Record Award Against Ecuador Demonstrates Willingness of Tribunal to Review State Decisions on Grounds of Proportionality

In an award notified to the parties on 5 October 2012 (the Award), the majority of a three-member arbitral tribunal established under the ICSID Convention has directed the Republic of Ecuador (Ecuador or the Respondent) to pay US companies Occidental Petroleum Corporation (Occidental) and Occidental Exploration and Production Company (OEPC)(collectively, the Claimants) damages in the sum of approximately USD1.77 billion (if interest is taken into account it has been reported that this sum would exceed USD2.3 billion)¹.  It has been reported that this is the largest sum ever awarded by a tribunal under the ICSID Convention and, unsurprisingly, will be challenged by Ecuador.

The dispute arose out of Ecuador's decision to terminate in April 2006 by way of a decree (the Decree) the contract (the Participation Contract) under which the Claimants were undertaking oil operations in an area known as Block 15 (which covers 200,000 hectares situated in the Oriente Basin, in the Ecuadorean Amazon rainforest).

Notwithstanding the fact that the Claimants breached the Participation Contract (and, according to one member of the tribunal, acted illegally), Ecuador was found to have acted disproportionately and therefore had violated the US-Ecuador bilateral investment treaty (the BIT).  In particular, the tribunal held that Ecuador failed "to accord fair and equitable treatment to the Claimants' investment, and to accord to the Claimants treatment no less than that required under international law"; and breached the BIT "by expropriating the Claimants' investment in Block 15 through a measure 'tantamount' to expropriation." [876]

Whilst the tribunal –comprised Yves Fortier QC (presiding arbitrator), David AR Williams QC and Professor Brigitte Stern –was unanimous in respect of liability, the impact of the Claimants' breach of the Participation Contract upon the calculation of damages divided the arbitrators.  The majority concluded that due to their breach of the Participation Contract, "the Claimants have contributed to the extent of 25% to the prejudice they suffered when the Respondent issued the Caducidad [termination] Decree." [687] Prof Stern, in a strongly-worded dissenting opinion, considered that a 50/50 split would have been justified as she concluded that "the Claimants have acted both very imprudently and illegally." [7]

The Award is significant for both States and investors for the following reasons:

• The tribunal considered it within its power to review the suitability of the administrative decisions of Ecuador, particularly on the basis of the principle of proportionality (considered by this tribunal as an aspect of the fair and equitable treatment (FET) standard).
• Also taking into account the principle of proportionality, the tribunal found that misbehaviour on the part of the investor did not preclude it from obtaining redress against the State.  The breach of the Participation Contract was punished by a reduction in the damages instead.
• The Award also highlights the importance of dissenting opinions: it is no surprise that Ecuador reportedly plans to rely upon Prof Stern's dissenting opinion to seek the annulment of the Award.

Background

In 1993, Ecuador amended its Hydrocarbons Law (the HCL) to allow the negotiation of participation contracts (a type of production sharing agreement under which the State and contractors share in the production of crude oil, with all expenditures borne by the contractor).

In May 1999, OEPC and Ecuador (through PetroEcuador) concluded the Participation Contract. The Participation Contract provided that it could be terminated, inter alia, by a declaration of forfeiture or termination (in Spanish, caducidad) under the HCL or by reason of the transfer of rights and obligations in the Participation Contract without the relevant Ministry's authorisation.

The HCL provided that the Ministry of Energy and Mines (the Ministry) may declare the termination of Participation Contracts if the contractor transferred rights or entered into private contracts or agreements for the assignment of one or more of its rights, without the Ministry's authorisation.

In October 2000, OEPC and Alberta Energy Corporation Ltd (AEC) (of Chinese ownership at the time of the Award) concluded an agreement whereby OEPC committed to transfer to AEC 40% of future legal title corresponding to 40% interest in the Participation Contract (the Farmout Agreement). The tribunal found that, notwithstanding the confusing nature of communications from OEPC to the Ministry concerning the nature of the agreement, Ecuador was aware of the Farmout Agreement at that time. The tribunal also found that OEPC had wrongly concluded that authorisation was not required at that time.

