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Max Planck Encyclopedia of Public International Law [MPEPIL]

AAPL v Sri Lanka Case

Irmgard Marboe

Subject(s):
International investment law — Most-favoured-nation treatment (MFN) — International minimum standard — Damages — BITs (Bilateral Investment Treaties) — Arbitration — 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 between the parties to the dispute (Investment Disputes; Investments, Bilateral Treaties); Negotiation; see also Compromis). Due to the lack of an express agreement on the choice of law, 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 needed to be interpreted by the tribunal. It had to be 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 large 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 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 argued 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 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 it agreed that the treaty constituted the primary source of legal obligations but simply demonstrated prudence and caution. As there was no mutual agreement between the parties as to the rules of law governing the dispute, the dissenting arbitrator maintained that Art. 42 (1) sentence 2 Convention on the Settlement of Investment Disputes between States and Nationals of Other States should have prevailed and that the majority had erred in not applying Sri Lankan law as the main source of law together with ‘such rules of international law as may be applicable’. According to this approach, Art. 157 of the Sri Lankan Constitution, which would have allowed the weighing of the obligations under the bilateral investment treaty against actions taken in the interest of national security, should have received more attention.

2. Full Protection and Security

The tribunal noted the fundamental differences of the parties’ interpretation 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 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 served as a reference towards other sources indicating the solution to be followed. By this renvoi, the host State’s responsibility would be entailed if a failure to comply with its ‘due diligence’ obligation under the minimum standard of customary international law were established. The tribunal added that any foreign investor, even if that investor’s national State had not concluded with Sri Lanka a bilateral investment treaty containing a provision similar to that of Art. 2 (2) UK/Sri Lanka Agreement, would be entitled to a protection which requires ‘due diligence’ from the host State, ie Sri Lanka.

11 The tribunal consequently turned to the question whether Sri Lanka’s responsibility was entailed under customary 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. It extensively considered pertinent case law, starting from the Spanish Zone of Morocco Claims, and academic literature in order to establish the level of protection required under customary international law. After a review of the evidence submitted by both parties the tribunal came to the conclusion that the governmental authorities should have undertaken precautionary measures to get suspected rebels 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 for operations and support, the expected course of action would have been either to institute judicial investigations against the suspected persons or to undertake the necessary measures 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 earlier. The tribunal concluded that 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. Sri Lanka was therefore responsible under international law.

12 The dissenting arbitrator argued that the precautionary measures envisaged by the majority would only have been a reasonable police action if the situation in question had been no more than an ordinary case of civil disorder. However, 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 suspected 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 that, in 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, an alternative method must be applied to determine the reasonable price a willing 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. It then proceeded to examine the compensability of the loss of intangible assets, mainly goodwill, and the loss of future profits. The tribunal opined that goodwill required prior presence on the market for at least two or three years. Serendib, however, had operated for less than one year, did not have a record 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 value. 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.

15 Taking note of the claimant’s offer to give up its shares in Serendib, the tribunal invited the two parties, upon reception of the amount awarded, to conclude an agreement according to which AAPL would transfer all its shares in the company to the government of Sri Lanka or to any other entity the government might nominate. Such transfer would also include the passing of any potential liability under a bank guarantee from AAPL to the new owner of the shares.

16 The dissenting arbitrator pointed out that the tribunal, in its determination of damages, should have appropriately distinguished Art. 4 (1) from Art. 4 (2) and Art. 5 UK/Sri Lanka Agreement. The first of these, unlike the two other provisions, did not mandate the payment of compensation, but merely prescribed national and most-favoured-nation treatment with respect to compensation in case of losses suffered owing to war or other armed conflict. He was, moreover, critical of the fact that despite the absence of a stipulated compensation standard the majority arrived at a quantum of compensation relying on rules and principles that are normally applicable to the calculation of compensation for expropriation or compensation for damage to property under Art. 4 (2) UK/Sri Lanka Agreement. He suggested the actual amount of the claimant’s equity contribution as the fairest basis for compensation, if any. This would represent an amount he would have also recommended as an ex gratia payment by the government, if the tribunal had been competent to decide the case ex aequo et bono.

4. Interest

17 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. The tribunal also took into consideration that, according to Art. 8 (3) UK/Sri Lanka Agreement, the foreign investor became entitled to file a recourse before ICSID only in case agreement with the host State could not be reached within three months. It concluded that interest should therefore begin accruing from 9 July 1987, the day after the claimant’s submission of the request for arbitration.

D. Conclusion

18 The difficulty in this case was in particular the determination of the host State’s responsibility for damage incurred by a foreign investor during an internal armed conflict (Armed Conflict, Non-International). As the tribunal 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 a standard is not complied with, 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 large number of awards and academic publications. According to the arbitral decision on the Spanish Zone of Morocco Claims, the degree of vigilance required depended on the circumstances. In the absence of any higher standard provided for by a 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) was stricter than the ‘due diligence’ obligation already required under customary international law. In view of the facts of the case, the tribunal came to the conclusion that even the customary law standard of protection had not been met and that the State’s international responsibility therefore became engaged. In front of this background it did not matter whether the damage incurred by the investor was caused by the government security forces or by the rebels.

19 On the other hand, the tribunal only awarded a relatively modest amount of money in comparison with the damages claimed. The main reason, according to the tribunal, was that a willing buyer would have estimated a low profitability of the shrimp farm at the time of its destruction. However, the assessment by a willing buyer is not necessarily pertinent in the case of a violation of international law. It rather pertains to the standard for the calculation of compensation upon expropriation. 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 victim before and after the unlawful act of the State must be compared (German Interests in Polish Upper Silesia Cases).

20 Relying on the balance sheet of the company and comparing the assets with the outstanding indebtedness is a valuation approach a hypothetical willing buyer would most probably not apply. It rather represents a variant of the book value method, which is generally not regarded as an appropriate tool to assess the value of a company because of its dependence on legal, taxation, and other factors. The Chorzów standard, in contrast to the expropriation standard, does not depend on the hypothetical willing buyer’s perspective but provides rather broad discretion to tribunals. It allows for various valuation approaches, including the book value method or, as the dissenting arbitrator recommended, an approach relying on the amount of equity investment.

21 An appropriate amount of interest shall generally ensure that the loss of time and money between the unlawful act and payment is adequately reflected. The tribunal’s choice of the date on which interest started to accrue, namely the date after which arbitral proceedings were initiated, is rather unusual. More frequently interest begins to accrue on the date on which the wrongful act was committed.

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