Exxon Mobil is awarded US$1.6 billion in ICSID claim against Venezuela – to be set off against award in parallel contractual arbitration

On 9 October 2014, a tribunal of H.E. Judge Gilbert Guillaume (President), Professor Kaufmann-Kohler and Dr. Ahmed Sadek El-Kosheri rendered a final Award on the case Venezuela Holdings and others v. the Bolivarian Republic of Venezuela, ICSID Case NO. ARB/07/27.

Five subsidiaries of Mobil Corporation (the "Claimants") initiated the arbitration in 2007 claiming compensation for Venezuela's alleged breaches of the Netherlands-Venezuela BIT in relation to a series of state actions which affected the Claimants' investments in the Cerro Negro Project in the Orinoco Belt and the La Ceiba Project adjacent to Lake Maracaibo.

After 7 years of proceedings the Tribunal ordered Venezuela to pay to the Claimants: (i) US$9,042,482 in compensation for the production and export curtailments imposed on the Cerro Negro Project; (ii) US$1,411.7 million in compensation for the expropriation of their investments in the Cerro Negro Project; and (iii) US$179.3 million in compensation for the expropriation of their investments in the La Ceiba Project. The compensation amount is much closer to the valuations put forward by Venezuela in the arbitration, than the US$ 16.6 billion requested by the Claimants.

Of particular note in the Award is the Tribunal's finding that Venezuela's expropriation of Claimants' assets was lawful. Even when no compensation was paid, the Tribunal concluded that: the expropriation was conducted in accordance with due process; it was not carried out contrary to undertakings given to the Claimants; and the Claimants did not establish that the offers made by Venezuela were incompatible with the "just" compensation requirement of Article 6(c) of the BIT.

This approach contrasts with the decision of the majority of the tribunal hearing a similar claim against Venezuela brought by ConocoPhillips (ConocoPhillips Petrozuata B.V., ConocoPhillips Hamaca B.V. and ConocoPhillips Gulf of Paria B.V. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/07/30). In that case, the majority found that the expropriation was unlawful because Venezuela did not approach negotiations with ConocoPhillips in good faith and it only offered book-value, rather than fair market value compensation for the assets (Decision on Jurisdiction and Merits dated 3 September 2013).

There are a number of open questions about the level of compensation payable following an illegal expropriation as compared to a legal expropriation. In this case the Claimants submitted that the expropriation was unlawful and that, as a consequence, Venezuela was under the obligation to make full reparation for the damages caused, in conformity with international law. By contrast, Venezuela contended that even if the expropriation were deemed to be unlawful the indemnity to be paid to the Claimants must represent the market value of the investment at the date of the expropriation. The Tribunal decided that since it had found that the expropriation was lawful it did not need to consider the standard for compensation in case of unlawful expropriation or whether it would differ from the standard for compensation to be paid in case of lawful expropriation. It held that the compensation must be calculated in conformity with the requirements of the BIT which required "just compensation" and that "just compensation" should represent the market value of the investments affected immediately before the measures were taken. Therefore, it employed the date of the expropriation of Claimants' assets (June 2007) as the valuation date, which had considerable significance in the amount of compensation since the market price of oil increased in the years that followed the expropriations.

The Tribunal also grappled with the parties' respective cases on whether a risk of confiscation is part of the country risk that is taken into account in determining the discount rate for the purposes of valuing the assets using the Discounted Cash Flow Method. The Tribunal concluded that a confiscation risk remains part of the country risk and must be taken into account in the determination of the discount rate.

To avoid double-recovery, the Tribunal held that the amount already received by the Claimants under a parallel ICC Award should be discounted to the total compensation payable to the Claimants.

SUMMARY OF KEY FACTS

In the 1980s Venezuela adopted a series of measures, collectively known as the Apertura Petrolera ("Oil Opening"), with the goal of exploring new fields in its vast reserves of extra-heavy oil. The Oil Opening allowed foreign investors to participate in the Venezuelan oil industry by entering into operating services agreements and association agreements (joint ventures) with PDVSA.

