Damages in International Arbitration under Complex Long-term Contracts 0199680671, 9780199680672

Table of contents :
Series Editor’s Preface
Preface
Author Biographies
Contents
Table of Cases
Table of Legislation
List of Abbreviations
1 Introduction
2 Function, Role, and Importance of Damages Law
3 The Complex Long-Term Contract
4 Damages Claims for Breach of Contract under Comparative and Transnational Law
5 Analysing, Framing, and Proving a Damages Claim
6 Valuation of Damages in International Arbitration
7 Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration
8 Conclusions
Index

Citation preview

OXFORD INTERNATIONAL ARBITRATION SERIES Series Editor:  Loukas Mistelis Professor of Transnational Commercial Law and Arbitration Queen Mary, University of London

DAMAGES IN INTERNATIONAL ARBITRATION UNDER COMPLEX LONG-TERM CONTRACTS

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OXFORD INTERNATIONAL ARBITRATION SERIES Series Editor: Loukas Mistelis The aim of this series is to publish works of quality and originality on specific issues in international commercial and investment arbitration. The series aims to provide a forum for the exploration of important emerging issues and those issues not adequately dealt with in leading works. It should be of interest to both practitioners and scholarly lawyers.

Editorial Board Professor Lawrence Boo National University of Singapore, Bond University, Australia

Lord Lawrence Collins of Mapesbury Professor, University College London Honorary and Emeritus Fellow, Wolfson College, Cambridge

Professor Catherine Kessedjian Professor of European Business Law and International Dispute Resolution, University of Panthéon-Assas, Paris II, France

Professor Vaughan Lowe Chichele Professor of Public International Law and Fellow of All Souls College, University of Oxford

Professor William W. Park Professor of Law, Boston University

Professor Hans Van Houtte Director of the Institute for International Trade Law, University of Louvain (KULeuven)

Professor Francisco Orrego Vicuña Professor of law at the Heidelberg University Center for Latin America in Santiago

Paul Friedland Global Head of the White & Case International Arbitration practice group, New York

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DAMAGES IN INTERNATIONAL ARBITRATION UNDER COMPLEX LONG-TERM CONTRACTS Herfried   Wöss , Adriana San Román   Rivera , Pablo T. Spiller, Santiago Dellepiane

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Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Herfried Woss, Adriana San Román, Pablo Spiller, Santiago Dellepiane 2014 The moral rights of the authors have been asserted First Edition published in 2014 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2013950203 ISBN 978–0–19–968067–2 Printed in Great Britain by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

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SER IES EDITOR’S PR EFACE

This series of monographs is dedicated to specific issues in international arbitration law and practice, and gives authors the opportunity and the challenge of a more in-depth treatment than is possible in leading generalist works. It also provides an international forum for the profound exploration of important practical and theoretical matters and will further the development of arbitration as a self-luminous academic discipline and major international legal practice area. This ninth book in this series addresses a topic of major practical importance and also one that has various pervasive theoretical and comparative law ramifications, namely damages in international arbitration under complex long-term contracts. Ultimately all parties involved in arbitration are concerned about the amount of damages they may recover or the amount of damages they will have to part with. There are already a few very good books on damages, including one in this series (focusing on investment arbitration and law) but one has the feeling, given the complexity of the topic, that further thorough analysis of the topic is needed. This is most certainly what this book does with particular focus on complex long-term contracts. This book offers a systematic analysis of the different legal and financial implications associated with damages in international arbitration and provides a lucid analysis of how different rules of law on damages and loss of income are applied to various heading of damages in long-term contracts, including infrastructure contracts and public-private partnerships. The systematically surveyed jurisdictions include the UK, US, France, Germany, Mexico, and also international instruments such as the CISG and the UNIDROIT Principles. The authors also refer to best national and international practices on determination and quantification of damages. Throughout the book the authors make extensive references to major awards in ICC, UNCITRAL (ad hoc) and ICSID proceedings. This book also addresses the many competing factors that define the nature and amount of damages and is written by prominent lawyers and economists/damages experts. This is a measured, academically thorough and practically very useful analysis of methods used for calculation of damages against specific categorizations and headings of damages claims. Consequently the book provides a comprehensive coverage of issues arising when planning, structuring, arbitrating, or making an award on damages.

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Series Editor’s Preface The book is arranged in eight chapters. Chapter 1 introduces the subject and the terminology used and also spells out the methodology and the scope of the monograph. Chapter 2 addresses the role and importance of damages for breach of contracts, while Chapter 3 focuses on the features and key characteristics of complex long-term contracts. Chapter 4 examines damages claims for breach of contract under comparative and transnational law. Then Chapter 5 highlights the main aspects of structuring, analysing and proving a damages claim and proposes legal solutions that facilitate the application of general rules of law to damages deriving from complex long-term contracts, particularly those based on income stream, Chapter 6 focuses on the quantification of damages while Chapter 7 explores interest as damages and other related claims. Finally Chapter 8 provides a systematic and insightful set of conclusions. On this highly important topic the team of authors offer their readership thorough research, profound analytical skills and practical experience which combines facilitate insights, measured critique, and a very accessible style of writing, taking an important topic and presenting it in an appealing fashion for both academics and practitioners. The book will provide very useful guidance to lawyers and arbitrators alike as well as to damages experts. I am pleased to introduce this book, the ninth in the Oxford International Arbitration Series, which originates from the desire of the authors to systematize their vast professional expertise and to provide also to that practical experience an academic backbone so that it appeals both to an academic and professional audience. It certainly makes a real contribution. Loukas Mistelis London 19 November 2013

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PR EFACE

I am delighted to introduce this latest book on damages in international arbitration under complex long-term contracts, which is authored by four respected practitioners and scholars in the field. It is a distinguished and valuable addition to the Oxford International Arbitration Series. Damages have arguably become one of the most important and complex issues in international arbitration, and for good reason, because for a claimant at least, the damages are the arbitration’s very raison d’ être. As is commonly observed, an arbitration award is worth only as much as the prevailing party’s ability to obtain the payment awarded to it. Yet, at the same time, damages remain an issue that is little understood generally and is oftentimes inaccurately addressed by arbitrators, leading all involved in an arbitration to expect results that resemble the proverbial ‘splitting of the baby’. The participation of economists and damages experts, particularly those well-versed in international arbitration, has greatly improved the understanding of how to value and calculate damages, but out of concern that tribunals may be diverted while being walked through the particulars of this process, many continue to treat damages as a thorny path that should be carefully trodden. This book therefore comes as a welcome addition—particularly because it focuses on complex long-term contracts, which govern large-scale private and public infrastructure and technology projects that implicate a matrix of different actors with different risks and, for this reason, necessitate more complicated damages calculations than those required for discrete transactions or simple long-term contracts. As the authors observe, complex long-term contracts are fundamentally important to the global economy and have been at the centre of many high-profi le and high-stakes commercial and investor–State arbitrations. Complex long-term contracts are used, for instance, in virtually all major energy and mining projects and in projects involving the construction of transportation infrastructure. Compared to their importance, however, international legal rules for such contracts are underdeveloped. The authors believe that, as a solution, in situations of breach of complex long-term contracts in international arbitration, private law can and should be adapted as a guideline for formulating damages. To that end, they provide a detailed comparative analysis of the domestic laws of the United Kingdom, United States, and other jurisdictions, as well as frameworks such as the CISG and the UNIDROIT Principles of International Commercial Contracts

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Preface (PICC), to facilitate this adaptation of general rules to damages deriving from the breach of complex long-term contracts. The authors also discuss in great depth the but-for premise that was first developed by Frederick Mommsen and which is now common parlance in international arbitration. The premise provides a framework for analysing, framing, and proving damages claims, beginning from the point that the contract was breached to ensure that the injured party is awarded compensation that places it in the financial position in which it would have been had the wrongful act not occurred. The but-for premise leads ultimately to a so-called expectation interest that is seen by the authors as achieving a fairer measure of damages because it avoids both overcompensating and undercompensating the claimant. A portion of this discourse is devoted, in particular, to the distinct features of damages claims under complex long-term contracts with state entities in investment arbitration. The foundation of the modern international law of restitution and compensation is of course the well-known and almost universally referenced Chorzów Factory case of the Permanent Court of International Justice, which established a general reparation obligation that required states to put the victim of an internationally wrongful act in the same economic position that it would have possessed but for the unlawful act. As the authors note, the importance of the Chorzów case comes from its comprehensive damages analysis based on clear legal principles and its guidelines on how to achieve the full compensation principle in international law—both of which are now followed by many arbitral tribunals. Based on the Chorzów standard, when a business is taken illegally or its value is destroyed by a government’s illegal act, the measure of damages is the fair market value of the business; when the business is not taken or is only partially destroyed, the measure of damages is the difference between the but-for situation and the business’ fair market value. Also provided in this book is a chapter, especially valuable for practitioners, that uses Chorzów and more recent investment arbitration cases as a basis for identifying specific strategies for valuing the damages arising from the breach of complex long-term contracts or the violation of an international legal rule affecting such contracts. Finally, besides the primary damages awarded to a claimant, complicated issues are also raised by such secondary items as interest. The currency in which an award should be denominated is also an issue that has gained importance in light of exchange rate fluctuations and tax obligations that the prevailing party may have in certain jurisdictions. While tribunals have traditionally expressed their disapproval of misbehaviour during the arbitration by awarding the costs of arbitration against the misbehaving party, other forms of damages that have more recently sparked debate in investment arbitration are moral and punitive damages, awarded in cases in which the state has acted in a manner that the arbitral tribunal considers particularly reprehensible. As our understanding of these issues continues to viii

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Author Biographies evolve, I imagine that further works will emerge that address these issues in greater detail. Of the eight chapters in this content-rich publication, Mr Herfried Wöss and Ms Adriana San Román have authored Chapters 1 through 5 and 7 through 8, while Professor Pablo T. Spiller and Mr Santiago Dellepiane have authored Chapter 6. In aggregate, what they offer the reader is an authoritative and comprehensive work for understanding, valuing, and calculating damages arising from the breach of complex long-term contracts, and both the international arbitration practitioner and the academic will find this book to be of great insight and value. I invite you to delve into, and to benefit from, this product of the authors’ combined professional expertise and scholarship. Stanimir A. Alexandrov Washington DC 15 January 2014

Author Biographies Herfried Wöss Herfried Wöss is partner of Wöss & Partners (Mexico D.F.-Washington DC) and has extensive experience in international commercial and investment arbitration, as acknowledged in the International Who’s Who of Commercial Arbitration. His arbitration experience spans from refinery-ships, thermo-electrical plants and substations, gas and oil pipelines, EPC turnkey projects, public-private partnerships, M&A, joint venture agreements, franchise agreements, international sales contracts, and the telecommunications, automotive, and pharmaceutical industries. He has trained and practiced in Austria, the legal service of the EU-Commission, Great Britain, and Mexico and was visiting scholar at the Georgetown University Law Center. He is the founder of the Investment Arbitration Forum and special editor of Transnational Dispute Management and holds, amongst others, a doctorate in international economic law (summa cum laude). Adriana San Román Rivera Adriana San Román Rivera is partner of Wöss & Partners (Mexico DF-Washington DC) and also a financial analyst with more than 20 years of experience in corporate banking, financial engineering, and risk analysis. She engages in the legal-financial structuring of projects including infrastructure projects; she has vast experience in the preparation of legal-financial strategies in damages claims, case and evidence analysis, and the preparation of submissions in complex arbitrations; mergers & acquisitions, and anti-dumping and subsidy procedures. She is attorney at law with ix

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Author Biographies highest honours and was Ford foundation scholar of the University of Exeter where she studied for an M.A. in Finance & Investment. Pablo T. Spiller Pablo T. Spiller is the Jeff rey A. Jacobs Distinguished Professor Emeritus of Business & Technology, at the Haas School of Business, and Professor of Graduate Studies, University of California, Berkeley, Research Associate, NBER and Senior Consultant at Compass Lexecon, an international economic consulting company. His current research is in the interface of law, economics, and organizations. He has consulted for the World Bank, the InterAmerican Bank, the UNDP and multiple governments and private companies throughout the world on regulatory, antitrust and investment issues. He has testified in numerous international arbitrations involving contract, regulatory, and investment disputes. Apart from his multiple editorial duties, he has been the President of the International Society for New Institutional Economics, a Special Advisor to the Bureau of Economics of the US Federal Trade Commission, and an elected Member of the Board of Directors of the American Law & Economics Association. Santiago Dellepiane Santiago Dellepiane, a Senior Vice President at the firm Compass Lexecon, works as an economic and valuation consultant for utilities, regulated, and non-regulated businesses, and often acts as independent economic expert in damages assessment in international disputes. His experience spans various industries and geographies in investment and commercial disputes under ICSID, ICC, ICDR, U.S. Court, Canadian Court proceedings, as well as other venues. He is a frequent speaker on damages issues and has been recognized among the world’s top arbitration expert witnesses by Who’s Who Legal.

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CONTENTS

Table of Cases Table of Legislation List of Abbreviations

xiii xix xxiii

1. Introduction 2. Function, Role, and Importance of Damages Law A. Function of Damages Law B. Economic and Social Role of Damages Law 3. The Complex Long-Term Contract A. Introduction B. The Development of Complex Long-Term Contracts C. The Nature of Complex Long-Term Contracts D. Classification of Complex Long-Term Contracts E. Identification, Allocation, and Mitigation of Risks in the Preparation of Complex Long-Term Contracts F. Examples of Typical Complex Long-Term Contracts G. Contract Guidelines and the Recovery of Damages H. Cases and Arbitrations Related to Complex Long-Term Contracts 4. Damages Claims for Breach of Contract under Comparative and Transnational Law A. Requisites for Damages Claims under Different Rules of Damages Law: UK, USA, France, Mexico, Germany, CISG, and PICC B. United Kingdom C. United States D. France E. Mexico F. Germany G. CISG

2.01 2.28

3.01 3.04 3.41 3.62 3.79 3.106 3.157 3.172

4.01 4.04 4.88 4.174 4.226 4.252 4.341

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Contents H. UNIDROIT Principles of International Commercial Contracts (PICC) I. Systemic Aspects of Rules of Damages Laws

4.373 4.432

5. Analysing, Framing, and Proving a Damages Claim A. Introduction B. Relevant Characteristics of Complex Long-Term Contracts for Damages Claims C. Full Compensation as the Guiding Principle D. The But-for Premise as the Analytical Framework for the Damages Claim E. The Measure of Damages F. Limitations G. The Relevant Date for Valuation of Damages H. Other Conceptual Issues Related to Damages Assessment I. Relevance of the Evidence Available and Burden of Proof J. Role of the Experts K. Particularities of Damages Claims in Investment Arbitration

5.08 5.68 5.96 5.116 5.121 5.127 5.152 5.163

6. Valuation of Damages in International Arbitration A. Introduction B. The Economics of Public and Private Contracts C. Principles of Compensation under the Chorzów Formula D. Causality and Completeness: The But-for Premise E. Investment vs. Contract Disputes F. Date of Valuation G. Avoiding Double Counting Damages H. Loss of Income vs. Loss of Value I. Avoiding Undercompensating J. Valuation of Damages

6.01 6.04 6.24 6.26 6.35 6.53 6.84 6.93 6.97 6.136

5.01 5.03 5.05

7. Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration A. Interest as Damages B. Currency of the Award and Exchange Rate Fluctuations C. Cost of Arbitration

7.02 7.42 7.49

8. Conclusions Index

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TABLE OF CASES

INTERNATIONAL ARBITRATION AND COURT CASES ADC Affiliate Ltd and ADC & ADMC Management Ltd v. The Republic of Hungary, ICSID Case No. ARB/03/16, Award, 2 October 2006 . . . . . . . . . . . . . . . . . . . 5.149, 5.188, 6.01, 6.80–6.83, 6.110, 6.150, 6.191, 7.30, 7.40, 7.50 Aguas del Tunari S.A. v. República de Bolivia, ICSID Case No. ARB/02/3, Decision on Jurisdiction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.17 Aguas del Tunari S.A. v. República de Bolivia, ICSID Case No. ARB/02/3, Decision on Respondent’s Objections to Jurisdiction, 21 October 2005 . . . . . . . . . . . . 6.16 Amco Asia Corp. v. Indonesia (Amco I), Award, 20 November 1984 (1993) 1 ICSID Reports 413 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6.150, 6.161, 7.36 Amco Asia Corporation, Pan American Development Limited, PT Amco Indonesia v. Republic of Indonesia, ICSID Case 1984-1990 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.200 American International Group v. The Islamic Republic of Iran (1983) 4 U.S.C.T.R. 106 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.185, 8.33 Anglo-Iranian Oil Co. Case (Jurisdiction) [1952] ICJ Rep. 93. . . . . . . . . . . . . . . . . . . . . . . 5.170 Antoine Goetz et al. v. Burundi, Award, 10 February 1999, (2000) 15 ICSID Review 457. . . 7.36 Archer Daniels Midland Company and Tate & Lyle Ingredients Americas Inc. v. United Mexican States, ICSID Case No. ARB(AF)/04/5, Award redacted version 21 November 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.108 Asian Agricultural Products v. Sri Lanka, Award, 27 June 1990 (1997) 4 ICSID Reports 4 246 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.36 Astaldi SpA v. Honduras, ICSID Case No. ARB/07/32, 17 September 2010, IIC 454 (2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.77 Autopista Concesionada de Venezuela, C.A. (‘Aucoven’) v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/00/5, Award, 23 September 2003, IIC 20 (2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.77, 5.29, 5.32–5.33, 5.57–5.59, 5.85, 5.138–5.142, 7.36 Bechtel Enterprises International Ltd v. Overseas Private Investment Corporation, Case No. 50 T 195 00509 02 (American Arbitration Association) . . . . . . . . . . . . . . . . . 3.78 Biloune v. Ghana, Award, 30 June 1990, 95 ILR 211. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.43 Bridas S.A.P.I.C. v. Turkmenistan, ICC Case No. 9058/FMS/KGA, Interim Award, 26 January 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.78 Capital India Power Mauritius I v. Maharashtra Power Development Corporation Ltd, ICC Case No. 12913/MS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.78 Caso arbitraje 144 (CANACO), Laudo I, 2 de septiembre de 2004, Laudo II, 6 de mayo de 2005 (National Chamber of Commerce of the City of Mexico) . . . . . 4.422, 4.426 CDC Group plc v. Seychelles, ICSID Case No. ARB/02/14, Award, 29 June 2005, IIC 47 (2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.77 Ceskoslovenska Obchodni Banka, a s (CSOB) v. Slovak Republic, ICSID Case No. ARB/97/4, Award, 29 December 2004, IIC 51 (2004) . . . . . . . . . . . . . . . . . . . . . . 3.77, 7.36 Channel Tunnel Group Limited and France-Manche v. The Secretary of State for Transport of the Government of the United Kingdom of Great Britain and Northern Ireland and Le Ministre de l’Équipement, des Transports, de l’Aménagement du Territoire, du Tourisme et de la Mer du Gouvernement de la République Française, Partial Award, 30 January 2007 (Permanent Court of Arbitration) . . . . . . . . . . . . . . . . 3.74

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Table of Cases CME Czech Republic BV v. Czech Republic, Final Award on Damages, 14 March 2003, (2005) 8 ICSID Reports 246 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.36 CMS Gas Transmission Company v. The Argentine Republic, ICSID Case No. ARB/01/8, Award, 12 May 2005 . . . . . . . . . . . . . . . . . . . . . . 6.34, 6.109, 6.150, 6.161, 7.40 COMMISA v. PEMEX, ICC Case No. 13613/CCO/JRF, Final Award, 16 December 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.78, 3.185, 3.191, 3.193–3.195, 3.197, 3.199 Compañía de Aguas del Aconquija S.A. and Vivendi Universal S.A. v. Argentine Republic, ICSID Case No. ARB/97/3, Decision on Annulment, 3 July 2002 (Vivendi I Decision on Annulment), (2001) 41 ILM 1135 . . . . . . . . . . . . . . . . . . . . . . 5.165 Compañía de Aguas del Aconquija S.A. and Vivendi Universal S.A. v. Argentine Republic, ICSID Case No. ARB/97/3, Award, 20 August 2007. . . . . . . . . . . . . . 6.08–6.09, 6.108, 6.114, 6.119, 7.15 Compañia del Desarrollo de Santa Elena SA v. Republic of Costa Rica, ICSID Case No. ARB/96/1, 17 February 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.108 Duke Energy International Peru Investments No. 1 v. Peru, ICSID Case No. ARB/03/28, Award, 18 August 2008, IIC 334 (2008) . . . . . . . . . . . . . . . . . . . . . . . . . . 3.77 EDF International S.A., SAUR International S.A. and Leon Participaciones Argentinas S.A. v. Argentine Republic, ICSID Case No. ARB/03/23, Award, 11 June 2012 . . . . . . . . . . . . . . . . . . . . . . . . 5.21–5.22, 5.173, 5.191, 6.01, 6.191, 6.196, 7.26 El Paso Energy International Company v. The Argentine Republic, ICSID Case No. ARB/03/15, Award, 31 October 2011 . . . . . . . . . . . . . . . . . . . . . . 6.01, 6.31, 6.60 Enron Corporation and Ponderosa Assets L.P. v. The Argentine Republic, ICSID Case No. ARB/01/13, Award, 22 May 2007. . . . . . . . . . . . . . . . . . . 5.159, 6.01, 6.52, 6.103, 6.131, 6.135, 6.191, 6.193–6.194, 6.200 Factory at Chorzów, 1928 PCIJ Series A, No. 17 . . . . . . . . . . . . . . . 1.02, 1.20, 1.28, 2.04, 2.06, 4.338, 4.461, 5.163, 5.175–5.176, 5.178–5.181, 5.183–5.184, 5.187–5.189, 5.196–5.199, 5.202, 5.204–5.205, 6.03, 6.23–6.26, 6.53, 6.58, 6.60, 6.65, 6.67–6.69,6.71, 6.74–6.82, 6.84, 6.92, 6.97, 6.121, 6.131, 7.29–7.30, 7.39, 7.47, 8.12, 8.30, 8.32–8.35 Fedax N.V. v. Venezuela, Award, 9 March 1998 (1998) 37 ILM 1391 . . . . . . . . . . . . . . . . . . 7.36 Himpurna California Energy Ltd (Bermuda) v. PT (Persero) Perusahaan Listruik Negara (Indonesia), UNCITRAL Final Award, 4 May 1999, (1999) 14 Mealey’s International Arbitration Report A-1, A-57. . . . . . . . . . . . . . . . . . . . . . . . . . 3.78, 5.13–5.14, 5.91, 6.46, 6.85–6.87, 6.89, 6.121 ICC Case No. 15909/JRF. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.58 In Desert Line Projects v. Yemen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.108 Joint Venture Yashlar (Turkmenistan), Bridas S.A.P.I.C. (Argentina) v. The Government of Turkemensitan (or Turkmenistan, or the State of Turkmenistan and/or The Ministry of Oil and Gas of Turkmenistan), ICC Case No. 9151/FMS/KGA, Interim Award, 8 June 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.201–3.202, 3.204, 3.206, 5.25–5.27 Joint Venture Yashlar (Turkmenistan), Bridas S.A.P.I.C. (Argentina) v. The Government of Turkemenistan (or Turkmenistan, or the State of Turkmenistan and/or The Ministry of Oil and Gas of Turkmenistan), ICC Case No. 9151/FMS/KGA, Final Award, 18 May 2000 . . . . . . . . . . . . . . . 3.78, 3.201, 3.207–3.213, 5.27, 5.47–5.48, 5.50–5.56, 5.80–5.82, 5.123, 5.132, 5.135–5.136 Karaha Bodas Company LLC v. Reusahaan Pertambangan Minyak Dan Gas Bumi Negara and PT PLN (Persero) . . . . . . . . . . . . . . . . . . . . . . . 5.13, 5.79, 5.91 LG&E v. Argentina, Decision on Liability, 3 October 2006 . . . . . . . . . . . . . . . . . . . . .5.19–5.20 LG&E Energy Corp., LG&E Capital Corp., LG&E International Inc. v. Argentine Republic, ICSID Case No. ARB/02/1, Award, 3 October 2006. . . . . 5.15, 5.19

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Table of Cases LG&E Energy Corp., LG&E Capital Corp., LG&E International Inc. v. Argentine Republic, ICSID Case No. ARB/02/1, Award, 25 July 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.52, 6.131–6.132, 6.196 Lusitania (German–American Claims Commission) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.05 Maffezini v. Spain, ICSID Case No. ARB/97/7, Award, 13 November 2000. . . . . . . . . . . . . 7.40 Metalclad Corporation v. The United Mexican States, ICSID Case No. ARB(AF)/97/1, 30 August 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.108, 7.40 Mobil Cerro Negro, Ltd v. Petróleos de Venezuela, S.A. and PDVSA Cerro Negro, S.A., ICC Case No. 15416/JRF/CA, Final Award, 23 December 2011. . . . . . . .6.104, 6.106 MTD Equity et al. v. Chile, 24 May 2004 (2005) 44 ILM 91 . . . . . . . . . . . . . . . . . . . . . . . . 7.36 National Grid v. Argentina, UNCITRAL Award, 3 November 2008 . . . . . . . . 5.159, 5.192, 7.25 Patuha Power Ltd (Bermuda) v. PT (Persero) Perusahaan Listruik Negara (1999) 14 Mealey’s International Arbitration Report B-1, B-23–24. . . . . . . . . . . . . . . . . . . . . . 3.78 Occidental Petroleum Corporation and Occidental Exploration and Production Company v. The Republic of Ecuador, ICSID Case No. ARB/06/11, Award, 5 October 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . 3.68, 5.16–5.17, 5.113–5.114, 6.127, 6.161, 6.184, 6.191, 6.195, 6.200, 7.29, 7.37, 7.40, 8.31 Phillips Petroleum Company Venezuela Limited, ConocoPhillips Petrozuata B.V. v. Petroleos de Venezuela, S.A., ICC Case 16848/JRF/CA (C-1649/IRF) Final Award, 17 September 2012 . . . . . . . . . . . . . . . . . . . . . . 5.36–5.37, 6.49, 6.104, 6.118–6.119, 7.38 PSEG Global Inc. and Konya Ilgin Elektrik Üretim ve Ticaret Limited Sirketi v. Republic of Turkey, ICSID Case No. ARB/02/5, 19 January 2007. . . . . . . . . . . . . . 6.108 Railroad Development Corporation v. Republic of Guatemala, ICSID Case No. ARB/07/23, Award, 29 June 2012 . . . . . . . . . . . . . . . . . . . 6.01, 6.90–6.91 Rompetrol Group N.V. v. Romania, ICSID Case No. ARB/06/03, Award, 6 May 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.210–6.211, 6.213 Sapphire International Petroleums Ltd v. National Iranian Oil Company, Award, 15 March 1963, (1967) 35 ILR 136. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.78, 5.124 S.D. Myers v. Canada, Second Partial Award, 21 October 2002 . . . . . . . . . . . . . . . . . . . . . . 7.36 Sempra Energy International v. Argentine Republic, ICSID Case No. ARB/02/16, Award, 28 September 2007, IIC 34 (2007). . . . . . . . . . . . . . . . . . . . .3.77, 5.159, 6.01, 6.43, 6.50–6.52, 6.108, 6.131, 6.135, 6.141–6.142, 6.144, 7.24, 7.38 Siemens AG v. The Argentine Republic, ICSID Case No. ARB/02/8, Award, 17 January 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5.92, 7.27, 7.48 Starrett Housing Corporation v. Government of the Islamic Republic of Iran (1987) 16 U.S.C.T.R. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.185, 6.150–6.161, 8.33 Técnicas Medioambientales SA v. Mexico, Award, 29 May 2003 (2004) 19 ICSID Review 158 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.36 Waguih Elie George Siag and Clorinda Vecchi v. The Arab Republic of Egypt, ICSID Case No. ARB/05/15, 1 June 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.01, 6.121, 6.123–6.126, 6.156, 6.191–6.192 NATIONAL COURT CASES France Cass. Civ., 31.3.1965, Gaz Pal. 1965, p. 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.223 Cass. Com., 4 décembre 1990 pourvoi n° 89-16338 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.122 Civ, 7 July 1924, Sirey 1925.1, 321 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.213, 5.98 Civ (2) 4 February 1982, JCP 1982.II.19894 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.179 Civ (3) 9 January 1991, Bull civ III no. 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.207, 4.223

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Table of Cases Cour de cassation, Cass. Req. 24 mars 1942, D.A. 1942 . . . . . . . . . . . . . . . . . . . . . . 4.216, 5.119 Cour de cassation, Deuxiéme chambre civile, 9 July 1981, Bull civ II, p. 1561 . . . . . . . . . . . 7.07 Cour de cassation, Civ (3) 5 Dec. 1979, JCP 1981.II.19605 . . . . . . . . . . . . . . . . . . . . . . . . . 4.204 Cour de cassation, Civ (3) 6 May 1981, Juris-Data no. 1981-001783 . . . . . . . . . . . . . . . . . . 4.204 Germany BGH, 06.04.1976 – VI ZR 246/74, BGHZ, 66, 182 (192) . . . . . . . . . . . . . . . . . . . . . . . . . 4.322 BGH, NJW 76, 1144 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.316 BGH, NJW 86, 1331 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.316 BGH, NJW-88, 1373 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.314 BGHZ 2, 138 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.316 BGHZ 7, 204 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.316 German Imperial Court, RGZ 141 (1933) 365. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.298, 5.198 German Imperial Court, RGZ 169 (1951) 117 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.298, 5.198 German Imperial Court, BGHZ 78, 209 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.298, 5.198 Mexico Novena Época, Tribunales Colegiados de Circuito, Semanario Judicial de la Federación y su Gaceta, XV, Mayo de 2002, tesis I.80.C.J/14, jurisprudencia, 951 . . . 4.231 Octava Época, Seminario Judicial de la Federación 79, tesis jurisprudencial, I.40.C.J/60, materias penal y civil, julio de 1994, registro no. 210939, 35 . . . . . . . . . . 4.250 Octava Época, Seminario Judicial de la Federación 85, tesis jurisprudencial, I.40.C.J/61, materia civil, enero de 1995, registro no. 209385, 61. . . . . . . . . . . . . . . . . 4.250 Primera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación LXXII, Quinta Época, tesis aislada, materia civil registro no. 352591, 5877 . . .4.241, 4.247 Tercera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación XXXII, tesis aislada, material común, registro no. 363686, 1222 . . . . . . . . . . . . . . . . 4.248 Tercera Sala de la Suprema Corte de la Nación, Sexta Época, informe 1958, tesis aislada, material civil, registro no. 813305, 28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.242 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación LXXXV, Quinta Época, tesis aislada, materia civil, 1804, registro no. 348727 . . . . . . . . . . . . . . 4.245 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación 34 Sexta Parte, Séptima Época, amparo directo 532/68, 30 October 1971, registro no. 256654, 27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.240 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación 157-162, Sexta Parte, Séptima Época, tesis aislada, materia civil, registro no. 250270, 57 . . . . . 4.243 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación y su Gaceta XXXI, Novena Época, febrero de 2010, amparo directo 236/2009, unanimidad de votos, tesis aislada I.40.C.226 C, materia civil, 2819, registro no. 165295 . . . . . . . . 4.239 Switzerland Sammlung der Entscheidungen des Schweizerischen Bundesgerichts, BGE 118 IB 562 . . . . 3.75 United Kingdom Addax v. Arcadia [2000] 1 Lloyd’s Rep 493 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.27 Albacruz (Cargo Owners) v. Albazero (The ‘Albazero’) [1977] AC 774 (HL) . . . . . . . . . . . . . 4.49 Alfred McAlpine Construction Ltd v. Panatown Ltd [2001] 1 AC 518 (HL) . . . . . . . . . . . . . 4.11 Amalgamated Building Contractors v. Holy Cross, UDC [1952] 2 All ER 453 . . . . . . . . . . . 4.79 ASM Shipping Ltd of India v. TTM1 Ltd of England (The Amer Energy) [2009] 1 Lloyd’s Rep 293 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.59 Attorney General v. Blake [2001] 1 AC 268 (HL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.50 Beswick v. Beswick [1968] AC 58 (HL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.49 British Sugar v. NEI Power Projects (1998) 87 BLR 42 (CA) . . . . . . . . . . . . . . . . . . . . . . . . . 4.28

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Table of Cases Clydebank Engineering and Shipbuilding Co. Ltd v. Don Jose Ramos Yzquierdo y Castaneda [1905] AC 6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.77 Crehan v. Inntrepreneur Pub Co. (CPC) [2004] EWCA Civ 637 . . . . . . . . . . . . . . . . . . . . . 4.42 Croudace Construction Ltd v. Cawoods Concrete Products [1978] 2 Lloyd’s Rep 55 . . . . . . 4.26 Despinas R. (The) & The Folias [1979] 685 (HL). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.44 Ease Faith Ltd v. Leonis Marine Management Ltd [2006] 1 Lloyd’s Rep 673 . . . . . . . . . . . . 4.29 Golden Victory (The) [2007] UKHL 12 (HL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.119 Hadley v. Baxendale (1854) 9 Ex 341 . . . . . . . . . . . 1.16, 4.23, 4.29, 4.54–4.55, 4.60, 4.152, 5.98 Hoechster v. De la Tour, 118 Eng Rep 922 (QB 1853) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.19 Johnson v. Agnew [1979] 2 WLR 487 (HL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.119 Koufos v. C. Czarnikow Ltd (The Heron II) [1969] 1 AC 350 (HL) . . . . . . . . . . . . . . . . . . . 4.56 Miliangos v. George Frank (Textiles) Ltd [1976] AC 433 (HL) . . . . . . . . . . . . . . . . . . . . . . 5.117 Photo Production Ltd v. Securicor Ltd [1980] AC 827 (HL) . . . . . . . . . . . . . . . . . . . . . . . . . 4.08 Robsinon v. Harman (1848) 1 Exch 850 (Exch), (1848) 13 P.D. 191 (CA) . . . . . 2.03, 4.05, 5.07 Ruxley Electronics & Construction v. Forsyth [1996] 1 AC 344 . . . . . . . . . . . . . . . . . . . . . . 4.45 Southampton Container Terminals Ltd v. Schiffahrtsgesellscahft ‘Hansa Australia’ mbH and Co. [2001] 2 Lloyd’s LR 275. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.82 Supershield Ltd v. Technologies FE Ltd [2010] EWCA Civ 7, [2010] 1 Lloyd’s Rep 387 . . . . 4.58 Transfield Shipping Inc. v. Mercator Shipping Inc. (The Achilleas) [2008] UKHL 48, [2008] 3 WLR 345 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4.58, 4.61 Victoria Laundry (Windsor) Ltd v. Newman [1949] 2 KB 528 (CA) . . . . . . . . . . . . . . . 4.10, 4.55 United States Ambassador Hotel Co. v. Wei-Chuan Investment, 189 F. 3d . . . . . . . . . . . . . . . . . . . . . . . . 4.119 Ashland Management Inc. v. Janien, 82 N.Y. 2d, 395 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.157 Bigelow v. RKO Radio Pictures, 327 U.S. 251 (1946) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.111 Fiberlok, Inc. v. LMS Enterprises, Inc., 976 F. 2d 958 (5th Cir. 1992). . . . . . . . . . . . . . . . . 4.149 Griffin v. Colver, 16 N.Y. 489 (1858) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.109 Hardwick v. Dravo Equip. Co., 569 P. 2d 588 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.164 Locke v. United States, 283 F. 2d 521 (Ct. Cl. 1960) . . . . . . . . . . . . . . . . . . . . . . . . . 4.112, 4.114 McDermott v. Middle East Carpet Co. Assoc., 811 F. 2d 1422 (11th Cir. 1987) . . . . . . . . . 4.113 Moritz v. First National Bank of Chicago, 148 F. 3d . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.118 Patton v. Mid-Continent Systems, Inc., 841 F. 2d 742 (7th Cir. 1988) . . . . . . . . . . . . . . . . . 6.05 Texas Power & Light Co. v. Barnhill, 639 S.W. 2d 331 (Tex. App. 1982) . . . . . . . . . . . . . . 4.146 Tractebel Energy Marketing, Inc. v. AEP Power Marketing, Inc., 487 F. 3d 89 (2nd Cir. 2007) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.106–4.107, 4.136, 4.140, 4.142, 5.102, 5.106–5.108 United States v. Cartwright, 411 U.S. 546 (1973), (CL-068) . . . . . . . . . . . . . . . . . . . . . . . . . 6.37

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TABLE OF LEGISL ATION

INTERNATIONAL TREATIES, CONVENTIONS, AND INSTRUMENTS Abs-Shawcross draft Convention on Foreign Investment 1959. . . . . . . . . 5.170 Geneva Convention . . . . . . . . . . 5.204–5.205 IBA Rules on the Taking of Evidence in International Arbitration, 2010 Art. 9(5), (6) . . . . . . . . . . . . . . . . . . . . 5.151 International Law Commission (ILC) Draft Articles on Responsibility of States for Internationally Wrongful Acts . . . . 5.178 Arts. 31–39 . . . . . . . . . . . . . . . . . . . . . 5.178 Art. 31. . . . . . . . . . . . . . . . . . . . . . . . . .2.05 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . 5.178 Comment (1). . . . . . . . . . . . . . . . . . 5.178 Comments (7), (9)–(11) . . . . . . . . . 5.178 Art. 36 (1), (2) . . . . . . . . . . . . . . . . . . . . . . . 5.178 Comments (21), (22) . . . . . . . . . . . . 5.186 Comment (27) . . . . . . . . . . .5.182, 5.178 Comments (28)–(31). . . . . . . . . . . . 5.182 Comment (30) . . . . . . . . . . . . . . . . 5.178 Art. 38 . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 Comment (7) . . . . . . . . . . . . . . . . . . 7.07 Ch. II . . . . . . . . . . . . . . . . . . . . . . . . . 5.178 OECD draft Conventions on the Protection of Foreign Property 1962 and 1976. . . . . . . . . . . . . . . . . 5.170 Principles of European Contract Law . . . 4.255 Treaty between France and the United Kingdom concerning the Construction and Operation by Private Concessionaires of a Channel Fixed Link, 1986 (‘The Canterbury Treaty’) . . . . . . . . . 3.73 Preamble, para. 3 . . . . . . . . . . . . . . . . . 3.73 UNGA Res. 799 56/83, 12 December 2001 . . . . . . . . . . . . . 5.178 UNIDROIT Principles of International Commercial Contracts 2004. . . . . .4.378 UNIDROIT Principles of International Commercial Contracts 2010 . . . . . . .1.11, 1.13, 1.22, 4.373–4.375, 4.377–4.382, 4.387, 4.393, 4.419–4.421, 4.426, 4.436,

4.443–4.447, 4.453, 4.459, 4.460–4.461, 5.86, 8.12 Art. 1.3 . . . . . . . . . . . . . . . . . . . . . . . .4.380 Art. 1.7 . . . . . . . . . . . . . . . . . . . . . . . .4.404 Art. 5.1.3. . . . . . . . . . . . . . . . . 4.399, 4.403 Art. 5.1.4(2) . . . . . . . . . . . . . . . . . . . .4.387 Art. 6.2.2 . . . . . . . . . . . . . . . . . . . . . .4.399 (d) . . . . . . . . . . . . . . . . . . . . . . . . . .4.407 Art. 7.1.1 . . . . . . . . . . . . . . . . . 4.386, 4.405 Art. 7.1.2 . . . . . . . . . . . . 4.399, 4.401, 4.408 Art. 7.1.6 . . . . . . 3.222, 4.399, 4.406, 4.409 Art. 7.1.7 . . . . . . . . . . . . . . . . . . . . . . .4.399 (1) . . . . . . . . . . . . . . . . . . . . . . . . . .4.406 Art. 7.2.2. . . . . . . . . . . . . . . . . 4.381, 4.397 Art. 7.3.5(1), (2) . . . . . . . . . . . . . . . . .4.398 Art. 7.4 . . . . . . . . . . . . . . . . . . . . . . . .4.384 Art. 7.4.2. . . . . . . . . . . 4.383, 4.385, 4.394, 4.389, 4.396, 4.413–4.414, 5.119 (1) . . . . . . . . . . . . . . . . . . . . . . 2.03, 5.07 Official Comment 2 . . . . . .4.390–4.391, 4.394–4.395 Art. 7.4.3. . . . . . . 1.22, 4.392–4.393, 4.416 (2), (3) . . . . . . . . . . . . . . . . . . . . . . .4.395 Art. 7.4.4. .4.399, 4.4.07, 4.410–4.411, 5.98 Art. 7.4.5. . . . . . . . . . . . . . . . . . . . . . .4.398 Art. 7.4.7. . . . . . . . . . . . . . . . . 4.339, 4.408 Art. 7.4.8. . . . . . . . . . . . 4.339, 4.408, 4.412 Art. 7.4.9. . . . . . . . . . . . . . . . . . . . . . . 4.431 (3) . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 Official Comment 3 . . . . . . . . . . . . . 7.07 Art. 7.4.10 . . . . . . . . . . . . . . . . . .4.431, 7.07 Art. 7.4.12 . . . . . . . . . . . . . . . . . . . . . . 4.431 Art. 7.4.13 . . . . . . . . . . . . . . . . . . . . . . 4.417 Official Comment 2 . . . . . . . . . . . . 4.418 United Nations Convention on Contracts for the International Sale of Goods (Vienna, 1980) (CISG) . . . . . . . . . . 1.13, 1.21, 4.255, 4.341–4.344, 4.356, 4.368, 4.370, 4.372–4.374, 4.437, 4.443–4.447, 4.460–4.461, 8.12 Preamble, paras. 5, 6. . . . . . . . . . . . . .4.373 Art. 3 . . . . . . . . . . . . . . . . . . . . . . . . .4.344 Art. 7(1) . . . . . . . . . . . . . . . . . 4.343, 4.373 Art. 25 . . . . . . . . . . . . . . . . . . . . . . . .4.347 Art. 28 . . . . . . . . . . . . . . . . . . . . . . . .4.346

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Table of Legislation Art. 48 . . . . . . . . . . . . . . . . . . . . . . . . 4.350 Art. 74. . . . . . . . .2.03, 4.345, 4.347–4.348, 4.350, 4.353, 4.355, 4.357–4.358, 4.360, 4.363, 4.368, 5.98, 7.07 Art. 75 . . . . . . . . . . . . . . . . . . . . . . . . 4.359 Art. 76. . . . . . . . . . . . . . 4.359, 4.369, 5.119 Art. 77 . . . . . . . . . . . . . . . . . . . . . . . .4.366 Art. 78 . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 Art. 81(1). . . . . . . . . . . . . . . . . . . . . . . 4.351

FIDIC Multilateral Development Banks (MDB) Harmonised Construction Contract . . . . . . . . . . . . . . . . . . . . . . 3.31 Guidelines for the Application of the Petroleum Resources Management System, November 2011 p. 13 . . . . . . . . . . . . . . . . . . . . . . . . . . 6.128 para. 748 . . . . . . . . . . . . . . . . . . . . . . . 6.128 HM Treasury Standardisation of PFI Contracts . . . . . . . . 1.07, 3.33, 3.161 s. 1.2.1. . . . . . . . . . . . . . . . . . . . . . . . . . 3.33 s. 21.1.3 . . . . . . . . . . . . . . . . . . 3.168–3.169 s. 24.6 . . . . . . . . . . . . . . . . . . . . . . . . . 3.167 ICC Model Turnkey Contract for Major Projects. . . 3.32, 3.46, 3.188, 4.344 ICE Conditions of Contract . . . . . . . . . . .4.79 Infrastructure Conditions of Contract . . .4.79 IVSC Guidance Note No. 4 – Intangible Assets Section 5.8.3.1 . . . . . . . . . . . . . . . . . . 6.214 IVSC Guidance Note No. 6 – Business Valuation . . . . . . . 6.146, 6.171 Section 3.1 . . . . . . . . . . . . . . . . . . . . . 6.217 Section 3.3.1 . . . . . . . . . . . . . . . . . . . . 6.217 Section 3.3.2 . . . . . . . . . . . . . . . . . . . . 6.217 Section 5.14.3.1. . . . . . . . . . . . . . . . . . 6.214 Section 5.14.3.3 . . . . . . . . . . . . . . . . . 6.178 Joint Contracts Tribunal Standard Form of Contract . . . . . . . . . . . . . . .4.79 UNCITRAL Legal Guide on Drawing up International Contracts for the Construction of Industrial Works . . . . . . . . .3.28–3.29, 3.161, 3.163 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.29 47–9 . . . . . . . . . . . . . . . . . . . . . . . . . . .3.43 UNCITRAL Legislative Guide on Privately-financed Infrastructure Projects . . . . . 1.05, 1.08, 3.35–3.36, 3.54 IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.54 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10 38–39 . . . . . . . . . . . . . . . . . . . . . . . . . .3.80 42 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3.85 166, para. 46. . . . . . . . . . . . . . . . . . . . 3.165 197–8 . . . . . . . . . . . . . . . . . . . . . . . . . 3.163 UNCITRAL Model Legislative Provisions on Privately Financed Infrastructure Projects . . . . . . . . . . . . . . . . . . 3.36, 3.53 Art. 28 . . . . . . . . . . . . . . . . . . . . . . . .4.426 Provision 47 . . . . . . . . . . . . . . . . . . . . 3.166 UNIDO Guidelines for Infrastructure Projects through Build-OperateTransfer Projects . . . . . . . . . . . 1.05, 1.08, 3.13–3.14, 3.161, 3.164 Guideline 3 . . . . . . . . . . . . . . . . . . . . . . 3.14

EUROPEAN UNION Directive 99/44/EC of the European Parliament and of the Council of 25 May 1999 on certain aspects of the sale of consumer goods and associated guarantees (1999) OJ L171/12 . . . . . . . . . . . . . . . . . . .4.254 ARBITRATION RULES ICC Rules of Arbitration 2012 Art. 21. . . . . . . . . . . . . . . . . . . . . . . . . 4.375 Stockholm Chamber of Commerce Arbitration Rules. . . . . . . . . . . .7.51, 8.38 UNCITRAL Arbitration Rules . . . . . . . 7.25, 7.51, 8.38 GUIDELINES, MODELS, STANDARDS AND CONDITIONS ASA Business Valuation Standards Section SBVS-2 ‘Guidelines Transactions Method’. . . . . . . . . . . . . 6.178 Chartered Institute of Arbitrators Practice Guideline 10: Guideline on the Use of Tribunal-Appointed Experts, Legal Advisors and Assessors Para. 3.3 . . . . . . . . . . . . . . . . . . . . . . . 5.159 CISG Advisory Council Opinion No. 4: Contracts for the Sale of Goods to be Manufactured or Produced and Mixed Contracts . . . . . . . . . . . . . . .4.344 CISG Advisory Council Opinion No. 6 on the ‘Calculation of Damages under CISG Article 74’ . . . . . . . . . . . . . . . . . . . . . 1.21 Para. 3.16 . . . . . . . . . . . . . . . . . . . . . . 4.357 Para. 3.19 . . . . . . . . . . . . . . . . . 4.358, 5.98 FIDIC Conditions of Contract for Design, Build and Operate Projects (2008) (‘the Gold Book’) . . . . . . . . . . 1.07, 3.31, 3.52 FIDIC Conditions of Contract for EPC/Turnkey Projects (‘the Silver Book’) . . . . . . . . . 3.30, 3.181 Sub-cl. 1.5. . . . . . . . . . . . . . . . . . . . . . .3.44

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Table of Legislation Guideline 5 . . . . . . . . . . . . . . . . . . . . . . 3.81 Guidelines 154–8 . . . . . . . . . . . . . . . . .3.82 Guidelines 160–1 . . . . . . . . . . . . . . . . 3.109 Guidelines 214–15 . . . . . . . . . . . . . . . .3.38 Guideline 215 . . . . . . . . . . . . . . . 1.08, 3.39 Guideline 235 . . . . . . . . . . . . . . . . . . . 3.162 Guidelines 236–7 . . . . . . . . . . . . . . . . 3.164 UNIDO Model Form of Turnkey Lump-Sum Contract for the Construction of a Fertilizer Plant Including Guidelines and Technical Annexures 1983 . . . . . . . . . . . . . . . .3.27 UNIDROIT Principles Art. 7.4.3. . . . . . . . . . . . . . . . . . . . . . . 4.357 World Bank ‘Guidelines on the Treatment of Foreign Direct Investment’ 1992 . . . . . . . . . . . . . . . . . . . .6.37, 6.161 Paras. 5, 6 . . . . . . . . . . . . . . . . . . . . . . 6.150 NATIONAL LAWS Argentina Mendoza Provincial Law Nos. 6497 and 6498 . . . . . . . . . . . . . . . . . . . . . . 5.21 Ecuador Caducidad Decree . . . . . . . . . . . . .5.16, 5.114 Law 42, 25 April 2006 . . . . . . . . . . 5.16–5.17 France Avant-project Catala . . . . . . . . . . 4.221–4.222 Art. 1375. . . . . . . . . . . . . . . . . . . . . . .4.222 Civil Code . . . . . . . 1.19, 4.190, 4.198, 4.218, 4.221–4.222 Art. 1121. . . . . . . . . . . . . . . . . . . . . . . 4.195 Art. 1134. . . . . . . . . . . . . . . . . . . . . . . 4.175 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.174 (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.183 Art. 1136. . . . . . . . . . . . . . . . . 4.188, 4.199 Art. 1142. . . . . . . . . . . . . . . . . .4.177, 4.188 Art. 1144. . . . . . . . . . . . . . . . . 4.184, 4.195 Art. 1147 . . . . . . . . . . . . . . . . . 4.199–4.200 Art. 1148. . . . . . . . . . . . . . . . . . . . . . .4.200 Art. 1149. . . . . . . . . . . . . 4.178, 4.189, 5.07 Art. 1150 . . . . . . . . . . . . . 4.201, 4.211, 5.98 Art. 1151 . . . . . . . . . . . . 4.197, 4.225, 4.240 Art. 1152 . . . . . . . . . . . . . . . . . . . . . . .4.220 Art. 1153 . . . . . . . . . . . . . . . . . . 4.201, 7.07 (1) . . . . . . . . . . . . . . . . . . . . . . . . . .4.201 Art. 1184. . . . . . . . . . . . . . . . . . . . . . .4.209 Art. 1226 . . . . . . . . . . . . . . . . . . . . . .4.220 Art. 1315 . . . . . . . . . . . . . . . . . . . . . . . 4.217

Code de Organisation Judiciaire Art. L.411-2 II. . . . . . . . . . . . . . . . . . . 4.218 Germany Civil Code (Bürgerliches Gesetzbuch – BGB) . . . . . . . 4.247, 4.253–4.255, 4.266 § 241. . . . . . . . . . . . . . . . . . . . . . . . . .4.265 (1) . . . . . . . . . . . . . . . . . . . . . . . . . .4.256 (2) . . . . . . . . . . . . . . . . . . . . 4.281–4.282 §§ 249–255 . . . . . . . . . . . . . . . . 2.03, 4.259 § 249. . . . . . . . . . . . . . . . . . . . . 2.03, 4.259, 4.268, 5.07 (1) . . . . . . . . . 4.268, 4.296–4.297, 4.301 § 251 . . . . . . . . . . . . . . . . . . . . 4.268, 4.283 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.259 § 252 . . . . . . . . . . . . . . 4.270, 4.302, 4.304, 4.317, 4.335, 5.98 § 253 . . . . . . . . . . . . . . . . . . . . 4.268, 4.272 § 254. . . . . . . . . . . . . . . . . . . . 4.318, 4.321 (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.317 § 275 (1)–(3) . . . . . . . . . . . . . . . . . . . . . . .4.285 (1), (2) . . . . . . . . . . . . . . . . . . . . . . . 4.257 (3) . . . . . . . . . . . . . . . . . . . . . . . . . .4.258 § 276. . . . . . . . . . . . . . . . . . . . . . . . . .4.290 (1) . . . . . . . . . . . . . . . . . . . . . . . . . .4.292 § 278. . . . . . . . . . . . . . . 4.318, 4.320, 4.322 §§ 280–283. . . . . . . . . . . . . . . . . . . . .4.286 § 280. . . . . . . . . . . . . . . . . . . . . . . . . . 4.274 (1) . . . . . 4.255, 4.279, 4.281, 4.285, 7.07 (2) . . . . . . . . . . . . . . . . . . . . . 4.291, 7.07 § 281. . . . . . . . . 4.274, 4.278–4.280, 4.296 (1), sentences 2, 4 . . . . . . . . . . . . . .4.285 (5) . . . . . . . . . . . . . . . . . . . . . . . . . .4.285 § 282. . . . . . . . . . . . . . .4.274, 4.278, 4.281 § 283. . . . . . . . . . . . . . .4.274, 4.278, 4.285 § 284. . . . . . . . . . . . . . . 4.311–4.313, 4.322 § 286. . . . . . . . . . . . . . . . 4.274, 4.276, 7.07 § 287. . . . . . . . . . . . . . . . . . . . . . . . . .4.292 § 288. . . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 (1) . . . . . . . . . . . . . . . . . . . . . . . . . .4.277 (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 § 289, sentence 1. . . . . . . . . . . . . . . . . . 7.07 § 291. . . . . . . . . . . . . . . . . . . . . . . . . . . 7.35 § 309(5) . . . . . . . . . . . . . . . . . . . . . . .4.336 §§ 320–322. . . . . . . . . . . . . . . . . . . . .4.306 § 323. . . . . . . . . . . . . . . . . . . . . . . . . .4.307 §§ 346–348 . . . . . . . . . . . . . . . . . . . .4.280 § 346. . . . . . . . . . . . . . . . . . . . . . . . . .4.279 § 348. . . . . . . . . . . . . . . . . . . . . . . . . .4.279 § 536a . . . . . . . . . . . . . . . . . . . . . . . . .4.305 § 827. . . . . . . . . . . . . . . . . . . . . . . . . .4.290 § 828. . . . . . . . . . . . . . . . . . . . . . . . . .4.290

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Table of Legislation Code of Civil Procedure (ZPO) . . . . . . . 4.450 § 287. . . . . . . . . 4.328–4.329, 4.331, 4.333 § 452(1), sentence 1 (1), sentences 1, 2 . . . . . . . . . . . . . .4.329 (2)–(4). . . . . . . . . . . . . . . . . . . . . . .4.329 Mexico Civil Code of the District (Coahuila) . . .4.248 Civil Code of the Federal District 1884 Art 1466 . . . . . . . . . . . . . . . . . . . . . . .4.247 Commercial Code Art. 78 . . . . . . . . . . . . . . . . . . . . . . . .4.426 Art. 362 . . . . . . . . . . . . . . . . . . . . . . . . 7.07 Art. 1445. . . . . . . . . . . . . . . . . . . . . . .4.426 Federal Civil Code 1928. . . . . . . . . . . . .4.226 Art. 1466 . . . . . . . . . . . . . . . . . . . . . .4.241 Art. 1796. . . . . . . . . . . 4.230–4.231, 4.426 Art. 1797. . . . . . . . . . . . . . . . . 4.230–4.231 Art. 1842 . . . . . . . . . . . . . . . . . . . . . .4.250 Art. 1910 . . . . . . . . . . . 4.229, 4.244–4.245 Art. 1913. . . . . . . . . . . . . . . . . . . . . . .4.245 Art. 1915 . . . . . . . . . . . . . . . . . . . . . . .4.229 Art. 1936. . . . . . . . . . . . . . . . . . . . . . .4.245 Art. 1949. . . . . . . . . . . . . . . . . . . . . . .4.235 Art. 2010. . . . . . . . . . . . . . . . . . . . . . .4.238 Art. 2017. . . . . . . . . . . . . . . . . . . . . . .4.233 Art. 2025 . . . . . . . . . . . . . . . . 4.233, 4.245 Art. 2028 . . . . . . . . . . . . . . . . 4.232, 4.234 Art. 2104. . . . . . . . . . . . . . . . . . . . . . .4.232 Art. 2107. . . . . . . . . . . . . . . . . . . . . . .4.230 Art. 2108. . . . . . . . . . . . . . . . . 4.236, 4.239 Art. 2109. . . . . . . . . . . . . . . . . 4.236, 4.239 Art. 2110 . . . . . . . . . . . . . . . . . . . . . . .4.242 Art. 2111 . . . . . . . . . . . . . . . . . . . . . . .4.234 Art. 2112. . . . . . . . . . . . . . . . . . . . . . .4.237 Art. 2114 . . . . . . . . . . . . . . . . . . . . . . .4.237 Art. 2117(2). . . . . . . . . . . . . . . . . . . . .4.235 Ley de Amparo Art. 129 . . . . . . . . . . . . . . . . . . . . . . .4.249 Public Private Partnerships Law Art. 87 . . . . . . . . . . . . . . . . . . . . . . . . . 3.52 United Kingdom Arbitration Act 1996 (c. 23) s. 49. . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.07 Official Secrets Act . . . . . . . . . . . . . . . . . . 4.51

Federal Rules of Evidence . . . . . . . . . . . . 4.164 Restatement (Second) of Contracts. . . . . .1.17, 2.03, 4.88, 5.40 § 344 (a) . . . . . . . . . . . . . . . . . 2.03, 4.124, 5.07 (b) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.125 (c) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.126 § 347. . . . . . . . . . . . . . . . . . . . . 4.89, 4.101 § 350. . . . . . . . . . . . . . . . . . . . . . . . . . 4.160 (1) . . . . . . . . . . . . . . . . . . . . 4.159–4.160 (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.160 § 351 . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.98 (1) . . . . . . . . . . . . . . . . . . . . .4.152, 4.173 Comment (a). . . . . . . . . . . . . . . . . . 4.158 § 352 . . . . . . . . . . . . . . . . . . . . 4.104, 4.108 Ch. 16, Topic 2, Introductory Note . . . . . . . . . . . . . . . . . .2.03, 4.89, 5.07 Revenue Procedures 79-24, 1971-1, C.B. 565 . . . . . . . . . . . . . . . . . . . . . .6.39 Treasury Regulations . . . . . . . . . . . . . . . .6.39 Uniform Commercial Code . . . . . . .1.17, 4.88 § 1-305 . . . . . . . . . . . . . . . . . . . . 4.90, 5.07 Comment 1. . . . . . . . . . . . . . . . . . . 4.109 § 2-715 . . . . . . . . . . . . . . . . . . . . . . . . . 5.98 (1) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.103 (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 4.153 § 2-718(1) . . . . . . . . . . . . . . . . . . . . . . 4.166 Venezuela Decree Law No. 138 . . . . . . . . . . . . . . . . . 5.32 Nationalisation Law 1975. . . . . . . . . . . . .5.36 ‘Organic Law’ . . . . . . . . . . . . . . . . . . . . . .5.36 INVESTMENT TREATIES Bilateral Investment Treaties Algeria–Luxembourg BIT . . . . . . . . . . . .6.36 Argentina–France BIT Art. 3 . . . . . . . . . . . . . . . . . . . . . . . . . 5.173 Art. 5 . . . . . . . . . . . . . . . . . . . . . . . . . .6.36 Hungary–Cyprus BIT . . . . . . . . . . . . . . 5.149 UK– Argentina Treaty . . . . . . . . . . . . . . 5.192 US–Argentina BIT . . . . . . . . . . . . . 5.20, 6.50 Art. IV.1 . . . . . . . . . . . . . . . . . . . . . . . 6.139 USA–Ecuador Investment Protection Treaty . . . . . . . . . . . . . . . . . . . . . . . . 5.16

United States 28 U.S.C.A. § 1961 . . . . . . . . . . . . . . . . . . . . . . . . . . 7.35

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LIST OF ABBR EV I ATIONS

ABV AdT APV BGB BIT BLT BOO BOOT BOT Canterbury Treaty CCF CISG DBO DCF ECA EPC FIDIC GICS ICC ICC ICSID IRR ILC IRT IVSC JCT MIGA NAICS NAV O&M PCIJ PECL PFI

Adjusted book value Aguas del Tunari Adjusted Present Value German Civil Code (Bürgerliches Gesetzbuch) Bilateral Investment Treaty Build-Lease-Transfer Build-Own-Operate Build-Own-Operate-Transfer Build-Operate-Transfer Treaty concerning the Construction and Operation by Private Concessionaires of a Channel Fixed Link Capitalized Cash Flow United Nations Convention on Contracts for the International Sale of Goods Design-Build-Operate Discounted Cash Flow Export Credit Agencies Engineering, Procurement and Construction International Federation of Consulting Engineers Global Industry Classification Standard Infrastructure Conditions of Contract International Chamber of Commerce International Centre for Settlement of Investment Disputes Internal Rate of Return International Law Commission Invalid Round-Trip International Valuation Standards Council Joint Contracts Tribunal Multilateral Investment Guarantee Agency North American Industry Classification System Net Asset Value Operation and Maintenance Permanent Court of International Justice Principles of European Contract Law Private Finance Initiative

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List of Abbreviations PICC (or UNIDROIT Principles) PNAV PPA PPP RAF SIC SoPC UCC UNCITRAL UNCITRAL Contracts Guide UNCITRAL Legislative Guide UNCITRAL Model Legislative Provisions UNIDO UNIDO BOT Guidelines UNIIDROIT VC WACC

UNIDROIT Principles of International Commercial Contracts Price-to-NAV Power Purchase Agreement Public Private Partnership Reserve Adjustment Factor Standard Industrial Classification Standardisation of PFI Contracts Uniform Commercial Code United Nations Commission on International Trade Law Legal Guide on Drawing up International Contracts for the Construction of Industrial Works Legislative Guide on Privately-financed Infrastructure Projects Model Legislative Provisions on Privately Financed Infrastructure Projects

United Nations Industrial Development Organization Guidelines for Infrastructure Development through Build-Operate-Transfer Projects International Institute for the Unification of Private Law Venture Capital Weighted Average Cost of Capital

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1 INTRODUCTION

This work aims to provide an in-depth analysis of the legal, financial, and eco- 1.01 nomic issues involved in the preparation of claims and arbitral awards for damages for the breach of complex long-term contracts in international arbitration, and to provide guidelines for attorneys, financial and economic experts, and arbitrators, in order to overcome the challenges faced when preparing a damages claim or an arbitral award. In particular, it examines the way in which general principles of damages law have to be applied to the determination and the assessment of damages under complex long-term contracts. Chapter 2 analyses the following question: ‘What is the standard for compensa- 1.02 tion?’ As explained by Professor Hersch Lauterpacht, states were originally reluctant to provide full compensation, however, at the beginning of the twentieth century, both the award of lost profits and the full compensation principle were already duly recognized, as shown by the well-known Factory at Chorzów case, which reflected contemporary state practice.1 Full compensation nowadays is considered a general principle of law and it is also the international customary law standard. The principle of full compensation, which is the leitmotiv running throughout this 1.03 work, leads to the next question: ‘Full compensation of what?’. In his seminal analysis of the ‘Doctrine of Interest’ in 1855, Professor Friedrich Mommsen developed the notion of interest through the so-called differential hypothesis, which is the difference between the economic situation with and without the breach of contract. This refers to the ‘expectation interest’ as further developed by Rudolf von Jhering. Nowadays, the expectation interest is the difference between the hypothetical and the actual economic situations after the application of limitations, and which can be proved through the evidence available, which leads to the compensation of the actual loss. This doctrine has spread throughout Europe, and was introduced by Professor Lon L. Fuller and his assistant William Perdue in the USA in 1937 and raised to perfection under the notion of the ‘but-for ’ premise in antitrust damages 1 Hersch Lauterpacht, The Development of International Law by the International Court (Cambridge University Press 1958) 315–16.

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Chapter 1: Introduction claims in that country. The compensation of the expectation interest corresponds to full compensation and is used in international arbitration, as will be shown in examples throughout this book. Full compensation of the actual loss avoids overand undercompensation. This book will examine in detail how legal, procedural, and quantification issues may affect the principle of full compensation and how both under- and overcompensation will be unfair to one of the parties. 1.04 Chapter 2 also examines the role, function, and importance of damages law. It

outlines the relevance of compensation of losses caused by the breach of a contract or an illegal act, which is necessary for the proper functioning of any legal, social, and economic system. It provides an overview of the historic development from the commutative and distributive justice of Aristotle as applied by Roman law and further developed by the late scholastics in the Middle Ages, through to contemporary legal scholars and eminent economists, where the underlying notions with respect to compensation are fairness and justice. These provide the necessary legitimation to any legal rules on damages. Fairness is the guiding principle on which this book is based. However, as a subjective notion it needs to be translated into verifiable standards. 1.05 Chapter 3 starts with an overview showing that large infrastructure projects such as

water distribution, railways, the Gotthard tunnel, and the Suez Canal were financed and operated by private parties, which predominantly owned and operated infrastructure until the early twentieth century. Thereafter, the first and second World Wars and de-colonization led to massive nationalization. The situation changed again in the 1970s with the appearance of the first Build-Operate-Transfer (BOT) projects in Turkey. This led to the Private Finance Initiative (PFI) in the UK in 1992 and the promulgation of Public Private Partnerships (PPPs) around the world. In 1996 the United Nations Industrial Development Organization (UNIDO) published the Guidelines for Infrastructure Projects through Build-Operate-Transfer Projects (‘the UNIDO BOT Guidelines’) and a significant contribution was made by the United Nations Commission on International Trade Law (UNCITRAL) through its Legislative Guide on Privately-financed Infrastructure Projects published in 2001 (‘the UNCITRAL Legislative Guide’) to assist countries in reforming their legislations in order to make them suitable and attractive for privately-financed infrastructure projects in order to promote economic growth and welfare. During the last decades, the need for the provision of public infrastructure and services by private parties has increased exponentially, supported by multilateral institutions such as the World Bank, UNIDO, UNCITRAL, regional development banks such as the Inter-American Development Bank, and other multilateral and regional institutions. According to Professor Don Wallace Jr, private participation in infrastructure and the provision of public services is inevitable and difficult. 1.06 Complex long-term contracts used in project agreements for privately-financed

infrastructure projects in order to provide public infrastructure and services 2

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Introduction through private parties, such as PPP or BOT projects, are of primordial importance for the world economy and disputes often result in high-profile and high-value damages claims in commercial and investment arbitrations. Therefore, they will be analysed in chapter 3 together with private-to-private complex long-term contracts, which are found in industrial joint venture agreements, telecommunications, air-space, and other high-technology projects. As shown in chapter 3, whereas detailed international rules have been developed in 1.07 the area of public procurement, models for complex long-term contracts have been left to private institutions such as FIDIC (International Federation of Consulting Engineers, for its acronym in French), ICC (International Chamber of Commerce), and other institutions, which are mostly limited to construction contracts. In 2008, FIDIC published the FIDIC Conditions of Contract for Design, Build and Operate Projects, which are useful for a particular type of privately-financed infrastructure projects. A fully fledged contract model for PPPs can be found in the UK in HM Treasury’s Standardisation of PFI Contracts, which served as a model for the first Mexican PPPs. Contract guidelines are provided by the World Bank PPP in Infrastructure Resource Center. The development and the most important legal documents, contract models, and legislative and contract guidelines for privately-financed infrastructure projects are examined in this book. Both legislative and contract guidelines and model contracts contain interesting provisions reflecting fair practices for the award of damages in case of breach of contract, using contractual mechanisms. Complex long-term contracts for private and public infrastructure projects are the 1.08 domain of project finance lawyers and experts. Project finance is a legal and financial discipline originally developed in the USA. It was used for oil and gas projects in the 1970s and later extended to power plant projects, roads, railways, bridges, telecommunication facilities, and water treatment plants. It is based on a ‘nonrecourse or limited recourse financing structure in which debt, equity and credit enhancement are combined for the construction and operation, or the refinancing, of a particular facility in a capital-intensive industry, in which lenders . . . rely on any revenue-producing contracts and other cash flow generated by the facility. . . ’.2 In essence, project finance is about the contractual and financial mechanisms used to make a project or investment happen. In the case of privately-financed infrastructure projects, the state or state entity wishes to obtain public infrastructure and services for its citizens it could not otherwise afford, and the lenders and investors wish to obtain a reasonable profit in accordance with the risks taken. An understanding of the role of project finance for complex long-term contracts based on income stream, and the design of such contracts using sophisticated risk

2 Scott L. Hoff man, The Law and Business of International Project Finance (3rd edn., Cambridge University Press 2008) §1.01.

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Chapter 1: Introduction allocation mechanisms in order to make a project or investment viable or ‘bankable’, is of importance when framing a damages claim or awarding damages. The UNIDO BOT Guidelines and the UNCITRAL Legislative Guide provide recommendations for the ‘reasonable sharing of the benefits between the investors and the host government’,3 in order to make such projects successful. The ultimate aim of project finance, as further explained in chapter 3, is to structure financings that are robust enough to withstand long-term volatility and be sufficiently attractive to lenders and investors. 1.09 An understanding of the risk allocation mechanisms contained in complex long-term

contracts, as explained in chapter  3, is of utmost importance for the awarding of damages. Risk identification, risk allocation, and risk mitigation are essential elements of complex long-term contracts, where the long-term character and the complexities of the underlying project, multi-parties, multi-contracts, technology issues, and the quality of the legal framework in host states requires the elaboration of risk profiles based on a reasonable risk-reward approach. Project agreements are structured in accordance with such risk profiles. The corresponding risk determination and allocation is relevant not only at the planning stage and during the execution of the complex long-term project, but also when establishing a breach, as well as when evaluating damages and determining the applicable discount rate to calculate the present value of a future income stream, as analysed in chapter 6. 1.10 Complex long-term contracts may be classified in different manners. Contracts

with states or state entities and international administrative contracts found in legal systems where these contracts are subject to public law, such as under the French notion of ‘contrat administratif’ applicable throughout Latin America, are of particular importance. Even when under the public law domain, states may act de jure imperii or de jure gestionis, which gives rise to different legal issues. These contracts are more rigid and more likely to lead to disputes due to political concerns. 1.11 It has been recognized that there are no provisions that regulate complex long-term

contracts in European codes of law.4 The International Institute for the Unification of Private Law (UNIDROIT) has already identified the need for particular rules on long-term contracts and prepared a document for possible inclusion in the next edition of the UNIDROIT Principles of International Commercial Contracts (PICC). The notion of the ‘relational contract’ developed in the USA as a flexible framework agreement for co-operation does not seem to correspond to the realities of complex long-term contracts, because the latter are characterized by ‘very detailed and extensive regulation with the aim to avoid any ambiguity’.5 3

UNIDO BOT Guidelines 215. See Stefan Grundmann and Martin Schauer, The Architecture of European Codes and Contract Law (Kluwer Law International 2006) 12, 60–61. 5 Michel Kerf et al., Concessions for Infrastructure: A Guide to their Design and Award , World Bank Technical Paper No. 399 (The World Bank and the Inter-American Development Bank 1998) 108. 4

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Introduction The rules of law on damages analysed in this work are ‘one size fits all’. Under the 1.12 respective rules of law, the same rules apply to simple cases such as Pothier’s case of a sick cow under French law, or the UK case of the swimming pool which did not meet specifications (both mentioned in chapter 4), as well as to the loss of income stream due to breach of complex long-term contracts The latter situation has a different nature and therefore it is necessary to analyse the application of general rules of damages to these particular situations. The understanding of the characteristics of complex long-term contracts, and, in particular, those based on income stream, is, therefore, important for the identification of the relevant rules applicable to damages claims. Chapter  4 provides a ‘functional’ analysis of seven different rules on damages 1.13 as applied in the UK, USA, France, Mexico, Germany, the United Nations Convention on Contracts for the International Sale of Goods (CISG), and PICC. The different rules of law analysed provide different insights and solutions for damages claims under complex long-term contracts by using different approaches in order to arrive at full compensation. These rules of law contain normative requirements such as breach of contract, the existence of a loss, causation, the measure of damages, and limitations such as foreseeability, remoteness or adequacy, mitigation, and contributory negligence. The normative requirements, measures of damages (interest protected), and limitations reflect the legal policy and systemic aspects under the different rules of law. For example, the expectation interest and the reliance interest, a distinction originally developed by Rudolf von Jhering and further developed by Lon Fuller with William Perdue are subject to the social and economic values of the applicable rules of law. Systemic differences are evident in the measure of damages, where certain rules of 1.14 law protect ‘specific’ performance through the performance principle, while others protect the monetary equivalent of performance under the economic benefits principle. This reflects the difference between the cost of cure under civil law and the difference in value under common law, as will be explained in detail in chapter 4. However, whether the difference in value or the cost of cure is applied, full compensation is the basic premise. This is valid even under the US theory of efficient breach of contract developed as part of the Economic Analysis of Law, where the respondent may breach the contract if it gains enough from the breach so that it can compensate the injured party for its losses, yet still gain some benefits from the breach. The analysis of the different rules of law in chapter 4 follows the order mentioned 1.15 here, which includes other issues such as contributory negligence, undue enrichment, and the notion of loss of a chance: (1) Principles for damages claims. (2) Requisites for a damages claim: (a) breach of contract, (b) existence and classification of losses, and (c) causation. 5

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Chapter 1: Introduction (3) Measure of damages. (4) Limitations to damages claims such as (a) foreseeability and similar concepts, and (b) avoidance or mitigation of damages. (5) Other aspects affecting the damages claim in the form of (a) the date of the determination of damages and (b) the level of evidence required and the burden of proof. (6) Penalties and liquidated damages. (7) Considerations. 1.16 Chapter 4 starts with English law, which is without doubt one of the principal

rules of law applicable to complex long-term contracts, and which is characterized by simple straightforward rules recognizing both expectation and reliance interest. The aim of English law does not appear to be full compensation as this is considered too harsh upon defendants and courts are afraid of overcompensation. This has led to broader grounds on which the right to performance is protected. The distinction between general and special damages derived from the landmark case Hadley v. Baxendale is the benchmark for the determination of remoteness of losses, in particular as regards the question of when consequential losses are general damages within the first limb of the aforementioned case. Recent case law contains particular rules as regards the assumption of responsibility and its effect on the non-remoteness of losses related to risks assumed. The common measure of damages under English law is the expectation interest in the form of compensation for the difference in value between the promised performance and the defective performance, which leads to a financial equivalent but not to a factual equivalent. This also includes loss of profits. In particular, English law recognizes the but-for premise. 1.17 US law is characterized by partial codification through the Uniform Commercial

Code and the Restatement (Second) of Contracts, which led to a significant development of the law. As will be shown in chapter 4, US law appears to be based on fairness to both parties, aiming at avoiding over- and undercompensation through full compensation of the actual loss, and is influenced by doctrines such as the Economic Analysis of Law and the principle of efficient breach of contract, which, however, do not reduce the level of protection of the promisee. US law, like English law, does not recognize the principle of pacta sunt servanda in the form of specific performance. According to Oliver Wendell Holmes: ‘The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it—and nothing else.’ The principal measure of damages is expectation interest based on the but-for premise. The modern version of contractual reliance interest was developed by Lon Fuller with William Perdue and both expectation and reliance interest are expressly established in the law. Both English and US law are rich in damages cases, due to their highly developed court systems, capable of handling complex economic damages situations using balanced rules of evidence, which will be discussed in detail in chapter 4. 6

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Introduction French law is based on a very high level of protection for the injured party, where 1.18 expectation interest in the form of cost of cure may be recovered even if this is unreasonable. This, however, is irrelevant for income stream based complex long-term contracts, as will be shown throughout this book. The function of damages law is to put the injured party in the position in which it would have been had the contract been performed, which is the but-for situation, although using a very high benchmark of full compensation. The main instruments of limitation are the requirements of causality and foreseeability; however, the latter does not apply in case of bad faith. In spite of the idealistically high level of protection, the application of the law is a matter of considerable discretion for the trial judge, with control by the appeal court and the Cour de cassation limited to legal issues. French law does not impose an express duty to mitigate damages but comes to similar results through the notion of causality, as will be examined in detail in chapter 4. French law is of particular interest due to its influence in many countries. The measure of damages of damnum emergens and lucrum cessans provides a general indication of damages and its distinction is not particularly relevant in judicial practice. Mexican damages law follows the French Civil Code, however, with few judi- 1.19 cial precedents. Due to its important oil and energy sector, Mexico is the source of important commercial and investment arbitration cases relating to damages under complex long-term contracts with state entities. Mexico has been a pioneer in privately-financed infrastructure projects in Latin America, and state contracts have been submitted to arbitration since 1993. Issues deriving from the French law notion of the ‘contrat administratif’, such as limitations to the arbitrability of acts of authority under complex long-term contracts entered into with state entities, appear throughout Latin America.6 German law is the source of many important doctrines of damages law, such as 1.20 the differential hypothesis or but-for premise to determine the expectation interest. Rudolf von Jhering developed the reliance interest as an extra-contractual notion which was only recently included into German law as a contractual measure of damages. German legal doctrine explains the relationship between the scope of protection of a contractual provision (Schutzzweck der Norm) and foreseeability of the loss through the test of adequacy. It has influenced international law with the notion of the hypothetical normal course of events found in the Factory at Chorzów case. Modern German damages law, as reformed in 2002, follows contemporary developments of international sales and contract law; however, it is characterized by a casuistic approach and a strong influence of doctrine that makes access to

6 Herfried Wöss, ‘Solución de Controversias al amparo de la Nueva Ley Mexicana de Asociaciones Público-Privadas’ (2012/2013) 5 Lima Arbitration 185–94; Herfried Wöss, ‘Mexico:  Dispute Resolution under the New Public-Private Partnerships Law’ (2013) Global Arbitration Review (23 May).

