Fair market value (FMV) seems, at least to investors, a reasonable basis for compensating investment losses caused by sovereigns, but the concept involves many issues and complexities. Here are some insights into international law and practice regarding FMV, and some thoughts about the possibility of FMV compensation under political risk insurance (PRI) policies.
International law and practice.
PRI policies typically contain subrogation, transfer and assignment provisions that allow the insurer, in the event of a claim payment, to step into the shoes of the insured investor and seek recovery from any person or entity as the insurer may consider appropriate. The insurer’s prospects for a successful recovery from a host government may be considerably enhanced if the insurer meets the nationality and eligibility criteria under the relevant investment treaty and the insurer’s claim derives from losses attributable to the host government’s breach of its investment treaty obligations. Alternatively, because PRI policies provide that the insured investor shall cooperate with the insurer in pursuing recovery from the host government, the investor may be called upon to act on its insurer’s behalf in the pursuit of remedies under an investment treaty or such other rights as the investor may have in the circumstances. If these conditions are present, what type of compensation would be due to an insurer as subrogee, or to the project enterprise fronting the recovery efforts on behalf of the insurer?
Investment treaties accept FMV or some formulation of market value (as opposed to book value and other non-market value approaches) as the most common measure of compensation in expropriation. For example:
US Model BIT (2004). The US Model BIT specifically refers to compensation at FMV and provides that investors are entitled to such compensation plus interest at a commercially reasonable rate.
French Model Bilateral Investment Treaty (BIT) (2006). France’s Model BIT provides that compensation for any “measures of dispossession” shall be equal to the “real value of the investments concerned.” Although the term “real value” does not in and of itself resolve whether compensation shall be on the basis of FMV, the relevant provision in France’s BIT adds that compensation shall be set “in accordance with the normal economic situation prevailing prior to any threat of dispossession.” The provision, therefore, approaches and is consistent with the notion of compensation at market value.
German Model Bilateral Investment Treaty (2008). Germany has generally been able to establish in its BITs with Bolivia, China, Mexico, Peru, Bulgaria and others, that compensation for expropriation must be determined by reference to the “value of the expropriated investment” immediately before the date on which the actual or threatened expropriation became publicly known. This probably means, from a practical standpoint, that the value of the investment will be its market value. It should be noted that Germany and Kuwait opted for a more elaborated language in their BIT that expressly refers to compensation at FMV and even provides additional guidelines as to how FMV should be calculated: “equivalent to the fair market value of the investment, as determined in accordance with recognized principles of valuation such as, inter alia, the capital invested, replacement value, appreciation, current returns, goodwill and other relevant factors.”
North American Free Trade Agreement (NAFTA). NAFTA’s standard of compensation follows the United States’ approach with respect to FMV but adds specific examples of valuation criteria, including “going concern value,” “asset value including declared tax value of tangible property” and “other criteria as appropriate to determine fair market value.”
The Energy Charter Treaty (ECT). The ECT provisions also expressly provide that compensation for expropriation shall amount to the FMV of the investment.
World Bank Guidelines on the Treatment of Foreign Direct Investment. The World Bank’s Development Committee issued relevant guidelines with respect to the appropriate compensation standards for expropriation. The guidelines not only establish that compensation to investors will be adequate if it is based on FMV standards, but also recognize certain acceptable approaches to determine FMV, including discounted cash flow calculations, liquidation value, replacement value or book value (so long as it has been recently assessed).
The state’s facility to agree to FMV standards in the text of its investment treaties and international instruments contrasts with the complexity of determining what FMV means in actual investment disputes.
FMV compensation lends itself to varied approaches: replacement value (American Independent Oil Company v. Government of Kuwait); diminution value (CMS Gas Transmission Company v. Argentine Republic); historical losses (Alpha Projektholding GmbH v. Ukraine); value to a well-informed third party (Azurix v. Argentine Republic); lost profits (Phillips Petroleum Co. Iran v. Islamic Republic of Iran) and others. The amount of the actual investments prior to the injury date has also been considered by some tribunals as an adequate basis for compensation at FMV (e.g. Metalclad Corporation v. United Mexican States, Compañía de Aguas del Aconquija S.A. and Vivendi Universal S.A. v. Argentina, Southern Pacific Properties (Middle East) Ltd. v Arab Republic of Egypt and others). It is also possible to find book value or liquidation value or share value as FMV approaches to compensate injured investors.
