Mitigating cross-border investment risk through investment treaty protections

With almost unprecedented levels of undeployed capital presently sitting as dry powder within companies and financiers across the world, international cross-border investment will form an almost inevitable component of the near to mid-term investment strategy for many investors. 

But with a confluence of geopolitical trade tensions and the extraordinary use of pandemic-driven sovereign power, international investment – particularly in long-term capex-intensive projects – has never been riskier. 

The risks of cross-border investment to investors are manifesting globally in a variety of ways. Authorities of the host country may assert their sovereignty against the investor’s contractual rights or adopt measures that otherwise impact the economic viability of the investment. Unlawful expropriation is an extreme example of that but there may be less overt ways in which government action can deprive a company of the economic use of its rights or the value of its assets – from withdrawals of industry subsidies, to discriminatory denials of permits required to conduct operations or arbitrary criminal proceedings against the company’s personnel, to name but a few examples.

When this occurs, recourse before a foreign country’s domestic courts may not provide a meaningful remedy for a range of reasons including a perceived lack of judicial independence and impartiality, an absence of adequate protections under the local laws and the application of sovereign immunity rules.

Australian companies and shareholders can reduce the risk of operating overseas by ensuring that their activities benefit from protections available under investment treaties.

Investment treaties are international agreements concluded between two or more countries which protect qualifying investors (from one country) against certain types of government conduct (in the other country). They include treaties that are dedicated exclusively to the protection of foreign direct investments (often called bilateral investment treaties or ‘BITs’), as well as free trade and other trade liberalisation agreements that include investment protection provisions. Today, there are over 3000 investment treaties in force worldwide and Australia is a party to several dozens of them, including with countries such as Indonesia, the Philippines, Papua New Guinea and Peru where significant Australian assets are located.

Investment treaties offer substantive and procedural protections. Substantive protections typically guarantee that the investor’s rights will not be nationalised or expropriated (either directly or indirectly) without just compensation, that the investor will not be treated less favourably than comparable domestic and other foreign investors or subjected to discriminatory, grossly unfair or arbitrary treatment, and that the investment will be protected from harm by government and private actors. Treaties may also contain other substantive guarantees, like the right to a free transfer of profits in and out of the host country. They may even protect the investor’s legitimate expectations about future matters that may come to impact the investment. These protections can restrict arbitrary conduct by host countries in the form of new laws and regulations or the application of the existing laws in a way which affects the value of an investment.

Apart from the substantive protections, many investment treaties offer important procedural advantages. They may enable the investor to claim damages, including lost profit, from the host country for alleged treaty breaches in front of a privately appointed, independent and depoliticised panel of arbitrators, without needing to resort to domestic courts first. Moreover, unlike under most domestic law systems, a claim for damages for losses sustained in respect of an investment may be made by the company’s shareholders, sometimes several levels up the corporate chain.

In this way, investment treaties can be a powerful tool for companies and shareholders wishing to reduce risks to their foreign investments. If an investment is impacted by conduct of the host state’s authorities, they can – and often do – provide leverage when negotiating with foreign governments, and if a settlement cannot be reached, recourse to an international tribunal may result in an award of damages enforceable against the host country in a range of jurisdictions where the country holds assets.

However, to benefit from investment treaty protections, investments must be structured in a way which enables access to the most favourable treaty. While a number of treaties contain similar broad guarantees, we increasingly see differences among more recent species of investment treaties. Some limit access to investor-state arbitration to claims for breaches of distinct treaty guarantees only, such as expropriation, or even exclude investor-state arbitration entirely. Others might exclude certain types of investments or investors from their scope, and some contain specific provisions that preserve the host country’s right to regulate in certain areas, even if to the detriment of the investor. Some have begun to impose obligations on investors.

The foregoing underscores the need to understand the full range of investment treaties that may be available to de-risk foreign investments. Without careful corporate and transaction structuring, Australian companies and shareholders may only able to benefit from a limited number of treaties to which Australia is a party. Where there is no investment treaty between Australia and the host country of the investment, obtaining the most favourable treaty protections may require the investment to be channelled through a corporate entity of a third country with which the host country of the investment has concluded an investment treaty, offering a greater degree of protection to the investor and allowing disputes to be resolved in a binding dispute settlement process. Maximising treaty coverage may even require spreading the chain of ownership across a number of different jurisdictions so that a larger number of investment treaties can potentially be available.

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It is important to bear these matters in mind early in an investment’s cycle. Restructuring after a potential dispute has arisen may be treated as ‘abusive’ and may ultimately disallow the investor(s) from relying on a treaty’s protections. To de-risk operations by reference to investment treaty, corporate, transactional and operational structuring must be considered prior to the time of making an investment.

