Readers of the last edition of this Newsletter will recall our discussion of the importance and challenges of developing PRI wordings that are clear and appropriate. We invited Frederick Jenney and Thomas Eldert of Morrison & Foerster LLP to explore a problem of meaning and wordings of a particular interest: regulatory takings.

In the past, expropriation events tended to involve explicit government expropriatory acts, such as wholesale nationalizations in Cuba, Libya and Iran. For the political risk insurance business, those were the good old days — at least with respect to clarity.

Today, outright nationalizations have become relatively uncommon, replaced instead with varying degrees of regulatory actions, ranging from the transparent, such as recent actions in Bolivia and Venezuela, to the more subtle, such as targeted environmental or consumer safety laws. In extreme cases, regulatory action can constitute a type of expropriation known as a “regulatory taking”. Until recently most political risk insurance policies have covered expropriations generically, without distinguishing outright expropriations from regulatory takings. Unfortunately, recent evolution of international law has made that approach nearly unworkable.

Scope of the Problem of Defining Wrongful Regulatory Takings

Limits of Traditional Expropriation Coverage

To an investor, any regulatory action that causes significant economic harm to its investment seems like an expropriation that should be covered by political risk insurance expropriation coverage.

However, expropriation coverage is not designed to protect against the effects of most regulatory actions. The reason is basic: when a political risk insurer pays an expropriation claim to an insured investor, the insurer needs to be in a position to make a claim back against the host government for its action.

A host government, however, is only liable for the consequences of its actions if those actions are unjust (or “wrongful,” as lawyers tend to say), as opposed to legitimate. Legitimate regulatory actions do not give rise to a right of recovery against the government. If they did, no government could afford to make changes to a regulatory regime.

But what actions are “legitimate” is a complex question. The host government’s internal law regarding takings has long been rejected as a standard for legitimacy, in large part because the same government that takes the regulatory action in question can change the internal law (or the interpretation of it) as to the legitimacy of that action.

Need to Resort to International Law

Accordingly, a body of international law, not dependent on the law or interpretation of any one country, has developed as the standard for expropriation claims against a host government. In turn, most political risk insurance policies over the years have required that for there to be an expropriation, the government’s actions must be in violation of this standard of international law.

Traditional international law regarding takings is complex, but generally has required that, to be legitimate, a taking must be (i) for a public purpose, (ii) nondiscriminatory, and (iii) accompanied by just compensation.

Application of the traditional standard to regulatory takings has proven to be difficult. Because of the “public purpose” test, normal regulation or change of law is not a wrongful action under international law—and therefore is not an insurable event under political risk insurance expropriation coverage. On the other hand, it is easy to imagine a host government attempting to cloak a wrongful expropriation with the appearance of legitimate regulatory action.

Problems With International Law as a Standard

International law has some serious shortcomings, many of which are evident in regulatory takings cases. There is no system under international law, much of which is determined by arbitral tribunals, for assuring consistency of results, reasoning, or analysis. International tribunals have no stare decisis principle (i.e., requiring consistency with previous decisions), there is no appeals process to review the rationale for decisions, and there is no World Supreme Court to sort out inconsistent results. As a result, current international law on the subject of regulatory takings can be fairly characterized as vague, inconsistent, evolving, political and (ultimately) unclear.

Problems for Political Risk Insurers in Defining Regulatory Takings

The prevalence of host government actions that clearly impair a foreign investor’s position but are not clearly wrongful presents a big problem for a political risk insurer seeking to offer expropriation coverage. Put simply, the goal for an insurer is to write policy language that describes regulatory actions that are as likely as possible to be violations of international law, so that the insurer has a right of recovery against the host government. But given the confused state of international law, how can this be done? Recent discussions among political risk insurers have focused on the following questions: Should a policy define expropriation by (a) attempting to define the difference between legitimate regulation and wrongful expropriation, or (b) referring to international law to draw that line? If a cross-reference to international law is impractical, how should specific policy language draw the line between legitimate regulation and wrongful regulatory taking?

