Arbitration with Foreign States and State Entities: a Primer

Arbitration with Foreign States and State Entities: A Primer

by

Robert Wisner[1]

Although many Canadians continue to think of their economy as being a host country for foreign investment, Canada is now a net exporter of capital. Each year, Canadian businesses invest more in establishing operations outside of Canada than foreign businesses invest in this country. As Canadians increasingly venture abroad, they are more likely to find themselves doing business with foreign governments or their state enterprises.

Some common examples of international business transactions that are likely to involve a foreign government party include:

1. Natural Resources and Energy: Canadian companies in the oil, gas and mining sectors have long been used to negotiating agreements for the exploration and development of these resources with the foreign governments that own them.

1. Public – Private Partnerships: More recently, foreign governments have sought to develop their infrastructure by privatizing water, electricity and gas utilities or by inviting foreign investors to take an ownership interest in major infrastructure projects.

1. China: Hardly a day goes by without some news story on the economic rise of China. Yet, it is often forgotten that most major Chinese enterprises remain in the hands of the government.

Where business is done, business disputes inevitably follow. Yet, disputes involving foreign governments inevitably contain unique political elements. Failure to anticipate and address these political risks in drafting the contract or in structuring the transaction can leave clients without an effective remedy when a dispute arises.

This paper will address some of the more salient issues to be considered when planning a transaction with a foreign state or state entity, including the need for:

a.  an effective arbitration clause;

b.  waivers of sovereign immunity defences;

c.  mechanisms to reduce political risk; and

d.  planning to obtain protection of the foreign investment under relevant international treaties.

II.  Advantages of Arbitration With State Entities

The use of arbitration clauses in international business transactions comes with well-known advantages and disadvantages. Yet, in transactions involving foreign state entities, the advantages of arbitration are magnified and are much more likely to outweigh any disadvantages. In particular:

1. Arbitration provides a neutral forum: Foreign state entities are even less likely to agree to the exclusive jurisdiction of Canadian courts to resolve their disputes than private foreign businesses. At the same time, the risks of home town justice are exponentially higher when litigating against a government in its own courts. Many countries simply lack the degree of judicial independence from government that Canadians take for granted. The lack of judicial independence can be especially problematic in legal systems where contracts with state entities are resolved in “administrative courts” where the government regularly appears as a litigant.

In order to ensure that the government’s own courts do not have the last word, an effective arbitration clause must select a place of arbitration outside the government’s territory. The place of arbitration determines the jurisdiction that may set aside the arbitral award. While selecting a place of arbitration within the foreign state may appear convenient for the parties, it may undermine this key benefit of arbitration. A neutral place of arbitration does not preclude holding the actual hearing in a more convenient location.

1. Arbitration facilitates enforcement: Even if the foreign state entity can be sued in Canada, it may not have assets within this jurisdiction. Enforcement against assets in third countries is likely to be a necessity. Third countries that are parties to the widely-ratified New York Convention are bound to recognize and enforce arbitration awards. There is no similar agreement that covers foreign judgments and many countries will not recognize such a judgment even it was properly obtained.

1. Arbitration helps to control disruptive tactics: Although both private and public defendants have an incentive to delay legal proceedings, state entities are less likely to be subject to cost-benefit constraints in making these decisions. Arbitration provides a very effective form of case management to control disruptive tactics. Once established, the same arbitration tribunal will hear all aspects of the dispute, thereby discouraging tactics that are likely to diminish the credibility of a defendant in the eyes of the final decision-maker. At the same, the tribunal has an incentive to ensure that the merits are heard promptly. While arbitration clauses do create the opportunity for a state to attempt to disrupt the establishment of the arbitration tribunal, this risk can be addressed by an arbitration clause that selects a well-respected institution to administer the arbitration and act as appointing authority.

While all of the leading international arbitration institutions are competent to handle disputes involving state parties, the Court of Arbitration of the International Chamber of Commerce (“ICC”) has the greatest experience in this regard. The ICC is often more acceptable to state parties as it is seen as a more truly international institution.