On the basis that the conditions for the transfer of legal title under the Farmout Agreement were fulfilled, in July 2004, OEPC requested that the Ministry approve the transfer of OEPC to AEC of legal title to a 40% interest in Block 15. [168]

The approval sought was not granted.  Instead, on 24 August 2004, on the basis that OEPC had already transferred part of its interest in Block 15 to AEC in 2000, the Attorney General of Ecuador ordered the Minister of Energy and Mines (the Minister) to terminate the Participation Contract.[169]  It is suggested in the Award, that the Attorney General's decision was influenced by the fact that OEPC had earlier that year secured a USD75 million award against Ecuador (in relation to a VAT refund issue). [175]

Strong political pressure was put on the Minister to issue a decree terminating the Participation Contract in 2005 and 2006.  In April 2006, the Minister issued the Decree terminating the Participation Contract.  As a result, on 17 May 2006, the Claimants filed with ICSID a Request for Arbitration invoking Ecuador’s consent to ICSID arbitration in the BIT and PetroEcuador’s consent to ICSID arbitration in the Participation Contract.  The Claimants argued that the termination of the Participation Contract was made without legitimate cause and therefore would amount to a breach of the Participation Contract and the BIT.  The Claimants argued that no termination event had taken place under the Participation Contract but, even if it had, the Decree would still be in breach of Ecuador's obligations under the BIT and Ecuadorean law because it "was unfair, arbitrary, discriminatory and disproportionate." [206]

Ecuador argued that the Decree was fully compliant with Ecuadorean law because OEPC's conduct amounted to grounds for the termination of the Participation Contract.

The Award

FET and principle of proportionality

The tribunal's decision on liability largely rests on its analysis of the principle of proportionality. The tribunal concluded that the Farmout Agreement amounted to an unauthorised transfer of rights under the Participation Contract but that OEPC's failure to request the Ministry's approval "while imprudent and ill advised, did not amount to bad faith." [384]

The tribunal then discussed the principle of proportionality under Ecuadorean law and within the context of international investment disputes.  The tribunal concluded (based on expert evidence) that, under Ecuadorean law, administrative acts must be in accordance with the principle of proportionality.  In respect of investment arbitration law, the tribunal indicated that "the obligation for fair and equitable treatment has on several occasions been interpreted to import and obligation of proportionality." [404]

The tribunal acknowledged that the Minister had discretionary authority to terminate the Participation Contract under the HCL.  However, the tribunal considered that the exercise of the authority's discretion should be proportionate to the relevant violation.

The tribunal considered that the fact that the Participation Contract provided for termination in the event of an unauthorised transfer of rights did not dispose of the Minister’s duty to act proportionately. [422] It added that, in any event, termination had not been sought under the machinery of the Participation Contract and therefore "whatever OEPC agreed in the Participation Contract is only relevant to actions taken under or pursuant to the contract – it cannot be relevant to action which is taken independently of the contract and which does not proceed in reliance upon it.  It is a matter of central importance in this case that the Caducidad Decree was issued pursuant to the provisions of the HCL." [423]. 

The tribunal reasoned that the consequences of the Decree, i.e. the loss of an investment of hundreds of millions of US dollars "was out of proportion to the wrongdoing alleged against OEPC" [450].  As a result, the tribunal concluded that

"the Caducidad Decree was not a proportionate response in the particular circumstances, and the Tribunal so finds. The Caducidad Decree was accordingly issued in breach of Ecuadorian law, in breach of customary international law, and in violation of the Treaty.  As to the latter, the Tribunal expressly finds that the Caducidad Decree constituted a failure by the Respondent to honour its Article II.3(a) obligation to accord fair and equitable treatment to the Claimants’ investment, and to accord them treatment no less than that required by international law." [452]

Expropriation

The tribunal's decision in respect of expropriation appears to rest on its conclusions on FET.   In this regard, the tribunal stated that:

"Having found in the previous Section of the present Award that the Caducidad Decree was issued in breach of Ecuadorian law, in breach of customary international law and in violation of the Respondent’s Article II.3(a) obligation to accord fair and equitable treatment to the Claimants’ investment, the Tribunal now has no hesitation in finding that, in the particular circumstances of this case which it has traversed earlier, the taking by the Respondent of the Claimants’ investment by means of this administrative sanction was a measure “tantamount to expropriation” and thus in breach of Article III.1 of the Treaty." [455] 

Quantum

The tribunal concluded that a Net Present Value approach of the Claimants' investment should be used to determine the quantum of the compensation to be awarded to the Claimants.

