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Executive Summary

Calculation of damages is an important and probably the most complex stage of an international arbitration. Counsel should obtain support from quantum and technical experts to address various issues that may arise at this stage. Great care must be used in choosing the right group of experts. Counsel must also identify relevant compensation standards, various categories of loss (known as heads of recoverable damage), and principles limiting the amount of compensation, and explain the implications of those principles to the experts in order to enable the experts to quantify damages. Close coordination between counsel and experts and a simplified but effective presentation of a party’s case on damages are necessary to help increase the chances of success.

1.0 Introduction

In any international investment arbitration, once responsibility of a state for breach of an investment treaty or customary international law is established, the arbitral tribunal must assess damages caused by the breach. That assessment is arguably the most complex phase of an international arbitration. Claimants, using a variety of techniques, tend to overstate the quantum of their losses, while respondents naturally take a contrary view. Arbitral tribunals can easily get lost in the web of conflicting financial information about the quantum of damages. Ultimately, quantifying damages is not an exact science and to some degree tribunals will have to exercise discretion to quantify the losses. That discretion, however, is not unlimited and its boundaries are defined by a number of principles, such as prohibition of double recovery or the general principle of causation, that set limits on recovery of damages.

This Chapter provides an overview of the main legal principles governing assessment of damages and how valuation experts apply them in practice.¹

2.0 Valuation of Damages and the Role of Experts

In investment treaty arbitrations involving major projects, counsel will normally need to hire valuation and technical experts to help quantify the damages. In order for the expert to start work, counsel must provide instructions setting out the legal and factual parameters of the case. The legal parameters include the applicable standard of compensation and are discussed in Section 3.0 below. The factual parameters include the counsel’s understanding of the facts, which the expert is asked to assume to be true. The expert then quantifies the damages based on those parameters, using valuation techniques that he or she believes to be appropriate.

Sometimes more than one expert may be needed to quantify damages. The parties may not only require a valuation or financial expert, but also may need an expert in the relevant industry, eg oil and gas, mining or construction. For example, in a case involving the nationalisation of an oil project, the parties may need both valuation and oil industry experts. The former might create cash flow models, assess the discount

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rate to be applied to those cash flows, and determine the net present value of the project as of the date of valuation. The latter would provide a variety of inputs that would go into the cash flow models.

In oil projects, for example, one of the contentious issues is the future price of oil at relevant points in time. An oil price expert can provide such estimates. Further, if there is a dispute relating to how much oil the project could produce, the parties may need a reservoir expert and a geologist to testify about the size of the reservoir and how much oil could realistically be extracted. Other experts, such as economists and investment bankers, may also be useful in shedding light on what investors in the market would have paid for similar projects or identifying various risks that would have affected the project. All of these factors have an impact on the value of the project.

Because the experts perform a very important role in this phase of an arbitration, it is important to choose experts who have the requisite qualifications as well as experience handling similar projects. Experience in providing testimony before an international tribunal or a court is an important advantage. Counsel will have to work closely with the experts to quantify damages and to refine the presentation of the damage claim.

3.0 Standards of Compensation

Investment treaties and the customary international law of reparations are the main sources of legal principles used by tribunals to assess damages.² Investment treaties generally have a standard of compensation for expropriation, but they do not set forth a standard of compensation for the breach of other investment protection provisions, such as fair and equitable treatment³ and umbrella clause provisions.⁴

3.1 Compensation for Legal Expropriation Pursuant to Investment Treaties

Expropriation or nationalisation is not unlawful per se, provided that it is for a public purpose, non-discriminatory and is carried out upon payment of compensation (see Chapter 8). Most modern BITs require states to pay the “fair market value” (FMV) of the expropriated or nationalised assets immediately before expropriation or before the expropriation was known publicly.⁵

The purpose of calculating the FMV “immediately before” expropriation is to exclude the impact of expropriation (and in some cases the announcement of expropriation) on value (whether negative or positive). In other words, the expert has to assess the FMV as if no expropriation had occurred. NAFTA Article 1110, for example, provides in relevant part that:

NAFTA Article 1110: Expropriation and Compensation

2. Compensation shall be equivalent to the fair market value of the expropriated investment immediately before the expropriation took place (“date of expropriation”), and shall not reflect any change in value occurring because the intended expropriation had become known earlier. Valuation criteria shall include going concern value, asset value including declared tax value of tangible property, and other criteria, as appropriate, to determine fair market value.

