Investment opportunities and risks

Reducing the risks and achieving a sufficient level of protection is essential

By Dr. Sabine Konrad and Arne Fuchs, LL.M.

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Investments in a foreign country can offer tremendous opportunities: taking advantage of a growth market or diversifying if the market at home is less robust are just two examples. At the same time, foreign investments are also subject to certain risks that may be less calculable than at home and that may extend beyond ’normal’ economic and business risks. Political and regulatory risks in particular play a major role and should be carefully analyzed and mitigated by intelligent project structuring and contracting. Notably, political and regulatory risk is no longer – if it ever was – restricted to less developed or geographically distant states. In the last few years, dozens of investment disputes have arisen with regard to investments in EU Member States, often in the energy sector.

One recent example is Spain. More than 30 investment arbitrations are pending before the International Centre for Settlement of Investment Disputes (ICSID) of the World Bank, and in other fora, as a result of Spain’s radical cuts of guaranteed feed-in tariffs in the renewable energy sector prior to the expiration of guaranteed the terms. Similar arbitrations are pending against the Czech Republic.

While the regulatory measures at issue in these European countries may be of a different character to, for example, the mass nationalizations in Venezuela, they illustrate the risks that foreign investors can be exposed to when investing even in the near abroad. Reducing these risks and achieving a sufficient level of protection is still essential for the success of a project.

A comprehensive approach will consist of a number of elements: economic and legal due diligence, project structuring taking into account investment treaties and contracts with the host state. Depending on the risk profile of the project, political risk insurance should also be considered.

Advantages of investment treaties

Perhaps the most important element of this package is protection under a (sufficiently robust) investment treaty.

There are between 2500 and 3000 investment treaties globally. Germany alone has concluded bilateral investment treaties (BITs) with over 130 countries and has also entered into a multilateral treaty, the Energy Charter Treaty (ECT).

Typically, these treaties not only offer substantive protection regarding the treatment of investments, they also include the right to bring the host state before an independent international tribunal if the state violates its obligations under the treaty, known as investor-state arbitration. Such arbitrations are often carried out either under the auspices of the World Bank’s ICSID or the Permanent Court of Arbitration under the arbitration rules of the UNCITRAL (United Nations Commission on International Trade Law).

Contrary to a misconception spread in the media, investment arbitration is neither private nor secret. Much like a domestic court, the arbitral tribunal in an investor-state arbitration derives its powers from a mandate by the one or more states. Most often, this mandate comes in the form of consent to arbitration given in the public international investment treaty. Similarly, ICSID, the most popular forum for investment arbitrations, is based on a public international law treaty with more than 150 member states. The big difference – and for investors the most important advantage – is that unlike domestic courts, investment arbitration offers an independent forum for the resolution of disputes that is not under the control of a single state (the host state that is being sued), but that exists on the public international law level. Indeed, besides its crucial role offering foreigners access to independent justice for their investments, investor-state arbitration is one of the biggest motors of the international promotion and proliferation of the rule of law.

Amongst the substantive protections, the most important are the right to fair and equitable treatment, protection against expropriation without compensation and against discrimination, the right to repatriate the investment and transfer returns, as well as most favored nation and national treatment. Often, they also include the important obligation for the host state to honor other commitments vis-à-vis the foreign investor. This includes contractual commitments a state may have taken on, for example, in a concession contract.

Another advantage, especially for small and medium-sized enterprises, is that the protection of an investment treaty does not have to be bought. Unlike political risk insurance (that has to be purchased), treaty protection is for free. Costs only arise if the investment is harmed and the investor needs to trigger the arbitration mechanism.

Also, the investor does not personally have to enter into negotiations and conclude special contracts with the host state as this was undertaken for the investor by their home state when the two states negotiated the treaty. As long as the investor falls within the scope of the applicable treaty, it enjoys reliable protection in critical situations.

Applicability of investment treaties

In order to benefit from the protection under an investment treaty, a person or entity must qualify as the investor under the applicable treaty. While investment treaties contain different definitions, most define an investor as a company or natural person that is a national of one of the countries that has signed the relevant treaty. The term company typically includes corporations, partnerships, associations or other organizations that are legally constituted.

The nationality of a company generally is determined by either the company’s country of incorporation or primary place of business, depending on the applicable treaty. It may also be required to demonstrate that it conducts economic activity in the country of its alleged nationality.  Again, it all depends on the specific language of the particular treaty, as well as the rules and regulations of the home country.

Not only must the person or entity qualify as investor for the treaty to be applicable, the investment itself must also fall within the scope of the same. Most treaties give a broad definition of investment and define it as every kind of asset. Thereby all categories of asset are included and a broad applicability of the treaty is ensured.

Other investment protection ­mechanisms 

While investment treaties provide the most prominent means to protect foreign investments abroad, investors should also consider the other mechanisms for investment protection noted above to increase the scope of protection.

Depending on the circumstances of the relevant project, it may, for example, be advisable for the foreign investor to obtain investment guarantees. These offer insurance solutions against political risk. While this means that – in contrast to investment treaties – they cost money, it may be worthwhile for the investor to obtain at least partial coverage to mitigate the risks.

Political risk insurance is provided by different institutions, both private and public. In Germany, the Federal Government has tasked PwC/Euler Hermes with this service. The Multilateral Investment Guarantee Agency (MIGA) operates under the auspices of the World Bank group. The leading international association for the investment insurance industry is the Berne Union.

One thing that must be noted is that most government-backed guarantees or those provided by MIGA must be concluded at the time the investment is made – it cannot be done later.

Contractual provisions can also play a major role when the investment is based on a contract with the host state or a state-owned enterprise. An intelligent contract design can often extend the scope of protection even beyond the applicable investment treaty. Conversely, errors can also lead to a loss of protection. As with all international contracts (including those with private companies), it is important to include a well-functioning arbitration clause.

Changes over the lifetime of the ­investment

Investors should pay close attention to investment protection issues and not only when they embark on new ventures. These issues should also be assessed when existing investments are purchased, restructured or sold.

For example, careful structuring of the sales transaction may be necessary to ensure that existing claims are not lost in the process. In general, public international law does not provide for the assignment of investment claims. This means that any claim arising from an investment treaty will remain with the entity protected as investor under the applicable treaty. Accordingly, if the buyer intends to pursue these claims after the acquisition, it is imperative that not only the operative business of the target is transferred but also the entity qualified as investor under the treaty (i.e., the potential claimant). Conversely, if the parties agree that any claims should remain with (and be enforced by) the seller, the entity qualified as investor under the treaty must remain with the seller.

As always, the devil is in the detail. For example, if the nationality of the entity defined as the investor changes during the transaction (or even the nationality of the controlling parent companies), this may allow the host state to deny the benefits of the investment treaty. A sale also impacts the calculation of damages in an international arbitration (irrespective of whether it is brought by the buyer or seller). The host state may argue that the purchase price should be considered indicative of the remaining value of the investment after the harm has been inflicted. Therefore, it is necessary to clearly identify any other factors that were considered by the parties in determining the price to avoid problems when assessing damages in an arbitration. Where the seller is the one pursuing claims in international arbitration, it must also be noted that the seller can only challenge measures (and claim the corresponding damages) which became effective prior to the sale.