Reforming International Investment Law: Objectively Measuring Indirect Expropriation

Excessive regulation by a host state of a cross-border investment after its establishment can lead to claims by the foreign investor of indirect expropriation (amongst other things). As opposed to direct expropriation which is the physical taking of asset ownership or title, indirect expropriation leaves the ownership of the asset in the investor’s hands but the host state materially impairs the economic rents or profits to be received from the investment. As Dolzer and Schreuer recount, ‘[a]n indirect expropriation leaves the investor’s title untouched but deprives him of the possibility of utilizing the investment in a meaningful way’.[1] The tribunal in Starrett Housing stated ‘it is recognized in international law that measures taken by a State can interfere with property rights to such an extent that these rights are rendered so useless that they must be deemed to have been expropriated’.[2] In Pope & Talbot v Canada, the tribunal in the interim award stated that ‘that under international law, expropriation requires a "substantial deprivation”’.[3] Essentially the test for indirect expropriation is to achieve the same effective outcome as a direct expropriation where the investor loses title to the property and hence its value.

Significant damage to an investment can be done including wiping out all of an investor’s profits and some of its initial capital outlay without achieving economic uselessness. Proving substantial deprivation of the economic value of an investment is both difficult for an investor and slanted in favour of the host state. However, substantial deprivation is easier for an arbitration panel to verify compared to determining a partial expropriation where the investor is left with something of value, albeit severely diminished. As the tribunal in Feldman v Mexico stated, ‘it is much less clear when governmental action that interferes with broadly-defined property rights – an “investment” – crosses the line from valid regulation to a compensable taking, and it is fair to say that no one has come up with a fully satisfactory means of drawing this line’.[4] The 2012 US model BIT has evolved to consider indirect expropriation more fully whereby Annex B states ‘[t]he determination of whether an action or series of actions by a Party, in a specific fact situation, constitutes an indirect expropriation, requires a case-by-case, fact-based inquiry that considers….the economic impact of the government action’.[5]

The main criteria used by investors for evaluating a foreign investment are financial and the most well-known is the internal rate of return (IRR) which considers the time value of money[6]. According to Brierly & Myers, the internal rate of return is defined as ‘the discount rate which that NPV=0’ where NPV is the net present value of the all future cashflows discounted back to today’s value less the initial investment.[7] Put another way, in a simple figure the IRR expresses the return (in %) arising from an initial (negative) investment outlay and the (positive) capital and profit returns received over time, thus neatly capturing three of the criteria that the Salini tribunal embraced as key to defining an investment: commitment, duration and regularity of profit and return[8]. By way of an example (below), an initial investment of 50, with annual returns of 7 for the 14 subsequent years will deliver an IRR of 11% over 15 years.

Imagine the same example where the state intervenes in the fifth year and the investor’s annual returns from year 6 onwards are reduced to 5 instead of 7. In this case the IRR drops to 7%.

In this second above example the investor’s IRR has suffered a 32% reduction due to the host state’s intervention but it still remains positive. In this situation, substantial “deprivation” of the investment has not occurred and therefore under customary law, it is unlikely that a finding of expropriation would prevail in any arbitration hearing. The point is however, that government regulation and interference leading to indirect expropriation should always be measurable (if not to a discrete number, at least to a range which is informative to a tribunal). The author accepts that host states can be devious in exercising punitive regulation whereby the link to investor returns is not obvious or by masquerading the interference as a public purpose.[9]

Host states also understand the symbiotic relationship that can exist with investment returns. Each pound, euro or dollar clawed back from investors is a pound, euro or dollar that remains in the host state’s coffers or is saved from end consumers, the voters. Also, if host states conclude that (i) not all affected investors will seek redress, (ii) not all investors will be successful when seeking redress through arbitration or whichever forum, and (iii) compensation awards are restorative and not punitive, then expropriatory regulation of an investment sector dominated by foreign investors will always be a net gain to host states. As stated by UNCTAD, ‘governments have entered into a phase of evaluating the costs and benefits of IIAs and reflecting on their future objectives and strategies as regards these treaties’.[10] Equally, host state can undertake the same cost-benefit analysis as to the effects of a prospective regulation. For these reasons, tribunals should consider the amount of indirect expropriation even when it does not lead to “substantial deprivation” of an investment.