From 1996 to 2007, Mobil Corporation, through its subsidiaries, invested in two projects in the framework of the Oil Opening: (i) the Cerro Negro investment – a joint venture entered by Mobil Cerro Negro to exploit extra-heavy crude in the Orinocco Oil Belt ("Cerro Negro Project"); and (ii) the La Ceiba investment - a joint venture entered by Mobil Venezolana to explore, develop and exploit, on share-risk-and-profit bases, an area with light and medium crude potential adjacent to Lake Maracaibo ("La Ceiba Project"). In both projects, since the beginning of the investment, Mobil Cerro Negro and Mobil Venezolana were granted a reduced exploitation tax (Royalty) of 1% which was set in a Royalty Reduction Agreement.

In 2001, Venezuela enacted a new Organic Law of Hydrocarbons which provided that: (i) private parties would only be authorized to participate in production activities through mixed enterprises in which the State owned more than 50% of the shares; and (ii) any production from a mixed enterprise would be subject to a royalty of 30% and would have to be sold to PDVSA or another State-owned company. The only activities remaining outside of this legal framework were the Orinoco Oil Belt associations (such as the Cerro Negro Project) and the Profit Sharing Agreements (such as the La Ceiba Project).

From 2004 to 2007 Venezuela took a series of measures in its oil & gas legal framework which had a direct impact on the Claimants' investments:

• Increase in the Royalty Rate in 2004 and 2005: In 2004 and 2005 Venezuela unilaterally stated it was "leaving without effect" the Royalty Reduction Agreements and raised the royalty rate to 16 2/3%. In the case of Mobil Cerro Negro, the average monthly production above 120,000 barrels per day would be subject to a royalty rate of 30%.
• Creation of the Extraction Tax in 2006: In May 2006, Venezuela passed a partial amendment to the 2001 Organic Law of Hydrocarbons, which created an "extraction tax" of 33 1/3%. Royalty payments were to be credited to the liability for the extraction tax.
• Increase in the Income Tax Rate Applicable to Participants in the Orinoco Oil Belt: In August 2006 Venezuela amended the Income Tax Law to repeal a provision that subjected income from the extra-heavy oil projects in the Orinoco Oil Belt to the general corporate rate, instead of the higher rate applicable to the oil industry, which meant an increase from 34% to 50% to the rate applicable to income from those projects.
• Production and export curtailments on the Cerro Negro Project: From late 2006 through the first part of 2007, Venezuela imposed a series of production and export curtailments on the Cerro Negro Project.

Expropriation of the Claimants’ Investments

On 26 February 2007, President Chávez issued Decree No. 5200 on the "Migration to Mixed Companies of the Association Agreements of the Orinoco Oil Belt, as well as of the At-Risk-and-Shared-Profits Exploration Agreements". The Decree provided, among other things:

• that the associations located in the Orinoco Oil Belt (such as the Cerro Negro Project), and the At-Risk-and-Shared-Profits Associations (such as the La Ceiba Project), be "migrated" into new mixed companies under the 2001 Organic Law of Hydrocarbons, in which PDVSA or one of its subsidiaries would hold at least a 60% participation interest;
• a roadmap and schedule for the "migration" of the associations;
• that the operators of the projects should transfer control of all activities and operations to an affiliate of PDVSA by 30 April 2007;
• a four month period (until 26 June 2007) in which the participants in associations in the Orinoco Oil Belt and in At-Risk-and-Shared-Profits Associations should agree to participation in the new mixed companies;
• if no agreement was reached on the establishment and functioning of the new mixed companies by the end of the four-month period, Venezuela, through PDVSA or any of its affiliates, would directly assume the activities of the associations.

Throughout the four-month period, discussions took place between Mobil Cerro Negro, Mobil Venezolana and Venezuela about the potential participation of the Mobil's subsidiaries in the new mixed enterprises.

By 27 June 2007, no agreement had been reached. Venezuela seized the investments of Mobil Cerro Negro in the Cerro Negro Project and the investments of Mobil Venezolana in the La Ceiba Project.

The ICC Arbitration

In 2008, Mobil Cerro Negro initiated ICC proceedings against PDVSA and PDVSA-CN pursuant to Clause 15 of the Association Agreement, which afforded Mobil Cerro Negro the right of indemnification by PDVSA-CN in the event of certain governmental measures. The measures on which the ICC claim was founded were among those considered by the Tribunal in the ICSID case.

On 23 December 2011, the ICC tribunal issued an award finding PDVSA and PDVSA-CN jointly and severally liable for the economic consequences of the measures, ordering them to pay Mobil Cerro Negro US$746,937,958, with interest.

