Denial of Benefits and Investor’s Rights: Erasing an Apparent Protection

Studiu publicat în volumul In Honorem Flavius Antoniu Baias. Aparența în drept, tomul III, Ed. Hamangiu, 2021, p. 199-205.

Introduction

While the investor-State dispute settlement (ISDS) is now facing questions of legitimacy in the context of the United Nations Commission on International Trade Law (UNCITRAL) Working Group III discussions, States are resorting to the mechanisms in place to ensure that only the those covered investors and investments are protected under International Investment Agreements (IIAs) they have entered into. One such mechanism is the “denial of benefits” (DoB) clauses.

The purpose of the DoB clauses is to exclude from the protection of the relevant IIA investors and their investments who, although formally satisfying the definition of investor, do not have a real (economic) connection with the home State. The arbitral tribunal in Amto v. Ukraine referred to the scope of the DoB clause in the context of Article 17 of the Energy Charter Treaty (ECT) and concluded that “[a]s the purpose of the ЕСТ is to establish a legal framework «in order to promote long-term cooperation in the energy field, based on complementarities and mutual benefits (…)» then the potential exclusion of foreign owned entities from ЕСТ investment protection under Article 17 is readily comprehensible. «Long term economic cooperation», «complementarities» or «mutual benefits» are unlikely to materialise for the host State with a State that serves as a nationality of convenience devoid of economic substance for an investment vehicle, or a State with which it does not enjoy normal diplomatic or economic relations”^[1].

While the DoB has gained traction in the past years, it is not an often occurrence in the IIAs, be it Bilateral Investment Treaties (BITs) or Free Trade Agreements (FTAs). It is interesting to note that the United Nations Conference on Trade and Development (UNCTAD) Investment Policy Hub lists a little over 215 IIAs (most of them concluded by the US, Canada, China and Australia) containing a DoB, out of a total number of about 2,500 mapped IIAs. While DoB clauses can be traced back to the Treaties of Friendship, Commerce and Navigation (‘FCNs’), in which the contracting States reserve the right to deny any of the rights and privileges accorded by a FCN to a corporation, the DoB are not a creation of investment law and are often encountered in public international law instruments. For example, Art. 9 of the Draft Articles on Diplomatic Protection adopted in 2006 by the International Law Commission, while establishing that the state of nationality of a corporation is the state of incorporation of the corporation, it adds that when certain conditions are met, such as the nationality of the controllers and the lack of substantial business activities of such corporation, the real nationality would be upheld for the purposes of the Draft Articles.

The typical example of DoB clause and often relied on by Contracting Parties is the one in Article 17, “Non-Application of Part III in Certain Circumstances”, of the ECT. The provision reads as follows: “Each Contracting Party reserves the right to deny the advantages of this Part to: (1) a legal entity if citizens or nationals of a third state own or control such entity and if that entity has no substantial business activities in the Area of the Contracting Party in which it is organized; or (2) an Investment, if the denying Contracting Party establishes that such Investment is an Investment of an Investor of a third state with or as to which the denying Contracting Party: (a) does not maintain a diplomatic relationship; or (b) adopts or maintains measures that: (i) prohibit transactions with Investors of that state; or (ii) would be violated or circumvented if the benefits of this Part were accorded to Investors of that state or to their Investments”.

More recently, Article 8.16 of the Canada-EU Comprehensive Trade and Economic Agreement (CETA), not yet in force, provides for the following DoB: “A Party may deny the benefits of this Chapter to an investor of the other Party that is an enterprise of that Party and to investments of that investor if: (a) an investor of a third country owns or controls the enterprise; and (b) the denying Party adopts or maintains a measure with respect to the third country that: (i) relates to the maintenance of international peace and security; and (ii) prohibits transactions with the enterprise or would be violated or circumvented if the benefits of this Chapter were accorded to the enterprise or to its investments”.

§1. Controversial issues in the application of the DoB Clause

Several issues had been addressed by arbitral tribunals, in particular by those sitting under the ECT. The list of questions below highlights these complex issues, some of them as a result of the ambiguous or rather broad language of the relevant DoB and which requires treaty interpretation.

1.    Should respondent State exercise its DoB right or does this right apply automatically?

2.    What should respondent State do exactly to exercise the DoB right?

3.    When should the DoB right be exercised? Before the investment is made? Before the dispute arises? When the cooling off notification is communicated? When the request for arbitration is communicated?

