Rethinking the quantification of damages in international investment arbitration
Over the last few years, Investor-State Dispute Settlement (ISDS) has received an increasing amount of critical attention. Where previously only specialists were aware of the existence of this field of international adjudication, now even the general press discusses its shortcomings and lack of legitimacy. Criticism can be divided into two broad categories. The first focuses on the competence of the arbitral tribunals to adjudicate investor-State disputes involving public interest considerations. People for instance question whether private arbitrators, rather than courts or public authorities, are in a position to decide whether a certain country ought to be able to regulate economic activity in a certain way. The second concerns the extent of the protection offered to foreign investors. Thus, many do not accept that foreign investors should be treated more favourably than domestic actors.
Beyond the questions of arbitral
jurisdiction and investor rights (or State duties), there is a key third pillar
of ISDS that has largely escaped attention. Once an arbitral tribunal has
decided that it is competent to adjudicate the investor’s claim against the
State and found the latter in breach of its obligations, it will proceed to
consider the appropriate remedy. Such a remedy will practically always consist
in damages. That is, States will be ordered to pay a sum of money to compensate
the investor for the breach. The sums are often gigantic, particularly in cases
involving natural resources. For example, last summer Pakistan was held liable
for $5,84 billion, which amounts to around 2% of the country’s GDP, for
refusing to grant a mining licence. Other recent examples of so-called
‘mega-awards’, amounting to similar fractions of the domestic GDP, include Occidental
v Ecuador ($2,3 billion, for the termination of an oil concession), Yukos
v Russia ($50 billion, for the expropriation of the oil company), or ConocoPhillips
v Venezuela ($8,7 billion, for the nationalisation of the oil giant’s
It is certainly true that many people have
shown disquiet at the sheer figures. However, there has practically been no
critical examination of the principles developed by arbitrators to produce
these dizzying amounts. Indeed, there is a remarkably solid consensus in ISDS
about how damages should be calculated. Four key propositions are now held to
be unquestionable. First, the so-called ‘Hull formula’: expropriation must be
accompanied by prompt, adequate and effective compensation. Second, full
reparation: investors must be restored to the position they would be in but for
the State’s breach. Third, ‘fair market value’ (FMV): compensation for
expropriation or damages for a breach should be based on the amount a
hypothetical buyer would have paid to acquire the investment in an open market.
Fourth, FMV will usually be calculated according to the DCF method (discounted
cash flow): the value of the investment will be calculated as equal to its
future expected income, discounted through an appropriate discount rate to
reflect inflation, uncertainty and the time-value of money.
Value as a fact
It is possible that at this point the
reader has already lost interest in what I am describing. Why indeed should we
care about the technicalities of valuation? I wish to argue that this is a key
question of major legal and political significance, that ought to attract as
much attention as the issues of arbitral jurisdiction or investor rights.
Beyond the sheer figures awarded against States, there are several major
reasons to get interested in quantum-related matters.
The first is that the consensus that we
observe today is in fact a very modern phenomenon. One may be surprised to
learn that, until the early 90s, the question of how damages to investors were
quantified was extremely controversial in international law. Indeed, it used to
be seen as the site of an insoluble political conflict between
capital-exporting and capital-importing countries, where the former would push
for compensation and valuation standards more favourable to investors and the
latter viceversa (see e.g. here). In practice, the actual sums would
often result of compromise and negotiation rather than expert determination.
Also, the DCF method was viewed with great suspicion, as valuation tended to be
based on the historic costs incurred by investors rather than on speculation
about future revenue.
Two essential things happened around the
turn to the 90s that swept away prior approaches to quantification of damages.
The first is the well-known boom in international investment arbitration. Where
political compromise was previously so common, arbitrators now had the
responsibility of calculating damages. Called upon to adjudicate as legal
experts, they were forced to search for some objective foundation on which to
determine the right amounts.
