Investor state arbitrations: should states investigate misconduct allegations?

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

The Hague District Court has recently quashed six arbitration awards of the Permanent Court of Arbitration (PCA) in a case concerning international investments based on the Energy Charter Treaty (ECT). The PCA’s awards and the full Dutch judgment are available here.

In July 2014, the PCA awarded what is thought to have been one of the largest arbitration awards in history when it ordered the Russian Federation to pay damages in excess of US$50bn to the shareholders of the now bankrupted Russian oil giant, OAO Yukos Oil Company (Yukos).

However, those awards have been set aside by the Dutch court on the basis that the PCA lacked jurisdiction to arbitrate the case. The judgment represents a victory for the Russian Federation, however, one of the lingering questions is what steps the state should now take to investigate and address the allegations of misconduct by the Russian tax authorities.

Material facts and issues in the Yukos saga

The material facts of this case can be traced back to December 1994, when the Russian Federation signed the ECT but failed to ratify it. Pursuant to Article 45(1) of the ECT, the Russian Federation became a signatory to the treaty. Article 45(1) ECT provides that: "(1) Each signatory agrees to apply this treaty provisionally pending its entry into force for such signatory in accordance with Article 44, to the extent that such provisional application is not inconsistent with its constitution, laws or regulations." The Russian Federation did not make use of the exception, provided under Article 45(2) ECT, for a signatory to submit a declaration that it is not able to accept provisional application of the ECT.

In 2003, the Russian tax authorities determined that Yukos had been involved in systemic and large-scale tax evasion in the Russian Federation. This resulted in substantial tax reassessments (including additional tax assessments and fines) and Yukos’ assets were seized. The enforcement of the various claims asserted by the Russian tax authorities ultimately resulted in the sale of Yukos’ assets and its eventual bankruptcy in August 2006.

Three of Yukos’ shareholders (the Shareholders) commenced arbitration proceedings, under Article 26(4) ECT, against the Russian Federation. The claim was based on the misconduct of the Russian public officials. The Shareholders complained of criminal harassment of Yukos, its employees and related persons and entities. The Shareholders argued that from July 2003 the Russian federation initiated a series of criminal investigations against Yukos management. The Shareholders submitted that this was a deliberate and sustained campaign targeting Yukos’ employees, its auditor, in-house counsel, lawyers and it included searches and seizures, threats to revoke Yukos’ oil licenses, mutual legal assistance requests and extradition proceedings against Yukos management in order to affect Yukos and persons associated with it. The Shareholders alleged that this "harassment" and "intimidation" campaign was motivated by Mr Mikhail Khodorkovsky’s participation in Russian opposition politics (who at the outset of the dispute was the principal shareholder and CEO of Yukos). The Shareholders alleged that the sole purpose of the tax reassessments was for the Russian government to obtain Yukos’ significant assets by fabricating massive tax claims against the company and transferring Yukos’ most valuable asset to state-owned companies. The Shareholders argued that the state had unlawfully expropriated Yukos’ assets.

The Russian Federation defended the arbitration proceedings and argued that it was not bound by the ECT as it had not ratified the treaty. The state therefore contended that it had not agreed to the arbitration provision under Article 26 ECT. Moreover, it was advanced by the state that only those provisions of the ECT that did not violate Russian law could provisionally apply, and Article 26 of the ECT was excluded from this ambit.

In the arbitral proceedings, the PCA found that Article 45(1) of the ECT prohibits provisional application of the ECT only where the principle of provisional application is itself inconsistent with the constitution, laws or regulations of the signatory state and the PCA found that in the Russian Federation there was no such inconsistency. The PCA concluded that the ECT in its entirety applied provisionally in the Russian Federation until 2009, when the state had notified the depository of its intention not to ratify the ECT. Accordingly, the PCA held that it had jurisdiction to hear the matter and it went on to award the Shareholders US$50bn in damages. The Russian Federation immediately applied to the Hague District Court for the awards to be set aside.

The Dutch court held that Article 45(1) ECT should be interpreted to allow for provisional application dependent on the compatibility of separate treaty provisions with national laws. In light of this meaning, the question arose whether the arbitration provision in Article 26 of the ECT, from which the PCA had derived its competence, was compatible with the constitution of the Russian Federation and its laws and regulations. The Dutch court held that Russian law does not provide a separate legal basis for the arbitration of disputes between an investor and a state in international arbitral proceedings. From this reasoning it followed that the Russian Federation never made an unconditional offer for arbitration and, moreover, there was no valid arbitration agreement.

The Dutch Court ruled that the PCA lacked jurisdiction and the awards have been set aside. The basis of the Shareholders’ claims related to allegations of misconduct by the Russian tax authorities. However, that issue did not feature in the judgment of the Hague District Court and it appears that for the time being the state has been able to avoid liability as a result of its failure to ratify the relevant treaty.

Comment

Recent media reports indicate that the Shareholders are preparing to challenge the Dutch ruling and they have expressed confidence in the prospects of their appeal. Whilst the appeal proceedings are underway, enforcement proceedings are ongoing in six different countries. This of course raises interesting issues as to whether, given that the arbitration awards have been set aside at the seat of the arbitration, those awards can and should be recognised and enforced elsewhere in order to provide a remedy to the Shareholders.

An equally important consideration, however, is whether it is incumbent on a state to investigate and address allegations of misconduct perpetrated by its officials notwithstanding that the substantive arbitral claim has (for the time being) been procedurally thwarted. This seems particularly relevant given the PCA’s finding that the Russian tax authorities appeared determined to impose a massive liability on Yukos and that the bankruptcy of Yukos was initiated by the Russian Federation.

Obvious difficulties arise where senior officials have been implicated in alleged misconduct and an investigation into those acts may lead to scandalous and embarrassing results for a state. Clearly, there are reputational issues at play where senior state officials are accused of misconduct and this might serve to stifle prosecutions so as to preclude the state from being exposed to more intensified, public scrutiny and possible embarrassment. There may also be limited state resources available to commit to investigating and prosecuting state officials.

It will be interesting to see whether the Dutch appellate court, or indeed any of the local courts who are currently dealing with the enforcement proceedings, address the misconduct allegations head on when determining whether to allow the Shareholders’ appeal and whether to enforce the PCA’s award.