4.    Is there a consultation procedure mandatory before the respondent State exercises the DoB?

5.    Is the exercise of DoB right an issue of jurisdiction or merits?

6.    Does the DoB apply prospectively or retroactively?

7.    What is meant by ownership and control of a legal entity?

8.    What is meant by substantial business activities?

Before briefly addressing these concerns, it is important to note that in a typical situation, an investor X, from a State Y, having an investment in State Z, will only be challenged that it does not meet the requirements of the applicable IIA, under the DoB provision, only after engaging in an arbitration under that IIA against State Z. Conversely, State Z may only be in a position to decide whether it should exercise the DoB right after receiving the request for arbitration from investor X, thus having sufficient information to assess whether the DoB clause may apply. As such, it is interesting to note that the arbitration proceedings are usually the trigger of the DoB challenges. Therefore, an investor is under an apparent or provisional acceptance as a qualified investor, subject to the successful invocation of the DoB clause.

It is, thus, important to briefly survey the issues highlighted above and understand, to what extent, State’s discretion may wipe out the benefits afforded to a putative investor.

As to the exercise of the DoB right, the Plama v. Bulgaria arbitral tribunal held that Bulgaria must exercise this right, as “the existence of a «right» is distinct from the exercise of that right. For example, a party may have a contractual right to refer a claim to arbitration; but there can be no arbitration unless and until that right is exercised”^[2]. As mentioned, the practice shows that States rely on DoB clauses when a dispute is well underway. As explained by the tribunal in Guaracachi v. Bolivia, “[a]s a matter of fact, it would be odd for a State to examine whether the requirements of Article XII [DoB clause] had been fulfilled in relation to an investor with whom it had no dispute whatsoever. In that case, the notification of the denial of benefits would – per se – be seen as an unfriendly and groundless act, contrary to the promotion of foreign investments. On the other side, the fulfilment of the aforementioned requirements is not static and can change from one day to the next, which means that it is only when a dispute arises that the respondent State will be able to assess whether such requirements are met and decide whether it will deny the benefits of the treaty in respect of that particular dispute”^[3]. The practice of arbitral tribunals as to the right moment when to exercise the DoB right varies, with some tribunals, such as Ascom v. Kazakhstan tribunal concluding that “Art. 17 ECT would only apply if a state invoked that provision to deny benefits to an investor before a dispute arose”^[4], while others, such as the EMELEC v. Ecuador holding that “Ecuador announced the denial of benefits to EMELEC at the proper stage of the proceedings, i.e. upon raising its objections on jurisdiction”^[5].

After establishing that the DoB right must be actively exercised by the respondent State, arbitral tribunals assess the proper manner in which such exercise should be effected. In Plama v. Bulgaria, the tribunal considered that this exercise must be made publicly, in an effective way so it becomes available^[6]. Further, as explained by the same tribunal, “[b]y itself, Article 17(1) ECT is at best only half a notice; without further reasonable notice of its exercise by the host state, its terms tell the investor little; and for all practical purposes, something more is needed”^[7]. It is to be noted that certain IIAs require a prior notification or/and consultation procedure between the parties to the applicable IIA, before effectively denying the benefits of that treaty to the putative investors. For instance, Article 2(2) of the Australia-Czech Republic BIT, refer to a joint consultation between the Contracting Parties upon which they “may decide (…) not to extend the rights and benefits of this Agreement”.

Equally important is whether tribunals retain the DoB clause as pertaining to the jurisdiction or the merits. When arbitral tribunal considers a matter to pertain to its jurisdiction, that decision may be challenged under the appropriate available mechanism. As such, erroneously considering an issue pertaining to jurisdiction, could “result in an unjustified extension of the scope for challenging the awards”^[8]. When addressing this issue, tribunals are mindful of the position of the DoB clause in the structure of the relevant IIA, as well as the wording of the clause, overall. As explained by the Plama v. Bulgaria tribunal, “[t]he express terms of Article 17 refer to a denial of the advantages «of this Part», thereby referring to the substantive advantages conferred upon an investor by Part III of the ECT. The language is unambiguous; but it is confirmed by the title to Article 17: «Non-Application of Part III in Certain Circumstances»”^[9]. Similarly, the tribunal in the Yukos cases concluded that “Article 17 specifies – as does the title of that Article – that it concerns denial of the advantages of «this Part», i.e., Part III of the ECT. Provision for dispute settlement under the ECT is not found in «this Part» but in Part V of the Treaty. Whether or not Claimant is entitled to the advantages of Part III is a question not of jurisdiction but of the merits”^[10]. Nonetheless, non-ECT tribunals, such as the one in Ulysseas v. Ecuador considered the exercise of the DoB right under Article I.2 of the US-Ecuador BIT as pertaining to jurisdiction, rather than to the merits of the dispute^[11]. Similarly, in Guaracachi v. Bolivia, the tribunal held that the DoB will deprive the tribunal of jurisdiction over the dispute^[12].

