Bilateral and multilateral investment treaties aim to protect foreign investors against adverse acts committed by a host country, particularly with regard to expropriation.

In this edition of Raising the Bar, we examine several questions which have arisen in recent years following divergent arbitration awards involving Venezuela:[1] When quantifying damages, to what extent should the risk of expropriation be reflected and, if relevant, how should it be accounted for? Should country risk capture the possibility that a host state breaches its obligations to the investor?

Country risk and expropriation risk

There is broad consensus among valuation practitioners that it is riskier to invest in certain countries than in others. These specific and adverse risks, which encompass macroeconomic, political, social and environmental risks, are collectively referred to as “country risk.” Rational investors consider those when making decisions.

Expropriation risk, a key component of political risk, can be defined as the risk of the host state taking property belonging to a foreign investor.[2]

How country/expropriation risk is usually accounted for in practice

Theoretically, when valuing an investment using the discounted cash flow (DCF) method, country risk should be reflected in this investment’s cash flows, having identified the risks, their probability and their impact. The same applies to expropriation risk.

In practice, however, quantum experts tend to account for country/expropriation risk by adjusting the discount rate in their DCF calculations, using methods developed to address country risk (usually by adding a premium to the discount rate). Including a risk premium in the calculation leads to a lower quantum value from the claimant’s perspective. Frequently, practitioners apply a country risk premium derived by reference to the sovereign yield spread, which is itself related to the country’s government debt rating. However, this is by no means the only possible approach.

Divergent awards in recent years

Investor-state arbitration tribunals have been split as to whether expropriation risk should be reflected in the quantum of damages at the valuation stage and, if so, how this should be done.

Claimants in such disputes tend to argue that investment treaties protect them from adverse government acts such as expropriation, thus suggesting that tribunals should not include expropriation risk in the assessment of damages.[3] Another common argument is that including such an additional risk premium might also be seen as creating an incentive for respondent states to drive down the value of foreign investments through the threat of expropriation.[4]

Ultimately, the appropriate treatment of expropriation risk is a legal question which depends on the compensation principles relevant to the case at hand. Expropriation, in this context, can be categorised into two main types:

1. Lawful Expropriation: This occurs when a government takes private property for a legitimate public purpose and provides fair compensation[5] to the owner in accordance with the law and established legal standards. The conditions vary from one investment treaty to another. In such cases, the government’s actions are typically in compliance with applicable laws and treaties and are usually deemed to be consistent with the public interest.
2. Unlawful Expropriation: This refers to situations where a government's actions in taking private property violate established legal standards, often by failing to provide fair compensation or by acting without a valid public purpose.

Tribunals have therefore adopted different approaches:

1. Reflect expropriation risk existing on the eve of the expropriation without adjustment. This is the approach adopted where an investment was found to have been lawfully expropriated.

In Venezuela Holdings v. Venezuela and Tidewater v. Venezuela, the claimants tried to argue that expropriation risk should be ignored in the discount rate due to the protection provided by the relevant bilateral investment treaties.

In Venezuela Holdings v. Venezuela, the claimants sought to exclude “confiscation risk,” although they accepted that it was appropriate to include other elements of country risk (such as a volatile economy and civil disorder).[6]

The tribunal disagreed and decided, based on the provisions of the applicable investment treaty, that compensation for expropriation should be the market value of the investment immediately before the measures were taken or became of public knowledge.[7] The tribunal reasoned that the country risk premium should reflect the risk of potential expropriation that existed at the time, as a "hypothetical buyer would take [expropriation risk] into account when determining the amount he would be willing to pay in that moment."[8]

In Tidewater v. Venezuela, the claimant contended that all political risks should be excluded and only took account of currency, macroeconomic and social risks.[9]

Again, the tribunal disagreed, explaining that a potential buyer would consider “the general risks, including political risks, of doing business in the particular country” as they applied “immediately before the expropriation or before the impending expropriation became public knowledge.”[10]

In each case, the tribunal’s reasoning appears to have been guided by the provisions of the relevant investment treaty, in order to rule on the applicable standard of compensation (market value) and the date at which it should be assessed (immediately prior to the expropriation).

2. Exclude all expropriation risk. This is the approach adopted where an investment was found to have been unlawfully expropriated.