One of the world’s leading arbitration institutions, the World Bank’s International Centre for Settlement of Investment Disputes (“ICSID”), specializes in disputes between businesses and governments. For Canadian businesses, however, an ICSID arbitration clause is likely to be pathological. ICSID arbitrations are governed by a special treaty, the ICSID Convention, containing its own advantageous review and enforcement rules. Unfortunately for Canadians, the benefits of this treaty are restricted to investors from Contracting States. Canada is the only OECD country that has not yet signed the ICSID Convention and Canadian businesses that have sought to take advantage of ICSID arbitration rules by assigning their claims to nationals of a Contracting State have found themselves without a remedy.[2]

ICSID does offer an Additional Facility for businesses from countries that are not Contracting States. These arbitrations are subject to the same review and enforcement procedures as ordinary international commercial arbitrations under the New York Convention. However, even contract clauses containing a submission to the ICSID (Additional Facility) must be treated with special care. The Additional Facility is still limited to “investment contracts” as opposed to ordinary sale of goods transactions. In addition, the state entity of the Contracting State must be designated in advance to the ICSID.[3] Given these complexities, it is best for Canadian businesses to avoid any form of ICSID arbitration clause until Canada accedes to the ICSID Convention.

III.  Dealing With Sovereign Immunity Issues

One of the advantages of an arbitration clause in a contract with a foreign state entity is that it constitutes a clear waiver of any claim to sovereign immunity against suit. In Canada, the customary international law doctrine of sovereign immunity is codified in the State Immunity Act which states that “Except as provided in this Act, a foreign state is immune from the jurisdiction of any court in Canada”.[4] The term “foreign state” includes any subdivision or agency of a foreign state.

While the Act does include an exception for proceedings relating to “commercial activity”,[5] the scope of this exception remains uncertain. Immunity from suit can be waived, however, by a written agreement such as an arbitration clause or an unconditional submission to the Canadian courts.

It is important to note, however, that a waiver of immunity from suit does not waive immunity from enforcement proceedings. Thus, to ensure that any judgment or arbitration award is enforceable, contracts with foreign state entities should also include a separate clause such as:

The [state entity] hereby waives any right of sovereign immunity as to it and its property in respect of the enforcement and execution of any award rendered by an Arbitral Tribunal established pursuant to this agreement.

This provision should be included regardless of whether arbitration or litigation is chosen as the form of dispute resolution.

IV.  Mitigating Political Risk

Contracts with foreign states and state entities regularly involve political risks over and above the usual business risks of the transaction. Unlike private parties, governments have the power to unilaterally change the contract’s governing law or engage in other political interference that deprives a party of the benefits of its bargain. Governments are also vulnerable to nationalistic and xenophobic pressures that increase the risk of non-payment or other breaches of contract. Conversely, foreign investors can be special targets for political violence and social unrest. These risks of doing business with governments or in emerging markets are commonly referred to as “political risk”.

Some options for mitigating political risk include:

1. Stabilization Clauses: The governing law clause of the contract may be modified so as to exclude subsequent changes in the state’s law that would interfere with the contract. These “stabilization” clauses often take the following form:

“All laws, decrees and regulations of [the Host State], whether legislative, judicial or administrative in nature, that apply to this Contract, or to the relationship between the Parties, shall be the laws, decrees and regulations in effect as of the date of this Contract.”

There are a number of well-known international arbitration awards arising out of petroleum concession contracts that have held states liable for acts tantamount to expropriation contrary to the stabilization clause in the contract.[6] However, these clauses are subject to a number of limitations. First, the party to the contract may be a state-entity that is separately incorporated and therefore does not bind other agencies of the state. Second, the clause may not cover political risks that do not involve a direct interference with the contract. Third, the stabilization clause may be deemed to be subordinate to mandatory provisions of the governing law.

1. Political Risk Insurance: Export Development Canada and some private insurers offer political risk insurance coverage for breaches of contract by sovereign parties, expropriation, political violence, currency and transfer restrictions. However, coverage is usually limited to specific new overseas investments and may not extend to existing investments. Risk premiums may also be costly and policy limits may not cover the full value of the investment.