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Chapter 1: Introduction German law difficult. Courts have a wide discretion when assessing damages and strict rules of burden of proof do not necessarily apply. 1.21 CISG hardly plays a role for complex long-term contracts, even if it could apply in

the absence of an express opting-out provision, to power purchase agreements or construction contracts where the value of the goods exceeds the value of services. CISG is based on the principle of full compensation and the traditional notion of damnum emergens and lucrum cessans as measure of damages, which may easily be applied to sales contracts, but not to complex long-term contracts based on income stream, as further explained in chapters 4 and 5. The CISG Advisory Council Opinion No. 6 on the ‘Calculation of Damages under CISG Article 74’ provides an interesting insight into legal policy in favour of lost profits and loss of a chance or opportunity, which is of general relevance, as discussed in chapter 4. 1.22 The PICC represent best legal practices of leading jurisdictions rather than a com-

mon minimum standard. PICC are based on the principle of full compensation, however, they refer to the traditional notions of damnum emergens and lucrum cessans instead of the modern notion of expectation interest, which is a considerable shortcoming, as explained in detail in chapter  5. PICC contain express references to risk allocation, with respect to co-operation clauses and other provisions that govern the effect of the interference of the other party, or as regards the relationship between exemption and justification clauses, force majeure, and the foreseeability of losses, which are of particular relevance for complex long-term contracts. Reasonable certainty of loss has been incorporated into Article 7.4.3 PICC (Certainty of harm), which is further examined in chapter 4. The last paragraph of this provision expressly states that where damages cannot be established with a sufficient degree of certainty, the discretion of the court prevails. The procedural equilibrium established in that article is of utmost importance in order to allow for full compensation of damages through a learned estimate of damages, as the application of strict rules of burden of proof may lead to undercompensation and windfall profits for the respondent. 1.23 Chapter 5 provides an insight when analysing, framing, and proving a damages

claim under a complex long-term contract. It is divided into two parts. The first part refers to commercial arbitration, whereas the second part focuses on the particularities of investment arbitration and the measure of damages under the Chorzów formula. This chapter also contemplates three different damages situations: (1) the breach of a typical synallagmatic complex long-term contract such as a power purchase agreement or a construction contract; (2) the breach of an atypical synallagmatic complex long-term contract based on income stream; and (3) the breach of a complex long-term contract based on income stream entered into with a state entity that amounts to a violation of an international legal standard or international tort in investment arbitration. The emphasis of chapter 5 is on the lost profits or lost income stream in typical and atypical synallagmatic contracts, 8

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Introduction and their differences and similarities when analysing, framing, and proving a damages claim. Particular attention is paid to the examination and explanation of fundamental 1.24 legal concepts such as the measure of damages in the form of expectation interest and its intimate relationship with the differential hypothesis or but-for premise, which is the means by which over and undercompensation can be avoided, that is, full compensation of the actual loss is achieved. The but-for premise is: (a) a principle accepted under all rules of law analysed including international law (‘to wipe out all consequences’), (b) a comprehensive analytical method, to determine loss, causation, and the measure of damages, and (c) the framework required in order to calculate the quantum. The but-for premise is increasingly used in international arbitration, especially in the recent leading commercial and investment arbitration cases, which are examined throughout this work. Chapter 5 explains how the reasonable certainty of income stream is related to 1.25 the reconstruction of the hypothetical course of events under the but-for premise, which has to be compared with the actual course of events to obtain the expectation interest. It further shows the importance of the analysis of contingencies when reconstructing the hypothetical course of events in order to provide evidence of the reasonable certainty of income. It also explains the relevance of isolating the effect of the breach or violation of an international standard in order to reconstruct the but-for situation to be compared with the actual situation and then to obtain the actual loss to be compensated. Th is chapter also explains how legal issues such as the hypothetical normal course of events under the German law and the notions of concurring and interrupting causality under English law may lead to completely different results, as well as the differences of burden of proof when applied to reliance interest under those rules of law. Particular considerations as regards the measure of damages under international customary law are also found in chapter 5. In addition, it analyses the difference between the reasonable certainty of income and the notion of foreseeability of losses and examines the relevance of the test of foreseeability for contracts whose very nature is the generation of income. These issues are compared with damages situations under typical synallagmatic contracts and loss profits arising from collateral transactions. Chapter 5 further aims to clarify general damages law concepts, which cause con- 1.26 siderable confusion when applied to the interruption of income stream caused by breach of contract or the violation of an international standard, such as damnum emergens and lucrum cessans, expectation interest, and reliance interest. The justification of the reliance interest from a legal policy perspective will be further analysed in chapter 5. It examines in detail, both from a legal and economic perspective, the implications of choosing the relevant date for the assessment of damages in the light of the full compensation principle. 9

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Chapter 1: Introduction 1.27 The evidence available and the burden of proof are essential for damages claims.

Chapter 5 further analyses the effects of procedural rules on evidence and burden of proof already mentioned in chapter 4, all of which reflect a rather liberal approach based on procedural equity, taking into consideration the evidentiary difficulties in forecasting the with and without breach courses of events. Damages claims under complex long-term contracts based on income stream require particular economic and financial expertise from the outset of the preparation of a damages claim and as experts during the arbitration. The analysis of damages claims is a cross-disciplinary matter where legal issues are tied to economic and financial concepts and ‘language’ problems such as the understanding of economic concepts by lawyers and of legal issues by economists are of utmost importance. This chapter provides clarification on how these issues should be dealt with when framing and proving a damages claim. In particular, chapter 5 discusses the notion of ‘judging economists’ and the importance of the proper communication and treatment of legal and economic issues in order to arrive at a well-structured damages claim and a well-reasoned award. The experience in damages claims in antitrust or competition law damages arbitrations are of particular relevance in that respect, as further discussed in chapter 5. 1.28 The last part of chapter 5 analyses the principal features of damages claims under

complex long-term contracts based on income stream with state entities in investment arbitration. International law as applied in investment arbitration is analysed in the light of the influence of private law in the formation of international customary damages law, as recognized in the Factory at Chorzów case. The particular measure of damages in this case and the rationale behind are explained. The objective is to show the difference in damages determination in commercial and investment arbitration. Particular attention is paid to fair market value (FMV) as the measure of damages in investment arbitration and its application in case of partial interruption of income stream over a certain period of time, as explained in more detail in chapter 6. 1.29 Chapter 6 provides an insight into the economics of public and private contracts

and the application of the but-for premise with respect to damages analysis both under its original notion as well as the particular aspect of the but-for premise applied to FMV in investment arbitration. It begins by identifying the key aspects of complex long-term contracts that tend to differentiate them from other types of agreements, and draws parallels with agreements typically seen in infrastructure and utilities in public-private contracts, allowing inferences from investment arbitration to be made. It further analyses the economic and financial effects on damages of choosing the appropriate date of valuation and how to make the corresponding adjustments in the situation where the date of valuation is different from the date of the award. Double counting as well as situations of undercompensation are subject to extensive economic and financial analysis. Finally, the experts survey the most frequently used valuation methods (and other methods not used 10

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Introduction as frequently), and comment on their application in the determination of damages in international disputes. The experts make the important distinction between two exercises that often are not the same: valuation and damages assessment; the former as a more ‘canned’ exercise which may or may not coincide with the determination of damages, and the latter in a role whose mission is first and foremost, to assist tribunals in determining the specific impact of specific actions in accordance with the merits of a case, the facts, and the economic reality or assumptions that the merits dictate. In examining this, the experts draw examples from public awards in investment disputes and address, where appropriate, the key differences in damages assessment between commercial and investment arbitration. The role of interest is examined in chapter 6 from an economic and financial per- 1.30 spective and in chapter 7 under the notion of interest as damages and as an integral part of damages valuation. If discount and pre-award interest rates are not properly determined this may seriously affect full compensation, as analysed in chapters 6 and 7. These chapters explain how pre- and post award interest rates form an integral part of damages valuation; in particular, how undercompensation and unfairness results from the so-called invalid round trip (described by Abdala, López, and Spiller7) or when not applying the correct pre-award interest rate or not choosing the correct date of valuation. Chapter 7 examines how the currency and cost of arbitration issues are to be solved as part of the damages analysis through the but-for premise. This book underlines the fundamental necessity for arbitral tribunals to learn to 1.31 deal with uncertainty and not to spare any effort to make a learned, fair, and well-reasoned estimate of income or profits lost, rather than taking a shortcut to reliance interest or ‘splitting the baby’. The aim of this book is to provide tools for the preparation of damages claims, which lead to well-reasoned and fair awards where the damages section can be reconstructed, and the congruence of legal principles and the economic and financial models can be ‘verified’ or ‘falsified’ in the sense used by Sir Karl Raimund Popper, which means that findings may be replicated. As such, a selection of the relevant issues to be analysed must be made, which necessarily means the exclusion of topics that might be of interest but are not relevant for the purpose of this book. Hypothetical and real arbitration and court cases are extensively used throughout 1.32 this book as examples of how to overcome the aforementioned legal, procedural, and quantification challenges and to avoid insufficient or incongruent analyses, misunderstandings, and misconceptions when claiming and awarding damages, and to illustrate best practices in damages analysis and the award of damages. Any

7 Manuel A. Abdala, Pablo D. López Zadicoff, and Pablo T. Spiller, ‘Invalid Round Trips in Setting Pre-Judgment Interest in International Arbitration’ (2011) 5(1) World Arbitration and Mediation Review 1–21.

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Chapter 1: Introduction statements and analyses contained in this book are of a purely academic and illustrative character and may not be used as a statement or opinion of the authors in any arbitrations and related procedures where they are involved. Chapter 6 of this book was contributed by economic experts Professor Pablo T. Spiller and Santiago Dellepiane; all other chapters were written by Dr. Herfried Wöss and Adriana San Román Rivera.

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2 FUNCTION, ROLE, AND IMPORTANCE OF DA M AGES L AW

A. Function of Damages Law 1. Compensatory function 2. Legal certainty and protection of legitimate expectations

3. Preventive function 4. Punitive function limited to tort

2.01 2.01 2.21

B. Economic and Social Role of Damages Law

2.26 2.27 2.28

A. Function of Damages Law 1. Compensatory function The principal function of damages law, which is confirmed by the different rules 2.01 of law on damages including international law, is the compensation of the loss caused by a breach of contract or an illegal measure affecting a complex long-term contract. The payment of an amount of money should place the injured party in the financial position he would be in if the damaging act had not occurred; that is, to wipe out all the consequences of the breach. This rule can be regarded as a general principle of law.1 The compensation function of damages law has its origins in Greek philosophy 2.02 and Roman law: Aristotle dealt with compensation under the notion of ‘corrective or commutative justice’, which is a description of a how a private law relationship should be approached. In those days, rectification of an injury through the acknowledgement and execution of one party’s claim against the wrongdoer was recognized. Commutative justice treats the wrong and the transfer of resources that undoes it, as a link between the injured party and the wrongdoer.2 Corrective

1

Irmgard Marboe, Calculation of Compensation and Damages in International Investment Law (Oxford University Press 2009) 27, with further references; Ingeborg Schwenzer, Pascal Hachem, and Christopher Kee, Global Sales and Contract Law (Oxford University Press 2012) para. 44.19; see chapter 4. 2 Ernest J. Weinrib, The Idea of Private Law (Oxford University Press 1995) 56.

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Chapter 2: Function, Role, and Importance of Damages Law or commutative justice seeks to subtract the unjust gain of one party to make up for the loss of the other party. In his Nichomachean Ethics, Aristotle states that ‘the law has regard only to the difference made by the harm done; they are on the same footing, apart from the fact that one has perpetrated and the other suffered the harm’.3 Under Roman law, the actual loss suffered by a contracting party owing to a breach of a contract constitutes ordinary damages (quanti ea res est ; ‘that is how much the plaintiff has lost’), which are compensated based on market values.4 2.03 This ancient concept of compensatory function of damages is also valid under the

rules of law analysed in this work: (1) Under the leading UK case, Robinson v. Harman, the aim of damages is to give the injured party the necessary amount of money to put him ‘so far as money can do it, in the same position as he would have been in had the contract been performed’.5 (2) The US Second Restatement of Contracts establishes that ‘[t]he initial assumption is that the injured party is entitled to full compensation for his actual loss’.6 In order to achieve this purpose, US courts award the expectation interest, which aims to put the injured party in the economic position he would be in but for the breach.7 (3) French law recognizes the principle of full compensation or reparation integrale. Full compensation is the objective ( principle de réparation intégrale du préjudice) and has to be in accordance with the loss suffered (tout le prejudice mais rien que le prejudice). The essence of the full compensation principle is to return the victim ‘as closely as monetary possible to the position in which he would have been had the wrong not being done’.8 (4) German damages law contained in §§249 to 255 of the German Civil code (Bürgerliches Gesetzbuch or BGB) is based on the principle of total reparation leading to the situation which would have existed if the damaging event had not occurred (§249 BGB). (5) The formula used in paragraph (1)  of Article 7.4.2 PICC (Full compensation) to measure the harm states that: ‘The aggrieved party is entitled to full compensation for harm sustained as a result of the non-performance. Such harm includes both any loss which it suffered and any gain of which it was 3 Gerard J. Hughes, Th e Routledge Guidebook to Aristotle’s Nicomachean Ethics (Taylor & Francis Group 2013); V, 4, 1132a2–6. 4 Charles Phineas Sherman, Roman Law in the Modern World , Vol. 2 (Baker, Voorhis & Co. 1924) 299; D.50.16.193, D.39.2.4.7. 5 Robinson v. Harman (1848) 13 P.D. 191 (C.A.), 200. 6 Restatement (Second) of Contracts, Chapter 16, Topic 2, Introductory Note. 7 Restatement (Second) of Contracts, §344 (a) (Purpose of Remedies). 8 Konstanze Brieskorn, Vertragshaftung und responsabilité contractuelle, Ein Vergleich zwischen deutschem und französischem Recht mit Blick auf das Vertragsrecht in Europa (Mohr Siebeck 2010) 252, with further references; Solène Rowan, Remedies for Breach of Contract: A Comparative Analysis of the Protection of Performance (Oxford University Press 2012) 109.

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A. Function of Damages Law deprived, taking into account any gain to the aggrieved party resulting from its avoidance of cost or harm.’ (6) Article 74 CISG reads: ‘Damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach.’ With respect to international law, the judgment of the Permanent Court of 2.04 International Justice (PCIJ) in the Factory at Chorzów case stated: The essential principle contained in the actual notion of an illegal act—a principle which seems to be established by international practice and in particular by decisions of arbitral tribunals—is that reparation must, as far as possible, wipe out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed.9

In the Lusitania decision, the German-American Claims Commission stated that 2.05 damages aim at reparation for the loss suffered:  ‘The remedy should be commensurate with the loss, so that the injured party may be made whole.’10 Article 31 of the International Law Commission (ILC) Articles on State Responsibility establishes with respect to the reparation of damages, that the responsible state is obliged ‘to make full reparation for the injury caused by the internationally wrongful act’. a. Full compensation principle The foregoing paragraphs refer to the principle of full compensation. This prin- 2.06 ciple is explained in detail in Professor Friedrich Mommsen’s Doctrine of Interest. Mommsen developed the notion of ‘interest’ from the Roman law maxim id quod or quanti actoris interest according to which, the term ‘interest’ corresponds to full compensation of the loss, which is the expectation interest.11 As explained in detail in chapter 4, if a defendant was to be condemned in id quod or quanti actoris interest, the judge had to estimate claimant’s losses and his material situation which would have resulted if the fact for which the respondent was liable had not occurred. The differential hypothesis or but-for premise also developed by Mommsen provides the framework to determine such loss and to quantify it, as explained later in this book. Under the but-for premise, the question of what would be the position of the injured party but for the breach implies full compensation. Under the Chorzów

9

1928 PCIJ Series A, No. 17, p. 47. Marboe, Calculation of Compensation and Damages in International Investment Law 28, accessed 7 November 2013. 11 Friedrich Mommsen, Beiträge zum Obligationenrecht: Abth. Zur Lehre von dem Interesse (E.U. Schwetschke und Sohn 1855), ‘Das Interesse ist allerdings ein Schadensersatz; und sofern man den Ausdruck Schadensersatz allein auf die vollständige Entschädigung bezieht, treffen beide Ausdrücke in ihrer Bedeutung zusammen’ 27 (‘Interest means, however, damages; and if the expression damages is exclusively understood as full compensation, both terms coincide in their meaning.’) The notion of interest used by Mommsen corresponds to ‘expectation interest’. 10

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Chapter 2: Function, Role, and Importance of Damages Law standard, which is the measure of damages as applied in international law, to wipe out all consequences of the breach means full reparation or full compensation.12 2.07 The principle of full compensation means that damages should compensate the

injured party for the actual loss, or, in other words, to make the injured party whole. The but-for premise provides an effective approach to obtain the actual loss under complex long-term contracts and investments. Under these contracts, the actual loss is the economic difference between the but-for situation and the actual situation; this means the economic difference between the hypothetical course of events but for the breach or illegal measure and the actual course of events. The reference to the course of events is important as the time element plays an essential role for the determination of the actual loss under complex long-term contracts. 2.08 The determination of the actual loss is subject to the following general requirements:

(1) a reasonable degree of certainty of the loss; (2) the test of causality between the breach and the loss; (3) the application of limitations such as foreseeability, remoteness, adequacy, and mitigation; (4) the measure of damages; and (5) evidence and burden of proof. 2.09 The application of these normative requirements may result in a different actual

loss to be compensated under the different rules of law according to the interest protected. Particular considerations apply with respect to complex long-term contracts based on income stream, as will be discussed throughout this book.13 2.10 Once the actual loss is determined by applying the aforementioned normative

requirements under the different rules of law, this actual loss has to be compensated. Full compensation of the actual loss leads to a fair and adequate compensation. 2.11 The proper compensation, that is full compensation of the actual loss, aims to

avoid over- or undercompensation. This implies, that neither the claimant nor the respondent should obtain a benefit at the other’s expense. The following issues have to be carefully analysed when framing and awarding damages in order to achieve full compensation of the actual loss: 2.12 Legal issues:

(1) the contractual risk allocation between the parties; (2) the difference between damnum emergens, lucrum cessans, the expectation and reliance interest;14 12

1928 PCIJ Series A, No. 17, p. 27, 47; chapter 5, paras. 5.180 et seq. See chapter 3, paras. 3.41–3.42, 3.45, 3.48; chapter 5, paras. 5.3–5.4. 14 Jan Paulsson, ‘The Expectation Model’ in Yves Derains and Richard H. Kreindler (eds.), Evaluation of Damages in International Arbitration, Dossiers of the ICC Institute of World Business Law (2006) 61–5. 13

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A. Function of Damages Law (3) the standard of the reasonable certainty of loss; (4) the burden of proof; (5) the correct classification of lost profits as direct or indirect damages as this involves the application of different levels of limitations such as foreseeability which may result in higher burden of proof; (6) the appropriate date to make the injured party whole, amongst others. Quantification issues: (1) (2) (3) (4)

2.13

the choice and proper application of the valuation methods; the adequate determination of the discount rate; the correct determination of the pre-award interest; and the evidence available, amongst other issues.

Procedural issues:

2.14

(1) Due process. Full compensation of the actual loss is contingent on a well-structured arbitral procedure. In particular, due process in international arbitration is of utmost importance when awarding full compensation for the actual loss and, therefore, to avoid over- and undercompensation. Some of the challenges for the arbitral tribunal related to due process in damages claims are: (a) performing a thorough analysis of all relevant circumstances; (b) conducting the arbitration with procedural equity; (c) the procurement and equitable assessment of all relevant evidence;15 and (d) transparency and proper reasoning of the award. (2) Burden of proof and procedural equity. Damages arbitrations are fact based and often highly complex. As an example, the rules of burden of proof and procedural equity play a particular role in order to achieve the determination of the actual loss and to avoid over- or undercompensation. Under the Roman law maxim ei incumbit probatio qui dicit non negat, meaning that the burden of proof is upon the party that asserts a fact, the arbitral tribunal has to be aware that the burden of proof is not always upon the claimant, rather, it may shift from one party to the other depending on who is asserting additional elements.16 Moreover, arbitral tribunals have a contractual and moral duty to award damages in a professional, ethical,17 structured, and learned manner, which should be reflected in the reasoning of the award.

15

Paulsson, ‘The Expectation Model’ 67–70 (n. 14), with further references. Sherman, Roman Law in a Modern World 417 (n. 4). 17 Jan Paulsson, ‘Moral Hazard in International Dispute Resolution’ (2010) 25(2) ICSID Review 339–55. 16

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Chapter 2: Function, Role, and Importance of Damages Law b. Avoidance of over- and undercompensation 2.15 Overcompensation leads to unjust enrichment of the injured party and undercompensation gives rise to unjust enrichment of the party in breach. This is what the above-mentioned normative requirements aim to prevent. Once the actual loss has been duly determined, it should be fully compensated. If the actual loss is not updated at the proper rate from the date of the breach to the date of the award, which is the date when the injured party should receive the damages, the injured party is not made whole and the party in breach is paying less than he should, resulting in unjust enrichment of the party in breach. 2.16 Undercompensation would not place the injured party in the situation he would

be but for the breach or would not wipe out the consequences of the breach or illegal act, leaving the illegal act partially or totally unremedied. In the case of undercompensation, the arbitral tribunal would actually sanction the original illegality. 2.17 According to the Roman law maxim, ‘Natura aequum est, neminem cum alterius det-

rimento fieri locupletiorem’ (no one should be enriched at another’s expense).18 This principle was further developed by Aristotle under the notion of corrective or commutative justice. According to Aristotle where one person takes another’s resource against his will, commutative justice requires that he gives it back at its monetary equivalent.19 Thomas Aquinas took this maxim as the basis for the principle against unjust enrichment: ‘Restitution . . . is an act of commutative justice . . . ’20 2.18 Commutative justice aims to protect and preserve the property of each citizen.

Thomas Aquinas expressed the concept that private property was a legitimate institution because it avoids the situation where some people would work little and receive a lot, while others would work a lot and get little. In that same line, commutative justice is violated if one person takes or uses another’s resources for his own benefit. Aquinas further said that a person might violate commutative justice either by interfering with another’s property in a wrongful manner or simply by taking what belongs to another. This was further developed by the late scholastics, who demanded that no one should be enriched at another’s expense.21 Over- or undercompensation have two basic implications: on the one hand, they result in unjust enrichment of one of the parties and, on the other hand, the principle of full compensation of the actual loss is not achieved.

18

D.12.6.14, 50.17.206. James Gordley, Foundations of Private Law:  Property, Tort, Contract, Unjust Enrichment (Oxford University Press 2006) 14. 20 Thomas Aquinas, Summa Theologica cited in Kit Barker, ‘Understanding the Unjust Enrichment Principle in Private Law’ in Jason W. Neyers, Mitchell McInnes and Stephen G.A. Pitel (eds.), Understanding Unjust Enrichment (Hart Publishing 2004) 98. 21 Gordley, Foundations of Private Law 423–4 (n. 19). 19

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A. Function of Damages Law Even under the efficient breach theory of the Economic Analysis of Law, the com- 2.19 pensation of the loss is protected and opportunistic breaches are not encouraged at the expense of the injured party. Under the theory of the ‘efficient breach’, ‘if the promisor’s profits from the breach exceed the loss to the promisee, the breach is to be permitted or even encouraged on the ground that it leads to maximization of resources’. This means that the promisor ‘is given the option not to perform his contract as long as he is prepared to pay plaintiff his expectation damages, that is, a sum necessary to make the plaintiff indifferent between the performance of the contract and the damages so paid’.22 The function of compensation in damages law is widely recognized and it is 2.20 undisputed amongst legal systems—both domestic and international—that the aggrieved party is entitled to recover all losses incurred due to the breach of contract, which leads to the principle of full compensation.23 If full compensation of the actual loss is regarded as the primary purpose of damages, under- and overcompensation should be avoided. In the light of the multiple legal and factual barriers to arrive at full compensation of the actual loss, there is a higher risk of undercompensation than of overcompensation. 2. Legal certainty and protection of legitimate expectations Damages law aims to give legal certainty to protect the legitimate expectation of 2.21 the injured party to obtain what he was promised.24 There are different levels of protection of the underlying interest under the different rules of law, such as the protection of the economic benefit or of the underlying performance: a. Economic benefit principle The expectation of contracting parties is to obtain an economic benefit. As a con- 2.22 sequence, damages law ‘is perceived to protect only the economic position of the aggrieved party’. This economic benefit principle is obtained through the differential hypothesis or but-for premise. Under this premise, the calculation of the economic difference between the actual position of the injured party and the hypothetical position but for the breach is the actual definition of loss. As a consequence, ‘anything which cannot be calculated under this formula is by definition not a legally recoverable loss’, which takes the economic benefit analysis to its extreme by disregarding non-economic losses.25 This differential hypothesis is also

22 Daniel Friedmann, ‘The Efficient Breach Fallacy’ in Randy E. Barnett (ed.), Contracts, Cases and Doctrine (3rd edn., Aspen 2003) 53. 23 Schwenzer, Hachem, and Kee, Global Sales and Contract Law paras. 44.04, 44.06, 44.19 (n. 1). 24 Christian Heinrich, Formale Freiheit und materiale Gerechtigkeit (Mohr Siebeck 2000) 255. 25 Schwenzer, Hachem, and Kee, Global Sales and Contract Law paras. 44.22, 44.24 (n. 1).

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Chapter 2: Function, Role, and Importance of Damages Law used as a framework to determine loss, causation, the measure of damages, and the quantification of the damages under complex long-term contracts. 2.23 This economic benefits principle is also found in the Economic Analysis of Law

which provides that ‘[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it . . . ’. This theory further states that if someone enters into a contract and breaches it, that party is liable to pay a compensatory sum.26 b. Performance principle 2.24 Under the so-called performance principle, contractual obligations are considered assumed by the parties and not imposed by law. It is the will of the parties that binds them, while the law is a tool giving effect to their will. Therefore, ‘remedies for breach of contract are not provided by law merely as a deterrent, punishment or compensation but also an enforcement of contractual obligations’. It acknowledges that there is more to the law of contract to protect in the contract than just the financial interest. As a result, damages also serve as a way to secure performance of the obligations stated in the contract.27 The notion of the cost of cure mentioned in this work is an application of the performance principle but does not apply to lost profits under complex long-term contracts.28 However, even the cost of cure can be measured in money and, therefore, also allows for the application of the differential hypothesis or but-for method. 2.25 The function of damages law is to compensate the injured party’s protected inter-

est. The different rules of law aim to protect interests such as performance or the difference in value under the differential hypothesis or but-for premise. This affects the actual loss determined under rules of law, according to their normative requirements. 3. Preventive function 2.26 Another function of damages law is the prevention of breach of contract or illegal

measure.29 The preventive function of the law of damages is increasingly recognized.30 In particular, damages awards in investment arbitrations have an influence

26 Barak Medina, ‘Renegotiation, “Efficient Breach” and Adjustment: The Choice of Remedy of a Contract-Modification Theory’ in Nili Cohen and Ewan McKendrick (eds.), Comparative Remedies for Breach of Contract (Hart Publishing 2005) 52. 27 Schwenzer, Hachem, and Kee, Global Sales and Contract Law para. 44.27 (n. 1), with further references; David McLauchlan, ‘Expectation Damages: Avoided Loss, Off setting Gains and Subsequent Events’ in Djakhongir Saidov and Ralph Cunnington (eds.), Contract Damages: Domestic and International Perspectives (Hart Publishing 2008) 349–88. 28 Chapter 5, para. 5.95. 29 Hermann Lange and Gottfried Schiemann, Schadensersatz , 3. Auflage (J.C.B. Mohr (Paul Siebeck) 2003) 9–13. 30 Schwenzer, Hachem, and Kee, Global Sales and Contract Law para. 44.08 (n. 1).

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B. Economic and Social Role of Damages Law on the structuring of complex long-term contracts in order to avoid liability for the violation of international standards.31 Preventive elements may also be observed in post-award interest rates at a higher rate than pre-award interest rates in order to avoid late payment.32 4. Punitive function limited to tort Finally, damages may have a punitive function. The punitive function of damages 2.27 is traditionally related to common law jurisdictions, where it is available only in tort actions such as triple damages in antitrust law, but not where the claim is based on a contract.33

B. Economic and Social Role of Damages Law The principle of full compensation of the actual loss has been considered a value 2.28 in itself, which is ideology-free and serves the principle of legal certainty.34 By providing a substitute to the underlying obligation, damages law based on full compensation is aimed at the application of the law itself. As argued by Jan Paulsson, ‘[t]he very fact that a bargain is likely to become less advantageous for one of the parties at some future time is what makes it so important that the law allows the other party to rely on its performance’ or its proper compensation. Ignoring such preposition would ‘cause great harm to the very foundation of our economies’.35 The relevant issue is that by not protecting legitimate expectations or by not honouring the general principle of full compensation, economies are harmed. The mere fact that one of the parties obtains free financing by breaching the contract brings inefficiency to the economy. The effect of this will not only be that one of the parties will be unjustly enriched by the harm caused to the other, but the injured party and the whole business community will learn that they cannot trust the legal system. Therefore, not respecting basic principles of damages increases legal uncertainty and also increases transaction costs. The role of damages law is to promote economic efficiency through the avoidance of waste of resources. Damages law aims to ‘prevent the waste of resources in society, since they are obviously limited’. Damages law

31 Jan Ole Voss, Th e Impact of Investment Treaties on Contracts between Host States and Foreign Investors (Martinus Nijhoff 2011); Ivar Alvik, Contracting with Sovereignty:  State Contracts and International Arbitration (Hart Publishing 2011); Santiago Montt, State Liability in Investment Treaty Arbitration:  Global Constitutional and Administrative Law in the BIT Generation (Hart Publishing 2009); Catherine Donnelly, ‘Public-Private Partnerships:  Award, Performance, and Remedies’ in Stephan W. Schill (ed.), International Investment Law and Comparative Public Law (Oxford University Press 2010) 475–501. 32 Chapter 7, para. 7.41. 33 Schwenzer, Hachem, and Kee, Global Sales and Contract Law para. 44.13 (n. 1). 34 Lange and Schiemann, Schadensersatz, 3. Aufl age 10 (n. 29). 35 Paulsson, ‘The Expectation Model’ 57 (n. 14).

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Chapter 2: Function, Role, and Importance of Damages Law provides means to avoid ‘additional costs, such as opportunity costs of using money elsewhere’ for both the injured party and the party in breach. In case of the party in breach, the avoidance of additional costs is through mitigation by the injured party.36 2.29 According to Ottho Heldring:

There is also an economic reason for the ethical and legal frameworks of economic life. If actors were to systematically breach their contracts or defraud each other, the economic process would never succeed. A poorly functioning legal system is therefore not only an ethical and legal problem; it also has consequences in the economic area. Efficient economic life assumes a broadly based legal certainty and predictability. Where mutual trust is lacking, transaction costs increase for the economic actors, which makes trading with countries lacking a trustworthy legal system so difficult. . . . This would increase my transaction costs even further. But even without this element, law is fundamental to the economic order.37 2.30 According to Ludwig von Mises and Friedrich August Hayek, the institution of

private property and the rule of law provide legal certainty, which encourages investment – a motivation for responsible decision-making on behalf of owners, the background for social experimentation – which spurs progress. Clearly defined property rights embedded in the rule of law are fundamental to a sustainable political economy.38 2.31 Damages law plays a major role in this context. If damages are not properly

awarded, leading to less than full compensation of the actual loss, fewer people would be willing to invest as the risk that they will not recover their investment is higher. The same happens with creditors, resulting in less credit. This slows the economy down. In addition, investors will ask for a higher rate of return and creditors will increase their interest rates. If the risk is increased by legal uncertainty, projects become more expensive, in accordance with the risk. The higher the risk, the higher the price. This is called economic inefficiency and causes great harm to the economy. 2.32 As stated by Thomas M. Franck:

[H]umanity wants to be reassured that the . . . legal system is capable of ensuring stability and progressive change. Any legal system, which is not perceived as fair will eventually cease to evolve and may shrivel. Any system of law is vulnerable if the public perceives it as illegitimate . . . ; only a system which is perceived as

36 Djakhongir Saidov, Th e Law of Damages in International Sales:  Th e CISG and Other International Instruments (Hart Publishing 2008) 126. 37 Ottho Heldring, ‘Business Administration and Concept Formation’ in Christian Krijnen and Bas Kee (eds.), Philosophy of Economics and Management & Organization Studies: A Critical Introduction (Kluwer 2009) 165. 38 John M. Cobin, A Primer on Modern Themes in Free Market Economics and Policy (2nd edn., Universal Publishers 2009) 246, with further references; Hans-Herrmann Hoppe, The Economics and Ethics of Private Property, Studies in Political Economy and Philosophy (2nd edn., Ludwig van Mises Institute 2006).

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B. Economic and Social Role of Damages Law legitimate can contain within its framework the tensions between stability and change. Legitimacy thus is the first aspect of fairness to which we must turn our attention.39

The adequate and fair compensation of damages is a fundamental element of any 2.33 legal system. In the light of the compensation and prevention principles, damages law has an important economic and social role. It provides stability in contractual relationships and prevents opportunistic behaviour, which in turn results in legal certainty and predictability. This has a positive effect in the perception of risk, which is reflected in lower transaction costs and a more efficient economy. An efficient economy creates welfare. Not granting damages or granting them deficiently, in particular when disregarding fundamental issues of due process and the principle of full compensation adds further grievance to loss with the corresponding social and economic implications. The same happens in case of overcompensation due to the application of inadequate measures of damages. The function and role of damages is, therefore, full compensation of the actual 2.34 loss caused by the breach or illegal measure. The determination of the actual loss may vary according to normative requirements under the applicable rules of law, however, it is universally recognized, that the award of damages avoiding over- and undercompensation plays a fundamental role with respect to legal certainty of contractual obligations and for the stability of any legal and economic system. This book aims to provide guidelines so that fair and adequate compensation of damages can be obtained by using suitable approaches, which facilitate such a complex undertaking.

39 Thomas M. Franck, ‘Fairness in the International Legal and Institutional System’, General Course on Public International Law (1993) 240 Recueil des cours 26.

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3 THE COMPLEX LONG-TER M CONTR ACT

A. Introduction B. The Development of Complex Long-Term Contracts 1. Historic overview 2. Guidelines and models for complex long-term contracts 3. The role of project finance in structuring complex long-term contracts

C. The Nature of Complex Long-Term Contracts D. Classification of Complex Long-Term Contracts E. Identification, Allocation, and Mitigation of Risks in the Preparation of Complex Long-Term Contracts 1. Identification of risk 2. Risk allocation 3. Risk mitigation

F. Examples of Typical Complex Long-Term Contracts 1. PPP contracts

2. Turnkey construction contracts 3. Operation and maintenance agreements 4. Off-take sales agreements 5. Implications of risk allocation in take-or-pay modality or contract 6. Joint venture agreements 7. Conclusion

3.01 3.04 3.05 3.26

G. Contract Guidelines and the Recovery of Damages 3.41 H. Cases and Arbitrations Related to Complex Long-Term Contracts 3.62

3.111 3.124 3.127 3.140 3.145 3.156

3.37

1. Turnkey construction contracts of power plant projects 2. Processing plant turnkey construction project 3. Oil platform construction contract 4. Gas exploration and exploitation joint venture agreement in Turkmenistan 5. Joint venture agreement in the automotive industry

3.79 3.79 3.84 3.96 3.106 3.109

3.157

3.172 3.173 3.180 3.185

3.201 3.214

A. Introduction Damages claims under complex long-term contracts are different from those under 3.01 discrete transactions such as isolated sales operations, or simple long-term contracts such as lease contracts. To develop a damages claim for the breach of complex long-term contracts, it is necessary to understand their fundamental structures and mechanisms. The aim of this chapter is to provide such insight. We start this chapter with an overview of the development of complex long-term 3.02 contracts. We then follow with an analysis of the nature of such contracts and the 25

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Chapter 3: The Complex Long-Term Contract core differences between contracts used in purely private projects and contracts involving state entities. The focus is on the relevant elements of such contracts, for the purpose of structuring damages claims. Finally, we provide some examples of complex long-term contracts and their breaches. 3.03 In this chapter, we do not aim to provide or discuss abstract legal concepts and defi-

nitions, but rather to show how long-term contracts are structured and executed in practice and the problems faced with respect to damages claims.

B. The Development of Complex Long-Term Contracts 3.04 Complex long-term contracts govern infrastructure and technology projects in the

public and private spheres. They are the result of economic, social, and technological development throughout history.1 1. Historic overview 3.05 Early privately-financed infrastructure projects can been seen in antiquity, such as

the construction of the Via Appia Antigua in 312bc. In the thirteenth century, the Italian Frescobaldi bankers financed silver mine projects in Devon in the form of concession agreements.2 3.06 During the seventeenth century canals were constructed in France with private

financing. In the eighteenth and early nineteenth centuries, in Britain, so-called ‘turnpike trusts’ raised money from private investors to repair roads. The money was then repaid through a toll charged to the users of such roads. The French government gave the Perrier brothers a 15-year concession to collect and distribute water to households in Paris in 1777. In London there were six private water companies in the 1820s. By that time most of the waterworks in the United States were private. In the gas sector, 14 private gas companies operated in London in 1850. As regards power projects, private firms were responsible for developing utility projects in the USA, Brazil, Chile, and Costa Rica during the nineteenth century.3 1 Fritz Nicklisch, ‘Vorteile einer Dogmatik für komplexe Langzeitverträge’ in Fritz Nicklisch (ed.), Der komplexe Langzeitvertrag:  Strukturen und Internationale Schiedsgerichtsbarkeit (The Complex Long-Term Contract: Structures and International Arbitration), Heidelberger Kolloquium Technologie und Recht 1986 (C.F. Müller Juristischer Verlag 1987)  17–19; Joachim G.  Frick, Arbitration and Complex International Contracts: With Special Emphasis on the Determination of the Applicable Substantive Law and on the Adaptation of Contracts to Changed Circumstances (Kluwer Law International/Schulthess 2001) 3–6. 2 A. Merna and N.J. Smith (eds.), Projects Procured by Privately Financed Concession Contracts , Vol 1 (2nd edn., Hong Kong 1996) 1, 4. 3 Michel Kerf with David Gray, Timothy Irwin, Céline Levesque, and Robert R. Taylor, under the direction of Michael Klein, Concessions for Infrastructure: A Guide to their Design and Award, World Bank Technical Paper No. 399 (World Bank and Inter-American Development Bank 1998) 1–3, with further references.

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B. The Development of Complex Long-Term Contracts At the same time, most of London’s bridges were financed through ‘bridge trusts’. 3.07 The Brooklyn Bridge in New York was built with private-sector capital in the late nineteenth century.4 Many of the roads built in the USA in the late nineteenth century were private and maintained by state-chartered private turnpike companies, although they were later turned over to the state as a result of competition from railroads.5 This century also witnessed privately-financed railroad projects in the USA, Europe, including the Gotthard rail tunnel, 6 and the Ottoman Empire Baghdad railway.7 The first railways in Mexico were private in around 1880 but nationalized in 1909. During that same period, the Suez Canal was constructed with private finance.8 By the late nineteenth century, private companies provided public services such as 3.08 gas street lightning, power distribution, telegraphy and telephony, steam railways, and electrical tramways under government concessions. In the twentieth century setbacks were suffered in this area, in part due to the first 3.09 and second world wars, which caused political and economic instability leading to the nationalization of infrastructure and the re-establishment of the pre-eminence of the public sector in infrastructure service provision. Further, former colonies nationalized private infrastructure and hence deterred private sector involvement. The influence of nationalist or socialist ideologies ended such projects in some countries. The situation changed in the late 1970s for reasons such as: (1) (2) (3) (4) (5)

3.10

increased demand for public services; the lack of capacity of states to finance infrastructure for public services; improved access to private funding; positive experience with private sector involvement; and the adoption of specific legislation promoting private sector involvement in infrastructure projects.9

During the last 30 years privately-financed infrastructure projects in the form of 3.11 BOTs and PPPs have been developed. In 1979, the Turkish premier minister Turgut Özal requested a financial participa- 3.12 tion from, and partial risk allocation to, foreign contractors in several power plant 4 E.R. Yescombe, Public-Private Partnerships:  Principles of Policy and Finance (Butterworth-Heinemann 2010) 5. 5 Kerf et al., Concessions for Infrastructure 3, with further references (n. 3). 6 Fritz Nicklisch (ed.), Rechtsfragen privatfinanzierter Projekte:  Nationale und internationale BOT-Projekte, Technikrechtsforum Heidelberg 1993 (C.F. Müller Juristischer Verlag 1994) 7, 12. 7 Udo N.  Wagner, ‘BOT-Projekte:  Chancen oder Risiko?’ in Fritz Nicklisch (ed.), Partnerschaftliche Infrastrukturprojekte: Rechtsfragen und Projektentwicklung, Projektfinanzierung und Projektrealisierung im internationalen und nationalen Bereich (Heidelberg 1996) 3. 8 Sidney Levy, Build, Operate, Transfer:  Paving the Way for Tomorrow’s Infrastructure (John Wiley 1996) 18–21. 9 UNCITRAL Legislative Guide 1.

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Chapter 3: The Complex Long-Term Contract projects under concession agreements. This is known as the so-called ‘Özal-formula’ and is considered the first modern BOT.10 3.13 In 1996, the UNIDO published the UNIDO BOT Guidelines in recognition of

the strategic importance of BOT projects. These Guidelines provide information, advice, and guidance for BOT projects in developing countries. 3.14 BOT projects are defined in the UNIDO BOT Guidelines as follows:

In a BOT project, a private company is given a concession to build and operate a facility that would normally be built and operated by the government. The facility might be a power plant, airport, toll road, tunnel or water treatment plant. The private company is also responsible for financing and designing the project. At the end of the concession period, the private company returns ownership of the project to the government. The concession period is determined primarily by the length of time needed for the facility’s revenue stream to pay off the company’s debt and provide a reasonable rate of return for its efforts and risk.11 3.15 BOTs exist in different variations such as BOO (Build-Own-Operate),

BOOT (Build-Own-Operate-Transfer), BLT (Build-Lease-Transfer), DBO (Design-Build-Operate), amongst others. They normally use the following types of contracts: (1) (2) (3) (4)

the project or concession agreement; the off-take or purchase agreement; the EPC (Engineering, Procurement and Construction) contract; and O&M (Operation and Maintenance) agreements.12

3.16 In 1992, the British government introduced PPPs for infrastructure projects

through PFI. Since then, PPPs have spread around the world. For example, the first Mexican service delivery projects (‘Proyectos de Prestación de Servicios’) used contract models similar to those developed under PFI. 3.17 The key principles of PFI are: (a) the purchase of services not assets; (b) value for

money to the public sector; (c) project risk management between public and private sectors; (d) utilization and incorporation of private sector know-how and expertise; and (e) incorporation of whole life cycle costing in infrastructure projects.13

10 Therese Leichter, BOT-Modell am Beispiel des Wasserkraftwerks Birecik (Innsbruck University Press 2003)  66; Tim Martin Metje, Der Investitionsschutz im internationalen Anlagenbau, Eine Untersuchung unter besonderer Berücksichtigung internationaler BOT-Projekte (Mohr Siebeck 2008) 16. 11 UNIDO BOT Guidelines 3. 12 Matthias Herdegen, ‘Der Konzessionsvertrag aus öffentlich-rechtlicher Sicht am Beispiel des Kanaltunnelprojekts’ in Nicklisch (ed.), Rechtsfragen privatfinanzierter Projekte 41 et seq. (n. 6); John Dewar (ed.), International Project Finance: Law and Practice (Oxford University Press 2011) Appendix 4, 477. 13 Mustafa Alshawi, Concept and Background to Public Private Partnership (PPP)/Private Finance Initiative (PFI), UK Experience (Iraq Institute for Economic Reforms (IIER) 2009).

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B. The Development of Complex Long-Term Contracts According to the World Bank:

3.18

There is no one widely accepted definition of Public Private Partnerships (PPP). Broadly, PPP refers to arrangements between the public and private sectors whereby part of the services or works that fall under the responsibilities of the public sector are provided by the private sector, with clear agreement on shared objectives for delivery of public infrastructure and/or public services. . . . Public private partnerships (PPPs) in infrastructure can be a means to enabling the development or improvement of energy, water, transport and telecommunications and information technology through the participation of private and government entities. . . . In order to achieve a successful partnership, a careful analysis of the long-term development objectives and risk allocation is essential. In addition, the legal framework must adequately support this new model of service delivery and be able to monitor and regulate the outputs and services provided. A well-drafted PPP agreement would be informed by both the laws of the country and international best practices to clearly delineate risks and responsibilities.14

In general, PPPs may range from simple procurement to the acquisition of part of 3.19 the shares by a private entity of a state-owned company. However, certain principles in the definition of PPPs have evolved, such as the outsourcing to the private sector of infrastructure projects and social services that would traditionally be undertaken by the government, with the resulting benefits of increased investment capacity, increased efficiency, and optimal risk allocation.15 Under a PPP contract a private party makes a major investment in infrastructure 3.20 and renders services to the public or a public entity and receives payments for services rendered to the satisfaction of the public entity. Such satisfaction is measured using complex matrix models in order to assure the quality of the services rendered. Typical PPP contracts, therefore, go a step further than traditional BOT contracts, as no payment is made for the infrastructure investment (no capacity fee), but only for the services satisfactorily provided and measured through performance monitoring. This results in a shift of additional risk to the contractor. If performance standards are not met, deductions apply followed by penalties and, as last recourse, contract termination, which may end up in significant damages claims.16 According to the World Bank, the following types of contracts are used for PPP 3.21 projects:

14 World Bank, PPP in Infrastructure Resource Center: ‘PPP Overview’, accessed 4 September 2012. 15 Marcia A.  Wiss and Teresa Maurea Faria, ‘Public-Private Partnerships in Latin America: Governmental Salvation or Deception’ (2007) 8 Business Law International 187, 189. 16 Herfried Wöss, presentation on:  ‘Recent experience with Public-Private Partnerships for Public Speciality Hospitals in Mexico, Best practices in developing and protecting investments in privately financed infrastructure projects’, International Bar Association, Rio de Janeiro, Brazil, 30–31 August 2007; Herfried Wöss, ‘Long-term Performance Monitoring in Public Private Partnerships’ (2010) 5(2) Construction Law International 28–9.

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Chapter 3: The Complex Long-Term Contract (1) (2) (3) (4)

management and operating contracts of infrastructure; lease/affermage; concessions, BOT, and DBO contracts; and joint venture contracts, or contracts for the partial divesture of public assets through mixed companies (companies with public and private shareholders).17

3.22 In general, PPP contracts have the following key elements:

(1) duration: a long-term relationship between a public-sector party and a private-sector party; (2) objective: the design, construction, financing, and operation of public infrastructure (the ‘facility’); (3) payments: throughout the life of the PPP contract to the private-sector party for the use of the facility, made either by the public-sector party or by the general public users of the facility; and (4) ownership of the facility: remains in public sector, or is reverted to the public sector at the end of the PPP contract.18 3.23 The increase of PPPs goes hand in hand with the development of fairly standard-

ized contract forms and models and a favourable legal framework. The World Bank has been very active in this field through the creation of the ‘PPP in Infrastructure Resource Center’, which focuses on: (1) (2) (3) (4)

legislation and regulation; agreements; sectors; and financing of PPP projects.

3.24 Public-private contracts nowadays represent an important part of technology and

infrastructure related contracts. The EU public authorities, for example, spend around 16 per cent of their GDP on purchasing supplies, works, and services.19 3.25 Private participation in infrastructure and the provision of the public services has

been characterized as ‘inevitable and difficult’ by Professor Don Wallace Jr: 20 There is an obvious problem for Governments. By and large they increasingly realize that they do not have the skills to manage industries, factories and the like well. On the other hand, they feel responsibility to see that basic services are delivered. The evolving solution: privatization of what have been public services and regulation. 17 World Bank, PPP in Infrastructure Resource Center:  ‘PPP Arrangements/Types of Public-Private Partnership Agreement’, available at accessed 18 September 2012. 18 Yescombe, Public-Private Partnerships 3 (n. 4). 19 Europa.eu, Public Contracts, available at accessed 27 July 2012. 20 Don Wallace, Jr, ‘Private Participation in Infrastructure and the Provision of Public Services— Inevitable and Difficult’ (2004) 18(1) Transnational Lawyer 117.

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B. The Development of Complex Long-Term Contracts The imperatives of economic development, and the limited sources of capital for Government in many countries, seem to leave little alternative; and these realities trump resistance to privatization and nationalism in many countries.21

2. Guidelines and models for complex long-term contracts As regards the development of complex long-term contract models, standardiza- 3.26 tion has mostly occurred in the areas of construction contracts and PFI. The need for contract models for public contracts was recognized in the early 1980s. 3.27 In 1983, UNIDO published the UNIDO Model Form of Turnkey Lump-Sum Contract for the Construction of a Fertilizer Plant Including Guidelines and Technical Annexures. This contract is directed towards the needs of developing countries, in particular, ‘for greater built-in safety and reliability in plants which warrant a commensurate liability and financial compensation’, which should reflect a fair and realistic balance between the interests of the parties.22 In 2001, the Working Group on the New International Economic Order of 3.28 UNCITRAL drafted the Legal Guide on Drawing up International Contracts for the Construction of Industrial Works (‘the UNCITRAL Contracts Guide’). This legal guide was based on the premise that a study of contractual provisions commonly occurring in international industrial development contracts would be of special importance to developing countries in order to enhance their industrialization. The UNCITRAL Contracts Guide recognizes that contracts for the construction 3.29 of industrial works are typically of great complexity, with respect to the technical aspects of the constructions, the legal relationships between the parties, and, in particular, the extension of such contracts over a relatively long period of time. Furthermore, the guide recognizes that existing rules of law may not settle many issues arising in contracts for the construction of industrial works in an appropriate manner. This requires regulating such issues through contract provisions.23 In the field of construction of infrastructure, the FIDIC has had a leading role for 3.30 providing EPC contract models for civil engineering contracts to be used in private and public projects, such as the FIDIC Conditions of Contract for EPC/Turnkey Projects (‘the Silver Book’).24

21 Don Wallace, Jr, ‘Public Procurement, Long-Term Government Contracts and Dispute Settlement: The Need for National Systems to Prevent and Resolve Disputes Between Regulators and Private Operators of Infrastructure and Providers of Public Services’ in Modern Law for Global Commerce, Proceedings of the Congress of the United Nations Commission on International Trade Law (United Nations 2011) 352. 22 UNIDO Model Form of Turnkey Lump-Sum Contract for the Construction of a Fertilizer Plant including Guidelines and Technical Annexures (Unido 1983). 23 UNCITRAL Contracts Guide 1. 24 Nael G. Bunni, Th e FIDIC Forms of Contract (Blackwell 2007) 581–98.

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Chapter 3: The Complex Long-Term Contract 3.31 The importance of FIDIC contracts is enhanced through their obligatory use

in projects financed by the World Bank, multilateral or regional development banks. In 2005, FIDIC released its FIDIC Multilateral Development Banks (MDB) Harmonised Construction Contract to be used as part of such development banks’ standard bidding documents. In addition, they are also used as models for modern contract administration and claim management. The most recent FIDIC contract model is the FIDIC Conditions of Contract for Design, Build and Operate Projects (2008) (‘the Gold Book’), which may be used for BOTs and PPPs. 3.32 The ICC has developed contract models, such as the ICC Model Turnkey Contract

for Major Projects. This contract provides an excellent example of a modern turnkey project contract to be used in private and public infrastructure projects. It is based on an equilibrium of the rights and obligations between the employer and contractor, and a balanced risk allocation.25 3.33 The core document of the PFI of HM Treasury is the Standardisation of PFI Contracts

(SoPC),26 which aims to ‘provide guidance on the key issues that arise in PFI projects in order to promote the achievement of commercially balanced Contracts and enable public-sector procurers to meet their requirements and deliver best value for money’. According to section 1.2.1, the three main objectives of the guidance are as follows: (1) to promote a common understanding of the main risks which are encountered in a standard PFI project; (2) to allow consistency of approach and pricing across a range of similar projects; and (3) to reduce the time and costs of negotiation by enabling all parties concerned to agree a range of areas that can follow a standard approach without extended negotiations. 3.34 PFI contracts aim to maintain a balance between the government authority and the

contractor. In case of changes in the law, contractors are expected to draft PFI contracts which accommodate risk-sharing in respect to changes in the law, and ‘to provide for price variation clauses, which allow for inflation indexation, market testing, and benchmarking at periodic stages throughout the performance of the contract with a view to protecting both the governmental authority and the contractor. . . . In PFI contracts, very detailed policy guidance is given for negotiating changes, and such contracts generally also include a provision, which requires periodic value-testing.’27 25 Herfried Wöss, ‘The ICC Model Turnkey Contract for Major Projects’ (2008) 3(2) Construction Law International 6–11. 26 HM Treasury, Standardisation of PFI Contracts (SoPC), Version 4 (March 2007). The PFI has been thoroughly revised with a new version already available as draft, the Standardisation of PF2 Contracts (Draft), December 2012, . 27 Catherine Donnelly, ‘Public-Private Partnerships:  Award, Performance, and Remedies’ in Stephan W. Schill (ed.), International Investment Law and Comparative Public Law (Oxford University Press 2010) 484–5, with further references.

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B. The Development of Complex Long-Term Contracts The need for a legal framework to foster privately financed infrastructure pro- 3.35 jects led UNCITRAL to prepare the UNCITRAL Legislative Guide in 2001. The UNCITRAL Legislative Guide contains recommendations for the creation of a legislative framework favourable to privately-financed infrastructure projects as regards financial, regulatory, legal, policy, and other issues related to such projects. The Legislative Guide consists of 71 recommendations and extensive comments, followed by notes offering an analytical introduction with references to aforementioned issues. The Legislative Guide is intended for use in the preparation or modernization of laws and regulations relevant to attracting private capital investment in public infrastructure projects. In 2004, UNCITRAL published the Model Legislative Provisions on Privately 3.36 Financed Infrastructure Projects (‘the UNCITRAL Model Legislative Provisions’) as an addition to the Legislative Guide, consisting of legislative recommendations and model legislative provisions. The legislative recommendations refer to the general legislative and institutional framework, as well as to project risks and government support. The model legislative provisions deal with the selection of the concessionaire, contents and implementation of the concession contract, duration, extension, and termination of the concession contract, and the settlement of disputes between the contracting authority and the concessionaire and those involving customers or users of the infrastructure facility. 3. The role of project finance in structuring complex long-term contracts Project finance is a technique which was first applied in the USA for commercial 3.37 real estate projects and further developed in the 1970s for oil and gas projects. Later it was used in power plants, roads, railways, bridges, telecommunication facilities, and water treatment plants. It is based on: a nonrecourse or limited recourse financing structure in which debt, equity and credit enhancement are combined for the construction and operation, or the refinancing, of a particular facility in a capital-intensive industry, in which lenders base credit appraisals on the projected revenues from the operation of the facility, rather than the general assets or the credit of the sponsor of the facility, and rely on the assets of the facility, including any revenue-producing contracts and other cash flow generated by the facility, as collateral for the debt.

Project performance, both technical and economic is, therefore, the nucleus of project finance.28 Project finance is the cornerstone of any project. In order to be viable, a project 3.38 must be ‘bankable’, which means that it must generate a sufficiently certain revenue stream governed by a project agreement to finance the project. For example,

28 Scott L. Hoff man, Th e Law and Business of International Project Finance (3rd edn., Cambridge University Press 2008) §1.01.

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Chapter 3: The Complex Long-Term Contract in a power plant project, the revenue stream will be embodied in a long-term power off-take contract or power purchase agreement, containing a sophisticated pricing formula, which normally guarantees a minimum payment in the form of a capacity fee. Such capacity fee should be sufficient to guarantee the operation of the project and to service the project debt. Additionally, the contract would provide for an energy fee for the power actually generated and sold.29 3.39 According to the BOT Guidelines:

The combined capacity fee and energy fee should be designed to do three things: to assure the lenders that sufficient revenues will be available to cover project debt service; to assure the equity investors that, if they build and operate the project as planned, they will recover their investment and earn a reasonable return to compensate them for the equity risk they are taking, which should be based on expectations as to revenues that are agreed between the host government and the investors; and to afford a reasonable sharing of the benefits between the investors and the host government if the project is more successful (for instance, if it is able to generate and sell more power or to do so more efficiently) than had been expected.30 3.40 The ultimate aim of project finance is to structure financings that are robust enough

to withstand long-term volatility and be bankable.31 The complex long-term contract is a means by which this aim can be achieved.

C. The Nature of Complex Long-Term Contracts 3.41 Complex contractual structures evolve by

allocating rights and obligations between the project participants, spreading risks and responsibilities, to create a bankable project. . . . [T]hough there is likely to be a detailed web of interconnections and relationships between parties . . . , the constituent elements in isolation, or in smaller pieces, rarely fall outside the boundaries of relatively standard framework.32 3.42 However, there is a significant difference between typical synallagmatic contracts,

such as sales and construction contracts, and complex long-term contracts based on income stream. In typical synallagmatic contracts the purpose of the contract is the delivery of goods or services to the other party against the payment of the price agreed. In complex long-term contracts based on income stream, such as joint venture agreements, concessions for toll roads, PPPs or BOT projects, the parties contribute assets of any kind including concessions in order to generate income

29

UNIDO BOT Guidelines 214–15 (n. 11). UNIDO BOT Guidelines 215 (n. 11). 31 Phillip Fletcher, ‘Approaching Legal Issues in a Project Finance Transaction’ in Dewar (ed.), International Project Finance 4 (n. 12). 32 Cathy Marsh and Andrew Pendleton, ‘Project Participants and Structures’ in Dewar (ed.), International Project Finance 21–2 (n. 12). 30

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C. The Nature of Complex Long-Term Contracts from a third party, which is the market.33 As a result, the generation of the income stream is the very purpose of such contracts. In synallagmatic contracts the income stream is generated through collateral transactions. In both cases, the purpose is to obtain a profit. This is of particular relevance when framing a damages claim, as will be examined in chapter 5. Additional complexity results from the interaction of multiple contracts with the 3.43 multiple parties and multiple variables that arise from the long-term character of the contract.34 The complex international contract is rarely a single isolated contract but rather a hierarchical,35 pyramidal, or tri-dimensional, system of contracts that exceeds in complexity purely horizontal networks of contracts such as in retail franchise36 or just-in-time supply agreements in the automotive industry.37 For example, in a BOT project, the concession agreement with the special purpose 3.44 company is normally the master or controlling agreement. The EPC and O&M agreements are sub-agreements. Those sub-agreements may be subject to sub-contracts, which are subordinated using a mirror-image technique to allow the pass-through of risks from the contractor to the sub-contractor. The hierarchical order is also often reflected in the exhibits of a contract.38 At the same time, such contracts are interconnected through the different parties, their rights and obligations, and the risks allocated amongst them. Complex international contracts in the private sphere are normally atypical or innom- 3.45 inate and not subject to particular legal regimes. Legal rules or doctrines applying to typical long-term contracts (e.g. Dauerschuldverhältnisse or ‘relational contracts’)39 rarely provide default rules to complex long-term contracts. In particular, complex long-term contracts are neither framework agreements nor open-ended. In fact, such contracts consist of very detailed and extensive regulation with the aim to avoid any ‘ambiguity as to whether any provision in the [contract] is effective and enforceable’.40

33

Hoffman, The Law and Business of International Project Finance §18.01 (n. 28). Bernard Hanotiau, Complex Arbitration:  Multiparty, Multicontract, Multi-issue and Class Actions (Kluwer 2005); Herfried Wöss, ‘Consolidation of Arbitration Proceedings and Joinder of New Parties by the Respondent under the ICC Rules’, IBA Arbitration Committee Newsletter (September 2005) 55–8; Bernard Hanotiau and Eric A. Schwartz, Multiparty Arbitration (Dossiers of the ICC Institute of World Business Law 2010). 35 UNCITRAL Contracts Guide 47–9 (n. 23). 36 Gunther Teubner, Networks as Connected Contracts, International Studies in the Theory of Private Law, No. 7 (Hart Publishing 2011). 37 Knut Werner Lange, Das Recht der Netzwerke:  Moderne Formen der Zusammenarbeit in Produktion und Vertrieb (Heidelberg 1998). 38 See Sub-clause 1.5 of the FIDIC Conditions of Contract for EPC/Turnkey Projects. 39 Ian R. McNeil, ‘Restatement (Second) of Contracts and Presentation’ (1974) 60 Virginia Law Review 590–610; O.E. Williamson, ‘The Lens of Contract: Private Ordering’ (2002) 92 American Economic Review 438–43; Ewan McKendrick, ‘The Regulation of Long-Term Contracts in English Law’ in Jack Beatson and Daniel Friedmann (eds.), Good Faith and Fault in Contract Law (Oxford University Press, 1995) 305, 308–9. 40 Kerf et al., Concessions for Infrastructure 108 (n. 3). 34

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Chapter 3: The Complex Long-Term Contract 3.46 Complex international contracts are also characterized by the creation of

self-contained contract systems, which reduce the need to resort to the applicable law. This is expressly confirmed in the ICC Model Turnkey Contract for Major Projects.41 Complex long-term contracts are often surrounded and tailored according to the needs of the project. Apart from that, drafting techniques developed in common law countries and the necessity to minimize the risk of the application of different national laws in international projects, favours self-contained and rather exhaustive contract packages. 3.47 The standardized contracts in the construction industry have even been described

as the ‘self-made law of the building industry’.42 The self-contained character of complex long-term contracts also favours arbitration as the preferred means of dispute settlement, rather than before domestic courts.43 3.48 In joint ventures, BOTs, and PPPs, the parties create partnership-like structures

that depend on a future or actual revenue stream from the market. These contracts have also been referred to as ‘symbiotic contracts’ or ‘synallagmatic triallagmas’.44 3.49 Complex long-term contracts are also considered self-enforcing agreements 45 based

on mechanisms that procure performance such as the retention of payments during the construction phase, effective guarantees, penalty clauses, and carefully drafted claim mechanisms. Part of the self-enforcement mechanism is a carefully drafted dispute resolution clause, using multi-tier dispute resolution, including the use of Dispute Boards, which has also a preventive effect and enhances co-operation. Whereas disputes cannot be avoided in complex contracts, diligent structuring of a project through the corresponding contracts may limit the frequency, amount, and complexity of disputes. 3.50 Part of the self-enforcing mechanism is using incentives and punishments in order

to achieve performance of the parties.46 Bonuses may be paid for improving technology or delivering before the established milestone. On the other hand, penalties or liquidated damages are often imposed for late and defective performance. 41

Wöss, ‘The ICC Model Turnkey Contract for Major Projects’ 7 (n. 25). Michael Schneider, ‘The Predominance of Collective Conditions of Contract’ in International Construction Contracts, Droit et Pratique du Commerce International—International Trade Law and Practice, Part II, No. 3 (Masson 1983) 430, with further references. 43 Nicklisch, ‘Vorteile einer Dogmatik für komplexe Langzeitverträge’ 22, with further references (n. 1). 44 Erich Schanze, ‘Symbiotic Contracts:  Exploring Long-Term Agency Structures and Corporations’ in Christian Joerges (ed.), Das Recht des Franchising—Konzeptionelle, Rechtsvergleichende und europarechtliche Analysen (Nomos 1991)  67, 68–9; for the dogmatic explanation of the synallagmatic ‘triallagma’, see Stefan Grundmann, ‘Contractual Networks in German Private Law’ in Fabrizio Cafaggi, Contractual Networks, Inter-firm Cooperation and Economic Growth (Edward Elgar Publishing 2011) 116–21. 45 Robert E. Scott, ‘Risk Distribution and Adjustment in Long-Term Contracts’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 79 (n. 1). 46 Scott, ‘Risk Distribution and Adjustment in Long-Term Contracts’ 79–80 (n. 45). 42

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C. The Nature of Complex Long-Term Contracts For example, in turnkey construction contracts, the down payment serves to 3.51 finance the initial cost of the contractor to buy materials. Such down payment is normally amortized during the initial contract period. After amortization, the owner usually retains a certain percentage of the milestone payments as a guarantee fund, which is paid at substantial and total termination. This allows the owner to replace the contractor in case of non-performance. Claim management established under such contracts permits the contractor to request extra time and extra payment in case of events within the risk sphere of the owner, without the need for contract renegotiation or lengthy disputes. PPP contracts use sophisticated performance-monitoring mechanisms, which contain incentives for performance and penalize non-performance. As regards duration, contracts of up to 50 years are no longer rare. The new FIDIC 3.52 Conditions of Contract for Design, Build and Operate Projects refers to a 20-year operation period awarded to a single contracting entity such as a consortium or joint venture to ‘optimize the coordination of innovation, quality and performance’. Article 87 of the new Mexican Public Private Partnerships Law47 accepts a duration of more than 40 years for PPPs (‘Asociaciones Público Privadas’). The need for flexibility of complex long-term contracts to cope with the financial, 3.53 economic, and technical requirements that must be met to make a project feasible 48 has been considered in most laws governing PPPs,49 public works, and public acquisition, where the framework for the project contract is often limited to key issues. For example, the UNCITRAL Model Legislative Provisions only govern particular aspects of concession agreements without establishing an exhaustive and overall legal framework for these agreements. With respect to legislative approaches, the UNCITRAL Legislative Guide recog- 3.54 nizes that in order to maintain the flexibility required to meet the needs and particularities of a specific project, it is advisable to ‘limit the scope of general legislative provisions concerning the project agreement to those strictly necessary, such as, for instance, provisions on matters for which prior legislative authorization might be needed or those which might affect the interests of third parties or provisions relating to essential policy matters on which variation by agreement is not admitted’.50 Essential elements of complex long-term contracts are risk identification, risk allo- 3.55 cation, and risk mitigation. Risks are enhanced due to the long-term character of

47

Mexico, Official Journal of the Federation (16 January 2012). Phillip Fletcher, ‘Rules for Negotiating Project Finance Deals’ (2005) 25 International Financial Law Review 37. 49 World Bank, PPP in Infrastructure Resource Center:  ‘Public-Private Partnerships Laws / Concession Laws’ accessed 25 September 2013. 50 UNCITRAL Legislative Guide, ‘IV. Construction and operation of infrastructure: legislative framework and project agreement’ 103, para. 4 (n. 9). 48

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Chapter 3: The Complex Long-Term Contract such contracts and the likelihood that circumstances will change. In order to make a project viable, the risk profile has to be balanced using a reasonable risk-reward approach. A careful initial assessment of the project and a common understanding of all parties of the structure of the project serve to reduce risks and, therefore, limit disputes. Projects are structured considering the financial, technical, political, and legal risks, amongst others, of each individual project.51 3.56 Disputes are likely to arise in any complex long-term contract but they are not nec-

essarily due to lacunae in the contractual structure or the applicable law. The origin of disputes is often a change of ‘the economics of the project’ or ‘the negotiating leverage of the parties’ as well as changing circumstances throughout the life of the contracts. However, even in case of such changing circumstances, the parties may not depart from the contract without sacrificing their investment, which leads to a change in the bargaining structure throughout the life of the project,52 renegotiation, or disputes. 3.57 The challenge of a complex long-term contract is how the complex relationships

amongst the parties may be sustained through economic, political, and legal changes, and in spite of technical or commercial problems.53 3.58 Disputes are, therefore, not necessarily the consequence of an incomplete con-

tract or non-identified risks, but rather due to a change of circumstances and a shift in negotiating power during the term of such contracts and, which are frequently tackled through stabilization or renegotiation clauses.54 However, even such clauses may give rise to lengthy disputes.55 3.59 Arbitration and pre-arbitral dispute resolution mechanisms, such as dispute

boards, in combination with a carefully designed complex long-term contract, aim to guarantee predictability, reducing the risk of disputes. Many of the advantages of commercial arbitration are of special importance in international long-term contracts, such as the expertise of the arbitrators, their neutrality, multi-party procedures, and the enforcement of arbitral awards. 3.60 In the words of prominent project finance specialists:

No matter how comprehensive the legal documentation, virtually every project encounters some form of technical or commercial problem over its life that leads to legal difficulty. Sometimes that difficulty arises because two parties have a 51

Fletcher, ‘Approaching Legal Issues in a Project Finance Transaction’ 3–5 (n. 31). Erich Schanze, Investitionsverträge im internationalen Wirtschaftsrecht (Frankfurt am Main: A. Metzner 1986) 91. 53 Fletcher, ‘Approaching Legal Issues in a Project Finance Transaction’ 3–4 (n. 31). 54 Norbert Horn, ‘Changes in Circumstances and the Revision of Contracts in Some European Laws’ in Norbert Horn (ed.), Adaption and Renegotiation of Contracts in International Trade and Finance (Deventer 1985) 15 et seq.; Nagla Nassar, Sanctity of Contracts Revisited: A Study in the Theory and Practice of International Commercial Transactions (Springer 1994). 55 See public court fi les with respect to ICC Case No. 15909/JRF. 52

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D. Classification of Complex Long-Term Contracts legitimate disagreement over the meaning or effect of a few of the words contained with the mountain of documents governing their relationships. In other cases, issues that had not been contemplated at the time of financial close arise with a consequent absence of guidance in the documents as to how to resolve them. Not infrequently, the underlying economics of the project and the negotiating leverage of the parties, change such that what seemed fair at closing may years later appear to one of the parties as oppressive. . . . When the stakes are high enough, it may be impossible to secure compromise.56

Therefore, the nature of a complex long-term contract may be characterized as 3.61 follows: • • • • • • • • •

complex long-term contracts derive from complex long-term projects, regulate multi-party relationships through multiple contracts, throughout a long period subject to changing circumstances, on different hierarchical levels, subject to sophisticated risk allocation and mitigation mechanisms, forming a self-contained rules system, with a self-enforcing structure, often based on income stream derived from a market, normally subject to international arbitration.

D. Classification of Complex Long-Term Contracts Complex long-term contracts can be classified in different ways. However, 3.62 the classification in the following paragraphs seems to be the most relevant in practical terms. Complex long-term contracts may be classified as domestic or international. 3.63 Domestic contracts refer to those between private entities or with a public entity, where all parties under a contract have their domiciles in the same country. International contracts may be entered between private parties or with a public 3.64 entity. In both cases, contracts are considered international when one of the parties is domiciled in another country.57 Additionally, contracts with a public entity are considered international under the following circumstances: (1) when the contracts are the consequence of international public procurement; (2) when financing from international development banks is involved;58

56

Fletcher, ‘Approaching Legal Issues in a Project Finance Transaction’ 4 (n. 31). See Comment 1 (‘ “International” contracts’) to the Preamble (Purpose of the Principles) of the PICC. 58 Guido Santiago Tawil, ‘On the Internationalisation of Administrative Contracts, Arbitration and the Calvo Doctrine’ in Albert Jan van den Berg (ed.), Arbitration Advocacy in Changing Times, ICCA Congress Series No. 15 (Kluwer 2011) 336–41. 57

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Chapter 3: The Complex Long-Term Contract (3) when the contract stipulates dispute settlement ‘at a forum different from the host State’s local courts and under a law different from the host State’s law’.59 3.65 For example, Mexican public works and acquisition laws do not apply in con-

tracts financed by international development banks. These contracts are governed by the international procurement rules and contract forms of the relevant development banks. 3.66 BOTs and PPPs are based on complex long-term contracts, which may be domestic

or international. Different laws may apply to different contracts, such as private, public or even international law. The form of the contract may be a private agreement, a public law concession agreement, or an international treaty. 3.67 Complex long-term contracts with state entities may be contracts under public

or private law, depending on the respective applicable rules of law.60 There are countries that do not distinguish between public and private law with respect to contracts with a public entity such as England. In Germany contracts for infrastructure projects are private agreements. 3.68 In contracts under public law, public entities may act de jure imperii or de jure

gestionis.61 In Mexico, for example, the termination, rescission and ‘other acts of authority’ of public contracts are considered acts of state. Acts of authority are subject to the presumption of validity and have to be recurred through administrative or constitutional litigation and are not arbitrable.62 This is without prejudice of other contractual provisions that are considered de jure gestionis. The question arises whether the effects of administrative termination or rescission such as the determination of damages is arbitrable. This evidently gives rise to disputes.63 The question of non-arbitrability of the termination of the participation contract arose, for example, in Occidental v. Ecuador.64 3.69 The imperative character of public contract law may limit the application of essen-

tial modern contract clauses such as stabilization and change of law clauses, and may even render these clauses unenforceable. On the other hand, in public works,

59 Jan Ole Voss, The Impact of Investment Treaties on Contracts between Host States and Foreign Investors (Martinus Nijhoff Publishers 2011) 25. 60 Christian Haas, Vertragsstrukturen privatfinanzierter Infrastrukturprojekte (Peter Lang 2005) 81–98. In England there is no distinction between public and private law in government contracts. 61 Veijo Heiskanen, ‘State As a Private: The Participation of States in International Commercial Arbitration’ (2010) 7 TDM 1. 62 Herfried Wöss, ‘El Orden Público, Derecho Público, Cosa Juzgada e Inarbitrabilidad en el Derecho Mexicano—La Anulación del Laudo en el caso ICC 13613/CCO/JRF’ (2012) 14(2) Spain Arbitration Review 111–31. 63 Herfried Wöss, ‘Arbitration, Alternative Dispute Resolution and Public Procurement in Mexico: The 2009 Reforms, Analysis and their Impact’ (2010) 7 Spain Arbitration Review 19–31. 64 Occidental Petroleum Corporation Occidental Exploration and Production and Production Company v. The Republic of Ecuador, ICSID Case No. ARB/06/11, para. 39.