Tribunals often determine compensation using more than one valuation approach, such as combining replacement value with going concern value, or using different methodologies like sunk costs plus lost profits depending on the particular damages claimed. FMV is therefore always determined on a case by case basis taking into account the specific nature of the assets, the project, the injury date, the foreign enterprise’s track record of profitability, the local jurisdiction, contributory fault elements, concurring circumstances and a variety of other factors. There is no single FMV concept that fits every case. The fact that the determination of FMV is invariably one of the most litigated points in investment disputes illustrates the difficulty in connecting treaty wording (or policy wording for that matter) with the actual calculation of compensation when events materialize.
Implications of FMV for political risk underwriting.
To the best of our knowledge, political risk insurers do not expressly offer a blanket FMV compensation (i.e., without providing that it cannot exceed book value) for expropriation, forced abandonment or war-caused cessation of operations, although there may be rare exceptions.
Might underwriters offer FMV-based compensation?
Given the variety of methods to calculate FMV and the difficulty of finding an expert party whose calculations would readily be acceptable to host governments, the prospects of recovery of claim payments from those governments on a basis other than book value (if that) are not promising, absent an FMV-based arbitral award. Still, FMV compensation and, in particular, compensation based on forward-looking calculations, such as discounted cash flow methods or capitalization of earnings, might be offered under extraordinary circumstances.
For policy reasons, and assuming that underwriting aspects of the project suggest a low likelihood of a covered event occurring, some public agency underwriters might be willing to assume the added risks of higher compensation values and limited prospects of recovery from the host government, especially if the amounts at stake are not significant. In such cases the agency would probably discuss with the host government its intention to offer such coverage and seek a favorable reaction. Private sector underwriters are unlikely to take this step even where small amounts are involved because such business is not very profitable to begin with.
Even if an underwriter were willing to offer FMV-based coverage, it would be risky to do so until the foreign enterprise became successfully underway for a reasonable period of time; prior to that, market valuations might be too speculative a basis for coverage.
Were FMV-based coverage offered, for the avoidance of later disagreement underwriters would be wise to specify in the policy both the authority for determining FMV and the accepted methodologies, both of which specifications should be tailored to the specific investment and to what is most likely to be acceptable, in principle, to the host government (and thus has greater prospects of recovery).
FMV is likely to exceed book value, and insureds who would want FMV are likely to require substantially higher-than-book value limits to reflect that likelihood. How should the limits be established? In this negotiation, assuming that the cost of coverage will vary with that limit, the insured may have some difficulty deciding what it thinks it should request. The insurer likewise has to consider matters of exposure management, risk tolerance and what it thinks that FMV is likely to yield. Yet another complication is that FMV, however calculated, will vary over time.
Given the difficulties associated with FMV compensation, is there some middle ground—something better than book value—that investors and insurers might find acceptable, at least on a case-by-case basis? One approach could be to adjust compensation so that it reflects the value of the investment as it appears on the books of the insured rather than the value appearing on the books of the foreign enterprise.
Another approach, admittedly inviting much discussion during the damages stage of claims processing, would be for the underwriter to offer (in its sole discretion or otherwise): (i) to make adjustments to the foreign enterprise’s book value when such book value is substantially less than the fair market value of the foreign enterprise and/or (ii) to reflect the value of contracts or intangibles that do not appear on the books of the foreign enterprise.
Conclusion
FMV is a well-accepted standard in international law and practice, in investment treaties, and in investment dispute arbitrations, but it is an elusive standard that allows for many different approaches and techniques, and even these can yield different results in the hands of different experts. The availability of PRI coverage compensation on an FMV basis is likely to remain rare, but other alternatives to traditional book value compensation may be achievable. ■