Expropriation and default: Recourse against Russia through Arbitration

Since Russia’s invasion of Ukraine, its commercial relationships with the rest of the world have either collapsed or are under considerable strain - is recourse available to investors through international arbitration?

Introduction: ties with Russia under strain

As the Russian invasion of Ukraine continues, pre-existing commercial relationships between Russia and the rest of the world continue to come under intense pressure, particularly in light of Western sanctions. There are large volumes of Russian sovereign debt in circulation throughout the West, and many multi-nationals still have business interests in Russia.

Draft legislation introduced in the Russian Duma (one of the chambers of the Russian parliament) looks set to allow Russia to expropriate or nationalise assets of foreign investors. In addition, (as we noted in our previous insights piece) on 7 June 2022, the Credit Derivatives Determination Committee (CDDC) (the body responsible for making factual, evidence-based determinations to apply definitions in respect of credit default swap documentation) issued a statement determining that Russia had defaulted on certain of its sovereign debt obligations. Further reports of default have arrived even more recently: on 26 June 2022, Russia came to the end of its 30-day grace period following its failure to make a $100m interest payment due on 27 May 2022. Russia says their failure to make this payment was caused by Western sanctions. Each of these developments will have significant implications for investors with Russian interests, who will need to consider potential routes of recourse to protect their investments. As this article will explain, pursuing claims against Russia via investment treaty arbitration may present a solution to those investors who are otherwise faced with significant impaired assets on their balance sheets.

This article will examine the implications of (i) the potential expropriation by Russia of the assets of foreign investors and (ii) a Russian sovereign debt default, and potential avenues of recourse that may be available through investment treaty arbitration. Although challenges remain around enforcing any award against Russia (and with enforcement in Russia out of the question), persistent and patient investors may be able to recoup their losses.

Proposed expropriation legislation

Since Russia’s invasion of Ukraine and the announcement of Western sanctions, hundreds of multi-nationals have announced their intentions to scale back or shut down their business operations in Russia – including many in the consumer services, energy and construction sectors.

In light of this, and in response to the international sanctions imposed on Russia following its invasion of Ukraine, on 8 April 2022, the Russian Duma introduced a draft law which would allow Russia to expropriate the property of foreign nationals/companies from “unfriendly” countries, ie those that have imposed sanctions on Russian entities and individuals.¹ On 24 May 2022, the bill passed its first reading by the lower house of Russian parliament. As at the date of this article, the bill has yet to go through its detailed second reading and third formal reading, which it must pass before it is reviewed by the upper house and signed into law by Vladimir Putin. If it passed, the law could have retroactive effect from 24 February 2022.

In summary:

• The proposed regime would give Russian courts the power to appoint an ‘external administrator’ of a foreign-owned Russian company if: (1) 25% or more of that company’s shares are owned by foreign shareholders based in “unfriendly” states, and (2) the company has either exited Russia or taken actions to terminate its business there. If those grounds are satisfied, then the Russian courts may appoint a Russian State entity, or other Russian entities, as the external administrator.
• The external administrator would be entitled to liquidate the company and transfer all of its assets to a new company. The shares (and therefore the seized assets) of the new company would then be transferred and sold by way of public auction (in which the original shareholders would not be permitted to participate). The external administrator would have priority to purchase the new shares. If no bidders participate, the Russian government may purchase the shares, at a price to be set by the Russian Ministry of Economic Development.
• The draft bill expressly states that seizure is to be carried out without compensation and that the original shareholders’ right of ownership over the company is to be terminated.

Sovereign wealth default

Since the start of Russia’s invasion, there have been a number of potential credit default events in respect of its sovereign bonds:

• On 4 April 2022, due to the US Treasury blocking Russia from accessing its US dollar reserves in US banks, Russia technically defaulted on its sovereign debt by failing to pay its 2022 (interest) and 2042 (principal) Eurobond obligations in US dollars, instead sending the Ruble equivalent of $650m to its own National Settlement Depository.
• On 29 April 2022, Russia made an attempt to repay $649.2m (in US dollars – the currency specified on the bonds) to foreign banks in respect of its 2022 and 2042 Eurobonds.
• On 11 May 2022, bondholders of the 4.5% 2022 Russian sovereign bonds submitted a default notice via Euroclear demanding the payment of approximately $1.9m in accrued interest payments in respect of the delayed principal repayment upon maturity of the bonds as Russia did not include accrued interest beyond 4 April 2022 in its 29 April 2022 payment.
• On 1 June 2022, the Credit Derivatives Committee recognised that that the technical default of 4 April 2022 had converted into a real default after the grace-period as Russia did not pay the 30-day grace period interest of c. $1.9m.