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D. Classification of Complex Long-Term Contracts acquisitions, and PPP contracts under the model of the French ‘contrat administratif’, which applies in most countries of Latin America, the public authority possesses exorbitant powers with respect to the modification or termination of contract.65 Contracts with state entities are often characterized by formalized, standardized, 3.70 bureaucratic, and rigid procedures under public procurement provisions. These contracts are more likely to be subject to formal renegotiation and show a higher tendency of litigation. Increased contract specificity derived from public procurement laws limits the potential discretion granted to the authority. Rigidity combined with complexity increases conflict. This leads to a higher legal risk, which increases transaction costs to be paid by the public entity. Moreover, it leads to an opting out from the state litigation system to international arbitration.66 According to Professor Pablo T. Spiller ‘[p]ublic contracting is exposed to a larger set of hazards than purely private contracting. . . . ’.67 Whereas ‘contract engineering’ in the private sphere usually follows financial and 3.71 risk aspects applying the art of project finance, public contracts are submitted to government procurement rules and policy considerations, which may limit the proper risk allocation, and lead to a significant increase in price or simply to the lack of participation in such tenders. Complex long-term contractual relationships may also be entered between states in 3.72 the form of treaties or with international organizations. An example of an international treaty between states, relating to an infrastruc- 3.73 ture project, is the treaty on which the Channel Tunnel project is based,68 the Treaty concerning the Construction and Operation by Private Concessionaires of a Channel Fixed Link signed on 12 February 1986 (‘the Canterbury Treaty’). This lays down the international legal framework to ‘permit the construction and

65 Hector A. Mairal, ‘The Impact of Public Procurement and Rules of Government Contracting on Public Spending and Attracting Private Infrastructure Investment’ in Modern Law for Global Commerce, Proceedings of the Congress of the United Nations Commission on International Trade Law (United Nations 2011) 349–50; Hector A. Mairal, ‘Government Contracts under Argentine Law: A Comparative Law Overview’ (2002) 26(6) Fordham International Law Journal 1716–53. 66 Pablo T. Spiller, An Institutional Th eory of Public Contracts: Regulatory Implications (University of California and NBER 2008), 15–16; Pablo T. Spiller, ‘Transaction Cost Regulation’ (2013) 89(C) Journal of Economic Behaviour and Organization 232–42. 67 Brian Levy and Pablo T.  Spiller, ‘The Institutional Foundations of Regulatory Commitment:  A  Comparative Analysis of Telecommunications Regulation’ (1994) 2 Journal of Law, Economics and Organization 201–246; Pablo T. Spiller, ‘A Positive Political Theory of Regulatory Instruments:  Contracts, Administrative Law or Regulatory Specificity?’ (1996) 69 Southern California Law Review 477–515; Pablo T. Spiller, ‘Institutions and Commitment’ (1996) 5 Industrial and Corporate Change 421–52. 68 France-United Kingdom, Treaty concerning the Construction and Operation by Private Concessionaires of a Channel Fixed Link, Canterbury, 12 February 1986, 1497 United Nations Treaty Series 334 (‘the Canterbury Treaty’).

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Chapter 3: The Complex Long-Term Contract operation of a Channel fixed link by private enterprise in accordance with the criteria laid down by the Government of the United Kingdom and the French Government’.69 The applicable law is stated to be the ‘principles common to both English and French law, and in the absence of such common principles [the] general principles of international trade law as have been applied by national and international tribunals’.70 3.74 The Channel Tunnel was subject to a major arbitration before the Permanent

Court of Arbitration in The Hague. The dispute was about the failure of the UK and France to protect the fixed link between France and the UK from multiple incursions and related delays, damage, and expenses caused by large numbers of clandestine migrants, the governments’ discrimination against the fixed link in favour of other operators in relation to such migrants (the ‘Sangatte’ claim), and large subsidies to SeaFrance allowing it to renew its fleet and to compete with the fixed link on an unfair basis (the ‘SeaFrance’ claim). On 30 January 2007, the tribunal ruled that the concessionaire ‘was entitled to recover the losses directly flowing from this breach to be assessed if necessary in a separate phase of these proceedings. . . ’.71 The fixed link is entirely financed by private investment through Eurotunnel plc (Great Britain) and Eurotunnel S.A. (France). 3.75 An example of a complex long-term contract with an international organiza-

tion is the contract entered into between the European Organization for Nuclear Research (CERN), and Groupement Fougerolle for the construction of a circular tunnel as the site for a large electron/position collider on French and Swiss territory. The contract provided for ad hoc arbitration. In 1986 Groupement Fougerolle claimed the payment of 430 million Swiss francs related to the construction. In the award, the arbitral tribunal granted only 45 million Swiss francs for ‘costs incurred by the acceleration of the works’. The contract was based on general principles of law.72 The public law appeal lodged by Groupement Fougerolle before the Swiss Federal Tribunal was held inadmissible as CERN had jurisdictional immunity, recognized by the Swiss Federal Council under the headquarters agreement concluded in 1955.73 69

Preamble, para. 3 of the Canterbury Treaty. Klaus Peter Berger, ‘The New Law Merchant and the Global Market Place: A 21st Century View of Transnational Commercial Law’ in Klaus Peter Berger (ed.), The Practice of Transnational Law (Wolters Kluwer 2002)  accessed 14 October 2013. 71 Th e Channel Tunnel Group Limited and France-Manche v. Th e Secretary of State for Transport of the Government of the United Kingdom of Great Britain and Northern Ireland and Le Ministre de l’Équipement, des Transports, de l’Aménagement du Territoire, du Tourisme et de la Mer du Gouvernement de la République Française, partial award, 30 January 2007. 72 Mathew T.  Davidson, ‘The Lex Mercatoria in Transnational Arbitration:  An Analytical Survey of the 2001 Kluwer International Arbitration Database’, footnotes 31–2, with further references accessed 25 September 2013. 73 Elihu Lauterpacht, International Law Reports, Vol 102 (Cambridge University Press 1996)  209–10; Sammlung der Entscheidungen des Schweizerischen Bundesgerichts, BGE 118 IB 562. 70

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D. Classification of Complex Long-Term Contracts Concession or infrastructure contracts with public entities may be incorporated 3.76 in international investment agreements through a so-called ‘umbrella clause’ contained in such treaties. Although the effect of such ‘umbrella’ clauses is still subject to discussion,74 they serve to elevate contractual breaches with a state or its entities into violations of a treaty.75 Such umbrella clauses have produced several investment arbitration cases dealing 3.77 with damages for the breach of contract, such as Astaldi SpA v Honduras,76 Duke Energy International Peru Investments No. 1 v. Peru,77 Sempra Energy International v. Republic of Argentina,78 Ceskoslovenska Obchodni Banka AS v. Slovakia,79 CDC Group plc v. Seychelles,80 and Autopista Concesionada de Venezuela, CA v. Bolivarian Republic of Venezuela.81 Several complex long-term contracts with public entities are the subject of impor- 3.78 tant commercial arbitration cases such as the American Arbitration Association Case No. 50 T195 00509 02 (Bechtel Enterprises International Ltd v. Overseas Private Investment Corporation);82 ICC Case 12913/MS Capital India Power Mauritius I v. Maharashtra Power Development Corporation Ltd;83 ICC Cases 13613/CCO COMMISA v. PEMEX;84 the UNCITRAL ad hoc arbitration cases Himpurna California Energy Ltd v. PT (Persero) Perusahaan Listruik Negara (PLN), Patuha Power Ltd (Bermuda) v. PT (Persero) Perusahaan Listruik Negara (PLN);85 ICC Case 9151/FMS/KGA Bridas S.A.P.I.C. v. Turkmenistan;86 ICC Case 9058/FMS/

74 James Crawford, ‘Treaty and Contract in Investment Arbitration’ (2008) 3 Arbitration International 351–74. 75 For an overview and analysis of the current state of the discussions, see Katia Yannaca-Small, ‘What About This “Umbrella Clause”?’ in Arbitration under International Investment Agreements: A Guide to the Key Issues (Oxford University Press 2010) 479–503. See also chapter 5, paras. 5.168–72. 76 ICSID Case No. ARB/07/32, 17 September 2010, IIC 454 (2010). 77 ICSID Case No. ARB/03/28, award, 18 August 2008, IIC 334 (2008). 78 ICSID Case No. ARB/02/16, award, 28 September 2007, IIC 304 (2007). 79 ICSID Case No. ARB/97/4, award, 29 December 2004, IIC 51 (2004). 80 ICSID Case No. ARB/02/14, award, 29 June 2005, IIC 47 (2003). 81 ICSID Case No. ARB/00/5, award, 23 September 2003, IIC 20 (2003). 82 American Arbitration Association International Centre for Dispute Resolution, accessed 25 September 2013. 83 Ronald J. Bettauer, ‘India and International Arbitration: The Dabhol Experience’ (2009) 41 George Washington University International Law Review 381–7; Preeti Kundra, Note, ‘Looking Beyond the Dabhol Debacle: Examining its Causes and Understanding its Lessons’ (2008) 41 Vanderbilt Journal of Transnational Law 907–35. 84 Wöss, ‘El Orden Público, Derecho Público, Cosa Juzgada e Inarbitrabilidad en el Derecho Mexicano’ 111–31 (n. 62). 85 Mark Kantor, ‘International Project Finance and Arbitration with Public Sector Entities: W hen is Arbitration a Fiction?’ (2000–2001) 24 Fordham International Law Journal 1122; (1999) 14 Mealey’s International Arbitration Report A-1, A-57 (Himpurna v.  PLN ); (1999) 14 Mealey’s International Arbitration Report B-1, B-23-24 (Patuha v. PLN ). 86 Final award, 18 May 2000, accessed 14 October 2013.

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Chapter 3: The Complex Long-Term Contract KGA Bridas S.A.P.I.C. v. Turkmenistan;87 and Sapphire International Petroleums Ltd. v. National Iranian Oil Company, 88 some of which will be analysed or discussed throughout this book.

E. Identification, Allocation, and Mitigation of Risks in the Preparation of Complex Long-Term Contracts 1. Identification of risk 3.79 In legal terms, risk has been defined as ‘uncertainty in regard to cost, loss, or dam-

age’.89 In economic terms, ‘risk is an unpredictable variation in value’.90 3.80 According to the UNCITRAL Legislative Guide, ‘project risk refers to those cir-

cumstances, which, in the assessment of the parties, may have a negative effect on the benefit they expect to achieve with the project’. The parties’ risk exposure depends on their role in the project.91 3.81 Risks may threaten the generation of such revenues and, therefore, have to be care-

fully analysed, allocated, and mitigated. However, as the UNIDO BOT Guidelines confirm, ‘[n]otwithstanding that different projects involve different risks, financial markets have become increasingly sophisticated in devising packages to finance almost any type of reasonably predictable revenue stream’.92 3.82 A traditional and very useful risk classification is found in the UNIDO BOT

Guidelines,93 according to which risks are divided into general or country risks and specific project risks. Such classification is used as a guide here, without ignoring that risk identification in project finance is much more complex. • General or country risks are associated with the political, economic and legal environment of the host country over which the project participants have little or no control. These risks are considered when rating the sovereign risk of a country and are the result of an analysis of the country’s economic, political, and social indicators. They are divided into political risks, country commercial risks, and country legal risks:

87 Interim award, 26 January 2001, accessed 14 October 2013. 88 accessed 25 September 2013. 89 C. Hardy, Risk and Risk-bearing (1923), cited in Hoff man, The Law and Business of International Project Finance 27 (n. 28). 90 Timothy C. Irwin, Government Guarantees, Allocating and Valuing Risk in Privately Financed Infrastructure Projects (World Bank 2007) 5. 91 UNCITRAL Legislative Guide 38–39 (n. 9). 92 UNIDO BOT Guidelines 5 (n. 11). 93 UNIDO BOT Guidelines 154–8 (n. 11).

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E. Identification, Allocation, and Mitigation of Risks – Political risks are related to the political and economic stability of the host country of a project, the government’s attitude towards the private sector, changes in the host country’s fiscal and regulatory regime, the risk of expropriation and nationalization of projects by the host country, cancellation of concessions, and similar factors. These risks are particularly harmful as once the investment has been made, it cannot be removed.94 – Country commercial risks refer to the risks related to the convertibility of profits from a project into foreign currencies, foreign exchange rate risk, interest fluctuation, and inflation. These risks are of particular importance as they have an impact on the cost of finance. – Country legal risks are represented by changes in laws and regulations, the so-called law-enforcement risk, and delays in compensation for expropriation. • On the other hand, any other risk that is not general or country risk is categorized as specific risk. This refers to risks that are generally under the control of the parties, which consist in whether the project will perform at agreed performance levels within budget. • Operating risks consist of the risk that a plant or facility does not achieve performance requirements. Such risk may be due to deficient infrastructure, technical problems, lack of demand or inability of customers to pay the price, insufficient or expensive supplies, inexperienced management, force majeure events, loss or damage to project facilities, and liability risk due to deficient products or services. These are usually classified as follows: – Management risks refer to quality of management in a project. – Supply risks are the market risks, which refer to the volume and price of the raw materials. – Demand risk: Most projects rely on market-based revenues and, therefore, face demand risks related to volume and/or prices. Whereas the revenue from a power plant project depends on a well-defined independent power purchase agreement with the host government, in case of a toll road, the revenue depends on the individual travelling decisions of potential users, which results to be primarily based on travel forecasts by experts, which are obviously less certain. – Technical risks: These risks refer to design defects in project equipment. In general projects are required to meet certain levels of performance. This risk is especially important in projects that deal with high technology. – Force majeure risk: Such risks are the result of exceptional events beyond the control of the parties such as fire, earthquakes, war, flood, and strikes.

94 Thomas W.  Wälde and George Ndi, ‘Stabilizing International Investment Commitments: International Law Versus Contract Interpretation’ (1996) 31 Texas International Law Journal 225.

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Chapter 3: The Complex Long-Term Contract 3.83 In infrastructure projects there are additional operating risks, such as the following:

• Development risks may be the failure or delays in planning and approval of the project by government authorities, and any other authorizations. • Construction and completion risks refer to the risk that the project will not be constructed on time and within the estimated cost. Such classification only provides a general overview of the risks involved in a project. Each project has its particular risks, which have to be duly analysed and allocated amongst the parties, on a case-by-case basis. 2. Risk allocation 3.84 Once risks have been determined, they have to be allocated. Each project has a

different risk profile, which depends on the host country, the infrastructure sector in question, and many other factors. The basic rule in risk allocation is that a particular risk should be borne by the party most suited to control, influence, and bear the cost of such risk. A party bearing a risk will normally take measures to avoid or mitigate such risk. 3.85 Sometimes, risks are allocated according to the negotiating strength of the par-

ties, or policy considerations of the contracting authority, in case of BOTs and PPPs.95 Unreasonable risk allocation may lead to significantly higher project costs, non-performance, and disputes. 3.86 Typical participants in a project are the sponsor, the construction lender, the per-

manent lender, the contractor, the operator, the supplier, the output purchaser, the host government, and equity investors. The sponsor is the entity that co-ordinates the development of the project and bears the development risk. The construction lender bears the design, engineering, and construction risks. The permanent lender relies on the economic value and legal adequacy of the project contracts as support for the financing until the end of the life of the project. The project company is allocated the operating risks through performance requirements. The equity investor invests in and holds the shares of the project company. 3.87 Contractual risk of a party means the obligation to perform a long-term con-

tract even if the underlying circumstances develop differently from the expectations and to the detriment of such contractual party. Each party assumes the risks, which it has accepted under the applicable model of risk allocation, and is liable if it does not perform the contract according to the obligations it has assumed or the occurrence of risk it has been allocated.96 In particular, ‘it is no

95

UNCITRAL Legislative Guide 42 (n. 9). Joachim Frick, ‘Komplexe Langzeitverträge im Spiegel der Rechtsentwicklung’ in Fritz Nicklisch (ed.), Komplexe Langzeitverträge für neue Technologien und neue Projekte (München: Verlag C.H. Beck 2002) 5–6. 96

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E. Identification, Allocation, and Mitigation of Risks ground for relief that performance of the contract has become unprofitable for the promisor’.97 The contractor has to foresee events that might result in delays or an increase of 3.88 price, which it has to bear, for example, under a turnkey construction contract. The operator normally bears the price risk in the form of cost overruns. The supplier is concerned about obtaining a market price for fuel or raw materials and wishes to have the supply risk shifted to the operator or project company through price adjustment clauses in the supply contract. The output producer, normally the operator or the project company, requires a fixed price and quantity at a minimum of uncertainty. The host government in a BOT project may take over financial risk as equity con- 3.89 tributor, debt or guaranty provider, supplier of raw materials, or output purchaser and provider of fiscal support. Equity investors contribute capital or assets to the project and have an interest in the corresponding returns and the residual value in the project that exists after the debt is paid or substantially reduced. However, they bear the overall investment risk. In turnkey construction contracts, the risk of termination of the works on time 3.90 at a certain price is usually of the contractor. However, certain risks normally remain with the project owner, such as those related to its obligations to provide the access road and basic infrastructure, and to avoid obstacles which will affect the performance of the contractor such as force majeure and unfavourable ground conditions, amongst others. The verification of such risks gives rise to contractor’s claims for time extensions and additional costs. Risks in an infrastructure project are allocated according to a so-called ‘risk matrix’, 3.91 which varies from transaction to transaction. The risk matrix focuses on the project participants in the context of the life cycle of a project, taking into consideration that risks may change during the phases of a project. For example, in an infrastructure project, such phases are: (1) development, (2) design and engineering, (3) construction, and (4) operation.98 A construction risk matrix for an electric generation facility normally includes 3.92 the following elements: (1) risk, (2) party, (3) mitigation mechanism, (4) effect on lender, and (5) effect on developer. For example, the risk of a failure to satisfy performance guarantees at the completion date is allocated to the contractor. Reduced performance leads to liquidated damages payable by the contractor, which has to compensate for the effect on lender and the developer. The risk of cost overruns in a

97 Ole Lando, ‘Renegotiation and Revision of International Contracts’ (1980) 23 German Yearbook of International Law 52. 98 Hoffman, The Law and Business of International Project Finance §2.02 (n. 28).

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Chapter 3: The Complex Long-Term Contract project under a turnkey project has to be borne by the contractor, who will include such risk in the price.99 3.93 Any unallocated risks have to be borne by the project sponsor in exchange for the

economic return expected from the project operation. Risk borne and the expected return on investment have to relate reasonably. Where the risk-reward equation is out of balance, major problems are likely.100 3.94 Concession agreements tend to incorporate the basic regulatory framework under

a long-term contract and may be considered a rigid legal instrument whereby the concessionaire is benefitting from a public good in exchange of a high level of investment. Lack of adequate adaptation mechanisms to deal with economic shocks caused by abrupt changes of the economic conditions contemplated in the concession agreement may trigger contract re-negotiations, termination, and litigation.101 3.95 Once the risks have been allocated, different measures can be used for mitiga-

tion. Mitigation measures vary according to the project, the parties, and the risk allocated. 3. Risk mitigation 3.96 In construction contracts or the construction phase of a BOT project, typical risk

mitigation tools are (1) contractual mechanisms, (2) guaranties, and (3) insurances. (1) Contractual mechanisms are milestone payments, retentions, and liquidated damages. Milestone payments refer to payments at the moment of certain contractual events, which can easily be verified. This requires a synchronization of the work schedule with the payment schedule. Retentions of 5 to 10 per cent of the milestone payments serve to achieve the timely termination of the works at the corresponding quality. The retention amount is paid once the testing has taken place at the provisional or final acceptance of the works. Liquidated damages apply in case of delay or defective performance consisting in pre-established amounts corresponding to the likely damages. Normally a per diem rate is applied for delays measured at the contractual milestone dates, subject to adjustment at provisional and final termination of the works. Such liquidated damages for delay are used to compensate the owner or the project company for additional interest caused by the delay. Liquidated damages, for not meeting the performance requirements, compensate the owner or project company for decreased revenue and increased operating costs.

99 See Table 2-1 (Sample construction period risk matrix for electric generation facility) in Hoffman, The Law and Business of International Project Finance §2.04 (n. 28). 100 Hoffman, The Law and Business of International Project Finance §§2.01, 2.08 (n. 28). 101 Spiller, An Institutional Theory of Public Contracts 23–7 (n. 66).

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E. Identification, Allocation, and Mitigation of Risks (2) Typical guaranties in a construction project are down payment, performance and defects liability guaranties in the form of bank guarantees, standby letters of credit, or surety bonds. Down payment guarantees serve to protect the down payment made by the owner to the contractor in order to purchase materials. Performance guaranties protect the owner against deficient performance by the contractor. Performance guaranties may be equal or less than the corresponding liquidated damages for deficient performance. Defects liability guaranties cover hidden defects that affect performance and which appear after the final acceptance of the works, and are normally limited to a certain time corresponding to the warranty period of the plant and equipment. (3) Insurances mitigate the consequences of risk of damage of the project’s assets. Typical insurance policies are the construction ‘all risk’ and property damages insurances. Such insurances provide cover against material loss or damage to any works, the completed project and any materials incorporated. Another typical insurance covers delay in start up, which protects the project against the financial cost of delay. Third party liability insurance protects against indemnity payments to be made to third parties for bodily injury or damage to property.102 Operating risks, such as force majeure, loss or damage to facility, and liability 3.97 risk, can be mitigated through insurance; management risk can be mitigated through supervision and training. Supply risk can be mitigated by entering into contracts to secure long-term supplies at the appropriate quality and with stable prices. The demand risk may be mitigated through take-or-pay contracts in energy projects or shadow tolls in toll road projects. Technical risks are mitigated through pre-contractual due diligence and the measures applying to deficient performance, maintenance and repair, and quality control procedures. Risks arising from the public law framework of a concession agreement may be 3.98 decreased through: (1) (2) (3) (4)

rate-of-return regulation of concession agreements and price cap regulation, limited investment requirements; a well-defined system of penalties for quality; and a limit to the transfer of concessions based on annual payments or lowest prices.103

In addition to these risks, there is always a risk of material non-performance. 3.99 Mitigation of such risk can be achieved through dispute resolution mechanisms.

102 103

Martin Benatar, ‘Insurance’ in Dewar (ed.), International Project Finance 133–7 (n. 12). Spiller, An Institutional Theory of Public Contracts 28 (n. 66).

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Chapter 3: The Complex Long-Term Contract 3.100 Litigation to force a party to perform a contract has been considered a ‘disaster for a

project financing’. From the point of view of a project financing lawyer, the discussion of remedies and enforcement serves two purposes: (1) the creation of disincentives to guard against a breach; and (2) as a negotiation tool in case a problem develops.104 3.101 The risk of breach of contract by governments may be due to political changes.105 In

order to minimize this risk, it is important that the contractual terms are justified over the life of the project in the light of the underlying economics.106 3.102 Political risks forming part of the country or general risk may be mitigated through

political risk insurance as offered by the Multilateral Investment Guarantee Agency (MIGA)107 and so-called export credit agencies (ECAs).108 The involvement of lending institutions such as the World Bank, the International Finance Corporation, and regional development banks in projects serves to reduce political risk. 3.103 Currency and interest risks are important country risks, which can be mitigated

through different capital market instruments such swaps and futures in order to hedge currencies and interest rates. 3.104 Risk allocation and mitigation mechanisms are part of the structure of the differ-

ent complex long-term contracts. Some contracts, such as the O&M contract are considered risk mitigation tools themselves. 3.105 Rather than attempting to provide a detailed analysis of typical complex long-term

contracts, the object of the following paragraphs is to show the relevant implications of risk allocation in claim management and damages claims.

F. Examples of Typical Complex Long-Term Contracts 3.106 Complex long-term contracts are used in the private and public spheres, in

particular in the fields of information and communications technologies,109 104

Hoffman, The Law and Business of International Project Finance 119 (n. 28). Danielle Mazzini, ‘Stable International Contracts in Emerging Markets: An Endangered Species?’ (1997) 15 Boston University International Law Journal 343; Nassar, Sanctity of Contracts Revisited (n. 54); Jeswald W. Salacuse, ‘Renegotiating International Project Agreements’ (2000) 24(4) Fordham International Law Journal 1319–70; J. Luis Guasch, Granting and Renegotiating Infrastructures Concessions—Getting it Right, World Bank Development Studies (World Bank 2004). 106 Hoff man, Th e Law and Business of International Project Finance §18.13, 219 (n. 28); Wolfgang Peter, Arbitration and Renegotiation of International Investment Agreements (Kluwer Law International 1995) 205–325. 107 accessed 25 September 2013. 108 accessed 25 September 2013. 109 Jan Dinter, Internationale Infrastrukturprojekte im Telekommnikationssektor—eine vergleichende Untersuchung der Governance- und Regulierungsstrukturen (Nomos 2010); Katharina Deppert, ‘IT-Verträge und Kooperationspflichten aus der Sicht der Rechtsprechung’ in Nicklisch 105

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F. Examples of Typical Complex Long-Term Contracts biotechnology,110 industrial joint ventures,111 technology transfer agreements,112 space projects,113 software contracts,114 mining projects,115 natural resources,116 and gas supply projects,117 amongst others. In general, the most commonly used contracts in complex long-term projects are 3.107 the following: the development agreement or BOT or PPP agreement, the joint venture agreement, the construction contract, the management agreement, the operating agreement, the technology agreement, the lease agreement, the supply agreements, the off-take agreements, the waste disposal agreement, and any other project-related contracts. These contracts are used and combined according to the needs of the project. The following paragraphs provide more detail about the contracts used in typical 3.108 project structures.

(ed.), Komplexe Langzeitverträge für neue Technologien und neue Projekte 35–44 (n. 96); Ragnar Nilsson, ‘Outsourcing—Strategische und Taktische Allianz’ in Nicklisch (ed.), Komplexe Langzeitverträge für neue Technologien und neue Projekte 45–51 (n. 96). 110 Dirk Kruse, ‘Vertragliche Aspekte bei der Zusammenarbeit mit kleinen Pharmaunternehmen (einschließlich Biotech Unternehmen)’ in Nicklisch (ed.), Komplexe Langzeitverträge für neue Technologien und neue Projekte 63–70 (n. 96); Gottfried W.  Freier, ‘Rechtliche Aspekte von Forschungs- und Entwicklungskooperationen im Bereich Pharma und Biotechnologie’ in Nicklisch (ed.), Komplexe Langzeitverträge für neue Technologien und neue Projekte 71–90 (n. 96). 111 Ronald Wolf, The Complete Guide to International Joint Ventures with Sample Clauses and Contracts (3rd edn., Wolters Kluwer 2011). 112 Miklós Bauer, ‘Technologie-Transfer-Verträge—Struktur und typische Probleme’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 207–24 (n. 1); Roderick W. Macneil, ‘Technology Transfer Contracts in China:  A  Relational Perspective’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 225–40 (n. 1). 113 Eckart Wolff, ‘Aufträge der öffentlichen Hand über Entwicklungsprojekte in der Raumfahrt’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 241–61 (n. 1); Peter Kleber, ‘Verträge über die kommerzielle Nutzung der Raumfahrt’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 263–75 (n. 1). 114 Wolfgang W. Fritzemeyer, ‘Die rechtlichen Rahmenbedingungen des Software-Vertrages— Plädoyer für einen Sonderrechtsschutz der Computer-Software’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 277–87 (n. 1); Jochen Schneider, ‘Strukturen von Software-Projekten und Mitwirkungspflichten des Auftragsgebers’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 289– 307 (n. 1). 115 Harald Rieger, ‘Mining Investment Contracts’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 105–17 (n. 1); Ch. Kirchner, E. Schanze, F. von Schlabrendorff, A. Stockmayer, Th. Wälde, and R. Patzina, Mining Ventures in Developing Countries, Part 1: Interests, Bargaining Process, Legal Process (Frankfurt am Main: Kluwer 1979); Part 2: Analysis of Project Agreements (Kluwer 1981); D.N. Smith and L.T. Wells, Negotiating Third World Mineral Agreements: Promise as a Prologue (Ballinger 1975). 116 Terrence C. Daintith, ‘Contract Design and Practice in the Natural Resources Sector’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 151–70 (n. 1). 117 Lutz Eckert, ‘Langfristige Erdgaslieferverträge’ in Nicklisch (ed.), Der komplexe Langzeitvertrag 171–86 (n. 1).

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Chapter 3: The Complex Long-Term Contract 1. PPP contracts 3.109 Public-private partnership or PPP contracts may have multiple forms according to

the nature of the project and extent of the risks transferred from the government to the operator. The World Bank classifies PPP contracts as follows: (1) Management contracts: Such contracts range from technical assistance agreements to maintenance and operation agreements. In a management contract, an operating company manages or operates an existing facility against the payment of a fixed fee. The operator normally bears the risk of the condition of the assets. Such contracts are commonly found in the water sector and are often transitional contracts. (2) Leases or ‘aff ermage’: In a lease or affermage the operator is responsible for the operation and maintenance of a facility but not for investment in the infrastructure. In such contracts commercial risks are passed to the operator with incentives to perform. The operator charges an operator fee to customers. In a lease, a portion of the fees must be paid to the authority, the owner of the assets, as a lease fee and the remainder is retained by the operator. The operator’s profits depend directly on the fees paid by the customers. Operating risks are, therefore, fully transferred to the operator. In an affermage, the operator retains the operator fee out of the fees paid by the customers and a surcharge to the authority for investments made or to be made in the infrastructure. Examples of leases and affermages may be found in the water and sanitation and energy sectors. (3) Concession is defined as a long-term right of an operator to use public assets and obtain revenue from such assets, governed by an agreement. The responsibility of the operator includes the operation and maintenance of the assets, and financing all required investment. The operator typically obtains its revenues directly from the customer. The risk of the condition of the assets and the investment is allocated to the operator. Therefore, a concession agreement requires a duration of between 25 to 30 years. Through concessions, the operator supplies goods and services to the public, subject to performance standards. Tariff levels may be capped, due to public policy considerations, and in this situation subsidies or other government support will be required.118 (4) In a BOT, the project company commits to build, refurbish, operate and maintain, and, finally, transfer a so-called facility to the public entity. Typical BOTs are water treatment plants that allow for the delivery of water to the public. The revenues are normally obtained from a government entity as the

118 World Bank, PPP in Infrastructure Resource Center: ‘Concessions, Build-Operate-Transfer (BOT) and Design-Build-Operate (DBO) Projects’, accessed 27 September 2012.

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F. Examples of Typical Complex Long-Term Contracts ‘off-take purchaser’ of the project output. In a BOT the main contract is the project agreement, normally in the form of a concession agreement between the government and the project company. Derived from this basic contract, the project company will sign different contracts with other parties in the project, such as the financing agreements, the EPC contract, the off-take contract with the project’s long-term output purchaser or the tariff agreement with the relevant regulatory authority, and the O&M contract with the project operator.119 In the following paragraphs we provide examples of typical complex long-term 3.110 contracts that are being used in PPPs, BOTs, and in purely private projects as well as independent contracts. 2. Turnkey construction contracts Turnkey construction contracts are used in any PPP project and refer to the refur- 3.111 bishment or the construction of infrastructure. However, they may also be used in projects between private parties. Turnkey construction contracts are complex per se, even if they do not form part of a PPP. In construction contracts on a turnkey basis, the sponsors or the owners normally 3.112 shift completion related risks to the EPC contractor. The increased risk of the contractor is normally reflected in the price. Payments are made through milestone payments, which also absorb the initial down payment paid for the purchase of the necessary materials. A guaranty fund is normally established by retaining between 5 and 10 per cent, which is paid at provisional and final acceptance of the works. Therefore, it is important that the work and the payment schedules are duly synchronized. Sub-contracts have to be made in a mirror-image-like manner in order to pass risks of the contractor through to the respective sub-contractor. If the contractor is delayed in a turnkey construction contract or underper- 3.113 forms (defective performance), liquidated damages may apply, which will be deducted from the price. In the absence of a liquidated damages clause, the damages are normally the difference between the agreed performance and the actual performance. The risk of non-performance of the contractor refers to delayed performance or 3.114 performance not meeting performance requirements. Such risks are normally covered through performance guarantees and liquidated damages. In most of these contracts, the total liability tends to be capped by the value of the works or a percentage thereof. Termination for breach of contract leads to the elimination of liability caps and allows full damages claims; however, this is considered a means

119

UNIDO BOT Guidelines 160–6 (n. 11).

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Chapter 3: The Complex Long-Term Contract of last resort. Unlawful termination is considered breach of contract, which gives rise to damages claims against the party terminating the contract. 3.115 With respect to risk allocation, the performance risk of the contractor is limited to

the liquidated damages. The enforcement risk of the liquidated damages is low if such damages are guaranteed through guarantees such as a performance bond, a bank guarantee, a standby letter of credit, or a surety bond. Therefore, the owner or project company bears the risk of exceeding damages caused by deficient performance. According to this, the owner would have to terminate the contract if a substantial non-performance occurs. 3.116 In a turnkey construction all risks have to be borne by the contractor, save cer-

tain risks which expressly remain with the owner of the works, such as underground conditions, force majeure and the non-performance of the owner’s obligation to provide the site, the access road, electricity, and safe conditions, and the performance of other sub-contractors acting on behalf of the owner. If these adversely affect the performance of the contractor this will give rise to claims such as time extension and of additional costs for (1) delay and, if applicable, (2) additional works. 3.117 Under turnkey construction contracts, risks remaining with the owner of the pro-

ject, such as change orders leading to variations, are subject to claim management by the contractor. Claims not made in time and duly substantiated will not be considered admissible. The typical claims are scope issues, time extension, and additional cost claims. Claims require a high degree of evidence and prepare the field for dispute board procedures and arbitration. 3.118 Damages claims arise in the aforementioned context, when apart from the right

to claim there is a breach of contract, such as refusal by one of the parties to accept the claim of the other party. The question arises whether the damages claim will relieve the affected party from its obligations under the claim procedures or not, and if the amount to be claimed may exceed the limits for claims under the contract. 3.119 In this respect, the most critical element of a turnkey construction contract is the

scope. The scope may be changed through variations or change orders, which trigger time extension claims. Time extension normally causes additional costs, which have to be substantiated and claimed by the contractor. 3.120 Essential features of a turnkey construction contract are claim procedures and dis-

putes mechanisms in the form of dispute boards, which serve to mitigate the risk of the exponential effects of disputes in infrastructure projects (‘avalanche effect’). 3.121 Claims also proceed if risks allocated to the owner, which affect the performance

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F. Examples of Typical Complex Long-Term Contracts of an access road that was to be provided by the owner. The effects of such events are normally determined through a critical path method.120 The critical path method is similar to the one used to establish a so-called ‘Gantt 3.122 chart’ for project planning. The basic rule of such a chart is that in case of sequential activities, an activity is considered ‘critical’ if it has to be terminated before another activity commences. There may be parallel activities that are not critical at a certain time as they do not delay subsequent activities but they may become critical at a later stage. The critical path method measures the effect of a certain event on the progress of works.121 This method applies both to time extension claims but also to additional cost and damages claims and shows the causal effect on the other parties of event within the sphere of risk of one of the parties. The situation becomes more sophisticated in case of productivity losses, if the pace 3.123 of works of the contractor is reduced due to risks which are verified to be in the sphere of the owner. In such a case it is necessary to compare the productivity with and without the damaging event through methods such as the ‘measured mile’ calculation. This calculation compares identical activities on impacted and non-impacted sections of the project in order to ascertain the loss of productivity resulting from the impact of an event in the risk sphere of the other party.122 3. Operation and maintenance agreements O&M agreements are an essential part in a PPP project. They are usually struc- 3.124 tured as fixed-price agreements subject to a broad range of adjustments including the cost of spare parts or consumables. As an alternative, the operator might receive a fixed fee, while passing operating costs back to the project company. This requires incentives or sanctions such as: (1) performance bonuses; or (2) sanctions in the form of liquidated damages if performance levels are not achieved. In the case of PPPs, the ‘satisfactory performance of services’ is measured through a 3.125 complex matrix. For example performance monitoring in a university PPP includes interviewing students to measure satisfaction with the classrooms, or in hospitals reviewing the cleanliness of an operating room used for surgeries. 120 Vivian Ramsey, ‘Problems of delay and disruption damages in international arbitration’ in Evaluation of Damages in International Arbitration, Dossiers of the ICC Institute for World Business Law (2006) 200–1. 121 Samuel L. Baker, ‘Critical Path Analysis (CPM)’, University of South Carolina, 2004, accessed 25 September 2013; ‘The Critical Path Analysis and PERT Charts: Planning and Scheduling More Complex Projects’, accessed 25 September 2013. 122 William Schwartzkopf and John J. McNamara, Calculating Construction Damages (2nd edn., Wolters Kluwer 2011) 63–4.

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Chapter 3: The Complex Long-Term Contract 3.126 O&M agreements include provisions on service and maintenance programmes

and budget reviews.123 4. Off-take sales agreements 3.127 The principal means to manage revenue risk is through the off-take agreement,

which is a sales agreement structured according to the market into which the output of the project is sold. Typical off-take agreements are tolling contracts and power purchase agreements, whose payment modalities are pay and take, pay or take, or a combination of both. 3.128 Such contracts are subject to considerable risks:

If the buyer commits to paying more than the then current market price, it may be put under financial stress that leads it to look for ways of avoiding the stipulations of the contract. The disputes that arise in such circumstances often end up in court or before an arbitral panel.124 3.129 The structure of the off-take agreement depends whether the project is contract-led

or market-led. Contract-led projects are those where the output is being sold to a single dominant purchaser or a reduced group of purchasers. Typical contract-led projects include power plant projects with a power purchase agreement to be signed with a local state entity, water treatment projects with a municipal authority, and perhaps also telecommunication projects. In a market-led project, general market risk in form of a fluctuating demand prevails. Such projects include toll roads, ports, airports, and hospitals.125 3.130 The key issue for toll road contracts is to regulate how the concessionaire is to be

paid and who is to bear traffic risk and revenue risk. Traffic risk is the risk of how many vehicles will travel on the road, whereas the revenue risk is a factor of both traffic volumes and toll rates. In an ‘availability’ structure, the private sector does not bear any of these risks. In the case of ‘shadow tolls’, traffic risk is transferred to the private sector but not the revenue risk. In ‘real toll’ structures both risks are being transferred to the private sector.126 3.131 Shadow tolls refer to a pre-set amount of revenue due to projected customer income,

which replace actual tolls paid by the facility users where the project benefits public interest, such as in PPPs.127 123 Cathy Marsh, Daisy East, and William Fyfe, ‘Allocation of Risks in Project Documentation’ in Dewar (ed.), International Project Finance 122–3 (n. 12). 124 Marsh et al., ‘Allocation of Risks in Project Documentation’ 124–5 (n. 123). 125 Haas, Vertragsstrukturen privatfinanzierter Infrastrukturprojekte 8 (n. 60). 126 World Bank, PPP in Infrastructure Resource Center: ‘Road Concessions, BOTs, DBOs’, accessed 27 September 2012. 127 Raymond Tillman, ‘Shadow Tolls and Public-Private Partnerships for Transportation Projects’ (1997) 3 The Journal of Structured Finance 30–7.

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F. Examples of Typical Complex Long-Term Contracts The power purchase agreement or power sales agreement creates the revenue flow 3.132 necessary to finance an energy project, in particular, to service debts, pay operating costs, and provide equity return to the sponsors. It is characterized by its dual role as the financing document and as the operating document. In a power purchase agreement there is normally one dominant purchasing utility.128 The principal obligation of the power provider in a power purchase agreement is 3.133 to make available the contracted capacity on a commercial operation date at the stipulated performance levels, which have to be maintained throughout the life of the contract. The risks associated with such obligations, which have to be borne by the provider, 3.134 are the acquisition of land and property for the construction of the plant, permissions necessary for construction and operation, and the risk of achieving the established performance level and maintaining this performance level throughout the contract. Contractual milestones may be linked to permits, the execution of construction, 3.135 fuel and operating agreements, testing, and financial closing. Delay may trigger the payment of damages or contract termination. Delay damages are normally in the form of liquidated damages for each day of delay.129 Commissioning and generation of energy may be delayed because of risks borne 3.136 by the purchaser, which are usually compensated subject to claim management through time extension and extra payments by the purchaser. Deficient performance and failure to meet capacity tests normally give rise to the 3.137 payment of liquidated damages if repairs are unsuccessful. Damages are normally measured as the difference between the contracted capacity and the actual percentage of contractual capacity demonstrated in testing. In case of contract termination because of deficient performance, the termination value of the plant must be deduced from the damages claim against the operator.130 Off-take contracts may have the following payment modalities:

3.138

(1) take and pay, (2) take or pay, or (3) a combination of both. They are also referred to as take-and-pay and take-or-pay agreements:131

3.139

128 Hoff man, The Law and Business of International Project Finance §19.01 (n. 28); Marsh et al., ‘Allocation of Risks in Project Documentation’ 126 (n. 123). 129 Hoff man, Th e Law and Business of International Project Finance §19.04 (n. 28). 130 Marsh et al., ‘Allocation of Risks in Project Documentation’ 120 (n. 123). 131 Hoff man, Th e Law and Business of International Project Finance §19.07 (n. 28).

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Chapter 3: The Complex Long-Term Contract • Take-and-pay modality or contract. The purchaser takes and pays for the project output or the service. The purchaser is only obliged to pay for the product or service produced and delivered. • Take-or-pay modality or contract. The purchaser is obliged to purchase a minimum level of output at a certain price, independent from whether it actually takes delivery, provided the output was available. Such contracts are also called ‘hell or high water’ in the project finance jargon.132 • Combination of take-and-pay and take-or-pay modalities. Sometimes, both modalities arise under the same agreement. For example, in a power purchase agreement, the power purchaser may agree to pay a two-part tariff separated into capacity and energy components. The capacity charge covers fixed costs and, in particular, financing charges, and the energy charge covers fuel cost, which is incurred only if the energy is dispatched to the purchaser. Capacity charges may also be payable under specified force majeure events. Penalties may be imposed when capacity is not available. This results in a combination of a take-or-pay tariff for the installed capacity and a take-and-pay tariff for the energy dispatched. 5. Implications of risk allocation in take-or-pay modality or contract 3.140 The risk allocation through a take-or-pay obligation and its implications for a dam-

ages claim may best be understood under a power purchase agreement. This agreement is the foundation of the viability of a power project. The rate paid for energy under the agreement must be sufficient to cover debt service and fixed and variable costs including operation and maintenance expenses.133 3.141 Take-or-pay obligations mean that the power purchaser must pay without excep-

tion. This is due to the fact that the acceptance and payment for power is the most important provision in a power purchase agreement, as it is the basis of the revenue stream which finances the project. Most power purchase agreements place the risk of business termination and quantity variations on the power purchaser, who bears the risk of demand uncertainty (so-called ‘output contracts’).134 3.142 Take-or-pay clauses normally exclude force majeure and hardship as an excuse

for non-payment. This has to be examined under the corresponding contractual clauses. The allocation of risk leads to an absolute guarantee of the purchaser for its payment.135 In case of a take-or-pay contract, this would mean that there is absolute 132 M. Elsey, P. Hurst, and A.M. Crisp, ‘Supply and Off take Contracts’ in A. Merna and N.J. Smith (eds.), Projects Procured by Privately Financed Concession Contracts, Vol. 1 (2nd edn., Asia Law & Practice 1996) 173; Anthony Merna, Yang Chu, and Faisal Fahad Al-Thani, Project Finance in Construction, A Structured Guide to Assessment (Wiley-Blackwell 2010) 61–5. 133 Marsh et al., ‘Allocation of Risks in Project Documentation’ 126–7 (n. 123). 134 Hoff man, Th e Law and Business of International Project Finance §19.05 (n. 28). 135 Jan Kleinheisterkamp, ‘Art. 7.1.7’ in Stefan Vogenauer and Jan Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) (Oxford University Press 2009) para. 6.

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F. Examples of Typical Complex Long-Term Contracts payment obligation until the term of the contract period. Under the take-or-pay modality, the purchaser must pay for capacity whether or not the project company uses the energy, provided that such energy is available. ‘The payment obligation of the buyer for the capacity component is unconditional.’136 This implies that the take-or-pay modality has a payment guarantee function. 3.143 Payment is not subject to the availability of an income stream or the profitability of the project or the economic or financial situation of the purchaser. The loss is the payment promised and not received, which is determined in the pay-or-take contract. In a damages claim, future payments are the loss and would have to be discounted at the proper discount rate determined by the experts to calculate their present value. It should be noted that risk allocation clauses are subject to validity control under 3.144 the applicable rules of law. 6. Joint venture agreements137 Joint ventures are partnership-like complex long-term contracts, which serve a 3.145 common purpose. They may be limited to the contractual relationship or establish the framework for the incorporation of a company in order to execute the joint purpose. A production joint venture often consists of a joint venture agreement, a supply agreement for the parts and materials, a lease agreement for the premises, and license agreements relating to technology transfer, trade marks, patents, and know-how. The law chosen to govern the joint venture contract should be flexible and is often 3.146 different from the company law applicable to the joint venture company, in order to safeguard the validity of certain clauses, which may not be admissible under some domestic laws. Company law is often rigid and does not necessarily permit modern joint venture contract clauses. The main issues covered in a joint venture agreement are the governance of the 3.147 joint venture, the means of financing, non-competition between the partners and the joint venture company, and exit clauses. Risk mitigation mechanisms in the form of typical clauses aim to prevent disputes, which result in the loss of the joint investment. Governance of a joint venture takes place through joint committees or the board 3.148 of directors of the joint venture company. The principal planning instruments are long and medium term business plans. Within the framework of such business plans, the management acts with a certain freedom. This avoids disputes between

136 137

Hoffman, The Law and Business of International Project Finance §18.02 (n. 28). Wolf, The Complete Guide to International Joint Ventures (n. 111).

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Chapter 3: The Complex Long-Term Contract the joint venture partners as they are not involved in the everyday business. Their participation is limited to strategic decisions and controlling the execution of the business plan. The joint venture partners also intervene in case of matters that are not within the scope of the business plan, or if there are changes in the financial and commercial situation which are not contemplated by the business plan. 3.149 With respect to governance there are essential issues which require a qualified

majority of the joint venture partners in order to be resolved, such as, for example, the approval of the aforementioned business plan, dividend payments, the authorization of share transfers, and the acceptance of new partners in the joint venture. The lack of a qualified majority may result in a deadlock. The relationship between the joint venture company and the joint venture partners or related entities should be arm’s length. 3.150 The provision of finance is of utmost importance in joint ventures in order to make

the project viable and to provide the necessary funds so that the purpose of the joint venture may be achieved. The joint venture agreement establishes provisions with respect to capital increases to avoid a ‘buy out’ of one of the joint venture partners, and financing through banks and capital markets. 3.151 In order to avoid conflicts of interest, non-competition and confidentiality clauses

are essential, as one of the parties might use the contacts, local experience, know how, or clients of the other parties for its own benefit. Clearly drafted exit clauses are important in order to protect the substance of the joint venture from pernicious disputes. 3.152 Modern exit clauses are in the form of ‘put and call’ options. In the case of so-called

‘shot gun’ clauses, an offer to sell shares may be made to the other partners in the case of a deadlock between the joint venture partners. The other partners must accept the offer or return it at the same price. In practice, this leads to the offer to sell being made at a reasonable price, as if it is set too high, the partner which made the original offer to sell might be obliged to purchase at that price. 3.153 The so-called ‘piggy-back clause’ means that if one party does not take up its right

of first refusal of shares which are to be sold by another party, these shares may be offered to a third party. However, this third party must commit to buy all shares from all the other parties of the joint venture if required. This avoids the danger that a new party may be brought in without the acceptance of all the parties to the joint venture. 3.154 Share sales are normally restricted during a certain period after the date of the joint

venture agreement. The sale of shares of one of the partners in the joint venture to a third party is normally subject to pre-emption rights or rights of first refusal by the other joint venture partners.

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G. Contract Guidelines and the Recovery of Damages In case of dispute, arbitration is the preferred venue in international joint venture 3.155 agreements. Care must be taken that an arbitration clause is also contained in the by-laws of the joint venture company in case of a corporate joint venture and worded in a manner which is broad enough to include disputes between the partners, the partners and the company, the members of the board of directors, and combinations thereof. 7. Conclusion Complex long-term contracts are self-contained and self-executing agreements, 3.156 which contain risk allocation and adaptation mechanisms such as claim management, which provide for adjustment of risks which have occurred in the other party’s risk sphere. The aim of these mechanisms is to achieve the performance of the contract and the successful execution of a project and to avoid disputes. When these mechanisms fail or one of the parties refuses to co-operate, litigation and arbitration are the consequence. However, arbitral tribunals must respect the underlying risk allocation of a complex long-term agreement and may not rewrite the rules agreed by the parties in the contract.

G. Contract Guidelines and the Recovery of Damages Complex long-term contracts are aimed to be self-contained and self-executing 3.157 agreements, in order to avoid breach of contract and litigation. Litigation normally occurs when one of the parties refuses to perform in spite of the contractual adaptation mechanisms, penalties and incentives. This self-regulatory function has also been extended to provide rules for the recovery of damages through contractual clauses in order to ensure that general principles of damages law are correctly applied in arbitrations. Generally, in the case of deficient performance, the parties may chose between payment of liquidated damages or termination of contract. The liquidated damages are normally measured as the difference between the contracted capacity and the actual capacity demonstrated in testing. In case of termination of a Power Purchase Agreement (PPA) because of breach of 3.158 contract by the operator, the PPA normally provides a methodology for calculating the buyout price such as a combination of: (1) the estimated net present value of the cash flows over the remaining period of the PPA plus a specified residual value of the plant; (2) a construction period evaluation consisting of a specified percentage of equity subscriptions paid into the company plus an allowed return on the equity at a specified rate; (3) a terminal evaluation set at a specified percentage of the plant’s depreciated replacement cost; 61

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Chapter 3: The Complex Long-Term Contract (4) the company’s outstanding long- and short-term loans and any accrued interest and financing fees; and (5) transfer cost. 3.159 This means that the purchaser actually buys the plant and steps into any contracts

on behalf of the operator and pays for such buyout. Any damages claim against the operator has to be set-off against the buyout price.138 3.160 In the case of a breach of contract by the purchaser and a damages claim made by

the operator, this formula should be taken into consideration as it establishes the minimum threshold to be paid to the contractor. In this respect it is important for an arbitral tribunal to consider such buyout clauses, which indicate the compensation agreed by the parties in case of the termination of contract. 3.161 This is in line with the recommendations in international contract guidelines,

which refer to best practices as regards the recovery of damages in infrastructure projects. The UNCITRAL Contracts Guide, the UNIDO BOT Guidelines, and SoPC provide recommendations with respect to best practices as regards clauses governing the recovery of damages. 3.162 As regards breach of contract and other failures to perform the project agreements,

the UNIDO BOT Guidelines state: Strict adherence to contract performance of obligations is particularly important in BOT arrangements, as a failure by one party to adhere to the contract terms might have serious financial consequences for the other party and for the lenders. Infrastructure projects usually involve vast sums of money at every state of project implementation; moreover the non- or limited recourse nature of financing for BOT projects makes the investors particularly vulnerable to defects, delays or other failures to build and operate the project. It is therefore advisable to prepare and agree upon precise stipulations in the project agreement defining the obligations to be performed and the consequences of a failure to perform those obligations.139 3.163 This is repeated in the UNCITRAL Contracts Guide, which underlines the serious

financial repercussions of failure by a party to adhere to the contract terms, which are frequently the cause of long and complicated disputes. Failure to perform refers to two situations: (1) delay in performance, and (2) defective performance and normally results in a right to recover damages, which are often agreed in the form of liquidated damages or penalties.140 Such failure to perform may be excused in case of impediments beyond the control of the parties (force majeure) or due to risks to be borne by the other party, such as the risk of unfavourable underground conditions which are normally borne by the owner of the works.

138 139 140

Kerf et al., Concessions for Infrastructure 109–10 (n. 3). UNIDO BOT Guidelines 235 (n. 11). UNCITRAL Legislative Guide 197–8 (n. 9).

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G. Contract Guidelines and the Recovery of Damages The UNIDO BOT Guidelines recommend lump-sum payments in case of a sub- 3.164 stantial breach of contract or of force majeure situations exceeding a reasonable period, supplemented by liquidated damages specified in the delay and penalty clauses of the project agreement. Cases not covered by liquidated damages and penalties should be dealt with by contract provisions containing: (1) (2) (3) (4) (5) (6)

terms and conditions for compensation; exemptions from the obligations to pay compensation; benefits gained from failure to perform; duty to mitigate the loss; currency of damages; exclusion of consequential damages in cases where the party in breach of contract has not acted with gross misconduct.141

As regards ‘termination due to breach by the contracting authority’, the 3.165 UNCITRAL Legislative Guide states: The concessionaire is usually entitled to full compensation for loss sustained as a result of termination on grounds attributable to the contracting authority. The compensation due to the concessionaire usually includes compensation for the value of the works and installations, to the extent they have not already been amortized, as well as for the loss caused to the concessionaire, including lost profits, which are usually calculated on the basis of the concessionaire’s revenue during previous financial years, when termination occurs during the operational phase, or are based on a projection of the expected benefit during the duration originally envisaged. The concessionaire may be entitled to full compensation of debt and equity, including debt service and lost profits.142

With respect to ‘Compensation upon termination of the concession contract’, pro- 3.166 vision 47 of the UNCITRAL Model Legislative Provisions reads: The concession contract shall stipulate how compensation due to either party is calculated in the event of termination of the concession contract, providing, where appropriate, for compensation for the fair value of the works performed under the concession contract, cost incurred or losses sustained by either party, including, as appropriate, lost profits.

Section 24.6 of SoPC emphasizes the necessity to limit the ability of the author- 3.167 ity and the contractor to make claims against each other for breach of obligation under the contract as ‘there is an incentive to perform and . . . any deduction as a result of the payment mechanism reflects the loss to the Authority and so should usually be the exclusive remedy of the Authority’. The payment mechanism aims to ensure that the ‘absence of the Service reflects the costs the Authority incurs in not receiving the Service’. This excludes any double remedy of the authority against

141 142

UNIDO BOT Guidelines 236–7 (n. 11). UNCITRAL Legislative Guide 166, para. 46 (n. 11).

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Chapter 3: The Complex Long-Term Contract the contractor. In particular, the authority should not seek to obtain or preserve a general damages claim for service failures but rather stipulate liquidated damages such as deductions from termination compensation payments, save where the corresponding amounts are not reflected in a reduced market value compensation.143 3.168 The objective of ‘Compensation on Termination for Authority Default’ under

section 21.1.3 of SoPC is that ‘the Contractor and its financiers are fully compensated’. This means that the contractor and its financiers should not be worse off because of the default of the authority than if the contract had proceeded as expected. The footnote establishes that the compensation payable should reflect a realistic calculation of an anticipated claim for damages and should be an exclusive remedy of the contractor. 3.169 As regards damages calculations, section 21.1.3 of SoPC establishes that ‘[t]he

Contractor should be required to specify its preferred method of calculation of equity return at the time of its bid. It should choose between the level set out in the original base case, the market value at the time of termination and the original base case return from the Termination Date.’ The PFI Contract, therefore, establishes a rather detailed mechanism as regards the calculation of damages to be paid by the authority to the contractor in the case of default by the authority. 3.170 The understanding of the elements of complex long-term contracts such as risk

allocation is important for the proper determination and awarding of damages. The UNCITRAL and UNIDO as well as the PFI contract guidelines provide an insight to the best practices for the recovery of damages under such contracts. 3.171 Risk allocation has an important role in the financial structure and viability of

complex long-term contracts and has to be duly considered by the arbitral tribunal when awarding damages, which in turn results in legal certainty and predictability. These two concepts, as explained in chapter 2, have a positive effect in the perception of risk, which is reflected in lower transaction costs and a more efficient economy.

H. Cases and Arbitrations Related to Complex Long-Term Contracts 3.172 The nature of complex long-term contracts makes conflicts inevitable. The cases

examined in this section refer to both typical and atypical synallagmatic complex long-term contracts and show: (1) how disputes arise under those contracts; (2) how contractual claim management mechanisms work in some cases as a means of contract adaptation in order to avoid further disputes; and (3) the difficulties that arise

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H. Cases and Arbitrations when analysing, framing, and awarding damages, which are discussed in detail in chapters 5, 6, and 7. An understanding of the factual situation and the legal issues in the cases described here will be necessary when considering the analysis carried out in the following chapters. 1. Turnkey construction contracts of power plant projects During the construction of a thermoelectric power plant, a tropical storm occurred 3.173 that lasted for 15 days. The contractor made a claim for a 15-day time extension under the contractual force majeure provision due to the heavy rain, which had affected the works on several fronts. This claim was accompanied by weather reports from adjacent weather stations, and proof of additional costs which had been incurred to remedy flooding. The owner rejected the claim, arguing that the tropical storm was not a hurricane and that the effect of the storm had not been proven. The contractor re-filed the claim arguing that the force majeure clause of the turn- 3.174 key construction contract did not require a hurricane, but only a ‘storm’, and that a ‘tropical storm’ is of a higher category than a storm. The new claim included a critical path analysis together with the measured mile method, showing that the effect of the heavy rain on the works was 11 days and not 15 as previously argued. Under the contract, the risk of a storm was allocated to the owner. However, such risk allocation only applied to the consequences which could reasonably be proved. The critical path analysis is a recognized method used to order to evidence the consequences of risks verified in multi-task works contracts. Finally, the claim was accepted and duly paid. This is an example of how risk allocation clauses and contractual claim management avoid further dispute. In another power plant project, the scope of works included the redundancy soft- 3.175 ware for a sub-station, which would take over control if there was a problem relating to the main software. A database provided by the owner was necessary in order to complete the programming of the redundancy software by the contractor. The delivery of the software was delayed by several months, which led to the imposition of significant liquidated damages on the contractor. The question was whether the delay was imputable upon the contractor, the owner, or both. An analysis of the situation using a critical path analysis showed that the database which had been due to be provided within 30 days from the date of the contract was actually provided by the owner three months later. Based on the critical path analysis and the contractual claim procedure, the contractor made a time extension and additional cost claim, which led to a significant reduction of the liquidated damages. This is another example of the avoidance of a dispute through proper claim and contract management. As regards the same redundancy software, as originally delivered, once it became 3.176 active it displayed data from 600 measuring points for a few minutes. The owner 65

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Chapter 3: The Complex Long-Term Contract considered this display to be a defect of the software and instructed the contractor to reprogram it in order to avoid this display. The reprogramming caused three programmers in the headquarters of the contractor to work for three months. An analysis of industry standards showed that the display of initial measures was part of good manufacturing practices and could not be considered as a defect. It would at best be a minor defect, which was not of relevance. The request to remove the display was, therefore, a change order or variation, which gave rise to a time extension and a claim for additional cost in favour of the contractor. The time extension led to an elimination of the liquidated damages and the avoidance of arbitration. 3.177 In another power plant project, the scope of the works for the electrical installa-

tion in the sub-contract was reduced to less than that required under the master agreement against a corresponding reduction of the price. A dispute arose when the contractor claimed the original scope of works under the master agreement. The contractor therefore argued that the scope of the master agreement was applicable, whereas the sub-contractor insisted that due to the price reduction a reduced scope applied, as could be deduced from several exhibits of the sub-contract. The dispute led to arbitration, which at the end confirmed the reduced scope of the sub-contract. According to the privity of contract, the only contract applicable between the contractor and the sub-contractor is the sub-contract. This is an example of how the lack of synchronization between the master and a sub-contract results in disputes. 3.178 In another power plant project, a static VAR Compensator, which regulates the

voltage of the power that comes out of an energy plant, showed higher losses from some of its individual components than those proposed in the bid and lower losses from other individual components. However, the weighted average of losses was considerably below the maximum losses quoted in the bid. The value of losses is part of the price offered. Liquidated damages were imposed by the owner and deducted from the final price payment. The contractor argued that the owner did not suffer damages as the weighted average losses were below the total losses offered in the bid. Apart from that, the technical standards containing the liquidated damages formula applied to transformers, which are substantially different from static VAR compensators. Static VAR compensators do not have the phases which are characteristic of transformers. In this case, the problem arose as the contract was not clear as to whether the individual losses of the components or the weighed average of the losses of the components were to be applicable to determine the liquidated damages. Independently from that, the formula applied under the contract to calculate the liquidated damages was for transformers and not for VAR compensators. The parties settled the dispute in favour of the contractor. This is an example of the problems caused by contradictory liquidated damages clauses. 3.179 In a similar case, the loss happened with respect to autotransformers. From the

technical specifications it was clear that the losses for each of the four phases were 66

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H. Cases and Arbitrations guaranteed and it was irrelevant if the weighted average total loss was below the maximum amount. The excess losses during some of the phases were causing accelerated wear and tear and, therefore, had been individually guaranteed. In this case the liquidated damages could not be avoided and were accepted, subject to a prior analysis avoiding further disputes. 2. Processing plant turnkey construction project In 2009, the parties signed a contract for the engineering, procurement, and con- 3.180 struction of a processing plant for the freezing of fish packed in cartons using a novel energy saving method developed in country X. Although the developer of the technology participated in the contract negotiations and the proposal, the contract was signed with one of its subsidiaries. The contract established as a performance requirement a temperature of minus 18 3.181 degrees Celsius after 24 hours of freezing for different sizes of boxes filled with fish. The parties used the FIDIC Conditions of Contract for EPC/Turnkey Projects, which contains detailed provisions for claim management. In particular, the contract provided for an ad hoc dispute board, which could not be put in place due to the refusal by the contractor to appoint its member.144 The works suffered from delays and deficiencies from the outset. Testing took place 3.182 according to the general and particular conditions of contract and resulted in a performance rate of only 12 per cent, which, in practice was of no value since it was impossible to determine which boxes had achieved the required temperature. Therefore, all boxes had to be submitted to an additional freezing process provided by a third party, causing significant costs, which exceeded the actual value of the plant. The owner granted an additional period of time to the contractor in order to rem- 3.183 edy the defects. However, such remediation never took place. Apart from that, under the particular conditions of the contract, performance risk was partially covered by standby letters of credit, which had not been renewed by the contractor when the original contractual period lapsed. Due to total non-performance, the owner of the plant terminated the contract 3.184 and made a corresponding claim for damages. This gave rise to different possible scenarios of how the damages claim might be structured, which will be further analysed in chapter 5.

144 Herfried Wöss, ‘The Relationship between Arbitration and the Dispute Adjudication Board under the FIDIC Silver Book (EPCT)’, presentation at the ICC/FIDIC Seminar on International Construction Contracts and the Solution of Disputes, Sao Paolo, Brazil, 16–17 June 2011, accessed 25 September 2013.

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Chapter 3: The Complex Long-Term Contract 3. Oil platform construction contract 3.185 In ICC Case No. 13613/CCO/JRF, a construction company (CC),145 sued a state

oil firm (SOF) for the payment of claims and damages arising from the construction of an oil platform in relation to the administrative rescission of the contract. The claims were based on extraordinary work not contemplated in the original scope of work subject to change orders. The procedure for change orders was established in one of the exhibits to the contract referring to almost any type of change in relation to the contract, such as drawings, designs, specifications, construction methods, contractor’s work method or sequence, equipment, premises, material, services, work places, acceleration and de-acceleration of the execution of the works, modification of the work plan or the critical dates of the contract, provided such amendment was made through a written agreement. The change procedure was to commence with a change notice prepared by the contractor containing a detailed written proposal stating the nature of the change, effect on the work plan, and financial impact, to allow SOF to carry out a thorough analysis before acceptance of the proposal and a written agreement being made between both parties. 3.186 This contract was a unit price construction contract for the engineering, procure-

ment, manufacture, transport, installation, interconnection, testing, and commissioning of a compression platform pertaining to an oil complex. The unit prices were established in an exhibit to the contract. The unit prices were fixed amounts subject to adjustment with respect to direct cost according to the contract. The amount of the contract was subject to modification under the terms and conditions established in that contract. 3.187 The contract also established a revision and adjustment of the costs integrating

the unit prices in case of economic circumstances not foreseen in the contract. In particular, the contract referred to time extensions and their consequences in case of force majeure, which, by law, included delays caused by SOF. Th is would lead to contract modification, which required a detailed claim by the contractor, an analysis by the state entity of the monetary consequences of time extension, and the signing of a modification agreement. 3.188 In fi xed-price contracts any price and cost risks are borne by the contractor. The

exception are time extension claims which normally lead to cost claims, which shift such risks to the owner of the works, subject to detailed claim procedures which have to be obeyed. Examples for claim procedures are found in the FIDIC forms and the ICC Model Turnkey Contract for Major Projects. The problem with

145 The fi nal award and its translation was made public at executions proceedings before the courts of the State of New York; with respect to the annulment of the award in Mexico see Wöss, ‘El Orden Público, Derecho Público, Cosa Juzgada e Inarbitrabilidad en el Derecho Mexicano’ 111–31 (n. 62).

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H. Cases and Arbitrations claim procedures under the applicable federal public acquisition and works laws is that contractual provisions have to be read together with legal provisions.146 The object of the litigation was to establish whether CC had a right to the full 3.189 value of the claims. Due to the administrative rescission of the contract, SOF unilaterally determined the value of the claims in the final determination under the applicable law. The original completion date was 25 April 2000, which was extended to 14 January 3.190 2002. However this date could not be met due to the failure of SOF to supply working HPCs (high performance concrete), which were critical to the project, on time. This forced CC to undertake an extended hook-up period. Due to the extension of the project caused by the delay in the supply of working HPCs, the unit rates for pricing the labour, materials, construction, machinery, and equipment were no longer accurate and SOF sought the increased escalation costs incurred as a result of these delays. The arbitral tribunal ruled with respect to these claims, that ‘given that the supply 3.191 of HPCs made up the critical path, this Tribunal understands that [SOF] shall be liable for the delays affecting the project during the HUC operations and, therefore, [SOF] shall be entitled to the damages caused for the longer term of such operations pursuant to the provisions of [the applicable law]’.147 The arbitral tribunal took into consideration that SOF’s remuneration was agreed upon in fixed unit prices with the only exception in the form of cost adjustment provided in the contract, which would apply to the portion in domestic currency in the event of circumstances of an economic nature not provided for in the contract which caused an increase or reduction in the costs of the work yet to be executed, in accordance with the schedule agreed upon. Such circumstances, however, were not deemed to have occurred. According to the arbitral tribunal, SOF’s ‘failure to timely deliver completed 3.192 HPCs, clearly constitutes the prevailing and main cause for the delays in the schedule . . . In this specific case, the rules of compensation for damages arising out of breach of contract shall be applied, which provide for a full and comprehensive compensation of the injured party, pursuant to [the applicable law]’. The tribunal stated that there was no double claim as the greater cost sustained by SOF was limited to the increased costs due to inflation in the USA. According to the applicable law, both the financial loss resulting from breach of an obligation, as well as the impossibility of obtaining any lawful profit that should have been obtained had the obligation been fulfilled, must be compensated. 146 Herfried Wöss, ‘Mexico: Dispute Resolution under the new Public-Private Partnerships Law’ (2012) Global Arbitration Review (23 May); Herfried Wöss, ‘Solución de Controversias al Amparto de la Nueva Ley Mexicana de Asociaciones Público-Privadas’ (2012/2013) 5 Lima Arbitration 185–194. 147 ICC Case No. 13613/CCO/JRF, fi nal award, 16 December 2009, 208.

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Chapter 3: The Complex Long-Term Contract 3.193 The tribunal ruled with respect to the damages claim for increased inflation:

Therefore, [CC]’s compensation shall comprise, as consequential damages, the escalation of the costs afforded by the respondent as a result of the delays in the execution of HUC operations, including direct overcharges comprised in unit prices quoted in foreign currency, since the duly proven increase of all of the aforementioned costs shall be considered in order to fully compensate [SOF].148 3.194 In this respect, the respondent argued:

[T]he possibility of deferring or extending the term of the Contract was stipulated since the signing of the Contract. Consequently, CC cannot state that it has suffered damages in connection with costs (quoted in foreign currency) as a result of the update of such contract stipulations, and much less that such damages would be attributable to SOF. Furthermore, given the possibility of deferring or extending the term of the Contract, CC was under a duty to make all provisions, forecasts and projections as regards any potential variations of its costs during the execution of the project.149

This defence was, however, dismissed by the arbitral tribunal. 3.195 The question is what would have happened in a damages claim under a FIDIC

contract when claim procedures had not been obeyed by one of the parties. It seems that claim procedures not observed exclude additional damages claims, whereas damages claims exceeding the amounts to be claimed under a claims procedure are admissible.150 3.196 The arbitral tribunal concluded with respect to such claim that ‘at the time of exe-

cution of the contract, the claimant was not liable for foreseeing the effects of a potential breach of contract by SOF, and SOF could not raise that situation as a defence invoking its own negligence for its own benefit’. The issue is, however, that according to the contract, the relevant date of cost adjustment is the date of the increase of cost and not the time of execution of the contract, and it must be established who bears the responsibility for the omission of proper claim management.151 3.197 Another damages claim made in this arbitration was about ‘flushing damages’.152

As stated in section 2.4 of the award, CC mobilized personnel and equipment to the offshore EPC-1 project to flush the MDEA system and perform tightness tests and pipeline flushing. For that purpose, CC applied for a work permit from SOF, which was never granted. CC was forced to cancel the flushing work and demobilize the subcontracted personnel and their equipment. CC filed a claim against

148

ICC Case No. 13613/CCO/JRF, final award 209 (n. 147). ICC Case No. 13613/CCO/JRF, final award 209–10 (n. 147). 150 ICC Case No. 13613/CCO/JRF, fi nal award 210 (n. 147); such questions are discussed at ICP-Net, the blog of the International Construction Projects Committee of the International Bar Association. 151 Katharina Müller and Rainer Stempkowski (eds.), Handbuch Claim-Management (Linde-Verlag 2012). 152 ICC Case No. 13613/CCO/JRF, fi nal award 210–28 (n. 147). 149

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H. Cases and Arbitrations SOF for the costs associated to these futile activities. SOF argued that CC changed the order of the procedure previously established, given that it had not obtained the partial completion certificates. In arriving at its conclusions as to whether the claimant met the conditions 3.198 required to proceed with the flushing or if it was SOF that incurred in breach by denying the respective permit, the arbitral tribunal took into consideration the following elements: (1) the Original Contract, (2) Annex ‘Interpretation’, (3) the ‘Commissioning Manual’ which describes the stages of the project administration, procedure between mechanical completion, function testing, commissioning, and start up, (4) logbook excerpts, (5) letters between the parties, and (6) other documents. The arbitral tribunal ruled that SOF:

3.199

. . . acted in an inconsistent manner, as it did not grant the work permit to get on with the activities necessary for the flushing of the MDEA system, and thus breached the duties entrusted therewith, as it failed to prove that there was an objective cause justifying the refusal to grant the referred permit, especially as it has later acknowledged the need to conduct the flushing in an urgent manner, with a view to avoid the deterioration on the sweetening trains.153

The arbitration involved massive claims, which resulted in an award of nearly 3.200 US$300 million. The award was annulled due to parallel court procedures against the execution of contractor’s guarantees considered acts of state under the applicable law upon petition of SOF,154 which were erroneously considered as having a res judicata effect on the execution procedure.155 Such case shows that in construction arbitrations the overall dispute is normally presented in small slices according to the claims arising from the project, organized in a logical order. Proper claim management during construction is, therefore, of utmost importance. 4. Gas exploration and exploitation joint venture agreement in Turkmenistan The Joint Venture Yashlar was a Turkmenistan-based joint venture signed on 21 3.201 December 1991, between Production Association Turkmengeologia (25 per cent, Turkmenistan) and Bridas, S.A.P.I.C (75 per cent, Argentina) with the purpose of the exploration and exploitation of gas in an area consisting of 64 blocks of land of a total of 6,400 square kilometers in Turkmenistan.156 This agreement was based on English law.157 The project faced several risks such as the existence of high pressures 153

ICC Case No. 13613/CCO/JRF, final award 226 (n. 147). With respect to similar problems in countries with legislations based on French law, see Mairal, The Impact of Public Procurement and Rules of Government Contracting 349–50 (n. 65); Mairal, Government Contracts under Argentine Law 1716–53 (n. 65). 155 Wöss, ‘El Orden Público, Derecho Público, Cosa Juzgada e Inarbitrabilidad en el Derecho Mexicano—La Anulación del Laudo en el caso ICC 13613/CCO/JRF’ 111–31 (n. 62). 156 Bridas v. Turkmenistan , ICC Case No. 9151/FMS/KGA, interim award, 8 June 1999, 3. 157 Bridas v. Turkmenistan , fi nal award, 18 May 2000, 16. 154

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Chapter 3: The Complex Long-Term Contract from certain geological layers combined with concentrations of hydrogen sulfide gas, which made drilling difficult, as such gas is lethal even in very small amounts. Additionally, political risks existed. Due to the dissolution of the Soviet Union, Turkmenistan did not have access to the pipeline system and, therefore, was not able to export gas to Europe. 3.202 The joint venture achieved its general purpose of confirming the existence of a huge

gas reserve in the Yashlar through exploratory wells. However, there was disagreement in the way the exploratory drillings were executed by Bridas and the number of boreholes used.158 Drilling was highly complicated due to geological structures (high temperature high pressure wells) and dangerous due to the presence of lethal gas. Drilling got stuck on several occasions. Finally, gas rates in excess of 50 million cubic feet per day were found. 3.203 In spite of all these activities and the detection of significant gas reserves, the

Turkmenian party argued that it was not duly informed of the activities of the Joint Venture Yashlar. 3.204 Turkmenistan argued that the joint venture agreement was void or voidable as it

was procured improperly in breach of Turkmenian law, or should be terminated because of numerous and persistent repudiatory breaches of contract and breaches of the fiduciary duties by Bridas. Additionally, it argued that the joint venture agreement should be terminated because of frustration as prospective export markets had been lost due to the dissolution of the former Soviet Union.159 3.205 Bridas claimed the declaration of validity of the joint venture agreement and damages

for breach of contract. Bridas argued that in November 1995, Turkmenistan ordered the suspension of works and prohibited Bridas from making imports and exports in or from Turkmenistan. 3.206 With respect to the breach of contract and responsibility, the arbitral tribunal ruled:

. . . the Defendant itself has committed a fundamental breach of the JV Agreement, in that, without legal justification, it has refused to recognise the Agreement as subsisting and has purported to suspend its operation indefinitely. Indeed, it was that step on the part of the Defendant which brought about this arbitration.160 3.207 The damages were based on a loss of bargain, and, alternatively, on reliance dam-

ages. According to the arbitral tribunal: The main claim is for the present value of the loss of the profits which the Claimants contend they would have earned had the Joint Venture not been wrongfully terminated by the Defendant. This claim has been variously described as the loss of bargain claim, or the claim for ‘expectation’ damages. The alternative claim is for ‘reliance’

158 159 160

Bridas v. Turkmenistan, interim award 49–50 (n. 156). Bridas v. Turkmenistan, interim award 85–6 (n. 156). Bridas v. Turkmenistan, interim award 184 (n. 156).

