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Max Planck Encyclopedia of Public International Law [MPEPIL]

AAPL v Sri Lanka Case

Irmgard Marboe

International investment law — International minimum standard — Most-favoured-nation treatment (MFN) — International Centre for the Settlement of Investment Disputes (ICSID) — BITs (Bilateral Investment Treaties) — Arbitration — Damages — Interest, rate of

Published under the auspices of the Max Planck Foundation for International Peace and the Rule of Law under the direction of Rüdiger Wolfrum.

A.  Introduction

This arbitration is the first in which the jurisdiction of the International Centre for Settlement of Investment Disputes (ICSID) was based directly upon a bilateral investment treaty (‘BIT’) and not on a negotiated arbitration agreement concluded directly between the parties to the dispute (Investment Disputes; Investments, Bilateral Treaties); Negotiation; see also Compromis).. Due to this lack of an express agreement by the parties, there was no opportunity to agree on the choice of law. Therefore, the first interesting question concerned the law applicable to the dispute. Furthermore, the meaning of the obligation to provide full protection and security contained in a BIT represented a specific challenge to the tribunal. It had to be interpreted and applied in the context of a situation of severe internal unrest.(International Courts and Tribunals; Interpretation in International Law). The tribunal weighed it against the customary international law obligation of due diligence, and against the obligation of compensation for losses owing to war, revolt, insurrection or riot, the latter being a provision contained in a great number of BITs (Compensation; Reparations). Finally, the tribunal had to decide on the amount of damages, in particular on the applicability of the discounted cash flow method, and on the question of interest. The award was based on a majority vote, one arbitrator appending an extensive dissenting opinion.

B.  Summary of Facts and Contentions

The claimant, a company incorporated in Hong Kong, had invested in Sri Lanka through equity participation in Serendib Seafoods Ltd (‘Serendib’), a Sri Lankan public company established in 1983 for the purpose of cultivating and exporting shrimp. Serendib commenced operations in 1986 from its principal facility, a shrimp farm, in Eastern Sri Lanka. This area, however, became severely affected by a major insurrection of the Tamil rebels in 1986. On 28 January 1987, during a counter insurgency operation conducted by the Sri Lankan security forces, Serendib’s farm was destroyed.

In July 1987, the claimant filed a request for arbitration with ICSID pursuant to Art. 8 (1) Agreement for the Promotion and Protection of Investments (United Kingdom of Great Britain and Northern Ireland–Sri Lanka) (‘UK/Sri Lanka Agreement’), claiming compensation from Sri Lanka for the destruction of the farm (Investments, International Protection). It contended that Sri Lanka had violated its obligation to provide ‘full protection and security’ according to Art. 2 UK/Sri Lanka Agreement and therefore was internationally responsible for the damage suffered, ie the complete destruction of the farm (State Responsibility). As an alternative submission, the claimant relied on a supplementary argument based on Art. 4 (2) UK/Sri Lanka Agreement, namely the right to restitution or adequate compensation for the destruction of property by the State’s security forces not caused in combat action or not required by the necessity of the situation (Security; see also Military Necessity).

The respondent submitted that the standard of protection referred to by Art. 2 (2) UK/Sri Lanka Agreement to provide ‘full protection and security’ only required due diligence on the part of the State and reasonable justification for any destruction of property, but did not impose strict liability (Property, Right to, International Protection; see also Liability for Lawful Acts). The government of Sri Lanka had acted in pursuance of its sovereign right and duty to regain control and restore security in the region (Sovereignty). It maintained that the destruction of Serendib’s property was due to intense combat action between the Tamil rebels known as the Tigers, who were allegedly operating out of Serendib’s farm and violently resisted the counter-insurgency operation. The respondent emphasized that it would be ready to compensate for losses caused by ‘excessive destruction’. It doubted, however, whether this could be assessed by the tribunal without second-guessing tactical decisions made by commanders during the heat of combat. It was submitted that by investing in an area known as containing a vehement, and potentially violent, separatist presence, the claimant assumed the risk that its investment would be caught up in the Sri Lankan civil war.