The majority applied a 25% discount (with which Prof Stern disagreed) to the sum of USD2,359,500,000 which corresponded to "the Net Present Value of the discounted cash flows generated by the Block 15 OEPC production as of 16 May 2006 [i.e. the date of the Decree]". [824] This formula yielded a sum of approximately USD1.77 billion in damages.

Interest

The tribunal awarded the Claimants pre-award interest at the rate of 4.188% per annum, compounded annually from 16 May 2006 until the date of the Award. [848] The tribunal also awarded post-award interest at the US 6 month LIBOR rate compounded on a monthly basis. [849]

Prof Stern's dissenting opinion

In her dissenting opinion, Prof Stern stated that while she concurred that the Respondent acted in a disproportionate manner in its reaction to the "serious violation of its laws by the Claimants, I am in complete disagreement with the way damages have been calculated, which I consider to be resting on grossly incorrect legal bases." [1]

Prof Stern has found that the contribution of the Claimants to the damage had been underestimated by the majority because:

"as the Claimants deliberately took the risk of caducidad by their behaviour – meaning that caducidad could happen or not happen, and there were indeed more chances that it could happen than not, considering the text of the law and the reference to caducidad in the contract. It is interesting to note that in the MTD case both the tribunal and the ad hoc committee have endorsed a 50/50 split on the sole ground that the claimant had acted imprudently from a business point of view though not illegally. Here the split 50/50 would have been even more justified, as the Claimants have acted both very imprudently and illegally." [2]

Prof Stern also disagreed with a finding of the majority that the Claimants were entitled to recover a 100% of the established value of Block 15.  The majority found that the assignment to AEC was invalid under New York law (governing the Farmout Agreement) and Ecuadorean law.  As a result, the majority concluded that Ecuador "is obliged to compensate the Claimants for 100% of their interest in Block 15 which it acquired upon the issuance of the Caducidad Decree." [651] In this respect, Prof Stern stated that the most serious "gross error of law" committed by the majority, "is the manifest excess of power of the Award nullifying a contract concerning a company which not only was not a party to the arbitration, but moreover – even if it had been a party – could not be considered, being a Chinese company, as an investor over which the Tribunal had jurisdiction under the US/Ecuador BIT." [5]

Initial reaction in Ecuador

On 7 October 2012, at a press conference in Quito, Ecuador, Mr Diego García Carrión, Ecuador's Attorney General, announced that Ecuador will seek the annulment of the Award on three grounds: excess of power on the part of the tribunal; lack of reasons; and violation of procedural rules.  He added that the request for annulment will also rely upon the points raised in Prof Stern's dissenting opinion.

Comment

As indicated above, the Award is important for a number of reasons.  First, it illustrates how the tribunal was willing to review administrative decisions of a sovereign by reference to the FET standard, but more particularly by reference to the principle of proportionality.

Second, also on the basis of the principle of proportionality, the Award suggests that misbehaviour on the part of an investor does not necessarily preclude it from obtaining redress against a State.  It appears that some tribunals might be willing "to offset" the liabilities of investors and States when it comes to calculating damages. 

Third, the statements made by the Ecuadorean Government in respect of an attempt to annul the Award, are yet another testament to the impact that dissenting opinions can have on the outcome of an investment dispute.

For further information, please contact Christian Leathley (Partner) and Alejandro I Garcia (Senior Associate).

¹ References in square brackets are to paragraphs in the Award or the Dissent, as applicable.