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H. Cases and Arbitrations damages. It seeks recovery of wasted expenditure incurred by the claimants in reliance on the contract.161

The arbitral tribunal engaged in an extensive analysis of damages. One of the main 3.208 issues discussed in the context of the loss of bargain claim was the amount of gas that Bridas would have been able to produce during the time of the joint venture agreement.162 Another issue was the possibility for Yashlar gas to be marketed.163 In this respect, 3.209 Bridas argued that the risk of the pipeline access was allocated to Turkmenistan in the joint venture agreement. According to section 18.6 of the joint venture agreement, the Joint Venture has the ‘right to use the pipeline capacities in the USSR and Turkmenistan. Tukmengelogia guarantees timely utilization of these pipelines for the Joint Venture’s needs. . . . ’. However, this argument was not admitted by the arbitral tribunal.164 Other issues discussed in the arbitration were the price of the gas,165 the cost of 3.210 drilling the wells,166 and the discount rate167 for the expected income stream over the next 25-year period of the joint venture agreement. In the final award as of 18 May 2000, the arbitral tribunal arrived at the conclusion 3.211 that it ‘cannot, and does not, conclude that the Claimants lost profits as a result of the breach of the JV Agreement’ because there was not sufficient evidence that income would be generated through the joint venture.168 With respect to the reliance interest, the arbitral tribunal stated that the claimants 3.212 had put the innocent party into the position they would have been in had it not entered the contract, but not in a better position. As regards the burden of proof, the tribunal underlined that it is the defendant that has the burden to prove that the ‘expenditure would not have been recouped had the contract been performed’.169 As regards reliance damage, the arbitral tribunal held that ‘the object of reliance 3.213 loss damage is to obtain such compensation from the contract breaker as would put the innocent party in the position it would have been in had it not entered into the contract’.170 On 18 May 2000, Bridas was awarded US$193,000,000 as reliance damages plus 6 per cent interest per annum. The arbitral tribunal, therefore, awarded the so-called ‘sunk-investment’. 161 162 163 164 165 166 167 168 169 170

Bridas v. Turkmenistan, final award 16 (n. 157). Bridas v. Turkmenistan, final award 31–77 (n. 157). Bridas v. Turkmenistan, final award 77–83 (n. 157). Bridas v. Turkmenistan, final award 83–5 (n. 157). Bridas v. Turkmenistan, final award 112 et seq. (n. 157). Bridas v. Turkmenistan, final award 115 et seq. (n. 157). Bridas v. Turkmenistan, final award 117 et seq. (n. 157). Bridas v. Turkmenistan, final award 127 (n. 157). Bridas v. Turkmenistan, final award 137–8 (n. 157). Bridas v. Turkmenistan, final award 131 (n. 157).

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Chapter 3: The Complex Long-Term Contract 5. Joint venture agreement in the automotive industry 3.214 The automotive industry is one of the most globalized industries. Suppliers have to

deliver just in time, which requires local production facilities at the manufacturing sites of automotive producers or original equipment manufacturers (OEMs). 3.215 In 1999 a foreign automotive parts supplier (S) invited a local manufacturer (M) to

enter into a joint venture for the production of automotive parts in country X to be delivered to a subsidiary of an OEM in country X. Under the joint venture agreement, the joint venture company incorporated by S and M in country X was meant to produce car parts, with the technology and clients provided by the foreign partner. Both parties made equal capital contributions. M provided the plant for immediate production. The joint venture company incorporated by the partners had to pay substantial royalties for the additional technology provided by S. M had been rated as a top automotive parts supplier of the OEM subsidiary in country X for many years. 3.216 The reason for the joint venture was to become global suppliers to the OEM. 3.217 S originally was a major supplier to the OEM and was under pressure to supply

automotive parts for already existing projects in country X. Under the new structure, country X should be a global supply platform for such automotive parts. As a consequence, S needed an experienced automotive part producer with a good reputation, such as M. 3.218 S wished to immediately start production at the quality standards required in

the industry through M’s plant, and both aimed at global projects through the joint venture. One of the core provisions of the joint venture agreement was the non-competition clause. 3.219 Production for two existing projects started immediately. Two years later, another

domestic project was awarded to the joint venture, which soon afterwards, turned into a global and much larger project. The parties to the joint venture agreed upon a business plan for the global project and re-quoted. However, the global project was awarded to a new joint venture between S and a third party, violating the non-competition clause under the original joint venture agreement. 3.220 Negotiations followed during quite some time and finally failed. The case went to

arbitration. Though the existing business sufficed to maintain the joint venture in operation, no new business was brought in. The claimant sued for the profits generated by the new business according to the business plan agreed by the parties and showed that automotive production actually exceeded the numbers established in the business plan. The violation of the non-competition clause occurred in 2005. The business plan covered the period of 2005–2010, the arbitration ended in 2010, and the award was rendered in 2011. 3.221 The non-competition clause was subject to exceptions such as in case of the inabil-

ity of M to produce the parts in question or disputes that affected production. The 74

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H. Cases and Arbitrations arbitral tribunal recognized that such exceptions did not apply as production was on-going and there was no dispute about the request for quotation and the quotation of the joint venture for the new project. Exception clauses are a frequent cause for international arbitration, which is the 3.222 reason why Article 7.1.6 PICC contains particular provisions to that respect.171 Once an arbitral tribunal confirms a breach of contract and the liability of the 3.223 party in breach, the crucial question is what would have happened in the absence of the breach? In order to answer this question, first, the arbitral tribunal should have considered that the project contained in the business plans actually took place. Second, the project performance exceeded the results projected in the business plans as more cars were sold than projected based on industry information publicly available. Third, as the business plan and the project ended in 2010, and the award was rendered in 2011, no discount rates should have been applied. The arbitral tribunal only had to update the results of the business plan in 2010 to the date of the award in 2011 to make the injured party whole, which it did not do. The arbitral tribunal discounted the 2010 results to the date of the breach in 2005 without updating the amount to the date of the award, resulting in a considerable under compensation. This will be further analysed in chapters 5, 6, and 7. This shows that there is a problem in understanding business plans and their role in 3.224 damages claims, the determination of the date of valuation, the role of pre-award interest as part of the damages claim, and in the determination of discount rates. These matters will be discussed in detail in chapters 5 and 6. The relevant issue in damages claims is not necessarily the application of financial 3.225 valuation methods performed by experts, but the basic assumptions of a damages claim. When such assumptions are wrong, an award necessarily fails to deliver full compensation.

171 Marc Fontaine and Filip De Ly, Drafting International Contracts: An Analysis of Contract Clauses (Martinus Nijhoff Publishers 2009) Ch 7, 351–2.

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4 DA M AGES CL AIMS FOR BR E ACH OF CONTR ACT UNDER COMPAR ATIVE AND TR ANSNATIONA L L AW

A. Requisites for Damages Claims under Different Rules of Damages Law: UK, USA, France, Mexico, Germany, CISG, and PICC B. United Kingdom 1. 2. 3. 4. 5.

Principles for damages claims Requisites for a damages claim Measure of damages Limitations to damages claims Other aspects affecting the damages claim 6. Penalties and liquidated damages 7. Construction contracts 8. Considerations

C. United States 1. 2. 3. 4. 5.

Principles of damages claims Requisites for a damages claim Measure of damages Limitations to damages claims Other aspects affecting the damages claim 6. Penalties and liquidated damages 7. Special issues related to construction contracts 8. Considerations

D. France 1. 2. 3. 4. 5.

Principles for damages claims Requisites for a damages claim Measure of damages Limitations to damages claims Other aspects affecting the damages claim 6. Penalties and liquidated damages 7. Law reform 8. Considerations

E. Mexico 1. 2. 3. 4.

Principles of damages claims Requisites for a damages claim Limitations to damages claims Other aspects affecting the damages claim 5. Penalties and liquidated damages 6. Considerations

4.01 4.04 4.04 4.13 4.36 4.53

F. Germany 1. 2. 3. 4. 5. 6.

Law reform Principles for damages claims Requisites of a damages claim Measure of damages Limitations to damages Other aspects affecting the damages claim 7. Penalties and liquidated damages 8. Considerations

4.72 4.75 4.79 4.86 4.88 4.89 4.99 4.123 4.150

G. CISG 1. 2. 3. 4. 5.

Principles for damages claims Requisites of a damages claim Measure of damages Limitation of damages Other aspects affecting the damages claim 6. Considerations

4.162 4.166 4.168 4.172 4.174 4.174 4.187 4.202 4.211

H. UNIDROIT Principles of International Commercial Contracts (PICC) 1. 2. 3. 4. 5.

4.216 4.220 4.221 4.223

Principles for damages claims Requisites of a damages claim Measure of damages Limitation of damages Other aspects affecting the damages claim

4.226 4.229 4.232 4.241 4.246 4.250 4.251 4.252 4.253 4.256 4.263 4.293 4.316 4.325 4.336 4.337 4.341 4.345 4.347 4.361 4.363 4.369 4.372

4.373 4.380 4.385 4.397 4.399 4.414

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Chapter 4: Damages Claims for Breach of Contract 6. Penalties and liquidated damages 7. Considerations 8. CANACO Case 144 under PICC

I. Systemic Aspects of Rules of Damages Laws 1. Measures of damages 2. Requisites and limitations to damages claims

4.417 4.419 4.422

3. Level of evidence and burden of proof 4. Date of the determination of damages 5. The protective effect of the norm, risk spheres, and the purpose of the contract 6. Conclusions

4.432 4.433 4.442

4.447 4.451

4.452 4.454

A. Requisites for Damages Claims under Different Rules of Damages Law: UK, USA, France, Mexico, Germany, CISG, and PICC 4.01 This chapter aims to identify the differences and similarities between the rules of

law examined here with respect to (1) underlying principles, (2) the requirements for damages claims such as breach of contract, loss, causality, and fault, (3) the applicable limitations to damages claims such as remoteness, foreseeability, adequacy, contributory negligence, and mitigation, (4) the measure of damages and the interest protected by law, and (5) the effect of rules of evidence and the standard of proof. The rules of evidence and the burden of proof are of utmost importance for awarding damages and are found in the substantive law or in the procedural law depending on the rules of law applicable. Therefore, though this book is about arbitration, the rules on evidence and the burden of proof, contained in procedural laws, are included in the following outline. 4.02 In order to make the rules of law analysed comparable, this chapter will follow

a functional approach outlining their different effects when framing a damages claim or when awarding damages. As none of the rules of law analysed contain particular provisions with respect to damages under complex long-term contracts, the aim is to identify legal solutions that might facilitate the application of general rules of law to damages deriving from the breach of complex long-term contracts. The term damages used herein has two meanings, which have to be ascertained within their context: (1) loss as the damaging effect of the breach of contract, or (2) the actual compensation for such losses. 4.03 The analysis contained herein is based on the works of leading scholars and, in

particular, on recent comparative law analyses, which provide an insight into some of the rules of laws that considerably influence international business and trade. This requires a certain simplification and generalization, which cannot be avoided, and is necessary in order to allow comparison. The application of the legal principles or standards identified in this chapter to international arbitrations dealing with the breach of complex long-term contracts will be considered in the following chapter. 78

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B. United Kingdom

B. United Kingdom 1. Principles for damages claims In English law, damages are the primary remedy for breach of contract and not 4.04 specific performance.1 Compensatory principle:  The main principle when damages are awarded is the 4.05 compensatory principle, according to which damages are a substitutional remedy, whose aim is to give the injured party the necessary amount of money to put that party ‘so far as money can do it, in the same position as he would have been in had the contract been performed’.2 Damages are compensatory to the loss suffered by the claimant as a consequence of 4.06 the breach of the contract and are not aimed to restitute the performance promised to the claimant. The objective is to give the claimant compensation for the damage, loss, or injury that the claimant has suffered,3 based on the following criteria:4 (1) Loss to claimant: Damages are based on the loss to the claimant caused by the breach of the contract but not on the gain to the defendant, save certain exceptions. (2) Damages are not to exceed loss: An award of damages should not enrich the claimant. Claimants are not entitled to recover more than their loss. (3) Damages are not intended to be punitive: The tribunal does not use damages to disapprove of the conduct of the defendant or to use damages as a general means of prevention of breach of contract. The compensatory principle does not protect the specific performance of the con- 4.07 tract or the well-known principle of pacta sunt servanda. This means that damages under English law do not aim to put the claimant in the precise situation that the claimant would have been in had the contract been performed, save certain exceptions, which will be explained later. Therefore, even if English law uses the term performance interest (expectation interest) it means the protection provided is compensation for the loss and not performance of the contract. What is protected is the claimant’s interest to recover its loss, but not to obtain what it was promised.5 This was explained by Lord Diplock in Photo Production Ltd v. Securicor Ltd:

4.08

1 Guenter H. Treitel, Remedies for Breach of Contract: A Comparative Account (Clarendon Press 1988) 75. 2 Robinson v. Harman (1848) 1 Exch 850 (Exch) 855. 3 Harvey McGregor, McGregor on Damages (16th edn, Sweet & Maxwell 1997) 8, para. 9. 4 Treitel, Remedies for Breach of Contract 76–8 (n. 1). 5 Solène Rowan, Remedies for Breach of Contract: A Comparative Analysis of the Protection of Performance (Oxford University Press 2012) 109.

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Chapter 4: Damages Claims for Breach of Contract Leaving aside those comparatively rare cases in which the court is able to enforce a primary obligation by the decreeing specific performance of it, breach of primary obligations give rise to substituted or secondary obligations on part of the party in default . . . . The secondary obligation on part of the contract breaker to which it gives rise by implication of the common law is to pay monetary compensation to the other party for the loss sustained by him in consequence of the breach . . . . 6 4.09 In particular, English authors consider specific performance to be:

in some cases, over-compensatory, because it seems to override the plaintiff ’s duty to mitigate her loss during the period between breach and judicial order. And even apart from mitigation, specific performance more generally leads us to ignore facts, which have occurred after the breach but before the trial, even if the effect of those facts would be to reduce the measure of compensatory damages.7 4.10 Under English law, the aim is not full compensation, as the latter is considered ‘too

harsh upon defendants’ and courts are afraid of over compensation.8 The situation is different in case of tort, intentional causation of damages, or bad faith, which, however, will not be examined in this book. The law on damages places various conditions and restrictions on the principle that the claimant is generally entitled to recover all that the claimaint has lost by the breach.9 4.11 In Alfred McAlpine Construction Ltd v. Panatown Ltd,10 the promisee entered into

a contract with a building contractor, for the design and construction of an office block and multi-storey car park on land owned by a third party, a company in the same group as the promisee. The construction was defective and the promisee sought damages for the cost of repair, loss of use, and delay. The House of Lords refused to award damages in favour of the promisee. According to Lord Clyde, loss equates to financial damages. A breach of contract is not in itself a loss in any meaningful sense. A failure in performance of contractual obligations does not entail a loss of the bargained-for contractual rights.11 It is worth mentioning that such reasoning was not unanimous, with Lord Goff and Lord Millet dissenting and arguing that the promisee had suffered contractual loss.12 4.12 In this respect, several authors have argued for a broader ground to award damages

in order to protect the right to performance.13 However, others have criticized such 6

[1980] AC 827 (HL) 848–9. Lionel Smith, ‘Understanding Specific Performance’ in Nili Cohen and Ewan McKendrick (eds.), Comparative Remedies for Breach of Contract (Hart Publishing 2005)  221, with further references. 8 McGregor on Damages 10, para. 12 (n. 3); Victoria Laundry v. Newman [1949] 2 KB 528, CA at 539. 9 Chitty on Contracts (30th edn, Sweet & Maxwell 2008) para. 26-001A. 10 [2001] 1 AC 518 (HL), , last accessed 26 October 2013. 11 [2001] 1 AC 518 (HL) 534 (Lord Clyde). 12 [2201] 1 AC 518 (HL) 547–8 (Lord Goff ) and 592 (Lord Millet). 13 Brian Coote, ‘Contract Damages, Ruxley, and the Performance Interest’ (1997) 56 CLJ 550– 1; E. McKendrick, Contract Law: Text, Cases, and Materials (4th edn., Oxford University Press 7

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B. United Kingdom a broad ground as this does not encompass consequential damages.14 It has also been criticized as potentially leading to double jeopardy, as the promisee may fail to actually pay to the third party.15 Therefore the losses suffered by the third party should only be recovered by the promisee on behalf of such third party.16 2. Requisites for a damages claim a. Breach of contract In order to claim damages, there must be a wrong in the form of a breach of contract. 4.13 A breach of contract occurs where a party to a contract fails to perform precisely and exactly its obligations under the contract.17 English law distinguishes between three categories of contract terms related to the parties’ obligations: (a) warranties; (b) conditions; and (c) innominate terms:18 A warranty is a term that relates to an obligation that is not sufficiently important 4.14 for the performance of the contract. The term condition refers to a fundamental obligation which if not performed does 4.15 not allow the other party to carry out its obligations. The breach of a condition, by its nature, will deprive the other party of the benefit of the contract. The parties may expressly agree that a certain term be considered a condition even if the effect of the breach is not relevant for the performance of the contract. In the case of breach of a condition, the innocent party may claim damages for breach of contract. An innominate term is the most common contractual provision. It does not neces- 4.16 sarily have a serious effect on the ability of the other party to perform the contract. The affected party may ask for damages for breach of an innominate term if it has been deprived of the benefit of the contract. English law also distinguishes between a so-called strict obligation, which prom- 4.17 ises a result, and a duty of care. Such distinction determines which damages may be claimed. For example, in case of a breach of a contractual obligation of reasonable duty of care and skill, the damages claim of the affected party is limited to the wasted expenditure, however, if the breach refers to a strict obligation, damages in the form of expectation interest as understood under English law, may be 2010) 939; Charlie Webb, ‘Performance and Compensation: An Analysis of Contract Damages and Contractual Obligation’ (2006) 26 OJLS 41 at 63. 14 John Cartwright, ‘Damages, Th ird Parties and Common Sense’ (1996) 10 JCL 244 at 256; H. Beale, ‘Privity of Contract: Judicial and Legislative Reform’ (1995) 9 JCL 103 at 107. 15 Hannes Unberath, ‘Th ird Party Losses and Black Holes: Another View’ (1999) 115 LQR 535 at 541. 16 Rowan, Remedies for Breach of Contract 131 (n. 5). 17 James Gordley, Foundations of Private Law:  Property, Tort, Contract, Unjust Enrichment (Oxford University Press 2006) 289. 18 Richard Wilmot-Smith, Construction Contracts: Law and Practice (Oxford University Press 2005) 255–6.

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Chapter 4: Damages Claims for Breach of Contract sought.19 The considerations in this book will be limited to damages resulting from the breach of strict obligations. 4.18 In assessing damages for breach of contract, ‘the court can take account of only the

defendants strict legal obligations’. The court cannot take account of ‘the expectations, however, reasonable, of one contractor that the other will do something that he has assumed no legal obligation to do’.20 4.19 The refusal of a party to perform before its performance is due is considered antici-

patory breach through repudiation.21 The effect of repudiation is that the innocent party can choose either to accept the breach and keep the contract in existence or to treat the contract as actually terminated. In either case the right to damages for any loss caused by the breach or early termination of the contract is preserved. This leads to the injured party not having further obligations.22 b. Existence and classification of losses 4.20 Breach of contract has to cause loss or injury. Claimant must suffer loss: ‘no damages are recoverable if the plaintiff has suffered no loss’.23 The heads or elements of damages are divided into two main groups: pecuniary and non-pecuniary loss. Pecuniary loss comprises ‘all financial and material loss, such as loss of business profits or expenses’.24 Non-pecuniary loss is not relevant in complex long-term contracts and will not be dealt with in this book. 4.21 Damages only compensate the net loss in which gains made by the claimant as

the result of the breach must be set aside. If the claimant cannot establish an actual loss, the claimant is entitled to so-called nominal damages, which consist of a non-significant sum awarded to indicate that the contract was breached even though the breach has caused no loss, which mainly serves in order to obtain an award in the cost of the proceedings.25 4.22 i. Classification of losses

Damages are generally classified as normal or consequential. (a) The normal loss is the loss which every claimant in a similar situation will suffer; and (b)  consequential loss is a loss which is special to the circumstances of the claimant.

4.23 This classification follows the distinction between general and special damages

derived from Hadley v. Baxendale:26 normal or direct loss (general damages) is 19 John Cartwright, ‘Compensatory Damages: Some Central Issues of Assessment’ in Andrew Burrows and Edwin Peel (eds.), Commercial Remedies:  Current Issues and Problems (Oxford University Press 2003) 7–8. 20 Chitty on Contracts para. 26–001 (n. 9). 21 Hoechster v. De la Tour, 118 Eng Rep 922 (Q.B. 1853). 22 Charles Boundy, Business Contracts Handbook (Gower 2010) 370. 23 Treitel, Remedies for Breach of Contract 79 (n. 1). 24 McGregor on Damages 8, para. 9 (n. 3). 25 Treitel, Remedies for Breach of Contract 80 (n. 1). 26 (1854) 9 Ex 341.

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B. United Kingdom treated as loss ‘that follows naturally from the breach within the first rule, while indirect or consequential loss falls within the second rule and is legally recoverable only if special circumstances were brought to the defendant’s attention’.27 This distinction is intimately related to the principle of remoteness or foreseeability, which will be dealt with in more detail later in this chapter. This is explained in McGregor on Damages as follows:

4.24

In contract the normal loss can generally be stated as the market value of the property, money or services that the claimant should have received under the contract, less either the market value of what he does receive or the market value of what he would have transferred but for the breach. Consequential losses are anything beyond this normal measure such as profits lost or expenses incurred through the breach and are recoverable if not too remote.28

However, lost profits may be a normal loss or direct loss if such lost profits are a 4.25 natural consequence of the breach. Depending on the nature of the contract at issue in certain contractual situations it will be reasonably foreseeable to all as a natural consequence of a certain breach of that contract that a party will loose profits . . . 29

In Croudace Construction Ltd v. Cawoods Concrete Products30 the contract provided 4.26 that ‘we are not under any circumstances to be liable for any consequential loss or damage caused or arising by reason of late supply or any fault failure or defect in any material or goods supplied by us or by reason of the same not being of the quality or specification ordered or by any other matter whatsoever’. The Court of Appeal held that the word consequential did not cover any loss which directly and naturally resulted in the ordinary course of events from late delivery, which included the indemnification of a claim made by sub-contractors against the claimants, which was made in respect of a delay in the sub-contractor’s work caused by the absence of the material which the defendants ought to have delivered. A similar reasoning was adopted in Addax v. Arcadia 31 where a contract clause pro- 4.27 vided that the seller or buyer were not liable for indirect or consequential damages. The case was about trade in oil and the entering into a back-to-back contract by the claimant because of breach by the defendants. The court held that hedging costs were not consequential loss and found: I can think of no sensible or commercial reason why the Court should not take into account the cost of the hedging instruments. It seems to me that, if the direct loss

27 Andrew Burrows, ‘Limitation on Compensation’ in Burrows and Peel (eds.), Commercial Remedies 32 (n. 19). 28 McGregor on Damages 20, para. 26 (n. 3). 29 Andrew Iyer, ‘Consequential Losses in Offshore Contracts’ 2  accessed 8 November 2014. 30 [1978] 2 Lloyds Rep 55. 31 [2000] 1 Lloyds Rep 493.

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Chapter 4: Damages Claims for Breach of Contract is that which represents their net position with the NPCC, it is wrong in principle to ignore part of what actually happened by describing it as either too remote or as consequential loss. The costs of the hedging devices are in integral part of the calculation of the net position, and if the net position is a directly relevant loss, so must the hedging costs be so regarded. To extract the costs of the hedging devices is wrong in principle and has no commercial merit.32 4.28 In British Sugar v. NEI Power Projects33 the court held that increased production

cost and loss of profit for the claimant beyond normal loss caused by faulty power station electrical equipment was not considered within the exclusion of liability for consequential losses, but a direct loss.34 4.29 A similar reasoning is found in Ease Faith Ltd v. Leonis Marine Management Ltd 35

where the court held that the exclusion of liability for loss of profits only referred to indirect losses, which did not apply to the claim for loss of profits that was considered a direct loss within the first limb of Hadley v. Baxendale: I interpret the terms loss of profit as referring to loss of profits generated by future use of the tug or tow by the tow-owner or the hirer as the case might be. It seems to be that these losses are similar in kind to loss or use or loss of production and are naturally connoted by the phrase ‘loss of profits’ when read in its context.36 4.30 Though the cases mentioned above refer to the specific case of the exclusion of

consequential losses through contractual provisions, the criteria applied are of relevance for the breach of complex long-term contracts. Direct losses are intimately related to the object or nature of the contract. When the object is to obtain projects together with their income stream, then the loss of such income stream due to breach of contract is considered direct loss and therefore, never too remote. This is the case in a considerable number of complex long-term contracts. 4.31 ii. Loss of a chance

The recovery of loss of a chance is recognized under UK law as a form of loss of profits. Such chance may depend on contingencies including acts to be performed by third parties or the defendant. The question is whether the profits would have occurred, on the basis of the balance of probabilities. If the answer is yes, then loss profits are awarded on a pro rata basis with respect to the likelihood of such losses. The notion of loss of a chance is intimately related to the requirement of the certainty of loss.37

32

[2000] 1 Lloyds Rep 496. (1998) 87 BLR 42, CA; McGregor, McGregor on Damages (2nd Supplement to the 16th edn) (2001) 5, para 26 (n. 3). 34 Iyer, ‘Consequential Losses in Off shore Contracts’ 3 (n. 29). 35 [2006] 1 Lloyds Rep 673. 36 [2006] 1 Lloyds Rep 143. 37 McGregor on Damages 246–59 (n. 3). 33

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B. United Kingdom c. Causation There must be a causal connection between the defendant’s breach of contract 4.32 and the claimant’s loss. Causality is a requirement for establishing a damages claim, but also a limitation to such claim. Where the breach of contract is not the effective or dominant cause of the loss, damages may not be recovered. English courts do not use a formal test for causation, but rely on their common sense as to whether a breach of contract is a sufficiently substantial cause of the claimant’s loss.38 Causation under English law is rather a question of interruption of causation through intervening acts of a third party or of the claimant. English law considers a matter of causation the following situations: (a) the claim- 4.33 ant’s lost opportunities and hypothetical consequences, (b) a hypothetical action of the claimant, and (c) a hypothetical action of a third party. This refers to a situation where the claimant argues that in the absence of the defendant’s breach, it might have obtained a benefit or avoided a loss,39 and refers to the question: what would have happened if the breach of contract had not occurred? This is the expression of the ‘but for ’ approach in the context of causation. Additionally, English law also considers contingencies in the context of causation: 4.34 If, at the time when damages are assessed, a relevant contingency has not yet occurred, the future risk that it might occur should be assessed as a percentage chance and damages adjusted accordingly: e.g. the risk that war might break out as to entitle a party to cancel a long-term contract under a war clause.

In such cases, the claimant has to prove that in the absence of breach there was a real chance of the hypothetical action that would have avoided the loss.40 Contributory negligence by the plaintiff may result in additional losses not caused 4.35 by the breach of contract or may intervene in the causal relationship. The ‘break of the chain of causation’ depends on the court’s appraisal of the particular circumstances. Sometimes the court holds that the defendant’s breach of contract was not the cause but merely gave the claimant the opportunity to injure itself.41 Causation is not only a requirement sine qua non for a damages claim but has also a limiting function.42

38

Chitty on Contracts para. 26-032 (n. 9). Chitty on Contracts paras. 26-042 to 26-045 (n. 9). 40 Chitty on Contracts paras. 26-046 to 26-047, 26-044 (n. 9). 41 Chitty on Contracts para. 26-037 (n. 9). 42 Alexander Komarov, ‘The Limitation of Contract Damages in Domestic Legal Systems and International Instruments’ in Djakhongir Saidov and Ralph Cunnington (eds.), Contract Damages: Domestic and International Perspectives (Hart Publishing 2008) 252–3. 39

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Chapter 4: Damages Claims for Breach of Contract 3. Measure of damages 4.36 Chitty on Contracts distinguishes between expectation interest, performance inter-

est, and reliance interest:43 a. Expectation interest 4.37 Expectation interest refers to the gains or benefits which the claimant expects to receive from the completion of the promised performance of the other party’s obligation but which were in the event prevented by the breach of contract committed by the defendant. In general, such gains are based on the difference in value. 4.38 The normal measure of damages under English law is the compensation for the dif-

ference in value between the promised performance and the defective performance, which leads to a financial equivalent but not a factual equivalent. According to Guenter H. Treitel, ‘in a contractual action . . . damages are recoverable as a matter of course for loss of the expectations created by the very contract for breach of which the action is brought. That is why damages of this kind are the distinctive feature of a contractual action.’ The expectation interest includes not only the receipt of goods to be delivered, but also the loss of profits suffered as a result of not being able to use the goods that were not delivered due to breach of contract.44 b. Performance interest 4.39 A distinction is made with respect to performance interest, where ‘a party to a contract may have an interest in performance which is not readily measurable in terms of money’,45 which means that the loss of the injured party cannot be measured as a difference in value under an abstract valuation and can only be measured through the actual (concrete) valuation of the cost of cure. Performance interest, then, refers to the interest in the performance under the contract and, in case of non-performance, the compensation of the cost of cure through concrete valuation. 4.40 The interest of a party is that its contract is performed. In order to compensate the

individual and actual loss suffered by a party, compensation corresponds to the cost of cure. However, curing such a loss through compensation often exceeds the difference in value between the situation as it exists and the situation which would exist but for the breach. English law is traditionally unwilling to grant such cost of cure and insists on the abstract difference in value. However, there are exceptions from this rule, as will be discussed later. Performance interest according to this definition is the substitution in money of the specific performance of the contract, which means cost of cure.

43

Chitty on Contracts, paras. 26-002 to 26-003 (n. 9). Guenther Treitel, The Law of Contract (11th edn., Thomson, Sweet & Maxwell 2003) 937–8, 940, 944. 45 Chitty on Contracts para. 26-003 (n. 9). 44

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B. United Kingdom Reliance interest relates to the expense or loss which the claimant has itself incurred 4.41 in reliance on the promised performance and which is wasted by the defendant’s breach. According to Chitty on Contracts, it is not yet clear whether English law permits the claimant to recover both his expected profit on the contract and the consequential expense he has incurred in reliance on the defendant’s promise. In principle, he should be entitled to recover his expected net profit plus any of his incidental expenditure of a type reasonably contemplated by the parties at the time the contract was made, but not his gross profit (e.g. the full contract price) plus his disbursements which would have been incurred in earning that gross profit.46

In the case of breach of contract, where more than one type of claim is applicable, 4.42 the choice depends on the claimant who may present alternative claims. If the breach of contract affects the value of a business or its profits, the court may select the most appropriate way to measure the loss, either by the effect on the value of the business or by the effect on its profits. If such breach of contract leads to the ceasing of the business, the court would have to use the difference between the actual value of the business and the value it would have had if the defendant had not committed the wrong. This requires determining the hypothesis that no wrong had been committed, but also how the business would have developed in the absence of such wrong.47 c. Increasing the protection of performance interest English authors have recognized the need to increase the protection of perfor- 4.43 mance interest and have argued for: • the provision of damages to remedy the defect of performance in the form of cost of cure; • the compensation of so-called ‘intangible benefits’ (such as amenity) lost by the claimant through the breach; • the recovery of losses which in substance are suffered by a third party;48 and • gains-based restitutory damages.49 Cost of cure provides the claimant with the means to pay for substitute performance 4.44 by a third party and puts the claimant in the same position as if specific performance had taken place. In Ruxley Electronics & Construction v.  Forsyth50 the House of Lords indicated 4.45 the circumstances in which a claimant may be able to recover contract damages 46

Chitty on Contracts para. 26-002, footnotes omitted (n. 9). Chitty on Contracts para. 26–097A (n. 9); Crehan v.  Inntrepreneur Pub Co (CPC) [2004] EWCA Civ 637, 179–180. 48 Cartwright, ‘Compensatory Damages’ 9–11 (n. 19). 49 Ralph Cunnington, ‘The Measure and Availability of Gains-based Damages for Breach of Contract’ in Saidov and Cunnington (eds.), Contract Damages 207–42 (n. 42). 50 [1996] 1 AC 344. 47

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Chapter 4: Damages Claims for Breach of Contract calculated as the cost of cure. The case involved a claim of Mr Forsyth against the builder Ruxley, who constructed a swimming pool to a depth of 6 feet instead of 7 feet 6 inches. Mr Forsyth claimed damages to cover the cost of demolition and reconstruction of the pool to the contracted specification, which amounted to £21,560, exceeding the original contract price by £4,000. Ruxley argued that he was liable only for the difference in value between the pool as promised and as delivered, which was zero as the pool could be perfectly used for the purposes intended. 4.46 The trial judge in this case had refused to award the cost of cure due to the unrea-

sonableness of the rebuilding cost and the fact that the value of the house was not affected. The Court of Appeal disagreed and by a majority awarded the cost of cure as being the only way of giving Mr Forsyth what he had bargained for. The House of Lords reversed the Court of Appeal, and restored the trial judge’s award. Costs of cure seem only to be granted in case of construction contracts. However, they will not be awarded where they are unreasonable. The cost of curing the breach has to be in proportion to the benefit that would accrue to the claimant. Additionally, the claimant must intend to use the damages to cure the defect. Finally, the claimant should not obtain any financial benefit from the damages award.51 The cost of cure is granted only under very exceptional circumstances. 4.47 As regards the loss of amenity, which is considered an intangible benefit which the

claimant had lost as the result of defective performance, Lord Mustill stated that: [T]he law will very often consist only of the monetary detriment brought about by the breach of contract. But these remedies are not exhaustive, for the law must cater for those occasions where the value of the promise to the promisee exceeds the financial enhancement of his position which full performance will secure . . . . the law should recognise [such excess of the financial enhancement] and compensate the promisee if the misperformance takes it away. 4.48 According to Lord Mustill, this excess of financial enhancement or so-called ‘con-

sumer surplus’52 is found when the value of the promise to the claimant exceeds the financial enhancement of his position, which represents a ‘personal, subjective and non-monetary gain’. The compensation of loss of amenity aims to protect the performance interest where the cost of cure might result in a financial benefit to the claimant and the difference in value is nil.53 Daniel Friedmann stated that ‘this development is predicated on the approach that pacta sunt servanda and that the plaintiff ’s performance interest should be respected’.54 51 Cartwright, ‘Compensatory Damages’ 10, with further references (n. 19); Rowan, Remedies for Breach of Contract 109, 112 (n. 5). 52 D. Harris, A. Ogus, and J. Phillips, ‘Contract Remedies and the Consumer Surplus’ (1979) 95 LQR 581. 53 M. Furmston, Cheshire, Fifoot & Furmston’s Law of Contract (15th edn., Oxford University Press 2007) 773–4. 54 Daniel Friedmann, ‘The Performance Interest in Contract Damages’ (1995) 111 LQR 628, 650; Rowan, Remedies for Breach of Contract 113 (n. 5).

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B. United Kingdom Regarding damages caused to a third party, damages suffered by a third party under 4.49 a connected contract are not normally compensated.55 The general principle that a party may only recover for its own loss excludes any loss suffered by the third party.56 This is relevant for complex long-term contracts, where the non-performance of one contract may affect the performance of the claimant under a related contract. Regarding damages for enrichment of promisor or gain-based relief for breach of con- 4.50 tract, as a general rule, the defendant’s profit arising from the breach of contract is irrelevant. Only in very limited cases will courts grant exceptions from such rule. One of these exceptions is the so-called ‘disgorgement of the defendant’s profit’ granted in Attorney General v. Blake.57 George Blake was a member of the UK security and intelligence service from 1944 4.51 to 1961. In 1951, he became an agent for the Soviet Union and was finally sentenced to 42 years in prison from where he escaped in 1966. In 1989 he wrote his autobiography entitled No Other Choice58 and granted the publishing house Jonathan Cape an exclusive right to publish the book in his country in return for significant royalties. Certain parts of his book related to his activities as a secret intelligence officer, but were no longer confidential, nor was the disclosure of such information damaging to the public interest. In May 1991, the Attorney General commenced an action against Blake in order to bar him from receiving further royalties from his treachery. The claim was based on a contractual undertaking by Blake when signing the Official Secrets Act declaration in 1944, which lead to a ‘private law claim to restitutionary damages for breach of contract’ referring to cases of ‘skimped’ performance, and cases where the defendant obtained his profit by doing ‘the very thing he contracted not to do’. The House of Lords held that ‘[i]n a suitable case damages for breach of contract may be measured by the benefit gained by the wrongdoer from the breach. The defendant must make a reasonable payment in respect of the benefit he has gained.’59 However, the House of Lords held that Blake was an exceptional case, which ena- 4.52 bled the court ‘to grant the discretionary remedy of requiring the defendant to account to the plaintiff for the benefits he has received from his breach of contract’ and that the plaintiff ’s interest in performance may make it just and equitable that the defendant should retain no benefit from his breach of contract.60 The accounts of profits was awarded not because the promisor had obtained a profit

55 Cartwright, ‘Compensatory Damages’ 14–17 (n. 19); Michael Bridge, ‘The Market Rule of Damages Assessment’ in Saidov and Cunnington (eds.), Contract Damages 434 (n. 42). 56 Beswick v. Beswick [1968] AC 58 (HL), Albacruz (Cargo Owners) v. Albazero (The ‘Albazero’) [1977] AC 774 (HL); Rowan, Remedies for Breach of Contract 129 (n. 5). 57 [2001] 1 AC 268 (HL). 58 Johnathan Cape, London, 1990. 59 [2001] 1 AC 268, 283–4. 60 [2001] 1 AC 268, 284–5.

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Chapter 4: Damages Claims for Breach of Contract gained through the breach of the contract, but because the promisee had a legitimate interest in depriving the promisor of these profits. Such legitimate interest was the protection of information relating to the secret service. This case opened the door to so-called ‘restitutionary damages’ under English law, which means that English law comes closer to the availability of performance interest, which means compensating for specific performance. Therefore, it does not appear that the law on gain-based relief increases the protection of the claimant but rather serves other means,61 such as to avoid unjust enrichment of the defendant.62 4. Limitations to damages claims a. Remoteness 4.53 Under English law, a defendant is not liable for loss, which is too remote. Remoteness of damages refers to the legal test used to decide which types of loss may be compensated through damages. If there is no explicit clause in the contract dealing with the allocation of responsibility, a standard test applies which specifies the extent of responsibility undertaken by the promisor. Under the standard test, the promisor bears the responsibility for the usual consequences of a breach of the promise, while the promisee implicitly accepts the risk of unusual consequences. Unusual consequences are to be borne by the promisee, unless an explicit clause transfers the risk to the promisor.63 4.54 According to Hadley v. Baxendale,

The damages . . . should be such as may fairly and reasonably be considered either by arising naturally, i.e. according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract as the probable result of the breach.64 4.55 In Victoria Laundry (Windsor) Ltd v. Newman65 it was said the test of remoteness

was whether the loss was ‘reasonably foreseeable as liable to result from the breach’, which depended on the state of the defendant’s knowledge. This case transformed the two rules of Hadley v. Baxendale into two types of knowledge and ‘integrated them into a single test of reasonable foreseeability’.66 The requirement of remoteness or foreseeability refers to the type of loss as such but not to its extent.

61 Andrew Burrows, ‘Are “Damages on the Wrotham Park Basis” Compensatory, Restitutionary or Neither?’ in Saidov and Cunnington (eds.), Contract Damages 165–85 (n. 42). 62 Stephen Waddams, ‘Gains Derived from Breach of Contract:  Historical and Conceptual Perspectives’ in Saidov and Cunnington (eds.), Contract Damages 187–206 (n. 42). 63 Chitty on Contracts para. 26-051 (n. 9). 64 (1854) 9 Exch 341 at 354. 65 [1949] 2 KB 528 (CA). 66 Sirko Harder, Measuring Damages in the Law of Obligations:  Th e Search for Harmonised Principles (Hart Publishing 2010) 39.

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B. United Kingdom In Koufos v. C. Czarnikow Ltd (The Heron II)67 the House of Lords referred to the 4.56 degree of probability with which the loss occurred could have been foreseen, considering less than 50 per cent as sufficient. Assumption of responsibility. It has been argued that a loss occurring in the sphere 4.57 of responsibility allocated to one of the parties is foreseeable.68 This seems to be particularly applicable in complex long-term contracts, where risk allocation and mitigation have to be seen in the light of remoteness. Risk allocated under a contract may not be considered as unforeseen. In Transfield Shipping Inc. v. Mercator Shipping Inc. (The Achilleas)69 Lord Hoffmann 4.58 introduced the test of assumption of liability.70 In Supershield Ltd v. Technologies FE Ltd 71 the assumption of responsibility was held to have an inclusionary effect: If on the proper analysis of the contract against its commercial background, the loss was within the scope of the duty, it cannot be regarded as too remote, even if it would not have occurred in ordinary circumstances.72

In ASM Shipping Ltd of India v. TTM1 Ltd of England (The Amer Energy),73 Lord 4.59 Hope stated: Assumption of responsibility, which forms the basis of the law of remoteness of damage in contract, is determined by more than what at the time of the contract was reasonably foreseeable.

Whereas the remoteness rule in Hadley v. Baxendale is a question of fact depending 4.60 on whether the loss was substantially likely or not unlikely to occur, or whether the risk of unusual loss could have been foreseen at the time the contract was made in such a way that a reasonable person in this position would have taken it into account, the assumption of responsibility is a question of law.74 However, even in case of the express assumption of responsibility, there may be 4.61 situations where the English law bars responsibility of the party in breach. Lords Hoffmann and Hope held in The Achilleas that a party will not be liable for losses that are not unlikely if it was not reasonable to assume that the party in breach was assuming responsibility for the loss.75

67

[1969] 1 AC 350 (HL). Adam Kramer, ‘An Agreement-Centred Approach to Remoteness and Contract Damages’ in Cohen and McKendrick (eds.), Comparative Remedies for Breach of Contract 250 (n. 7); Adam Kramer, ‘Remoteness: New Problems with the Old Test’ in Saidov and Cunnington (eds.), Contract Damages 277–8 (n. 42). 69 [2008] UKHL 48, [2008] 3 WLR 345. 70 [2008] UKHL 39. 71 [2010] EWCA Civ 7, [2010] 1 Lloyds Rep. 387. 72 [2010] EWCA Civ 7, [2010] Lloyd’s Rep. at [43]; Chitty on Contracts para. 26-100H (n. 9). 73 [2009] 1 Lloyd’s Rep. 293, cited in Chitty on Contracts para. 26-100F (n. 9). 74 Chitty on Contracts para. 26-100D (n. 9). 75 Chitty on Contracts para. 26-100E (n. 9). 68

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Chapter 4: Damages Claims for Breach of Contract 4.62 The House of Lords seems to have established a rule according to which a claim-

ant will not recover, even for losses that were not unlikely to occur in the usual course of things, if the defendant cannot reasonably be regarded as having assumed responsibility for losses of the particular kind suffered, which has been considered an ‘additional and probably separate requirement to the remoteness rule’.76 4.63 When the profits are the object of the contract or within the nature of the contract,

the defendant cannot argue that the loss was not foreseeable when it breached the contract. These are direct losses within the scope of the duty and, therefore, within the limits of remoteness. Risk allocated or responsibilities assumed mean that losses deriving from the realization of such risk are considered not too remote, even if the losses might be contemplated as special losses. b. Mitigation 4.64 Mitigation refers to two different concepts:77 (1) the claimant is not entitled to recover damages for a loss, which it could reasonably have avoided, which means that the claimant has a duty to mitigate; and (2) where the injured claimant mitigates its loss, the promisor is only liable for the loss as reduced, even if mitigation was not a requirement on the claimant (this is known as the non-recoverability of the mitigated loss). In both cases, the applicable principle is reasonableness. 4.65 i. Duty to mitigate

There are two aspects of such duty: (1) the claimant must take reasonable steps to reduce its loss as much as possible, and (2) the claimant must avoid any unreasonable steps to increase its loss. Therefore, the duty to mitigate only arises when the claimant becomes aware of the breach of the contract.

4.66 ii. Minimizing loss

The claimant must take reasonable steps to minimize its loss. However, the claimant will not be required to do anything that is out of the ordinary course of business. The duty does not require the claimant to engage in risky activity or to risk money, to embark on complicated or uncertain litigation, risk damage to its commercial reputation or sacrifice its property rights in order to discharge the duty. The test of reasonableness is subject to such assumptions.78

4.67 iii. Not increasing loss

The claimant should not take unreasonable steps when attempting to mitigate the loss. This means that the claimant should not try to cure a defect in performance at an excessive cost. In particular, the claimant should not continue to expend for the attempt of achieving performance when it already knows that the defendant refuses to fulfil its obligations under the contract.79

76 77 78 79

Chitty on Contracts para. 26-100A (n. 9). Treitel, The Law of Contract 977 et seq (n. 44). Rowan, Remedies for Breach of Contract 144 (n. 5). Treitel, The Law of Contract 978 et seq. (n. 44).

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B. United Kingdom This is in accordance with the fundamental principle that damages compensate for 4.68 the loss and do not aim to enrich the claimant. The importance of the mitigation principle under English law leads to the consequence that damages ‘do not represent the full value of the defendant’s promised performance because the damages have been assessed on the basis that the claimant should have taken reasonable steps after the breach of contract to avoid or minimise his loss caused by the breach’.80 The rationale of mitigation is ‘to reduce social costs and to protect and conserve 4.69 economic welfare and prosperity of the whole community’.81 Therefore, any conduct in contravention of this aim should be discouraged. iv. The tension between loss mitigation and performance interest According 4.70 to Solène Rowan, referring to scholars such as McKendrick, Atiyah, and Harris: Loss mitigation may be criticized as encroaching too heavily upon the contractual performance interest, in that the duty to perform can be made to appear imaginary. . . . The doctrine also places the innocent party in a dilemma. If he fails to mitigate his loss will be cut, and if he does mitigate, he may find that his only recoverable damages are trivial reliance cost not worth pursuing.82

v. Contributory negligence This occurs where the claimant suffers damages 4.71 as result of its own fault and, partially, of the fault of any other person. As a general rule contributory negligence either interrupts causality or is a matter of mitigation.83 5. Other aspects affecting the damages claim a. Date of the determination of the damages Damages are assessed by reference to the time of breach. The theory behind this 4.72 rule is that: ‘any loss suffered by reason of market movements after the time of breach is not caused by the breach, but rather by the injured party’s failure to mitigate by making a substitute contract’. This principle is applied, however, with some latitude and is based on two assumptions: (1) the knowledge of the injured party of the breach once it is committed, and (2) and the possibility of taking steps to mitigate the loss. Where the facts do not meet these assumptions, the court may deviate from such date, and assess damages by reference to the date that is appropriate in the circumstances.84 These assumptions do not appear to be applicable to the breach of long-term con- 4.73 tracts where one party has already rendered its investment, for example in form

80 81 82 83 84

Chitty on Contracts para. 26-003 (n. 9). Rowan, Remedies for Breach of Contract 146 (n. 5). Rowan, Remedies for Breach of Contract 152 (n. 5). Chitty on Contracts para. 26-049 (n. 9). Treitel, The Law of Contract 959–60 (n. 44).

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Chapter 4: Damages Claims for Breach of Contract of a plant to produce energy. First, the investment may not normally be used for a substitute contract. Second, the purchaser is unlikely to find a third party who is willing to make the same investment in a reasonable period of time. A substitute contract seems, therefore, to be excluded. Thus, the determination of damages at the moment of the breach does not seem appropriate due to the nature of such contracts. b. Level of evidence required and burden of proof 4.74 In English contract law, the injured party must show on the balance of probabilities that it suffered the loss or damage and that the latter was caused by the breach of contract, and that there was no break in the chain of causation in the form of an intervening event.85 The balance of probability is the determination on the basis of the whole of the evidence that the case for the asserting party has been shown to be more probably true than not true. If the probabilities are equal and the tribunal of fact is wholly undecided, the party bearing the burden of proof will fail.86 6. Penalties and liquidated damages 4.75 A contract may establish the payment of a fi xed amount of money by the defendant

for breach of contract. The courts classify such fixed amounts either as a penalty or as liquidated damages. 4.76 The question whether a sum stipulated is a penalty or liquidated damages is a

question of interpretation of the contract, taking into consideration the terms and circumstances of the contract at the time of its making and not at the time of the breach.87 The following criteria are used to determine whether a fixed amount for breach of contract represents a penalty or liquidated damages: • whether the sum agreed is extravagant and unconscionable in amount in comparison with the greatest loss which could conceivably be proved to have followed from the breach; • whether the breach consists only in not paying an amount of money and the sum stipulated is greater than the sum which had to be paid; • when a single lump-sum payment is made to compensate as a means of compensation on the presence of one or more events, some of which may be serious and others which may be irrelevant. 4.77 The corresponding contractual clause is enforceable as liquidated damages if the

fixed amount reflects the loss that the claimant would suffer in case of a breach. 85 Jonathan Luz and Reema Shour, ‘Assessment of Damages for Repudiatory Breach of a Charter Party: Latest Developments in English Law’ (2011) 22(1) ICC International Court of Arbitration Bulletin 20; Vivian Ramsey, Construction Law Handbook (Thomas Telford Publishing, ICE 2007) 762. 86 Peter Murphy, Murphy on Evidence (10th edn., Oxford University Press 2008) 107. 87 Chitty on Contracts para. 26-127, with further references (n. 9).

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B. United Kingdom The aim of this clause is to recover damages in an easier and less expensive manner and to avoid the risk of under compensation or to give the claimant insurance that the promise will be fulfilled.88 The essence of liquidated damages is a genuine pre-estimate of damage.89 The aim is to find out whether the level of damages is reasonable.90 The pre-estimate 4.78 of damage will be the estimated net loss after taking account of the claimant’s expected ability to mitigate its loss. The sum reserved by the contract must be set at a level intended to avoid the expense and difficulty of assessment of the loss.91 Otherwise such a clause is considered a penalty not enforceable under English law. 7. Construction contracts Special considerations regarding construction contracts. English law does not contain 4.79 particular rules on construction contracts, which are normally made through elaborate forms such as the Joint Contracts Tribunal (JCT) Standard Form of Building Contract, or the Infrastructure Conditions of Contract (ICC) (formerly the ICE Conditions of Contract)92 ‘which have been said to resemble a legislative code’.93 Construction contracts are subject to the rule on privity, according to which 4.80 ‘no-one but the parties to a contract can be entitled under it, or bound by it’. This rule is concerned with who can enforce a contract. This rule has been subject to criticism by the judiciary and academic lawyers, as the party who suffers the loss caused by defects in a building is often different from the party with whom the builder has a direct contractual relationship. This has led to the suggestion for systemic reform by the legislature, founded on a contract-based approach to the privity rule and the recovery of damages suffered by a third party.94 Damages claims by the employer against the constructor are of two different types: 4.81 (1) damages for breach of the obligation to build to specification, and (2) damages for breach of the obligation to deliver on time. The latter is normally subject to liquidated damages. With regards to the former, there are two different measures of damages: (a) the cost of remedial works, and (b) the diminution in value of the structure due to the defect. The measure normally applied by the Technology and Construction Court (TCC) is 88

Chitty on Contracts para. 26-125 (n. 9). Clydebank Engineering and Shipbuilding Co. Ltd v. Don Jose Ramos Yzquierdo y Castaneda [1905] A.C. 6. 90 Chitty on Contracts para. 26-128 (n. 9). 91 Chitty on Contracts, para. 26-129 (n. 9). 92 accessed 26 October 2012. 93 Amalgamated Building Contractors v. Holy Cross, UDC [1952] 2 All ER 453. 94 Chitty on Contracts paras. 37-223 et seq., with further references (n. 9). 89

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Chapter 4: Damages Claims for Breach of Contract the cost of remedial works. In a situation where it is not reasonable for an employer to remedy the defect, in particular if the defect has no effect on the value of the construction, such remediation is not obligatory.95 4.82 The modern English law of damages with respect to construction con-

tracts may be summarized as set out in Southampton Container Terminals Ltd v. Schiff ahrtsgesellschaft ‘Hansa Australia’ mbH and Co.:96 (1) A loss is only recoverable if it is caused by the breach of duty or contract and it could not have been mitigated. (2) Damages are only recoverable if reasonable. (3) Where replacement costs exceed market value, they will only be recoverable if shown to be reasonable. (4) The commercial context is relevant to the question of reasonableness. (5) The essential question is: ‘What loss did the claimant really suffer?’ This is a question of fact and degree. The standard is again that of reasonableness. 4.83 The obligation defines the scope of recoverable loss in the event of breach. Even

where there is a failure of the party in breach to confer the benefit for which the innocent party contracted, there are different ways to calculate the affected party’s loss. Such calculation depends on how the claim is framed.97 4.84 The causal connection between breach and loss is ‘the core of most construction

disputes, since the connection, or possible competing connections will not be clear-cut and will be a matter of impression or inference from the primary facts’. The courts have resolved these issues through apportionment rather than on an all or nothing basis.98 4.85 As regards mitigation, a failure by the employer to permit the contractor to return

to the site to correct minor defects may amount to a failure to mitigate. In this regard, the question arises whether it is reasonable to permit the contractor to carry out repairs where more substantial defects appear after completion and different views exist between the employer and the contractor as regards the scope of repair necessary, which requires a complex analysis.99 8. Considerations 4.86 The compensatory principle under English law aims to compensate the difference

in value but for the breach. This is known as expectation interest under these rules of law. In complex long-term contracts, the concept of compensation of loss is

95 96 97 98 99

Wilmot-Smith, Construction Contracts 245–6 (n. 18). [2001] 2 Lloyds LR 275. Cartwright, ‘Compensatory Damages’ 3, 8–9 (n. 19). Chitty on Contracts para. 37-205, with further references (n. 9). Chitty on Contracts para. 37-203, with further references (n. 9).

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C. United States the difference between the hypothetical course of events and the actual course of events but for the breach, which corresponds to the expectation interest under English law. Cost of cure is considered an amenity and the difference in value is usually obtained through abstract valuation on the basis of market values. Though English law puts emphasis on the mitigation of damages and avoidance 4.87 of over compensation, it allows for the recovery of loss of a chance and provides favourable rules of evidence as regards reliance interest.

C. United States US law for contractual damages has the following features: (1) US contract and 4.88 damages law has been partially codified through the Uniform Commercial Code and the Restatement (Second) on Contracts, which led to a significant development of the law, (2) it focuses on expectation interest establishing a higher protection of the promisee based on a principle of fairness, (3) it is influenced by the doctrine of economic analysis of law and the principle of efficient breach of contract, which, however, do not reduce the level of protection of the promisee with respect to damages. This will be explained in detail in the context of the following headings. 1. Principles of damages claims a. Full compensation for the actual loss The US Restatement (Second) of Contracts establishes that ‘[t]he initial assump- 4.89 tion is that the injured party is entitled to full compensation for his actual loss’.100 In order to achieve this purpose, US courts award the expectation interest, which means to put the injured party in the economic position it would be in but for the breach.101 b. Fairness The underlying principle of US damages law seems to be one of fairness to both 4.90 parties, avoiding both over- and undercompensation.102 In accordance with this principle, the basic principle for the measurement of damages is compensation but based on the injured party’s expectation.103 At the same time, fairness is also reflected in ‘the theory that reliance damages are ultimately compensatory in nature and that the injured party will not be put in a better position than she

100

Restatement (Second) of Contracts, Chapter 16, Topic 2, Introductory Note. Restatement (Second) of Contracts, §347 (Measure of Damages in General). 102 Randy E. Barnett, ‘How Should Damages for Breach of Contract be Measured’ in Randy E. Barnett (ed.), Perspectives on Contract Law (3rd edn., Aspen Publishers 2003) 3. 103 E. Allan Farnsworth, Contracts (4th edn., Aspen Publishers 2004) 730. 101

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Chapter 4: Damages Claims for Breach of Contract would have occupied had the contract been performed’.104 According to §1-305 of the Uniform Commercial Code (UCC), remedies are to be liberally applied. 4.91 The US law of contract does not intend to oblige the promisor to keep his promise.

As stated by Oliver Wendell Holmes: The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it—and nothing else.105 4.92 Therefore, it is not the policy of the law to compel adherence to contracts but only

require each party to choose between performing in accordance with the contract, or compensating the other party for any injury resulting from a failure to perform. This also means that damages do not have a preventive or punitive effect.106 4.93 In this sense, US law is not concerned with the question of how a promisor can be

made to keep his promise, but with a different question: how can people be encouraged to deal with those who make promises? The legal system tries to encourage the promisee to rely on the promises of others by protecting the expectation interest, the reliance interest, and the restitution interest. 4.94 These terms were introduced by Lon L. Fuller and his assistant William R. Purdue

in their seminal work ‘The Reliance Interest in Contract Damages’ under the heading of ‘Purposes Pursued in Awarding Contract Damages’,107 referring to the Aristotelian concept of distributive justice, philosophy of law, and German legal scholars. These terms have been further developed and refined through codification, scholarly works, and legal practice. c. Efficient breach 4.95 A particular feature of US damages law is the influence of the school of economic analysis of law and the notion of efficient breach. Economic theory seeks to maximize the welfare of the parties. At the time the agreement is made, each party presumes that the agreement will be profitable. If non-performance of the agreement would result in a profit of the defendant at the expense of a loss by the injured party, the result of non-performance is considered economically efficient if the value of the defendant’s profit is greater than the value of the injured party’s loss. This means that the breach would be efficient if the party in breach gains enough from the breach to receive a benefit after compensating the injured party for the resulting loss according to the subjective preferences of the injured party. Following this school of thought, non-performance is economically and socially desirable

104

Gregory Klass, Contract Law in the USA (Wolters Kluwer 2010) 228. Oliver Wendell Holmes, ‘The Path of the Law’ (1897) 10 Harvard Law Review 457, 462. 106 Richard A.  Posner, ‘Fundamental Principles of Contract Damages’ in Barnett (ed.), Perspectives on Contract Law 49 (n 102). 107 Lon L. Fuller and William R. Perdue, ‘The Reliance Interest in Contract Damages’ (Pt. 1) (1936) 52 Yale Law Journal p. 52–96. 105

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C. United States and economic theory encourages breach. On the other hand, to prevent such a breach by compelling performance would not achieve the aim of wealth distribution, since the defendant would lose more than the injured party would gain.108 According to Professor E. Allan Farnsworth, this economic theory is compatible 4.96 with the US law on contract remedies, in which the interest protected is the expectation interest measured by the amount of money necessary to place the injured party in as good a position as that party would have been in had the contract been performed. The effect is to give the reluctant party an incentive to break the contract if, but only if, that party gains enough from the breach that it can compensate the injured party for its losses yet still retain some of the benefits from the breach. . . . The goal is compensation and not compulsion.

Therefore, the promisor should not be sanctioned with punitive damages for breach of contract.109 The rationale underlying the efficient breach doctrine has been criticized by schol- 4.97 ars such as Daniel Friedmann who argues that: The relaxation of contract remedies also has deleterious effects on the willingness of parties to enter into mutually beneficial contracts in first place. If the legal system imposes severe limitations on specific performance (irrespective of whether they are based on the right to breach the contract theory or its modern efficient breach offshoot), it undermines the parties’ faith in getting what they bargained for, and the consequence is inefficiency and a waste of resources.110

In international arbitration, the principle of efficient breach is widely misunder- 4.98 stood and in practice leads to a reduction of the amount of damages due to the apparent liberty to breach the contract. In this respect it is important to underline that this doctrine is based on the compensation of at least the expectation interest and, even under the efficient breach theory of the Economic Analysis of Law, the compensation of the loss is protected and opportunistic breaches are not encouraged by breaches at the expense of the injured party.111 2. Requisites for a damages claim a. Breach of contract As a general rule, virtually any breach of contract gives the injured party a claim 4.99 for damages. Nominal damages will be awarded if breach caused no loss or if

108

Farnsworth, Contracts 736 (n. 103). Farnsworth, Contracts 737 (n. 103). 110 Daniel Friedmann, ‘The Efficient Breach Fallacy’ (1989) 18 Journal of Legal Studies 1; Barnett (ed.), Perspectives on Contract Law 52–8, at 57 (n. 102); Alan Schwartz, The Case for Specific Performance (1979) 89 Yale Law Journal 271. 111 Friedmann, ‘The Efficient Breach Fallacy’ 53 (n. 110). 109

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Chapter 4: Damages Claims for Breach of Contract loss cannot be proved. In general, anticipatory repudiation gives the injured party an immediate claim to damages for total breach, in addition to discharging that party’s remaining duties of performance. This requires the courts to forecast the course of the contract in the absence of breach. The right to termination because of anticipatory repudiation is subject to exceptions, such as when the repudiating party has received all of the agreed performance,112 which is, however, not applicable to long-term contracts with bilateral obligations throughout the life of the contract. b. Existence and classification of loss 4.100 Losses may be direct, consequential, or incidental:113 4.101 Direct or general loss is the difference between the value of the performance prom-

ised and the value of the performance rendered. These values are calculated from the point of view of the injured party. §347 of the Restatement (Second) of Contracts requires ‘a determination of the values of those performances to the injured party himself and not their values to some hypothetical reasonable person or on some market’. This also refers to the concrete valuation of damages. 4.102 Consequential losses are all other losses ‘caused by the defective performance such

as lost profits on sales that might have been made but for the breach or injuries to a buyer’s person or property resulting from a defective product’. They usually affect collateral transactions by not allowing the injured to party to fulfil its obligations arising from other contracts or operating its own business. In this case it is important to mention that the burden of proof of consequential loss of profits is upon the injured party and the party in breach should have been aware at the time of the contract of the possibility of such damages as a special requirement of foreseeability.114 4.103 Incidental losses are the cost that the injured party incurs related with the defective

performance and while trying to avoid additional losses. For example, §2-715 (1) of the UCC provides that a buyer’s incidental losses include: expenses reasonably incurred in inspection, receipt, transportation, and care and custody of goods rightfully rejected, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expense, incident to the delay or other breach.

112

Farnsworth, Contracts 584, 757 (n. 103). Klass, Contract Law in the USA 218 (n. 104). 114 Jonathan M. Dunitz, ‘Context of the Lost Profits Damages Claim’ in Nancy J. Fannon (ed.), The Comprehensive Guide to Lost Profits Damages for Experts and Attorneys (BVR 2011) 8. 113

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C. United States c. Reasonable certainty of loss It is necessary to show evidence of the loss caused by the breach of the contract. 4.104 In this sense, §352 of the Restatement (Second) of Contracts establishes that the injured party may recover the losses that it can prove with reasonable certainty. Otherwise, they will be considered speculative and are not to be recovered. The certainty requirement is necessary for losses that result from the injured party’s expected profits or from its reliance costs. However, the last one is easier to prove. The reasonable certainty rule is also required for claims involving lost profits.115 The requirement of certainty of loss is different for direct and consequential dam- 4.105 ages. In case of direct damages, certainty refers to the fact of loss, but not to the amount, while in case of consequential damages, in addition to proving the existence of losses, the amount must be proved with reasonable certainty. In Tractebel Energy Marketing, Inc. v. AEP Power Marketing, Inc.,116 the Circuit 4.106 Judge stated that certainty refers to the fact of damage and not to the amount, referring to direct damages, which result from the breach. Failure to satisfy the certainty requirement can be a ground for alternative damages measures such as cost of completion, rather than diminution in value, or reliance interest rather than expectation interest.117 Reasonable certainty is also considered as a limitation to a damages claim as the injured party can only recover damages for the amount proved with reasonable certainty.118 The certainty of the amount of damages claimed as expectation interest is an issue 4.107 with respect to consequential or collateral damages, where such damages have to be proved with reasonable certainty. In case of direct or general damages, the courts are much more flexible in that respect. As shown in Tractebel Energy Marketing. v. AEP Power Marketing119 the court did not require certainty with respect to the amount of damages, as far as they were considered direct damages. In this case, the court required reasonable assumptions on which the loss of profit claim was based. The rule of reasonable certainty recognizes that loss of profit damages cannot be precisely calculated. Moreover, lost profits damages are not necessarily to be proved with mathematical certainty, but it is sufficient that there is enough support to arrive at a rational conclusion. Such damages must be based upon reliable factors without undue speculation.120

115

Klass, Contract Law in the USA 220 (n. 104). Tractebel Energy Marketing, Inc. v.  AEP Power Marketing, Inc., 487 F.3d 89, 109–10 (2nd Circuit 2007), accessed 26 October 2013. 117 Klass, Contract Law in the USA 220–1 (n. 104). 118 Farnsworth, Contracts 760 (n. 103). 119 Tractebel Energy Marketing v. AEP Power Marketing (n. 116). 120 Dunitz, ‘Context of the Lost Profits Damages Claim’ 9, with further references (n. 114). 116

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Chapter 4: Damages Claims for Breach of Contract 4.108 The requirement of reasonable certainty has been considered as probably ‘the most

distinctive contribution of American courts to the common law of damages’.121 Originally, it was strictly applied requiring that damages for breach of contract ‘be shown, by clear and satisfactory evidence, to have been actually sustained’ and to ‘be shown with certainty, and not left to speculation or conjecture’. According to §352 of the Restatement (Second) of Contracts, the recovery ‘for loss beyond an amount that the evidence permits to be established with reasonable certainty’ may not be recovered. 4.109 In the last decades, the requirement of reasonable certainty has been relaxed.

‘Doubts are generally resolved against the party in breach on the rationale . . . that it is not improper, given the inherent uncertainty, to exercise generosity in favor of the injured party rather than in favor of the breaching party.’ Moreover, ‘[c]ourts are therefore less demanding the requirement if the breach was wilful’.122 Comment 1 to §1-305 UCC establishes that damages need ‘not be calculable with mathematical accuracy’, are ‘at best approximate’, and ‘have to be proved with whatever definiteness and accuracy the facts permit, but no more’. 4.110 The requirement of certainty has been relaxed due to various factors:

(1) the influence of leading economic doctrines, in particular damages awarded for breach of antitrust and competition law; (2) the recognition that the proof of lost profits may be a particularly difficult undertaking; (3) and that the party in breach should not benefit from the difficulties of evidence.123 4.111 As regards antitrust and competition law, the US Supreme Court does not require

certainty for the damages caused but only a ‘just and reasonable estimate of the damages based on relevant data’ since the ‘most elementary conceptions of justice and public policy require that the wrongdoer shall bear the risk of the uncertainty which his own wrong has created’.124 In this respect, US courts have admitted, in the absence of a history of profits, the valuation of damages through methods such as the yardstick test by comparing profits with those of a similar business.125 4.112 Additionally, US courts recognize the right to damages even in aleatory con-

tracts including insurance contracts and the game of chance, which allow for the

121 Charles Tilford McCormick, Law of Damages (West Publishing Co. 1935)  124; Robert M.  Lloyd, ‘The Reasonable Certainty Requirement in Lost Profits Litigation:  What It Really Means’ in Nancy J. Fannon (ed.), The Comprehensive Guide to Lost Profits Damages for Experts and Attorneys 373–411, at 374 (n. 114). 122 Griffin v. Colver, 16 N.Y. 489, 491 (1858); Farnsworth, Contracts 799–800 (n. 103). 123 Farnsworth, Contracts 800–5 (n. 103). 124 Bigelow v. RKO Radio Pictures, 327 U.S. 251, 264, 265 (1946). 125 Farnsworth, Contracts 804 (n. 103).

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C. United States recovery of damages according to the value of a chance, which has been applied to lost opportunities. In the case of Locke v. United States126 the court said: where [the value of a chance for obtaining business and profits] is fairly measureable by calculable odds and by evidence bearing specifically on the probabilities . . . the court should be allowed to value [the] lost opportunity.

This led to a greater receptivity on the part of the courts to proof by expert opin- 4.113 ion and through sophisticated economic and financial data in order to meet the requirement of certainty of damages including new business without a track record of profitability using an expert witness in economics to testify as to the natural life cycle of a company using arithmetic and geometric models.127 Courts have recognized that doubts should generally be resolved against the party 4.114 in breach on the rationale that it is not improper, given the inherent uncertainty, to exercise generosity in favour of the injured party rather than in favour of the breaching party, in particular where such breach has been wilful.128 In another case, a court states that ‘who has wrongfully broken a contract should not be permitted to reap advantage from his own wrong by insisting on proof which by reason of his breach is unobtainable’.129 d. Causation or proximate cause A fundamental requirement for the award of damages is that the breach of con- 4.115 tract is the proximate cause in fact of the loss, which means that damages have to be directly and proximately caused by the breach of contract. If the breach is total and terminates the contract, the question is whether the damages would have occurred if the breach had not taken place, or what would have happened but for the breach.130 With regards to the but-for causation, US law distinguishes between loss causation 4.116 and transaction causation. Loss causation means that defendant’s conduct caused the loss. This is what is 4.117 required for a damages loss claim. Transaction causation means that the defendant caused the claimant to behave in a certain way, which then lead to the loss. This is relevant only in cases of tort such as fraud or breach of a fiduciary duty, but has recently been extended to breach of contract. This form of causation is considered inadequate and insufficient for a damages claim.131

126 127 128 129 130 131

283 F.2d 521, 524 (Ct. Cl. 1960), cited in Farnsworth, Contracts 804 (n. 103). McDermott v. Middle East Carpet Co. Assoc., 811 F.2d 1422 (11th Cir. 1987). Farnsworth, Contracts 800 (n. 103). Locke v. United States, 283 F.2d 521, 524 (Ct. Cl. 1960). Farnsworth, Contracts 731–2, 764 (n. 103). Robert L. Dunn, Recovery of Damages for Lost Profits, Vol. 1 (6th edn., Lawpress 2005) 6–7.

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Chapter 4: Damages Claims for Breach of Contract 4.118 In Moritz v. First National Bank of Chicago,

the court distinguished between transaction causation and loss causation and came to the result that no loss causation existed and therefore did not award any damages even if there was transaction causation. In such case the claimant purchased a building in Houston upon the advice of and after investigation by the defendant, a bank, which was also to manage the building. The defendant however did not revise the structural situation of the building and had also miscalculated the net cash flow arising from the use of the same. The claimant alleged breach of contract and breach of a fiduciary duty of the bank. Shortly after the sale, the Houston real estate market crashed and the plaintiff lost the building in foreclosure. The court held that though the claimant would not have entered into the transaction had it known the deficiencies of the building and the insufficient cash flow produced (transaction causation), ‘there is no loss causation, because the kind of loss that occurred was not the kind that the disclosure requirement that the defendant violated was intended to prevent. To hold the defendant liable for the loss would produce over-deterrence by making him an insurer against conditions outside his control.’ It is, however, evident, that in this case the court could have come to the same result finding intervening causality. 132

4.119 In Ambassador Hotel Co. v. Wei-Chuan Investment,133 the court found loss causa-

tion in a fairly similar case as the investment was lost due to the breach of the contract:  Ambassador claimed the loss of investment in a hotel project under construction due to defects. Ambassador decided not to pursue the hotel project further as the completion of the hotel would have cost an additional US$6 million. The defendants represented (guaranteed) that the total cost would not exceed US$22 million with the shell costing not more than US$16.6 million. Ambassador abandoned the project as the cost substantially exceeded the projected cost. The defendants argued that Ambassador would have lost its investment as the hotel would have been unsuccessful and that there would be no loss causation. The court rejected this argument and held, confirming loss causation: By arguing what might have been, defendants seriously distort general principles of causation. Questions of proximate cause arise when more than one factor can be identified as the cause of any particular event, or harm. However, to have been the cause (or one cause) of a particular event, any given factor must have contributed to the actual outcome; events which occur after the injury has occurred cannot be said to have caused the injury. To put it in another way, a wrong cannot be the proximate cause of harm if it was not an actual cause of that harm. Therefore, any argument that the hotel project would have failed down the line, given market conditions, must be regarded as irrelevant. Defendant’s only possible argument must be that the market decline, rather than foreclosure, was the proximate cause of the injury to Ambassador. . . . To demonstrate loss causation, Ambassador did not have to prove that the hotel project would have succeeded if the misrepresentations

132 133

148 F.3rd at 763. 189 F.3rd at 1029.

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C. United States made by defendants had been accurate; Ambassador had to prove only that the deception practiced by defendants caused its injury, in the sense that no other factor could more properly be said to have been the legal cause.134

The recovery of the investment refers to reliance interest. Causation problems are 4.120 less likely to occur in claims for reliance interest.135 According to Robert L. Dunn,

4.121

The question whether but-for causation should be enough to satisfy the requirement of proximate cause is not one that yields to logical analysis. It is a question of policy. The courts should make this decision when it is presented on the facts, recognizing that acceptance of but-for causation imposes liability for loss upon a defendant to the limit of the concept of proximate cause.136

No damages will be awarded if they were not caused by the breach of contract. This 4.122 may affect the damages claim as such or the amount of damages to be awarded. Causation in contract is a factual relationship between the breach of contract and the damages. ‘Breach may not be precluded, however, by the presence of other contributing causes—multiple or intervening.’137 3. Measure of damages US law recognizes three measures of damages, following Fuller and Perdue.138

4.123

a. Expectation interest This means the measure of damages is putting the injured party in the position 4.124 it would have been in had the contract been performed, that is, had there been no breach. In this sense, the aim is to give the injured party the benefit of the bargain. The expectation interest is not based on the expectation of the injured party at the time of celebrating the contract, but on the actual value the contract would have had to the injured party had it been performed.139 Under §344 (a) of the Restatement (Second) of Contracts, the expectation interest is defined as ‘his interest in having the benefit of his bargain by being put in as good a position as he would have been in had the contract been performed’. The expectation interest may consist of direct, incidental and consequential damages as mentioned above. b. Reliance interest Reliance interest is the loss suffered by the claimant by relying on the performance 4.125 of the contract of the other party, which did not occur. In such case the aim is to

134 135 136 137 138 139

189 F.3rd at 1029–30. Farnsworth, Contracts 733 (n. 103). Dunn, Recovery of Damages for Lost Profits 15 (n. 131). Farnsworth, Contracts 731 (n. 103). Fuller and Perdue, ‘The Reliance Interest in Contract Damages’ 52–96 (n. 107). Farnsworth, Contracts 730 (n. 103).