1. Investment Treaties: There are over 2,300 bilateral investment treaties around the world as well as similar provisions in multilateral trade agreements such as NAFTA and the Energy Charter Treaty. Under all of these agreements, governments agree to respect the property rights of foreign investors and follow standards of fairness, transparency and non-discrimination. Each of these treaties contains a standing offer of international arbitration to foreign investors that allows them to obtain damages for breach of treaty obligations. In addition to NAFTA, Canada has signed over 21 such treaties, known as Foreign Investment Protection Agreements (“FIPAs”), with various emerging market countries (see Appendix A). However, even in the absence of a Canadian agreement, careful investment planning may allow Canadian businesses to take advantage of similar treaties signed by third countries.

V.  Arbitration Under Investment Treaties

International investment treaties permit arbitration between foreign investors and host states without the need for privity of contract. In fact, as claims against governments are brought for breaches of the treaty rather for breaches of the contract per se, even clauses in state contracts granting local courts exclusive jurisdiction do not preclude resort to international arbitration by the foreign investor.[7] Instead, a business will have standing to bring a claim if:

1. The business is a national of one Party to the treaty;
2. The business owns or controls an investment in the territory of the other Party to the treaty; and
3. The claim arises out of the latter Party’s breach of an obligation in the ratified treaty.

While the specific obligations of each treaty will vary, most treaties contain a core set of key protections for investors, including:

a.  Payment of compensation for acts tantamount to expropriation;

b.  International law standards of fairness, due process and transparency;

c.  Protections from discrimination in favor of nationals or investors from third parties; and

d.  Prohibitions against performance requirements and controls on capital transfers.

There is now a growing jurisprudence under international investment law that considers the meaning of each of these broad treaty obligations. While a detailed review of these obligations is beyond the scope of this paper, readers should be aware that investment treaties have proven to be a valuable tool for obtaining compensation for losses due to political risks.[8]

Nearly all significant emerging markets have ratified multiple bilateral investment treaties with developed countries. With only 21 FIPAs, Canada has fallen behind most other capital-exporting nations in assuring protections for its investors. However, Canadian businesses may seek to protect themselves from political risks by holding their investments through corporations established under the law of a third country that has a bilateral investment treaty with the host state.

Many treaties (but not all) define eligible investors as corporations established under the law of the home state, regardless of the nationality of their shareholders. International arbitration tribunals have held that, in these circumstances, they will not lift the corporate veil to examine beneficial ownership unless there is evidence that the claimant has been incorporated solely for the purpose of bringing the treaty claim. [9] Transactions can therefore be structured in ways that minimize the political risks by taking advantage of applicable investment treaties. Expert advice on international law issues should be sought in these cases to ensure that treaty protections are available and effective.

[1] Counsel and Litigation Practice Leader, Appleton & Associates International Lawyer, Toronto. The author may be contacted at .

[2] See, e.g., Banro American Resources, Inc. v. Democratic Republic of Congo (ICSID Case No. ARB/98/7) and Mihaly International Corporation v. Democratic Socialist Republic of Sri Lanka (ICSID Case No. ARB/00/2) [Insert cites to Appleton’s WL database]

[3] More information about ICSID is available at www.worldbank.org/icsid

[4] R.S.C. S-18, s.3(1)

[5] Ibid.., s.5

[6] Sapphire International Petroleum Ltd. v. National Iranian Oil Co., 35 I.L.R. 136 (1967); Saudi Arabia v. Arabian American Oil Co., 27 I.L.R. 117 (1963); BP Exploration Company (Libya) Ltd. v. Government of the Libyan Arab Republic, 53 I.L.R. 297 (1979); Texas Overseas Oil Petroleum Company v. Government of the Libyan Arab Republic, 53 I.L.R. 389 (1979); Libyan American Oil Company v. Government of the Libyan Arab Republic, 62 I.L.R. 140 (1977); AGIP v. Popular Republic of Congo, 21 I.L.M. 726 (1982).