In the event of a bond default, the usual course would be to look to the dispute resolution provisions in the bond itself. In this case, Russia has expressly stated in its offering circular for the 2022 and 2042 Eurobonds that it has not waived its right to sovereign immunity and has not submitted to the jurisdiction of any court. This is likely to make litigating these instruments through domestic Courts very challenging. Investors will therefore need to consider alternative routes to enforce their rights under the bond documentation against Russia.

Investment treaties and their availability

In light of the developments highlighted above, investors should consider whether they can invoke the protections found in any applicable investment treaties. A bilateral investment treaty (a “BIT”) is an investment treaty between two States, which guarantees certain standards of treatment for investors, including guarantees of fair and equitable treatment, protection from unlawful expropriation and unfair / discriminatory treatment, and a guarantee that investments / income can be repatriated to the investor’s home State.

Where these standards are violated by the host State, BITs typically allow foreign investors to bring claims for breaches of their provisions before independent arbitration tribunals – providing a neutral forum to resolve the dispute. Russia currently has 62 BITs in force with other jurisdictions, including 27 BITs with “unfriendly” states (eg the UK, Singapore, France and Germany - but notably not the United States).²

The scope of Russia’s consent to arbitrate disputes under its BITs varies between treaties. Many of Russia’s late Soviet-era BITs (eg its BIT with the UK) provide that only certain types of disputes may be arbitrated. By contrast, BITs negotiated by Russia in the late nineties provide for a wider array of claims to be arbitrated.

To benefit from investment treaty protection, (assuming the offer to arbitrate in the treaty is wide enough to cover the dispute) a would-be claimant must usually qualify as an “investor” with an “investment” in Russia, as defined in the treaty. These definitions vary between treaties, but they are typically very broad. “Investor”, for example, usually means a national of the contracting State or a company incorporated there. Similarly, most asset classes will fall within the definition of “investment”.

Some BITs also permit claims in respect of investments which are indirectly owned, allowing the corporate structuring of investments to take advantage of BIT protections. Investors should take note, however, that it is too late to start restructuring investments to take advantage of BITs with Russia; a claimant must have been an “investor” with an “investment” within the meaning of the treaty at the time the relevant breaches by the host-State took place.

Investors with pre-2009 investments in the Russian energy sector may also be able to rely on protections found in the Energy Charter Treaty (the “ECT”). The applicability of the ECT to investments in Russia is controversial; Russia signed the ECT in 1994 but never ratified it, which meant that it applied provisionally. Russia sought to terminate that provisional application in 2009, triggering a 20-year “survival” mechanism. This arguably means Russia will remain bound by investment protection guarantees in the ECT until 2029. Russia denies having consented to arbitration under the ECT, however in the famous Yukos case an arbitral tribunal dismissed Russia’s jurisdictional objection on this point.³

What protections might investors invoke against Russia?

Expropriation legislation

Although States have a sovereign right to introduce measures concerning the nationalisation, seizure or forced sale of any privately owned assets, international law recognises that such expropriations require fair market value compensation where the assets are owned by foreigners. The difficulty is finding a forum in which an international law claim can be made and a binding award rendered.

Most of the BITs with Russia protect against acts of expropriation “except for a purpose which is in the public interest and is not discriminatory and against the payment, without delay, of adequate and effective compensation” or words to that effect (eg Article 5(1) of the Russia-UK BIT; Article 5(1) and 5(2) of the Russia-Singapore BIT). These BITs typically require that in return for the expropriation the compensation shall amount to “the real value of the investment expropriated” or words to that effect (eg Article 5(1) of the Russia-UK BIT). The effect of these provisions is to allow States to expropriate investments legitimately if they can satisfy certain conditions (eg the provision of adequate compensation).

The draft bill being introduced by the Russian Duma expressly seeks to deny such compensation; no attempt appears to have been made to provide for the repatriation of the value of the assets to the foreign investors, notwithstanding the provision for a public auction. The expropriation of foreign assets effected by Russia pursuant to the draft legislation may therefore give rise to a claim for unlawful expropriation under applicable investment treaties.