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Chapter 4: Damages Claims for Breach of Contract put the injured party back in the position in which it would be had the contract not been made. Under modern contract theory, there are two kinds of reliance interests: the first one consists of preparation and performance under the contract. The second consists of preparations for collateral transactions that are to be carried out when the contract is performed.140 c. Restitution interest 4.126 The object of the restitution is not the enforcement of a promise but to prevent unjust enrichment. The restitution interest acts to restore to the injured party any benefit that it has conferred on the other party. The party in breach is required to disgorge what it has received in money or services by returning the benefit to the injured party.141 Under this measure, the defendant has to pay the money value of its performance. The restitution interest applies when the claimant confers some value on the defendant in reliance of the latter’s promise, which, however, the defendant fails to perform. In this case the court may force the defendant to disgorge the value that it received from the claimant, which leads to the prevention of unjust enrichment of the defendant.142 This however, seems to be an exceptional remedy and has been dealt with by Farnsworth under the heading ‘restitution as a remedy for breach’. It seems to correspond to the performance interest under English law mentioned above. 4.127 It has been pointed out that courts generally award the expectation interest when

such interest can be ascertained with reasonable certainty. When expectation interest cannot be proved with reasonable certainty, claimant may ask for reliance interest, which may be easier to prove. However, reliance interest plays only a modest role in US law ‘filling in as an ascertainable measure when, for whatever reason, the court refuses to award the full expectation interest’.143 d. Measure of expectation interest 4.128 In order to award the expectation interest, US law distinguishes between partial and total breach and whether the injured party has terminated the contract. In the case of partial breach, the claimant may continue performance and ask for damages based on a calculation of the loss caused by the breach of the contract. In the case of total breach, the following general elements may be identified: (1) loss in value, (2) other loss, (3) avoidance of some cost, and (4) avoidance of some loss.144 4.129 Loss in value is the difference between the value of the performance that should

have been rendered and the value of what was actually received. The loss in value 140

Farnsworth, Contracts 732–3 (n. 103); §344 (b) of the Restatement (Second) of Contracts. §344 (c) of the Restatement (Second) of Contracts. 142 Fuller and Perdue, ‘The Reliance Interest in Contract Damages’ 54 (n. 107). 143 Michael B. Kelly, ‘The Phantom Reliance Interest in Contract Damages’ in Barnett (ed.), Perspectives on Contract Law 23–4 (n. 102). 144 Farnsworth, Contracts 764 et seq. (n. 103). 141

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C. United States depends on the circumstances of the injured party. ‘If the injured party’s expected advantage consists of the realization of profit, it may not be difficult to express that party’s loss in value in terms of money.’145 Such loss in value refers to direct damages. Other loss refers to incidental and consequential damages, which have been 4.130 explained above. Cost avoided. If the injured party terminates the contract for total breach and this 4.131 brought benefits to the injured party, such benefit is considered cost avoided. Loss avoided. If the injured party terminates the contract for total breach and such 4.132 total breach avoids some loss to the injured party, this is considered loss avoided. The general measure of damages for total breach can be expressed as follows:

4.133

general measure = loss in value + other loss - cost avoided - loss avoided146

Loss of profits can be considered as expectation interest if it would have been real- 4.134 ized with reasonable certainty but for the breach. Lost profits are considered ‘as the amount necessary to place the injured in the position that it would have been had the injury/incident not occurred. Accordingly, lost profits damages calculations represent the amounts that are potentially recoverable due to the defendant’s specific actions/inactions or incidents.’ Lost profits will typically not equal the harmed party’s gross profits related to lost revenues. ‘In most cases the correct measure of the plaintiff ’s damages will be its lost revenues lest the incremental expenses that it would have incurred to achieve those lost revenues. Only net profits are recoverable, not gross profits without deduction of expenses.’ Loss of profits is an essential claim for damages in complex long-term contracts. The US law provides a quite elaborate system to determine and measure loss of profits, which will be analysed with more detail in the following paragraphs. 147 Within the expectation interest, loss of profits may be considered either as direct 4.135 losses, ‘because making a profit was the purpose of the contract’, or consequential damages, because of ‘the non-breaching party’s inability to fulfill other agreements or inability to operate its business’ due to the breach. As regards loss of profits damages, it has been recognized that such damages cannot be calculated with absolute exactness and do not have to be proved with mathematical certainty. However, lost profits must be capable of measurement based upon reliable factors without undue speculation.148

145

Farnsworth, Contracts 765 (n. 103). Farnsworth, Contracts 768 (n. 103). 147 James O’Brien and Robert P. Gray, ‘Lost Profits Calculations: Methods and Procedures’ in Fannon (ed.), The Comprehensive Guide to Lost Profits Damages 339–40, with further references (n. 114). 148 Dunitz, ‘Context of the Lost Profits Damages Claim’ 8–9, with further references (n. 114). 146

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Chapter 4: Damages Claims for Breach of Contract 4.136 Loss of profits is considered as loss in value in case of total breach.149 Loss of prof-

its is considered direct loss if making the profit was the purpose of the contract. Otherwise they are considered as consequential. This distinction is intimately related to foreseeability. This was established in Tractebel Energy Marketing v. AEP Power Marketing.150 4.137 This case arises out of a contract entered into in 2001 for the development of a

gas-fired cogeneration facility between AEP and Dow Chemical Company at the Dow complex in Plaquemine, Louisiana. Under the contract, AEP had to operate the facility and to purchase the electricity produced, whereas Dow used the energy generated in its manufacturing processes. 4.138 On 15 November 2000, AEP entered into the Power Purchase and Sale Agreement

(PPSA) with Tractebel (TEMI) under which AEP promised to supply energy to Tractebel from the facility, and, in return, Tractebel promised to take a minimum amount of energy and make associated payments at prices stipulated in the contract. The PPSA set a target commercial operation date (COD) of 2 May 2003. In 2001, the energy market collapsed and TEMI sought to be released from the contract with AEP; however, the negotiations failed. TEMI finally repudiated the contract and rejected the energy offered by AEP. 4.139 In September 2003, the parties commenced litigation and AEP sought damages

from Tractebel for breach of contract for the profits it expected to make had the contract been performed during its 20-year term, in the amount of approximately US$500 million. This claim was based on s. 12 of the PPSA, which provides that, in the event of either party’s default, the non-defaulting party is entitled to any net loss the party incurs as a result of the other party’s early termination of the agreement. 4.140 The Circuit Judges held:

Lost profits are consequential damages when, as a result of the breach, the non-breaching party suffers loss of profits on collateral business arrangements. In the typical case, the ability of the non-breaching party to operate his business, and thereby generate profits on collateral transactions, is contingent on the performance of the primary contract. When the breaching party does not perform, the non-breaching party’s business is in some way hindered, and the profits from potential collateral exchanges are ‘lost’. . . . By contrast, when the non-breaching party seeks only to recover money that the breaching party agreed to pay under the contract, the damages sought are general damages. . . . The damages may still be characterized as lost profits since, had the contract been performed, the non-breaching party would have profited to the extent that his cost of performance was less than the total value of the breaching party’s promised payments. But in this case, the lost profits are the direct and probable 149 150

Farnsworth, Contracts 765 (n. 103). Tractebel Energy Marketing v. AEP Power Marketing (n. 116).

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C. United States consequence of the breach. The profits are precisely what the non-breaching party bargained for, and only an award of damages equal to lost profits will put the non-breaching party in the same position he would have occupied had the contract been performed. . . . In characterizing AEP’s claim as one for consequential damages, the district court confused the benefit of the bargain with speculative profits on collateral transactions. . . . AEP seeks only what it bargained for-the amount it would have profited on the payments TEMI promised to make for the remaining years of the contract. This is most certainly a claim for general damages.151

This case clearly shows that loss of profits for breach of a long-term contract, which 4.141 is the object of such contract such as in any income based complex long-term contract, is clearly a direct of general damage and not a consequential damage. With respect to the determination of the amount of general damages, the Circuit 4.142 Judges further held that: While certainty of amount is not an element of general damages in New York, it is an element of consequential damages. In addition to proving that the existence of damage is reasonably certain, and that the damages were foreseeable and within the contemplation of both parties, a party claiming consequential damages must also prove the amount of damages with reasonable certainty. Thus, there exists a higher burden for proving consequential damages than for general damages. This is the burden that the district court erroneously imposed to AEP. The district court erred in requiring AEP to prove the extent of its damages to a reasonable certainty. The law of New York is clear that once the fact of damage is established, the non-breaching party needs only provide a ‘stable foundation for a reasonable estimate [of damages]’ before an award of general damages can be made. The district court noted that ‘it is inherently speculative’ to determine AEPs loss over the twenty-year period, and that the method offered for determining AEP’s loss ‘require a large number of assumptions’. . . . . . . The variables identified by the district court exist in every long-term contract. It is not the case that all such contracts may be breached with impunity because of the difficulty of accurately calculating damages. New York courts have significant flexibility in estimating general damages once the fact of liability is established. . . . To the extent certain variables must be assumed in order to arrive at a reasonable estimate, the district court may do so, unless evidence is presented that undermines the basis for the assumption. For example, while changes in the political and regulatory environments would likely affect AEPs profit margin, and thus the extent of AEP’s actual damages, if there is currently no evidence of an impeding change, the district court may assume these environments will remain stable. This is precisely what the parties did when they estimated the value of the PPSA prior to the signing. The risk that the future might reveal the district court’s assumptions to be false is appropriately borne by TEMI as the breaching party.152

151 152

Tractebel Energy Marketing v. AEP Power Marketing 18–19, footnotes omitted (n. 116). Tractebel Energy Marketing v. AEP Power Marketing 20–1, footnotes omitted (n. 116).

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Chapter 4: Damages Claims for Breach of Contract 4.143 In footnote 25, the Circuit Judges added that:

The record contains internal TEMI memoranda that show that, prior to entering the PPSA, TEMI assessed the risk that certain variables might change in such a way as to adversely affect TEMI’s financial interest in the deal. TEMI concluded that politic, regulatory, and market risks were low. 4.144 Further, in footnote 26, it was held that:

It is no less speculative for the district court to determine AEPs loss over the twenty-year period than it was for TEMI to calculate its expected profit from the PPSA at the time it entered into the agreement. The district court stated that the parties’ respective experts could ‘have done as well had they consulted tealeaves or a crystal ball.’ If it is true that projecting profits over twenty years is so absurdly speculative that economists can do no better than fortune tellers, it would have been imprudent for the parties to enter a contract for such a long period in the first place. The reality, however, is that long-term contracts are entered into regularly, and a degree of speculation is acceptable in the business community. 4.145 Therefore, in case of loss of profits for breach of complex long-term contract

based on income stream, being direct and not consequential damages, certainty of amount is not a requirement. The burden of proof to establish the amount of damages may be met through risk allocation between the parties and underlying projections when signing the contract. This leads to a shift of the burden of proof to the defendant showing that the underlying projections were not reasonable. 4.146 As regards loss of profits in the form of consequential damages, in Texas Power &

Light Co. v. Barnhill153 the claimant alleged that he was unable to secure bonds necessary to bid on other construction contracts, because of loss of the income from the contract in issue. The claimant’s lost profits from these collateral contracts were held recoverable if within the contemplation of the parties at the time the contract was made. The court stated: This case involves a specific application of this rule. The only damage to his business for which Barnhill had any apparent basis for recovery under contract law was loss profits from collateral contracts. Lost profits from collateral contracts, however, are recoverable only if such collateral contracts are known to or are within the contemplation of the parties at the time they enter into the contract, which is subsequently breached.154 4.147 In this case, the court found evidence of foreseeability of loss based on the long his-

tory of business between the parties. The calculation of losses was determined upon the usual percentage of profits on bids, which were held to be adequate proof of the amount awarded.155 Therefore, in case of consequential or collateral damages, there is a higher threshold with respect to the certainty of damages, foreseeability

153 154 155

639 S.W.2d 331 (Tex. App. 1982). 639 S.W.2d 336 (Tex. App. 1982). Dunn, Recovery of Damages for Lost Profits 73–4 (n. 131).

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C. United States and burden of proof. In particular, the amount of damages has to be reasonably certain and such damages have to be reasonably be contemplated by the defendant. A particular issue is whether a loss of profits claim is available to new businesses. US 4.148 courts are split in that respect. It has been established that lost profits must meet a higher evidentiary burden in satisfying the reasonable certainty standard for the obvious reason that there does not exist a reasonable basis of experience upon which to estimate lost profits with the requisite degree of reasonable certainty. Lost profits have been denied when the profit calculations were depending ‘upon a host of assumptions concerning uncertain contingencies’ and apply ‘numerous variables about which an expert can only surmise’.156 In Fiberlok, Inc. v. LMS Enterprises, Inc.,157 the court established that ‘the general 4.149 rule that lost profits are not recoverable for a new and unestablished business does not apply to a business established on the basis of a contract sufficiently specific in nature as to allow credible prediction of the amount of lost profits, particularly if factual data is available to furnish a sound basis for computing probable loss’. 4. Limitations to damages claims US law establishes three limitations for damages claims:

4.150

(1) forseeability; (2) avoidability; and (3) reasonable certainty of loss. The last limitation has already been considered as a requisite for a damages claim as there may not be any damages recoverable without a loss and also to make this requirement comparable with similar requirements under other rules of law. a. Foreseeability Foreseeability is the limitation that restrains the injured party from recovering loss, 4.151 which the party in breach did not have a reason to foresee as a probable result of the breach at the time the contract was made. US courts follow the rule stated in Hadley v. Baxendale, already mentioned under 4.152 English law, which states that unforeseeable damages are not recoverable. §351 (1) of the Restatement (Second) of Contracts establishes that ‘[d]amages are not recoverable for loss that the party in breach did not have reasons to foresee as a probable result of the breach when the contract was made’. This means that risk allocation under a contract excludes the limitation of foreseeability.

156 Dunitz, ‘Context of the Lost Profits Damages Claim’ 11, with further references (n. 114); Neil J. Beaton and Tyler L. Farmer, ‘Calculating Damages for Early-Stage Companies’ in Fannon (ed.), The Comprehensive Guide to Lost Profits Damages 413–27 (n. 114). 157 976 F.2d 958, 937 (5th Circuit 1992).

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Chapter 4: Damages Claims for Breach of Contract 4.153 It is important to mention that this rule is particularly relevant with respect to con-

sequential and incidental damages as direct damages are in most cases foreseeable. §2-715 (2) of the UCC establishes the foreseeability requirement for consequential damages, which includes ‘any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know’. What is relevant is what the defendant knew or should have known at the moment of the formation of the contract that the loss could have been a probable result of the breach.158 4.154 The foreseeability requirement applies to both the expectation and reliance interest.

In case of the expectation interest, the rule applies to both the direct and consequential or collateral damages. However, in case of consequential damages, the injured party must present more evidence showing the defendant knew or should have known of the consequences of the breach.159 When a risk is allocated its consequences are foreseen and the requirement of evidence is met. 4.155 Foreseeability requires that the losses resulting from a breach of contract are foresee-

able and probable. However, it is not necessary that the specific breach that caused the loss was foreseeable, but only that the breach or conduct was likely to cause damage.160 4.156 As regards lost profits, the question arises whether the parties contemplated that

breach of the contract could result in lost profits. In this respect, the court would look at the ‘nature, purpose and particular circumstances of the contract known by the parties . . . as well as what liability the defendant fairly may be supposed to have assumed consciously, or to have warranted the plaintiff reasonably to suppose that is assumed, when the contract was made’.161 4.157 In Ashland Management Inc. v. Janien162 the court held that the defendant should

not have foreseen the breach itself or the particular way the loss came about. It was only necessary that loss from a breach was foreseeable and probable. The claimant was required to show only that the defendant’s conduct was likely to cause injury but not the specific injury. 4.158 The Restatement (Second) of Contracts requires only objective foreseeability of

damages, ‘which the party in breach had reason to know’. Comment (a) of §351 expressly rejects any subjective test: It is enough, however, that the loss was foreseeable as a probable, as distinguished from a necessary, result of his breach. Furthermore, the party in breach need not have made a ‘tacit agreement’ to be liable for the loss. Nor must he have had the loss 158 159 160 161 162

Klass, Contract Law in the USA 219 (n. 104). Klass, Contract Law in the USA 220 (n. 104). Dunitz, ‘Context of the Lost Profits Damages Claim’ 7 (n. 114). Dunitz, ‘Context of the Lost Profits Damages Claim’ 7, with further references (n. 114). 82 N.Y.2d at 395, 403.

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C. United States in mind when making the contract, for the test is an objective one based on what he had reason to foresee.

b. Avoidance or mitigation of damages The injured party is not entitled to recover damages for losses that could have 4.159 been avoided if that party had taken the appropriate measures according to §350, paragraph (1), of the Restatement (Second) of Contracts to avoid the damage ‘without undue risk, burden or humiliation’. Particular rules exist with respect to sales contracts, which are not relevant to complex long-term contracts. Exceptions to the duty of mitigation apply where the injured party’s fi nancial situation makes mitigation impossible or where mitigation is difficult or impractical.163 §350 of the Restatement (Second) of Contracts states under the heading 4.160 ‘Avoidability as a Limitation on Damages’: (1) Except as stated in Subsection (2), damages are not recoverable for loss that the injured party could have avoided without undue risk, burden or humiliation. (2) The injured party is not precluded from recovery by the rule stated in Subsection (1)  to the extent that he has made reasonable but unsuccessful efforts to avoid loss.

Proof of mitigation of damages requires showing that the claimant made reason- 4.161 able steps to stop or diminish its losses, but not that the claimant did what the defendant would have to do, or what is most effective to reduce the damage. The reasonableness of the plaintiff ’s efforts is a question of fact. The defendant must prove that the claimant failed to mitigate damages, as well as the amount of benefit that the claimant obtained from mitigation.164 5. Other aspects affecting the damages claim a. Date of the determination of the damages Damages are normally determined on the trial date. This means that courts would 4.162 have to award fewer damages where the loss decreased or more where such loss increased after the breach of contract and until the trial date. However, they may refer to dates beyond such date in order to contemplate future losses, when this is necessary to return the claimant to the position in which it would have been in the absence of breach.165

163 164 165

O’Brien and Gray, ‘Lost Profits Calculations’ 371 (n. 147). Dunn, Recovery of Damages for Lost Profits 571–2 (n. 131). O’Brien and Gray, ‘Lost Profits Calculations’ 353–5 (n. 147).

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Chapter 4: Damages Claims for Breach of Contract b. Level of evidence required and burden of proof 4.163 The level of evidence required is intimately related with the notion of certainty of damages. According to the fact and amount rule, once the loss is proven the amount need not be proven with reasonable certainty. However, such fact and amount rule has been considered as: one of the more misleading statements in American jurisprudence, not because it is totally untrue, which it is not, but because it grossly overstates the importance of the plaintiff being able to prove it suffered some amount of damage, elevating that proof from one of a number of factors courts consider to a sine qua non for recovering lost profits. Even though many courts state it as an absolute rule . . . they do not apply it as a rule. They instead make the certainty that there has been some loss one factor to be considered when determining whether the plaintiff has proven its damages with reasonable certainty. It is an important factor to be sure, but it is still just one of a number of factors they consider.166 4.164 According to the Federal Rules of Evidence (FRE) and those of a majority of US

states, the claimant has the burden of proof of establishing both the existence of the loss and the amount of the damages.167 The level of evidence is one of reasonable certainty, which is less than beyond the reasonable doubt, or to a moral certainty.168 In practice, it is up to the court to decide whether the injured party presented sufficient proof in order to substantiate the loss and its quantum. It is a matter of discretion of the court. The question with respect to reasonable certainty is, ‘does the court think that, given all the circumstances this plaintiff has presented sufficient evidence to make it fair to award it the damages in question?’169 4.165 The factors normally considered by the courts are: (i) the court’s confidence that

the estimate is accurate; (ii) whether the court is certain that the injured party has suffered at least some damage; (iii) the degree of blameworthiness or moral fault on the part of the defendant; (iv) the extent to which the plaintiff has produced the best available evidence of lost profits; (v) the amount at stake; and (vi) whether there is an alternative method of compensating the injured party.170 6. Penalties and liquidated damages 4.166 The advantages of stipulating a sum payable as damages is to facilitate the calcula-

tion of risks and to reduce the cost of proof.171 According to §2-718 (1) UCC: Damages for breach by either party may be liquidated in the agreement but only at an amount, which is reasonable in the light of the anticipated or actual harm 166

Lloyd, ‘The Reasonable Certainty Requirement in Lost Profits Litigation’ 387–8 (n. 121). Tom Burrage, ‘Establishing Evidence in Lost Profits Cases’ in Fannon (ed.), The Comprehensive Guide to Lost Profits Damages 429 (n. 114). 168 Hardwick v. Dravo Equip. Co., 569 P.2d 588, 594. 169 Lloyd, ‘The Reasonable Certainty Requirement in Lost Profits Litigation’ 379, with further reference (n. 121). 170 Lloyd, ‘The Reasonable Certainty Requirement in Lost Profits Litigation’ 378 (n. 121). 171 Farnsworth, Contracts 811 et seq. (n. 103). 167

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C. United States caused by the breach, the difficulties of proof of loss, and the inconvenience or non-feasibility of otherwise obtaining an adequate remedy. A term fi xing unreasonably large liquidated damages is void as a penalty.

The requirements for the validity of liquidated damages are the following:

4.167

(1) the reasonableness of the forecast in the light of the presumed loss at the time when the contract was made; (2) the difficulty of proof of loss at the time the contract was made; and (3) the intention of the parties to provide fair compensation and not to secure performance by compulsion. This means that it is sufficient that the criteria of reasonableness are met for the actual harm, which follows the trend favouring enforcement of liquidated damages.172 7. Special issues related to construction contracts Damages claims have evolved considerably in the construction industry and pro- 4.168 vide an insight of damages situations, which are also faced in complex long-term contracts. US legal practice provides particular experience with respect to the calculation of construction damages as described in the seminal work by William Schwartzkopf and John J. McNamara.173 A construction damages claim consists of two major parts:

4.169

(1) the so-called entitlement section; and (2) the damages section. The entitlement section refers to the establishment of liability of the defendant. 4.170 Damages claims may often be framed under various theories, which apply to the same factual situation, but may result in alternative damages analyses. Different damages analyses may increase the likelihood of a finding of damages when such different approaches confirm similar quantities of damages. The damages analysis should be undertaken in parallel with the analysis of liability and is normally the more technical and time-consuming part of a damages claim.174 The measure of damages to a contract for the owner’s breach of a construction 4.171 contract is the contract price less the cost of completion. In a number of cases, lost profit damages were permitted measured by a percentage of profit on the contract or on costs incurred. In case of breach of contract by the contractor, the owner may recover the difference between the contract price and the cost of completion and

172

Farnsworth, Contracts 814–17 (n. 103); Banta v. Stamford Motor Co. 92 A . 665, 667 (Conn.

1914). 173 William Schwartzkopf and John J. McNamara, Calculating Construction Damages (2nd edn., Wolters Kluwer 2001). 174 Schwartzkopf and McNamara, Calculating Construction Damages 3 (n. 172).

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Chapter 4: Damages Claims for Breach of Contract other damages. Both the owner and the contractor may recover lost profits from the other party for delays caused.175 8. Considerations 4.172 Under US law the applicable standard is full compensation for the actual loss.

The notion of actual loss is explained in chapter 2. The underlying principle of US damages law seems to be one of fairness to both parties, avoiding both over- and under compensation.176 In accordance with this principle, the measurement of damages is expectation interest.177 Expectation interest has the same meaning as under English law and is the difference in value between the but-for situation of the injured party and its actual situation. However, there does not seem to be any preference for either abstract or concrete valuation. 4.173 Under US law, loss profits are direct or general losses when they are within the

purpose or the object of the contract. Lost profits that are considered consequential damages are fully recoverable, when they were foreseen as evidenced by the risk allocation under the contract. §351 (1) of the Restatement (Second) of Contracts establishes that ‘[d]amages are not recoverable for loss that the party in breach did not have reasons to foresee as a probable result of the breach when the contract was made’. In this context, risk allocation has a relevant role in order to avoid the limitation of foreseeability with respect to certain obligations established under the contract. The importance of the determination of loss in case of lost profits is underlined under US law through the notion of certainty of loss. Under this notion, loss profits need not necessarily be proved with mathematical certainty, but it is sufficient that there is enough support to arrive at a rational conclusion.

D. France 1. Principles for damages claims 4.174 French law is characterized by a stronger protection of the performance interest

in comparison with other legal systems.178 This means that the French legal system protects specific performance, which leads to performance interest as defined under English law above. In particular, French law recognizes specific performance or pacta sunt servanda as a fundamental principle of contractual obligations. Article 1134, paragraph 1, of the Civil Code states that ‘agreements legally formed have the force of law for those who have agreed to them’. Under this rule (known as force

175 176 177 178

Dunn, Recovery of Damages for Lost Profits 179, 184, 186, 188 (n. 131). Barnett, ‘How Should Damages for Breach of Contract be Measured’ 3 (n. 102). Farnsworth, Contracts 730–1 (n. 103). Rowan, Remedies for Breach of Contract 110 (n. 5).

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D. France obligatoire), which is the basis of all remedies for breach of contract, contracts are made legally enforceable.179 a. Pacta sunt servanda Under French law a contract is conceived as an act of free will. The parties are not 4.175 obliged to enter into the contract, but once they have entered into it, they must perform their obligations. The court’s role is to compel the parties to perform the contract. The function of the contract is to manage risks and to control facts for the security of a business. Neither party may modify the contract unilaterally if such power has not been provided in the agreement. According to article 1134 of the Civil Code, the injured party cannot terminate the contract unilaterally and only the judge has the power to terminate it. The courts have a duty to preserve this goal in spite of the promisor’s accidental fault in the breach of the contract.180 Specific performance is a means to grant the injured party satisfaction in the form 4.176 of the expected benefit, but it becomes an aim itself, by providing the promised performance and not only by paying damages. In this sense, the judge is entitled to order the debtor to perform its promise, regardless of the burden upon the defendant. This also means that there is no general duty to mitigate damages.181 However, even under this system of strict performance, article 1142 of the Civil 4.177 Code states that ‘every obligation to do or not to do resolves itself into damages in case of non-performance by the debtor’. This provision is meant to apply to personal obligations, but it is now used by courts to award damages in lieu of specific performance.182 b. Full compensation or principle de réparation intégrale Article 1149 of the Civil Code establishes that ‘the promisee is entitled to damages 4.178 in respect of the loss which he has suffered and the gain of which he was deprived’. The full compensation is the objective ( principle de réparation intégrale du préjudice) and according to the loss suffered (tout le préjudice mais rien que le préjudice).183 The essence of the full compensation principle under French law is to return the 4.179 victim ‘as closely as monetarily possible to the position in which he would have

179 Yves-Marie Laithier, ‘Comparative Reflections on the French Law of Remedies for Breach of Contract’ in Cohen and McKendrick (eds.), Comparative Remedies for Breach of Contract 105, 117 (n. 7). 180 Laithier, ‘Comparative Reflections on the French Law of Remedies for Breach of Contract’ 104–106 (n. 178). 181 Laithier, ‘Comparative Reflections on the French Law of Remedies for Breach of Contract’ 114–116 (n. 178). 182 Andrea Pinna, La Mesure de Préjudice Contractuel (L.G.D.J. 2007) 1. 183 Rowan, Remedies for Breach of Contract 109, 150 (n. 5); Konstanze Brieskorn, Vertragshaftung und responsabilité contractuelle, Ein Vergleich zwischen deutschem und französischem Recht mit Blick auf das Vertragsrecht in Europa (Mohr Siebeck 2010) with further references.

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Chapter 4: Damages Claims for Breach of Contract been had the wrong not being done’. Through the full compensation principle or principle de réparation intégrale du préjudice, French law attempts to avoid default of the defendant whenever he finds a better opportunity for the resources that he intended to use under the contract. French law, by fully compensating the claimant, aims to discourage the promisor from breaching the contract.184 4.180 Under French law, it should not simply be taken for granted that the injured party

is satisfied or should be satisfied by performance that almost reaches the contractual specification, as this would mean at least a partial waiver of its contractual rights, ‘and this does little for the security of transactions’.185 4.181 French law recognizes a series of remedies in order to protect the injured party. The

claimant may choose between specific relief, replacement, and compensatory damages according to its specific situation. In case of specific relief, the French courts would not have a problem in ordering the defendant to take the necessary steps to cure the breach. Hardship, disproportionality, and unreasonableness do not afford any defence. Damages are aimed to remedy the non-performance. The objective is to give the claimant full compensation for the damage, loss, or injury that it has suffered, which may include cost of cure.186 4.182 The injured party:

is not obliged to take any particular course of action and in many instances, may choose his preferred remedy without considering how it impacts on the defaulting promisor. Most notably, where performance of the unfulfilled contractual obligation is still possible, the injured promisee may, depending on the circumstances, elect between specific performance, replacement and compensatory damages.187 4.183 French law is not in favour of giving the right to avoid a contract, except by mutual

consent (article 1134, paragraph 2, of the Civil Code). In other words, if one of the parties wants to avoid it, the other could refuse to accept such avoidance, keep on performing and claim performance or damages from the other party. However, in case of a works contract, contrat d’entreprise, the owner can avoid the contract unilaterally by paying damages to the other party.188 4.184 Under French law, the principle of réparation intégrale aims to give the injured

party the amount of money that corresponds to the specific performance according to the concrete valuation. This includes performance from a source other than the promisor, which is often granted as an indirect form of specific performance.189

184 Civ (2) 4 Feb 1982, JCP 1982.II.19894 note J-J Barbiéri; Rowan, Remedies for Breach of Contract 150, 152 (n. 5). 185 Rowan, Remedies for Breach of Contract 120 (n. 5). 186 Rowan, Remedies for Breach of Contract 114 (n. 5). 187 Rowan, Remedies for Breach of Contract 151 (n. 5). 188 Treitel, Remedies for Breach of Contract 128 (n. 1). 189 Rowan, Remedies for Breach of Contract 114–16 (n. 5).

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D. France According to article 1144 of the French Civil Code, the claimant may seek the permission of the court to obtain performance from a third party at the debtor’s expense ( faculté de remplacement): A creditor may also, in case of non-performance, be authorised to have the obligation performed himself, at the debtor’s expense. The latter may be ordered to advance the sums necessary for that performance.190

The faculté de remplacement is considered particularly appropriate where specific 4.185 performance has become impossible for the respondent, or where the claimant has lost trust in the respondent; in particular, this may happen in the case of building contracts. This measure is, however, subject to judicial discretion. Reasonableness is not a criterion for the judicial exercise of such discretion.191 The principle, therefore, is full compensation of the equivalent to specific perfor- 4.186 mance, which is achieved through the award of the cost of cure, where applicable, based on the pacta sunt servanda principle. French damages law for breach of contract is based on both the provisions on the law of extra-contractual and contractual liability.192 2. Requisites for a damages claim According to the Cour de cassation, ‘damages may only be awarded where loss 4.187 results from breach of contract’.193 In other words, under French law four requirements must be met: breach of contract, loss, causality, and fault. a. Breach of contract Article 1136 of the Civil Code establishes that ‘[a]ny obligation to convey carries 4.188 that of delivering the good and keeping it until conveyance, subject to damages to the creditor in case of contravention’.194 Article 1142 of the Civil Code states that ‘[a]ny obligation to do or not to do resolves itself into damages in case of non-performance on the part of the debtor’.195 This means that both the violation of the obligations to convey a good or to do or not to do a thing gives rise to damages.

190 ‘Le créancier peut aussi, en cas d’inexécution, être autorisé à faire exécuter lui-même l’obligation aux dépens du débiteur. Celui-ci peut être condamné à faire l’avance des sommes nécessaires à cette exécution.’ Cited in Rowan, Remedies for Breach of Contract 114 (n. 5). 191 Rowan, Remedies for Breach of Contract 115–17, with further references (n. 5). 192 Juris Classeur-Régime de la réparation/Perrier, Fasc. 202-20 et seq. 193 Rowan, Remedies for Breach of Contract 139, with further reference (n. 5). 194 ‘L’obligation de donner emporte celle de livrer la chose et de la conserver jusqu’à la livraison, à peine de dommages et intérêts envers le créancier.’ 195 ‘Toute obligation de faire ou de ne pas faire se résout en dommages et intérêts en cas d’inexécution de la part du débiteur.’

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Chapter 4: Damages Claims for Breach of Contract b. Existence and classification of losses 4.189 i. Loss Article 1149 of the Civil Code196 states that damages are ‘for the loss suffered and the gain of which the creditor has been deprived’. Therefore the breach alone is not sufficient for an award equivalent in monetary terms. French law emphasizes the notion of loss, which is defined in the broadest possible manner in accordance with the principle of full reparation.197 4.190 The reference to the loss which the claimant has suffered (la perte qu’ il a faite known

as damnum emergens) and the gain of which the claimant has been deprived (du gain dont il a été privé, known as loss of profits or lucrum cessans) derives from Roman law and refers to sales contracts, this means that (i) the failure to obtain the goods without defects and at the time promised gives rise to damnum emergens, and (ii) the failure to obtain profits at resale is related to lucrum cessans.198 This distinction, however, is not further used in the Civil Code and is considered insufficient.199 4.191 The Cour de cassation uses different terms in order to award damages and loss of

profits, such as commercial loss ( prejudice comercial ), which refers to both damages and loss of profits. This would include loss of profits due to loss of clients ( perte de clientèle) and the consequent reduction in the value of the good will. Another term used is economic loss ( préjudice economique), which is used as a synonym for commercial damage. However, this expression includes any diminution in the claimant’s assets and not only the gain of which the claimant has been deprived due to the breach of contract. Financial loss ( préjudice financier) includes both loss of profits and loss of exploitation and also non-monetary damages and any financial expenses incurred by the claimant due to the breach.200 4.192 In her monograph La Mesure du Préjudice Contractuel, Andrea Pinna analyses the

particular issues arising from the breach of long-term contracts under French law. The matter is considered difficult, in particular, with respect to gains deprived or loss of profits, raising questions such as: (i) whether lost profits may be claimed by the party who has correctly executed its contract, or whether this notion is limited to the conclusion of a substitute contract; (ii) whether the brute or net profit margin has to be awarded; (iii) whether the measure of damages is the same in case of termination or non-termination of the contract; and (iv) whether future profits must

196 ‘Les dommages et intérêts dus au créancier sont, en général, de la perte qu’il a faite et du gain dont il a été privé, sauf les exceptions et modifications ci-après.’ 197 Pauline Rémy-Corlay, ‘Damages, Loss and Quantification of Damages in the Avant-projet de réforme’ in John Cartwright, Stefan Vogenauer, and Simon Whittaker (eds.), Reforming the French Law of Obligations: Comparative Reflections on the Avant-projet de réforme du droit des obligations et de la prescription (‘the Avant-project Catala’) (Hart Publishing 2009) 307. 198 José Edgardo Muñoz López, Modern Law of Contracts and Sales in Latin America, Spain and Portugal (Eleven International Publishing 2011) 248. 199 Pinna, La Mesure du Préjudice Contractuel para. 8 (n. 182). 200 Pinna, La Mesure du Préjudice Contractuel para. 248 (n. 182).

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D. France be measured the same way as past profits. Such questions have hardly ever been analysed by French courts and doctrine.201 With respect to the determination of the lost profits following breach of long-term 4.193 contracts, Pinna establishes the following criteria: as a first step, the determination of a reference period is necessary. In this respect, the duration of the contract is of importance. When the duration of the contract is undetermined, the notice periods for termination established by the law are relevant. As a second step, it is necessary to calculate the present value of future profits.202 The calculation of future lost profits is based on two principles: (i) the establish- 4.194 ment of the individual indices of the company; and (ii) the determination of the present value of future income. The first refers to the evolution of financial data with respect to the historical performance of the business. Profits are normally determined by comparing the profits of the injured party with the profits of a similar company in the same market. This, however, creates difficulties with respect to newly established companies, and French courts often refuse to grant damages due to the lack of sufficiently certain damages. With respect to the second, the question of the calculation of the present value of future profits is considered a question of law, which provides the Cour de cassation with a ground of revision. However, the French courts have not determined rules for the calculation of the present value. In long-term contracts, investments made to perform the contract are taken into consideration when awarding damages. In particular, courts consider the amortization and the residual value of such investments according to the moment of the breach and the duration of the contract.203 ii. Damages caused to a third party Although the privity of contract rule 4.195 exists under French law, a subsequent purchaser of a building, as a third party, may claim for damages against the building contractor who constructed the building. Another exception to this rule is the stipulation pour autrui under article 1121 of the Civil Code, which means that the contracting parties may designate a third party as beneficiary of the contract, giving him the right to claim damages against the promisor in case of breach. Article 1144 of the Civil Code allows the injured party to have the contract performed by a third party in lieu of the promisor in order to achieve full compensation.204 French law does not make any further distinction or classification with respect 4.196 to damages. There is no distinction between expectation and reliance interest.

201 Pinna, La Mesure du Préjudice Contractuel paras. 2, 8 (n. 182): ‘Les notions de perte subie et de gain manqué n’étant généralement pas définies, la mise en ouvre pratique du principe est malaisée’, and 249. 202 Pinna, La Mesure du Préjudice Contractuel para. 265, 272, and 282 (n. 182). 203 Pinna, La Mesure du Préjudice Contractuel para. 282, with further references (n. 182). 204 Rowan, Remedies for Breach of Contract 137–8 (n. 5).

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Chapter 4: Damages Claims for Breach of Contract Damages may be recoverable under contractual liability if there is a causal link depending on the limitation of foreseeability and the discretion of the court.205 c. Causality 4.197 According to article 1151 of the Civil Code206 the loss suffered and the gains deprived must be a direct and immediate consequence of the breach (une suite immédiate et directe de l’ inexécution de la convention) establishing that causality is a requirement sine qua non for the award of damages. The question of what is considered to be a direct and immediate consequence of the breach is solved through the foreseeability test, which is considered as a limitation for the award of damages.207 The determination of whether a loss or lost profits have been caused by the breach of contract is subject to the full appreciation of the circumstances of the case, to be determined by the trial judge. d. Fault 4.198 French contract law follows the fault principle, though such principle is not expressly mentioned in the Civil Code as a requisite for a damages claim. The requirement of fault as a prerequisite for liability for damages originates in Roman law. Under Roman law, negligence or culpa was assumed where a reasonable person would have foreseen the loss in case of breach of contract.208 4.199 Under article 1136 of the Civil Code, fault is necessary in case of the violation of

obligations of care (obligations de moyens). The standard is that of care of a good father (soumet celui qui en est chargé à y apporter tous les soins d’un bon père de famille). The debtor of an obligation of care is responsible to provide the diligence normally necessary to achieve a certain objective (d’apporter les soins et diligences normalement nécessaires pour atteindre un certain but).209 Fault is presumed in case of breach of an obligation of result (obligations de resultat). According to article 1147 of the French Civil Code: ‘A debtor shall be ordered to pay damages, if there is occasion, either by reason of the non-performance of the obligation, or by reason of delay in performing, . . . ’.210

205 V.P. Remy-Corlay, ‘Exécution et réparation, deux concepts?’ in Colloque: Exécution du contrat en nature pour par équivalent (RDC 2005) 13. 206 Ingeborg Schwenzer, Pascal Hachem, and Christopher Kee, Global Sales and Contract Law (Oxford University Press 2012) paras. 44.44, 44.141, and 44.142. 207 La Causalité dans le droit de la responsabilité civile européenne: Définition de la causalité en droit française, Seminaire du GERC, 26–27 March 2010, Genève. 208 Herbert Hausmanninger, Das Schadenersatzrecht der lex Aquilia (Manz 1996) 27–8. 209 Karl Riesenhuber, ‘Damages for Non-Performance and the Fault Principle’ (2008) 4 European Review of Contract Law 119 et seq. 210 ‘Le débiteur est condamné, s’il y a lieu, au paiement de dommages et intérêts soit à raison de l’inexécution de l’obligation, soit à raison du retard dans l’exécution, toutes les fois qu’il ne justifie pas que l’inexécution de provient d’une cause étrangère que ne peut lui être imputée, encore qu’il n’y ait aucune mauvaise foi de sa part.’

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D. France In both cases, obligations of care and of result, non-performance is excused in 4.200 the event of force majeure or contributory fault of the claimant as established in the second half of article 1147, which reads, ‘whenever he does not prove that the non-performance comes from an external cause which may not be ascribed to him, although there is no bad faith on his part’,211 and in article 1148 of the Civil Code, ‘[t]here is no occasion for any damages where a debtor was prevented from transferring or from doing that to which he was bound, or did what was forbidden to him, by reason of force majeure or a fortuitous event’.212 According to article 1150 of the Civil Code, foreseeability as a limitation to dam- 4.201 ages does not apply in case of intentional or gross negligent acts, and liability may not be limited even through liquidated damages or penalty clauses. In case of delay of payments, damages are limited to interest at the legal rate under article 1153, paragraph 1, of the Civil Code. However, in the case of bad faith, article 1153, last paragraph of the French Civil Code, allows for the claim of all damages caused by such delay.213 3. Measure of damages The measure of damages under French law is based on the principle of full compen- 4.202 sation in its broadest sense (réparation intégrale), of any losses considered a direct and immediate consequence of the breach, including cost of cure and difference in value, according to what the injured party claims.214 a. Cost of cure French law protects the specific performance, by fully compensating the 4.203 bargained-for performance even through cost of cure. In accordance with the aforementioned principle of damages in lieu of specific performance, the measure of the damage is the cost of establishing the situation without the breach, which is known as cost of cure. The Cour de cassation takes the view that the level of cost of repair is irrelevant to the assessment of damages. Therefore, it is not important whether such costs are reasonable or not.215 According to the Cour de cassation, ‘it will generally be immaterial that the cost 4.204 of the cure is high or significantly in excess of the original contract price’. In one

211 ‘ . . . toutes les fois qu’il ne justifie pas que l’inexécution provient d’une cause étrangère qui ne peut lui être imputée, encore qu’il n’y ait aucune mauvaise foi de sa part.’ 212 ‘Il n’y a lieu à aucuns dommages et intérêts lorsque, par suite d’une force majeure ou d’un cas fortuit, le débiteur a été empêché de donner ou de faire ce à quoi il était obligé, ou a fait ce qui lui était interdit.’ 213 Treitel, Remedies for Breach of Contract 147 (n. 1); ‘Le créancier auquel son débiteur en retard a causé, para sa mauvaise foi, un préjudice indépendant de ce retard, peut obtenir des dommages et intérêts distincts des intérêts moratoires de la créance.’ 214 Rowan, Remedies for Breach of Contract 117, with further references (n. 5). 215 Rowan, Remedies for Breach of Contract 118 (n. 5).

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Chapter 4: Damages Claims for Breach of Contract case, the Cour de cassation awarded the cost of demolishing and rebuilding a house, which, in breach of the contract, was constructed below the agreed height. In another case, the Cour de cassation awarded damages for a roof that was not constructed in conformity with the contract, even if the roof was adequate for its purpose.216 4.205 The aim is to avoid giving incentives to the promisor to breach the contract or to

grant the promisor the right to change the contract unilaterally. French law aims to protect the interest of the promisee through specific performance or its equivalent in money and to prevent under compensation, because otherwise, the interests of the promisee would be subordinated to those of the promisor. The focus of French law is on the loss suffered by the injured party, rather than on the costs of curing the breach, which are the consequence of breaching the contract.217 4.206 French courts have discretion upon the measure used to award damages, however,

they will have a ‘general aversion to going behind the preference of the injured promisee’. The discretion will not be towards rejecting damages on the basis of the high or unreasonable costs to cure the breach of the contract. In general, French law seeks to fully compensate the losses incurred and the gains deprived. Assessment of damages is a matter for the discretion of courts of first instance and lower appeal courts, whereas the Cour de cassation is limited to the application of the law. French courts rarely question the measures claimed by the claimant and will not refuse the cost of cure on the ground of unreasonableness or disproportionality.218 b. Diff erence in value 4.207 According to French courts, ‘[t]he function of damages is to put the promisee in the position in which he would have been had the contract been performed’219 (‘La fonction des dommages et intérêts qui consiste à remplacer la victime dans las situation qui aurait été la sienne si le contrat avait été correctement exécuté. . . . ’)220 which leads to the but-for method. Under French law, this could be achieved either through the cost of cure, which is a general measure of damages available and not considered a mere amenity, or through the difference in value. Damages measured through the difference in value are likely to be higher when using concrete valuation rather than abstract valuation. Concrete valuation is the standard under French law.221

216

Civ. (3) 5 Dec 1979, JCP 1981.II.19605; Civ (3) 6 May 1981, Juris-Data no. 1981-001783. Rowan, Remedies for Breach of Contract 119 (n. 5). 218 Yves-Marie Laithier, Étude Comparative des Sanctions de L’Inexécution du Contrat (L.G.D.J. 2007) 393 et seq. 219 Civ (3) 9 Jan 1991, Bull civ III no 12; Rowan, Remedies for Breach of Contract 109 (n. 5). 220 Pinna, La Mesure de Préjudice Contractuel para. 253 (n. 182). 221 Gerhard Wagner, Schadensersatz—Zwecke, Inhalte, Grenzen (Karlsruher Forum 2006), Egon Lorenz (Hrsg.) (VVW 2006) 39; Wolfgang Wurmnest, Grundzüge des europäischen Haftungsrechts, Max-Planck-Institut für ausländisches und internationales Privatrecht (Mohr Siebeck 2003) 271–2. 217

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D. France The wide margin of discretion of French courts and the limitation of the Cour 4.208 de cassation to legal questions, leads to global awards of damages without precise reasoning of the particular headings of damages, which makes it difficult to understand how French judicial practice actually works beyond typical situations of breach of contract.222 Under article 1184 of the Civil Code, the injured party may insist on performance 4.209 and claim damages for non-performance, or terminate the contract and claim damages.223 In the first case, the injured party has to keep performing the contract even if the other party is in breach, which would put him in disadvantage, in particular, in long-term contracts. Therefore, the courts allow for the suspension of obligations of the injured party, while being entitled to damages for the breach of contract. As regards the second case, termination requires the restitution of the mutual performances. Restitution is aimed to achieve the status quo ante and has a retroactive effect as if the contract had never existed. When this is not possible such as in the case of the construction of a plant, the equivalent in money to restitution has to be rendered. French courts have resolved this issue by allowing the injured party to suspend the performance of its obligations and to claim the equivalent in money to specific performance with the corresponding adjustments in order avoid over compensation.224 c. Loss of a chance The perte d’une chance or loss of a chance is considered damage. The extent of dam- 4.210 age depends upon the probability that the chance would have led to the desired result.225 Under French law the loss of a chance to profit is considered a recoverable loss according to the probability of its realization,226 which is to be solved according to the discretion of the court. In order to obtain damages under the heading of loss of a chance, two requirements have to be met: (a) the probability of the realization of a profit, and (b) the amount of such profit.227 4. Limitations to damages claims a. Foreseeability Article 1150 of the French Civil Code228 limits recoverable losses to losses that are 4.211 foreseeable. Only damages foreseen at the moment of the execution of the contract 222

Rowan, Remedies for Breach of Contract 117 (n. 5). Pinna, La Mesure de Préjudice Contractuel paras. 534, 537 (n. 182). 224 Pinna, La Mesure de Préjudice Contractuel paras. 322, 534 (n. 182). 225 Christian von Bar and Ulrich Drobnig, Th e Interaction of Contract Law and Tort and Property Law in Europe: A Comparative Study (European Law Publishers 2004) 84. 226 Gerald Mäsch, Chance und Schaden:  Zur Dienstleisterhaftung bei unaufklärbaren Kausalverläufen (Mohr Siebeck 2004) 162 et seq. 227 Pinna, La Mesure de Préjudice Contractuel para. 287 (n. 182). 228 ‘Le débiteur n’est tenu que des dommages et intérêts qui ont été prévus ou qu’on a pu prévoir lors du contrat, lorsque ce n’est point par son dol que l’obligation n’est point exécutée.’ 223

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Chapter 4: Damages Claims for Breach of Contract are subject to compensation. This requirement is not applicable in case of malice in accordance to article 1150 of the French Civil Code. However, even in such a case unforeseeable damages have to be a direct consequence of the breach.229 In practice, this means that the court has a wider margin of discretion of where to set the limit in case of a chain of causal events. 4.212 The foreseeability test is an abstract assessment, where the defendant is held liable

for the loss a reasonable person could have foreseen (un bon père de famille . . . a pu prèvoir). The defendant may not reduce its liability by showing that it foresaw less.230 The foreseeability requirement refers to the moment the contract was entered into.231 4.213 There has been an extensive debate about the scope of foreseeability. Originally,

the French Supreme Court required that the quantum of loss had to be foreseeable. However, this position has been modified in favour of the claimant in later jurisprudence.232 b. Contributory negligence 4.214 Under French law the injured party does not have a duty of mitigation, therefore, it is not required to minimize its loss.233 However, even if French law does not impose a duty of mitigation to the injured party, there are cases in which the courts have refused to award damages where the loss was not an inevitable consequence of the breach. In this sense, the French courts consider that there is a break in the causality and tend to penalize the injured party for its passivity in accruing damages. This is called faute de la victim and has been used to minimize the quantum in the award. In certain cases, this has been linked to foreseeability by arguing that if the injured party had taken action, the damage would have been limited. In this sense, any damages resulting from this ‘passivity’ can be claimed to be unforeseeable and therefore irrecoverable. Failure to take proper actions in order to limit the damages can also be considered as bad faith, where a claim for damages is dismissed. The reasonableness is not considered—the real concern is not to allow the injured party to increase damages for losses, which were avoidable.234 Even when mitigation is not recognized as a limitation to a damages claim, the mechanisms previously mentioned produce a similar result. 229 Muñoz López, Modern Law of Contracts and Sales in Latin America, Spain and Portugal 418 (n. 198). 230 Guenter H. Treitel, ‘Remedies for Breach of Contract (Courses of Action open to a Party Aggrieved)’ in Arthur T. von Mehren (Chief Editor), International Encyclopaedia of Comparative Law, Vol. VII, Chap. 16 (1976) 63, para. 86, with further references. 231 Franco Ferrari, ‘Comparative Ruminations on the Foreseeability of Damages in Contract Law’ (1993) 53 Louisiana Law Review 1264. 232 Civ., 7 July 1924, Sirey 1925.1, 321; Schwenzer, Hachem, and Kee, Global Sales and Contract Law 600–1 (n. 206). 233 Solène le Pautremat, ‘Mitigation of Damage: A French Perspective’ (2006) 55 ICLQ 205. 234 Rowan, Remedies for Breach of Contract 148 (n. 5).

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D. France The duty to mitigate is incompatible with French law, where the injured party has 4.215 to obtain from the court authorization for replacement. This prevents the injured party from seeking a solution in order to minimize its loss. The aim is to protect the specific interest.235 5. Other aspects affecting the damages claim a. Date of the determination of the damages Since 1942, the Cour de cassation established that the damages had to be quantified 4.216 as of the date of the judgment, which is considered in accordance with the principle of réparation intégrale. Therefore inflation and price increases or reductions between the moment of breach and the award have to be considered.236 Special rules apply for sales operations237 which are rarely relevant for damages claims for the breach of complex long-term contracts. For example, in sales operations, in the case of a concrete valuation, the date of valuation is the moment of the substitute operation. In the case of an abstract valuation the relevant date for the comparison with the market value is the date of the breach. b. Level of evidence required and burden of proof The burden of proof for the existence of damages as well as the causal link between 4.217 the damage and the non-performance of the contract is with the claimant. However, the proof of the absence of fault ( faute contractuelle) lies with the defendant. This follows from article 1315 of the Civil Code. There is a difference regarding the burden of proof between the obligation of result and the obligation of means. With respect to the former, it falls upon the claimant to prove that the result owed was not achieved. In case of an obligation of means, the claimant has to prove that the defendant has failed to employ the means to fulfil the contract.238 Art. L.411-2 II of the Code de Organisation Judiciaire limits the jurisdiction of the 4.218 Cour de cassation to legal questions. The existence and the scope of damages are considered questions of fact to be resolved by the lower instances such as the trial and the appeal courts. Due to the absence of detailed legal rules in the Civil Code and under the principle of the sovereign appreciation by the trial judge (appréciation souveraine des juges du fond ) the trial judge has a wide margin of discretion as regards the measure and quantification of the damages. In particular, the judge is not obliged to make a detailed reasoning of the different headings of damages in

235

Rowan, Remedies for Breach of Contract 151 (n. 5). Brieskorn, Vertragshaftung und responsabilité contractuelle 285–6 (n. 183), with further references; Cass. Req. 24 mars 1942, D.A. 1942. 237 Pinna, La Mesure de Préjudice Contractuel para. 294 et seq (n. 182). 238 von Bar and Drobnig, The Interaction of Contract Law and Tort and Property Law in Europe 54 (n. 225). 236

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Chapter 4: Damages Claims for Breach of Contract his judgment.239 With respect to the faculté de remplacement it is considered that there should be little court discretion as it is similar to specific performance.240 4.219 As regards lost profits, the Cour de cassation requires that such profits be proved

with sufficient certainty. However, there is divergence as regards the techniques applied to perform such proof. As a general rule, the techniques of evidence applied are those used in tax and accounting matters. In particular, in some cases a strong probability that such profits would have occurred in the absence of breach is required. In other cases, a more liberal approach was accepted with the court being satisfied with market studies prepared before the conclusion of the contract. In case of franchise contracts, it is often sufficient to present the pre-contractual market study showing the envisaged profit margin. This liberal approach prevails in commercial matters within the competence of the Commercial chamber of the Cour de cassation, where a concrete valuation is not considered necessary, but valuation is made with respect to market data (abstract valuation).241 6. Penalties and liquidated damages 4.220 There is no provision regarding the validity of liquidated damages (clause pénale)

under French law. However, such a clause is subject to the moderating power of a judge, where the stated sum is either manifestly excessive or insufficient, which is mandatory (articles 1152 and 1226 of the Civil Code).242 7. Law reform 4.221 In 2003, a group of 36 eminent lawyers commenced work on a reform of the French

law of obligations, which culminated in the presentation of the Avant-project Catala consisting of 200 articles in September 2005, a year after the 200-year anniversary of the French Civil Code.243 4.222 The Avant-project Catala has 92 articles dealing with civil liability as compared to

the five contained in the 1804 Civil Code, and aims to relate the case law applying the few articles of the Civil Code to the complexities of the modern world. The application of provisions on both extra-contractual liability and on contractual liability referred to as civil liability has been taken over in the Avant-project, without,

239

Brieskorn, Vertragshaftung und responsabilité contractuelle 234–8 (n. 183). Rowan, Remedies for Breach of Contract 116 (n. 5). 241 Pinna, La Mesure de Préjudice Contractuel para. 259, with further references (n. 182). 242 Xavier Lagarde, David Méheut, and Jean-Michel Reversac, ‘The Romanistic Tradition:  Application of Boilerplate Clauses under French Law’ in Giuditta Cordero-Moss (ed.), Boilerplate Clauses, International Commercial Contracts and the Applicable Law (Cambridge University Press 2011) 222; Larry DiMatteo, The Law of International Contracting (2nd edn.,Wolters Kluwer 2009) 77; Peter Nayler, Business Law in the Global Marketplace: The Eff ects on International Business (Elsevier Butterworth-Heinemann 2006) 133. 243 Faut-il reformer le titre III du livre III du Code Civil? (RDC 2004) 1145 et seq. 240

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D. France however, achieving a complete unification of both regimes. The Avant-project is orientated towards the victim and the harm which he has suffered, and not on the conditions for liability such as fault, harm, and a causal relationship between both. It emphasizes loss, which is defined in a wide manner. The notion of full reparation is dealt with in 34 articles on the effects of liability and the quantification of damages. According to article 1375 of the Avant-project, ‘the court must assess distinctly each of the heads of loss claimed of which it takes account’.244 This would allow the Cour de cassation to revise the proper assessment as a legal question, and would provide for more certainty as regards the application of French damages law. 8. Considerations Under French law full compensation (réparation intégrale) means damages in lieu 4.223 of specific performance. ‘The function of damages is to put the promisee in the position in which he would have been had the contract been performed.’245 The function of damages under French law is achieved through the but-for method, either through the cost of cure or through the difference in value. Under French law cost of cure is a general measure of damages available and not considered a mere amenity. This is due to the fact that French law recognizes the pacta sunt servanda principle, which aims to place the injured party in the actual (concrete) position promised in the contract. On the other hand, damages measured through the difference in value are likely to be higher under the French legal system, where the standard method applied is concrete valuation.246 Cost of cure is similar to performance interest under English law, where it is an 4.224 exceptional remedy. Another important distinction is that under French law the cost of cure is normally obtained through concrete valuation, whereas under English law the difference in value it is based on abstract market values. This is clearly shown in the example of the swimming pool, which was not built according to specification. No damages were granted under English law because of the application of abstract valuation, as the market value did not change, but under French law damages would compensate for the demolishing and rebuilding of the swimming pool according to cost of cure and concrete valuation. Though French law sets a high standard of compensation, the loss suffered or dam- 4.225 num emergens, and the gains deprived or lucrum cessans, are subject to a rather strict requirement of causality and of foreseeability. According to article 1151 of the Civil Code the loss suffered and the gains deprived must be a direct and immediate consequence of the breach (une suite immédiate et directe de l’ inexécution de la convention). As regards lost profits, French law does not distinguish them into 244 Pauline Rémy-Corlay, ‘Damages, Loss and the Quantification of Damages’ 305–310 (n. 197). 245 Civ (3) 9 Jan 1991, Bull civ III no 12; Rowan, Remedies for Breach of Contract 109 (n. 5). 246 Cass. civ. 31.3.1965, Gaz. Pal. 1965, p. 2, 76.

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Chapter 4: Damages Claims for Breach of Contract direct or indirect, what is essential is that they are foreseeable, however the Cour de cassation requires that such profits be proved with sufficient certainty. All these requirements lead to the actual loss, which is subject to compensation.

E. Mexico 4.226 The damages law in the Mexican Civil Code of 1928 follows French civil law.

Whereas classical French authors are frequently cited in Mexican legal literature and judicial precedents, the influence of French law has been replaced through the reception of US law or international legal instruments developed by institutions such as UNCITRAL. Mexican commercial law has been subject to an important and profound modernization as from 1993 as a consequence of NAFTA.247 4.227 The main source of law is judicial precedents (tesis aislada) of federal courts or the

Supreme Court of Justice of the Nation, which after four repetitions become binding jurisprudence (tesis jurisprudencial or jurisprudencia). Such judicial precedents are scarce in Mexican damages law. Both jurisprudence and doctrine hardly go beyond basic notions of damages law. 4.228 The principal features of Mexican damages law are:

(1) contractual and extra-contractual liability are not clearly distinguished and applied simultaneously; (2) there is no foreseeability requirement; (3) fault seems to be a requirement; (4) legal practice demands a rather strict burden of proof for both the damages and causality.248 1. Principles of damages claims 4.229 The fundamental principle to award damages is reparation or full compensa-

tion. Article 1915 of the Civil Code referring to illicit acts establishes that the primary remedy is reparation or the re-establishment of the situation before the act. According to article 1910 of the Federal Civil Code, ‘[a]nyone who acting illegally or against good faith causes damage to another, is obliged to repair it, . . . ’. If such

247 See, in general, Herfried Wöss, ‘Die rechtlichen Vorteile des NAFTA aus deutscher unternehmerischer Sicht’ in Roland Bomhard and Heinrich Dörner (eds.), Rechtliche Aspekte des Aussenhandels zwischen Deutschland, Mexiko und Argentinien (Nomos 1998) 101–18. 248 Herfried Wöss, ‘Arbitraje y principios para la recuperación de daños y perjuicios por la violación de contratos al largo plazo’ in Sonia Rodríguez Jiménez and Herfried Wöss (eds.), Foro de Arbitraje en Materia de Inversión, Tendencias y Novedades (Instituto de Investigaciones Jurídicas/ UNAM 2013)  67–112, accessed 8 November 2013; Primera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación LXXII, Quinta Época, tesis aislada, materia civil, registro no. 352591, 5877.

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E. Mexico reparation is not possible, full compensation consists of the payment of damages and lost profits, which have to amount to such reparation. The principle of reparation is confirmed by article 2107 of the Federal Civil Code 4.230 on contractual damages, according to which ‘[t]he responsibility mentioned in this Title, besides returning the thing or the price, or both, as applicable, shall carry repair and payment of damages’. The aforementioned principle of full compensation derives from the principle of pacta sunt servanda. Article 1796 of the Federal Civil Code establishes that ‘[f]rom the moment of their perfection, contracts are mandatory for the parties, not just for the expressly agreed upon, but also for the consequences that, according to their nature, are applicable according to good faith, usage or law’. Article 1797 of the Federal Civil Code adds the prohibition of unilateral modification of the contract by one of the parties. The principle of pacta sunt servanda has been defined in the following jurispru- 4.231 dence, which also excludes the application of the theory of hardship (imprevisión) or rebus sic stantibus as a consequence of the strict application of this principle. The text shown in capitals refers to the dicta in Mexican ‘isolated’ or jurisprudential ‘theses’ or rulings: CONTRACTS. THOSE WHICH ARE LEGALLY EXECUTED MUST BE FAITHFULLY PERFORMED, REGARDLESS OF FUTURE UN-FORSEEABLE EVENTS WHICH MAY ALTER THE PERFORMANCE OF THE OBLIGATION, IN ACCORDANCE TO THE CONDITIONS THAT RULED AT THE MOMENT OF EXECUTION. In accordance with articles 1796 and 1797 of the Civil Code for the Federal District, which perfectly complement the system of contract efficacy, they do not adopt the theory of hardship or rebus sic stantibus stemming from unforeseen events that could modify the original conditions on which the contract was executed but, in all cases, the system followed by the Civil Code referred to adopts in a generic way the thesis of pacta sunt servanda, which means that one must refer to what was agreed to by the parties, that is to say, that legally executed contracts must be faithfully performed, regardless of future unforeseeable events that could alter the performance of the obligation, in accordance with the conditions that were set at the moment of the execution, not allowing the judge to modify the conditions of contracts.249

2. Requisites for a damages claim a. Breach of contract Mexican law establishes in article 2104 of the Federal Civil Code that ‘[w]hoever 4.232 is obligated to perform an act and does not do it according to the agreement, shall be responsible for losses and gains deprived . . . ’. According to article 2028 of the Federal Civil Code, ‘[w]hoever is obligated to refrain from an act, shall be liable 249 Novena Época, Tribunales Colegiados de Circuito, Semanario Judicial de la Federación y su Gaceta, XV, Mayo de 2002, tesis I.8o.C.J/14, jurisprudencia, 951.

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Chapter 4: Damages Claims for Breach of Contract to pay damages and loss of income in case of contravention . . . ’. This refers to an obligation to do or not to do. 4.233 Article 2017 of the Federal Civil Code establishes a similar rule for the non-delivery

of a certain good if such omission is due to fault, referring to an obligation to give or to convey. Fault is defined in article 2025 of the Federal Civil Code as an act contrary to the obligation of conservation of the good or omission of the necessary acts of conservation. 4.234 As regards obligations to do, it has been argued that fault consists in any act con-

trary or performance different from such obligation. With respect to obligations not to do, from articles 2028 and 2104 of the Federal Civil Code it can be inferred that fault is presumed by the mere violation of such obligation.250 Therefore, in both obligations of to do or not to do or to convey, fault seems to be presumed through the mere fact of breach of contract, unless the breach was due to force majeure according to article 2111 of the Federal Civil Code; this risk may, however, be assigned by an express provision in the contract. Liability exists where the party in breach has provoked the force majeure event. 4.235 In synallagmatic relationships, the performing party may insist on the perfor-

mance of the party in breach or terminate the contract for breach and, in both cases, sue for damages and loss of income (article 1949 of the Federal Civil Code). Damages may be claimed for non-payment.251 Damages for delay in payment must not exceed the legal interest, which is 6 per cent for commercial transactions and 9 per cent for civil transactions, unless the parties have agreed to a higher default interest rate, as established in paragraph 2 of article 2117 of the Federal Civil Code. b. Existence and classification of losses 4.236 According to article 2108 of the Federal Civil Code, ‘damage is understood as the patrimonial loss or detriment suffered as a consequence of non-performance of an obligation’. Article 2109 of the Federal Civil Code establishes that ‘[l]oss of profit is defined as the deprivation of any legal gain that should have been obtained due to the performance of an obligation’. This follows the distinction between damnum emergens and lucrum cessans, whereby the former consists of a reduction of the claimant’s patrimony, and the latter in the lack of increase of such patrimony due to the breach.252 4.237 In case of the loss of a good, the owner has to be compensated in the full amount

of its value (article 2112 of the Federal Civil Code). The price is determined at the 250 Joaquín Martínez Alfaro, Teoría de las Obligaciones (Octava Edición, Editorial Porrúa 2001) 190. 251 Rafael Rojina Villegas, Derecho Civil Mexicano, Tomo Quinto Obligaciones, Vol. II (Octava Edición, Editorial Porrúa 2001) 301. 252 Ignacio Galindo Garfi as, Teoría de las Obligaciones (Tercera Edición, Editorial Porrúa 2011) 87–88.

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E. Mexico moment it should have been conveyed (article 2114 of the Federal Civil Code). If the good has not been totally destroyed, the damages not only consist of the difference in value, but also include the cost of reparation. c. Causality Article 2010 of the Federal Civil Code establishes that ‘[d]amages and loss of profit 4.238 must be a direct and immediate consequence of the non-performance of an obligation, whether caused or necessarily will be caused’. The reference to ‘direct and immediate consequence’ refers precisely to causality. This formula contemplates two situations, damages that have been caused and loss of profits that necessarily will be caused. In this respect, the following judicial precedent is applicable:

4.239

DAMAGE CAUSED BY THE LACK OF DELIVERY OF A  GOOD. IT IS PROVED WITH THE RETENTION. According to articles 2108 and 2109 of the Civil Code for the Federal District, regarding the existing consensus about the goods and rights that comprise patrimony, it is concluded that the proof of damages consists of the deprivation of the use of a good due to the non-performance of an obligation to deliver at the agreed time, it is obtained with the same proof of such non-performance, with no necessity of presenting further proof, in accordance with the established doctrine and foreign jurisprudence. In fact, according to such articles, damage is the patrimonial loss or detriment suffered as a consequence of non-performance of an obligation, and loss of profit is defined as the deprivation of any legal gain that should have been obtained due to the performance of an obligation; damages must be a direct and immediate consequence of the non-performance of an obligation, whether caused or necessarily will be caused. Likewise, there is consensus in the fields of litigation and judicial practice in the sense that in a person’s patrimony one can find a universal group of goods and rights derived from that property, among which there is the right to possess the acquired good, use it and receive its gains, within the legal boundaries, as the owner sees fit. In these conditions, if damages are the patrimonial loss or detriment caused by the non-performance of an obligation, and the property rights derived therefrom, are, among others, those to possess, use and receive gains of the acquired good, the logical and legal conclusion that must be arrived at through a deductive operation, consists of the consideration that if a person transmits the property of a good to another, operation through which the object of sale is incorporated in the buyer’s patrimony, and then the seller incurs default by not delivering the good, such non-performance constitutes the immediate and direct cause that the new owner cannot possess the good, and therefore, is unable to use it and receive gains from it, which undoubtedly includes a patrimonial detriment, even if temporary, as long as the unjustified non-performance prevails, which will never be restored, and therefore it is included in the legal definition of damages, and must be subject to compensation.253

253 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación y su Gaceta XXXI, Novena Época, febrero de 2010, amparo directo 236/2009, unanimidad de votos, tesis aislada 1.4o.C.226 C, materia civil, 2819, registro no. 165295.

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Chapter 4: Damages Claims for Breach of Contract 4.240 The doctrine of causality is further explained by the ancient example of the sick

cow used by the French jurist Pothier: DAMAGES AND LOSS OF PROFIT. THEY MUST BE AN IMMEDIATE AND DIRECT CAUSE OF THE FACTS IMPUTED TO THE DEFENDANT AS THE CAUSE FOR ACTION. In order to have a right to collect damages, as with loss of profits, there must be, as known, a direct and immediate cause of the accident; this because additional consequences derived from new outstanding causes, that is, the presentation of new amplifying or originating causes for damages, remove the logical connection between cause and effect, which constitutes the base of responsibility. Planiol and Rippert, referring to the reasons for damages, which are also applicable to loss of profit; with justification, explain: ‘DISTINCTIONS BETWEEN DIRECT AND INDIRECT DAMAGES. Article 1151 (of the French Civil Code), states that damages can in no case involve anything else than “what is a direct and immediate consequence of the non-performance of the contract” . . . This statement has been taken from Pothier, who offered as an example of it the case of a merchant who has knowingly sold a sickened cow; the disease has spread to the buyer’s oxen therefore preventing him from farming his land. The seller will undoubtedly have to compensate the price of the deceased oxen due to the contagion, not for the damage caused by the impossibility of farming, which only constitutes an indirect consequence of the seller’s malice; the lands, due to not being farmed, lose profit for the farmer who is not able to re-pay his creditors, who seize his possessions. . . . The debtor will not be held accountable for the indefinite chain of events that are not related to the non-performance of the obligation. . . . In the opposite case, there would be no limit to his responsibility and the debtor would have to suffer damages for which his responsibility was remote and partial. . . . From the moment in which other causes occur with the former, the causality chain is interrupted and new repercussions, from the performance, due to not being immediate but indirect and hypothetical, will not be taken into consideration in order to calculate the amount of damage and loss of profit . . . after the fault has been determined (as may be in a case where objective facts from where responsibility stems), the consequences due to the intervention in other posterior events will be removed from the compensation . . . the amplifying and worsening consequences from the culpability for new factors produced a posteriori, must be dismissed.’ (Tratado Práctico de Derecho Civil Francés, Cuban edition, volume VII, page 170 ss.). In accordance with these explanations, damages were not proven, in one case, if the extension of those seems determined by or depends on the speed with which the Judge can dispose of the return, to the claimant, of the damaged good, as well as on the speed with which a craftsman can carry out the repair, in order to take the good to the state in which it was and suitable for service; it is noted, then, that in determining the loss of profit, new causes occurring later, unrelated to the accident, remove the logical connection necessary to a cause and effect, between the accident in question and the other loss of profit.’254

254 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación 34 Sexta Parte, Séptima Época, amparo directo 532/68, 30 October 1971, registro no. 256654, 27.

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E. Mexico 3. Limitations to damages claims a. Causality The concept of causality under Mexican law has two functions. On the one hand, 4.241 it is a requisite to establish a damages claim. On the other hand, it serves to limit the scope of the damages and loss of income to be awarded. The following legal precedent expressly refers to remoteness as a ground to exclude damages. DAMAGES AND LOSS OF PROFIT, PROOF OF THE. . . . The words immediate and direct consequence used by the article mentioned, when correctly interpreted, not only mean that lawmakers wanted to exclude from the compensation those damages and loss of profit that were not derived directly and immediately from the damaging event, but that the concurrence of new causes ex nova causa, as said by Roman law scholars, was necessary for it to be produced. The generally admitted opinion holds that the new cause arises when, between the damaging or neglectful event and the claimed damages and loss of profit, a series of acts or events occur that were not necessarily originated by the former and were the cause for the patrimonial detriment. The fact that the loss of profit must be a direct and immediate consequence from the damaging event does not mean that lawmakers required the proof of loss of profit to always be direct, rigorously mathematical and concluded with absolute certainty. The loss of profit must be a consequence of the damaging event, that is to say, a correct inference must expose the relationship between cause and effect and, besides, that consequence must be immediate and direct and not indirect and remote. Nothing more is demanded from article 1466 of the Civil Code in order to have an obligation to compensate for the loss of profit.255

The federal tribunals refer to the requirement of the determining cause in case of 4.242 multiple causes: DIRECT AND IMMEDIATE CAUSE. Article 2110 of the Civil Code for the Federal District and Federal Territories, states that damages must be a direct and immediate consequence of the non-performance of an obligation. Th is precept is additionally applied in commercial law. Now, cause must be understood as efficient cause, this means, the determining factor, in order to understand that because of the non-performance, damages and loss of profit are necessarily caused. If the non-performance is solely a secondary factor subordinate to other factors, it cannot be concluded that it is the direct and immediate cause for damages and loss of profit.256

The criteria for the interruption of causality are mentioned in the following judicial 4.243 precedent: DAMAGES AND LOSS OF PROFIT. THESE MUST BE REAL, NOT HYPOTHETICAL, AND BE A  DIRECT AND IMMEDIATE

255 Primera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación LXXII, Quinta Época, tesis aislada, materia civil, registro no. 352591, 5877. 256 Tercera Sala de la Suprema Corte de la Nación, Sexta Época, informe 1958, tesis aislada, materia civil, registro no. 813305, 28.

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Chapter 4: Damages Claims for Breach of Contract CONSEQUENCE OF THE GENERATING ACT. The loss suffered and the frustrated gain must have as a direct and exclusive cause, the generating event that causes damage. Since other causes occur with the former, the chain of causality must remain uninterrupted and new repercussions, since they are not an immediate consequence, but indirect and hypothetical, must not be taken into consideration in order to calculate the amount of damages and loss of profit, since it is easy to realize that if they are not prevented, the series of consequences could be developed infinitely . . . 257

b. Contributory negligence 4.244 The liability of the party in breach is limited in case of contributory negligence of the injured party. Article 1910 of the Federal Civil Code establishes with respect to tortious liability that: Anyone who acting illegally or against good faith causes damage to another, is obliged to repair it, unless he proves that the damage was caused as a consequence of the inexcusable fault or negligence of the victim. 4.245 In this respect to the question whether only negligence of the victim may be excused

but not a higher degree of fault, the Third Chamber of the Supreme Court of the Nation established the following: CIVIL LIABILITY, FAULT OR EXCUSABLE NEGLIGENCE OF THE VICTIM, IN CASE OF. Article 2025 of the Civil Code of the Federal District establishes the concept of ‘fault’, when referring that ‘there is fault when the obliged commits acts contrary to the conservation of the good, or omits acts necessary for the same.’ However, it is not correct that such fault is always non excusable, nor that the contrary conclusion be found, . . . . It is inadmissible that the adjective ‘inexcusable’ repeated in articles 1910, 1913 and 1936 of the civil law, refers only to negligence, . . . , as there is no reason not to admit ‘fault’ as excusable . . . . The existence of fault on behalf of the victim . . . , may be excusable or not, according to the circumstances of the case in question, which has to be judged by the tribunal.258

4. Other aspects affecting the damages claim a. Date of the determination of the damages 4.246 Mexican law does not establish any reference as regards the date of the determination of damages. b. Level of evidence required and burden of proof 4.247 The standard of the burden of proof is governed by the principle actori incumbit probatio. However, the burden of proof in case of damages is stricter than in the case of loss of profit as can be deduced from the following legal precedent: 257 Tribunales Colegiados de Circuito, Semanario Judicial de la Federación 157–162, Sexta Parte, Séptima Época, tesis aislada, materia civil, registro no. 250270, 57. 258 Tribunales Colegiados de Circuito, Seminario Judicial de la Federación LXXXV, Quinta Época, tesis aislada, materia civil, 1804, registro no. 348727.