C.  The Substantive Issues

1.  Applicable Law

Due to the absence of a freely negotiated arbitration agreement directly concluded between the parties among whom the dispute had arisen, there was no express choice of law to govern the dispute. The tribunal, however, found that the parties had acted in a manner that demonstrated their mutual agreement to consider the provisions of the UK/Sri Lanka Agreement as the primary source of the applicable legal rules (see also Sources of International Law). It referred, in particular, to the written and oral submissions of both parties in which they had relied primarily on this treaty as lex specialis and, within the limits required, on the relevant international or domestic legal rules as a supplementary source (see also International Law and Domestic [Municipal] Law).

The dissenting arbitrator submitted, by contrast, that the response by one party to the interpretation of particular provisions of the treaty by the other did not necessarily imply that the parties agreed that the treaty constituted the primary source of legal obligations but simply demonstrated prudence and caution on both sides. As there was no real agreement between the parties as to the rules of law which should govern the dispute, Art. 42 (1) sentence 2 Convention on the Settlement of Investment Disputes between States and Nationals of Other States should have prevailed which pointed to the law of the host State, thus Sri Lankan law, as the main source of law, together with ‘such rules of international law as may be applicable’.

2.  Full Protection and Security

The tribunal noted the fundamental differences of the parties with regard to the meaning of the obligation to provide ‘full protection and security’ embodied in Art. 2 (2) UK/Sri Lanka Agreement. The claimant submitted that this obligation went beyond the minimum standards of customary international law and created an unconditional obligation to be borne by the host country. According to the claimant, the ordinary meaning of the words ‘full protection and security’ (Art. 2 (2) UK/Sri Lanka Agreement) as well as their interpretation in the context and with regard to the object and purpose of the UK/Sri Lanka Agreement pointed to the acceptance by the host State of strict or absolute liability.

After a detailed analysis of the rules of treaty interpretation enshrined in Art. 31 Vienna Convention on the Law of Treaties (1969), relevant case-law and the opinions of legal scholars, the tribunal refused to accept that Art. 2 (2) UK/Sri Lanka Agreement imposed a strict liability in the event of failure to provide ‘full protection and security’. Such a liability was also not contained in other BITs concluded by Sri Lanka, such as the one with Switzerland submitted by the claimant. It therefore could not be invoked by virtue of the most-favoured-nation clause contained in Art. 3 UK/Sri Lanka Agreement, either.

With regard to the claimant’s alternative submission concerning the obligation to provide compensation for losses owing to war, revolt, insurrection or riot embodied in Art. 4 UK/Sri Lanka Agreement, the tribunal did not find convincing evidence proving that the losses were incurred due to acts committed by the governmental forces and not by the rebels, or that the destruction and losses were not caused by the necessity of the situation (International Courts and Tribunals, Evidence). Instead, it was of the opinion that the losses occurred in combat action which only obliged the host government to treatment no less favourable than that which it accords to its own nationals or companies or to nationals or companies of any third State.

10  The tribunal noted that this obligation did not include any substantive rule providing remedies to the foreign investor. It emphasized, however, that it contained an indirect rule the function of which was to effect a reference towards other sources which indicate the solution to be followed. By this renvoi, the host State’s responsibility became engaged if a failure to comply with its due diligence obligation under the minimum standard of customary international law were established.

11  The tribunal, therefore, turned to the question whether Sri Lanka’s responsibility could be sustained under international law, applicable by virtue of the renvoi provided for in Art. 4 UK/Sri Lanka Agreement, combined with the conventional standard of ‘full protection and security’ stipulated in Art. 2 (2) UK/Sri Lanka Agreement. After a review of the evidence submitted by both parties the tribunal came to the conclusion that the governmental authorities should have undertaken important precautionary measures to get all suspected persons peacefully out of Serendib’s farm before launching the attack (Precautionary Approach/Principle). If they had information that the rebels used the farm as a base of operations and support, the legitimate expected course of action against those suspected persons would have been either to institute judicial investigations against them or to undertake the necessary measures in order to get them off the company’s farm. The failure to do so was particularly serious in view of the fact that the highest executive officer of Serendib had confirmed his willingness to comply with any governmental request in this respect just ten days before. Accordingly, the respondent had violated its due diligence obligation by not taking all possible measures that could be reasonably expected to prevent the eventual occurrence of killings and property destruction. It was therefore responsible under international law.