3. Compensation shall be paid without delay and be fully realizable.

4. If payment is made in a G7 currency, compensation shall include interest at a commercially reasonable rate for that currency from the date of expropriation until the date of actual payment.

[…]

6. On payment, compensation shall be freely transferable as provided in Article 1109.⁶

The FMV has been defined as:

[T]he price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical

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willing and able seller, acting at arm’s length in an open and unrestrained market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of relevant facts.⁷

The compensation standard and the definition of FMV are key parts of the instructions that counsel should discuss with the valuation expert in any given case. The expert then would determine the value using a suitable valuation method.

3.2 Damages for Breaches of Investment Treaties Pursuant to the Chorzów Factory Principle

Assessing damages⁸ for treaty breaches is governed by the reparation principle in customary international law. That principle, which was set forth in the Chorzów Factory case, provides that:

[R]eparation must, as far as possible, wipe-out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed. Restitution in kind, or, if this is not possible, payment of a sum corresponding to the value which a restitution in kind would bear; the award, if need be, of damages for loss sustained which would not be covered by restitution in kind or payment in place of it — such are the principles which should serve to determine the amount of compensation due for an act contrary to international law.⁹

Even though investment treaties have a provision specifically requiring payment of compensation for expropriation, some cases and commentaries take the position that when an expropriation is illegal (e.g., it is discriminatory or not for a public purpose)¹⁰ the Chorzów Factory principle should be the applicable standard for assessing damages, rather than the relevant treaty provision on compensation for expropriation.¹¹

In applying the Chorzów Factory principle, counsel must emphasise to the expert that he or she must eliminate the effect of an illegal act on the investment in assessing the value of the losses. That is, the valuation expert must quantify damages as if no illegal act had occurred. This is the so-called “but for” scenario or a counterfactual scenario used for valuation. It should be noted that a proper application of this principle does not call for eliminating all events that may have a negative impact on value; only those events that were caused by a breach must be eliminated.

If a country were affected by a financial crisis unrelated to a treaty breach, and that crisis negatively affected the investment, the effect of the crisis must be taken into account. In the hypothetical oil project discussed earlier, if a tribunal were to determine that the nationalisation was illegal for some reason, e.g., it was discriminatory, it would have to assess the reparation based on the Chorzów Factory principle. That requires determining damages based on the assumption that no nationalisation occurred and the project would have continued for the remaining years of its life, i.e., the number of years remaining under the concession. Damages would then be equal to the value of the lost cash flows as of the date of the award.

What then is the difference between valuing an asset based on the standard of compensation in a treaty versus valuing it based on the Chorzów Factory principle? The short answer is that the difference boils down first to the date of valuation, and second whether hindsight may be used.

First, with respect the date of valuation, the treaty standard of compensation requires valuing expropriated investments immediately before expropriation. When an asset is valued based on the Chorzów Factory principle, however, it may be valued at the date of the award. In other words, under Chorzów the claimant may try to move the valuation date to the date of the award. The rationale for moving the valuation date is to take advantage of any increase in the value of the investment between the two dates. For example, assume an investment whose value is driven by the price of oil; if

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the price of oil were rising, applying the Chorzów Factory principle would probably result in a higher value than if the BIT standard of compensation were applied (see Section 5.0).

Second, with respect to hindsight, where value is assessed based on a treaty standard of compensation, no hindsight in assessing damages is permitted; this is the so-called ex ante approach (based on forecasts), which means that the tribunal must calculate the value using only the “information” available immediately before the expropriation. “Information” includes anything that a hypothetical willing buyer/ willing seller, would have examined as part of its due diligence to determine FMV in an arms-length transaction.¹² By contrast, under the Chorzów Factory principle using hindsight is permitted, which allows the tribunal to take into account all available information up until it renders its award. This is known as the ex poste approach.

4.0 Assessing Fair Market Value of Income -Producing Properties

A variety of methods have been used to assess FMV of income-producing projects (sometimes known as going concerns).13 Assessing FMV is a forward-looking task, because it requires determining a project’s ability to generate cash into the future. Other methods like book value, which look at the historical performance of a project, cannot properly assess FMV, unless they are updated to present value using suitable techniques.