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E. Mexico DAMAGES AND LOSS OF PROFITS, PROOF OF. The evidence required in order to prove the existence of damage is radically different to that which must be met in order to prove loss of profits, so that it cannot be analysed with one and the same criterion. When dealing with proof of damage, concrete facts that have been realised in the past are present; it is about proving the extent of the patrimonial detriment caused by the damaging event, and therefore, the exact mathematical proof of that detriment is possible. When proving the loss of profit, the demonstration is not based, as with damage, on two concrete and consummated facts that will be compared in order to establish differences precisely: what was the amount of the patrimonial detriment before the damage was suffered and how was it reduced after it was suffered. When dealing with loss of profits, we are faced with future facts that were not realised (illegal gain obtained not as a consequence of acts or omissions attributed to a person). Experience and good sense teaches us that in most cases loss of profit is not subject to demonstration with direct and rigorous evidence that may produce absolute certainty of its existence; and in the most number of cases we must accept relative certainty. It is true that an abstract appreciation of the existence of loss of profit is not enough, a concrete proof on the facts that, according to all probability demonstrates the reality of the gain that has been lost is required; but, if article 1466 of the Civil Code of the Federal District of 1884 orders that the loss of profit must be a direct and immediate consequence of the damaging event, with an absolute demonstration that no other event would have occurred in order to prevent the securing of a legal profit that is claimed, then a claim for the payment of loss of profit would almost never prevail and lawmakers who, on the one hand granted the right to claim payment of that loss of profit, and on the other ignored that right, subordinating it to an almost impossible demonstration, would have to be accused of inconsequence . . . . Without doubt, desires for a profit must be excluded from the real concept of loss of profit; the simple possibility and probability of obtaining a profit is not enough for loss of profit to appear; but it is also not possible to get to the opposite position, demanding that, in order for the loss of profit to be compensated, it is demonstrated in a direct and exact way that only the damaging event, excluding any other event, could have prevented the obtaining of a legal profit. Commentators, when explaining the German Civil Code dispositions on this matter, state that the absolute certainty of future profit cannot be demanded, and that only the objective possibility of profit in the normal course of events and special circumstances of the specific case is enough. (Emphasis added) 259

This is confirmed by the following legal precedent:

4.248

LOSS OF PROFIT. The Civil Code of the District, in force in Coahuila, defines loss of profits as the reduction of any legal profit that should have been obtained by the performance of an obligation, and demands that such detriment is an immediate and direct consequence of the non-performance. The essential element, therefore, in order to justify the claim for loss of profits, is that the cause and effect relationship existing between the non-performance and the loss of profit is proven, without there being other circumstances between the cause and effect; however, not even the most rigid legal systems require, in order to have the claim justified,

259 Primera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación LXXII, Quinta Época, tesis aislada, materia civil, registro no. 352591, 5877.

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Chapter 4: Damages Claims for Breach of Contract that there is absolute security that a profit would have been obtained, since the prejudicial element has occurred. The only thing that is demanded by law, is the proof that the profit would have been obtained in normal circumstances; in such a way that, if in a lease contract, a fi xed rent is agreed upon, it must be considered in order to determine the loss of profit.260 4.249 Judicial opinion and Mexican doctrine deal with the subject of damages and loss of

income assessment still in an incipient way. The quantification has been mentioned in the following thesis, leaving responsibility solely to experts’ judgment: DAMAGES AND LOSS OF INCOME. THE NOTION DEALT WITH IN ARTICLE 129 OF THE LEY DE AMPARO. EXPERT OPINION AS A PROOF IS IDEAL IN ORDER TO CALCULATE THE ECONOMIC AMOUNT THAT HAS BEEN LOST BY THE CLAIMANT (THIRD PARTY), BY PROLONGING THE SUSPENSION OF THE CLAIMED ACT SINCE THERE IS NO POSSESSION OF THE DISPUTED REAL ESTATE. It is indisputable that, during the time lapse by which the suspension was prolonged, the claimant (third party) was prevented from requiring execution from the responsible authority, by which it follows that the injunction prevented him from possessing the real estate in controversy, in order to, in fact, use it for his own benefit by leasing it, selling it, etc. Now, such a circumstance exposes the cause-effect relationship between the standstill and the damage and loss of income that the claimant has claimed; in fact, the direct and immediate consequence of the failure to clear the house can be measured through an estimation of the economic value determined with the contribution of experts in real estate on the price that the property would have reached if it had been leased, by attending to its specific qualities, location and other specifications; therefore, the legal profit that was not achieved is translated in the economic interest so that the possession of the property is reflected in the obtaining of earnings for its use, being this the loss or detriment caused due to the inability to dispose of it during the time that the act of authority was suspended. Then, the extreme of demanding a direct proof of the acceptance of a legal business cannot be reached since it is enough to provide proof in the form of an expert opinion which states that income was lost due to the fact the third party could not dispose of the property as a cause of the suspension; in this way, the economic loss can be proved.261

5. Penalties and liquidated damages 4.250 Under Mexican law, penalties ( pena convencional ) may be established as liquidated

damages. According to jurisprudence such liquidated damages may not exceed the value of the principal obligation under the contract.262 It is not important what

260 Tercera Sala de la Suprema Corte de la Nación, Semanario Judicial de la Federación XXXII, tesis aislada, materia común, registro no. 363686, 1222. 261 Novena Época, Semanario Judicial de la Federación y su Gaceta XXX, tesis aislada IV.1o.C.97 C, materia civil, julio de 2009, registro no. 166980, 1909. 262 Octava Época, Seminario Judicial de la Federación 85, tesis jurisprudencial I.4o.C.J/61, materia civil, enero de 1995, registro no. 209385, 61.

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F. Germany name is given to such liquidated damages.263 It is also not necessary that an actual harm occurred but only that a breach took place (Article 1842 Civil Code). 6. Considerations Mexican damages law is based on French law and the principle of full reparation. 4.251 It aims to re-establish the situation before the damaging act or the payment of the loss suffered and the gains deprived. The concepts of damnum emergens and lucrum cessans are also applied under Mexican law. Causality is both a requisite and a limit, which combined with a heavy burden of proof might affect a damages claim. Contributory negligence is also relevant. There is little jurisprudence and scarce legal scholarship and doctrine as regards Mexican damages law.

F. Germany Germany has recently reformed its law of obligations. Whereas law reforms are 4.252 currently being discussed throughout Europe, Germany is the first country actually having undertaken one. The following paragraphs will provide an overview of this reform and the new law on damages. 1. Law reform The German law of obligations was reformed as of 1 January 2002.264 This reform 4.253 was the most comprehensive modification of the German law of obligations and of the German Civil Code (Bürgerliches Gesetzbuch or BGB) since its entry into force on 1 January 1900.265 The reform efforts initially started in 1978 with expert reports published in 1981 and 1983.266 A commission established in charge of the reform of the law of obligations presented its final report in 1992.267 Directive 99/44/EC of the European Parliament and of the Council of 25 May 1999 4.254 on certain aspects of the sale of consumer goods and associated guarantees268 triggered discussions in Germany about the effects of the incorporation of the directive into the German Civil Code. In particular, this led to discussions whether to pursue a solution limited to the changes required by the directive, or to achieve a comprehensive solution in the form of a modernization of the German law of obligations in order to 263 Octava Época, Seminario Judicial de la Federación 79, tesis jurisprudencial I.4o.C.J/60, materias penal y civil, julio de 1994, registro no. 210939, 35. 264 Gesetz zur Modernisierung des Schuldrechts vom 26. November 2001, BGBl I 2001 I, 3138. 265 Otto Palandt and Helmut Heinrichs, Bürgerliches Geseztbuch (C.H. Beck) para. 10 before §1. 266 Gutachten und Vorschläge zur Überarbeitung des Schuldrechts (Bundesministerium der Justiz, Bundesanzeiger, Köln 1981, 1983). 267 Abschlußbericht der Kommission zur Überarbeitung des Schuldrechts (Bundesministerium für Justiz 1992). 268 (1999) OJ L 171/12.

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Chapter 4: Damages Claims for Breach of Contract maintain its unity and consistency. The decision was made in favour of a full-fledged reform of the law of obligations of the German Civil Code. The goal of the reform was not only to improve the law, but also to ‘strengthen German law on an international scale’.269 4.255 The reformed German Civil Code incorporates the legal rules and definitions devel-

oped by the judiciary with respect to damages law and other aspects of German civil law. One of the fundamental changes to the law is the introduction of the concept of the violation of a duty as the universal prerequisite of a damages claim as now established in §280 (1) BGB.270 The new German law of obligations reflects the models of CISG and of the Principles of European Contract Law (PECL).271 It also led to an overhaul of the law of sales and works contracts making the general part of the law of obligations compatible with the regulation in those special types of contracts. Damages are now available in any kind of deviation from an obligation, regardless of whether they are classified as nonperformance, late performance, or malperformance, and independent from any impossibility or unwillingness of the defendant to perform.272 2. Principles for damages claims a. Pacta sunt servanda 4.256 The new German law of obligations has strengthened the principle of pacta sunt servanda by protecting specific performance. German law is very rigid with regards to the right to performance and sets incentives for performance. The creditor may insist and even enforce its right to specific performance, except for personal services.273 Under German law specific performance is the rule. §241 (1) BGB (Duties arising from an obligation) establishes that:274 By virtue of an obligation an obligee is entitled to claim performance from the obligor. The performance may also consist in forebearance. 4.257 According to §275 (1) BGB (Exclusion of the duty of performance), performance

is excluded, as far as such performance is impossible. This includes all kinds of impossibilities under German law such as objective, subjective, initial, subsequent, 269 Andreas Heldrich and Gebhard M.  Rehm, ‘Modernisation of the German Law of Obligations: Harmonisation of Civil Law and Common Law in the Recent Reform of the German Civil Code’ in Cohen and McKendrick (eds.), Comparative Remedies for Breach of Contract 123–4, 132 (n. 7). 270 Heldrich and Rehm, ‘Modernisation of the German Law of Obligations’ 128–30 (n. 269). 271 Gutachten und Verhandlungen des 60. Juristentages (C.B. Beck 1994). 272 Peter Schlechtriem, ‘The German Act to Modernize the Law of Obligations in the Context of Common Principles and Structures of the Law of Obligations in Europe’ (2002) Oxford University Comparative Law Forum 2, accessed 25 September 2013. 273 Dagmar Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ in Cohen and McKendrick, Comparative Remedies for Breach of Contract 136–9 (n. 7). 274 German Civil Code BGB [website], accessed 25 September 2013. All extracts from the BGB in this book are taken from this website.

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F. Germany partial, and total impossibility. The debtor may refuse performance in case of an obstacle leading to impossibility, according to §275 (2) BGB: The obligor may refuse performance to the extent that performance requires expense and effort which, taking into account the subject matter of the obligation and the requirements of good faith, is grossly disproportionate to the interest in performance of the obligee. When it is determined what efforts may reasonably be required of the obligor, it must also be taken into account whether he is responsible for the obstacle to performance.

Performance may also be refused in case of a personal obligation (§275 (3) BGB). 4.258 Refusal of performance in the cases mentioned earlier gives rise to a secondary obligation to pay damages.275 b. Principle of total reparation and full compensation German damages law contained in §§249 to 255 BGB is based on the principle of 4.259 total reparation leading to the situation, which would have existed if the damaging event had not occurred (§249 BGB). German law requires that the situation which would have existed had the damage not occurred must be established. This applies to monetary and non-monetary losses.276 As a first rule, as reflected in §251 (1) BGB, the remedy for damages in case of non-performance is for restoration in natura in the form of reparation. If restoration in natura is not possible, then compensation in money has to be made.277 c. Unitary approach to non-performance Another new principle of German damages law is the unitary approach to 4.260 non-performance, according to which any contractual non-performance triggers liability. This includes liabilities that were formerly treated separately, such as for defects, non-performance, impossibility, delay, or violation of incidental duties.278 d. Scope of protection of the norm According to the doctrine of the scope of protection of the norm (Schutzzweck der 4.261 Norm, Normzweck), the loss has to be within the scope of protection of the contractual obligation breached. This excludes damages which were not contemplated by the parties in the contract. What counts is whether the affected interest is protected by the contractual duties.279 The contents and the purpose of the contractual norm

275 Reinhard Zimmermann, ‘Remedies for Non-Performance:  The Revised German law of Obligations, Viewed Against the Background of the Principles of European Contract Law’ (2002) 6 Edinburgh Law Review 286. 276 Brieskorn, Vertragshaftung und responsabilité contractuelle 257–8 (n. 183). 277 Wolfgang Fikentscher and Andreas Heinemann, Schuldrecht, Zehnte Aufl age (De Gruyter 2006) paras. 670–7. 278 Heldrich and Rehm, ‘Modernisation of the German Law of Obligations’ 129–30 (n 269). 279 Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 152, with further references (n. 273).

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Chapter 4: Damages Claims for Breach of Contract determine which losses are subject to compensation.280 The harm suffered must be within the protective purpose of the rule violated.281 4.262 German law uses such doctrine for the interpretation of a contract and of the duties

of the parties, in particular, the parties’ obligations of information and protection. It also helps to determine whether a particular interest is protected by the contract. This leads to a determination of the rights and legally protected interests (Rechtsgut) of the claimant affected by the breach of the contract.282 This is particularly relevant for risk allocation in complex long-term contracts and shows the interconnection between contract design and damages claims as already discussed in chapter 3. 3. Requisites of a damages claim 4.263 In general, to make a damages claim under German law, the first step is to comply

with the applicable normative elements (Tatbestand ). Such normative elements in case of breach of contract are: (1) the objective elements in form of the (a) violation of an obligation, (b) loss, and (c) causality; and (2) the subjective element in the form of fault. In case of contracts, both the violation of an obligation and the illegality of the action or omission are represented by the breach of contract.283 a. Breach of contract 4.264 German law does not speak of a breach of contract but of a violation of an obligation because its rules refer to both contractual and statutory obligations. This means that the same set of rules applies to contractual and extra-contractual damages. Apart from that, the provisions on damages apply to both the breach of a promise and the breach of a contract.284 4.265 §241 BGB (Duties arising from an obligation) states that:

(1) By virtue of an obligation an obligee is entitled to claim performance from the obligor. The performance may also consist in forbearance. (2) An obligation may also, depending on its contents, oblige each party to take account of the rights, legal interests and other interests of the other party. 4.266 Under the reformed Civil Code, it is irrelevant whether performance has become

impossible, the goods have a legal or factual defect or whether the non-performing party has violated only an incidental duty of information or care. In any case, the non-performing party is liable for damages according to the aforementioned

280

Fikentscher and Heinemann, Schuldrecht para. 592 (n. 277). Ernst Rabel, Das Recht des Warenkaufs (De Gruyter 1936) 495 et seq. 282 Brieskorn, Vertragshaftung und responsabilité contractuelle 398–401, with further references (n. 183). 283 Fikentscher und Heinemann, Schuldrecht paras. 576–8 (n. 277). 284 Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 136 (n. 273). 281

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F. Germany unitary approach. The obligee is not liable for impossibility if the obligee proves that the impossibility was not the obligee’s responsibility.285 Despite the unitary concept of violations, the legal rules on damages differ depend- 4.267 ing on the kind of non-performance and the kind of damage that occurred, which will be outlined in the following paragraphs. b. Existence and classification of losses German law does not define the concept of loss. The law provides certain guide- 4.268 lines and references such as in §249 BGB regarding the calculation of damages, §251 BGB as regards lost profits and §253 BGB referring to non-monetary damages. According to §249 (1) BGB (Nature and extent of damages): A person who is liable in damages must restore the position that would exist if the circumstance obliging him to pay damages had not occurred.

In the case of a contract, loss may occur through defective performance or in the 4.269 form of expenses incurred when relying on a contract that was not entered into. When a contract is breached, the loss consists in the lack of the promised performance and any consequential damages (Folgeschäden), which is referred to as expectation interest. In case of the reliance on a contract, which did not take place, the loss consists of the futile expenses made in reliance thereof.286 This refers to the reliance interest under German law, which relates to culpa in contrahendo or pre-contractual liability and, therefore, is different from the reliance interest under US and UK law. In both cases, lost profits may be claimed under §252 BGB, according to which:

4.270

The damage to be compensated for also comprises the lost profits. Those profits are considered lost that in the normal course of events or in the special circumstances, particularly due to the measures and precautions taken, could probably be expected.

The reference to the ordinary course of events is similar to the foreseeability require- 4.271 ment under French and Anglo-American law. The courts also apply the standard of expectation in the ordinary course of events when exercising their discretion to determine the amount of damages.287 Damages also include non-monetary losses under §253 BGB (Intangible Damage) 4.272 such as expenditures involved for the enjoyment of goods owed under a contract.288 Furthermore, when specific performance or restoration is not possible or an 4.273 additional period has lapsed without performance, the injured party may claim 285 286 287 288

Zimmermann, ‘Remedies for Non-Performance’ 289 (n. 275). Fikentscher and Heinemann, Schuldrecht paras. 608, 617 (n. 277). Fikentscher and Heinemann, Schuldrecht para. 687 (n. 277). Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 153 (n. 273).

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Chapter 4: Damages Claims for Breach of Contract compensation, or the respondent may choose, under certain circumstances, to pay damages instead of restoration.289 4.274 i. Categories of damages

Under §280 BGB, three categories of damages for breach of duty may be claimed: (a) damages caused by a breach of a duty; (b) damages for delay in performance, subject to a warning notice, and (c) damages in lieu of performance, which are subject to the additional requirements of §§281, 282 or 283 BGB. §280 BGB (Damages for breach of duty) reads: (1) If the obligor breaches a duty arising from the obligation, the obligee may demand damages for the damage caused thereby. This does not apply if the obligor is not responsible for the breach of duty. (2) Damages for delay in performance may be demanded by the obligee only subject to the additional requirement of §286. (3) Damages in lieu of performance may be demanded by the obligee only subject to the additional requirements of §281, 282 or 283.

4.275 (1) Damages caused by a breach of a duty or simple damages are intended to cover

consequential loss; that is, damage suffered by the creditor as a result of the breach of contract, with respect to obligations of protection (Schutzpflichten) that refer to the proper execution of performance.290 4.276 (2) Damages for delay are without prejudice to the debtor’s duty to perform.

Such damages cover the loss caused by the debtor’s delay and include loss of gains or expenses incurred by the injured party due to the breach of the contract. The creditor must have requested performance from the debtor (Mahnung ; §286 BGB). While the delay continues the debtor is responsible for every degree of negligence, and the debtor is also responsible if performance now becomes impossible.291 4.277 If delay is related to payment of a sum of money, the creditor is entitled to interest

on that sum, which is specified as 8 per cent above the base rate of interest for legal transactions not involving a consumer (§288 (1) BGB). 4.278 (3) Damages in lieu of performance refer to §§281, 282 and 283 BGB. 4.279 §281 BGB (Damages in lieu of performance for non-performance or failure to

render performance as owed) reads: (1) To the extent that the obligor does not render performance when it is due or does not render performance as owed, the obligee may, subject to the requirements of section 280 (1), demand damages in lieu of performance, if has

289 290 291

Fikentscher and Heinemann, Schuldrecht paras. 668–77 (n. 277). Claus-Wilhelm Canaris, Schuldrechtsmodernisierung 2002 (C.H. Beck 2002) 671–2, 834. Zimmermann, ‘Remedies for Non-Performance’ 292–4, with further references (n. 275).

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F. Germany

(2)

(3) (4) (5)

without result set a reasonable period for the obligor for performance or cure. If the obligor has performed only in part, the obligee may demand damages in lieu of performance only if he has no interest in the part performance. If the obligor has not rendered performance as owed, the obligee may not demand damage in lieu of performance if the breach of duty is immaterial. Setting a period for performance may be dispensed with if the obligor seriously and definitely refuses performance or if there are special circumstances which, after the interests of both parties are weighed, justify the immediate assertion of a claim for damages. If the nature of the breach of duty is such that setting a period of time is out of the question, a warning notice is given instead. The claim for performance is excluded as soon as the obligee has demanded damages in lieu of performance. If the obligee demands damages in lieu of complete performance, the obligor is entitled to claim the return of his performance under sections 346 and 348.

The first paragraph of §281 BGB refers to non-performance and defective per- 4.280 formance. In order to claim damages instead of specific performance, the creditor has to grant an additional period for performance by the debtor. If there is non-performance during the additional period, the creditor may finally claim damages. The injured party may also ask for compensation in case of partial performance, if completing the outstanding performance is not in that party’s interest. Th is does not apply if the outstanding performance is not relevant. The requirement to grant an additional period of time does not apply in the case of refusal by the debtor to perform, or when special circumstances occur that justify immediate compensation. In case of wilful breach of contract, it is sufficient for the injured party to present a warning to the debtor, without the need to grant an additional period for performance, in order to claim damages. If creditor demands compensation, the creditor can no longer request performance. §§346 to 348 BGB refer to consumer contracts and are not relevant in this context. §282 BGB (Damages in lieu of performance for breach of a duty under §241 (2)) 4.281 establishes: If the obligor breaches a duty under section 241 (2), the obligee may, if the requirements of section 280 (1) are satisfied, demand damages in lieu of performance, if he cannot longer reasonably be expected to accept performance by the obligor.

§241 (2) BGB (Duties arising from an obligation) refers to the infringement of 4.282 ancillary duties, which do not affect the performance as such. Ancillary duties refer to obligations of protection of the legal interest of the claimant, which used to be called as ‘positive Vertragsverletzung ’ or positive malperformance, such as losses caused by breach of other obligations than the principal obligation of performance. This would be the case when the performance is rendered under circumstances

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Chapter 4: Damages Claims for Breach of Contract that the creditor does not tolerate, such as a painter properly painting a house but damaging a door.292 4.283 In case of impossibility of performance, the defendant has the right to pay damages

instead of restoration, under §251 BGB (Damages in money without the specification of a period of time): (1) To the extent that restoration is not possible or is not sufficient to compensate the obligee, the person liable in damages must compensate the obligee in money. (2) The person liable in damages may compensate the obligee in money if restoration is only possible with disproportionate expense . . . . 4.284 According to this provision, the creditor may claim its positive interest in all cases

of impossibility to perform. The debtor may opt for the payment of damages if restoration is too cumbersome. If the debtor proves that it was not responsible for the impossibility to perform, it is not responsible for damages.293 4.285 §283 BGB (Damages in lieu of performance where the duty of performance is

excluded) reads: If under section 275 (1) to (3), the obligor is not obliged to perform, the obligee may, if the requirements of §280 (1) are satisfied, demand damages in lieu of performance. Section 281 (1), sentences 2 and 4, and (5)  apply with the necessary modifications. 4.286 The principal function of §§280 to 283 appears to be to safeguard the princi-

ple of specific performance and systemic aspects of German law, while allowing for damages claims under a rather complicated mechanism. In particular, the qualification of damages claims under the different legal foundations is difficult, which not only affects the law of damages but also the law on sales and works contracts.294 4.287 ii. Loss of a chance

German law does not recognize the right of damages for the loss of a chance of profits. This is not considered as a loss (Vermögensnachteil ).295

c. Causation 4.288 Haftungsbegründende und haftungsausfüllende Kausalität. According to doctrine, causation is a requirement for the admissibility of a damages claim (haftungsbegründende Kausalität) and also for its extent (haftungsausfüllende Kausalität). Th is means that the defendant is liable for any effect of the breach of contract under the following formula: Any consequence that would not have occurred in the absence of breach is considered to be a causal effect of the breach (conditio sine

292 293 294 295

Zimmermann, ‘Remedies for Non-Performance’ 291–2 (n. 275). Zimmermann, ‘Remedies for Non-Performance’ 289 (n. 275). Fikentscher and Heinemann, Schuldrecht para. 485 (n. 277). Fikentscher and Heinemann, Schuldrecht para. 631 (n. 277).

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F. Germany qua non, Äquivalenztheorie).296 The relationship between the breach of contract (cause) and the effect is a factual matter determined under the rules of natural sciences.297 The application of the conditio sine qua non formula leads to a wide scope of effects, 4.289 however, not all effects that would not have occurred in the absence of breach give rise to damages. In particular, any effects not covered by the protective effect of the norm do not allow for damages. d. Fault Damages will only be awarded if the violation of a duty is imputable on the debtor. 4.290 According to §276 BGB (Responsibility of the obligor): (1) The obligor is responsible for intention and negligence, if a higher or lower degree of liability is neither laid down nor to be inferred from the other subject matter of the obligation, including but not limited to the giving of a guarantee or the assumption of a procurement risk. The provisions of sections 827 and 828 apply with the necessary modifications. (2) A person acts negligently if he fails to exercise reasonable care. (3) The obligor may not be released in advance from liability for intention.

The loss has to be caused negligently or wilfully. According to §280 (2)  BGB 4.291 (Damages for breach of duty), a damages claim does not proceed if the debtor is not responsible for the breach of duty. However, fault is presumed and the debtor has to prove that the failure or defect in performance was not imputable to the debtor. The degree of fault is irrelevant and even slight negligence is sufficient in order to award the totality of damages according to the principle of all or nothing. The requirement of fault is limited to the breach but not with respect to its consequences and their reach.298 German law also recognizes liability without fault in case of a guarantee or the 4.292 assumption of procurement risk under §276 (1) BGB (Responsibility of the obligor), default under §287 BGB (Liability during default), warranty and even force majeure if the respondent has accepted such risk.299 This refers to risk allocation as is widely used in complex long-term contracts. 4. Measure of damages Another principle developed under German law is the measure of damages in 4.293 form of the so-called interest. Such word originally derives from the Roman law

296

Fikentscher and Heinemann, Schuldrecht paras. 589–93 (n. 277). Herrmann Lange and Gottfried Schiemann, Schadensersatz, Handbuch des Schuldrechts. 3. Auflage (Mohr Siebeck 2003) 79. 298 Fikentscher and Heinemann, Schuldrecht para. 1704 (n. 277). 299 Fikentscher and Heinemann, Schuldrecht paras. 472, 654 (n. 277). 297

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Chapter 4: Damages Claims for Breach of Contract formula ‘id quod interest ’, which means ‘that what I have lost and what I would have gained’.300 If a defendant was to be condemned in id quod or quanti actoris interest, the judge had to estimate claimant’s losses and the material situation which would have resulted if the fact for which the defendant was liable had not occurred.301 4.294 The modern version of such interest was developed by Friedrich Theodor Mommsen

in 1855 and is known as the differential hypothesis or but-for method, which is the numerical difference between the patrimony of the claimant with and without the damaging event.302 The reference by Mommsen to interest is the expectation interest. The differential hypothesis or but-for premise is the modern framework to determine loss, damages, causality, and quantum in international commercial and investment arbitrations with respect to complex long-term contracts, as it serves as a roadmap in order to determine the economic difference between the hypothetical and actual course of events during a certain passage of time. This will be further explained in chapter 5. 4.295 Rudolph von Jhering (1818–1892) further developed the term interest to the mod-

ern meanings of expectation interest (positive interest) and reliance interest (negative interest), whereby the term interest refers not only to monetary aspects but also to the social values protected by a legal order.303 This means that the measure of damages is the protected interest under the different rules of law, which may or may not include the protection of the equivalent to the specific performance. The interest protected together with any applicable requirement and limitation results in the ‘actual loss’ to be compensated. The interest protected is a consequence of the legal policy and social values underlying the applicable rules of law. 4.296 According to §249 (1) BGB the protected interest is to place the injured party in

the situation it would have been in the absence of breach. §281 BGB establishes that the value of the promised performance is the amount of money equivalent to achieve the promised performance. This derives from the so-called guarantee function (Garantiefunktion) of the contractual liability, which guarantees the specific performance of the contract.304 This leads to the expectation or performance interest as the primary measure of damages, when restoration in natura is not possible. 300

D.46.8.13 pr. Adolf Berger, Encyclopaedic Dictionary of Roman Law (The American Philosophical Society 1953) 491. 302 Friedrich Mommsen, Beiträge zum Obligationenrecht, Zweite Abtheilung:  Zur Lehre von dem Interesse (E.U. Schwetschke und Sohn 1855) 3: ‘Unter dem Interesse in seiner technischen Bedeutung verstehen wir nämlich die Differenz zwischen dem Betrage des Vermögens einer Person, wie derselbe in einem gegebenen Zeitpunkte ist, und dem Betrage, welchen dieses Vermögen ohne die Dazwischenkunft eines bestimmten beschädigenden Ereignisses in dem zur Frage stehenden Zeitpunkte haben würde.’ 303 Rudolf von Jhering, Culpa in contrahendo oder Schadensersatz bei nichtigen oder nicht zur Perfektion gelangten Verträgen, Jahrbücher für die Dogmatik des heutigen römischem und deutschen Privatrechts IV (1861) 1 et seq.; Christian Schieder, Interesse und Sachwert, Zur Konkurrenz zweier Grundbegriff e des Römischen Rechts (Wallstein Verlag 2011) 45–53, with further references. 304 Brieskorn, Vertragshaftung und responsabilité contractuelle 287–8, with further references (n. 183). 301

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F. Germany a. Expectation or performance interest i. Definition of expectation or performance interest The expectation interest 4.297 under German law corresponds to the value of performance (in lieu of performance). Under German law, the expectation interest is the extent of compensation based on a comparison between two situations as established in §249 (1) BGB, that is the actual course of events caused by the breach as compared with the hypothetical normal course of events (hypothetischer Normalverlauf ) that would have existed in the absence of breach. The hypothetical course of events only refers to the normal course of events, which excludes extraordinary events, which may increase or reduce the damages.305 The German imperial court (Reichsgericht) established that events subsequent 4.298 to the occurrence of the loss (überholende Kausalität), which would also have caused the loss (reserve cause or Reserveursache), should be ignored.306 This is in line with the hypothetical normal course of events used to calculate the expectation interest under these rules of law. Extraordinary events such as force majeure, which would have affected the hypothetical course of events, will not be taken into consideration.307 The differential hypothesis under German law in its modern form includes the compensation of the whole interest including non-monetary interest.308 As explained in chapter 5, this is a deviation of Mommsen’s differential hypothesis, which takes into account any subsequent events until the end of the contract or the project that might affect the hypothetical course of events. Compensation for the expectation or performance interest is for the (a) injury 4.299 (Verletzungsschaden) caused by the breach of contract, which is the value of the performance that the claimant did not receive or value of the promised performance, and (b) its consequences (Folgeschäden), which may, for example consist in additional costs and losses through a substitute sales transaction, losses caused by lack of use of a good not delivered, or business interruption losses caused by a defective machine. Lost profits are a particular consequence of breach of contact.309 ii. Value of the promised performance The extent of damages depends on 4.300 whether the value of performance is being determined from the perspective of the injured party (concrete or subjective valuation) or from a third party perspective (abstract or objective valuation). From an objective point of view, performance may have a market value.310

305

Fikentscher and Heinemann, Schuldrecht para. 669 (n. 277). RGZ 141 (1933) 365; 169 (1951), 117; BGHZ 78, 209. 307 Fikentscher and Heinemann, Schuldrecht para. 701 (n. 277). 308 Peter Schlechtriem and Martin Schmidt-Kessel, Schuldrecht, Allgemeiner Teil, 6. Aufl age (Mohr Siebeck 2005) 141. 309 Fikentscher and Heinemann, Schuldrecht paras. 683–4 (n. 277). 310 Christian Huber, Fragen der Schadensberechnung (Springer-Verlag 1993) 169 et seq. 306

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Chapter 4: Damages Claims for Breach of Contract 4.301 Such market value may, however, be different from the concrete value of the dam-

ages due to the effect of the breach of contract on the injured party’s situation. In the concrete valuation, the particular circumstances of the injured party are being taken into consideration. This is relevant in case of non-monetary damages.311 The concrete valuation of damages is the preferred form to calculate damages under §249 (1) BGB. This valuation method may lead to a higher amount of damages than under abstract valuation. 4.302 iii. Consequential damages and lost profits

The injured party may claim consequential damages in the form of loss of profits under §252 BGB: The damage to be compensated for, also comprises the lost profits. Those profits are considered lost when in the normal course of events or in the special circumstances, particularly due to the measures and precautions taken, could probably be expected.

4.303 In this respect it is noteworthy that proof of probability of loss in the normal course

of events is sufficient to establish a damages claim for loss of profits. The defendant would have to prove that no profits would have occurred in a particular case.312 The calculation of damages under the ordinary course of events refers to the so-called abstract calculation of damages using market values. The ordinary course of events refers to typical average profits.313 4.304 However, the injured party may opt for a concrete calculation of damages in a

particular case under the special circumstances referred to in §252 BGB, such as the resale of goods at a certain price and loss of the profits in such transaction. Special circumstances such an increase of sales may be proved through actual measures preparing for such sales or other circumstances evidencing the probability of these profits. Loss of profits under the concrete calculation of damages would be the actual difference between the purchase and the sales price of a good.314 4.305 The expectation interest under sales contracts may be claimed in different

forms: The injured party may obtain substitute performance from a third party at a higher price, or cure the defect himself, such as the repair of the defect of works by the owner under §536a BGB. In case of non-delivery of goods under a sales contract, the buyer will have to purchase the goods somewhere else and claim the difference in prices. If the buyer does not purchase the goods, it could claim the difference of the agreed price to the market price or even the cost of production or

311 Brieskorn, Vertragshaftung und responsabilité contractuelle 325–6, with further references (n. 183). 312 BGHZ 29, 393. 313 Fikentscher and Heinemann, Schuldrecht paras. 669, 700–1 (n. 277). 314 Lange and Schiemann, Schadensersatz 79, 353–4 (n. 297).

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F. Germany procurement of such goods. This includes the cost of cure, reparation, and the difference in value of damaged goods or works even after reparation. 315 In case of refusal to perform, the injured party may or may not terminate a contract. 4.306 As regards the obligations pending of the injured party, these may be suspended due to the non-performance of the defendant according to §§320–322 BGB.316 Termination of the contract is compatible with all kinds of damages. However and normally, the claimant is likely to obtain a higher amount of damages by claiming damages in lieu of performance.317 Termination of contract in case of non-performance or non-conforming perfor- 4.307 mance according to §323 BGB proceeds: (1) If in the case of a reciprocal contract, the obligor does not render an act of performance which is due, or does not render it in conformity with the contract, then the obligee may revoke the contract, if he has specified, without result, an additional period for performance or cure. (2) The specification of a period of time can be dispensed with, if 1. the obligor seriously and definitively refuses performance, 2. the obligor does not render performance by a date specified in the contract or within a specific period and the obligee, in the contract, has made the continuation of his interest in performance subject to performance rendered in good time, or 3. there are special circumstances which, when the interest of both parties are weighed, justify immediate revocation. (3) If the nature of the breach of duty is such that setting a period of time is out of the question, a warning notice is given instead. (4) The obligee may revoke the contract before performance is due if it is obvious that the requirements for revocation will be met. (5) If the obligor has performed in part, the obligee may revoke the whole contract only if he has no interest in part performance. If the obligor has not performed in conformity with the contract, the obligee may not revoke the contract if the breach of duty is trivial. (6) Revocation is excluded if the obligee is solely or very predominantly responsible for the circumstance that would entitle him to revoke the contract or if the circumstance for which the obligor is not responsible occurs at a time when the obligee is in default of acceptance.

In synallagmatic contracts, the expectation interest may be claimed for complete 4.308 non-performance returning the goods already received ( grosser Schadensersatz, full damages), or in form of the difference between expected and defective performance (kleiner Schadensersatz, differential damages).318

315

Brieskorn, Vertragshaftung und responsabilité contractuelle 331–2 (n. 183). Fikentscher and Heinemann, Schuldrecht paras. 523–4 (n. 277). 317 Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 154 (n. 273). 318 Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 146, with further references (n. 273). 316

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Chapter 4: Damages Claims for Breach of Contract 4.309 In case of the acquisition of a company that does not conform to the representations

and warranties established in the contract, termination of contract, restitution, and the claim for total damages and the return of the company may be subject to practical difficulties.319 In such a case, differential damages will have to be claimed. b. Reliance or negative interest 4.310 Under German law, reliance or negative interest refers to the situation where a contract has not yet been made due to breach of pre-contractual obligations such as culpa in contrahendo.320 In absence of a contract and the absence of an arbitration clause, there will not be any arbitration. Therefore, this negative interest in form of wasted expenses under German law is outside the scope of this book. However, the rationale behind the reliance interest as introduced by Rudolf von Jhering in form of bad faith and misrepresentations, is applicable to the recovery of the reliance interest in general, as is further explained in chapter 5. 4.311 The new German law also provides for the recovery of the reliance damages as

damages for breach of contract in §284 BGB (Reimbursement of futile expenses). This new norm was necessary as these expenses were incurred before the breach of the contract and under German law were not considered to have been caused by the breach.321 4.312 In this respect §284 BGB322 establishes:

In place of damages in lieu of performance, the obligee may demand reimbursement of the expenses, which he has made and in all fairness was entitled to make in reliance on receiving performance, unless the purpose of the expenses would not have been achieved, even if the obligor had not breached his duty. 4.313 In order to claim damages for wasted or futile expenses, it is necessary that all

requirements for a damages claim in lieu of performance are met; in particular, breach of contract. The measure of the reliance interest under §284 BGB is not the full interest, which means that the injured party may not claim that it has lost the opportunity to enter into another profitable contract.323 4.314 The reference to fairness (Billigkeit) acts as a limitation of recovery for excessive

expenses, which were not necessary.324 The recovery of such damages is according to the presumption of profitability (Rentabilitätsvermutung), which means that it is necessary that such cost would have been amortized had the contract been

319

Fikentscher and Heinemann, Schuldrecht para. 926, with further references (n. 277). Fikentscher and Heinemann, Schuldrecht para. 104 (n. 277). 321 Jan Filip Stoppel, Der Ersatz frustrierter Aufwendungen nach §284 BGB , Univ.-Diss. (Universität Köln 2003) 34 et seq. 322 Birgit Schneider, §284 zur Vorgeschichte und Auslegung einer Norm (Duncker & Humblot 2007). 323 Hannes Unberath, Die Vertragsverletzung (Mohr Siebeck 2007) 350–1. 324 Palandt and Heinrichs, Vorbemerkungen v. §249 Rn 5 (n. 265). 320

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F. Germany performed.325 Therefore, such cost may not be claimed if they would not have been recovered in the absence of breach.326 However, profitability is presumed as no investor would invest substantial amounts 4.315 of money if the investor did not expect to obtain reasonable profits or at least recover the investment. The wasted expenses are, therefore, the lower limit of the damages to be recovered. The reason behind it is that there is no explanation why an investor would make an investment not aimed at profits.327 5. Limitations to damages a. Adequacy Adequacy is intimately related to the scope of the protective effect of the norm 4.316 mentioned before. The adequacy formula reads as follows: ‘An event in meaning of civil law is causal, if it is apt in general and not only under special and extraordinary, improbable circumstances beyond the ordinary course of things, to produce the effect in question.’328 In this context, adequacy refers to damage as a probable consequence of the breach, observed by an objective observer at the moment of the breach and not at the moment of entering into a contract and not seen from the defendant’s point of view, as in French and Anglo-American law. This refers to objective foreseeability of the probability of the damage as a consequence of the breach.329 Objective foreseeability is required in certain circumstances such as in the case of 4.317 a claim for loss of profits under §252 BGB, where (i) profits refer to those expected in the normal course of events, or (ii) those that could be expected under special circumstances, but were subject to particular measures and precautions of which the debtor was or should have been aware. According to §254 (2) BGB, the creditor has to draw the attention of the debtor to the danger of unusually extensive damage. b. Contributory negligence and mitigation of damages According to §254 BGB (Contributory negligence):

4.318

(1) Where fault on the part of the injured person contributes to the occurrence of the damage, liability in damages as well as the extent of compensation to be 325

Fikentscher and Heinemann, Schuldrecht para. 439 (n. 277). Brieskorn, Vertragshaftung und responsabilité contractuelle 348 (n. 183); BGH NJW-88, 1373. 327 Unberath, Die Vertragsverletzung 351 (n. 332). 328 BGHZ 2, 138. BGHZ 7, 204; 75., 141, BGH NJW 76, 1144; 86, 1331; ‘Ein Ereignis im Sinne des Zivilrechts ist aber nur kausal, wenn es im Allgemeinen und nicht nur unter besonders eigenartigen, unwahrscheinlichen und nach dem gewöhnlichen Verlauf der Dinge außer Betracht zu lassenden Umständen geeignet ist, einen Erfolg der eingetretenen Art herbeizuführen’; Fikentscher and Heinemann, Schuldrecht paras. 625–9 (n. 277). 329 Brieskorn, Vertragshaftung und responsabilité contractuelle 394–5, with further references (n. 183). 326

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Chapter 4: Damages Claims for Breach of Contract paid depend on the circumstances, in particular, to what extent the damage is caused mainly by one or the other party. (2) This also applies if the fault of the injured person is limited to failing to draw the attention of the obligor to the danger of unusually extensive damage, where the obligor neither was nor ought to have been aware of the danger, or to failing to avert or reduce the damage. The provision of section 278 applies with the necessary modifications. 4.319 This provision contemplates three situations: (i) the injured party has partially

caused the damages, (ii) not avoided further damages or reduced them, and (iii) not informed the other party of the danger of unusual damages. The reference to fault is not considered in its technical sense. It represents a lack of diligence of the injured party against itself in the sense that the injured party does not comply with its duty (as different from a legal obligation) to apply the necessary diligence in order to avoid damage to itself. The injured party has to take any reasonable measures, which ‘an ordinary and understanding person would have taken to avoid or mitigate the damages’.330 4.320 Contributory negligence not only refers to the damages caused by the claimant

but also by a third party acting for the claimant such as agents or legal representatives (§278 BGB).331 These damages may be caused by an act or an omission. The claimant has a duty to inform the defendant of the danger of any unusually high damages that might be caused by the breach of an obligation. The injured party has to make a substitution purchase or sale with a third party in order to reduce damages or to take measures, which the injured party could have taken having special knowledge or means to obtain an effective and comprehensive reduction of its damages.332 4.321 The essential criterion used in §254 BGB is prevailing causation including a valu-

ation of the degree of fault of the defendant and the claimant, which is dependent on whose acts have made the losses more likely.333 The defendant has to prove the contributory negligence of the injured party. If contributory negligence is proved, the injured party may lose part or the totality of its damages claim. This rule is considered a deviation from the principle of all or nothing.334 4.322 Any expenses incurred by the injured party in order to avoid or mitigate damages

are considered damages to be recovered from the defendant.335 The recovery of excessive wasted expenses is already barred under §284 BGB.

330 Tilman Finke, Die Minderung der Schadensersatzpfl icht in Europa: Zu den Chancen für die Aufnahme einer allgemeinen Reduktionsklausel in ein europäisches Schadensrecht (Universitätsdrucke Göttingen 2006) paras. 250–1. 331 Fikentscher and Heinemann, Schuldrecht paras. 709–11 (n. 277). 332 Brieskorn, Vertragshaftung und responsabilité contractuelle 402–5 (n. 183). 333 Finke, Die Minderung der Schadensersatzpfl icht in Europa para. 266 (n. 339). 334 Fikentscher and Heinemann, Schuldrecht paras. 709, 714 (n. 277). 335 BGH, 06.04.1976—VI ZR 246/74, BGHZ, 66, 182 (192).

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F. Germany c. Prohibition of enrichment Benefits obtained by the claimant due to the breach of contract have to be consid- 4.323 ered when calculating damages according to the principle of compensatio lucri cum damno, which means that the benefit will be compensated with the damages to be paid. This leads to a prohibition of enrichment of the claimant.336 German law also prohibits the enrichment of the defendant. A seller who is bound 4.324 to deliver certain goods to a buyer but sells them at a higher price to a third party, would have to pay to the buyer the money he has received from the third party. Accordingly, German law does not recognize the efficient breach of contract and considers the benefit obtained by the breaching party as enrichment to be transferred to the injured party.337 6. Other aspects affecting the damages claim a. Date of the determination of the damages With respect of the moment to calculate the damages, Friedrich Mommsen already 4.325 established in 1855 that the damages should be calculated at the ‘time of the judgment’, which is ‘the only determination of the time which truly corresponds to the essence of interest’.338 The date of determination of damages by a German judge is the date of the last 4.326 hearing of facts. This means that all adequate consequences of the violation are being considered until that time. This provision benefits the claimant only, and does not take into account any reduction of damages in favour of the defendant.339 b. Level of evidence required and burden of proof In case of German law, the discretion of the courts is intimately related to the level 4.327 of evidence required and the burden of proof. According to §287 of the Civil Procedural Code (ZPO), the court decides accord- 4.328 ing to its free conviction and under consideration of all circumstances known to it whether: (1) a loss has occurred; (2) and if and at what extent it awards damages. The court has to consult an expert with respect to technical issues only, when determining the losses.

336

Fikentscher and Heinemann, Schuldrecht para. 703 (n. 277). Coester-Waltjen, ‘The New Approach to Breach of Contract in German Law’ 138 (n. 273). 338 Mommsen, Zur Lehre von dem Interesse 3 (n. 302): ‘Heutzutage gilt jedoch allgemein die Regel, daß die Zeit des Urtheils, d.h. die Zeit, zu welcher die Berechnung des Interesse vorgenommen wird, zu Grunde zu legen ist.’ 339 Brieskorn, Vertragshaftung und responsabilité contractuelle 284, with further references (n. 183). 337

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Chapter 4: Damages Claims for Breach of Contract 4.329 §287 (Investigation and determination of damages; amount of the claim) of the

Federal Code of Civil Procedure (ZPO) reads: (1) Should the issue of whether or not damages have occurred, and the amount of the damage or of the equivalent in money to be reimbursed, be in dispute among the parties, the court shall rule on this issue at its discretion and conviction, based on its evaluation of all circumstances. The court may decide at its discretion whether or not—and if so, in which scope—any taking of evidence should be ordered as applied for, or whether or not any experts should be involved to prepare a report. The court may examine the party tendering evidence on the damage or the equivalent in money thereof; the stipulations of section 452 (1), first sentence, subsections (2)  to (4)  shall apply mutatis mutandis. (2) In the event of pecuniary disputes, the stipulations of subsection (1), sentences 1 and 2, shall apply mutatis mutandis also to other cases, insofar as the amount of a claim is in dispute among the parties and to the extent the full and complete clarification of all circumstances is authoritative in this regard entails difficulties that are disproportionate to the significance of the disputed portion of the claim. 4.330 The burden of proof of the injured party mainly refers to the existence of loss and the

causation referring to the extent of losses covered (haftungsausfüllende Kausalität). In this respect, it is sufficient that there is a preponderant probability of both the existence of loss and the extent of the damages caused. The quantification of damages, however, is subject to a wider discretion and estimation by the court.340 4.331 §287 ZPO relieves the court from the application of strict rules of evidence. In

particular, the court is not obliged to exclude less probable events when determining the hypothetical situation without breach, which favours the injured party. The injured party has to deliver the respective documents and evidence necessary for the court to make an estimation of the amount of damages. There have to be tangible elements ( greifbare Anhaltspunkte) in order to substantiate discretion of the court, at least for the determination of minimum damages. This means that the court needs sufficient elements of evidence in order to justify the amount of damages awarded. In case of technical issues, experts have to be appointed by the court. In any other case, the procurement of evidence by the court is subject to its discretion.341 4.332 This provision also leads to a reduction of the burden of proof of the injured party

in case of pecuniary disputes, in particular, when the determination of the damages and their quantification entail difficulties.342

340 Karl Heinz Boujong (co-author), Das Bürgerliche Gesetzbuch, mit besonderer Berücksichtigung der Rechtsprechung des Reichsgerichts und des Bundesgerichtshofs, Kommentar, Members of the Federal Court of Justice, Book 2, Part 6 (De Gruyter 1990) para. 253. 341 Boujong (co-author), Das Bürgerliche Gesetzbuch paras. 250–2 (n. 340). 342 Brieskorn, Vertragshaftung und responsabilité contractuelle 232–3, with further references (n. 183).

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F. Germany §287 ZPO provides that in case there is high probability of a loss caused by 4.333 non-performance, but if there is lack of sufficient evidence as regards the certainty of the loss and the causality, the judge may estimate minimum damages (Mindestschaden) according to the judge’s discretion. This reduces the burden of proof in cases where evidence is difficult to obtain and has been justified due to procedural economy.343 The discretion of the court is subject to control by appeal and even instances of 4.334 revision. The judgment has to be reasoned and any facts on which an estimation of damages has been based have to be stated. In particular, the court has to justify the existence of difficulties of evidence and the underlying grounds for its judicial discretion.344 The second sentence of §252 BGB on loss of profits mentioned above has been 4.335 considered as a special rule of evidence, reducing the burden of proof for extraordinary profits in particular circumstances due to the principle of total reparation. According to such rule, probability of the lost profits suffices.345 7. Penalties and liquidated damages According to §309 (5) BGB (Lump-sum claims for damages), a standard clause 4.336 that entitles the user to claim liquidated damages is void if (i) it is reasonably forseeable that the liquidated amount will exceed the amount of damages, or (ii) the clause does not expressly provide for the right of the other party to prove that, in a given case, there were no damages or that the actual damages were substantially lower than the liquidated amount.346 8. Considerations German law is based on the principle of total reparation in order to compensate the 4.337 equivalent to specific performance (damages in lieu of performance). The doctrine of the protective effect of the norm is an overarching principle, which helps to define the scope of damages subject to compensation solving issues of contractual risk allocation and foreseeability in the form of adequacy. The so-called ‘differential hypothesis’ or ‘but-for premise’ was first developed 4.338 in Germany in the nineteenth century and is a useful and widespread tool in

343

Rabel, Das Recht des Warenkaufs 167 (n. 281). Brieskorn, Vertragshaftung und responsabilité contractuelle 232–4, with further references (n. 183). 345 Lange and Schiemann, Schadensersatz 341–3, with further references (n. 297). 346 Ulrich Magnus, ‘The Germanic Tradition:  Application of Boilerplate Clauses Under German Law’ in Cordero-Moss (ed.), Boilerplate Clauses, International Commercial Contracts and the Applicable Law 202 (n. 242); Dietmar Voelker, Marco Adizzoni, Florian Wolff, and Feliz Prozorov-Bastians in German Tax and Business Law (Sweet & Maxwell 2005) para. 1-154. 344

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Chapter 4: Damages Claims for Breach of Contract particular for the assessment of damages in complex long-term contracts. The differential hypothesis is not applied in case of the hypothetical normal course of events where any subsequent or extraordinary events negatively affecting the claimant are not taken into consideration. Th is is reflected in the international law as ascertained in the well-known Factory at Chorzów case, analysed in chapter 5. Germany recognizes two measures of damages, the expectation or performance interest and the reliance interest. The performance interest aims to place the injured party in the position it would have been but for the breach protecting specific performance. The reliance interest under the new German law of obligations in the form of wasted expenses in reliance on the performance of the contract aims to place the injured party in the position it would have been had it not entered into the contract. The preferred valuation method is concrete valuation. 4.339 Whereas fault is a requirement for recovering damages, it is presumed under a con-

tractual relationship and the respondent has to prove the absence of fault. Fairness seems to be an element in the assessment of damages and there is ample judicial discretion and a reduced burden of proof with regards to lost profits, whereby the probability of profits suffices. 4.340 German law is highly complex and casuistic. Similar to most of the other rules of law

analysed in this book, it does not provide particular rules for the assessment of damages under complex long-term contracts based on income stream and the treatment of the so-called synallagmatic ‘triallagma’ as described in chapters 3 and 5.

G. CISG 4.341 The United Nations Convention on Contracts for the International Sale of Goods

(CISG) was prepared by UNCITRAL and adopted in Vienna in 1980. Its six authentic languages are Arabic, Chinese, English, French, Russian, and Spanish, and CISG has been translated into other languages such as German. CISG entered into force for the first 10 countries on 1 January 1988 and is an international convention characterized by its direct application in the Member States as if it were domestic law347 and refers to international sales only. It is, therefore, only applicable to complex long term contracts in the form of sales contracts such as power purchase or similar agreements. 4.342 CISG does not cover all aspects relating to sales transactions. The drafters were

unable to include provisions on penalties, liquidated damages, and interest rates

347 Herfried Wöss, ‘Die Anwendung des UN-Kaufrechts durch Gerichte und Schiedsgerichte in Mexiko’ in Bomhard and Dörner (eds.), Rechtliche Aspekte des Aussenhandels zwischen Deutschland, Mexiko und Argentinien 44 (n. 247).

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G. CISG due to fundamental differences between common law and civil law. In spite of this, CISG has been a worldwide success, with 78 Contracting States in 2012.348 The provisions on damages of CISG have been criticized for their lack of specific 4.343 rules, which lead to ‘vastly different results . . . which undermine the purpose of CISG’.349 Interpretation and integration of CISG is through international interpretation in accordance with Article 7 (1) CISG through the use of widely available international ‘jurisprudence’ found in Clout (UNCITRAL),350 UNILEX 351 (UNIDROIT) or in other databases such as that of Pace Law School352 and Global Sales Law.353 CISG may be applicable to international turnkey construction contracts where 4.344 the value of the goods supplied outweighs the value of the services.354 However, and as the ICC Model Turnkey Contract for Major Projects shows, in case of major turnkey projects the substantive law of the country where the site is located is applied.355 1. Principles for damages claims The principle of full compensation is recognized in article 74 CISG, referring to a 4.345 ‘sum equal to the loss’ which, however, has not been further defined in CISG.356 Article 74 CISG reads: Damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach. Such damages may not exceed the loss which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract, in the light of the facts and matters of which he then knew or ought to have known, as a possible consequence of the breach of contract.

According to Article 28 CISG, specific performance is not a principle of CISG. 4.346 Compensation has to be in money and there is no right to compensation in kind. 348

Schwenzer, Hachem, and Kee, Global Sales and Contract Law para. 3.19 (n. 206). John Y. Gotanda, ‘Using the UNIDROIT Principles to Fill Gaps in the CISG’ in Saidov and Cunnington (eds.), Contract Damages 107–8 (n. 42). 350 United Nations Commission on International Trade Law [website] accessed 26 October 2013. 351 UNILEX [website], accessed 25 September 2013. 352 CISG DATABASE [website] accessed 25 September 2013. 353 CISG online [website] accessed 25 September 2013. 354 CISG Advisory Council Opinion No. 4: Contracts for the Sale of Goods to be Manufactured or Produced and Mixed Contracts (Art. 3 CISG). 355 Herfried Wöss, ‘The ICC Model Turnkey Contract for Major Projects’ (2008) 3(2) Construction Law International 6. 356 Ingeborg Schwenzer and Pascal Hachem, ‘The Scope of the CISG Provisions on Damages’ in Saidov and Cunnington (eds.), Contract Damages 93–4 (n. 42). 349

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Chapter 4: Damages Claims for Breach of Contract Damages consist in a sum equal to the loss.357 Compensation is established by comparing the situation which the injured party is in as a result of the breach of the contract, with the situation the injured party would have been in had the contract been properly performed, which refers to the but-for method. Therefore, full compensation refers to the expectation interest.358 This confirms that the use of formulae such as loss and lost profits or damnum emergens and lucrum cessans is a wide notion that has not to be taken literally, as already observed under French law and which is further examined in chapter 5. 2. Requisites of a damages claim a. Breach of contract 4.347 Under Article 74 CISG breach of the contract is the basis of a damages claim. Such

breach need not be fundamental under Article 25 CISG (allowing for avoidance) and it is not necessary that such breach be specifically regulated by the Convention. Breach of contract refers to non-performance or deficient performance of a contract. In the case of late performance, it is not necessary that the promisor be put into default. The refusal to perform an obligation not yet due is considered a breach of contract.359 b. Existence and classification of losses 4.348 Article 74 CISG distinguishes between loss and loss of profits. This follows the traditional distinction between damnum emergens and lucrum cessans. Loss may be in the form of non-performance, incidental, and consequential losses.360 4.349 i. Loss

Compensation for damages is normally limited to material losses due to the commercial character of sales contracts. Damage to goodwill is only compensable according to its financial impact.361 Non-performance losses are the cost to the injured party to bring about the situation which would have existed had

357 Hans Stoll and Georg Gruber, ‘Art 74’ in Peter Schlechtriem and Ingeborg Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd (English) edn., Oxford University Press 2005), para. 24. 358 Jennifer Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken, Eine rechtsvergleichende Studie zum UN-Kaufrecht (CISG) und dem Entwurf für einen Gemeinsamen Referenzrahmen (DCFR) (Cuvillier Verlag Göttingen 2010) 53–4; Stoll and Gruber, ‘Art. 74, para. 2’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) (n. 357); Gotanda, ‘Using the UNIDROIT Principles to Fill Gaps in the CISG’ 111 (n. 349); E.  Allan Farnsworth, ‘Damages and Specific Relief’ (1979) 27 American Journal of Contract Law 247, 249; Jeffrey S.  Sutton, ‘Measuring Damages Under the United Nations Convention on the International Sale of Goods’ (1989) 50 Ohio State Law Journal 737, 742; Djakonghir Saidov, The Law of Damages in International Sales: CISG and Other International Instruments (Hart Publishing 2008) 26, 32. 359 Stoll and Gruber, ‘Art. 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) para. 8 (n. 357). 360 Stoll and Gruber, ‘Art. 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) paras. 12–22 (n. 357); Saidov, The Law of Damages in International Sales 39–44 (n. 358). 361 Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken 6 (n. 358).

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G. CISG the contract been properly performed, which corresponds to loss determination under the but-for premise. The losses to be claimed depend on whether the contract has been avoided or not. In case of non-avoidance of the contract, the damages claimed are limited to the 4.350 consequences of defective and late performance. This includes the cost of repair and substitution, provided that those costs are reasonable. The cost incurred in failed attempts to repair is also included. These damages may also be sought as difference in value, which is the difference between the objective value of the defective goods and the value which they would have had, had the contract been performed. The buyer can demand the full value of the goods if the delivered goods are worthless due to the defect. In case of late performance, the non-performance losses include the expenses to remedy the temporary loss of the benefit of performance and to avoid further losses. Damages under Article 74 CISG are normally calculated on the basis that the contract is continued and ultimately performed, which gives rise to damages for late and defective performance. Such damages may be precluded under Article 48 CISG if the defendant is willing to remedy the defect. 362 Non-performance may also lead to the avoidance of the contract. According to 4.351 Article 81 (1) CISG, ‘[a]voidance of the contract releases both parties from their obligations under it, subject to any damages, which may be due’. Therefore, the injured party may claim damages together with the avoidance of contract. Avoidance is recommended so that the injured party is relieved from its obligations under the contract. This leads to the restitution of the mutual performances by the parties.363 ii. Incidental losses These are the expenses incurred by the injured party, 4.352 which are not incurred in relation to the realization of its expectation interest, but are necessary in order to avoid additional disadvantages.364 Such losses are not mentioned explicitly in Article 74 CISG but are considered as 4.353 compensable losses under the principle of full compensation. This includes additional costs incurred by a party as a consequence of the other party’s refusal to perform as well as the seller’s expenses related to the preservation and storage of goods or sales efforts. If the delivery of goods is delayed because the promisor does not provide a bank guarantee as agreed in the contract, then the promisor is liable for the damages to the goods caused by delay. This includes the cost of mitigating damages.365 362 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), paras. 14–16 (n. 357). 363 Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken 101–2, 144–5 (n. 358); Jorge Ivan Salazar Tamez, The CISG Remedies of Specific Performance, Damages and Avoidance Compared (Ann Arbor 2007) 32–3. 364 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) para. 13 (n. 357). 365 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), paras. 14–15, 18 (n. 357).

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Chapter 4: Damages Claims for Breach of Contract 4.354 iii. Consequential losses

These refer to losses beyond non-performance such as the promisee’s liability to third parties resulting from the breach of the contract. Such losses concern third party relationships and may affect contractual obligations or even the loss of reputation.366

4.355 iv. Third party losses

In general, the injured party can only claim its own losses. However, if the promisee was acting in the interest of a third party, the loss would be considered as the promisee’s own loss for the purposes of Art. 74 CISG.367

4.356 v. Loss of profits

Loss of profits refers to any increase in assets which the breach prevented. The CISG does not determine the degree of probability of the lost profit. Therefore, in the absence of such specific provision, the judge should be convinced that the profit would actually have been made had the contract been performed. Under the full compensation principle it can be understood that not only the profit lost prior to the date of the judgment is recoverable but also the foreseeable future profit.368

4.357 There is no compensation for loss of a chance.369 However, paragraph 3.16 of the

CISG Advisory Council Opinion No. 6 on the ‘Calculation of Damages under CISG Article 74’ makes the following differentiation: The prohibition on damages for loss of chance or opportunity does not apply when the aggrieved party purposely enters into a contract in order to obtain a chance of earning a profit. In such a case, the chance of profit is an asset, and when a party chooses to enter into a contract to obtain such a chance, the party is entitled to compensation when the promisor unjustifiable does not perform. Otherwise, a promisor could breach that contract with impunity and avoid ‘liability solely on the basis of [the aggrieved party’s] difficulty of proving loss where it was clear at the time of formation that such loss would be impossible to prove with reasonable certainty.’ Moreover, allowing recovery in this circumstance would be consistent with the full compensation principle of Article 74. It also finds support in Article 7.4.3 of the UNIDROIT Principles, which provides for recovery of damages for the loss of chance of profit. In addition, allowing damages for loss of chance would be consistent with the practice of a number of countries.370

366 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), paras. 13, 14–15, 21 (n. 357); Joseph M. Lookofsky, Consequential Damages in Comparative Context, From Breach to Promise to Monetary Remedy in the American, Scandinavian and International law of Contracts and Sales (Jurist-og Okonombundets Forlag 1996) 270 et seq. 367 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), para. 26 (n. 357). 368 Schwenzer and Hachem, ‘The Scope of the CISG Provisions on Damages’ 97–8 (n. 356). 369 Stoll and Gruber, in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), Art. 74, para. 20 (n. 357). 370 , accessed 8 November 2013, footnotes omitted.

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G. CISG According to paragraph 3.19 of the aforementioned Advisory Council Opinion, 4.358 under Article 74, an aggrieved party is entitled to recovery of not only profits lost prior to the judgment, but also for future lost profits, to the extent that such lost profits can be proved with reasonable certainty and subject to the principles of foreseeability and mitigation. While the Convention does not expressly state that future losses are recoverable, its recovery is consistent with the principle of full compensation.

vi. Concrete valuation Concrete calculation of damages refers to costs that 4.359 have actually been incurred such as replacement purchases mentioned in Article 75 CISG. Loss and loss of profit must be specifically proved and an actual (concrete) calculation made. Exceptionally, Article 76 CISG permits the injured party to calculate the loss in an abstract manner through reference to a market price when the contract has been avoided. The concrete calculation of losses may take two forms (a)  substitute transactions, or (b)  repair. In case of substitute transactions the buyer may buy or rent substitute goods and claim the difference in value or the cost of the rent. In case of repair, the loss consists in the cost of repair.371 c. Causation According to Article 74 CISG the loss, including the loss of profit, has to be a con- 4.360 sequence of the breach. The rule applicable is the conditio sine que non. 3. Measure of damages a. Expectation interest The promisee is entitled to demand monetary compensation to put it into the 4.361 position it would have been in had the contract been properly performed. The expectation interest may be claimed when fulfilment of the contract can no longer be expected because the promisor has definitely and finally refused performance, a fixed deadline has elapsed, or a permanent impossibility of performance exists.372 b. Reliance interest The injured party may also claim its reliance interest in the form of expenses 4.362 incurred in reliance on the performance of the contract. However, and in order to prevent the injured party from shifting the risk of a loss-making contract to the promisor, such reliance interest is limited to the so-called contract cost, which refers to the costs that were necessary for the preparation and performance of the 371 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), para. 29 (n. 357); Schwenzer, Hachem, and Kee, Global Sales and Contract Law paras. 44.228–44.239 (n. 206). 372 Saidov, The Law of Damages in International Sales 52–4 (n. 358); Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), paras. 2, 17–18 (n. 357).

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Chapter 4: Damages Claims for Breach of Contract contract and which the promisor reasonably must have foreseen when the contract was concluded.373 4. Limitation of damages a. Foreseeability 4.363 Article 74 CISG applies the rule of foreseeability as a limit to damages claims. It limits the promisor’s liability for damages of risks, which were foreseeable at the time of the conclusion of the contract taking into account the circumstances and the purpose of the contract. It suffices that the loss is a possible consequence of the breach. The function of the foreseeability rule is to permit the parties to estimate financial risks and take out insurance against such risk. The foreseeability rule permits the parties to limit their contractual liability. Such rule also applies in case of deliberate breach of a contractual relation by a party.374 4.364 The loss has to be foreseeable from the point of view of the party in breach and not

by both parties. Foreseeability is based on objective (reasonable person) and subjective criteria (actual knowledge). The assumption of unusual risk normally requires information in that respect so that the promisor is able to reject such risk or to add a risk premium in the contract price. It is, therefore, relevant whether the obligor has expressly or impliedly assumed a certain risk.375 Such risk assumption may be the consequence of contractual risk allocation mechanisms as described in chapter 3. 4.365 Only the damages have to be foreseen but not the amount of damages or the breach.

However, it is argued that ‘when the extent of the loss is significantly higher than what was foreseeable, then a different loss materialized than that which was foreseeable’. Therefore, this significantly higher amount would not be recoverable.376 b. Mitigation 4.366 Article 77 CISG establishes the obligation of mitigation of the losses by the injured party: A party who relies on a breach of contract must take such measures as are reasonable in the circumstances to mitigate the loss, including loss of profit, resulting from

373 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), para. 18 (n. 357); Christoph Brunner, Force Majeure and Hardship under General Contract Principles:  Exemption for Non-Performance in International Arbitration (Wolters Kluwer 2009) 355–6. 374 Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken 35–47 (n. 358); Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), paras. 3, 36 (n. 357). 375 Stoll and Gruber, ‘Art 74’in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG), para. 38 (n. 357); Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken 21 (n. 358). 376 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) para. 39 (n. 357).

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G. CISG the breach. If he fails to take such measures, the party in breach may claim a reduction in the damages in the amount by which the loss should have been mitigated.

This article clearly establishes the obligation of the promisee to take reasonable 4.367 measures to mitigate the loss and the loss of profit once the breach has occurred.377 c. Prohibition of enrichment Compensation must not result in a profit for the injured party. CISG does not 4.368 recognize compensation intended to shift the profits gained by the party in breach to the injured party (disgorgement or restitutionary damages). Advantages gained by the injured party, such as insurance benefits, are not considered advantages referred to in Article 74 CISG and do not have to be taken into consideration when calculating the loss.378 5. Other aspects affecting the damages claim a. Date of the determination of the damages The only reference to the moment of calculation of damages is found in Article 76 4.369 CISG, which refers to the abstract calculation of damages. In case of an abstract calculation the date of calculation is the date of the taking over of the goods or the date of the avoidance, whatever occurs earlier. In case of a concrete valuation, the date of the determination of damages should be as late as possible, ideally the date of the judgment.379 b. Level of evidence required and burden of proof The burden of proof is not expressly established in CISG. As a general rule, the 4.370 party who has suffered the loss must prove not only that the loss actually occurred, but also the amount of the loss and causality. Any limitation to the damages claim must be proved by the promisor. The injured party carries the burden of proof of the foreseeability of the loss. The standard of proof has to be determined according to the procedural law of the lex fori.380 The standard of proof appears to be one of reasonableness, according to which the injured party has to prove with reasonable certainty both the fact and extent of loss, without requiring mathematical certainty.381

377 Offermanns, Methoden der Schadenbemessung in internationalen Regelungswerken 75–6 (n. 358). 378 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) paras 31–2 (n. 357). 379 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) para. 33 (n. 357). 380 Stoll and Gruber, ‘Art 74’ in Schlechtriem and Schwenzer (eds.), Commentary on the UN Convention on the International Sale of Goods (CISG) paras 51, 53 (n. 357). 381 Schwenzer and Hachem, ‘The Scope of the CISG Provisions on Damages’ 99 (n. 356).

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Chapter 4: Damages Claims for Breach of Contract 4.371 It may be argued that in international arbitration due to the intrinsic systemic

relationship between domestic or transnational damages law and the applicable standard of proof in the procedural law of the respective legal system, the standard of proof has to be considered, in particular, as regards to the determination of the quantum. 6. Considerations 4.372 CISG is limited to short-term sales or supply contracts. It does not provide addi-

tional tools or solutions in order to facilitate the analysis of damages claims under complex long-term contracts based on income stream. However, it incorporates and recognizes relevant notions of modern damages law such as the full compensation principle, the but-for method, expectation and reliance interest within the scope of damnum emergens and lucrum cessans, concrete valuation, the date of the award as the date of the assessment of damages, and it expressly recognizes lost profits. Risk allocation is relevant with respect to foreseeability. CISG might be relevant for energy supply contracts, which are in essence synallagmatic sales contracts.

H. UNIDROIT Principles of International Commercial Contracts (PICC) 4.373 The UNIDROIT Principles of International Commercial Contracts (PICC) are

not law. They may become rules of law through their incorporation in a contract or reference in international uniform law instruments. Article 7 (1) CISG refers to its interpretation in regard to its international character, the need to promote uniformity of application, and the observance of good faith in international trade which often leads to reference to the PICC for the interpretation of CISG.382 4.374 As compared with CISG, the PICC are not limited to sales contracts. The PICC

may be considered as a restatement383 and certainly represent best practices of international contract law. In particular, they take into consideration adequate solutions provided by the major jurisdictions of the world and contain modern and innovative rules tailored to meet the needs of international commerce.384 They do not necessarily reflect lex mercatoria,385 nor are they a common denominator 382

Paragraphs 5 and 6 of the preamble. Michael Joachim Bonell, An International Restatement of Contract Law: The UNIDROIT Principles of International Commercial Contracts (3rd edn. incorporating the UNIDROIT Principles 2004, Transnational Publishers, Inc. 2005). 384 Stefan Vogenauer, ‘Introduction’ in Stefan Vogenauer and Jan Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) (Oxford University Press 2009) paras. 21, 34–5. 385 On the history of the lex mercatoria, see Yves Dezalay and Bryan G.  Garth, Dealing in Virtue: International Commercial Arbitration and the Construction of a Transnational Legal Order (University of Chicago Press 1996) 90. 383

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H. UNIDROIT Principles of international contract law rules. Whereas lex mercatoria is a set of internationally recognized contract law principles,386 the black-letter rules of PICC read ‘like ordinary provisions in a domestic law’, which is codified on a general level387 and may or may not incorporate principles of lex mercatoria. The term ‘rules of law’ used in a lex arbitri and in rules of arbitration388 allows the 4.375 parties to apply PICC to a contract. This term is wider than the reference to applicable law, which means the domestic law of a particular jurisdiction. The importance of the PICC in international arbitration has been widely recognized.389 The PICC and the lex mercatoria may also serve as evidence for the existence of customary international law on damages, in particular, in investment arbitration. The PICC aim to eliminate the inadequacy of domestic contract law for international transactions.390 International contracts are subject to a higher level of risk as compared to domestic 4.376 contracts. One element of risk for at least one of the parties to an international contract is dealing with unknown law. Contract laws of the leading jurisdictions are part of legal systems with a high level of doctrine. These contract laws are hardly self-explanatory and, therefore, the assistance of lawyers trained in that particular system will be required, which increases the cost of transaction and puts at a disadvantage any party not familiar with those laws.391 The PICC were prepared by eminent jurists chaired by Professor Michael 4.377 Joachim Bonell with the Editorial Committee chaired by Professor Edward Allan Farnsworth. They were authorized for publication by the Governing Council of UNIDROIT in May 1994,392 and modified and extended in 2004393 and 2010.394

386 The most comprehensive undertaking to classify and codify the New Lex Mercatoria (NLM) is found in Prof. Klaus Peter Berger’s TransLex Principles, Center for Transnational Law (CENTRAL) at the University of Cologne ; as regards the limits of such transnational law, see Giuditta Cordero-Moss, ‘The Transnational Law of Contracts: What it Can and What It Cannot Achieve’ in Todd Weiler and Freya Baetens (eds.), New Directions in International Economic Law: In Memoriam Thomas Wälde (Martinus Nijhoff Publishers 2011) 45 et seq. 387 Vogenauer, ‘Introduction’ in Commentary on the UNIDROIT Principles para. 27 (n. 384). 388 E.g. Art. 21 of the ICC Rules of Arbitration 2012. 389 Matthias Scherer, ‘The Use of the PICC in Arbitration’ in Vogenauer and Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles Preamble II, 81 et seq. (n. 384); ICC International Court of Arbitration, UNIDROIT Principles of International Commercial Contracts: Reflections on their Use in International Commercial Arbitration, Bulletin, Special Supplement (2002). 390 Klaus Peter Berger, Th e Creeping Codification of the New Lex Mercatoria (2nd edn., Kluwer Law International 2010) 19–20. 391 Schwenzer, Hachem, and Kee, Global Sales and Contract Law, paras. 5.32–5.38 (n. 206). 392 (1994) CD (73), 22. 393 Michael Joachim Bonell, ‘UNIDROIT Principles 2004, The New Edition of the Principles of International Commercial Contracts adopted by the International Institute for the Unification of Private Law’ (2004) 5 Uniform Law Review 17–31. 394 Unidroit Principles of International Commercial Contracts [website], accessed 25 September 2013.

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Chapter 4: Damages Claims for Breach of Contract 4.378 PICC is currently available in eight languages. PICC 2004 have been commented

on in seminal works such as the multiple publications of Michael Joachim Bonnell including An International Restatement of Contract Law 395 and The UNIDROIT Principles in Practice,396 and in the Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) edited by Stefan Vogenauer and Jan Kleinheisterkamp.397 4.379 During the preparation of the third edition of the PICC, issues dealing with

long-term contracts were discussed, in particular as regards the termination of such contracts for just cause. However, no particular provisions related to long-term contracts were included in the third edition of PICC (2010). The provisions on damages were not modified. A draft chapter on long-term contracts in general was proposed to be included in a possible fourth edition of the PICC.398 1. Principles for damages claims a. Pacta sunt servanda 4.380 The PICC are based on the principle pacta sunt servanda. According to Article 1.3 PICC: A contract validly entered into is binding upon the parties. It can only be modified or terminated in accordance with its terms or by agreement or as otherwise provided in these Principles. 4.381 However, the PICC do not strictly adhere to the principle of specific performance.

Under Article 7.2.2 PICC (Performance of non-monetary obligation), performance may not be required when it is impossible in law or in fact, where it is unreasonably burdensome or expensive, where the injured party may reasonably obtain performance from another source, when performance is of an exclusively personal character, or where the injured party does not require performance within a reasonable time. 4.382 The right to damages is triggered by the non-performance of the contract. This

includes a refusal to perform, defective performance, and late performance. Damages may be awarded exclusively or in conjunction with other remedies such as performance or the termination of a contract. Such damages may not be recovered where non-performance is excused under the PICC, such as in the case of force majeure, an exemption clause, or hardship.399

395

Bonell, An International Restatement of Contract Law (n. 383). Michael Joachim Bonell, The UNIDROIT Principles in Practice: Caselaw and Bibliography on the Principles of Commercial Contracts (2nd edn., Transnational Publishers, Inc. 2006). 397 Vogenauer and Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles (n. 384). 398 Berger, The Creeping Codification of the New Lex Mercatoria 234 (n. 390). 399 Ewan McKendrick, Art. 7.4.1 in Vogenauer and Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles, para. 6 (n. 384). 396

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H. UNIDROIT Principles b. Full compensation Non-performance gives rise to remedies including damages. According to Article 4.383 7.4.2 PICC (Full compensation), the aggrieved party is entitled to full compensation as a result of the non-performance including for non-pecuniary harm. The formula used to measure the harm is the loss suffered and the gain deprived. Article 7.4.2 PICC (Full compensation) states that: (1) The aggrieved party is entitled to full compensation for harm sustained as a result of the non-performance. Such harm includes both any loss which it suffered and any gain of which it was deprived, taking into account any gain to the aggrieved party resulting from its avoidance of cost or harm. (2) Such harm may be non-pecuniary and includes, for instance, physical sufferings or emotional distress.

