Most submissions in international arbitration cases cite Chorzów Factory and the standard of full reparation under customary international law. The standard of full reparation enjoys widespread support. Yet its implementation always provokes intense debate. The devil lies in the details.
One of those details is debt financing. Many of the investor–state disputes recorded by UNCTAD have involved capital-intensive industries such as energy, water and financial services, where the use of extensive debt financing is typical.2 Accounting for outstanding debt is relevant to loss quantification in these cases, because international claimants tend to be shareholders and the damages claimed reflect shareholder loss. That is, a shareholder claims damages in its affected investment; the affected investment does not present its independent claim.3
This chapter considers several consequences of shareholders’ pursuit of international reflective loss claims.4
One consequence is the emergence of allegations of financial imprudence, typically directed by respondent states towards claimant shareholders. A common allegation is that claimants themselves were irresponsible in burdening an investment with excessive debt, prompting inevitably poor financial performance and a slide into financial distress. Such claims may be even more frequent after covid-19, given a general increase in debt levels and bankruptcy. The appropriate economic framework to assess allegations of financial imprudence is discussed below.
A second consequence concerns the magnitude of any shareholder reflective loss. Debt enjoys a priority right of payment, so a reliable damages analysis must first consider the impact of the measures at issue on the debtholders in an investment before quantifying any impact on shareholders. We explain that the presence of extensive debt typically reduces shareholder losses.
A third consequence relates to the incentives of both investors and a host state in the events leading to an arbitration. Extensive debt can sometimes lead to the escalation of a dispute, rendering arbitration the inevitable outcome. An analysis of financial incentives can often help explain the actions of the parties.
A common allegation by host states in international arbitrations is that claimant shareholders are the authors of their own misfortune. A claimant shareholder was imprudent, investing too little equity, while burdening an investment with too much debt. Counsel for the state may accuse claimants of inappropriately treating international arbitration like investment insurance, when the problem was always a claimant’s own financing choices and the inherent vulnerabilities.
Available evidence might confirm the presence of extensive debt financing. Accounting statements might reveal deteriorating financial performance, substantial debt and high financial leverage, which refers to the proportion of debt funding out of total investment funding. The extent of leverage might exceed that observed elsewhere, and may even have led to a restructuring or bankruptcy, either before or after covid-19.
Such evidence is informative and likely to be undisputed. However, it is insufficient by itself to indicate imprudent financing choices or excessive debt. Such conclusions require an analysis of causation. Did the measures at issue cause the observed deterioration in financial performance and the slide towards financial distress? Or was it just bad luck, or an inevitable consequence of under-investment and excessive risk taking by a claimant?
Assessing causation requires a detailed analysis of the financial impact of the measures at issue. The relevant analysis must reconstruct the financial performance of the investment in the absence of (but for) the measures at issue,5 and compare reconstructed performance to reality. Reconstructing financial performance can demand significant modelling effort, depending on the complexity of the investment in question and the terms of the relevant contracts or concessions. The modelling effort should aim to trace the evolution of key financial ratios such as financial leverage6 and debt service coverage ratios,7 and ultimately to identify if sufficient additional cash flows would have been available to satisfy outstanding debt obligations.
If so, then the company or project could have avoided bankruptcy in the absence of the measures at issue, and the measures at issue were the cause of the financial problems. If not, then financial distress was inescapable notwithstanding the measures at issue, and was either the result of bad luck unrelated to the legal claims or the inevitable consequence of poor financing decisions.
An analysis of claimant imprudence also needs to consider the original expectations of both the claimants and lenders when they undertook the loans.8 The available information at the time should inform the claimant’s financing choices; it would not be reasonable to second-guess them in the light of hindsight in general and the changed world following covid-19 in particular.
An investment’s debt capacity depends on the magnitude and certainty of expected cash flows.9 More debt is typically appropriate for activities with larger and relatively predictable cash flows; less debt for activities with smaller and highly volatile cash flows. More debt can provide significant financial benefits, including the imposition of business discipline and the opportunity to reduce a project’s overall tax bill, since debt interest is tax deductible in most jurisdictions. Business discipline includes a commitment to stay with a defined business, and to return the proceeds of the business to lenders instead of investing in new projects. However, the various advantages of debt can come at the expense of potential financial problems down the road.
The presence of financial risk per se is not evidence of undue risk taking. A major theory of finance defines the optimal debt level with reference to a trade off between the benefits of reduced tax payments on one side and the costs of potential financial distress on the other.10 From the perspective of this theory, eliminating financial risk altogether would be undesirable, since it would needlessly sacrifice project and shareholder value.
If debt is sizeable, third-party lenders will have had a natural financial incentive to perform due diligence on the borrower in question and to design the financing package to ensure the best possible chance of repayment. Prudent lenders will typically consider the legal rights and obligations of the borrower; analyse major business, market and technical risks; and develop a detailed financial model to forecast project cash flows that helps assess a project’s ability to meet its scheduled debt service.
Public bond offerings can also attract scrutiny from independent ratings agencies and investors. These sorts of considerations ultimately determine loan pricing; elevated risks naturally prompt higher interest rates.11
Analysing debt issuance and contemporaneous lender expectations is therefore likely to cast light on allegations of financial imprudence, in addition to but-for analysis. Lender expectations represent an important and independent reference point to assess the reasonableness of financing choices and, more broadly, a claimant’s overall expectations.12
ii Debtholder losses
The most that a shareholder can lose is the value of its equity in an investment.13 For example, if a state were to expropriate a house, the owner would lose only the value of its equity in the house, and not the entire value of the house itself.14
Allegations of overleverage primarily concern liability: the claimant shareholder caused its own downfall, not the host state. However, allegations of overleverage also have consequences for damages. Debt has a priority right to payment, so more debt implies that a larger share of project value must flow to debtholders before any residual value can flow to shareholders, including the claimant. Reliable assessments of shareholder damages must consider the priority payment of debt.15
Suppose a project were worth US$100 million, but that the measures at issue destroyed US$70 million of economic value, reducing the project’s value to US$30 million. Suppose also that the project was prudently financed with US$50 million in debt and US$50 million in equity. The project would face bankruptcy due to state measures, and the value would fall to US$30 million, with debtholders capturing all of the US$30 million in available value from the project after the measures. Debtholders incur a US$20 million loss, while the shareholder loses the entirety of its US$50 million investment.