Common among the methods for assessing FMV are those that assess the value by reference to the sale of comparable assets, or part of the same asset. If the expropriated asset is publicly traded, market capitalisation could be a good starting point for any valuation.

Sometimes, however, the asset may be unique or it may not have been traded on any stock exchange. Many of the major projects located in developing countries, particularly in natural resource sectors such as oil, gas and mining, are unique. In this situation, experts may use the discounted cash flow method (DCF) to assess value. The DCF determines the net cash flows that a project would have generated had it continued to operate through the end of its normal lifecycle.¹⁴ It then applies a discount rate to determine the value of those cash flows as of the date of valuation. The discount rate has a dramatic effect on the value of project cash flows. Small variations in the discount rate may lead to major changes in the value of a project.

For projects located in developing countries, an important part of a discount rate analysis is the country risk element. This element essentially allocates a higher risk premium to investments made in developing countries, making them more expensive than those made in mature economies.

Given the dramatic effect of the discount rate on value in a DCF analysis, it is important for counsel and experts to study and litigate anything relating to the discount rate thoroughly.

Prudent counsel should ask its experts to assess the value using two or three different valuation methods. Arbitral tribunals are more likely to be persuaded if those methods by and large yield the same value for a project. It is also advisable to provide tribunals with various “sensitivity analyses”, which enable a tribunal to see the effect of changing various assumptions that underlie each valuation model.

5.0 Case Study: Valuing a Nationalised Oil Project

The following Chart¹⁵ illustrates how applying the treaty standard of compensation and the Chorzów Factory principle affect valuation in a case involving nationalisation of an oil project. For illustration purposes, we take one important variable or driver of value, and examine how it would be treated under the various standards of compensation discussed above.

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The main facts reflected in the Chart are the following:

• An oil concession was nationalised in June 2007; at the time of nationalisation, 20 years remained under the concession;
• Oil prices at the time of nationalisation were around US$60/barrel; forecasts of future oil prices at the time predicted that during the next two decades the oil prices would gradually increase to around US$85/barrel; and
• Claimant sued the host government late in 2007; the tribunal rendered an award in October 2014.

In a lawful expropriation scenario under NAFTA Article 1110, for example, a tribunal would have to look into any information existing about future oil prices from the period before June 2007; that is the information that a willing buyer would have at its disposal in order to form a view as to how much it should offer for the project. By definition, a valuation would have to assess future project revenue based on an oil price that could reach as high as US$85 dollars per barrel as set forth in fact (b) above. That is the ex ante model.

In an unlawful expropriation scenario, the tribunal would apply the Chorzów Factory principle, which allows for hindsight. The tribunal would take into account actual oil prices between June 2007 and the time of the award in 2014 to assess the lost revenue during the years of arbitration (2007 through 2014). The tribunal would add to that the value of the future cash flows that the project would have generated from the award date until the end of the concession (13 years) calculated as of the date of the award. The figure generated under this analysis would be much higher given the actual increase in the price of oil.

6.0 Valuing Incomplete and Start-Up Businesses

Not all investments have an equal prospect of profitability. Assessing FMV, which requires taking into account the potential of a business to generate future cash, may be speculative when chances of profitability are low. International tribunals have generally been reluctant to assess damages for such projects using FMV. In most cases, particularly where the investment has no history of profitability, or less than two years history of profitability, tribunals have awarded the amounts invested in a project or sunk costs as a proxy for what the investment is worth.¹⁶ This is known as the “New Business Rule” in US law. In recent years, however, some tribunals have relaxed the mechanical application of this rule and have instead awarded FMV for some incomplete or start-up projects.¹⁷

Other methods that tribunals have used to assess damages, depending on the nature of the asset, are book value and liquidation value.¹⁸

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7.0 Interest

Arbitral tribunals normally award pre-award and post-award interest on the principal amount of damages, which is meant to compensate the aggrieved party for the time value of money. The amount of interest that may accrue on the principal award should not be underestimated. Interest accrued at a high compound rate over a long period of time could exceed the principal.¹⁹

The main issues that arise in connection with calculating the amount of interest due on an award are: the period during which interest accrues — particularly the date from which interest begins to accrue, the rate of interest, and whether the rate should be simple or compound.