Analysis of Regulatory Takings Cases

In recent years roughly twenty regulatory takings cases have been brought before international arbitral tribunals. In an attempt to find a consensus as to the key elements of what constitutes a regulatory taking, we reviewed eight of the leading international opinions and decisions involving alleged regulatory takings from the past seven years. Most of these were NAFTA and BIT cases, which collectively have developed new theories of regulatory takings under international law.

Not surprisingly, the arbitrators in these eight cases took a variety of different and sometimes inconsistent approaches. Each case hinged on two or three (or more) factors, but the tribunals generally did not state which factor was determinative in rendering an award, and did not comment on relative weighting of factors. Looking at recent arbitration cases to try to determine key elements of a workable standard for political risk insurance, we were able to ascertain some broad principles and common factors.

Three Key Dimensions Emerge

We believe that the factors that correlate closely with an overall finding that there was a regulatory taking can be grouped analytically in terms of the nature, subject, and effect of the regulatory action. Our analysis was limited to correlation between specific case factors and a finding of a regulatory taking.

Nature of the Host Government Regulatory Action

The first dimension that we considered was the nature of the regulatory action that the host government took. In descending order of apparent correlation, the key factors for this dimension were as follows:

  • Confiscation (of something) WAS correlated with a finding of a taking;
  • Transfer (of something) to a third party WAS correlated with a finding of a taking;
  • Deprivation (of something) to the investor WAS correlated with a finding of a taking; but
  • Mere interference (with something) generally was NOT correlated with a finding of a taking.

In other words, these arbitral tribunals have generally found that, to be compensatory, a regulatory action must involve the confiscation, transfer or deprivation of an asset, but not mere interference with an asset. Thus, a law forbidding foreign ownership of paper mills would clearly be confiscatory and satisfy this prong, while a law requiring paper mills to have only local managers might be an interference, but would not satisfy this prong.

Investor Rights That are the Subject of the Regulatory Action

In descending order of apparent correlation, the key factors for this dimension were as follows:

  • Impairment of ownership rights of the investor in the foreign enterprise WAS correlated with a finding of a taking
  • Impairment of management and control of the foreign enterprise WAS correlated with a finding of a taking
  • Impairment of other fundamental rights or benefits of the investor WAS correlated with a finding of a taking
  • Impairment of enjoyment of property by the investor was NOT correlated with a finding of a taking
  • Impairment of revenue stream to the investor was NOT correlated with a finding of a taking

That is, arbitral tribunals tend to find regulatory takings where fundamental ownership rights, including ownership, management and control of an enterprise, are affected, and no takings where only enjoyment of property and revenue streams are affected, even if the investor’s ability to realize a profit from that investment is curtailed. For example, a new tax on a paper mill as a foreign-owned enterprise might appear unfair and would certainly affect revenue streams, but would not likely constitute a taking. Although some panels have found a total or near total deprivation of revenue streams to be a taking, tribunals generally do not find a taking where the investor retains control of its investment.

Required Degree of Effect

Generally we found that:

  • A regulation that had a permanent effect on the investment WAS correlated with a finding of a taking, whereas one that had only a temporary effect was NOT correlated; and
  • A regulation that affected the total investment WAS correlated with a finding of a taking, whereas one that had only a partial impact on the investment was NOT correlated; and

For a regulatory action to constitute a taking, its effect must be permanent. An emergency regulation that shuts a factory down for a week may affect profits, but does not rise to the level of a taking. Accordingly, tribunals are likely to find that delays in economic opportunities caused by regulations do not constitute a taking. Similarly, the regulation must have a total or near total effect on the investment. Interference with some rights of ownership (e.g. requiring one board member to be government appointed) would not constitute a taking, while deprivation of all rights (e.g. requiring a controlling majority of the board to be government-appointed) likely would.

