach to their energy security, rather than the more market focussed approach favoured by Western states.
But what is the law when it comes to expropriation and other types of political risk? How can foreign investors commercially and legally structure their investments to help to minimise the risk of expropriation and other political risks affecting their investments or projects?
Doing that requires a 2 stage approach:
- Ensuring that the contracts underpinning the investment or project are flexible enough so as to minimise the likelihood that it might become cheaper for the host government to breach its obligations to the investor than it is for it to comply with them; and
- Including several important and interrelated protections in its contracts with the host government and any local investors to minimise political risk and ensure that if expropriation does occur, the investor can maximise its chances of recovering its losses.
This update will outline those commercial and legal approaches.
What is Expropriation?
Expropriation occurs when a government deprives an investor of its ownership of, or substantially the benefits it receives from, its property. Classically, it involves the outright confiscation of an asset or a company by a government.
However, it can also be achieved by a host government increasing taxes and royalties, adjusting management rights in respect of an investment or project, or by a combination of measures, to such an extent that an investor is effectively substantially deprived of the benefits of that investment or project.
These are measures “tantamount to expropriation”. Generally, under international law, and for the purpose of this update, they are treated as if they were expropriation in the classic sense.
Not all expropriation is unlawful. Governments may pass laws, particularly with regards to taxation, if that law has a legitimate public purpose. Under international law, expropriation will only be unlawful where the underlying measure taken is discriminatory, arbitrary or retaliatory.
Contractual tools to stabilise an investment
Most foreign investors know that a “stabilisation” provision is an important part of any modern project agreement in an emerging market (such as a concession agreement, production sharing agreement, host government agreement or economic development agreement) (EDA). Commonly, a stabilisation provision will seek to freeze the law of the relevant state as it applies to the asset and the EDA at the point in time at which the EDA comes into effect. However, this is only one type of stabilisation provision.
Stabilisation provisions may take a variety of forms. For example, they may be combined with a “Change of Law” provision allowing for either compensation to be paid to the investor, or a financial adjustment to be made under the relevant contract, to account for a change of law affecting the investor. These types of stabilisation provisions usually include a monetary or general threshold (such as “material adverse affect”) beyond which they are triggered.
Increasingly, these kinds of provisions are bi-directional. That is, the host government may insist that the provision is drafted such that it also shares in the upside brought about by any change of law. So long as the basis for making that adjustment is fair to both sides, and a robust approach to stabilisation is taken under the EDA, these kinds of positions should not be rejected outright by investors. Sharing the upside beyond a fair threshold which preserves a healthy rate of return for the investor can be a key way for an investor to maintain contractual balance, thus reducing political risk and thereby benefiting the investor and its shareholders.
Using International Law
Commonly, an EDA will necessarily need to be governed by the law of the host state. In any case, host states are increasingly reluctant to have their EDAs governed by foreign law (such as English or New York law).
However, investors may be able to improve the legal regime under which their investment is made by including international law as a governing law for the EDA. This does not mean that international law is the only law governing that EDA. Rather, where this approach is used, the EDA is governed by local law except to the extent that it is inconsistent with international law. By doing so, an investor receives the benefit of the protection of international law against expropriation. That protection includes the payment of adequate compensation to the investor by the government if the investment is expropriated.
Legally, under international law, there is nothing that prevents an investor from seeking to structure its EDA with the host government in this way. However, governments may sometimes be reluctant to do so.
Another important way to secure assets in emerging markets is by way of including a sovereign immunity provision. The doctrine of sovereign immunity prevents people in certain circumstances from initiating proceedings, and being awarded damages, against sovereign states in other jurisdictions (although it may not always be available to a State under international law where the State is contracting with a party in a commercial context). Consequently, it is important that host governments expressly waive their rights under this doctrine to allow the investor to effectively pursue a government if it breaches its obligation to the investor under an EDA. This is particularly important where the investor has secured the inclusion of international arbitration as the appropriate dispute resolution mechanism under the EDA (as described below).
Contractual Rights as Property
In many countries, contractual rights are not considered to be property. Under international law, contractual rights can be considered to be property. Consequently, if a host government unilaterally modifies a contract in its favour and, in doing so, expropriates the investor’s contractual rights or, for example, effectively substantially deprives it of its management rights (but without physically seizing the underlying assets), that may still constitute expropriation for the purposes of international law.
Consequently, it may be useful to ensure that the EDA contains a provision which expressly acknowledges that the investor’s contractual rights under the EDA constitute property of the investor. By doing so, the investor strengthens any arguments it has against a host government that its asset has effectively been expropriated if a government unilaterally moves the contractual goal posts between it and the investor in a discriminatory, arbitrary or retaliatory way that effectively deprives the investor of the benefit of its investment or project.
Seeking to remove disputes from the jurisdiction of the host government’s own courts is one of the most important, and commonly used, ways to help to stabilise an investment in an emerging market.