7.1 Period During Which Interest Accrues

Normally interest accrues from the date of the breach. The period between that date and the issuance of a final award is called the “pre-award” period. The subsequent period until payment of the award is called the “post-award” period. Tribunals normally award interest during both periods,²⁰ unless the valuation date is the date of the award, in which case by definition there would be no pre-award period, and therefore no pre-award interest. All awards normally accrue post-award interest.

While it may seem logical that interest should accrue on money debts, counsel should seek interest in its prayer for relief to ensure that the tribunal awards interest.²¹

Tribunals divide the period of interest accrual into pre-award and post-award periods. Most tribunals use the same rate of interest during both periods; some tribunals however have applied a different rate during the pre-award and post-award periods.²²

7.2 Rate of Interest

Some modern treaties provide guidance on the interest rate to be used. NAFTA Article 1110, for example, requires using a “commercially reasonable rate” for the currency concerned. Most treaties, however, do not address this issue, leaving international tribunals with discretion to determine the applicable rate. While there is no uniform practice, arbitral tribunals have considered a variety of factors to arrive at a rate by trying to ascertain how the investor would spend the proceeds of the award had it received them at the date of valuation: would he or she invest them back into the project; invest them in some interest-bearing investment vehicle;²³ or put them to some other use? Some tribunals have deemed an award as a loan to the claimant and used the claimant’s borrowing rate to assess the rate of interest.²⁴ Other tribunals have applied host state regulations on the applicable rate of interest.²⁵

Commentators, however, have cautioned that whatever rate is used it should not compensate for risks that were not borne. Therefore, pre-award interest should normally be risk-free.²⁶

Arbitral tribunals in most cases use risk-free rates such as the US Treasury Bills rate (or LIBOR), with or without a small premium, to determine pre-award interest. A recent survey of damage awards suggests that in three-quarters of cases tribunals use benchmark rates such as inter-bank rates, risk-free rates, cost of debt, and bank deposit rates.²⁷

7.3 Simple or Compound Interest

International tribunals, particularly in the context of state-to-state disputes, used to award interest under the presumption that simple interest was required unless a claimant could provide specific evidence in support of its claim for compound interest. The more recent arbitral practice, however, seems to be shifting towards awarding compound interest, especially since 2005.²⁸ The practice, however, is not uniform and from time to time arbitral tribunals award simple interest.²⁹

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Given that interest accrued on the principal sum of the award may be substantial and even exceed the principal, counsel must pay special attention early in the process to assessment of interest as an independent head of damages and confer with quantum experts to determine the three key factors discussed in this section, that is rate of interest, compound or simple, and the date from which interest may accrue. Ultimately, it falls to the quantum expert to propose a suitable rate.

8.0 Costs

Arbitral tribunals normally allocate the costs of arbitration at the end of the proceedings and as part of the damages phase. The magnitude of costs in an arbitration partly depends on whether the case has gone through all arbitral phases. The phases normally are: preliminary objections, jurisdiction, merits and damages. A case that has not proceeded beyond the preliminary objections phase would naturally be less costly than one that has gone through the full cycle. Further, once an award is rendered, there are various post-award mechanisms, such as annulment and set-aside or collection processes, which may add to the overall costs of litigation. Various aspects of cost allocation are discussed in Chapter 13.

9.0 Limitations on Recovery of Damages

Arbitral tribunals apply a number of principles to reduce the amount of damages,³⁰ which are not dissimilar to those used in various national law systems. Not all principles are used in every arbitration. They include:

• No double recovery: no party may recover damages twice for the same loss;
• Causation: a causal link must be established between a treaty breach and the alleged losses. Even if a claimant proves that a state has breached a BIT, but fails to show that the breach caused some harm to it, no damages may be awarded;³¹
• Contributory fault: some tribunals have discounted the amount of damages by taking into account a claimant’s contribution to its own injury. The discounts have ranged between 25% and 50% and seem to have been completely discretionary;³²
• Mitigation: the party suffering a loss has a duty to take the necessary steps to reduce its losses; failure to do so would be a basis for discounting the amount of damages;³³ and
• No recovery for speculative and uncertain damages: this principle is important, particularly in assessing the loss of profits under long-term contracts.³⁴ As claimants tend to exaggerate profits they would have made had the contract or project not been terminated, the assumptions underlying the claimant’s assertions must be carefully analysed.

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Notes

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