In the UK, owners of utilities in monopoly positions in electricity, water and transport negotiate and agree with the relevant regulator the investor’s allowable (maximum) return prior to investing in the required infrastructure.[11] In the Czech Republic, draft legislation is currently being considered for clawing back potential overcompensation earned by renewable energy generators under a long-term government-backed tariff offered in 2010 to incentivise new renewable energy projects.[12] Under this initiative from the Ministry of Industry and Trade, a maximum return of 6.3% (PV solar projects) or 7.0% (onshore wind projects) will be allowed and if projects are forecast to earn more than that, the remainder of their 2010 tariff will be reduced so as to cap the total return to investors accordingly. If host states and their regulators are used to capping or reducing investor returns to “acceptable” levels, then why cannot this work in reverse with arbitration tribunals? Any material and measured reduction in the investor’s returns should be returned through compensation which restores the IRR, rather than having to await and prove almost total deprivation of the investment’s value.

From the arbitration case studies read by this author, there is no evidence of numerical analysis or damage quantification being considered during the substantive evaluation of the case. This observation is from a small sample, and the arbitration awards are but a summary of what went on a closed and confidential meeting. If tribunals are to investigate a claim of expropriation, then only an objective and independent analysis of the effects of expropriatory regulation can be informative to evaluating the merits of the claim. This poses a broader question on the composition of arbitration panels beyond just lawyers or those from a legal background to include somebody with a financial background, or perhaps a separate financial sub-committee to advise the panel, however this is beyond the scope of this article.

Certain Asian states have taken a pre-qualification approach to significant investments thereby ‘reserving treaty protection only to ‘‘approved investments’’’ controls their exposure to treaty claims, particularly within investment sectors where the home state wants to retain a certain amount of regulatory freedom.[13] Building on this approach, there is no reason why the host state could not, on an international stage, extend this prequalification to specifying an acceptable return range commensurate with the risk capital employed. For example, for a large, complex infrastructure project the unlevered return expectation guidance could be, say, 8-12%, dependent on the expected risk and duration of payment milestones, the host state’s credit rating, taxation system, etc. This would not bind either the host state or the investor to returns only within this range but if the state wishes to exercise its right to regulate which could impact investor returns, then either side can take comfort that any redress arising from a later stage arbitration should be measurable and any compensation would be linked to restoring the project’s returns to the pre-agreed range. 

[1] Dolzer and Schreuer, Principles of International Investment Law (OUP, 2012)

[2] Starrett Housing Corporation, Starrett Systems, Inc. and others v. The Government of the Islamic Republic of Iran, Bank Markazi Iran and others IUSCT Case No. 24, Interlocutory Award, 16 July 1984 53

[3] Pope & Talbot Inc. v. Government of Canada, UNCITRAL, Interim Award of 26 June 2000 102

[4] Marvin Roy Feldman Karpa v. United Mexican States, Award of 16 Dec 2002, ICSID Case No. ARB(AF)/99/1 100

[5] 2012 U.S. Model Bilateral Investment Treaty <https://ustr.gov/sites/default/files/BIT%20text%20for%20ACIEP%20Meeting.pdf> accessed 23 April 2020 P41

[6] Korhan K. Gokmenoglu and Shahram Alaghemand, ‘A multi-criteria decision-making model for evaluating priorities for foreign direct investment’ (2015) 6 Croatian Operational Research Review 489

[7] Brierly and Myers, Principles of Corporate Finance (4th edn, McGraw-Hill 1991) 80

[8] Salini Costruttori S.p.A. and Italstrade S.p.A. v. Kingdom of Morocco, Decision on Jurisdiction on 16 Jul 2001, ICSID Case No. ARB/00/4 52

[9] T Wälde and A Kolo, ‘Environmental Regulation, Investment Protection and “Regulatory Taking” in International Law’ (2001) 50 International and Comparative Law Quarterly 812

[10] UNCTAD, ‘World Investment Report 2015’ <https://unctad.org/en/PublicationsLibrary/wir2015_en.pdf> accessed 25 May 2020 124

[11] Dejan Makovšek and Daniel Veryard, ‘The Regulatory Asset Base and Project Finance Models: An Analysis of Incentives for Efficiency’, (2016) OECD International Transport Forum 14

[12] Draft bill amending Act no. 165/2012 Coll. <https://www.psp.cz/sqw/text/tiskt.sqw?O=8&CT=870&CT1=0> accessed 7 August 2020

[13] M. Sornarajah, ‘A law for need or a law for greed?: Restoring the lost law in the international law of foreign investment’ (2006) 6(4) International Environmental Agreements: Politics, Law and Economics 353