Three Approaches to Avoid in Regulatory Takings Analysis

Finally, we note three aspects of political risk insurance policy language that are not helpful in delineating legitimate from wrongful regulatory actions.

Exclusion for Police Powers Not Relevant

Some political risk insurance policies exclude actions taken within an exercise of a host government’s so-called police powers (a government’s authority to regulate behavior and enforce order within the country). However, several tribunals have found that governments invoking police powers nevertheless violated international law, essentially concluding that the defense cannot excuse an inequitable expropriation. In other words, the international legal concept of “police power” provides no effective safe harbor for expropriating regulation. The trend seems to be that tribunals in general pay little heed to “police powers” arguments, such that they are basically inoperative. We therefore conclude that there is no longer any correlation under international law between the use by a government of its police powers and the finding that there has been no expropriation.

Exclusion for “Regulation of the Economy” Overbroad

Many political risk insurance policies also include an exclusion from coverage for “ . . . bona fide non-discriminatory measures of general application of a kind that governments normally take in the public interest for such purposes as ensuring public safety, raising revenues, protecting the environment, or regulating economic activities.”

The first three examples (ensuring public safety, raising revenues, protecting the environment) seem generally to correlate with a finding of a legitimate action by the host government. However, “regulation of economic activities” is not helpful in defining a legitimate action by the host government. Because those three words describe almost all regulation, they effectively eviscerate any coverage for regulatory takings.

Purpose Doctrine Not Relevant

Increasingly tribunals look to the effect of a Host Government action, rather than the intent behind it. Similarly, some political risk insurance policies exclude acts taken by the government with the intent to achieve legitimate public policy objectives. This language invokes the so-called “purpose doctrine,” in which a claim of regulatory taking is analyzed paying particular attention to the government’s purpose (whether stated or not) in enacting it. Applying the “purpose doctrine” serves only to increase the already unpredictable nature of tribunal decisions, and has fallen into disfavor generally.

Possible Policy Language and Some Conclusions

As noted above, reference in a political risk insurance policy to a “violation of international law” is confusing and unsatisfactory to insureds, and in any event causes more problems than it solves. Therefore, given the principles outlined in this article, a political risk insurer could attempt to define in policy language those regulatory takings that are violations of international law — or at least the subset of them that the insurer wishes to cover. Some political risk insurers have discussed the following sample regulatory takings language that addresses most of the issues (direct expropriation would be defined separately; provisions in brackets relate to issues not addressed in this article):

  • Indirect Expropriation means an act or series of acts by the Host Government, whether expressly regulatory in intent or not, that result in:
  • the Permanent confiscation, transfer or destruction of substantially all current and future economic benefit to the Insured of owning the Insured Investment, whether or not legal ownership has been affected, or
  • the Permanent deprivation of substantially all the fundamental rights and benefits to the Insured of ownership of the Insured Investment; provided, however, that it is not Indirect Expropriation if:
  • The acts constitute mere interference with the use, enjoyment, or disposal of the Insured Investment or diminution of the revenue stream or rate of return to the Investor from the Insured Investment; or
  • The acts (x) are taken by the Host Government to achieve legitimate public interest objectives, such as protection of the environment, public health, and public safety, and [(y) are proportional to the public interest intended to be served, taking into account the legal protection granted to the investment and the degree of financial impact on the investor]; or
  • [the actions violate international law principles of “fair and equitable treatment” or “national treatment” or “most-favored nation treatment”, but do not otherwise meet the requirements of an Indirect Expropriation as defined herein.]

Caveats and Conclusion

Given that there is no consistency in international arbitral awards with respect to regulatory takings, this language—and indeed any policy language constructed to embody the current international law on the topic—will prove to be imperfect. Nevertheless, some variation on this language would more closely align the expectations of insureds and insurers with respect to regulatory takings coverage. Surely some improvement is long overdue.■