12  The dissenting arbitrator submitted, however, that the precautionary measure envisaged by the majority opinion would only have been a reasonable police measure if the situation to be addressed were no more than an ordinary case of civil disorder. By contrast, in the face of a major insurrection launched by well-armed insurgents engaged in a sophisticated guerrilla warfare against the government (Land Warfare; Warfare, Methods and Means), it would be unrealistic and unreasonable to expect the government to remove suspect rebels from the farm by peaceful means before launching a sensitive security operation in the area (Reasonableness in International Law).

3.  Damages

13  According to the tribunal both parties were in agreement about the principle, according to which, in the case of property destruction, the amount of compensation due has to be calculated in a manner that adequately reflects the full value of the investment lost, thus, the value of the claimant’s shareholding in Serendib. The tribunal held that in the absence of a stock market at which the shares were quoted, it must, by an alternative method, determine the price a reasonable purchaser would have offered the claimant on the day before the destruction of the shrimp farm.

14  The tribunal first turned to the evaluation of the company’s tangible assets, such as the balance of global assets and outstanding indebtedness. Second, the tribunal examined the compensability of intangible assets as claimed by the claimant, mainly goodwill, and loss of future profits. In the opinion of the tribunal goodwill required prior presence on the market for at least two or three years. Serendib, however, had operated for less than one year. Furthermore it did not have records of profits and appeared under-capitalized. The tribunal therefore rejected the application of the discounted cash flow method as a tool to assess the company’s future profitability. It came to the conclusion that neither the goodwill nor the future profitability could reasonably be established with a sufficient degree of certainty. The amount awarded should therefore represent only the value of the tangible assets of the destroyed shrimp farm.

4.  Interest

15  Referring to the decision in the Alabama arbitration and other international arbitrations, the tribunal held that interest had to be considered as an integral part of the compensation itself. It decided that interest at a rate of 10% per annum should run from the date when the State’s international responsibility became engaged. According to the tribunal, this was 9 July 1987, the day after the claimant’s submission of the request for arbitration.

D.  Conclusion

16  The difficulty in this case lay in particular in the determination of the host State’s responsibility for damages incurred by a foreign investor during an internal armed conflict (Armed Conflict, Non-International). As the tribunal correctly pointed out, a State on whose territory an insurrection occurs is not responsible for loss or damage sustained by foreign investors, unless it fails to provide the standard of protection required by international law, either by treaty or under customary international law. If such standard is not provided, the State is internationally responsible, regardless of whether the damage occurred during an insurgents’ offensive act or resulted from governmental counter-insurgency activities. The level of protection required by international law has been the subject of a great number of awards and scholarly writings. According to the arbitral decision on the Spanish Zone of Morocco Claims the degree of vigilance required would differ according to the circumstances. In the absence of any higher standard provided for by the treaty, the degree of security reasonably expected would be necessary. The tribunal in the present case did not elaborate on the question whether the treaty obligation to provide ‘full protection and security’ (Art. 2 (2) UK/Sri Lanka Agreement) would be stricter than the due diligence obligation already required under customary international law. In view of the facts it came to the conclusion that even the latter standard of protection had not been met and that the State’s international responsibility was engaged, regardless of whether the damage was caused by the government security forces or by the rebels.

17  On the other hand, the tribunal drastically reduced the amount of damages claimed. The reasoning on this question is disputable. In particular, the standard of ‘prompt, adequate and effective’ compensation was only contained in the provision on compensation for expropriation in Art. 5 UK/Sri Lanka Agreement and not in the other UK/Sri Lanka Agreement provisions applied in this case. The tribunal referred to the agreement of ‘both parties’ (AAPL v Sri Lanka Case para. 88) to the effect that the amount due was to be calculated on the basis of the ‘full value’ (ibid) and, thus, the fair market value of the investment.

18  It is questionable whether the estimations of a hypothetical buyer with regard to the value of an asset can adequately reflect the damage actually incurred to a foreign investor. This is particularly true in light of on-going internal unrest when a reasonable buyer might not envisage future prospects of the asset at all and thus allocate a fair market value approximating zero. The separation of tangible assets from goodwill and future profitability in determining fair market value would not be in accordance with common economic valuation techniques. Instead, the principle of full reparation as formulated by the Permanent Court of International Justice (PCIJ) in Factory at Chorzów (Germany v Poland) should be followed according to which the financial situation of the affected individual before and after the unlawful act of the State must be compared (German Interests in Polish Upper Silesia, Cases concerning the ; Reparations).