Default on bond obligations

Russia’s failure to make the required payments on its 2022 and 2042 Eurobonds could give rise to a claim pursuant to any “umbrella clause” in the applicable treaty. Arbitral tribunals are divided on the effect of umbrella clauses, however in some cases such clauses have been held to have the effect of elevating contractual breaches to the status of treaty breaches (and therefore could be relied on by investors to assert that Russia’s breaches of its contractual obligations in its bond documentation are breaches of the relevant treaty). As discussed above, however, many of Russia’s early Soviet-era BITs do not provide for consent to arbitrate claims other than in respect of compensation due in relation to an expropriation, thereby ostensibly excluding claims pursuant to the umbrella clause.

Even where the arbitration clause in the BIT provides that such claims may be arbitrated, Russia is likely also to raise jurisdictional defences in relation to the definition of “investment” and whether, on a true interpretation, it includes the Eurobonds. Russia may argue that the threshold jurisdictional requirements needed to access international arbitration are not met because sovereign debt does not qualify as a “protected” investment under certain BITs. In landmark investment treaty cases against Argentina following its sovereign debt crisis, including Abaclat (which involved approximately 60,000 claimants)⁴ and Ambiente Ufficio⁵, arbitral tribunals found that interests in sovereign debt were entitled to protection under the Argentina-Italy BIT. By contrast, the tribunal in Poštová found that interests in sovereign debt were not protected investments under the specific terms of the Slovakia-Greece BIT.⁶

The availability of claims in respect of Russia’s sovereign default is therefore likely to be highly dependent on the specific terms of any applicable treaty.

Enforcement

Where a claimant is successful in an investment treaty arbitration, the tribunal will usually grant an award of damages in their favour. Arbitration awards may be enforced across the world, in one or more of the 169 State-signatories to the New York Convention.

However, the prospects of enforcement against Russia should (rightly) give many investors pause for thought before bringing claims. Russia has a poor track record when it comes to satisfying arbitration awards, and has long pursued a concerted strategy of organising its investments so as to make enforcement against it as difficult as possible. That approach is evidenced by the scores of investors with historic and (as yet) unsatisfied awards against the Russian State – such as the investors in the Yukos case, who are still seeking to enforce a $50bn award against Russia which was originally awarded in 2014.

Nevertheless, it has been reported that there are currently assets of the Russian Central Bank worth over $280bn frozen in the territory of seven Member States of the New York Convention.⁷ In most jurisdictions, reserves of foreign central banks are recognised as subject to sovereign immunity and therefore unavailable for enforcement. However, there is no telling how the war in Ukraine will progress, and what levers, beyond sanctions, nations may seek to deploy against Russia (and correspondingly, in what direction the law in this area may move). Persistent investors who are willing to test the law in this area may be able to find a way through to accessing these funds.

Those investors who are prepared to take an even longer-term view on Russia’s relations with the West may also be encouraged by the fact that there is no time limit within which they must enforce an arbitration award. As a result, despite the drawbacks and the difficulties, seeking relief through investment treaty arbitration may the most viable option for investors seeking to protect value on their balance sheets.

¹ This list includes the United States, Canada, the EU states, the UK, Ukraine, Montenegro, Switzerland, Albania, Andorra, Iceland, Liechtenstein, Monaco, Norway, San Marino, North Macedonia, and also Japan, South Korea, Australia, Micronesia, New Zealand, Singapore, and Taiwan https://tass.com/politics/1418197?utm_source=google.com&utm_medium=organic&utm_campaign=google.com&utm_referrer=google.com
² https://globalarbitrationreview.com/insight/know-how/investment-treaty-arbitration/report/russia
³ Yukos Universal Limited (Isle of Man) v. Russia, PCA Case No. 2005-04/AA227, Interim Award on Jurisdiction and Admissibility, 30 November 2009, paras. 106-174 (setting out Russia’s position) and paras. 289-294 (Tribunal’s decision)
⁴ Abaclat and Others v. Argentine Republic, ICSID Case No. ARB/07/5 - ita0236.pdf (italaw.com)
⁵ Ambiente Ufficio S.p.A. and others v. Argentine Republic, ICSID Case No. ARB/08/9
⁶ Poštová banka, a.s. and ISTROKAPITAL SE v. Hellenic Republic, ICSID Case No. ARB/13/8 italaw4238.pdf
⁷ https://www.nbcnews.com/data-graphics/russian-bank-foreign-reserve-billions-frozen-sanctions-n1292153