This is most often achieved by including in the EDA a comprehensive provision for the international arbitration of disputes by independent and impartial arbitrators in a jurisdiction disconnected from that in which the claim arises.
Commonly used fora for that arbitration include the International Centre for the Settlement of Investment Disputes (ICSID) or the London Chamber of International Arbitration. However, states are becoming reluctant to accept ICSID as an appropriate forum for international arbitration (as ICSID has handed down a number of decisions over the past decade favourable to investors in disputes relating to, or alleging, expropriation). Other appropriate or commonly used forums for International Arbitration include the United Nations Commission on International Trade Law and the Singapore Centre of International Arbitration.
Using Bilateral Investment Treaties (BIT)
Where possible, investors should always try to structure their investments so as to receive the benefit of an appropriate bilateral investment treaty. Commonly, BIT’s will include provisions which prohibit the expropriation by one state of the property of an investor from the other state without appropriate compensation being paid in the event that expropriation does occur.
Even if the investor’s home jurisdiction does not have or enjoy a BIT with the host state, it is often possible to structure the investment such that the investor receives the benefit of the protections provided by a BIT. This can be achieved by ensuring that at some point in the holding structure through which that investment is made, the investor uses a company incorporated in a jurisdiction which enjoys an appropriate and comprehensive BIT with the host state. This also involves an analysis of the provisions of the relevant BIT to ensure that they cover investments structured in this way and an analysis of the provisions of the best way to structure an investment from the home jurisdiction through to the BIT host jurisdiction.
Of course, this analysis should also be undertaken in conjunction with the appropriate tax planning.
Double Tax Treaties (DTTs)
As with BIT’s, ensuring investments are structured through an appropriate DTT can play an important part of appropriately stabilising an EDA.
If the home jurisdiction of the investor does not have a DTT in place with the host state, this may involve the incorporation of a company in a jurisdiction which enjoys a DTT with the host state provided that the jurisdiction in which that company is established also enjoys a DTT or similar taxation arrangement with the investor’s home jurisdiction. If an investor can structure their investment in this way, it may be able to receive more favourable tax treatment of receipts or income from the host state as well as lessening the ability of a host government agency to interfere with or interrupt these receipts. The company will need to sit below or above (but most often below) the BIT Holdco. By combining the protection of a BIT and DTT, an investor may also add a strong element of diplomatic strength to the protections available to it under international law, as well as stronger avenues of legal recourse in the event of a breach of contract by the host government.
Of course, structuring an investment to take account of any DTT protection which may be available will require specialised taxation analysis, not only with respect to the investment being made but also with respect to the taxation structuring of the group of which the investor is part as a whole.
Currency and Foreign Exchange
An EDA should include a waiver of any currency restrictions which may affect the ability of the investor to undertake its obligations or enjoy the benefit of its assets or investments. These provisions in the EDA are usually framed both positively and negatively so that the host government agrees not only not to hinder currency exchange but also to actively assist the investor by facilitating it.
Customs, Imports and Exports
If possible, an investor should also seek to include in the EDA provisions allowing for the importation and exportation of equipment used for the project or investment. As with provisions regarding currency exchange, these provisions are best framed both positively and negatively. Preferably, they will extend to immigration controls regarding key investor personnel (subject to security clearances, etc).
These provisions are especially useful where equipment would need to be removed and repaired abroad in the event of breakdown.
Commercial and other tools to stabilise an investment
Partial Risk Guarantees
Where a foreign investor is also seeking funds for its project (particularly in debt markets), a partial risk guarantee from a multi-lateral donor agency such as the Multi-lateral Investment Guarantee Agency or the Asian Development Bank (PR Guarantee) can also be useful. These guarantees can provide a backstop to political risks such as currency transfer restrictions, expropriation, war, civil unrest and certain pre-agreed, prescribed breaches of contract. Consequently, they can greatly improve the bankability and inherent value of projects and investments in emerging markets.
A PR Guarantee is often triggered where one of the risks it covers crystallises (such as the government breaching one of its primary obligations under the EDA or where expropriation occurs). The PR Guarantee will then require the multi-lateral agency to pay an amount to the investor in respect of that loss. The PR Guarantee is itself backed up by a back-to-back indemnity between the donor agency and host government.
The provision of a PR Guarantee by a multi-lateral donor agency may be made subject to strict conditions. Consequently, while PR Guarantees may improve an investor’s ability to access funds on debt markets and capital markets and, in some cases, may decrease the cost of those funds, the conditions which often come with the use of these guarantees may increase the total cost of the project. This is because those conditions will usually require a foreign investor to adhere to environmental, social, health and labour standards which are stricter than those ordinarily required under the laws of the host state.
It may, however, be the case that the reputational benefit of adhering to these stricter standards as well as the broader benefits of having a PR Guarantee in place outweighs those costs. It may also be the case that doing so is more consistent with the investors’ own standards for corporate social responsibility.