When it comes to the effects of the DoB clause, the conclusion reached by the tribunal is of utmost importance. If the respondent State is successful in relying on the DoB right and the tribunal assigns a prospective effect to this, the benefits afforded to the investor before the invocation of the DoB clause will remain unaffected, and, as such, they will remain investors for that period of time. In Plama v. Bulgaria, the arbitral tribunal explained that the DoB clause under the ECT has prospective effects: “the object and purpose of the ECT suggest that the right’s exercise should not have retrospective effect. A putative investor, properly informed and advised of the potential effect of Article 17(1), could adjust its plans accordingly prior to making its investment. If, however, the right’s exercise had retrospective effect, the consequences for the investor would be serious. The investor could not plan in the “long term” for such an effect (if at all); and indeed such an unexercised right could lure putative investors with legitimate expectations only to have those expectations made retrospectively false at a much later date^[13]. If tribunals, to the contrary, adopt a retrospective effect of the DoB clause, this will erase the benefits granted to investor for the past and for the future, in effect confirming that the apparent investor is not an investor for the purpose of the applicable IIA. In Ulysseas v. Ecuador, the arbitral tribunal preferred to give effect to the retrospective application of the DoB clause. In reaching this decision, the arbitrators held that “the protection afforded by the BIT is subject during the life of the investment to the possibility of a denial of the BIT’s advantages by the host State”^[14].

While the language of the DoB clause is not identical in the IIAs, they do refer to at least two cumulative conditions for such clause to be called in effect: (1) ownership or control of the legal entity by nationals of a third State, and (2) the legal entity has no substantial business activities at the place of incorporation^[15]. Therefore, while we have an apparent investor which formally satisfies the requirements of the definition of ‘investor’ under the applicable IIA, the ownership or control, and its business activities would prevent that investor from benefitting from the advantages offered by the applicable IIA. The Yukos tribunal held that “[i]t is apparent from the wording of Article 17(1) that two additional cumulative substantive conditions must be met before the “denial-of-benefits” clause can be exercised in respect of any particular legal entity. First, such legal entity must be owned or controlled by citizens or nationals of a third State; second, the legal entity must have no substantial business activities in the place in which it is organized”^[16]. It is important to note that few IIAs would include a definition of the notions of “ownership”, “control” and “substantive business activities”. Understandings no. 3 to Article 1(6) of the ECT, in the context of the definition of the notion of “investment”, explains “control” as follows: “control of an Investment means control in fact, determined after an examination of the actual circumstances in each situation. In any such examination, all relevant factors should be considered, including the Investor’s (a) financial interest, including equity interest, in the Investment; (b) ability to exercise substantial influence over the management and operation of the Investment; and (c) ability to exercise substantial influence over the selection of members of the board of directors or any other managing body”. Where there is doubt as to whether an Investor controls, directly or indirectly, an Investment, an Investor claiming such control has the burden of proof that such control exists”.

The tribunal in Ulysseas v. Ecuador has highlighted that while “[t]he Parties agree also that the term “control” means the “legal capacity to control”, they “disagree regarding whether control must be exercised “directly,” as argued by Claimant, or may be exercised “indirectly,” as asserted by Respondent”^[17]. The tribunal had to “determine whether the terms of Article I(2) of the [US-Ecuador] BIT, when read in their context and in the light of the object and purpose of the treaty, are meant to limit “control” to direct control or also embrace indirect control”^[18].

As to the meaning of ‘substantial activity’ the arbitral tribunal in AMTO v. Ukraine, concluded that, in the absence of a definition in the ECT, “«substantial» in this context means «of substance, and not merely of form». It does not mean «large», and the materiality not the magnitude of the business activity is the decisive question”^[19]. The new Dutch Model BIT explains in Article 1(c) that: “Indications of having «substantive business activities» in a Contracting Party may include: (i) the undertaking’s registered office and/or administration is established in that Contracting Party; (ii) the undertaking’s headquarters and/or management is established in that Contracting Party; (iii) the number of employees and their qualifications based in that Contracting Party; (iv) the turnover generated in that Contracting Party; and (v) an office, production facility and/or research laboratory is established in that Contracting Party; These indications should be assessed in each specific case, taking into account the total number of employees and turnover of the undertaking concerned, and take account of the nature and maturity of the activities carried out by the undertaking in the Contracting Party in which it is established”.