In Gold Reserve v. Venezuela, the tribunal sided with the claimants in considering that “it is not appropriate to increase the country risk premium to reflect the market’s perception that a State might have a propensity to expropriate investments in breach of BIT obligations.”[11] In that case, the tribunal excluded all expropriation risk, even that which may have existed at the time the investment was made.

However, it disagreed with the claimants that all political risks should be excluded altogether, explaining that “other genuine risks […] including political risk, other than expropriation” should be accounted for.[12]

This position stems from the Chorzow Factory principle that, under international law principles, compensation “should wipe-out the consequences of the breach and reestablish the situation as it is likely to have been absent the breach.”[13]

Although this decision appears to contradict the reasoning adopted in the Venezuela Holdings v. Venezuela and Tidewater v. Venezuela awards, it highlights the fact that, depending on the circumstances of the case (whether the expropriation is lawful or unlawful, for instance), different principles of compensation will apply.

3. Only reflect the expropriation risk prevailing at the time the investment was made.

In practice, a prudent investor would reasonably consider the perceived expropriation risk when making a decision, likely demanding higher returns in countries with a heightened perceived risk of expropriation. Consequently, it may be justifiable to reduce compensation to an extent commensurate with the expropriation risk that the investor would reasonably have factored into their initial investment decision.

This intermediate view has been adopted by some tribunals. In Flughafen v. Venezuela, for instance, the tribunal considered that the country risk (including expropriation risk) existing at the time of the investment should be reflected in the discount rate, given that when they decided to go ahead with their investment, the claimants were “perfectly aware” of the political and legal uncertainties that increased the risk of their investment.[14] The tribunal, however, reiterated that a state could not benefit from a reduction in the value of compensation due to its wrongful behaviour after the investment was made.[15]

This position also appears to be consistent with the fact that, even if investment treaties were to effectively protect investors against the risk of expropriation, some residual risk would remain, such as the risk that the host state may be unwilling or unable to pay the compensation that may be awarded to the investors.

Challenges facing quantum experts

In the awards previously discussed, the tribunals relied on industry standards (from academics such as Professor Damodaran, or prominent financial institutions) to assess the country risk premium. Although these measures reflect the general risks associated with a country as a whole, they are not industry- or company-specific. As such, whether and to what extent they reflect the expropriation risk facing a specific investment are open for question.

The sovereign default spread reflects the risk that a country may default on its debt. It may not have a direct link to the risk of expropriation. Further, different industries are likely to have varying degrees of exposure to the risk of expropriation — relying on the sovereign default spread may therefore overestimate or underestimate this risk.

On the one hand, where the country risk premium could be deemed to underestimate the risk of expropriation, quantum experts could prepare several cash flow projections that would reflect the possible and mutually exclusive outcomes for the investment, including the case of expropriation. A single valuation could then be calculated, depending on the probability assigned to each scenario.

Alternatively, a premium could be added to the discount rate to reflect the “true” risk of expropriation. Both approaches require quantum experts to exercise judgment when choosing their assumptions (as to the appropriate premium or the probability of each scenario).

On the other hand, where expropriation risk is overestimated, quantum experts would need to exclude from the country risk premium the component relating to the excess expropriation risk. This is no simple task, as measures of country risk are not normally separated into their various components. Econometric modelling may prove useful, as suggested by Bekaert et al. (2016)[16] who have shown that the sovereign default spread could be broken down into its various components (liquidity, macroeconomic risks, political risk, currency risk, etc.) using regression analysis.[17]

Conclusion

The extent to which expropriation risk should be incorporated into a valuation that is to be used as a basis for an award of compensation is first and foremost a legal question. In recent years, arbitration tribunals have expressed a range of opinions, reflecting the circumstances of each case under review and, consequently, the relevant applicable compensation principles.

For quantum experts, a pragmatic approach becomes imperative, one which demands careful consideration of the risks that the expert aims to incorporate into the valuation process, followed by a thorough qualitative evaluation of how closely the available methodologies capture the specific risks. In essence, then, in many cases addressing expropriation risk through the discount rate may be the most practical option, and one of the quantum experts' roles is to determine the most suitable risk premium given the specific circumstances of the case.
 

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