Suppose that a shareholder then responds by initiating an international arbitration, but that the debtholders do not do likewise. This assumption reflects our experience that shareholder claims predominate in international arbitration, while debtholder claims are less common, in part because project lenders often are domestic banks that lack standing to claim protection from an international investment treaty. The shareholder would likely advance claims under the relevant treaty and pursue damages equal to the entire US$50 million value of its lost equity.
The US$50 million claim for shareholder reflective loss would be necessarily lower than the US$70 million of enterprise value destroyed by the measures at issue. Any damages claim for shareholder reflective loss must first account for the debtholders’ priority right to payment, and deduct the US$20 million in value lost to the debtholders. With only a shareholder claim and no corresponding debtholder claim in our example, a state could take a total of US$70 million in economic value, for which it would owe only US$50 million in shareholder damages.
The consequence of overleverage is to reduce the compensation owed by a state even further. Suppose that a shareholder had financed our US$100 million project with US$90 million of debt and US$10 million of equity. The ensuing shareholder arbitration would likely involve allegations of overleverage and imprudence, which could affect liability. However, the resulting shareholder damages would relate only to the shareholder’s US$10 million investment, after proper accounting of the US$90 million in outstanding debt. US$10 million is less than the damages available to a comparable claimant utilising much less debt financing (US$50 million, for example), and far less than the total economic harm caused by the measures at issue (US$70 million).
The possibility of debtholder losses can arise even before there has been an outright event of default or insolvency, which arises when the value of the assets falls below outstanding liabilities. We distinguish between the book or face value of debt, and its market value. Book or face values indicate the amount of debt outstanding at any point in time. Market values depend on the current value of prospective scheduled interest and principal payments, which depends on the risk of default, considering the returns available elsewhere given prevailing market conditions. Debt market values can fall prior to events of default or insolvency, and these falls can represent losses suffered by debtholders due to the measures at issue.16 A reliable damages analysis needs to consider the possibility that debtholders shared in the overall economic losses due to the measures at issue.17
The presence of extensive debt financing affects not just the analysis of liability and damages in an international arbitration, but also the incentives of both investors and a host state in the lead up to the arbitration. Extensive debt can render early settlement less attractive to both investor and state, and leave arbitration as the inevitable outcome. A careful analysis of debt and financial incentives can help illuminate the actions of the parties and the events leading to the dispute, with potential consequences for both liability and damages.
For example, the measures at issue may have left shareholders with little or no remaining value, while covid-19 may have administered a further blow. And with little left to lose, shareholders may prefer to escalate a dispute and run the risks of an investment arbitration rather than to pursue negotiations through the underlying project company. Negotiations between the underlying project company and the host state are likely to require the involvement and consent of lenders, and any resulting settlement value could largely flow to them in any event. Escalating a dispute in the hope of triggering a response from the host state and proceeding to arbitration provides a better chance of obtaining at least some equity return. Of course, shareholder damages in an arbitration would need to consider the priority payment of debt, as explained above, but at least the arbitration process might proceed directly between the shareholder and the state, without the complications of lender involvement.18
At the same time, extensive debt financing could create a disincentive for host states to seek alternative solutions. Suppose that a host state displayed some willingness to negotiate with the project company and even to provide compensation (albeit partial). The state would logically consider whether compensation would benefit foreign shareholders sufficiently to avoid arbitration.
The state might foresee that lenders could capture a large part of any compensation, leaving shareholders with little. The state might therefore fear that an arbitration with a shareholder would emerge in spite of any realistic payment to the project company. A settlement with the project company would not therefore solve anything, and would only serve to compensate debtholders, the one class of investor unlikely to arbitrate anyway.
These considerations do not relate to the possibility of multiple legal proceedings and the potential for double recovery. Table 1 illustrates a scenario in which payment of partial compensation to a project company would not impact the shareholder damages claim in a subsequent arbitration. The state makes a partial payment, but shareholder damages remain unchanged, not because of double recovery by shareholders, but because the state’s partial payment represents an effective payoff to debtholders via the project company.
Table 1 Shareholder damages unchanged by partial compensation to project company
|But for [A]||Actual [B]||Actual plus partial compensation [C]|
|Total value|| +||100||60||70|
|Debt|| see note||80||60||70|
|Equity damages|| [A]-||20||20|
|Notes:  [A] and [B]: assumed  [C]: [B]+|
The ability of shareholders to pursue reflective international claims can often give rise to claims of excessive debt, and a need to analyse the causes of financial distress. The relevant analysis involves detailed but-for reconstruction and a review of the claimant and lender due diligence undertaken at the time of any major financing decisions. Avoiding hindsight will be necessary given that higher debt and more bankruptcies will be a feature after covid-19. At the same time, quantification of shareholder reflective loss must consider whether debtholders have suffered a portion of any economic harm alongside equity holders. Extensive debt financing actually reduces the magnitude of shareholder damages, all else being equal. Extensive debt financing can also affect shareholder and state incentives, making the escalation of disputes more likely. Careful financial analysis can help to explain the incentives and actions leading to a dispute, with potential consequences for both liability and damages.