JURISDICTION

Venezuela claimed that the restructuring of the Mobil Corporation through the creation in 2005-2006 of a Dutch holding constituted an abuse of rights, which deprived the Tribunal of jurisdiction under the BIT.

On 10 June 2010 the Tribunal rendered its Decision on Jurisdiction. It considered that, as far as future disputes were concerned, it was a legitimate goal to restructure Mobil's investments in Venezuela to protect those investments against breaches of their rights by the Venezuelan authorities by gaining access to ICSID arbitration through the BIT. However, the Tribunal, citing the tribunal in Phoenix Action, Ltd. v. The Czech Republic (ICSID Case No. ARB/06/5, Award dated 15 April 2009),considered that the situation was different with respect disputes existing before the restructuring. Restructuring investments with the purpose of gaining the protection of a BIT for such existing disputes would constitute, in the words of the Phoenix tribunal, "an abusive manipulation of the system of international investment protection under the ICSID Convention and the BITs…". On this basis, the Tribunal decided that it had jurisdiction over the claims presented relating to disputes born after 21 February 2006 for the Cerro Negro Project and after 23 November 2006 for the La Ceiba project, these being the dates of the restructuring in each case.

EXPROPRIATION

Indirect expropriation

The Claimants argued that the "pre-migration measures" (i.e. imposing a higher income-tax rate; adopting an extraction tax; imposing production and export curtailments; and appointing a new operator for the Cerro Negro Project) permanently deprived them of the benefit of their rights. The Tribunal considered that, under international law, a measure which does not have all the features of a formal expropriation may be equivalent to an expropriation only if it gives rise to an effective deprivation of the investment as a whole, which requires either a total loss of the investment's value or a total loss of control by the investor of its investment, both of a permanent nature. According to the Tribunal those conditions were not present and therefore it concluded that the pre-migration measures could not be characterized as equivalent to an expropriation.

Direct Expropriation of the Cerro Negro and La Ceiba Projects in June 2007

The Claimants submitted that the expropriations were unlawful and that, as a consequence, the Respondent was under the obligation to make full reparation for the damages caused, in conformity with international law. By contrast, Venezuela contested that the expropriation was lawful and that the indemnity to be paid to the Claimants must represent the market value of the investment in June 2007, as provided in Article 6 of the BIT.

The Tribunal considered that the expropriation was the result of laws enacted by the National Assembly and of decisions taken by the President of the Republic of Venezuela, the purpose of which was to create new mixed companies in which the State would own more than 50% of the shares. Negotiations with the oil companies were foreseen to that effect for a period of four months, and nationalization was contemplated only in case of failure of those negotiations.

The Tribunal explained that while in the present case the negotiations failed, in other cases negotiations with foreign investors were successful. In the Tribunal's view, the process, which enabled the participating companies to weigh their interests and make decisions during a reasonable period of time, was compatible with the due process obligation of Article 6 of the BIT.

The Tribunal noted that the mere fact that an investor has not received compensation does not, in itself, render an expropriation unlawful. An offer of compensation may have been made to the investor and, in such a case, the legality of the expropriation will depend on the terms of that offer. In order to decide whether an expropriation is lawful or not in the absence of payment of compensation, a tribunal must consider the facts of the case.

The Tribunal found that Venezuela made proposals during the negotiations and that there was no evidence which demonstrate that such proposals were incompatible with the requirement of "just" compensation of Article 6(c) of the BIT. Accordingly, the claim for unlawful expropriation was rejected.

FET

The Claimants argued that Venezuela had breached the standard of Fair and Equitable Treatment (FET) provided for in Article 3 of the BIT. The Tribunal analysed the alleged breach with respect to (i) the creation of the Extraction Tax; (ii) the imposition of production and export curtailments; and (iii) the expropriation of Claimant's assets.

