Canada: Reducing Risk In International Investments

CROSS-BORDER INVESTMENTS always involve political risk. This is particularly true in the case of natural resource assets, which cannot be spirited away in the event of political instability.

Potential losses arising from government interference include:

• the direct loss of assets upon expropriation;
• exchange controls preventing extraction of profits or proceeds on sale;
• the costs and distractions of litigation; and
• losses arising from the inability to manage sequestered assets during resolution efforts.

Tools for managing governmental risk can be incorporated into acquisition and management plans for exposed assets. Though such protection arrangements are unlikely to be "bulletproof," any significant reduction of such exposure is generally worthwhile even if it does not provide complete protection against all conceivable risks. The following provides an overview of some risk-mitigation strategies, including the use of investment protection agreements.

Plans to reduce political risk generally follow one of two basic patterns. The first involves shifting risk to another party. The second approach seeks an absolute reduction in risk. Insurance is the classic means of shifting risk, although this is costly and much less effective than commonly assumed because of the exclusions, performance warranties and waiting periods that are often built into policies.

A more interesting technique for shifting risk in a large undertaking is to take the company public, drawing in diverse shareholders to share the risk. As public investors generally hold only a small portion of the enterprise, they may be less concerned with pricing the risk attached to the investment. Where the promoter is able to retain value in the enterprise after taking the company public (e.g., by retaining a management contract) it may be possible to achieve a significant reduction in the promoter’s equity exposure while keeping a portion of the income stream from the assets.

The alternative option, structuring to achieve an absolute reduction of risk, is generally more attractive. Strategies for this include:

• reducing assets at risk (e.g., title to exported product should pass as early as possible);
• ownership of intangibles supporting the business should be held by foreigners;
• carefully considered financing arrangements (e.g., debt is generally safer than equity); and separating business components according to seizure risks in separate companies (i.e., trucks and other transport equipment in one company, natural resource assets in another).

Risks arising from the physical location of the investment are invariably the most challenging to mitigate, particularly where the nature of the local investment necessitates a large fixed cost (e.g., a mine). Investment protection agreements are a particularly attractive means for mitigating such risks.

Investment protection agreements are mechanically similar to tax treaties. They are negotiated and concluded on a government-to-government basis, and are designed to protect private-sector parties from one contracting state who invest in the other contracting state. Unlike tax treaties, investment protection agreements do not generally contain "limitation of benefits" provisions. Accordingly, a UK investor could, for example, take advantage of the protections available under the investor protection agreement between the Netherlands and Zimbabwe by investing through a company established in the Netherlands. Put another way, the Netherlands company would not generally be disentitled under an applicable investment protection agreement simply because it has controlling UK shareholders.

The use of investment protection agreements has taken off in the last decade and there are now approximately 1800 such agreements in existence worldwide, with nearly 150 countries participating. Emerging-market countries in Latin America, Asia and Africa are active participants in such agreements, as they see it as an inexpensive means to mitigate risk and so attract foreign investors.

The terms of individual investment protection agreements vary from treaty to treaty, though the following elements normally appear:

• protection from foreign exchange controls, in the form of guarantees for the repatriation of profits, capital gains, dividends and royalties including, in some treaties, provision for such payments at prevailing exchange rates in freely convertible currency;
• protection from discriminatory expropriation of property;
• entitlement to insist on reasonable and freely transferable compensation in the event of government seizure of assets;
• "most favoured nation" protections requiring a contracting state to extend to protected investors treatment no less favourable than that accorded to investments by nationals and companies of any third state; and
• provision for the adjudication of disputes by an international tribunal, which generally must determine its arbitral procedures by reference to a multilateral convention.

Investment protection agreements reduce risk at several levels. Initially, they restrain a government contemplating restrictive treatment, exchange controls or expropriation prior to the stage where entrenched positions have been taken up in the form of public declarations, decrees or legislation. Investment protection agreements thus discourage the host government from taking action prejudicial to investments of a treaty country’s nationals. As the International Chamber of Commerce has noted, "that these treaties are respected seems to be evident from the large scale measure of expropriation from which foreign enterprises protected by relevant treaties appear to have been deliberately excluded."

Structuring an investment to make effective use of an appropriate investment protection agreement requires careful attention to a number of factors. Investors must first identify the agreement that confers the most appropriate protection, as such agreements do vary considerably in their terms. Tiered corporate structures may inadvertently deprive assets of expected protection, and relevant time limits should be noted. A few investment protection agreements require ad hoc approval of the host country and so extend protection to investments only on a case-by-case basis. It is also critically important to integrate investment protection agreements with an appropriate tax plan for investments.

Investment protection agreements generally contain provisions for arbitration of disputes between signing parties (i.e., the governments) and, more importantly, disputes between the host state and the foreign investor. Generally, such agreements also confer rights on private investors to pursue claims directly against the sovereign signatory.

The majority of investment protection agreements provide for resolution of disputes under the auspices of the 1965 Convention on the Settlement of Investment Disputes between States and Nationals of Other States. The Convention is administered by the International Centre for Settlement of Investment Disputes (ICSID), which is part of the World Bank Group.

Signature of the Convention by a contracting state suspends any right of that state to assert diplomatic protection or bring an international claim in respect of a dispute. Arbitral awards rendered under the Convention are not subject to appeal beyond those remedies specified in the Convention. Courts in the contracting state are obliged, on simple presentation of a certified copy of an award, to enforce obligations under it as if it were a final judgement of the courts concerned. Parties (including states) to arbitration are obliged to comply with the terms of any award rendered in such proceedings; a failure by a contracting state to meet its obligations exposes the state to proceedings in the International Court of Justice.

Investment protection agreements have a well-established track record. They were widely used to seek relief against the Argentine Government following the peso devaluation crisis in 2001. Another example involving the Argentine government illustrates the value of "most favoured nation" status. An American petroleum company relied on the US/Argentina investment protection agreement to avoid confiscatory taxation imposed by a province of Argentina after the company had already made a substantial investment. No relief from confiscatory taxation was directly available under the US/Argentine agreement. However, the US investor was able to rely on "most favoured nation" language in the US/Argentine agreement to take advantage of the provisions of the Argentine agreement with Spain, which did protect investors against confiscatory taxation.

ICSID procedures encourage settlement, so the cases that have proceeded to formal arbitration represent only a fraction of the instances where investment protection agreements have proved useful. Often, an investor who is properly structured to take advantage of a investment protection agreement will find that the improved position prevents the initial imposition of foreign exchange controls or other interference with protected assets. In such a case there is no formal record of the actual protection afforded by investment protection agreements since no arbitration results from the complaint.

Surprisingly few investors make serious efforts to mitigate foreign-investment risk exposures, though this would seem an obvious step (i) to increase investments in markets that are profitable but risky, and (ii) to confer enhanced protection on existing investments in such markets. Significant uncontrolled political risk is not a necessary component of the commercial decision to invest. Risks arising from government interference can often be mitigated with a well-considered plan, leaving investors free to concentrate on the commercial attractions of the investment.