The second thing is probably the most
important. That moment in time also saw a shift in how value came to be
perceived. Value began to be understood as a purely factual matter, and
valuation as a purely technical endeavour. To put it otherwise, the
value of any particular investment ceased to be seen as legally constituted or
dependant on legal determination, but became instead a pre-legal datum that the
arbitrators were charged with ascertaining with the help of financial experts. Thus,
in its 1992 Legal framework for the treatment of
foreign investment, the World Bank claimed that the ‘ideological
approaches’ of the past should be replaced with ‘best practices’ of today
(meaning FMV and a preference for DCF).
As a result, considerations of fairness
(despite the misleading ‘F’ in FMV) or public interest are now generally seen
as irrelevant to quantification. It is simply thought to be a fact that a
willing buyer would rely on DCF, and that not following this valuation method
would lead to award the investor something less than what was taken away.
Challenges to FMV or DCF will be rejected for ‘misunderstanding economics’ or
‘modern financial principles of valuation’. The perception of market value as
fact is now so ingrained that putting forward any alternatives is seen as a
form of intolerable disruption. In the recent case of ConocoPhillips v
Venezuela, for instance, the arbitrators found that the State had acted in
bad faith for offering an amount as compensation that would not be based on
Law and the creation of value
This shift in the understanding of value
explains both why the consensus is so solid (dissent is seen as ideology-driven
denial of reality) and why people take so little interest in quantification (it
is a technical question, not a legal or political one). We wish nevertheless to
argue that value is, at root, very much a legal creation, rather than a
pre-legal fact (as Katharina Pistor’s recent book The Code of Capital convincingly
argues). Here are three examples of how it is so, all of which directly challenge
how valuation is performed in ISDS:
First, it should be self-evident that the
value of something largely depends on your ability to trade it in the market
(hence the term ‘exchange-value’). This does not depend on the thing’s inherent
properties, but on the law. Indeed, the law, and most obviously the law of
contracts, will determine not only what can be traded, but also how
it may be traded and under what conditions promises may be enforced. When
determining FMV, however, arbitral tribunals reason as if markets pre-existed
any legal regime. In Occidental v Ecuador, for instance, the investor
was awarded the market value of its investment even though the investment could
not legally have been sold under Ecuadorian law.
Second, the value of an asset depends also
on the ability to capture future benefits. Future profitability is also not a
matter of fact, but depends directly on legal determination. In particular, how
much profits the investor will reap in the future is largely in the hands of
the State, who can (legitimately) choose to raise taxes. This should lead to
the conclusion that damages should only cover some reasonable measure of
expected profits. Venezuela raised a similar argument against ConocoPhillips in
relation to the quantum of damages – when projecting future cash flows, surely
one has to take into account the fact that the measure of those cash flows will
be established by the State through its fiscal policy? Arbitrators brushed this
aside as mere speculation.
Third, liability rules themselves are also
constitutive of value. Indeed, they determine how strongly a certain expectation
is protected. Thus, different areas of the law will make it easier to claim for
certain kinds of harm than for others, will discriminate according to the
degree of wrongfulness of the harmful action, or will determine which of the harmful
consequences that follow from a breach of duty will be imputable to the author
of the breach. It is not therefore a purely factual matter. For instance, and
for reasons that depend on policy and context, in tort law a mere loss of
chance or pure economic harm will typically not be so easily recoverable as
other types of harm, and in the law of public procurement a tenderer who is
wrongfully denied will most often not be awarded the value of the forgone
contract. Arbitrators however tend to treat the relationship between the
State’s action and the investor’s recoverable harm as a purely factual matter.
In Tethyan Copper Company v Pakistan, where the investor had been denied
a mining licence, the arbitrators awarded almost $6 billion as this was thought
to be the value of the projected returns from exploiting the mines (even though
the corporation had never actually exploited them).
There is a clear consequence to all of this.
Investors are being systematically overcompensated. They are receiving monetary
damages that they would not be entitled to outside of ISDS, on the basis of an
unjustified and highly reductive understanding of value. The solution may be to
reintroduce considerations of fairness and public interest in damages
calculations, or to subject this assessment to the applicable domestic law. In
any case, it is high time to reclaim valuation as a legal and political issue
of the highest importance.