Minimising corporate risk through ‘responsible’ dispute resolution processes

The global pandemic has placed extraordinary pressures on trade across almost all industries and sectors, particularly those with exposure to cross-border transactions. These pressures have caused, or will cause, loss and disputes. The manner in which those losses are recouped and disputes managed can have a significant and potentially long-lasting effect on shareholder value and the investment profile of a company. Unwanted media attention on losses and disputes can erode market value, while not pursuing losses can impact the balance sheet and potentially spark shareholder-led claims. Confidential arbitration that is tailored to the needs of the parties and the nature of their disputes may be an effective and ‘responsible’ option for companies.

Arbitration has long been the dispute resolution method of choice for international transactions involving parties from different jurisdictions. In Australia, it has been commonly used for energy and resources and major infrastructure projects. More recently, its use has spread into sectors that traditionally opted for litigation, including big tech, the pharma industry, banking and finance. Why are these players increasingly choosing arbitration to resolve their disputes?

At its heart, arbitration is a private process, shaped by the parties involved in a transaction and often kept confidential and away from the media. The parties agree to resolve their disputes pursuant to a set of procedural rules of their choice and before one or more independent arbitrators instead of in court. In so doing, the process can be truncated, dispense with unnecessary steps, and be uniquely structured to suit the particular transaction or issues in dispute, including the appointment of subject-matter experts to determine the dispute. The parties can agree to replace costly discovery processes with targeted document production, avoid strict application of rules of evidence, or have their dispute determined expeditiously ‘on the papers’ without the expense of preparing for and attending a prolonged hearing. While the procedure is left to the parties, the result is a final and binding award that is enforced like a judgment domestically, and often more easily than a judgment internationally due to a common enforcement regime codified in the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, to which most countries in the world are parties. Making arbitration particularly attractive for cross-border transactions, this means that a common set of rules applies for having an award issued in one country recognised and enforced in another country.

For these reasons, arbitration can effectively and responsibly be used to manage the risk of disputation across an ever growing number of sectors beyond the traditional users in construction, engineering, infrastructure and oil and gas.

In the financial services sector, the choice of arbitration may ensure that increasingly complex claims involving financial products can be resolved by industry specialists familiar with financial instruments and models, and with the speed required to protect investments recoverability. The inclusion of optional arbitration clauses into the ISDA Master Agreement in 2013 recognised the distinct suitability of arbitration for resolving derivatives disputes. So too the suitability of arbitration increasingly is recognised for the effective and efficient determination of disputes arising out of syndicated loan investments. Likewise, arbitration reduces risks around enforceability when dealing with counterparties from emerging markets because of the relative ease of enforcement of arbitral awards compared to domestic court judgments.

Arbitration also brings advantages to resolving disputes at all stages of corporate and complex M&A transactions. Arbitral institutions are reporting increasing caseloads involving shareholders’ agreements, share purchase agreements and joint venture agreements, and this trend is set to continue with the evolution of arbitral rules to meet the parties’ needs. For example, arbitral rules are being revised to introduce provisions for urgent interim relief, allowing a tribunal to order interim or conservatory measures sought by parties to M&A transactions (e.g. to protect the valuation of the target).

The use of arbitration to resolve technology-related disputes has also significantly increased in recent years, as has its use for disputes involving intellectual property rights. While consumer agreements and intellectual property rights historically were linked to public policy and often considered not ‘arbitrable’, today many jurisdictions will enforce the choice of arbitration for disputes involving user agreements with big tech, as well as disputes involving intellectual property rights.

When considering arbitration, the negotiation of an arbitration clause should not be left to the eleventh hour. There are important choices to be made, including regarding the institutional or ad hoc arbitration rules that will govern the arbitration process, and the type of dispute resolution clause that will meet the parties’ needs. Parties may wish to adopt a ‘multi-tiered’ approach, starting with settlement negotiations, a mediation or the increasingly popular expert determination, and if this step is not successful, then transition to arbitration. Apart from the ability to tailor the arbitration process, it is critical to ensure that the arbitration agreement is enforceable under the law that applies to it, which may not be the law of the main contract. To be effective, the arbitration clause must clearly designate the parties’ agreement on certain key elements, such as the place of arbitration, the applicable rules, and the language of arbitration.

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Litigation before domestic courts will continue to play an important role and may be preferable for some disputes. However, it is overwhelmingly recognised by users of arbitration that it can be an effective tool for de-risking disputation due to the parties’ ability to keep the dispute confidential, tailor the process and shorten time for resolution, select arbitrators with specialised industry or transaction expertise, and easily enforce international awards.