Export Credit Agencies
Likewise, the use of export credit agencies’ (ECA) support for the procurement of any equipment required for the project can also be useful.
ECAs are private or quasi-government institutions that can act as intermediaries between national governments and exports or imports financing. For example, an ECA may provide funding to an investor for the purchase of EPC or turnkey equipment from an EPC contractor or turnkey contractor.
The relevant ECA to provide funding would be the export credit agency that is associated with the country in which the EPC contractor, equipment supplier or turnkey contractor is located. In return for providing that funding, the EPC contractor, equipment supplier or turnkey, contractor (as the case may be) would pay a premium to the relevant ECA.
Revenue Related Protections
As mentioned above, one of the key objectives of stabilising EDAs is to ensure that the contract remains sufficiently flexible so that the investor minimises the chances that it becomes cheaper for a host government to breach its obligations under the EDA then it is to comply with them over the project's life.
Depending on the circumstances, a shared revenue payment mechanism may be one of the best ways to do so. These mechanisms require an investor to pay to the host government a proportion of its profits in excess of a prescribed and healthy threshold (usually based on an agreed rate of return). For example, in a period where the investors’ profits result in an internal rate of return (IRR) in excess of that prescribed threshold (for example, say 20%), each additional dollar of profit beyond this level is then shared 50/50 with the host government. Of course, the threshold needs to be calculated in the context of the financial model and underlying risk for each individual project.
Where a shared revenue payment mechanism is used, it is advisable to include an agreed and appropriately comprehensive accounting procedure in the EDA to ensure the IRR threshold is calculated on an agreed and clear basis. If an accounting procedure is already included under the EDA, it may only need to be tweaked or amended to provide this clarity.
These mechanisms are becoming increasingly common as stabilisation tools. They have the benefit of allowing the local government to share in the upside of the project beyond a pre-agreed, robust and transparent IRR if circumstances change rapidly in favour of the investor. However, if well designed, they still allow the investor to make a very healthy rate of return being triggered.
Importantly, commercially, they make it more difficult for the project to arrive at a point where it becomes cheaper for the host government to breach the ETA than it is for it to comply.
Aligning Interests with Local Partners
Many countries require that foreign investments are structured so that they are made in joint venture or cooperation with local partners.
In many emerging markets the benefit of bringing local partners into a project comes from the local knowledge and networks of those people in the host state. Often, this requirement comes with some kind of “carry” or subsidy of the local partners’ interest in the underlying investment or project. Consequently, depending on the project or partners, and as a reflection of that value and the 'carry', it may be appropriate to include put options to those local partners by the foreign investor, where, within a specified period of time, an act or omission of the local partner directly results in expropriation or a measure which is tantamount to expropriation being taken by the host government against the investment or the project.
The put option will allow the foreign investor to “put” their investment to the local partners in circumstances where is it triggered at a pre-agreed price. While these mechanisms can be very useful in aligning the foreign investors’ and local partners’ interests, they are usually limited in scope and then only to larger investments as the practical enforceability of the put option against the local partners (or their interests in other jurisdictions) will be key to ensuring it achieves the desired effect.
However, having such a put option in place helps to keep a local partner well motivated to work in the interest of, and use their resources towards, the commonly held investment. Of course, significant consideration needs to be paid to the manner in which that option is structured and ensuring it is enforceable.
Some projects (for example, gas or power plants in emerging markets) can have their value significantly enhanced through an appropriate commodity hedging strategy. If implemented at an early stage, this may also help to enhance value beyond a sell-down of an interest in the project to a third party.
Commodity hedging strategies also offer the following benefits if properly implemented:
- minimum equity value remains protected;
- equity appreciation available from price increases on un-hedged volumes;
use of forward market (if applicable) allows investor to back-in production margins and leverage assets for financing so as to:
- improve the project’s debt service coverage ratio; and
- achieve pricing above the conservative assumptions used by banks and rating agencies in making their own evaluations; and
- ability to hedge against political risk associated with the host government’s off take obligations (if applicable).
Note that this is a longer term strategy rather than an immediate one. Hedging structures can be costly and those costs need to be weighed over the life of the project or investment.
Increasing investment in emerging markets creates new opportunities for Western companies. It also presents new challenges for them. Some of those challenges involve navigating very different legal and political environments.
While it will rarely be possible to include all of the above legal and commercial mechanisms in a single EDA and related arrangements with a host government and local partners, taking a combination of them will significantly improve the investor’s political risk profile, particularly as regards expropriation.
Consequently, it’s important for investors in emerging markets to choose the best mix of the above approaches for each individual investment or project. In doing so, given the long term nature of resources projects (particularly in emerging markets), any EDA should be structured flexibility enough, using commercial and legal mechanisms, so as to minimise the chances that it will become cheaper for the host government to breach that contract than to comply with it over the project's life.