§2. The Future of DoB Clauses

While there has been an increased reliance on the use of DoB clauses, most of the new generation IIAs tend to transfer the effects of this clause to the definition on “investor”. As such, an investor, when submitting a claim to arbitration, would have to show that it satisfies the nationality test under the applicable IIA, as well as the “substantive activities” requirement. The burden of proving this is thus shifted to investor. This is probably the direct result of the unsuccessful attempts by respondent States to defeat apparent investors by relying on DoB clauses. In particular, the cumulative test of ownership/control and substantive business activities has proved to be problematic, as one requirement may be met, while the other will not. One example of such shift is the proposed modernised ECT. On 27 May 2020, the EU published the proposed amendments to the ECT provisions, including those concerning Article 17 on the DoB^[20]. The proposed text appears to include solutions to the issues raised before ECT arbitral tribunals so far, including the possibility to deny the benefits of the ECT without any prior publicity or additional formality, and also aligns the DoB with the recent IIAs concluded by the EU, for example, the CETA. Furthermore, the propose amendments, as mentioned, would transfer the “substantial business activities” requirement of investor to the definition part, thus obliging investors to show that such requirement is met, at the outset of the arbitration proceedings.

Footnotes

^[1] Limited Liability Company Amto v. Ukraine, Arbitration No. 080/2005, Final Award, 26 March 2008, § 61.

^[2] Plama Consortium Limited v. Republic of Bulgaria, ICSID Case No. ARB/03/24, Decision on Jurisdiction, 8 February 2005, § 155.

^[3] Guaracachi America, Inc. and Rurelec PLC v. Plurinational State of Bolivia, PCA Case No. 2011-17, Award, 31 January 2014, § 379.

^[4] Anatolie Stati, Gabriel Stati, Ascom Group S.A. and Terra Raf Trans Traiding Ltd v. Republic of Kazakhstan, SCC Case No. V116/2010, Award, 19 December 2013, § 745. See also the conclusion of the tribunal in the Yukos cases [Yukos Universal Limited (Isle of Man) v. Russian Federation, PCA Case No. 227, Interim Award on Jurisdiction and Admissibility, 30 November 2009, § 458].

^[5] Empresa Eléctrica del Ecuador, Inc. v. Republic of Ecuador, ICSID Case No. ARB/05/9, Award, 2 June 2009, § 71.

^[6] Plama Consortium Limited v. Republic of Bulgaria, ICSID Case No. ARB/03/24, Decision on Jurisdiction, 8 February 2005, §157.

^[7] Ibidem.

^[8] J. Paulsson, Jurisdiction and Admissibility, in Gerald Asken (ed.), Global reflections on international law, commerce and dispute resolution: Liber Amicorum in honour of Robert Briner, ICC Publishing, 2005, 601-617, p. 601.

^[9] Plama Consortium Limited v. Republic of Bulgaria, ICSID Case No. ARB/03/24, Decision on Jurisdiction, 8 February 2005, § 147 and 148.

^[10] Yukos Universal Limited (Isle of Man) v. Russian Federation, PCA Case No. 227, Interim Award on Jurisdiction and Admissibility, 30 November 2009.

^[11] Ulysseas, Inc. v. Ecuador, Interim Award, 28 September 2010, § 172.

^[12] Guaracachi America, Inc. and Rurelec PLC v. Plurinational State of Bolivia, PCA Case No. 2011-17, Award, 31 January 2014, § 381.

^[13] Plama Consortium Limited v. Republic of Bulgaria, ICSID Case No. ARB/03/24, Decision on Jurisdiction, 8 February 2005, § 162

^[14] Ulysseas, Inc. v. Ecuador, Interim Award, 28 September 2010, § 173.

^[15] Some IIAs, such as the ECT, retains the ‘denial of benefits’ right when the putative investor is controlled by nationals of a third State with which the host State does not maintain normal economic relations.

^[16] Yukos Universal Limited (Isle of Man) v. Russian Federation, PCA Case No. 227, Interim Award on Jurisdiction and Admissibility, 30 November 2009, § 460.

^[17] Ulysseas, Inc. v. Ecuador, Interim Award, 28 September 2010, § 168.

^[18] Idem, § 169.

^[19] Limited Liability Company Amto v. Ukraine, Arbitration No. 080/2005, Final Award, 26 March 2008, § 69.

^[20] See here: https://trade.ec.europa.eu/doclib/docs/2020/may/tradoc_158754.pdf.