It has been argued that such provision does not contain a ‘crisp statement of the aim 4.384 of an award of damages’ referring, for example, to the expectation interest. This is however, not different from the situation under French law, where the performance interest is not expressly mentioned in the law but used in doctrine and jurisprudence. The aim of the award of damages is to compensate the injured party for the harm suffered but not to deprive the respondent of any gain resulting from its non-performance. Restitutionary or gain-based damages do not appear to be recoverable under Article 7.4 PICC. Punitive damages may not be recovered either.400 2. Requisites of a damages claim a. Breach of contract According to article 7.4.2 PICC, non-performance is a requisite for a damages 4.385 claim. The aggrieved party is ‘entitled to full compensation for harm sustained as a result of non-performance’. Article 7.1.1 PICC (Non-performance defined) states that:

4.386

Non-performance is failure by a party to perform any of its obligations under the contract, including defective performance or late performance.

Fault is not a prerequisite for the availability of damages under PICC. Fault is 4.387 irrelevant in case of an obligation of result. However, as regards an obligation of means, breach of contract consists of not making the efforts ‘as would be made by a reasonable person of the same kind in the same circumstance’, as required by Article 5.1.4 (2) PICC, which corresponds to a formula to determine negligence.401 The role of exemption clauses will be discussed in chapter 5 as regards their effect 4.388 in complex long-term contracts.402

400 401 402

McKendrick, Art. 7.4.2 in Commentary on the UNIDROIT Principles paras. 2, 5 (n. 384). Stefan Vogenauer, Art. 5.1.4 in Commentary on the UNIDROIT Principles paras. 1–7 (n. 384). Chapter 5, paras. 5.11–5.12.

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Chapter 4: Damages Claims for Breach of Contract b. Existence and classification of damages 4.389 i. Harm sustained Harm sustained under Article 7.4.2 PICC refers to the loss sustained and the gain deprived, that is damnum emergens and lucrum cessans. 4.390 ii. Loss suffered

Loss suffered or damnum emergens must be understood in a broad sense according to official comment number 2.  It may cover a reduction in the injured party’s assets or increase its liabilities. This occurs when a promisee that has not been paid by its promisor must borrow money to meet its commitments.

4.391 iii. Gain deprived or loss of profit

According to official comment number 2, the loss of profit or lucrum cessans, also referred to as consequential loss, is the benefit which would normally have accrued to the aggrieved party if the contract had been properly performed. Profits referred to are net profits.

4.392 iv. Certainty of harm

Loss and lost profits are subject to the requirement of a reasonable degree of certainty according to Article 7.4.3 PICC. This refers both to the existence and the extent of harm. Article 7.4.3 PICC (Certainty of harm) establishes: (1) Compensation is due only for harm, including future harm that is established with a reasonable degree of certainty. (2) Compensation may be due for the loss of a chance in proportion to the probability of its occurrence. (3) Where the amount of damages cannot be established with a sufficient degree of certainty, the assessment is at the discretion of the court.

4.393 Such certainty has to refer to the existence and extent of the harm according to the

official comment. However, the term ‘reasonable degree of certainty’ has not been defined in the PICC. With respect to future harm or lost profits, the same principle of reasonable degree of certainty applies. However, neither the official comments, nor Article 7.4.3 PICC explain the meaning of these words. This is important as it refers to the existence and extent of the loss.403 4.394 v. Loss of a chance

In case of lost profits a reasonable degree of certainty is required. When such lost profits are uncertain with respect to quantum, they may be considered as loss of a chance according to the official comment number 2 to Article 7.4.2 PICC: The benefit will often be uncertain so that it will frequently take the form of the loss of a chance.

4.395 In practice, arbitral tribunals will award damages either for loss of a chance under

Article 7.4.3 (2) or in its discretion under Article 7.4.3 (3). However, arbitral tribunals should not decline to award loss of profit or loss of a chance on the basis of

403

McKendrick, Art. 7.4.3 in Commentary on the UNIDROIT Principles paras. 1, 2 (n. 384).

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H. UNIDROIT Principles the complexity of the case. According to official comment number 2, the arbitral tribunal is entitled to ‘make an equitable quantification of the harm sustained’. c. Causation The use of the phrase ‘as the result of’ in Article 7.4.2 PICC clearly states that 4.396 there must be a causal link between the breach and the loss suffered and the gain deprived for the injured party. Causality is based on the concept of natural causality in form of the conditio sine qua non or the but-for test. This means that the injured party would not have suffered the harm but for the defendant’s breach.404 Harm caused by the aggrieved party is within the sphere of risk of such aggrieved party, as explained below, and may not be recovered from the non-performing party. 3. Measure of damages There are different options for a tribunal to provide the injured party with full 4.397 compensation. One would be the difference in value measure and, the other one, the cost of cure measure. The first one refers to the difference in value between what the injured party received and what it expected to receive had the contract been performed. The second refers to the cost of placing the injured party in the position it would have been had the contract been performed. In some cases, the result would be the same; however in others it would produce a great difference. The question arises, which measure would be applicable to recover damages. This may depend upon the choice of the injured party. The injured party is entitled to recover the difference in value. It may also recover the cost of cure, when such cost is not disproportionate. This may be deduced from Article 7.2.2 PICC, under which specific performance is barred when it is unreasonably burdensome. It has also been argued that the cost of cure may not be recovered if the injured party has no intention of carrying out the repair work and the cost of the repair is disproportional to the benefit obtained by the injured party.405 Termination does not preclude a claim for damages for non-performance, accord- 4.398 ing to paragraph 2 of Article 7.3.5 PICC (Effects of termination in general). According to paragraph 1 of this Article, termination releases both parties from their obligations. Damages are calculated under concrete valuation in case of a replacement transaction under Article 7.4.5 (Proof of harm in case of replacement transaction) and under abstract valuation according to the current price for the performance contracted for in the absence of a replacement transaction. However, none of these methods are particularly relevant for damages claims under complex long-term contracts based on income stream.

404 405

McKendrick, Art. 7.4.2 in Commentary on the UNIDROIT Principles para. 22 (n. 384). McKendrick, Art. 7.4.2 in Commentary on the UNIDROIT Principles para. 4 (n. 384).

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Chapter 4: Damages Claims for Breach of Contract 4. Limitation of damages a. Risk spheres 4.399 The doctrine of risk spheres used in modern laws406 and complex long-term contracts is relevant to the limitation of damages claims and finds its particular applications in the PICC in Article 5.1.3 (Co-operation between the parties), Article 6.2.2 (Hardship), Article 7.1.6 (Exemption Clauses), Article 7.1.7 (Force Majeure), Article 7.1.2 (Interference by the other party), Article 7.4.4 (Foreseeability), Article 7.4.7 (Harm due in part to aggrieved party), and Article 7.4.8 PICC (Mitigation of Harm). The assumption of risk may be express or inferred from the circumstances or the nature of the contract. 4.400 According to such doctrine each party is responsible for the risks occurred in its

sphere and that were allocated according to contractual risk allocation mechanisms already discussed in chapter 3. Risk allocation means that risks verified in one party’s sphere of risks, which lead to non-performance of such party, allow the other party to recover damages. On the other hand, risks which occur within the sphere of one party, which lead to non-performance of the other party, bar damages claims by the first party. 4.401 According to Article 7.1.2 PICC (Interference by the other party):

A party may not rely on the non-performance of the other party to the extent that such non-performance was caused by the first party’s act or omission or by another event to which the first party bears the risk. 4.402 Such provision refers to two situations: (i) the act or omission of the injured party,

or (ii) an event within the sphere of risk of the injured party: 4.403 The first situation refers to acts or omissions necessary for the defendant to perform

its obligation, such as the provision of an access road in order for the constructor to commence construction. Non-performance may also occur in the failure to perform a duty of co-operation in order to allow the other party’s performance.407 Article 5.1.3. PICC (Co-operation between the parties) establishes that: Each party shall co-operate with the other party when such co-operation may reasonably be expected for the performance of that party’s obligation. 4.404 The duty of co-operation applies to all types of contracts and is particularly impor-

tant to long-term contractual relationships, where co-operation is an essential element throughout the life of the contract. The duty of co-operation is a specific application of the general principle of good faith and fair dealing in Article 1.7 PICC and has also been considered an emerging general principle of law and 406 Brunner, Force Majeure and Hardship under General Contract Principles 145–6 (n. 373); Astrid Wallow, Risikozuweisung und Vertragshaftung (Lit Verlag 2008); Saidov, The Law of Damages in International Sales 102–3, 125–8 (n. 358). 407 Harriet Schelhaas, Art. 7.1.2 in Commentary on the UNIDROIT Principles paras. 1–4 (n. 384).

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H. UNIDROIT Principles of lex mercatoria. The duty of co-operation includes also the duty to inform the other party, where such information is necessary for the other party to perform the contract.408 The second situation refers to an event in the risk sphere of the promisee, which 4.405 causes the non-performance of the promisor. Non-performance caused by the other party or an event in the risk sphere of the other party is not considered non-performance under Article 7.1.1 PICC (Non-performance defined) and, therefore, does not give rise to damages.409 A default risk allocation rule may be found in Article 7.1.7 (1) PICC (Force majeure). 4.406 As stated by Professor Jan Kleinheisterkamp: The parties are free to either broaden or to narrow the excuses afforded by the default rule. They can agree on burdening the risk for any failure to perform on the obligor, who thereby assumes an absolute guarantee for its performance. In contrast, the possibility of limiting the obligor’s liability through exemption clauses or, more specifically, force majeure clauses, finds its limits in the prohibition of clauses whose application would lead to a grossly unfair result (Art. 7.1.6).410

Article 6.2.2 (d)  PICC (Definition of hardship) states that where a party has 4.407 assumed the risk of the event, it may not invoke hardship. The official comment to Article 7.4.4 PICC (Foreseeability) establishes that in order to recover damages, the benefits of which the injured party was deprived have to be within the scope of the contract. The scope of the contract is determined at the time of the conclusion of the contract and includes the contractual allocation of risk. Risks beyond such contractual allocation are only foreseeable when the harm flows from the ordinary course of things.411 The rationale behind Article 7.1.2 PICC (Interference by the other party) men- 4.408 tioned above may also be found in Articles 7.4.7 (Harm due in part to aggrieved party) and 7.4.8 PICC (Mitigation of harm). Under Article 7.4.7 PICC (Harm due in part to aggrieved party) damages caused by an act or omission of the injured party or an event within the risk sphere of the injured party shall not be borne by the non-performing party. This provision is an application of the principle contained in Article 7.1.2 PICC (Inference by the other party), according to which the damages claim for the portion caused by the injured party is being barred due to the lack of causality. According to Article 7.4.8 PICC (Mitigation of harm) the non-performing party is not liable for harm which could have been avoided by the aggrieved party taking reasonable steps. This refers to the avoidance of damages by the aggrieved party after the breach of contract. Whereas Article 7.4.7 PICC 408

Vogenauer, Art. 5.1.3 in Commentary on the UNIDROIT Principles paras. 1–7 (n. 384). Schelhaas, Art. 7.1.2 in Commentary on the UNIDROIT Principles paras. 6–7, 11 (n. 384). 410 Jan Kleinheisterkamp, Art. 7.1.7 in Commentary on the UNIDROIT Principles para. 6 (n. 384). 411 McKendrick, Art. 7.4.4 in Commentary on the UNIDROIT Principles para. 6 (n. 384). 409

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Chapter 4: Damages Claims for Breach of Contract (Harm due in part to aggrieved party) refers to causality at the moment of breach, Article 7.4.8 PICC (Mitigation of harm) applies to the period after the breach, which is of particular importance to complex long-term contracts where damages are usually awarded for the whole contract period. 4.409 Risk allocation clauses may find their limits in Article 7.1.6 PICC (Exemption

clause) when the exclusion of liability for non-performance would be grossly unfair with regard to the purpose of the contract. b. Foreseeability 4.410 In addition to the sphere of risk aspects of foreseeability, there are elements of limitation of damages claims, which have to be taken into consideration. According to Article 7.4.4 PICC (Foreseeability of harm): The non-performing party is liable only for harm which it foresaw or could reasonably have foreseen at the time of the conclusion of contract as being likely to result from its non-performance. 4.411 According to the official comment to Article 7.4.4 PICC (Foreseeability of harm),

the limitation of foreseeability has to be interpreted narrowly. It relates to the nature or type of harm but not to its extent. The moment of foreseeability by the non-performing party is the time of the conclusion of the contract. The test is what a normally diligent person could reasonably have foreseen as the consequences of non-performance in the ordinary course of things and the particular circumstances of the contract, such as the information supplied by the parties or related to their previous transactions. c. Mitigation of harm 4.412 In addition to the comments to Article 7.4.8 PICC above, the injured party has to take reasonable steps to limit the extent of any harm and to avoid any increase of such harm. As a consequence, the non-performing party is not liable for the whole of the loss that is attributable to the failure to take reasonable steps. The injured party may recover the expenses reasonably incurred in the mitigation of damages. In order to achieve mitigation, the injured party may have to enter into replacement transactions.412 d. No enrichment 4.413 Article 7.4.2 PICC requires that any gain to the aggrieved party resulting from the avoidance of performance due to the other party’s non-performance must be taken into account. This includes any savings or gains obtained through mitigation efforts such as income received through replacement transactions. 412

McKendrick, Art. 7.4.8 in Commentary on the UNIDROIT Principles paras. 6–8 (n. 384).

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H. UNIDROIT Principles 5. Other aspects affecting the damages claim a. Date of the determination of the damages The official comment to Article 7.4.2 PICC establishes that:

4.414

In application of the principle of full compensation regard is to be had to any changes in the harm, including its expression in monetary terms, which may occur between the time of non-performance and that of the judgment.

This indicates that the damages have to be determined at the moment of the judg- 4.415 ment or the arbitral award. Otherwise, such changes could not be taken into consideration. b. Level of evidence required and burden of proof The aggrieved party must prove:

4.416

(1) the defendant’s non-performance; (2) the certainty of the harm; and (3) the causal relationship between both. Where the amount of damages cannot be established with a sufficient degree of certainty, the assessment of damages is at the discretion of the court as established in Article 7.4.3 (Certainty of harm). This is of particular importance with respect to lost profits. The official comment refers to an equitable quantification by the tribunal of the harm sustained. 6. Penalties and liquidated damages Article 7.4.13 (Agreed payment for non-performance) establishes:

4.417

(1) Where the contract provides that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party is entitled to that sum irrespective of its actual harm. (2) However, notwithstanding any payment to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to the other circumstances.

The principle of this provision is that the specified sum may be recovered irre- 4.418 spective of the harm which the party has suffered from the breach. However, this is subject to a limit and reduction by the arbitral tribunal or court in case of grossly excessive liquidated damages. This may also be applicable in case of partial non-performance. According to official comment number 2 to Article 7.4.13, the term non-performance is broad and the specified sum may both serve for the recovery of damages and as a deterrent against non-performance. Whether the liquidated damages are payable in case of force majeure is a matter of contractual risk allocation.

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Chapter 4: Damages Claims for Breach of Contract 7. Considerations 4.419 The PICC do not contain particular provisions for damages under complex

long-term contracts, but provide flexible rules in order to achieve full compensation through a measure of damages such as the cost of cure or the difference in value. PICC uses the concepts of damnum emergens and lucrum cessans, the application of which, however, causes problems when applied to income-stream based complex long-term contracts. This includes the application of the expectation and reliance interest. 4.420 The most important contribution of PICC to the solution of damages claims under

complex long-term contracts is the recognition and regulation of risk allocation and the effect on damages claims with respect to breach of contract, foreseeability, contributory negligence, and mitigation of harm. 4.421 The PICC is based on the principle of good faith and fair dealing and contains pro-

visions in order to maintain a contractual equilibrium through force majeure and hardship provisions and limitations to grossly unfair exception clauses. 8. CANACO Case 144 under PICC 4.422 In arbitration 144 before the National Chamber of Commerce of the City

of Mexico,413 a European company (KM) entered into a Manufacturing License Agreement with a metal parts stamping company in Mexico (RF). The Manufacturing License Agreement was a toll manufacturing agreement whereby RF produced car parts with the robots, know how, technical assistance, and drawings provided by KM to RF under a gratuitous bailment and the corresponding know how license and technical assistance agreements, which were subordinated to the Manufacturing License Agreement. RF delivered the products to KM’s client (C) in Mexico and was paid by KM the corresponding toll manufacturing fee per part delivered to C. The Agreement contained a non-competition clause and an express prohibition against RF entering into any business with KM’s client (C) with respect to any competing or similar parts. This non-competition clause was valid for another five years after the termination of the Agreement. The PICC were chosen as the applicable law subject to the mandatory and complementary provisions of Mexican law. 4.423 After two years of successful operation of the Agreement, RF began delivering

products to KM’s client in its own name and directly receiving the payments from C, who ceased to pay KM. RF also terminated the Agreement as of 14 February 2002. As a consequence KM retained any outstanding payments. The arbitration

413 Caso arbitraje 144 (CANACO), Laudo I, 2 de septiembre de 2004, Laudo II, 6 de mayo de 2005.

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H. UNIDROIT Principles commenced on 6 May 2003, whereby KM claimed the return of the robots and the parts produced by the robots, as well as compliance with the non-competition clause for another five years from the date of the termination, payment of damages for the refusal to return the robots, and damages for the loss of income caused by the illegal competition. RF made a counterclaim for the amount retained by KM. The accounts receiva- 4.424 bles of RF against KM were subsequently assigned to the Mexican tax authorities, which did not pursue them in the arbitration but considered them tax credits subject to execution under the applicable tax laws. The counterclaim of RF was, therefore, not admitted in the arbitration. On 3 June 2003, RF entered into the settlement procedure under the new bankruptcy law.414 However, as the arbitration had commenced before the bankruptcy procedure it could proceed independently from such bankruptcy. On a separate line and before the arbitration commenced, KM obtained the first 4.425 Mexican judicial pre-arbitral provisional measure and obtained an order from a local judge for the return of the robots and the parts produced using such robots, as well as an order requiring RF to comply strictly with the non-competition clause. The execution of this provisional measure came to a halt when RF applied for bankruptcy. In the arbitration, the sole arbitrator confirmed the validity of the application of 4.426 PICC 1994 as governing law complemented by Mexican law due to the principle of pacta sunt servanda under article 1796 of the Federal Civil Code and article 78 of the Commercial Code. In particular, article 1445 of the Mexican Commercial Code incorporating article 28 of the UNCITRAL Model Law on International Commercial Arbitration 1985 expressly refers to the rules of law chosen by the parties, which allows for the application of transnational rules of law.415 KM presented an expert report prepared by SGS showing (i) the volume of cars 4.427 manufactured by the Original Equipment Manufacturer and final client (OEM) in 2002 and 2003, (ii) prices charged by RF to KM with respect to the products in question and delivery receipts by C, (iii) prices charged to C and the differential per part, as well as information about the production of the automotive parts in question. The expert report also contained information about the cost of the use of the robots retained and used by RF in order to deliver products to C. On 2 September 2004, the sole arbitrator rendered its first award ordering RF to 4.428 return the robots to KM and to pay damages caused by their illegal retention.416 The amount of damages, however, was reserved to a second award. The return of

414 415 416

Laudo II, para. 70 (n. 421). Orden Procesal 8, para. 2; Laudo II, para. 60 (n. 421). Laudo I, para. 25 (n. 421).

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Chapter 4: Damages Claims for Breach of Contract the robots had already been requested by KM on 8 May 2002, that is more than a year before the arbitration commenced.417 4.429 As regards the non-competition obligation, the sole arbitrator confirmed its valid-

ity and application until 16 March 2007,418 that is until five years after the date of termination of the Agreement as established in clause 12.3 of the Manufacturing License Agreement. In particular, the arbitral tribunal held that the obligation included sales through related third parties.419 4.430 In the second award, the sole arbitrator calculated the damages caused by the ille-

gal retention of the robots on the basis of the SGS expert report referring to (1) the unit cost per hour; (2) daily shifts of 16 hours; and (3) monthly operation of a robot of 384 hours. This was multiplied by the usage value per hour and the number of robots. As regards the car parts, the differential in value between the price of each part less the tolls paid to RF were calculated and multiplied by the car parts sold each year based on the car production number reported by OEM. The calculations were made from the date of the breach to the date of the award as of 31 March 2005.420 The arbitratal tribunal resolved without prejudice to any future claims of damages against RF. The arbitrator did not award damages for the cost of the judicial provisional measure.421 4.431 As regards the currency of payment, the arbitrator referred to the Agreement, the

trade usages between the parties, and Article 7.4.12 PICC, which refers to the payment of damages in the currency in which the loss was suffered.422 A substantial part of Award II was with respect to the calculation of interest. The interest rate was based on Article 7.4.10 PICC and calculated in accordance with Article 7.4.9 PICC as the average bank short-term lending rate to prime borrowers calculated for each monthly payment.423 According to the arbitral award, RM had to pay all cost of the arbitration, including the fees of the party counsel of KM.424 The arbitration finished short after the signing of a settlement agreement in the bankruptcy procedure of RM. Whereas all creditors in the bankruptcy procedure had to waive 60 per cent of their accounts receivables and were promised the outstanding amount in instalments payable during several years, KM obtained substantial damages which were not affected by such bankruptcy.

417 418 419 420 421 422 423 424

Laudo II, para. 77 (n. 421). Laudo II, para. 85 (n. 421). Laudo II, para. 88 (n. 421). Laudo II, paras. 107–10 (n. 421). Laudo II, paras. 112–13 (n. 421). Laudo II, para. 115 (n. 421). Laudo II, paras. 122–8 (n. 421). Laudo II, para. 137 (n. 421).

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I. Systemic Aspects of Rules of Damages Laws

I. Systemic Aspects of Rules of Damages Laws The rules of law applicable to damages for breach of contract have undergone a 4.432 significant development during the last few years. Such rules of law are increasingly subject to the comparative law analysis on which this chapter has been based. As may be seen from the overview in this chapter, each of the rules of law analysed contributes and provides particular solutions for the proving and awarding damages for the breach of complex long-term contracts. However, no particular rules may be found which contemplate damages situations arising from complex long-term contracts, in particular, income stream based complex long-term contracts, where the loss is in essence an interruption of the income stream coming from a market and the underlying contractual situation of the so-called synallagmatic triallagma poses particular challenges, as analysed in chapter 5. 1. Measures of damages The protected interest, also referred to as measure of damages, is the determina- 4.433 tion by the applicable rules of law of the recoverable damages. The question is how much the injured party can claim according to the applicable rules of law. The level of recoverable damages of the injured party depends on whether the rules 4.434 of law allow for damages in the amount of cost of cure (amount equivalent to the actual specific performance) or only the difference in value. The highest protection is the cost of cure, based on the principles of the pacta sunt servanda, and any damages have to be for an amount equivalent to specific performance. This would include cost of reparation or replacement. As analysed by Rudolf von Jhering, the social values underlying the measure of 4.435 damages lead to different results of compensation under different rules of law.425 The cost of cure principle applies in France, Mexico, Germany, and under PICC. 4.436 In France and Mexico, at least according to law, there is no limitation to the cost of cure, whereas in Germany and PICC the cost of cure is subject to the requirement of reasonableness. This does not mean that under all these rules of law, the injured party may not ask for the difference in value, which depends on the nature of the contract, the nature of the breach, the available evidence and the particular circumstances affecting the amount of damages recoverable, such as the applicable limitations. In general, in the UK, USA, and under CISG, the measure of damages is the differ- 4.437 ence in value. The economic analysis of law plays an important role under US law, which means that profits obtained by the party in breach may not be transferred to the injured party, and the party in breach may walk out of the contract for a better 425

See para. 4.295.

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Chapter 4: Damages Claims for Breach of Contract business, which has been referred to as efficient breach. Independently from the efficiency of such breach being questioned by leading scholars, what is important is that efficient breach does not reduce or minimize the general measure of damages, whose aim is to put the injured party in the position it would have been in without the breach. The party in breach would only be allowed to take the exceeding profit of the new business. 4.438 Whereas in the UK the emphasis is to avoid over compensation of the injured

party, the USA seems to rely on fairness based on a codified system. France is rather concerned with avoiding under compensation of the injured party and how to make a party perform a contract. 4.439 The cost of cure or difference in value are only available in a claim for the expecta-

tion interest, as the reliance interest is limited to the wasted expenditure made for the performance of a contract that was not duly performed. In spite of the use of the expectation interest as a measure of damages, different rules of law use different classifications of losses under such heading. As we have seen, the term expectation interest does not necessarily have the same meaning under the rules of law examined. The term of reliance interest is also not uniformly used, with Germany having a particular notion of such interest. 4.440 The but-for or differential method (What would be the position of the injured party

but for the breach?) is the formula admissible in all rules of law examined, without major differences, especially for complex long-term contracts. Under the heading of expectation interest, the distinction is with respect to the protected interest in form of cost of cure or only the difference in value. This distinction, however, does not play a role when claiming the expectation interest under complex long-term contracts based on income stream, as will be shown in chapter 5. 4.441 The recoverable damages may vary in case of the termination of the contract. This

depends of whether termination leads to restitution or not. Termination may limit the recoverable damages to the reliance interest, which might be beneficial for the injured party if the reliance interest exceeds the expectation interest leading to over compensation. 2. Requisites and limitations to damages claims 4.442 Regarding the requirements and limitations to damages claims, they are but ele-

ments in order to further define the protected interest. The division into requirements and limitations is a formal one as the requirement of causality may at the same time limit the scope of the protected interest such as the case of the haftungsausfüllende Kausalität under German law or foreseeability as a requirement of a damages claim and not only a limitation. 4.443 Different rules of law use different limitations. France does not recognize the duty

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I. Systemic Aspects of Rules of Damages Laws intentionally, does not apply foreseeability as a requirement. Under the PICC and CISG foreseeability is also applicable as a limitation in the case of intentional breach of contract. The foreseeability limitation applies in France, USA, UK (as remoteness), 4.444 UNIDROIT, and CISG. In Germany the principle is one of an enhanced concept of causality, haftungsbegründende and haftungsausfüllende Kausalität together with a retrospective criteria of adequacy. Increased remoteness often leads to an increase of the burden of proof. The limits of foreseeability and remoteness are a matter of legal policy. Fault is not a requirement in the UK, USA, PICC, and CISG. The fault require- 4.445 ment under German law is alleviated through a presumption and such requirement seems to be based on doctrinarian exigencies rather than practical importance. In case of US law, intentionality seems to reduce the burden of proof. Contributory negligence is a principle in UK, USA, France, Germany, Mexico, and PICC. However, the function of contributory negligence differs and it may simply be regarded as a lack of causality. Mitigation is a principle in UK, USA, Germany, PICC, and CISG. The prohibition of enrichment of the injured party has been mentioned in the con- 4.446 text of English law, PICC, and CISG in order not to overcompensate the injured party. As regards the possible enrichment of the party in breach, under the doctrine of efficient breach such enrichment is legitimate. Under certain circumstances UK law would allow for a gains-based relief when the breach cannot be easily measured in monetary terms. Under French law any enrichment of the party in breach has to be transferred to the injured party, and this result is also likely under German law, at least in sales transactions. 3. Level of evidence and burden of proof The protection of the injured party is not only determined by legal principles but also 4.447 by procedural standards of proof. In all legal systems analysed, the burden of proof is upon the claimant. Sufficient proof is required in France and Germany, whereas the USA, UK, UNIDROIT, and CISG refer to reasonable certainty of damages. The notion of certainty of damages is related to the existence of loss and the prob- 4.448 ability of the quantum. The acceptance of the modern notion of the loss of a chance together with techniques of financial and economic forecasting increase the protection of the injured party. Such protection is further increased when the party in breach is not allowed to benefit from the difficulty of establishing the relevant evidence. As regards court systems, the USA has considerably influenced modern techniques 4.449 for the determination of damages in case of complex situations such as damages for the breach of antitrust law, which are now being used in order to determine damages 181

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Chapter 4: Damages Claims for Breach of Contract both in international commercial and investment arbitrations. Both the UK and the USA have specialized courts dealing with construction and infrastructure projects, which have contributed significant case law commented on in leading literature. 4.450 While the German Civil Procedure Code provides considerable liberty for courts

to determine damages in case of difficulties of proof, the question arises how these rules apply to the breach of complex-long term contract situations. The same question applies to France where the trial courts have considerable discretion. Mexican law recognizes that a lesser level of evidence is required for the proof of future lost profits. However, the fact that any evidence has to be presented at the outset of civil procedures makes the system hardly apt to handle complex claims. 4. Date of the determination of damages 4.451 An important element in damages claims is the date of their determination. Nearly

all systems analysed refer to the date of the judgment as the relevant date in order to determine damages, in particular as regards future lost profits. The situation is different in the case of sales transactions where the determination of damages is made at the date of the substitute transaction or the breach or with respect to the market situation at the moment of breach. 5. The protective effect of the norm, risk spheres, and the purpose of the contract 4.452 Complex long-term contracts evolve around the identification of risk, risk alloca-

tion, and risk mitigation. Such elements are intimately related with the theory of the protective effect of the norm, risk spheres, and the purpose of the contract. This not only allows for making a complex contract financially and economically operative but also solves issues of foreseeability in the sense that a risk allocated is naturally a risk foreseen and not too remote. With respect to the interruption of income stream under complex long-term contracts, which involve huge amounts of investment with the sole purpose to obtain profits, the test of foreseeability has to be approached differently, as analysed in chapter 5. 4.453 The notion of the scope of the protective effect of the norm appears in different

variations in several of the rules of law analysed, in particular, under German law, and the relationship between the assumption of risk and remoteness under English law. In Germany this notion is a generally applied principle, which is not only relevant in order to determine adequacy but is also used for contract interpretation and other purposes such as the delimitation of risk spheres. This approach has been incorporated in several of the articles of PICC, which have been analysed in this chapter.

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I. Systemic Aspects of Rules of Damages Laws 6. Conclusions Different rules of law provide different solutions, which contribute to a better 4.454 determination of damages for the breach of long-term contracts. The application of such rules in international arbitration is analysed in chapter 5. The rules of law on damages for breach of contract analysed herein relate to a large 4.455 extent to sales transactions, commodities trade, but not to complex long-term contracts,426 which are based on income stream. For example, the cost of cure measure of damages does not apply to the interruption of income stream. This measure only applies to the party that receives non-conforming goods or services that can be cured or replaced. Cost of cure does not apply to income expectations under complex long-term contracts or to payment obligations under take-or-pay agreements. The typical situation that gives rise to a damages claim in commercial and invest- 4.456 ment arbitrations is the interruption of the income stream caused by the illegal act of one of the parties. This situation is not expressly contemplated under any of the rules of law analysed in this chapter. Therefore, concepts such as damnum emergens, lucrum cessans, expectation and reliance interest, or fair market value in investment arbitration must be analysed in order to determine the most appropriate measure for typical synallagmatic and atypical synallagmatic complex long-term contracts based on income stream. This is discussed in chapter 5. Chapter 5 aims to provide guidelines for analysing, framing and awarding dam- 4.457 ages in the most efficient and straightforward way avoiding both under- and over compensation under complex long-term contracts based on income stream whether derived from breach of contract or the violation of an international law standard. However, each of the rules analysed contributes tools that help to apply general 4.458 rules of law when analysing, assessing, and awarding damages under complex long-term contracts: The diff erential hypothesis or but-for method was originally developed in Germany. 4.459 Its application has been thoroughly examined and developed under the UK and US laws of damages. UK and US courts are accustomed to handling claims for breach of complex long-term contracts, and provide case law on how to handle damages claims under such contracts, using this premise. On the other hand the US notion of reasonable certainty of loss has been adopted by the PICC, and is widely used in international arbitration independent from the applicable rules of law, as it is particularly useful for lost profits. 426 Stefan Grundmann and Martin Schauer, Th e Architecture of European Codes and Contract Law (Kluwer Law International 2006) 12, 60–61.

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Chapter 4: Damages Claims for Breach of Contract 4.460 CISG and the PICC show how damages law may be reduced to a few general legal

principles. In particular the PICC provide modern notions of risk allocation techniques and their effect on breach of contract and damages. 4.461 The rules of law analysed affect international law and the practice of investment

arbitration. This can be observed in the Chorzów formula, which is based, in principle, on the Mommsen differential hypothesis when referring to the but-for situation, and the German law hypothetical normal course of events reflected in the Chorzów formula using the higher value between the date of the breach and the date of the award, as analysed in detail in chapter 5. Arbitrators are likely to be influenced by their domestic legal traditions, which through arbitral awards, fill in the gaps beyond the Chorzów formula; transnational law such as CISG and the UNIDROIT Principles are often referred to in arbitral awards; private rules of law may convert into public international customary rules when complying with the requirements of opinio juris sive necessitatis and the corresponding state practice, or into general principles of law. 4.462 Contract law is subject to major developments such as: the reform in Germany,

the shift from the economic benefits principle to the performance principle under English law, reform discussions in France and other jurisdictions, and tendencies such as the prevention and deterrence of breach of contract and the recognition of the economic justification to keep contracts.427 4.463 As mentioned in chapter 3, complex long-term contracts represent self-contained

and self-executing systems, whereby normal breach of contract situations are governed by contractual mechanisms. Damages law, which is the different rules of law applicable to damages, becomes relevant mainly in case of total breach of contract, which gives rise to international arbitrations. The question of how damages claims under complex long-term contracts may be analysed, structured, and framed in international arbitration are examined in chapter 5.

427

Schwenzer and Hachem, ‘The Scope of the CISG Provisions on Damages’ 92–3 (n. 356).

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5 ANA LYSING, FR A MING, AND PROV ING A DA M AGES CL AIM

A. Introduction B. Relevant Characteristics of Complex Long-Term Contracts for Damages Claims C. Full Compensation as the Guiding Principle D. The But-for Premise as the Analytical Framework for the Damages Claim

5.03 5.05

I. Relevance of the Evidence Available and Burden of Proof

5.08

1. Breach as the starting point when framing a damages claim 2. The loss 3. Causation

5.10 5.34 5.61

E. The Measure of Damages 1. 2. 3. 4.

1. Lost profits and lost value 2. Difference between lost income and loss of a chance 3. Effect of income taxes 4. Adjustment avoiding overcompensation

5.01

Expectation interest Reliance interest Damnum emergens and lucrum cessans Cost of cure

F. Limitations 1. Foreseeability 2. Mitigation 3. Contributory negligence

5.68 5.69 5.76 5.86 5.95

Breach and evidence Causation and evidence Quantum and evidence Reasonable certainty of income Reasonable certainty of loss Business plans and projections to evidence the difference in value under the but-for premise 7. Negative inference

J. Role of the Experts K. Particularities of Damages 5.96 Claims in Investment 5.97 Arbitration

5.106 5.111

G. The Relevant Date for Valuation of Damages H. Other Conceptual Issues Related to Damages Assessment

1. 2. 3. 4. 5. 6.

5.116 5.121

1. Damages claims in investment arbitration arising under complex long-term contracts 2. Chorzów as applicable in international customary damages law

5.121 5.122 5.125 5.126 5.127 5.127 5.128 5.131 5.133 5.145

5.147 5.151 5.152

5.163

5.164

5.175

A. Introduction The way a damages claim is structured depends on multiple factors, such as the 5.01 nature of the contract, the nature of the breach, loss, causation, the measure of damages, the limitations according to the applicable rules of law and the evidence available as well as the rules of evidence. Such factors are interdependent and, 185

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Chapter 5: Analysing, Framing, and Proving a Claim therefore, must be analysed jointly when framing a damages claim and awarding damages. 5.02 The first part of this chapter will have an emphasis on commercial arbitration,

where the but-for premise or differential hypothesis has a preponderant role. The second part will focus on the peculiarities of investment arbitration where the Chorzów formula sets the criteria for the measure of damages.

B. Relevant Characteristics of Complex Long-Term Contracts for Damages Claims 5.03 Complex long-term contracts may be typical synallagmatic contracts such as

long-term sales and construction agreements, or atypical synallagmatic contracts,1 referred to in this book as complex long-term contracts based on income stream, such as joint venture agreements, public-private partnerships, build-operate transfer, concessions, and similar agreements. In typical synallagmatic contracts the essential legal elements are, on one hand, the delivery of goods or services and, on the other, the payment of the price. In complex long-term contracts based on income stream the essential legal elements are the assets of any kind that the parties contribute, on one side, and the income coming from a third party, which is the market, on the other.2 This is relevant for the determination of loss, and with respect to foreseeability and mitigation. 5.04 The similarity between complex typical synallagmatic and atypical income stream

based contracts is that in both the purpose is the generation of income or profits coming from the market. The difference is that in typical synallagmatic contracts, the profits derive from collateral transactions, while in atypical complex long-term contracts based on income stream, the income stream or profits arising from a third party are expressly regulated or shared under the contract.

C. Full Compensation as the Guiding Principle 5.05 ‘It is undisputed among legal systems-both domestic and international-that the

aggrieved party must be entitled to recover all losses incurred due to the breach of contract. This principle is referred to as the principle of full compensation.’3 1 For the dogmatic explanation of the synallagmatic ‘triallagma’, see Stefan Grundmann, ‘Contractual networks in German private law’ in Fabrizio Cafaggi, Contractual Networks, Inter-firm Cooperation and Economic Growth (Edward Elgar Publishing 2011) 116–21. 2 Scott L. Hoff man, The Law and Business of International Project Finance (3rd edn., Cambridge University Press 2008) §18.01, §18.02. 3 Ingeborg Schwenzer, Pascal Hachem, and Christopher Kee, Global Sales and Contract Law (Oxford University Press 2012) para. 44.19.

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C. Full Compensation as the Guiding Principle The principal function of damages law is the compensation of the loss caused by a 5.06 breach. The payment of an amount of money should place the injured party in the financial position it would be in, if the damaging act had not occurred. This rule can be regarded as a general principle of law.4 The question of what would be the position of the injured party but for the breach 5.07 implies full compensation. The principle of full compensation applied through the but-for premise is, therefore, the guiding principle for any damages claim, under the different rules of law analysed: (1) The US Restatement (Second) of Contracts states:  ‘... the injured party is entitled to full compensation for his actual loss’.5 In accordance with this principle, US courts recognize the right of the injured party to be placed in the economic position it would be in but for the breach.6 (2) Under the leading UK case Robinson v. Harman (1848) the aim of damages is to give the injured party the necessary amount of money to put it ‘so far as money can do it, in the same position as it would have been in had the contract been performed’.7 This is without prejudice to mechanisms in English law aimed to avoid overcompensation.8 (3) French law recognizes the principle of full compensation or réparation intégrale. Article 1149 of the French Civil Code establishes that ‘the promisee is entitled to damages in respect of the loss which he has suffered and the gain of which he was deprived’. Full compensation is the objective ( principle de réparation intégrale du préjudice) and according with the loss suffered (tout le prejudice mais rien que le prejudice). The essence of the full compensation principle is to return the victim ‘as closely as monetarily possible to the position in which he would have been had the wrong not being done’.9 (4) German damages law is based on the principle of total reparation leading to the situation, which would have existed if the damaging event had not occurred (§249 BGB). This refers to both the differential hypothesis or but-for premise and to the principle of full compensation.

4 Irmgard Marboe, Calculation of Compensation and Damages in International Investment Law (Oxford University Press 2009) para. 2.72, with further references; see chapter 4. 5 Restatement (Second) of Contracts, Chapter 16, Topic 2, Introductory Note. 6 Restatement (Second) of Contracts, §344 (a) (Purposes of Remedies); §1-305 UCC (‘remedies provided. . . must be liberally administered to the end that the aggrieved party may be put in as good a position as if the other party had fully performed’). 7 Robinson v. Harman (1848) 13 P.D. 191 C.A., 200. 8 Chapter 4, paras. 4.12, 4.47, 4.49. 9 Konstanze Brieskorn, Vertragshaftung und responsabilité contractuelle:  Ein Vergleich zwischen deutschem und französischem Recht mit Blick auf das Vertragsrecht in Europa (Mohr Siebeck 2010) 252, with further references; Solène Rowan, Remedies for Breach of Contract: A Comparative Analysis of the Protection of Performance (Oxford University Press 2012) 150.

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Chapter 5: Analysing, Framing, and Proving a Claim (5) The formula used in paragraph (1) of Article 7.4.2 PICC (Full compensation), states that ‘[t]he aggrieved party is entitled to full compensation for harm sustained as a result of the non-performance’.

D. The But-for Premise as the Analytical Framework for the Damages Claim 5.08 The but-for premise is a useful tool when analysing, framing, and proving a dam-

ages claim under a complex long-term contract. This premise requires a breach of the contract’s performance obligations and leads to the reconstruction of the hypothetical course of events but for the breach in order to compare it to the actual course of events. This premise provides the framework for the determination of the loss, causation, and the measure of damages, as well as the quantum, including mitigation.10 5.09 The but-for premise was developed by Friedrich Mommsen under the notion of

differential hypothesis leading to the expectation interest.11 It was perfected by US legal practice in damages claims for lost profits due to the violation of antitrust law as well-explained in a monograph prepared by the American Bar Association,12 and has been used in leading international arbitrations. 1. Breach as the starting point when framing a damages claim 5.10 The first step in order to frame a damages claim is to establish the breach of a

contract. The nature of the breach is an important factor for the damages claim, as this is the starting point to determine the situation of the injured party but for the breach. This requires an analysis of the contractual provisions breached, risk allocation, and its consequences.

10 American Bar Association (ABA), Proving Antitrust Damages: Legal and Economic Issues (2nd edn., American Bar Association 2010) 4. 11 Friedrich Mommsen, Beiträge zum Obligationenrecht, Zweite Abtheilung:  Zur Lehre von dem Interesse (E.U. Schwetschke und Sohn 1855) 3, ‘Unter dem Interesse in seiner technischen Bedeutung verstehen wir nämlich die Differenz zwischen dem Betrage des Vermögens einer Person, wie derselbe in einem gegebenen Zeitpunkte ist, und dem Betrage, welchen dieses Vermögen ohne die Dazwischenkunft eines bestimmten beschädigenden Ereignisses in dem zur Frage stehenden Zeitpunkte haben würde.’ (‘We understand as interest in its technical meaning the numeric difference of the assets of a person at a certain moment, with and without the injuring event at precisely such moment.’) 12 The notion of expectation interest as developed under German law was apparently introduced the first time into US law by Prof. Lon Fuller and his assistant William Perdue in their seminal article on ‘The Reliance Interest in Contract Damages’, where they state, amongst other things, that ‘[i]n a society the breach of a promise works and “actual” diminution of the promisee’s assets— “actual” in the sense that it would be so appraised according to modes of thought which enter into the very fiber of our economic system’, Pt. 1, (1936) 52 Yale Law Journal 52–96 at 58; ABA, Proving Antitrust Damages 4 (n. 10).

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D. The But-for Premise as the Analytical Framework a. Principal difficulties when determining the breach The principal difficulties that may be observed as regards breach are exemption 5.11 and justification clauses,13 including changing circumstances, force majeure, and hardship, which might lead to renegotiation. The existence of such clauses and situations in complex long-term contracts may exclude or justify the breach and bar the damages claim and may also lead to the termination of the contract, without liability. These clauses are a frequent issue of controversy even where the breach is notorious. However, the application of such clauses must be duly proved by the respondent. In the arbitration of the automotive joint venture case,14 the non-competition 5.12 clause was subject to an emergency exception, where the technology partner could directly deliver products to the joint venture company’s clients in case of manufacturing problems in the joint venture company. Even in the absence of such manufacturing problems and the existence of top supplier quality certificates of the managing partner and claimant, this matter led to lengthy discussions in the arbitration before the arbitral tribunal confirmed that the facts did not give rise to the application of the exception clause. In the Karaha Bodas and Himpurna arbitrations,15 Karaha Bodas was granted 5.13 contractual rights to develop a geothermal electricity project in Indonesia through a joint operating contract and an energy sales contract with the state owned oil and gas company Pertamina. Under the contract, Karaha Bodas was required to develop geothermal energy, and build, own, and operate electricity-generating facilities. Himpurna was to supply PLN with electricity from a geothermal field in Java requiring large investments in wells, plant, and other infrastructure. Due to three presidential decrees in the context of the Asian financial crisis, PLN 5.14 and Pertamina could not perform their contractual obligations. As a consequence, the claimants sought the termination of the relevant contracts and damages. The tribunal held, inter alia, that the risk of governmental action was allocated to PLN,16 which shows how risk allocation bars exemption and justification arguments. Under all rules of law analysed, even the risk of force majeure may be allocated to one of the parties. Risk allocation is one of the fundamental instruments in structuring complex long-term contracts as already explained in detail in chapter 3

13 See Harriet Schelhaas, ‘Article 7.1.6 (Exemption clauses)’ in Stefan Vogenauer and Jan Kleinheisterkamp (eds.), Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) (Oxford University Press 2009); Marcel Fontaine and Filip De Ly, Drafting International Contracts: An Analysis of Contract Clauses (Brill 2009) 351–60. 14 Chapter 3, para. 3.214. 15 Karaha Bodas Company LLC v. Reusahaan Pertambangan Minyak Dan Gas Bumi Negara and PT. PLN (Persero), ad hoc arbitration under UNCITRAL rules; Himpurna California Energy Ltd v. PT. PLN (Persero), ad hoc arbitration under UNCITRAL rules. 16 Himpurna v. PLN, 36–42 (n. 15).

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Chapter 5: Analysing, Framing, and Proving a Claim and has to be respected by the parties and taken into consideration by the arbitral tribunal when determining breach. 5.15 In case of a renegotiation, there is no breach and the renegotiation prevents the

claim. In case there is no obligation to renegotiate, a hypothetical renegotiation scenario cannot be used as a substitute for the but-for scenario,17 as this would imply the non-recognition of the underlying contractual obligations. If there is an obligation to renegotiate, and one of the parties breaches this obligation, that party may be liable for damages on the basis of its refusal to negotiate. If there is an obligation to renegotiate but the parties do not come to an agreement, the arbitral tribunal has to decide on the basis of the original contractual provisions, unless the arbitral tribunal is, exceptionally, authorized to modify the contractual provisions. The issue of renegotiation is, therefore, a matter to be analysed by the arbitral tribunal when determining liability, based on the contractual provisions and the applicable law. 5.16 The case Occidental v. Ecuador,18 an investment arbitration based on an investment

agreement, dealt with the participation contract between Occidental Exploration and Production Company (OEPC), Ecuador, and Petroecuador in connection with the exploration and exploitation of hydrocarbons, as of 21 May 1999 for the exploitation of hydrocarbons in ‘Block 15’ of the Ecuadorian Amazon. The Ministry of Energy and Mines declared the decree of caducidad on 15 May 2006. Law 42 introduced by Ecuador as of 25 April 2006 provided for a state participation at the level of 50 per cent on extraordinary revenues earned by the claimants as a result of any increase in price above the monthly average price in effect at the time of the execution of the participation contract. The Investment Protection Treaty between the USA and Ecuador contains an umbrella clause which means that a breach of contract gives rise to investment arbitration, as will be explained later in this chapter. 5.17 In the light of the higher oil prices in 2005, the respondent sought to renegotiate

the participation agreement it had entered with OEPC seven years earlier. These negotiations, however, were not successful.19 The arbitral tribunal recognized that ‘in the Participation Contract, the Claimants knowingly accepted the risk of losses on its investment in case of low price scenario and the Respondent knowingly forewent the opportunity to increase its participation in case of a high price scenario’.20 This was the bargain which was struck by the parties and which was reflected in the

17 Kathryn Khamsi, ‘Compensation for Non-Expropriatory Investment Treaty Breaches in the Argentine Gas Sector Cases: Issues and Implications’ in Michael Waibel, Asha Kaushal, Kyo-Hwa Liz Chung, and Claire Balchin (eds.), The Backlash against Investment Arbitration (WoltersKluwer 2010) 182, stating that the arbitral tribunal in LG&E v. Argentina (see n. 25) did not analyse ‘the factors that might have increased the profitability of the licensee (and therefore diminished losses)— for example, the prospects of successful renegotiation of the license with the Argentine government’. 18 Occidental Petroleum Corporation Occidental Exploration and Production and Production Company v. The Republic of Ecuador, ICSID Case No. ARB/06/11, award, 5 October 2012. 19 Occidental v. Ecuador, para. 519 (n. 18). 20 Occidental v. Ecuador, para. 522 (n. 18).

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D. The But-for Premise as the Analytical Framework participation contract. The arbitral tribunal found that with the introduction of Law 42, the respondent modified unilaterally and in a substantial way the contractual and legal framework that existed at the time when the claimants negotiated and agreed the participation contract.21 OEPC had the right to freely dispose of its participation,22 and ‘did not have to expect to make concessions and hence comply with Law 42, because the Participation Contract shielded it precisely against such things’. The fact that economic benefits were given by oil companies in the past when oil prices went up was considered irrelevant in case of express risk allocation.23 The question is ‘what was the value of that which the claimants actually lost?’ and not ‘what is the value of that which the claimants might have lost had [the] history been different’.24 This shows that the contractual risk allocation has a direct impact even in invest- 5.18 ment arbitration. Changes in circumstances such as price increases do not allow for renegotiation if such changes have expressly been contemplated in the underlying contract without providing for renegotiation. Renegotiation that did not take place is irrelevant for the purpose of the determination of damages. For the purpose of damages analysis, what matters is whether there was a breach or not and not whether the breach could have been eliminated by renegotiation. In LG&E v. Argentina,25 the dispute concerned a claim by three US investors, 5.19 collectively called LG&E, which held shareholding interest in three local gas distribution companies in Argentina created during the privatization in 1999 and warrantied licenses until 2027. In order to attract foreign investors, Argentina enacted legislation to warranty that tariffs for gas distribution would be calculated in US dollars and that automatic semi-annual adjustments of tariffs would be based on the US Producer Price Index (PPI). Several other warranties related to the tariff regime were provided. As a consequence of the economic crisis, the Government abrogated the warranties provided at the time of privatization, which led to a great reduction in the profitability of the gas distribution business. LG&E initiated International Centre for Settlement of Investment Disputes (ICSID) arbitral proceedings claiming damages. The tribunal found that LG&E breached the umbrella clause, amongst others. The government took different measures such as the suspension of tariff adjustments and pesification to force claimants to renegotiate the licenses and waive their claims against the government, or face their rescission.26 Such right to negotiate was not admitted by the arbitral tribunal, as there was no obligation to renegotiate. 21

Occidental v. Ecuador, para. 525 (n. 18). Occidental v. Ecuador, para. 524 (n. 18). 23 Occidental v. Ecuador, para. 541 (n. 18). 24 Occidental v. Ecuador, para. 534 (n. 18). 25 LG&E Energy Corp., LG&E Capital Corp., LG&E International Inc. v. Argentine Republic, ICSID Case No. ARB/02/1, award, 3 October 2006. 26 LG&E v. Argentina, decision on liability, 3 October 2006, paras. 119–20 (n. 22). 22

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Chapter 5: Analysing, Framing, and Proving a Claim 5.20 However, the arbitral tribunal found that Argentina was in a state of necessity

between 1 December 2001 and 26 April 2003 and would be absolved from international responsibility for losses that occurred during this period.27 The state of necessity is an exceptional situation under international law, which has to be determined by the arbitral tribunal in order to relieve the claimant from its obligations, and the LG&E case was one of the few investment arbitration cases where such a state of necessity was recognized, because the requirements established under the treaty between Argentina and US of 1991 were met. It did not lead to renegotiation as there was no duty established in the contract, but it had an effect on the damages award, as the obligations of the state were deemed suspended during the period of the state of necessity. In the absence of valid obligations during such time, they could not be breached, and therefore no damages were awarded during that period.28 5.21 In EDF v. Argentina, 29 the dispute arose out of a concession agreement between

the Government of Mendoza and EDEMSA, signed on 15 July 1998 relating to the transmission and distribution of electricity. On 28 May 1997, the government of Mendoza had reformed the regulatory framework governing distribution of electricity within the Province of Mendoza through the enactment of the provincial law number 6497 and provincial law number 6498, collectively referred to as the regulatory framework.30 The claimants argued that the breach of the concession agreement was due to the regulatory measures adopted prior to the enactment of the national and provincial emergency laws, also known as pre-emergency measures, which allegedly affected the concession. These pre-emergency measures, the emergency tariff measures, and the renegotiation process caused injury to its investment. The emergency measures abrogated the regime provided under the convertibility law and invalidated key provisions in the concession agreement, in particular, the currency and cost-adjustment clauses. 5.22 In this case, the income stream of the claimant was protected through risk alloca-

tion. In its considerations, the arbitral tribunal expressly refers to the risk allocation under the concession agreement, which covers any ‘commitment undertaken in connection with the investment’. According to the contractual risk allocation, the devaluation risk was with Argentina through a currency clause, which represents an allocation of risks as between the host state and the foreign investor including a mechanism to protect the concessionaire against risks related to

27

LG&E v. Argentina, decision on liability, paras. 226–58 (n. 25). Ignacio Torterola, ‘Los Institutos de la Emergencia en el Derecho Internacional y el Estado Argentino’ in Sonia Rodríguez Jiménez and Herfried Wöss (eds.), Foro de Arbitraje en Materia de Inversión: Tendencias y Novedades (Instituto de Investigaciones Jurídicas/UNAM, , 2013), 113–55. 29 EDF International S.A., SAUR International S.A.  and Leon Participaciones Argentinas S.A. v. Argentine Republic, ICSID Case No. ARB/03/23, 11 June 2012. 30 EDF v. Argentina , para. 50 (n. 29). 28

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D. The But-for Premise as the Analytical Framework fluctuation of the Argentine currency. The very purpose and effect of the currency and cost-adjustment clauses were to protect the actual value of the tariffs from the likelihood of devaluation or depreciation of the local currency.31 Therefore as the risk was allocated to Argentina, the breach was established when Argentina did not pay in US dollars. b. The eff ect of termination on the damages claim The severity of breach, as analysed in chapter 4, may determine whether the con- 5.23 tract may be terminated or not. In case of total breach, termination may be necessary to relieve the injured party from its obligations under the contract. However, under some of the rules of law analysed, termination may have a retroactive effect leading to restitution or might limit the damages to be recovered to reliance interest. However, restitution might be impossible or not convenient in many complex long-term contracts as the investment is made for a special purpose. Therefore, termination must be carefully examined under the contractual provisions and the applicable rules of law. In the case of the processing plant mentioned in para. 3.180, the project agreement 5.24 was based on the FIDIC EPC turnkey contract form, which provides quite elaborate rules with respect to claims. Under the claim mechanism of such a contract form, the owner has to claim the difference in value between the price paid and the value received, as determined by the owner. Claims not made on time according to the rules on claim management are often claims lost. Furthermore, the amount of damages is limited to the amount of the contract. In order to overcome such limitation the contract has to be terminated for total breach. Termination, if not made according to the contract, may in itself constitute breach of contract giving rise to a damages claim by the other party. In Bridas v. Turkmenistan, which was a commercial arbitration under English law 5.25 (described in chapter 3), one of the issues resolved in the interim award was whether ‘the agreement is extant and should be respected’, or ‘void or to be terminated’.32 The claimant originally claimed that the agreement was still in existence, whereas the respondent argued that the joint venture agreement was void because it was improperly procured, or because of repudiatory breaches of the agreement and of fiduciary duties by Bridas, or frustrated by reason of supervening circumstances.33 If the joint venture agreement was considered valid, the arbitral tribunal had to decide whether the breakdown of mutual trust and confidence required the winding up of the joint venture Yashlar.34 31

EDF v. Argentina, paras. 943–69 (n. 29). Joint Venture Yashlar (Turkmenistan), Bridas S.A.P.I.C. (Argentina) v. The Government of Turkmenistan (or Turkmenistan, or the State of Turkmenistan and/or The Ministry of Oil and Gas of Turkmenistan), ICC Case 9151/FMS/KGA, interim award, 8 June 1999, paras. 4 and 19. 33 Bridas v. Turkmenistan , interim award, para. 20 (n. 32). 34 Bridas v. Turkmenistan , interim award, para. 21 (n. 32). 32

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Chapter 5: Analysing, Framing, and Proving a Claim 5.26 With respect to the breach of contract, the arbitral tribunal ruled that the respond-

ent had committed a fundamental breach of the joint venture agreement, in that, without legal justification, it had refused to recognize the agreement as subsisting and had purported to suspend its operation indefinitely. Indeed, it was that step on the part of the respondent, which brought about this arbitration.35 5.27 According to the final award, ‘the Defendant and Counter Claimant failed to

comply with the Yashlar Joint Venture Agreement as amended and has wrongfully repudiated the said Agreement’. The arbitral tribunal held that the joint venture agreement ‘has been terminated for cause, namely the defendant’s wrongful repudiation of the said Agreement and termination thereof’.36 According to the tribunal, the claimant had to satisfy ‘on a balance of probabilities that if the Defendant had not repudiated the contract they would have endeavoured to continue with the joint venture and bring it to a successful conclusion’.37 5.28 Anticipatory breach, as already mentioned in chapter 4, leads to the termination ex

nunc, that is non-retroactively, of the contract, which allows the claimant to claim for the expectation interest (loss of bargain) or the reliance interest under English law.38 5.29 Autopista Concesionada de Venezuela, C.A. (‘Aucoven’) v.  Bolivarian Republic of

Venezuela was an investment contract arbitration case based on the breach of a concession agreement by Venezuela, which was awarded in a public tender procedure in 1995.39 The concession agreement was for the design, construction, operation, exploitation, and maintenance of Venezuela’s main highway system including the construction of the new viaduct over the Tacagua Gorge (the Bridge) consisting of an investment of approximately US$215 million.40 5.30 The primary source of revenue was the collection of tolls by Aucoven, to be

increased by Venezuela according to a specific time frame. If the toll collections did not reach a minimum level, Venezuela was to compensate Aucoven (so-called ‘shadow tolls’, as explained in chapter 3).41 However, Venezuela refused to adjust the tolls in accordance with the agreement alleging force majeure due to violent protests against the increase of the tolls. In particular, Venezuela argued that the breach of the concession agreement was justified by force majeure according to Clause 31 of the concession agreement. The arbitral tribunal found that Venezuela

35

Bridas v. Turkmenistan, interim award, para. 535 (n. 32). Bridas v. Turkmenistan, interim award, 205 (n. 32). 37 Joint Venture Yashlar (Turkmenistan), Bridas S.A.P.I.C. (Argentina) v.  Th e Government of Turkmenistan (or Turkmenistan, or the State of Turkmenistan and/or The Ministry of Oil and Gas of Turkmenistan), ICC Case 9151/FMS/KGA, final award, 18 May 2000, para. 53. 38 See chapter 4, para. 4.19. 39 Autopista Concesionada de Venezuela, C.A. (‘Aucoven’) v.  Bolivarian Republic of Venezuela (‘Venezuela’), ICSID Case No. ARB/00/5, 23 September 2003, para. 16. 40 Aucoven v. Venezuela , para. 22 (n. 39). 41 See chapter 3, paras. 3.130–3.131. 36

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D. The But-for Premise as the Analytical Framework did not meet the conditions established in such provision to justify the breach of the concession agreement. In particular, the riots were not considered unforeseeable and were supported by local authorities. The arbitral tribunal found that Venezuela breached Clauses 22 (issuance of guar- 5.31 antee), 23 (refusal to pay Minimum Guaranteed Income), 31 (increase of toll), and 64 (breach of arbitration clause) of the concession agreement. In June 2000, Aucoven terminated the contract for breach of the concession agreement by Venezuela according to Clause 60 of the agreement. With respect to termination, the question arose whether Aucoven could terminate 5.32 the agreement unilaterally on the ground of Venezuela’s breaches. According to Aucoven’s legal expert, Clause 60(2) of the concession agreement constituted an ‘express resolutory clause’ permitted under Venezuelan law, which would allow for unilateral termination of the contract, whereas Venezuela argued that such termination could only be made under the terms of the Contract and Decree Law No. 138 by applying to the appropriate tribunal for an order approving such termination at Aucoven’s request.42 The arbitral tribunal found that under Clause 60(2) of the concession agreement, the concessionaire could unilaterally terminate the concession agreement, which: . . . is a classic provision in long-term contracts. There is no indication on record that could lead the tribunal to believe that the parties’ intent in drafting Clause 60 was not to provide for an ordinary resolution clause. Had the parties really intended to subject the termination of the Agreement to a ruling by a judicial body, they would have expressly referred to such requirement in Clause 60(2) of the concession agreement. Hence the Tribunal found that Clause 60(2) entitled Aucoven to terminate the Concession Agreement by a unilateral notice.43

Under French law and Latin American jurisdictions based on French law, unless 5.33 the contract expressly provides that the termination is without prejudice to a ruling by the competent tribunal, a contract may not be terminated unilaterally without judicial resolution, save by the public entity under its exorbitant powers.44 2. The loss a. Determination of loss Legally speaking, once the breach has been determined, the next step is to identify 5.34 whether there is a loss. Loss is the economic detriment of the claimant. A breach can be said to cause a loss if the claimant’s actual position is worse than its hypothetical 42 Aucoven v. Venezuela , para. 219 (n. 39); as regards the role of courts under French law, see chapter 4, paras. 4.183, 4.209. 43 Aucoven v. Venezuela , paras. 221, 234 (n. 39). 44 Hector A.  Mairal, ‘Government Contracts under Argentine Law:  A  Comparative Law Overview’ (2002) 26(6) Fordham International Law Journal 1737–8, 1740–1; Aucoven v. Venezuela, paras. 221–4 (n. 39).

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Chapter 5: Analysing, Framing, and Proving a Claim condition in the absence of the breach. The claimant suffers a loss by a breach of a contract when the claimant would be in a better financial position but for the breach; conversely if the claimant would be in the same financial position without the breach, the violation results in no loss. The but-for premise starts by establishing the hypothetical economic performance of the contract absent the breach, and it seeks to determine in money terms the difference between the hypothetical and the actual situation as a consequence of the breach for the injured party.45 Such difference is precisely the loss or the expectation interest under the differential hypothesis or but-for premise. 5.35 The ‘ultimate test’ is the comparison between the claimant’s hypothetical perfor-

mance and the actual performance over a certain period of time. The experts have to determine whether the but-for performance of claimant would have been superior to the actual performance.46 This requires the reconstruction of the hypothetical contract performance and in order to do this, each of the relevant contingencies that might affect such performance during the relevant period of time must be analysed. 5.36 In Phillips v. Venezuela, 47 which was an ICC commercial arbitration based on

a discrete damages case,48 Venezuela enacted the ‘Organic Law’, which reserved to the state the industry and trade of hydrocarbons. This law had the effect of reserving all activities related to the exploitation, manufacture, refining, transportation, or management of oil exclusively to Venezuela. The Nationalisation Law of 1975 provided for an exception entitling private parties to participate in projects in the petroleum industry. In the 1990s in view of the difficulty of unlocking the potential of the Orinoco belt, Venezuela initiated a process known as the ‘apertura petrolera’, aimed at attracting financial investments and know-how from foreign oil companies in order to exploit the heavy crude oil resources located in the Orinoco belt. This led to four projects relating to extraction, production, and upgrading of extra heavy crude oil in the Orinoco belt: the Petrozuata project, the Hamaca project, the Cerro Negro, and the Sincor project. Each of these projects was concluded between subsidiaries of the respondent and foreign oil companies. The dispute arose out of the two association agreements between the claimants and subsidiaries of the respondent in 1995 and 1997 with regards to the Petrozuata and the Hamaca projects. The claimants raised claims in relation to subsequent production and export curtailments allegedly imposed by the Venezuelan government in relation to the latter’s status as an OPEC member state.49 The breach consisted in the violation of the Petrozuata Side Letter and the PDVSA Pedrozuata Guaranty.50 45

ABA, Proving Antitrust Damages: Legal and Economic Issues 4 (n. 10). ABA, Proving Antitrust Damages 6 (n. 10). 47 Phillips Petroleum Company Venezuela Limited, ConocoPhillips Petrozuata B.V. v. Petroleos de Venezuela, S.A., ICC Case 16848/JRF/CA, 17 September 2012. 48 Referring to an isolated damaging event but not a continuous breach of contract situation. 49 Phillips v. Venezuela, paras. 23–5 (n. 47). 50 Phillips v. Venezuela, para. 282 (n. 47). 46

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D. The But-for Premise as the Analytical Framework In this case, the claimant used the but-for premise for the calculation of the loss, 5.37 which was the effect of the crude oil curtailments by the Venezuelan government. The arbitral tribunal stated ‘that when calculating losses suffered by the Claimants due to production curtailments, these calculations may only take into account relevant data concerning actual and/or but for production volumes from the first relevant curtailments (i.e. November 2006) until the takeover by PDVSA of the Petrozuata Project (i.e. May 2007)’.51 The reconstruction of the hypothetical course of events needs to isolate the effects 5.38 of the breach of the contract from any other factors which may affect a business or a company, and should be in accordance with the evidence available to prove the reasonable certainty of income. The most important issue when rebuilding the hypothetical situation is not only to isolate the effects of the breach, but that the data are credible. If the claimant purports to be unrealistically successful, this may indicate that the damages are overstated. Extremely high rates of return will raise doubt on the reasonableness of the claimant’s quantification. ‘Similarly the quantification will be weakened if the defendant can show that it conflicts with basic economic forces.’ Finally, the claimant’s damages case must be consistent with its liability case. Under the differential hypothesis, the loss may be quantified through different valuation methods. Any quantification method used to determine damages must pass the test of establishing a ‘just and reasonable estimate’, even if they are only ‘approximate’ and ‘probable’ damages.52 Losses under complex long-term contracts, resulting from the difference between 5.39 the hypothetical and actual scenarios, must be proved with reasonable certainty, which after the application of limitations under applicable rules of law, results in the actual loss. They may comprehend losses from the date of the breach to the date of the award, and future losses. As expressly referred to in the US Restatement (Second) of Contracts and French law 5.40 and analysed in detail in chapter 4, full compensation has to cover the actual loss or the loss suffered by the injured party. This is the difference between the but-for economic and the actual situation of the injured party, which can be proved with reasonable certainty. Therefore, evidence plays an essential role. In the light of this, full compensation of losses duly evidenced is nothing else than fair, just and adequate compensation. As stated by Mark Kantor, ‘[m]any legal systems reject consideration of lost earn- 5.41 ings opportunities when the future prospects of the enterprise are too speculative or uncertain to support such award’.53 This means that compensation is only due when a reasonable degree of certainty of the loss is established or proved. In English

51

Phillips v. Venezuela, para. 286(iii) (n. 47). ABA, Proving Antitrust Damages 57, 61 (n. 10). 53 Mark Kantor, Valuation for Arbitration, Compensation Standards, Valuation Methods and Expert Evidence (Wolters Kluwer 2008) 70. 52

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Chapter 5: Analysing, Framing, and Proving a Claim contract law, the injured party must show on the balance of probabilities that it suffered the loss or damage.54 5.42 Lost profits are recoverable when there is reasonable certainty of the income or

profits. In atypical synallagmatic contracts based on income stream, what matters is that the income stream was interrupted or affected by the breach of contract. The reasonable certainty of loss, in essence, depends on the reasonable certainty of the income stream and the evidence available. In the automotive joint venture case, revenues were based on the sales to a specific customer and the quantification of damages consisted in the determination of the difference between the revenues shown in the business plan prepared by both parties and the actual situation caused by the breach. In this case the actual sales numbers of automobiles in the market using the car parts object of the joint venture exceeded the expectations established in the business plan as evidenced in the industry records, which proved the certainty of income, which was lost due to the breach. However, the arbitral tribunal did not allow the injured party to reconstruct the but-for scenario upon the publicly available information presented in the arbitration and rejected requests for documents on actual sales of the competing joint venture, which were under the control of the respondent. This prevented the determination of the actual loss. As previously mentioned in chapter 2, evidence and the access to it, has a significant impact on a damages claim. Arbitral tribunals should not interfere in the injured party’s right to establish the reasonable certainty of loss as this violates the full compensation principle through procedural measures.55 5.43 In order to determine the losses in complex long-term contracts, the following situa-

tions should be considered: In typical synallagmatic contracts, the injured party may be the party receiving the money or the one receiving the goods or services. When the injured party is the one receiving the money, a payment action suffices and damages do not normally arise. When the injured party is the one that receives the goods or services, the losses derive from the non-performing goods or services and can be quantified as the difference in value between the conforming or non-conforming goods or services, or the cost of cure, plus the lost profits deriving from collateral transactions that did not take place because of the breach, which again result from the difference in value between the but-for and the actual scenarios of the injured party. In case of atypical synallagmatic contracts, the breach interrupts the income stream and the injured party may normally only claim lost profits. 5.44 The first kind of contract refers, for example, to the construction of a thermo-electrical

plant for a project company. The plant does not meet the performance requirements.

54 Jonathan Luz and Reema Shour, ‘Assessment of Damages for Repudiatory Breach of a Charter Party: Latest Developments in English Law’ (2011) 22(1) ICC International Court of Arbitration Bulletin 20. 55 See chapter 2 as regards typical factors that may affect full compensation of damages.

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D. The But-for Premise as the Analytical Framework This leads to damages in the form of the difference in value or cost of cure of the non-performing plant, plus lost profits from the lack of sale of energy. The second kind of contract refers, for example, to a project company that operates 5.45 a toll road under a concession. Due to government measures tolls are not increased as established under the project agreement or taxes are increased in breach of the concession agreement. This results in loss of income or lost profits. Under a joint venture agreement, the party obliged to provide technology may affect the sales of the joint venture company by breaching such obligation, causing considerable lost profits to the joint venture company and the joint venture partners. This is of relevance, as in this kind of contract the only loss is the lost profits. These lost profits result from the difference between the but-for income stream and the actual income stream. The loss is, in essence, the effect of the breach on the income stream and a matter of causation. As already mentioned, the differential hypothesis or but-for premise is particularly relevant in atypical synallagmatic contracts based on income stream, as the losses are lost profits and damages are measured numerically, albeit subject to complex financial models. This will be explained in detail throughout this chapter and in chapter 6. b. Analysis of contingencies to reconstruct the hypothetical course of events The identification and analysis of contingencies is useful when using the but-for 5.46 premise to reconstruct the hypothetical situation or course of events but for the breach. Each event has to be valuated as the probability of profit depends on it. Statistical methods may be used to determine probabilities with respect to the contingencies in order to establish the reasonable certainty of income. In Bridas v. Turkmenistan the analysis of the contingencies is based on the evi- 5.47 dence presented by the parties to determine whether there is reasonable certainty of income stream. Contingencies, a term used under English law, refer to events that might bar the bargain from happening. Contingencies may depend on other contingencies. The further the chain of contingencies advances, the less likely is an event to occur. The examination of claims by contingencies is similar to the decision-tree method56 and sometimes requires the use of econometrics or regression analysis in order to determine probabilities of future events. According to the seminal study on damages claims for the violation of antitrust law, ‘[p]roperly applied econometric techniques can provide both reliable estimates of the magnitude of damages and useful information about causation’.57 As may be discerned from the award, the parties use these techniques in order to prove their case, in

56 Klaus Peter Berger, Private Dispute Resolution in International Business:  Negotiation, Mediation, Arbitration, Volume II: Handbook (Kluwer Law International 2009) 212–21; Ulrich Hagel, ‘Der Unternehmensjurist als Risikomanager—die Mysteriöse Welt von Risikoanalysen und Entscheidungsbäumen’ (2011) 2 SchiedsVZ 65–75. 57 ABA, Proving Antitrust Damages 130 (n. 10).

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Chapter 5: Analysing, Framing, and Proving a Claim particular, with respect to the probability of finding gas in place through the Monte Carlo method mentioned in para. 5.51. 5.48 The dispute revolved around the treatment of uncertainty when assessing values.

Such uncertainties may be analysed through a deterministic or a probabilistic method. The former ‘treats uncertainties by determining one value as the best estimate of each uncertainty’, whereas the latter ‘treats each uncertainty by assigning to it a range or distribution of values’.58 5.49 The contingencies for the realization of the bargain were as follows: (i) the existence

of sufficient gas volume, (ii) transport through pipelines, (iii) the market for the Yashlar gas, (iv) price, and (v) the cost of exploration and exploitation of the Yashlar gas field. Once all the probable values of these elements had been determined, the discount rate had to be analysed in order to obtain the current value of the forecasted revenue stream. 5.50 i. Volume of gas

With respect to the amount of gas, the arbitral tribunal had to make an assessment taking into account all uncertainties. In fact the arbitral tribunal recognized that their conclusion could only be based on its best estimation.59 The tribunal stated, ‘that when future losses arising from breach of contract are to be assessed, on matters of doubt all reasonable presumptions are to be made in favour of the innocent party and against the wrongdoer’. However, the arbitral tribunal asserted that it could not assume in favour of the claimants the existence of the maximum possible volume of gas.60

5.51 There are several elements to take into account when trying to find out the probable

amount of gas, such as the bulk rock volume, the amount of reefal faces contained in such volume, and porosity, amongst others.61 Each of these elements reflects uncertainty, which is assessed through the Monte Carlo model. In this method, some of the inputs are deterministically chosen, while the important inputs are in the form of probability distributions.62 Under that model, the inputs may consist of empirical data, analogies, or others. The Monte Carlo model samples various input distributions on the basis that they are uncorrelated with each other. The user can, however, specify that certain inputs should be correlated in the simulation model, if this serves to reflect reality.63 This method was applied to the estimate of gas in place and in conclusion, the arbitral tribunal considered that there was gas in place and that the amount was closer to the claimant’s forecast.64

58 59 60 61 62 63 64

Bridas v. Turkmenistan, final award, para. 84 (n. 37). Bridas v. Turkmenistan, final award, para. 82 (n. 37). Bridas v. Turkmenistan, final award, para. 56 (n. 37). Bridas v. Turkmenistan, final award, paras. 78–80 (n. 37). Bridas v. Turkmenistan, final award, para. 87 (n. 37). Bridas v. Turkmenistan, final award, para. 88 (n. 37). Bridas v. Turkmenistan, final award, paras. 174, 176–8 (n. 37).

