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Nationalisation and expropriation

18 March 2009

This is the fifth in a series of articles written by Philip Wood, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.

Most of the current discussions about the nationalisation of the banks deal with the ideology, e.g. whether governments can run banks properly, whether this is creeping socialism and the like. This is a continuation of the discussion which has been going on for a long time and which we are simply repeating.

No doubt everyone will have their views about the ideology. To a lawyer, however, nationalisation is one of the most fascinating and ancient of all legal topics. It has a history going back centuries, a history of plunder and looting, of passions, of cynicism, of hope and desperation.

The English king Henry VIII seizing monasteries and Karl Marx were only two of the leading exponents of the genre.

This distant trail of events culminated in an unexpected development in the 1990s which totally transformed the legal landscape of the subject. This development has real teeth, law with all its power.

Before we deal with this development, it is worth describing the background to nationalisation under customary international law.  

It is no surprise that national courts have adopted a standoffish attitude to governments which engage in state plunder without paying
for it.

Unlike the law of private property which applies to the rest of us, governments are permitted by international law to expropriate other people's property within their domain.  But they must pay for it – "prompt, adequate and effective compensation". That at least is the consensus of Western countries. There are other principles, such as that the expropriation must be for a public purpose, so that the taking of George Finlay's land by the King of Greece for his garden in 1836 did not qualify.

In former times, some nations had a different approach to sovereign states which expropriated their national creditors. Thus, British premier Lord Palmerston thundered in the 19th century:

"The patience and forbearance of HM Government… have reached their limits, and that if the sums due to the British Claimants are not paid within the stipulated time and in money, HM's Admiral commanding on the West Indian Station will receive orders to take such measures as may be necessary to obtain Justice from the nation in this matter."

Force was used by Great Britain, Spain and France against Mexico in 1861. In 1902 Venezuela was subjected to a military blockade. 

The 20th century is remarkable for both its triumphs and its terrors. It was also incidentally a winning century for expropriation – probably the outright victor.  The Soviets led off in 1917, followed by other communist revolutions up to the 1960s, then to be repeated by the decolonisation expropriations. In the meantime many governments elsewhere nationalised the commanding heights of their economies. The quick grab with tanks at the gates is still a favourite of populist governments – for example Bolivia in 2006.

Public international law  traditionally favours national sovereignty. It is therefore no surprise that national courts have adopted a standoffish attitude to governments which engage in state plunder without paying for it. Under the act of state doctrine adopted by many countries, including the U.S. and the UK, a private citizen cannot sue a foreign state for expropriation if the asset was within the territory of the expropriating state. There are exceptions to this rule and different attitudes by the various countries, but the bottom line is usually that a government can, if it wants to, expropriate foreign shareholders' and bondholders' assets if they are within the territory of the government concerned. Thus, the shares of locally incorporated companies will ordinarily be deemed to be local.

The law has been built up on intriguing cases involving, for example, Persian oil in a ship in Aden, Chilean copper, Indonesian tobacco, Ethiopian spices, Princess Olga Paley's pictures in her palace in Russia, and bank deposits in Jerusalem, Saigon and Havana.

So the position of the foreign investor under public international law is not so good. 

Enter the investment protection treaty. This is the major development alluded to above. These are treaties mainly between developed and developing countries.  They were designed to overcome various problems of the customary international law of expropriation, including the 1970s, developing country version embodied in UN General Assembly resolutions which purported to allow decolonised countries to seize assets without paying for them – a view not accepted by advanced countries. Most of these treaties are bilateral but there are several significant multilateral treaties such as NAFTA and the Energy Charter Treaty.

These treaties provide that, amongst other things, neither contracting party will expropriate investments made by investors of the other party unless in the public interest, on a non-discriminatory basis and on payment of prompt, adequate and effective compensation. They also have other clauses, e.g. each party will accord investments by investors of the other party fair and equitable treatment and will observe obligations entered into with such foreign investors, such as bonds (the famous "umbrella clause", an amazing version of a cross-default).

Suddenly these treaties are not just woolly, unenforceable obligations between sovereign states, but have real bite.

There are now almost 3,000 of these treaties, most of them signed since 1990.  The maps below give an idea of the spread of these treaties – some of these may not yet have been ratified. The number of treaties ratified is estimated at over 2,000.

The extraordinary point about these treaties is that most of them are expressed to be enforceable directly by the private investor. The private investor is therefore a third party beneficiary of the contract. Typically, they allow enforcement action to be taken in international arbitration. Tribunals and courts have dutifully given effect to these provisions. Hence, suddenly these treaties are not just woolly, unenforceable obligations between sovereign states, but have real bite. There is much litigation going on at the moment – there are at least 300 pending or concluded investor-state arbitrations, about 40 featuring Argentina. 

Many developing countries use these treaties to encourage investment by developed countries. But the obligations are reciprocal. Hence, if a developed country nationalises banks, the government needs to look at the detail of its treaties – as shown, many developed countries have got dozens of them. The bite can therefore be a bite-back, as the U.S. has found with NAFTA.

One has to read the treaty to see which investors and investments are covered and, in particular, whether there is a carve-out for banks, as there sometimes is. 

One of the most contested areas is compensation – there is a mountain of law on this. Most states these days do pay compensation, but there can be fundamental disagreements about value. The reality is that the value of an asset like shares in a distressed bank is notoriously difficult to fix with any kind of precision. There are also issues of causation – did the state really cause the loss or was it a doomed investment from the start?

Another complex issue is whether the taking actually falls within the treaty definition of expropriation. For example, under public international law at least, it is not an expropriation if a government takes over a bank by simply underwriting the securities which other shareholders have not taken up. It is not an expropriation if a government guarantees loans and takes them over by subrogation. It is not an expropriation if a government converts preference shares into equity or buys shares as a commercial deal agreed by the seller. 

But sometimes measures which are not an outright taking do constitute a creeping or indirect expropriation. When do taxes, or regulatory interferences, or even bank rescue laws intervening on private rights, or restrictions on operations, amount to an interference so dramatic as to be equivalent to a taking in overall effect?

The massive case law on bilateral investment treaties has involved some very fine distinctions. The removal of permits to operate broadcast stations or licences for rubbish tips (toxic assets again) have been held to be violations of the terms of treaties – if not of the expropriation clause, at least of some other equivalent clause in these wide ranging instruments.

Even if measures do not amount to any kind of expropriation, many measures may still amount to unfair and inequitable treatment, thus entitling the investor to compensation.

In any event, the game has changed. A previously free space is now tied down by the bonds of contract and, even in exceptional times, there is the distant growl of the rule of law. For governments battling to save their banking systems and their industrial companies, whether in advanced or emerging countries, this is just another issue on the plate.

Maps for Bilateral Investment Treaties - Germany

Further information

If you have any queries relating to this article, please email Philip Wood or tel: +44 20 3088 2552.