A recent decision of the UK Supreme Court emphasizes the importance, when your transaction involves a state entity, of clarity about the extent to which the state itself will owe obligations.

What happens when you have a contract with an entity created by a state, but the entity no longer exists when you want to take it to arbitration? The United Kingdom Supreme Court recently decided in Dallah Real Estate and Tourism Holding Company v. The Ministry of Religious Affairs, Government of Pakistan, [2010] UKSC 46, that the factual circumstances did not allow the creditor to argue that it was the common intention of the parties that the state be bound by a contract between the creditor and the state-owned entity. Accordingly, it was decided that the foreign arbitral award issued against the state could not be recognized and enforced in the UK.

The facts of the case are the following. Dallah Real Estate and Tourism Holding Company ("Dallah"), a company based in Saudi Arabia, entered into a memorandum of understanding with the Government of Pakistan to provide housing in Saudi Arabia for Muslim pilgrims from Pakistan. The President of Pakistan passed an ordinance establishing the Awami Hajj Trust ("the Trust"), a body corporate capable of suing and being sued. The ordinance assigned functions within the Trust to various public officers, notably the Secretary of Pakistan's Ministry of Religious Affairs, who would act as Secretary of the Board of Trustees and, unless some other person was later appointed, as managing trustee of the Trust. An agreement was ultimately concluded between Dallah and the Trust (the "Agreement").

The Agreement made no reference to the government other than giving the power to the Trust to assign or transfer its rights and obligations under the Agreement to the government. The Agreement contained an arbitration clause that provided for arbitration under the auspices of the International Chamber of Commerce ("ICC") in Paris. The Agreement was signed on September 10, 1996, but the Trust ceased to exist as a legal entity at midnight on December 11, 1996, the expiry date under the ordinance creating the Trust. The government did not renew the ordinance.

Dallah initiated arbitration against the Ministry of Religious Affairs, Government of Pakistan, in May 1998, but the government consistently denied throughout the arbitration that it was a party to any arbitration agreement and it did nothing to submit to the jurisdiction of the ICC Tribunal. In June 2001, the Tribunal issued its first partial award concluding that it had jurisdiction over the government. Its final award held Pakistan liable for the claims made by Dallah.

The English courts at all three levels (Commercial Court, Court of Appeal, andthe Supreme Court) held that the final award could not be enforced against Pakistan since there was no common intention to consider the government to be a party to the Agreement. The English courts refused recognition of the award against Pakistan under Article V(1)(a) of the New York Convention (and its British statutory analogue), which provides that recognition of an award may be refused where the arbitration agreement is not valid under the law to which the parties have subjected it or the law of the country where the award was made. Since it was held that there was no common intention to consider Pakistan to be a party to the Agreement, the arbitration agreement contained in the latter could not be considered valid as against Pakistan.

For some reason, Dallah changed its strategy before the English courts. In arbitration, Dallah argued that either the Trust was the alter ego of the government or the government was the successor to the Trust or to the rights and obligations which the Trust had under the agreement prior to its demise. Neither of these ways of putting the case was put forward before the English courts. Rather, Dallah argued before the English courts that it was the common intention of the parties that the government should be a party to the Agreement. The Supreme Court concluded that there was no evidence in support of the view that there was a common intention to consider the government to be a party to the Agreement.

It is always necessary to be cautious when contracting with state entities. With the recent decision of the UK Supreme Court, the need for caution has simply increased. While contracting with foreign state entities can seem very lucrative in the initial stages, expectation can turn into disappointment once the foreign state behaves abusively and modifies the contractual relationship in a waythat no private party could. For example, under progressive corporate statutes, the winding-up of a corporation without satisfying that entity's liabilities may entail the personal liability of the corporation's directors and/or shareholders. However, such an avenue may not exist under local laws in respect of a state-owned entity created by statutory instrument.

There are various waysto guard against the nightmare scenario encountered by Dallah:

  • ensure at the stage of contract formation that the foreign state is also made party to the contract alongside its state-owned entity
  • ensure that the state guarantees the obligations of the state-owned entity
  • if the foreign state refuses to be a party or to provide a guarantee, the transaction should be structured in such a wayas to come under the protection of an investment treaty that that state has with another state:
  • for example, that protection may be obtained by incorporating the eventual contracting company in a jurisdiction that has a bilateral or multilateral investment treaty with the state in question. The protection may also exist if the owner of the contracting company is domiciled in such a jurisdiction. In this way, if the state takes steps, or omits to take steps, with the effect of harming the company'scontractual rights vis-à-vis the state-owned entity, the company or its owner may have recourse against the state directly under the investment treaty, relying on causes of action such as unlawful expropriation or violation of fair and equitable treatment
  • where an investment treaty exists between the state in question and the state where the eventual contracting company or its owner is domiciled, greater protection may be obtained where both states have ratified the Convention on the Settlement of Investment Disputes between States and Nationals of Other States, which established the International Centre for Settlement of Investment Disputes (ICSID), a specialist investment arbitration body. Contracting states are obliged to give effect to ICSID awards as if they were final judgments of their own national courts, with no possibility of review by those courts.