The Extraction Tax

The tribunal considered that the BIT contained a provision (Article 4), which comprehensively regulated the standards of treatment with respect to fiscal measures by providing for national and most favoured nation treatment, and a list of applicable exceptions (double-taxation agreements, customs, economic or similar unions and special treatment based on reciprocity with a third State). However, the Tribunal noted that such Article contained no mention of FET, which was provided in Article 3. The Tribunal explained that, if the purpose of the BIT had been to apply to fiscal measures the FET standards in Article 3, then the easiest way to achieve it would have been to incorporate the exceptions contained in Article 4 in Article 3(3) itself (which already contained exceptions). There would have been no need to draft an article dealing with fiscal measures and containing specific exceptions

Therefore, the Tribunal found that fiscal measures were only subject to the national and most favoured nation treatment obligations contained in Article 4 of the BIT, and are carved out of Article 3(1), which contains the obligation to provide FET. As the claim relating to the extraction tax was based only on Article 3(1) of the BIT, not on Article 4, it was rejected.

The Production and Export Curtailments

The Tribunal noted that the FET standard may be breached by frustrating the expectations that the investor may have legitimately taken into account when making the investment. It explained that legitimate expectations may result from specific formal assurances given by the host state in order to induce investment. The Tribunal considered that, since Clause 8 of the Association Agreement of the Cerro Negro Project fixed the level of extra-heavy oil production at 120,000 barrels per day, when making their investment, the Claimants could reasonably and legitimately have expected to produce at least such volume.

The Tribunal concluded that the production and export curtailments imposed from November 2006 were incompatible with the Claimants’ reasonable and legitimate expectations, and thus breached the FET standard contained in Article 3(1) of the BIT.

The Expropriation Measures

The Tribunal referred to its finding that the expropriation was conducted in a lawful manner and that there were no additional elements in the record establishing a violation of FET in respect of the expropriatory measures. It added that these claims had been too briefly and too unconvincingly developed to enable the decision sought from the Tribunal. Accordingly, it dismissed the claim.

COMPENSATION

The Tribunal considered that the "just compensation" under Article 6 of the BIT shall be determined immediately after the failure of the negotiations between the Parties and before the expropriation, i.e., on 27 June 2007, and it must correspond to the amount that a willing buyer would have been ready to pay to a willing seller at the time in order to acquire the expropriated interests.

With respect to La Ceiba Project, since it was in a very early stage of development, the Tribunal considered that a discounted cash flow (DCF) method of calculation was not appropriate and awarded Claimants their invested capital of US$179.3 million.

With respect to the Cerro Negro Project, the Parties agreed that the evaluation must be made in accordance with a DCF analysis for the Claimants' lost interests. Accordingly, the Parties evaluated the net cash flows that would have been generated by the investment over its remaining life, i.e., until June 2035, and discounted them to their present value. However, they diverged in their determination of the net cash flows and the discount rate.

In calculating the net cash flows that would have been generated by the investment, the Tribunal employed market prices for oil and considered the volume of expected production after the expropriation date, costs of the operations, additional capital investment and royalties and taxes payable to Venezuela.

After establishing the net cash flow amount, the Tribunal determined how that cash flow should be discounted to its value in June 2007. The Tribunal observed that the basic divergence between the Parties was whether the risk of confiscation should be taken into account when calculating the discount rate applicable to the compensation due for an expropriation.

The Claimants submitted that under Article 6(c) of the BIT, "a valuation of the expropriated property that complies with the Treaty cannot include the risk that the property might be expropriated later without the compensation required by the Treaty". On the Claimants' case, the discount rate could take into consideration country risks such as those resulting from a volatile economy or civil disorder, but not the confiscation risk. Venezuela contended that elements such as the risk of taxation, regulation and expropriation are essential to the country risk and must be taken into consideration in the determination of the discount rate.

The Tribunal considered that the confiscation risk remains part of the country risk and must be taken into account in the determination of the discount rate. The Tribunal noted that Venezuela's experts had taken into account the confiscation risk and had arrived at discount rates ranging from 18.5% to 23.9%. Considering that the tribunal in the ICC Award applied a discount rate of 18%, the Tribunal found that such discount rate appropriately reflected the risks in the present case. Accordingly, the Tribunal decided to adopt 18% discount rate, and arrived to a discounted net cash flow of US$1,411.7 million.

Finally, the Tribunal recalled Claimants’ representation that "in the event of an award in this case in favour of the Claimants, the Claimants are willing to make the required reimbursement to PDVSA" and concluded that the amount already received by the Claimants under the ICC Award should be discounted to the total compensation payable to the Claimants to avoid double recovery.

For further information, please contact Matthew Weiniger QC, Partner, Florencia Villaggi, Associate, or your usual Herbert Smith Freehills contact.