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D. The But-for Premise as the Analytical Framework ii. Transportation Access to the European market was through the Russian 5.52 pipelines. However, the use of the Russian pipelines was barred after the independence of Turkmenistan. The claimant argued that defendant assumed the risk of pipeline access under the Joint Venture Agreement. However, the arbitral tribunal found that defendant had not assumed such risk, referring to evidence such as a report to the Securities Exchange Commission in the USA.65 iii. Possible markets With respect to the product markets, each of the parties 5.53 made an estimate of the possible countries where they could sell the gas. The arbitral tribunal analysed and assessed the studies presented from both sides. It found that ‘the impression is that the claimant first and foremost sought to establish volumes, and then looked for evidence to confirm that all their forecasted volumes could be sold for more than the costs to produce them’.66 The arbitral tribunal concluded that the claimant should have considered in their forecasts how much supply already existed and the difficulty of entering those markets as well as the creditworthiness of some of the possible purchasers.67 iv. Price According to the arbitral tribunal price does not play a role if there is 5.54 no real possibility of entering into the market.68 The arbitral tribunal when assessing certainty of damages took into consideration 5.55 the real economic situation of the different possible purchasers and the difficulties of selling gas in those markets. In fact, the arbitral tribunal questioned the reasonableness of claimant’s risk assessment when entering into the project.69 The arbitral tribunal pointed out that once the existence of the reservoir is established, the market analysis should dictate the production schedule.70 The arbitral tribunal analysed the demand for the Turkmenian gas as well as its access to the exportation market and stated that neither the reservoir nor the discount factor were relevant in the absence of export markets.71 The arbitral tribunal arrived at the conclusion, based on the evidence presented 5.56 and analysed, that even if the transport problem could be solved, the Western European market would remain impenetrable for some years, due to the lack of pipelines, and even thereafter competition for that market share might be fierce. Therefore, there could be no certainty as to the quantity of Yashlar gas which might reach Western Europe. This removed significant quantities from claimant’s projections, especially in terms of future hard-currency revenues. The arbitral tribunal found that evidence did not prove there were better prospects for sale.72 Finally, 65 66 67 68 69 70 71 72

Bridas v. Turkmenistan, final award, paras. 196–7 (n. 37). Bridas v. Turkmenistan, final award, para. 202 (n. 37). Bridas v. Turkmenistan, final award, paras. 203, 263, 266 (n. 37). Bridas v. Turkmenistan, final award, paras. 221, 300 (n. 37). Bridas v. Turkmenistan, final award, para. 203 (n. 37). Bridas v. Turkmenistan, final award, para. 205 (n. 37). Bridas v. Turkmenistan, final award, para. 207 (n. 37). Bridas v. Turkmenistan, final award, paras. 241, 246, 259 (n. 37).

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Chapter 5: Analysing, Framing, and Proving a Claim after analysing all the evidence, the arbitral tribunal did not accept the proposition that the Joint Venture would so clearly be in the position of winning a share of the limited Turkmenian export possibilities.73 5.57 In Aucoven v. Venezuela, there was an obligation of the public entity to increase

the tolls (see para 5.30). The political risk of public opposition to toll increases was clearly allocated to the public entity as the party more capable to control such risk. As mentioned in chapter 3, proper risk allocation enables the contractor to offer a reasonable price in an unstable political environment. Therefore, the allocation of such political risk to the public entity makes sense from the perspective of risk and cost management. Contractual risk allocation is the core of the intention of the parties in project agreements and should be respected by the arbitral tribunal. The arbitral tribunal should have reconstructed the hypothetical course of events instead of making a shortcut to the reliance interest. This would lead to a hypothetical increase of tolls and the examination of the question of price elasticity, which means how an increase of tolls would have affected the market and, therefore, the income stream. 5.58 The principal contingency in the Aucoven case was, however, the construction of

the bridge. In this respect the question arises whether Aucoven was capable of building the bridge and within the cost margin established in the concession agreement within the 13-year period. This was not further analysed in the award as required under the but-for scenario, but was considered only as an element representing uncertainty. In particular, the arbitral tribunal did not analyse whether the contractor was capable of constructing the bridge in question and whether it had carried out similar projects in the past. 5.59 Therefore, it would have been necessary to determine what would have happened

if Venezuela had increased the tolls as agreed and Aucoven had built the bridge. However, the arbitral tribunal found that the expert evidence put forward by Venezuela established that the Concession Agreement would not have generated profits even if performed under its terms.74 In this respect, the question arises why a company would enter into a project if there is no opportunity to generate profits. The arbitral award did not give the answer to this question. 5.60 The Aucoven award does not reflect the analysis of contingencies in the light of

the risk allocation structure agreed by the parties when entering into the contract. There is no practical application of the but-for scenario, that is the reconstruction of the hypothetical course of events, taking into consideration a step-by step approach of the contingencies starting with the construction of the bridge. Based on the express provision in the agreement, the arbitral tribunal awarded the

73 74

Bridas v. Turkmenistan, final award, para. 289 (n. 37). Aucoven v. Venezuela, para. 365 (n. 39).

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D. The But-for Premise as the Analytical Framework reliance interest without further analysis and discussion but limited to the verification of the respective amounts. 3. Causation Once a loss is identified, the next step is to determine causation. Causation is the 5.61 test for establishing the connection between the loss and the breach. The claimant tries to show that the breach had a sufficient causal connection to the loss. Under the but-for premise, the question to be asked is what would have happened in the absence of the breach. If the claimant would be in the same situation without the breach, there would be no causation. Whether this situation is limited to economic terms or to the exact position including cost of cure depends on the contract and is a matter of the measure of damages under the applicable rules of law.75 The loss must be properly attributable to the breach.76 Liability is to the extent that losses would have been avoided in the absence of the breach.77 If a business or investment is not profitable even in the absence of the breach, then there is no loss caused by the breach. In case of lost profits the determination of the effect of the breach on the income 5.62 stream is defining loss caused by the breach in one single test. The loss is the effect of the breach on the income stream arising from the market. The loss and causality are determined precisely through the differential hypothesis or but-for premise. The difficulty lies in the construction by the respondent of hypothetical concurrent 5.63 causation situations such as contributory negligence in order to reduce the ‘scope’ of causation. For example, in the case of the violation of a non-competition obligation, the defendant may argue that the joint venture company would not have won the project even in the absence of the breach, or that the company was badly managed by the managing partner. It goes without saying that the burden of proof of such hypothetical lack of causation arguments is upon the respondent. Causation is not only a requirement for the recovery of damages, but also has 5.64 implications on the amount or extent of damages to be recovered. Partial causation may lead to a substantial reduction of the damages claim. Therefore, the fact of the existence of loss, the causation of the loss by the breach of contract and the quantification of the loss cannot be separated. Moreover, all three aspects are intimately related to the presentation of adequate evidence. In the automotive joint venture case, the respondent argued that the company 5.65 would not have won the project even in the absence of breach, as there were other competitors. The claimant showed that the company had obtained the initial

75 76 77

Chapter 4, paras. 4.38, 4.128, 4.203, 4.236, 4.296, 4.361, 4.362, 4.397. ABA, Proving Antitrust Damages 9 (n. 10). Mommsen, Zur Lehre von dem Interesse 137–8 (n. 11).

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Chapter 5: Analysing, Framing, and Proving a Claim project and that there were only two other competitors, which had never been registered as suppliers for the auto part in question. This demonstrates how even in a wilful breach of contract situation such as the violation of a competition clause through a competing joint venture by one of the parties to the original joint venture at the moment of the award of a major international project, the proof of causality may be a major obstacle for the claimant. 5.66 The aim of the causality test is to construct the but-for situation of the injured party

in such a way that the difference between the injured party’s but-for situation and its actual experience is a consequence only of the breach. The basic assumption is that the hypothetical values are unaffected by the alleged breach. If the defendant shows that the actual conditions during the damages period were substantially different from the assumptions taken in the projections, the injured party will not be able to prove that it failed to achieve its projected performance only due to the breach.78 5.67 Under German law, atypical events negatively affecting the injured party have to

be ignored under the doctrine of the hypothetical normal course of events. Under English law, atypical events such as war subsequent to the breach may lead to the interruption of causation through concurrent or intervening causation. The but-for premise is used to establish causality and it serves as a filter in order to determine whether the loss was caused by the breach and to what extent. What is important is that the arbitral tribunal determines the value of the loss suffered by the claimant due solely to breach. This poses particular challenges in case of extraordinary events such as crises or extraordinary economic situations.

E. The Measure of Damages 5.68 Under the but-for premise the damages are estimated under particular rules of law.

Whereas the loss is the actual impact of the breach of contract, the measure of damages is the protected interest under the applicable rules of law as already explained in chapter 4. Under the different rules of law analysed, the measures of damages are damnum emergens and lucrum cessans, or expectation and reliance interest. These measures of damages impose challenges when framing a damages claim under complex long-term contracts, especially with respect to lost profits. The following paragraphs analyse these challenges and provide tools to overcome them. 1. Expectation interest 5.69 The expectation interest protects the legitimate expectation of the parties in the per-

formance of the contract. Under the but-for method the question is ‘What would 78

ABA, Proving Antitrust Damages 56–9 (n. 10).

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E. The Measure of Damages have happened in the absence of the breach?’ In order to answer this question, the but-for premise compares the hypothetical situation without the breach and the actual situation with the breach. The result is a difference in value, which is the expectation interest.79 With respect to lost profits there are two main issues: (1) the reasonable certainty of the income stream or profits, and (2) the effect of the breach on the income stream. As regards the reasonable certainty of the income stream, claimant has to prove 5.70 that there would be income, according to the evidence available in the absence of the breach. The reasonable certainty of income in complex long-term contracts depends basically on the existence of a market and, as applicable, on the existence of the natural resources. The determination of the reasonable certainty of the income stream poses particu- 5.71 lar challenges in oil and gas cases, where such income stream is ‘fundamentally affected by the estimated ability of the company to produce crude oil and gas from existing reserves (proven and probable), and sell it at future prices, which are quite volatile’. However, even in such cases there are methods which allow the determination of the probability of finding oil and gas and methods in order to establish the value of future expected revenues with reasonable certainty.80 In a production joint venture, the parties co-operate so that the joint venture com- 5.72 pany reaches its common goal of generating income stream from the market. With respect to a toll road, the income generated from tolls depends on the number of users and, perhaps, shadow tolls from the government having granted the concession. In oil and gas concessions the income stream is through the sale of the oil and gas once it is found. With respect to the income stream under a take-or-pay agreement, that is, a sales contract, the payment is guaranteed and the market risk is allocated to the government.81 US courts recognize the expectation interest, which means that the injured party 5.73 should be put in the economic position it would be in but for the breach. Similarly, under English law, expectation interest is a measure of damages, where the aim is to put the injured party so far as money can do it, in the same position it would have been in had the contract been performed. This is also true for Germany and France.82

79 ‘Interest’ protected means expectation interest, which corresponds to full compensation, Mommsen, Zur Lehre von dem Interesse 27 (n. 11): ‘Das Interesse ist allerdings ein Schadensersatz; und sofern man den Ausdruck Schadensersatz allein auf die vollständige Entschädigung bezieht, treffen beide Ausdrücke in ihrer Bedeutung zusammen’. 80 Manuel A.  Abdala, ‘Key Damages Compensation Issues in Oil and Gas International Arbitration Cases’ (2009) American University International Law Review 547–8. 81 See chapter 3, paras. 3.138–3.139. 82 See chapter 4.

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Chapter 5: Analysing, Framing, and Proving a Claim 5.74 The difference in value between the but-for and the actual situation in collateral

transactions under typical synallagmatic contracts and in atypical income stream based complex long-term contracts refers only to lost profits. An investor has a legitimate expectation that it will obtain revenues in order to recover its investment, pay back credits and loans, and hopefully make some net profits that surpass the investment. The injured party may or may not recover its initial investment through the difference in value, as this depends on the performance of the project, but in any case, it cannot recover lost profits and the initial investment at the same time, as this would lead to double counting. 5.75 When the breach results in the loss of value of the company, damages is the dif-

ference between the but-for value of the company and its actual value, as further explained in chapter 6. 2. Reliance interest 5.76 This measure of damages is the loss caused by entering into a contract, which was

not performed due to its breach, in other words these are the so-called wasted expenses in reliance on the contract. Reliance interest and expectation interest are mutually exclusive. This derives from the underlying questions: under the reliance interest the question is what would be the position of the injured party if it had not entered into the contract; under the performance interest the question is what would be the position of the injured party but for the breach. 5.77 Certain rules of law such as English and German law establish the burden of proof

upon the injured party that the investment would have been recovered through the income generated by the contract. Both English and German law establish, however, a presumption in favour of recovery, which leads to a reversal of the burden of proof, that is, the party in breach has to prove that the investment would not have been recovered. However, even in that case, the injured party has to prove the possibility that income would be likely. This is a matter of so-called good or bad business. The injured party cannot recover lost profits it would not have obtained had the breach not occurred, which is in accordance with the but-for premise. The same applies if the project has no value.83 5.78 Reliance interest may lead to overcompensation, when an investor is compensated

for investments that would have never been recovered in the absence of the breach. Reliance interest may be justified from a legal policy perspective, in a case where the investor entered into a project due to misrepresentation or misleading information provided by the respondent, bad faith of the respondent, or the difficulty of obtaining evidence, in particular when such evidence is under the control of the respondent. If the injured party can prove that it invested in reliance on misleading

83

See chapter 4.

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E. The Measure of Damages information and representations provided by the respondent, there should be no need to prove the certainty of the income stream, but only the investments made in reliance on the contract. Otherwise, arbitral tribunals should learn to deal with uncertainty and use the but-for premise, instead of taking shortcuts by awarding the reliance interest based on a supposed higher certainty, which is likely to be unfair to one of the parties. In Kahara Bodas, the arbitral tribunal stated that:

5.79

. . . the Claimant has as a matter of principle to be compensated for all the proven sunken costs which were incurred with regard to activities carried out in reality, without any need to enter into an ex post facto debate about whether such expenditures were reasonable and profitable or not. In other words, the Claimant is entitled to recover all costs and investments adequately proven and directly related to the works undertaken in implementation of the Contracts concluded with the respondents.84

However, the reasoning of the arbitral tribunal does not convince: there is no reason to award the initial investments when there was no reasonable certainty of profitability of the project. If the claimant had proved profitability with reasonable certainty, it should have been awarded expectation interest, even it is less than the initial investment. The requirement of profitability in awarding the reliance interest was discussed in 5.80 Bridas v. Turkmenistan. The arbitral tribunal found that the measure of the reliance loss is to put the claimants in the position they would have been in had the contract never been made, which is fully accepted in English law, according to which the reliance loss is not subject to reasonableness, but may not put the claimant in a better position than if the contract had been performed.85 The claimant’s case is based on showing that whatever was spent would have been recouped had the contract not been repudiated and had the claimant not thereby been deprived of the opportunity to recoup its investment.86 However, in case of reliance loss, it is upon the defendant to show that not sufficient value would be generated from the project in order to pay back such investment. When the reliance loss has to be evaluated, ‘it is the respondent which has the burden of proving the negative—that the expenditure would not have been recouped had the contract been performed’.87 The arbitral tribunal expressed that it would be legitimate to apply the principle 5.81 ‘omnia praesumuntur contra spoliatorem’, which provides for a generous assessment of damages given the fact that it was the respondent’s breach that caused the claimant to lose its opportunity of succeeding with the project.88 In case of the expectation interest, uncertainties play against the claimants, whereas in reliance interest 84 85 86 87 88

Karaha Bodas v. PLN, para. 101 (n. 15). Bridas v. Turkmenistan, final award, para. 62 (n. 37). Bridas v. Turkmenistan, final award, para. 350 (n. 37). Bridas v. Turkmenistan, final award, para. 363 (n. 37). Bridas v. Turkmenistan, final award, para. 365 (n. 37).

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Chapter 5: Analysing, Framing, and Proving a Claim uncertainties are against the defendant.89 Moreover, the arbitral tribunal made a negative inference upon the respondent regarding the undisclosed documents, by assuming that they would tend to support the minister’s forecasts in favour of the claimant’s market expectations.90 5.82 The claimant recovered the reliance loss on the basis that the defendant could not

prove that there was no possibility of making at least the minimum business to recover its reliance loss.91 The reliance loss is calculated from the date of the signing of the contract.92 5.83 The question to ask is what would have happened if the agreement had not been

entered into. Under English and German law this requires showing that there is a possibility that the claimant would have recovered its investment but for the breach. The burden to show that the expenditure would have been recouped is minimized under both laws by reverting the burden of proof, which means that the defendant has to prove that such recovery would not have taken place. This shift of the burden of proof derives from the Roman law maxim omnia praesumuntur contra spoliatorem, according to which ‘all things have to be presumed against the wrong doer’. 5.84 The Roman law maxim cited seems to be equally applicable to the expectation

interest and not only to reliance interest as an extreme burden of proof upon the claimant may make a damages claim for lost income impossible which would severely affect the full compensation principle. As already mentioned in chapter 2, procedural equity based on fairness is essential in order to achieve full compensation of the actual loss. 5.85 In Aucoven v. Venezuela, the reliance interest was awarded as it was expressly estab-

lished in Clause 60(2) of the concession agreement as out-of-pocket cost, which was widely worded. The scope of such out-of-pocket costs included ‘all losses or damages beyond the costs and expenses pursuant to the terms of the Agreement’.93 3. Damnum emergens and lucrum cessans 5.86 The notion of damnum emergens and lucrum cessans derives from the violation of a

sales contract under Roman law.94 Whereas damnum emergens is the loss incurred by not receiving a good according to specifications, lucrum cessans is the gain deprived of not being able to sell it at profit.95 The notion of damnum emergens and

89 90 91 92 93 94 95

Bridas v. Turkmenistan, final award, para. 369 (n. 37). Bridas v. Turkmenistan, final award, para. 377 (n. 37). Bridas v. Turkmenistan, final award, 151 (n. 37). Bridas v. Turkmenistan, final award, para. 359 (n. 37). Aucoven v. Venezuela, para. 241 (n. 39). Chapter 4, para. 4.190. Schwenzer, Hachem, and Kee, Global Sales and Contract Law para. 44.119 (n. 3).

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E. The Measure of Damages lucrum cessans is expressly provided for in French law and other rules of law based on French law, as well as the PICC. These notions are understood to comprise any kind of losses and loss of profits due 5.87 to the breach of contract. They encompass a broad range of damages. However, under French law and according to Andrea Pinna, ‘C’est ainsi que la pratique judiciaire a pris l’habitude, en dépassant la distinction de la perte subie et du gain manqué, de créer des catégories particulières des préjudices qui peuvent être subis par le contractant. On peut citer à titre d’exemples le préjudice commercial, financier, jouissance, de change, immatériel, parfois consécutif, parfois non consécutif, ou les pertes d’exploitation.’96 This means that the French judiciary surpasses such distinction and creates different categories for typical damages situations. Therefore, the notion of loss suffered and gains deprived is not a test to be applied literally. These concepts are useful in sales and works contracts, however, they create difficulties in damages determinations under complex long-term contracts based on income stream. Friedrich Mommsen explains that damages may appear in the form of damnum 5.88 emergens or lucrum cessans and not necessarily as both,97 and that those notions refer to potential elements that may be comprised by the expectation interest, but are not a definition of such interest. Damnum emergens and lucrum cessans only lead to a list of possible losses. According to Mommsen what matters is the effect of the breach on the assets of the injured party, which leads to the expectation interest.98 In the processing plant construction case, the damnum emergens could be the dif- 5.89 ference of the amount paid by the owner under the FIDIC EPC turnkey contract and the actual value received of a non-functioning plant, or the cost of cure which is the cost of a new plant complying with the performance requirements as well as the cost of removing the non-functioning plant. Additional damages would be the overheads and external processing cost. The lucrum cessans would be lost profits arising from collateral sales of processed products that could not be realized due to the lack of performance of the existing plant. Under the damnum emergens and lucrum cessans measure of damages, the gains deprived have to be added to the losses. This works well, subject to mitigation, under typical synallagmatic contracts. In the automotive joint venture case, which was a complex long-term contract 5.90 based on income stream, applying both damnum emergens as lost investment and lucrum cessans as lost income stream would cause double counting of claims. In this case only lost profits as a result of the difference between the but-for and the actual scenarios may be claimed. Therefore, the notion of damnum emergens and lucrum

96 97 98

Andrea Pinna, La Mesure de Préjudice Contractuel (L.G.D.J. 2007) 11. Mommsen, Zur Lehre von dem Interesse 11–12 (n. 11). Mommsen, Zur Lehre von dem Interesse 1 (n. 11).

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Chapter 5: Analysing, Framing, and Proving a Claim cessans is inadequate in order to determine damages caused by breach of complex long-term contracts based on income stream. 5.91 In the Karaha Bodas case, the arbitral tribunal awarded both losses suffered (dam-

num emergens) and gains deprived (lucrum cessans) expressly referring to the danger of double counting.99 In such case the underlying contract was a take-or-pay power purchase agreement,100 where the only losses for the energy provider that might occur are lost profits as the non-performance refers to the payment obligation of the off-taker or energy purchaser. Therefore, awarding additional damages for the investments should be avoided as this may lead to double counting, if the proper adjustments are not done. Under the but-for premise only the difference between the but-for and the actual scenarios is recoverable, which avoids double counting. 5.92 Siemens v. Argentina101 is about a public contract between Argentina and Siemens

as regards the acquisition and operation of integral services for the implementation of an immigration control, personal identification and electoral information system, including the provision of all equipment necessary for data processing and the inter-communication of such equipment, as well as the preparation, printing, and home delivery of national identity cards. In the arbitration Siemens claimed (i) the present value of its estimated lost profits or lucrum cessans, plus (ii) the costs it actually incurred, which were ‘wasted’ in the effort to produce the revenues from which those profits would be derived, which corresponds to damnum emergens.102 According to the arbitral tribunal, while it ‘understands the reasons for the admittedly unusual approach followed by Siemens and considers that it has merit in the particular circumstances of this case, it has some concerns, as later explained, about how the valuation has been calculated, including the valuation of the lucrum cessans’.103 The book value was determined on the basis of funds invested by Siemens in the project as shown by its financial statements.104 The claim for lost profits was denied as the arbitral tribunal considered them very unlikely to materialize.105 In particular, the arbitral tribunal found that the novelty and complexity

99

Karaha Bodas v. PLN, para. 109 (n. 15); Himpurna v. PLN, para. 240–2 (n. 15). Louis T. Wells, ‘Double Dipping in Arbitration Awards? An Economist Questions Damages Awarded Karaha Bodas Company in Indonesia’ (2003) 19(4) Arbitration International 471–81; Mark Kantor, Noah Rubins, and Thomas Wälde, ‘Compensation for Non-compliance on PPAs and Similar Long-term Contracts’ (2004) 1 TDM; Herfried Wöss, ‘Arbitraje y principios para la recuperación de daños y perjuicios por la violación de contratos al largo plazo’ in Sonia Rodríguez Jiménez and Herfried Wöss (eds.), Foro de Arbitraje en Materia de Inversión: Tendencias y Novedades, (Instituto de Investigaciones Jurídicas/UNAM, , 2013), 67–112 at 81–2. 101 Siemens AG v. Th e Argentine Republic, ICSID Case No. ARB/02/8, fi nal award, 17 January 2007. 102 Siemens v. Argentina , para. 355 (n. 101). 103 Siemens v. Argentina , para. 357 (n. 101). 104 Siemens v. Argentina , para. 376 (n. 101). 105 Siemens v. Argentina , paras. 379–85 (n. 101). 100

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E. The Measure of Damages of the project, which was the first of its kind, could lead to delays that could have had a devastating effect on the profit rate.106 The claimants requested the investment incurred plus lost profits, which is double 5.93 counting. The problem is that the arbitral tribunal awarded the investment even when the profits were not proved with reasonable certainty. If lost profits cannot be proved with reasonable certainty, then investments should not be awarded, as these investments were undertaken only with the expectations of getting a return. Thus the arbitral tribunal should have rejected lost profits, on the basis that they were not proved with reasonable certainty. In this case, Siemens had not started operations and, therefore lost profits were rejected. However this rejection was more based on the lack of history than the knowledge that the project was not profitable. But if the income had been proved with reasonable certainty, would the tribunal have given both the investments and the lost profits? That would have led to double counting. In these cases, it is important to analyse all contingencies involved in the project and make a reasonable estimate of the lost profits. This avoids contradictory findings such as denying the possibility of profits and at the same time awarding the amount of an investment that would have never been recouped. The measure of damages of damnum emergens and lucrum cessans is applicable 5.94 when the injured party is the one that receives the goods and services, however, in case the injured party only receives the income stream, there is only lost income or lost profits and therefore applying these concepts at the same time creates confusion. In some recent cases damnum emergens has been considered as historical lost profits from the date of the breach to the date of the award and lucrum cessans as future lost profits from the date of the award until the end of the damages period, as explained in chapter 6. This, however, does not correspond to the classical definition of these measures of damages under Roman and civil law but is an adaptation of such terms for income stream based contracts for the valuation of damages in order to avoid double counting. In civil law, lost income stream is lucrum cessans, whether historical or future. 4. Cost of cure As explained in detail in chapter 4, French law recognizes the principle of full com- 5.95 pensation (réparation intégrale) even without the obligation of mitigation upon the injured party. French law recognizes the cost of cure as the measure of damages even if such cost is not reasonable.107 This derives from the pacta sunt servanda principle, which protects specific performance. However, cost of cure does not apply to income expectations under complex long-term contracts or payment obligations

106 107

Siemens v. Argentina, para. 383 (n. 101). Chapter 4, para. 4.203.

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Chapter 5: Analysing, Framing, and Proving a Claim under take-or-pay agreements as this measure only applies to the non-conforming goods or services that can be repaired or replaced.

F. Limitations 5.96 The following limitations are of particular interest when framing a damages claim

under complex long-term contracts: (i) foreseeability, (ii) mitigation, and (iii) contributory negligence. 1. Foreseeability 5.97 In all complex long-term contracts considerable investments are made, in par-

ticular, in privately-financed infrastructure projects, where the contractor builds a plant or infrastructure in order to provide the contracted public services such as energy, water treatment, health services, roads and highways, amongst others, in order to obtain income or profits. It is precisely the breach by the other party that interrupts the income stream. 5.98 Foreseeability is recognized as a limitation in one way or the other in all rules of

law analysed: • Under English law, a defendant is not liable for loss, which is too remote. Remoteness of damages refers to a legal test where the promisor bears the responsibility for the usual consequences of a breach of the promise, while the promisee implicitly accepts the risk of unusual consequences, unless an explicit clause transfers the risk to the promisor.108 According to Hadley v.  Baxendale:  ‘The damages . . . should be such as may fairly and reasonably be considered either by arising naturally, i.e. according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract as the probable result of the breach.’109 • US courts follow the rule in Hadley v. Baxendale, which states that unforeseeable damages are not recoverable. §351 of the Restatement (Second) of Contracts reads that ‘[d]amages are not recoverable for loss that the party in breach did not have reasons to foresee as a probable result of the breach when the contract was made’. §2-715 of the Uniform Commercial Code (UCC) establishes the foreseeability requirement for consequential damages, which includes ‘any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know’.

108 109

Chitty on Contracts (30th edn., 2008) para. 26-051. (1854) 9 Exch. 341 at 354.

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F. Limitations • Article 1150 of the French Civil Code110 limits recoverable losses to losses that are foreseeable. Only damages foreseen at the moment of the execution of the contract are subject to compensation. The foreseeability test is an abstract assessment, where the defendant is held liable for the loss a reasonable person could have foreseen.111 There has been an extensive debate about the scope of foreseeability. Originally, the French Supreme Court required that the quantum of loss had to be foreseeable. However, such position has been modified in favour of the claimant in later jurisprudence.112 • Under German law, adequacy refers to damage as a probable consequence of the breach, observed by an objective observer at the moment of the breach and not at the moment of entering into a contract and not seen from the defendant’s point of view, as in French and Anglo-American law. Objective foreseeability is required in certain circumstances such as in the case of a claim for loss of profits. Under §252 BGB profits are foreseen if they are expected in the normal course of events, or if they could be expected under special circumstances, but were subject to particular measures and precautions of which the debtor was or should have been aware. • Under Article 74 CISG the loss has to be foreseeable from the point of view of the party in breach and not by both parties. Foreseeability is based on objective (reasonable person) and subjective criteria (actual knowledge). According to para. 3.19 of the Advisory Council Opinion to Article 74 CISG, ‘an aggrieved party is entitled to recover not only profits lost prior to the judgment, but also future lost profits, to the extent that such lost profits can be proved with reasonable certainty and subject to the principles of foreseeability and mitigation. While the Convention does not expressly state that future losses are recoverable, its recovery is consistent with the principle of full compensation.’ • According to Article 7.4.4 PICC (Foreseeability of harm), ‘[t]he non-performing party is liable only for harm which it foresaw or could reasonably have foreseen at the time of the conclusion of contract as being likely to result from its non-performance’. In essence the test of foreseeability in all the rules of law analysed refers to whether 5.99 the respondent was aware that the breach could cause lost profits, however some rules of law state that foreseeability refers to the moment of the breach and others to the moment of the execution of the contract.

110 ‘Le débiteur n’est tenu que des dommages et intérêts qui ont été prévus ou qu’on a pu prévoir lors du contrat, lorsque ce n’est point par son dol que l’obligation n’est point exécutée.’ 111 Guenter H. Treitel, ‘Remedies for Breach of Contract (Courses of Action open to a Party Aggrieved)’ in International Encyclopedia of Comparative Law, Vol. VII, Chapter 16, Arthur T. von Mehren (Chief Editor), (1976) 63, para. 86, with further references. 112 Civ., 7 July 1924, Sirey 1925.1, 321; Schwenzer, Hachem, and Kee, Global Sales and Contract Law paras. 44.106–8 (n. 3).

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Chapter 5: Analysing, Framing, and Proving a Claim 5.100 In the joint venture agreement in the automotive industry, which is a complex

long-term contract based on income stream, the obligation violated was the non-competition clause. A non-competition clause is an essential clause in a joint venture agreement, as it protects the performance of the joint venture.113 The purpose of the contract is to obtain income stream or profits and that is why the parties established the non-competition clause and invested in the joint venture. Therefore, the breach of this clause through the transfer of a project by one of the parties, to its new joint venture with a third party, directly affects the purpose of the contract and lost income is a foreseeable and direct consequence of the breach. In these cases, the profits are not only foreseen, but they are the sole object and governed within the contract, and the defendant cannot argue that the loss was not foreseeable when it entered or breached the contract. 5.101 In complex long-term contracts based on income stream, the question whether

the lost profits caused by the breach are foreseeable, where the only losses that can exist in these contracts are income or profits, should not apply. This is similar to the power purchase agreement, where the payment is the object and governed by the contract and no one would argue that the lost payment or lost profits due to the breach were not foreseeable. The same situation applies to income stream based complex long-term contracts, where the income is the object and governed already in the contract, and therefore the test of foreseeability should not even apply. 5.102 With respect to the processing plant case,114 which is a typical synallagmatic

contract, the purpose of the contract was to receive a performing plant according to certain output requirements (volume and time), therefore, the loss caused by non-performance was clearly foreseeable. It is uncontroversial that the owner makes a considerable investment with the sole purpose of obtaining profits from collateral sales transactions of the goods processed. Therefore, lost profits arising from the impossibility to achieve the expected sales due to the lack of performance are foreseeable. If the injured party could successfully process the products externally, there would not be lost profits but the cost of mitigation, which is the differential cost of production against the external cost of processing. Contractual risk allocation in the form of the limitation of liability of the contractor prevails. As explained in a leading US case:115 The ability of the non-breaching party to operate his business, and thereby generate profits on collateral transactions, is contingent on the performance of the primary contract. When the breaching party does not perform, the non-breaching party’s business is in some way hindered, and the profits from potential collateral exchanges are lost.116 113

Chapter 3, para. 3.147. Chapter 3, para. 3.180. 115 Chapter 4, para. 4.140. 116 Tractebel Energy Marketing, Inc. v. AEP Power Marketing, Inc., 487 F.3d 89, 109–110 (2nd Circuit 2007); Djakhongir Saidov, The Law of Damages in International Sales: The CISG and Other International Legal Instruments (Hart Publishing 2008) 102–3. 114

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F. Limitations Under the foreseeability test, consequential damages in the form of lost profits 5.103 from a defective plant are normally foreseeable, as the contractor is always aware that the plant output is necessary to finance the plant and to generate profits for the owner. Otherwise the owner would not build the plant. The lost profits arising from collateral transactions are normally the purpose of a plant construction contract and lost profits resulting from the breach should also be considered foreseeable, even if such lost profits are not expressly governed by the contract. In the cases mentioned considerable investments were made with the sole purpose 5.104 of obtaining profits and, therefore, the respondent was aware that by breaching the contract the injured party would have lost profits. Lost profits due to the breach of these contracts were foreseeable and it is not relevant whether they were foreseeable by the respondent at the moment of the breach or the date of the execution of the contract. The question of foreseeability refers to whether it was foreseeable for the defend- 5.105 ant that the breach would have caused the lost profits, but not to the certainty of the amount of profits lost. The fact that lost profits are foreseeable does not mean that the damages should be awarded, as risk allocation may bar the damages claim even if lost profits are foreseen. The duty of mitigation is particularly relevant with respect to collateral lost profits, and the reasonable certainty of income or profits must be evidenced. 2. Mitigation In general, mitigation is a duty to be performed. Failed mitigation efforts may not 5.106 be to the detriment of the claimant. Mitigation leads to a reduction of the recoverable damages. Mitigation is not a duty in France and countries based on French law such as Mexico. The reasonable expenditures in order to mitigate the losses are recoverable even if such efforts are not successful. If mitigation is successful, the loss suffered while the claimant was trying to achieve mitigation may also be recoverable. However, losses may not be recovered if mitigation produces higher returns than would have been produced in the absence of the breach. If the claimant has taken reasonable measures to mitigate the consequences of the breach, the result of the but-for vs. the actual comparison damages calculation must incorporate the benefits and costs of mitigation.117 The burden of proving that the claimant did not mitigate losses is upon the respond- 5.107 ent. If the respondent proves it, the result could be that the tribunal would attribute the losses not to the respondent’s breach but to the claimant’s failure to mitigate losses.118 Therefore, the effect of lack of mitigation is similar to contributory 117 Tractebel v. AEP, 63 (n. 116); Saidov, The Law of Damages in International Sales 125–32 (n. 116). 118 Tractebel v. AEP, 63 (n. 116).

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Chapter 5: Analysing, Framing, and Proving a Claim negligence or lack of causality. However, mitigation applies as a duty to be taken by the claimant after the breach, whereas contributory negligence is a matter related to the breach. 5.108 The test of mitigation is to know if it was unreasonable for the claimant to go for

that particular mitigation opportunity, but not whether that opportunity was the next best alternative available. When quantifying the effect of failing to mitigate the positions of claimant and respondent change. In that case, the respondent will need to build a new hypothetical situation in which the claimant takes a reasonable mitigation opportunity that it did not take in the actual world.119 The recoverable damages would be the difference between the claimant’s hypothetical situation but for the breach, and the claimant’s hypothetical situation if it had mitigated.120 Even in case of the mitigation, the analysis of the but-for premise plays an important role and the damages result in the difference between the hypothetical situation with breach with mitigation and with breach but without mitigation. In arbitration, mitigation is an exception or defence but does not normally give raise to a claim of the party in breach. 5.109 In the case of the processing plant, as there is a duty to mitigate, the injured party

incurred overheads and external processing costs for external processing in order to avoid loss of profits. Therefore, the difference between the cost of production and the external cost of processing can be claimed. With regards to complex long-term contracts based on income stream, mitigation might not be possible, as the effect on the income stream of increased taxes, lack of permits, or non-delivery of technology to be provided by the other party, often cannot be mitigated. This has to be examined on a case-by-case basis. Even if lost profits cannot be mitigated, still the relevant issue is that the injured party proves that there would be profits with reasonable certainty. That is the issue. 5.110 Mitigation may play a role in the reliance interest where granted under the applica-

ble rules of law. Once the contract has been frustrated by the other party, the injured party may not carry on investing in the project and has to avoid an increase in the reliance loss. The rationale of mitigation is that the respondent should not carry with damages that could have reasonably be avoided so that economic resources are not wasted. 3. Contributory negligence 5.111 In income stream based contracts, contributory negligence is a matter of causality.

Income not received due to the fault of the injured party cannot be considered as lost profit caused by the other party’s breach. The question is what would be the

119 120

Tractebel v. AEP, 63 (n. 116). Tractebel v. AEP, 63–4 (n. 116).

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F. Limitations effect of the breach on the income stream. If the income stream is affected due to actions or omissions of the injured party, such an effect would not be caused by the other party’s breach. As the loss is the effect of the breach on the income stream or profits, lost profits as 5.112 a result of the injured party’s conduct or omissions may be considered as losses not caused by the breach under the but-for premise. When assessing lost profits, there is a certain overlap between causality, mitigation, and contributory negligence. Causality and contributory negligence refer to the moment of breach, whereas mitigation is relevant from the time of the breach onwards. In Occidental v. Ecuador OEPC assigned to AEC rights derived under the participa- 5.113 tion contract without the corresponding authorization by the Ecuadorian Ministry of Energy and Mines in breach of the law. The arbitral tribunal noted that OEPC ‘had agreed in the Participation Contract, that if it failed to obtain prior ministerial authorization to transfer rights under the Participation Contract to AEC, it ran the risk that the Respondent would declare the caducity of the Participation Contract. Since it did not seek nor obtain the required authorization, the Tribunal has found that it acted negligently and committed an unlawful act.’121 The arbitral tribunal found that in the absence of such authorization, ‘in consider- 5.114 ing the extent of the contribution of Claimant’s negligence to their injury, . . . the Caducidad Decree . . . was a disproportionate sanction and a measure tantamount to expropriation of the Claimant’s substantial investment in Ecuador.’122 The tribunal found that the claimant contributed 25 per cent to its loss by provoking the Caducidad Decree issued by the respondent through its violation of the law. This led to a reduction in the same proportion of the amount of damages determined which was considered fair by the arbitral tribunal.123 This situation relates to breach of contract by the claimant, which gives rise to ter- 5.115 mination by the respondent, rather than to contributory negligence. Termination for cause is subject to the applicable contractual provisions and the applicable law. If termination executed by the state was a termination for cause, due to illegal assignment of rights by OEPC to a third party, it would not give rise to damages. The right to damages might arise in this case through abuse of a right to termination by the state, which seems to be the case rather than contributory negligence. However, the contractual risk allocation should not only be respected with regards to tax increases, as mentioned before, but also with respect to the consequences of termination for cause. If the claimant took the risk of reduced damages in case of its breach of contract, then such contractual risk allocation should be observed

121 122 123

Occidental v. Ecuador, para. 679 (n. 18). Occidental v. Ecuador, para. 681 (n. 18). Occidental v. Ecuador, para. 687 (n. 18).

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Chapter 5: Analysing, Framing, and Proving a Claim by the arbitral tribunal, in particular as the case refers to natural resources which represent a significant part of the respondent’s wealth.

G. The Relevant Date for Valuation of Damages 5.116 The selection of the date for the assessment of damages, and to what extent the

damages expert should use ex-post breach or hindsight information in performing such assessment is particularly relevant. There is no pre-established practice as to the determination of a date of valuation of damages, in particular, in the case of complex long-term contracts. However, the date of the valuation has to be the most appropriate in the light of the full compensation principle, which means that the valuation has to restore the financial position that the injured party would have had at the date of the award, as this is the date when the injured party should receive the damages. This will be discussed in detail in chapters 6 and 7. 5.117 As eloquently stated by Charles Proctor, ‘the courts formerly adhered to the rule

that damages are to be assessed at the date of the breach (the “breach date rule”). Rigid rules have the merit of convenience and certainty, but they also have a habit of producing injustice.’124 This assertion was based on an observation made by Lord Wilberforce, according to which ‘it is for the courts or for arbitrators to work a solution in each case best adapted to giving the injured plaintiff that amount in damages, which will most fairly compensate him for the wrong which he has suffered’.125 5.118 It is important to say that the calculation of the expectation interest is not tied to

any date in particular; however under the full compensation principle, the question is what would be the situation of the injured party but for the breach at the moment of the award? This means that lost profits should be updated from the date of the breach to the date of the award, and, as applicable, lost profits from the date of the award till the end of the project have to be discounted to the date of the award. The discount and updating interest rates must be the same to avoid the invalid round trip (IRT) which is explained in detail in chapter 6. If the date of the breach is chosen for the damages valuation, in order to achieve full compensation, the lost profits from the date of the breach till the end of the project should be discounted to the date of the breach and updated to the date of the award at the same interest rate used to discount cash flows. The reliance interest is likely to be determined at the date of the investment and should be updated to the date of the award using the appropriate pre-award interest rate determined by the experts.

124 Charles Proctor, ‘Changes in Monetary Values and the Assessment of Damages’ in Djakhongir Saidov and Ralph Cunnington (eds.), Contract Damages, Domestic and International Perspectives (Hart Publishing 2008) 465. 125 Miliangos v. George Frank (Textiles) Ltd . [1976] AC 433 (HL) 468.

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G. The Relevant Date of Valuation As already observed in chapter 4, all rules of law analysed allow the calculation of 5.119 damages at the moment of the judgment: • Under English law, damages are assessed by reference to the time of the breach. However, the court may deviate from such date to assess damages by reference to the date that may be appropriate in the circumstances.126 The House of Lords, in The Golden Victory, stated that the assessment of damages should be at the date of the award as opposed to the date of the breach.127 In the case of Johnson v. Agnew, the House of Lords held that the breach-date rule ‘is not an absolute rule; if to follow it would give rise to injustice, the court has power to fix such other date as may be appropriate in the circumstances’.128 • Under US law, damages are normally determined on the trial date. This means that courts would have to award less damages where the loss decreased or more where such loss increased after the breach of contract and until the trial date. However, they may refer to dates beyond such date in order to contemplate future losses, when this is necessary to return the claimant to the position it would have had in the absence of breach.129 • The French Cour de cassation establishes, since 1942, that the damages have to be quantified as of the date of the judgment, which is considered in accordance with the principle of réparation intégrale. Therefore inflation and price increases or reductions between the moment of breach and the award have to be considered.130 Mexican law does not contain any legal or judicial criteria to that respect. • As regards Germany, the date of determination of damages by a German judge is the date of the last hearing of facts. This means that all adequate consequences of the violation are being considered until that time. This provision benefits the claimant only, and does not take into account any reduction of damages in favour of the respondent.131 Friedrich Mommsen established in 1855 that the damages should be calculated at the ‘time of the judgment’, which is ‘the only determination of the time which truly corresponds to the essence of interest’.132

126

Guenter H. Treitel, The Law of Contract (11th edn., Thomson, Sweet & Maxwell 2003) 959–60. The Golden Victory [2007] UKHL 12 (HL). 128 Johnson v. Agnew [1979] 2 WLR 487 (HL) 499. 129 James O’Brien and Robert P. Gray, ‘Lost Profits Calculations: Methods and Procedures’ in Nancy J. Fannon (ed.), The Comprehensive Guide to Lost Profits Damages for Experts and Attorneys (BVR 2011) 352–4. 130 Brieskorn, Vertragshaftung und responsabilité contractuelle 285–6, with further references (n. 9); Cass. Req. 24 mars 1942, D.A. 1942. 131 Brieskorn, Vertragshaftung und responsabilité contractuelle 284, with further references (n. 9). 132 Mommsen, Zur Lehre von dem Interesse 3 (n. 11): ‘Heutzutage gilt jedoch allgemein die Regel, daß die Zeit des Urtheils, d.h. die Zeit, zu welcher die Berechnung des Interesse vorgenommen wird, zu Grunde zu legen ist.’ 127

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Chapter 5: Analysing, Framing, and Proving a Claim • Under CISG, the only reference to the moment of calculation of damages is found in its Article 76, which refers to the abstract calculation of damages. In case of an abstract calculation the date of calculation is the date of the taking over of the goods or the date of the avoidance, whatever occurs earlier. In case of actual (concrete) valuation, the date of the determination of damages should be as late as possible, ideally, the date of the judgment.133 • The official comment to Article 7.4.2 (Full compensation) PICC seems to indicate that the damages have to be determined at the moment of the judgment or the arbitral award: ‘In application of the principle of full compensation regard is to be had to any changes in the harm, including its expression in monetary terms, which may occur between the time of non-performance and that of the judgment.’ 5.120 Under the but-for method, the difference could be between the but-for and the

actual situation at the date of the breach or at the date of the award. However, in order to achieve full compensation the but-for method should be applied at the date of the award including the losses between the date of the breach and the date of the award, which is permitted in all the rules of law analysed.

H. Other Conceptual Issues Related to Damages Assessment 1. Lost profits and lost value 5.121 The expectation interest under the but-for premise may be calculated as lost income

stream or as the loss of value of a business or investment. As shown in chapter 6, even when calculating a loss of value in the form of market value or fair market value (FMV), the income stream plays a preponderant role when the investment relates to a complex long-term contract based on income stream. Generally, it is not possible to recover as damages both lost profits and lost value for the same company. However, lost profits prior to the liquidation of the business may be recoverable in addition to the market value diminution, because they are not reflected in the market value determination.134 2. Difference between lost income and loss of a chance 5.122 In case of the loss of a chance, the profits depend on an aleatory element (‘alea’ or a

game of chance under Roman law) related to the performance of a contract, as they depend on exogenous circumstances not controlled by the parties. Damages are 133 Peter Schlechtriem and Ingeborg Schwenzer, Th e Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd (English) edn., Oxford University Press 2005) Art. 74, para. 33, with further references. 134 Thomas Burrage, ‘Lost Profit versus Lost Business’ in Fannon (ed.), The Comprehensive Guide to Lost Profits Damages 461 (n. 129).

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H. Other Conceptual Issues Related to Assessment limited to the pro rata probability of obtaining the profits.135 Under some rules of law, such as German law, loss of a chance is not recognized.136 Income expectations deriving from contractual obligations, even when subject to contingencies, should not be considered loss of a chance as contingencies refer to situations that can be overcome by the parties. That is why it is necessary to analyse the corresponding milestones or contingencies in order to determine the likelihood of the successful execution of a project. As mentioned previously, in Bridas v. Turkmenistan expectation interest was not 5.123 awarded but the tribunal awarded the reliance interest based on a reversal of the burden of proof as regards the profits not obtained. The injured party asked for the damages as loss of a chance, however, the arbitral tribunal stated that there is ‘a considerable difference between the loss of a specific contractual right and the loss of a general opportunity to trade in a speculative market’.137 Income stream refers to a contractual right, however reasonable certainty of the income must be proved in order for damages to be recoverable as expectation interest. The arbitral tribunal, instead of awarding the reliance interest, could also have determined the probability of achieving profits, by assigning probability estimates to each of the contingencies related to the profits and awarded the corresponding lost profits. There is a reasonable prima facie presumption that the project had some value. However, ‘[g]iving all reasonable scope to that principle in the context of this case, the Tribunal is unable to value the lost chance at any fi gure greater than the reliance loss established by the Claimants’.138 In Sapphire International Petroleums Ltd v. National Iranian Oil Company,139 the 5.124 National Iranian Oil Company (NIOC) and Sapphire Petroleums Ltd, a Canadian company, entered into a contract to expand the production and exportation of Iranian oil. Sapphire started works in the concession area and claimed the reimbursement of its expenses, which was, however, refused by NIOC due to lack of prior authorization. As a result, Sapphire did not start drilling in the concession area as planned. Sapphire initiated arbitration proceedings and claimed compensation for expenses before and after the conclusion of the contract, loss of profit, and the refund of an indemnity. The tribunal held that the object of the award was to put Sapphire in the position it would have been if the contract had been

135 Brieskorn, Vertragshaftung und responsabilité contractuelle 345 (n. 9), Cass. Com., 4 décembre 1990 pourvoi n˚89-16338: ‘attendu,. . . que la Cour d’appel. . . a tenu compte de l’aléa subsistant alors sur la réalisation de ces projets, en affectant d’un coefficient de minoration le préjudice considéré de façon à manifester qu’il ne consistait qu’en une perte de chance’; Saidov, The Law of Damages in International Sales 70–5 (n. 116). 136 Wolfgang Fikentscher and Andreas Heinemann, Schuldrecht, 10. Aufl age (De Gruyter 2006) para. 631. 137 Bridas v. Turkmenistan , fi nal award, para. 60 (n. 37). 138 Bridas v. Turkmenistan , fi nal award, paras. 384–6 (n. 37). 139 Sapphire International v. NIOC , award, 15 March 1963, (1967) 35 ILR 136.

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Chapter 5: Analysing, Framing, and Proving a Claim performed and damages for loss of the opportunity to find petroleum as the claimant showed sufficient probability of the success of the prospecting undertaking if it had completed the process. Such award was based, amongst other things, on the fact that NIOC would not have made a concession to the area if it did not think there was a serious chance of discovering oil.140 3. Effect of income taxes 5.125 In order to place the injured party, in the same position it would have been in

but for the breach, the amount of damages awarded should include the respective income tax, if applicable, so that after the payment of taxes by the injured party it will be in the same position but for the breach.141 4. Adjustment avoiding overcompensation 5.126 The but-for situation of the injured party must be adjusted to account for the off-

setting benefits caused by the breach in order to avoid overcompensation for the claimant. This is in accordance with the but-for premise and the full compensation for the actual loss.

I. Relevance of the Evidence Available and Burden of Proof 1. Breach and evidence 5.127 Breach and the application of exception or justification clauses must be duly

proved. Whereas the burden of proof of the breach is upon claimant, the burden of proof with respect to exception or justification clauses is upon the respondent. The existence of exception or justification clauses may sometimes result in challenging evidentiary issues. 2. Causation and evidence 5.128 As regards causation, it must be proved that there is a link between the breach and

the loss. The claimant must provide sufficient proof with respect to all contingencies involved in establishing the hypothetical course of events and the reasonable certainty of the income stream. Evidence must prove that the claimant would have been in a better economic situation in the absence of the breach of contract. The claimant has to show with sufficient evidence that the loss was attributable to the breach of contract. If the income stream but for the breach cannot be proved with reasonable certainty, the breach cannot cause any loss.

140 141

Sapphire v. NIOC 188–9 (n. 139). Burrage, ‘Lost Profit versus Lost Business’ 460 (n. 134).

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I. Relevance of the Evidence and Burden of Proof Whenever a defendant shows that different factors other than the breach explain at 5.129 least a substantial part of the difference between the but-for and the actual situation of the claimant, the claim will be significantly affected. The claimant’s evidence must show consistency between damages and causation. The nature of the breach and its effects, together with the evidence are of primary 5.130 importance to establish causation under the but-for premise. Lack of evidence with respect to causation eliminates a claim. There has to be certainty with respect to the causation of the loss, which is the effect of the breach on the income stream. This matter is different from proving the income stream with reasonable certainty, and these two concepts should not be confused. 3. Quantum and evidence The standard of proof is intimately related to the reasonable certainty of loss due to 5.131 the breach. With respect to the quantum of the loss, there is an element of estimation. However, the margin of estimation is being reduced through a step-by-step analysis of the relevant contingencies involved in reconstructing the hypothetical course of events. The evaluation of each contingency has to be based on the corresponding evidence. This reduces the margin of discretion as regards the estimate of the losses, which consist in the comparison of the hypothetical situation without the breach with the actual situation, in a given period of time. Therefore, the application of the but-for premise is to a large extent a question of evidence to prove economic losses. The claimant’s damages calculation model must be credible and realistic in accord- 5.132 ance with the existent economic factors. The quantification of the but-for hypothesis must be adjusted to make sure that any benefits from the breach are taken into consideration, so that the differential is not over-estimated and, therefore, the claimant is not overcompensated.142 Exaggerated claims diminish credibility and negatively affect claims due to the discrepancy between the amount claimed and the evidence available. In Bridas v. Turkmenistan143 the claimant tried to convince the arbitral tribunal of an income stream that was not in accordance with the evidence available, and therefore lost profits were not awarded. 4. Reasonable certainty of income With respect to lost profits, the injured party must prove with reasonable certainty 5.133 that there would be profits but for the breach. If the injured party can prove this, it may have losses. If it cannot do so, no lost profits are recoverable, as there is no difference between the economic situation of the injured party with and without the breach.

142 143

ABA, Proving Antitrust Damages 61 (n. 10). Chapter 3, para. 3.201.

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Chapter 5: Analysing, Framing, and Proving a Claim 5.134 From the analysis of representative cases performed throughout this book and the

experience of its authors as arbitrators, party counsels, and experts, the following criteria are relevant in order to prove reasonable certainty of income or profits: • When the claimant is trying to convince the tribunal that an uncertain situation will take place with a high degree of probability the tribunal will not consider it as reliable possibility. • Historical data will be relevant if it is proven with reasonable certainty that the income would continue but for the breach. • On the contrary, if there is no historical data, the experts will have to put forward methods and use realistic data. If the defendant can prove that the data used in the method is not in accordance with basic economic factors, the market or the industry, the quantification of the damages will be considered speculative. • Business plans agreed by the parties before the breach are relevant for the proof of the income, especially, when the project was successfully executed by one of the parties and the other party could not take part in the project because of the breach. • The evidence presented must be realistic, reliable, verifiable, and congruent with the overall case. 5.135 In Bridas v. Turkmenistan, the arbitral tribunal recognized that the precise assess-

ment of the damages is often impossible and any assessment is difficult. However, this should not bar a claimant’s claim. As regards the loss of a bargain or expectation interest, the central question is the degree of certainty of the loss of future earnings. Such degree of certainty depends on the contingencies and the probability that the bargain would have occurred.144 With respect to the chance of establishing a profitable business, according to the arbitral tribunal and after an analysis of the applicable law, the following factors were taken into consideration: (i) the nature of the contingencies, and (ii) the availability of expert evidence. Where the parties present detailed expert evidence and calculations, a thorough analysis has to be performed.145 5.136 The arbitral tribunal confirmed that ‘both parties presented expert evidence and

detailed calculations in order to persuade the Tribunal that a reasonably clear conclusion could be reached on the quantum of profits lost by reason of the repudiation of the contract. . . . The conflicting evidence and argument will have to be considered in detail. As a matter of law, however, if neither party is able to convince the Tribunal of the correctness of its figures, it will be open to the Tribunal to arrive at a figure between the two extremes on the basis of its own analysis. Alternatively, if it is unable to do so it will still be open to it, if it considers that the lost chance

144 145

Bridas v. Turkmenistan, final award, paras. 45 et seq. (n. 37). Bridas v. Turkmenistan, final award, paras. 50–1 (n. 37).

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I. Relevance of the Evidence and Burden of Proof of making profits was a real or significant one, to value that chance on a “broad brush” or jury approach’,146 that is not giving reasons for the assessment. This means that the arbitral tribunal may make a determination according to its discretion when it is not able to make a reasoned analysis. The arbitral tribunal could have made appropriate adjustments within its margin 5.137 of discretion and according to the large amount of evidence and analysis presented by the parties and come to an estimated amount that according to them was reasonably certain trying to arrive at the expectation interest rather than awarding the reliance interest. The expectation interest might have been below the reliance interest. With respect to Aucoven v. Venezuela, under Venezuelan law lost profits ‘must be 5.138 established with sufficient certainty and cannot be assessed on the basis of speculative assessment’, which is in accordance with the practice of international tribunals. The arbitral tribunal, therefore, sought to establish the existence and amount of the lost profits with a sufficient degree of certainty.147 The claim for lost profits was based on the Economic-Financial Plan (EFP) under 5.139 the concession agreement, which referred to an internal rate of return of 15.21 per cent over the investment in the project. The arbitral tribunal mentioned that the concession agreement required the EFP to be updated in case of any event listed in Clause 46 of such agreement. According to the arbitral tribunal, this was to restore the Economic-Financial-Equilibrium (EFE) but not to guarantee the projected amounts of the shareholders’ cash flows.148 However,

5.140

[t]he main purpose of this Agreement was the construction of the Bridge. The expected cash flows were agreed as part of broader agreement, pursuant to which Aucoven was to build the Bridge and would, in return, receive a ‘fair and equitable remuneration’. As a matter of contractual interpretation, one cannot rely exclusively on the figures set forth in the original EFP without taking into account that the Bridge was never built. Otherwise, Aucoven would obtain the same compensation that it would have received had it built the Bridge and, for that purpose, invested the amounts forecast. The Tribunal is of the opinion that such result cannot be deemed to correspond to the intent of the parties.149

The arbitral tribunal cited a series of ICSID cases and the Iran-U.S. Claims 5.141 Tribunal which show that arbitral tribunals are reluctant to award lost profits for a beginning industry and unperformed work. The arbitral tribunal stated that the claimant had no record of profits and that the investments in the project were not

146 147 148 149

Bridas v. Turkmenistan, final award, para. 51 (n. 37). Aucoven v. Venezuela, para. 351–2 (n. 39). Aucoven v. Venezuela, para. 356 (n. 39). Aucoven v. Venezuela, para. 357 (n. 39).

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Chapter 5: Analysing, Framing, and Proving a Claim made, nor was the bridge built as required under the concession agreement. It emphasized that the cases cited by the claimant were based on projects where the future cash flows could be reasonably determined and tribunals have awarded lost profits even if the project was in its initial stage. The arbitral tribunal considered that the claim for future profits was not based on sufficiently certain economic projections and thus appeared speculative. Hence it did not meet the standards for an award of lost profits under Venezuelan law or international law.150 5.142 The arbitral tribunal stated in paragraph 354 of the award ‘[it] is not disputed that

lost profits, if awarded, should be computed on the basis of the expected cash flows, under the Concession Agreement. There is no common ground, however, on the determination of such expected cash flows.’ Aucoven alleged that the expected cash flows were to be determined using the shareholder flow line appearing in the Economic-Financial Plan of the concession agreement, which represents the 15.21 per cent real annual return which Aucoven would have earned on its projected investment over the 30-year concession period. By contrast, Venezuela asserted that such internal rate of return had to be based on Aucoven’s actual investment. The arbitral tribunal did not make any further analysis with respect to the two positions taken by the parties as regards the character of the cash flows. It simply considered the profits speculative.151 5.143 A well-reasoned award would require the reconstruction of the hypothetical sce-

nario supposing the absence of breach of contract, which leads to what would have happened had the tolls been increased according to the concession agreement and the bridge been built. This would probably have meant a considerable decrease in the market, which would be reflected in the difference in value under the but-for premise which are the lost profits, perhaps leading to less than the investment for the construction of the bridge. The costs adjustment should also be reflected in the calculations of the lost profits. However, the reliance interest was awarded as it was contemplated in the agreement. 5.144 As regards evidence of the reliance interest the arbitral tribunal took into account

the financial statements of Aucoven, which were subject to adjustments. Such out-of pocket cost included pre-termination losses incurred, pre-termination assets contributed, post-termination losses incurred, and post-termination assets contributed. 5. Reasonable certainty of loss 5.145 There may be no loss if there is no reasonable certainty of income. Once the income

stream has been ascertained, it is important to determine the effect of the breach on the income stream. This determination is made through the assumptions used 150 151

Aucoven v. Venezuela, para. 362 et seq. (n. 39). Aucoven v. Venezuela, paras. 362–3 (n. 39).

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I. Relevance of the Evidence and Burden of Proof in the financial model prepared by the experts. The variables in the financial model have to correspond to the factors that change precisely because of the breach. This leads to the creation of the but-for scenario, which has to be compared with the actual scenario in order to obtain the difference in value, which is the loss caused by the breach, loss of income stream, or lost profits. Once the loss of income stream has been determined, the future lost income stream has to be discounted at the interest rate determined by the experts and the historical lost profits updated at the same rate used to discount the future income stream, to the date of the award. In the case of the automotive joint venture, income stream was proved with reason- 5.146 able certainty through the business plan that was in accordance with the public records of the industry. The certainty of loss was obtained through the difference between the business plan and the actual scenario, which was zero, which resulted in the actual loss. The problem was that the arbitral tribunal discounted the lost profits to the date of the breach without updating them at all, as explained in chapters 6 and 7. With respect to the processing plant case, the main evidence for the certainty of loss was the result from testing the performance according to the FIDIC EPC contract. Testing showed that the capacity of the plant was close to zero. Testing was made with certified equipment and before a notary public. The direct loss was calculated on the basis of the price of the plant as compared with the actual capacity of the plant. The lost profits were calculated as the difference between the scheduled increase of sales based on projections and the actual sales taking into consideration mitigation measures, which reduced lost profits. There must be sufficient evidence with respect to the loss caused by the breach. In case of various or alternative claims, the claims best supported by evidence, and not necessarily the highest ones, should be made in order to increase the likelihood of a favourable award. The evidence provided should allow the arbitral tribunal to make ‘a just and reasonable estimate of the probable amount of loss’.152 6. Business plans and projections to evidence the difference in value under the but-for premise Business plans and projections are relevant evidence when claiming the difference 5.147 in value of the income stream under the but-for premise. Its evidentiary value is different when such business plans are approved by the parties, known to the other party or only in the domain of one of the parties. If the business plan is performed before the date of the award, the information is verifiable. If the business plan refers to past and future events, the past performance provides relevant information as regards the reasonability of the future estimates. If the business plan only refers to a future period of time, contingencies analysis could be used to establish the probability of the realization of the assumptions underlying the business plan.

152

ABA, Proving Antitrust Damages 55 (n. 10).

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Chapter 5: Analysing, Framing, and Proving a Claim 5.148 Business plans approved by the parties should be accepted as such, unless the

defendant shows lack of reasonability. It cannot be presumed that financial institutions which specialize in project finance would admit projections which are not reasonable. Therefore, business plans, in particular, those approved by the parties before the arbitration, appear to be the starting point of the analysis of the hypothetical course of events when quantifying lost profits under the but-for premise. 5.149 ADC v. Hungary153 is based on an unlawful expropriation in relation to a con-

cession agreement of the Budapest airport. The applicable law is the Hungary– Cyprus bilateral investment treaty (BIT) and international law. In September 1992, the Air Traffic and Airport Administration (ATAA) initiated the tender process for the renovation of terminal 2/A and the design of a new terminal 2/B of the airport located south of Budapest, including the design of the adjoining public road and traffic entrance areas and related infrastructure, as well as the financing, construction, leasing, and operation of airport facilities. The project was awarded to ADC in 1995 and a project company was established. The terminals were constructed and renovated in 1998 and operated until 2001. In December 2001, Hungary took over all of the activities related to the operation of the airport. In this case, business plans were prepared according to the so-called regulatory framework, ‘which set forth the policies and procedures for preparing the Annual Business Plan’ and were an integral part of the Master Agreement. In relation to business plans, an arbitral tribunal seeks to ensure that the business plans are adjusted to the relevant economic factors in the most realistic way. As the arbitral tribunal stated in this award, damages calculation in this case ‘reflect a high degree of professionalism, clarity, integrity and independence by financial expert witnesses’.154 5.150 In the case of the automotive joint venture, the arbitral tribunal awarded lost prof-

its based on a business plan approved by both parties before the breach. The business plan contained the project, which was taken away by the competing joint venture. The award was rendered after the termination of the project, which had already been successfully finished by the competing entity, as evidenced through public records of the sector. Under normal circumstances business plans approved by both parties before the breach should be of considerable evidentiary value to prove lost profits, even if they extend to the future. 7. Negative inference 5.151 Negative or adverse inference means that documents or evidence presumed to be

under the control of the other party but not produced upon a request admitted by

153 ADC Affiliate Ltd and ADC & ADMC Management Ltd v. The Republic of Hungary, ICSID Case No. ARB/03/16, paras. 241–3. 154 ADC v. Hungary para. 516 (n. 153).

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J. Role of the Experts the arbitral tribunal, would adversely affect the interest of that party.155 The drawing of negative inference is an important tool in international arbitration, as the arbitral tribunal does not have the power to enforce the production of documents.156

J. Role of the Experts The analysis of the available economic evidence provided by experts is decisive for 5.152 establishing the most suitable structure, substantiation, and framing of the claim. The reconstruction of the hypothetical course of events in case of the breach of a complex long-term contract requires the analysis and use of considerable amount of data, to determine the existence of income and loss, whether and how far the loss is caused by the breach, the calculation of quantum, and the financial effects of the hypothetical mitigation situation. In particular, the financial experts prepare the financial and economic models in order to calculate both the hypothetical and actual income stream and the historical and future losses caused by the breach, as well as their present value by defining the pre-award interest and the discount rates. Both interest and discount rates are elements of damages valuation as further explained in chapters 6 and 7. Often, the injured party has only certainty of the breach and an idea of the loss 5.153 but is not able to define the loss in a sufficiently precise way in order to avoid the reproach of ‘speculation’. Lawyers and experts have to work together to frame the claim according to the evidence available. This includes the determination of causality, the measure of damages to be sought, and the quantum. The expert is in charge of defining the reliable and realistic economic assumptions 5.154 of the case, such as the country risk and the market risk, which are relevant in the determination of the discount rate. What is relevant for the arbitral tribunal is that such assumptions are sufficiently founded in evidence and substantiated. The counsel supported by the expert must make sure that the evidence supports the claim.157 The economic expert has a substantial role in the arbitral procedure both as con- 5.155 sultant to the parties as well as interpreter of economic information for the arbitral tribunal. This has been called the ‘epistemic asymmetry’ between the arbitral 155 Article 9(5) and 9(6) of the IBA Rules on the Taking of Evidence in International Arbitration, 2010. 156 Vera van Houtte, ‘Adverse Inferences in International Arbitration’ in Written Evidence and Discovery in International Arbitration, New Issues and Tendencies, Dossier of the ICC Institute of World Business Law (2009) 195–217. 157 R. Wisner, J.W. Rowley, and A.N. Campbell, ‘Effective Use of Economic Experts in International Arbitration: Counsel’s Role and Perspective’ in Gordon Blanke and Philip Landolt (eds.), EU and US Antitrust Arbitrations:  A  Handbook for Practitioners, Vol. I  (Wolters Kluwer 2011) 237–50.

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Chapter 5: Analysing, Framing, and Proving a Claim tribunal and the economic expert with regard to the economic content and dimension of the law. Epistemic asymmetry arises because economists are necessary to explain complex economic and financial situations within a legal framework. The principal role of the expert is that of an ‘educator’ or ‘translator’ for the arbitral tribunal, ‘translating signs/meaning from the language of economics to a language/ discourse that is understandable by the judge and/or the jury, in other words “common (shared) sense” ’.158 5.156 The interpretation of economic facts is necessary for the arbitral tribunal to make

normative judgments in damages cases. Specialized knowledge of the economic expert is necessary for the application of the law by the arbitral tribunal where ‘the law adopts an explicitly economic criterion of legality’159 such as in the case of the valuation of damages. 5.157 Experts acting as advocates have been identified as one of the main problems of

the adversarial system of expertise.160 Several measures have been proposed to address this issue, such as the ‘case management system’ in the UK, which characterizes itself by emphasizing the ‘scientific’ dimension of the debate between the different experts as compared to the ‘material’ aspects of the dispute. This may be achieved through procedures such as the ‘hot tub’ and the appointment of a tribunal-appointed expert under certain circumstances:161 5.158 The ‘hot tub’ procedure was originally developed by the Australian Competition

Tribunal in the 1970s162 and was later adopted in international arbitration.163 According to this procedure experts make comments on the evidence presented by the other experts guided by the arbitral tribunal and on the issue previously raised by both parties. 5.159 In cases with a high degree of complexity, ‘[t]ribunal-appointed experts, provided

they are appointed early in the proceedings, may have a vital role to play in establishing the terms of reference, especially with respect to delineating the nature and scope of the requisite expert evidence. However in such case, the terms of 158 Ioannis Lianos, ‘ “Judging” Economists:  Economic Expertise in Competition Law Litigation:  A  European View’ in The Reform of EC Competition Law:  New Challenges (Wolters Kluwer 2010) 189–92. 159 Richard A. Posner, ‘The Law and Economics of the Economic Expert Witness’ (1999) 13(2) Journal of Economic Perspectives 91–9. 160 Dushyant Dave, ‘Experts: Neutrals or Advocates?’ in Albert Jan van den Berg (ed.), Arbitration Advocacy in Changing Times (ICCA) (Wolters Kluwer 2011) 149; with respect to the same problem as regards party-appointed arbitrators, see Jan Paulsson, ‘Moral Hazard in International Dispute Resolution’ (2010) 25(2) ICSID Review 339–55. 161 Lianos, ‘ “Judging” Economists’ 252–3 (n. 158). 162 Gary Edmond, ‘Secrets of the “Hot Tub”:  Expert Witnesses, Concurrent Evidence and Judge-led reform in Australia’ (2008) 27 Civil Justice Quarterly 58. 163 Wolfgang Peter, ‘Witness Conferencing’ (2002) 18 Arbitration International 47–58; Hilmar Raeschke-Kessler, ‘Witness Conferencing’ in Lawrence W. Newman and Richard D. Hill (eds.), The Leading Arbitrator’s Guide to International Arbitration (Juris Publishing 2008) 415–28.

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J. Role of the Experts reference should clearly distinguish between the matters to be determined by the arbitral tribunal and the expert evidence to be prepared by the expert witness.’164 They should be appointed from the outset of the arbitration in order to assure that the expert has sufficient time available to become familiar with the case and to take part in all phases of the procedure. An expert of the arbitral tribunal was appointed in National Grid v. Argentina,165 Sempra Energy v. Argentina,166 and Enron v. Argentina.167 Another technique is expert teaming, which combines the advantages of 5.160 party-appointed and tribunal-appointed experts. According to this technique, each of the parties provides a short list of candidates of experts, which is then commented on by the other party as regards potential conflict of interest situations. After observations from the parties, the tribunal choses two experts, one from each list, which form the ‘expert team’ in order to establish the terms of reference. The expert team then establishes a joint report, which is circulated to the tribunal and the parties for their comments. The expert team is present at the hearing and may be examined by the arbitral tribunal, the parties, and the party-appointed experts.168 The disadvantage of using additional experts is that the procedure becomes 5.161 more expensive and does not guarantee that the arbitral tribunal will come to a well-reasoned and fair award. Arbitral tribunals are morally and professionally obliged to make an in-depth analysis of the case and ask the right questions to the experts available in the procedure and insist on the corresponding answers in order to arrive at a well-reasoned and fair award based on an equitable procedure. There is a risk, due to the economic complexity, that the arbitral tribunal is unable 5.162 to appraise the evidence properly. The best practice standard is that the claim is well supported by evidence, and the analysis and economic assumptions are objective and reasonable, using simple language and clear exposition of economic issues, which is understandable for the non-experts. This puts a burden on the claimant to present economic evidence as clearly as possible.169 The arbitral tribunal should use 164 Gordon Blanke and Thomas Eilmansberger, ‘The Role of the Expert Witness in Antitrust Arbitrations’ in Blanke and Landolt (eds.), EU and US Antitrust Arbitrations para. 9-042 (n. 157); see also Chartered Institute of Arbitrators Practice Guideline 10: Guideline on the Use of Tribunal-Appointed Experts, Legal advisors and Assessors, para. 3.3. 165 National Grid P.L.C. v. Argentine Republic, award, 3 November 2008, para. 46. 166 Sempra Energy International v.  Argentine Republic, ICSID Case No. ARB/02/16, 28 September 2007, para. 399. 167 Enron Corporation Ponderosa Assets L.P. v. Th e Argentine Republic, ICSID Case No. ARB/01/3, para. 38. 168 Klaus Sachs with the assistance of Nils Schmidt-Ahrendts, ‘Protocol on Expert Teaming: A New Approach to Expert Evidence’ in van den Berg (ed.), Arbitration Advocacy in Changing Times (ICCA) 135–147 (n. 160). 169 Matti Kurkela and Hannes Snellman, Due Process in International Commercial Arbitration (Oceana Publications 2005)  171 et seq.; Mike Walker, ‘The Use of Economic Evidence in Competition Law Arbitrations’ in Blanke and Landolt (eds.), EU and US Antitrust Arbitrations 213–14 (n. 166).

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Chapter 5: Analysing, Framing, and Proving a Claim decision-tree methods in order not to be confused by misleading arguments, which would also help them to ask the right questions.

K. Particularities of Damages Claims in Investment Arbitration 5.163 The following paragraphs relate to the particularities of damages claims in invest-

ment arbitration and the measure of damages in international law as identified in the Factory at Chorzów. An in-depth analysis of international damages law is outside the scope of this book and the reference to recent seminal literature on this topic shall suffice.170 1. Damages claims in investment arbitration arising under complex long-term contracts 5.164 Damages claims in investment arbitration related to complex long-term contracts

may arise in case of breach of an international legal standard, which is international tort, or in case of breach of contract protected by an umbrella clause contained in an international investment agreement or BIT. The following comments are based on the existence of an international investment agreement, and do not deal with the jurisdictional aspects in investment arbitration, but are limited to key issues related to damages claims. a. Violation amounting to international tort 5.165 Damages claims in investment arbitration may arise when a state or state entity frustrates or breaches a complex long-term contract and this amounts to a violation of international standards or international law giving rise to state responsibility,171 170 Marboe, Calculation of Compensation and Damages in International Investment Law (n. 4); Sergey Ripinsky with Kevin Williams, Damages in International Investment Law (British Institute of International and Comparative Law 2008); Borzu Sabahi, Compensation and Restitution in Investor-State Arbitration: Principles and Practice (Oxford University Press 2011); John Y. Gotanda, ‘Assessing Damages in International Arbitration: A Comparison with Investment Treaty Disputes’ in Andrea K. Bjorklund, Ian Laird, and Sergey Ripinsky (eds), Investment Treaty Law III: Remedies in International Investment Law, Emerging Jurisprudence of International Investment Law (British Institute of International and Comparative Law 2009) 77 et seq.; Thomas Wälde and Borzu Sabahi, ‘Compensation, Damages and Valuation’ in Peter Muchlinski, Federico Ortino, and Christoph Schreuer (eds.), The Oxford Handbook of International Investment Law (Oxford University Press 2008)  1049 et seq.; Meg Kinnaer, ‘Damages in Investment Treaty Arbitration’, Kaj Hobér, ‘Compensation: A Closer Look at Cases Awarding Compensation for Violation of the Fair and Equitable Treatment Standard’, both in Katia Yannaca-Small (ed.), Arbitration under International Investment Agreements: A Guide to Key Issues (Oxford University Press 2010) 551. et seq., 573 et seq.; Yves Derains and Richard H. Kreindler (eds.), Evaluation of Damages in International Arbitration, Dossiers (ICC Institute of World Business Law 2006). 171 R.Y. Jennings, ‘State Contracts in International Law’ (1961) 37 British Yearbook of International Law 162–4; Christoph H. Schreuer with Loretta Malintoppi, August Reinisch, and Anthony Sinclair, The ICSID Convention: A Commentary (2nd edn., Cambridge University Press 2009) 372, para. 83.

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K. Damages Claims in Investment Arbitration which is an international tort.172 The frustration of the purpose of a contract may occur through administrative and fiscal measures or changes in the regulatory framework by the state. The breach of contract may be in the form of the unjustified termination of a concession agreement by a state or a state entity. The frustration or breach of contract does not suffice for investment arbitration. The decisive issue is that the conduct alleged by claimants violates international law,173 which occurs in case of illegal expropriation, the violation of the fair and equitable treatment standard, discrimination through the violation of the national treatment and the most favoured nation standards and other standards contained in BITs and under customary law. As summarized by Stanimir Alexandrov:

5.166

The difficulty arises from the fact that a breach of contract by a State may well be and often is, also a breach of an investment treaty obligation. States incur international responsibility when they violate a contract in a manner that constitutes a ‘clear and discriminatory departure’ from the governing law of the contract or an ‘unreasonable departure from the principles recognized by the principal legal systems of the world.’ States are internationally responsible when they terminate a contract in an untimely manner and when a termination is effected ‘by the exercise of sovereign power instead of claimed contractual right’. States are also responsible under international law for contractual breaches when they have frustrated the contractual dispute settlement mechanism, leaving the foreign investor with no recourse to contractual remedies to redress a contractual wrong.174

A state measure may give rise to contractual non-performance of the state party. 5.167 Such a party may try to excuse its non-performance on the ground of force majeure or hardship. However, when the state measure is within the risk sphere of the state party, the respondent may not avoid liability and the underlying contractual relationship, including risk allocation, plays an important role in investment arbitration. b. Breach of contract protected by an umbrella clause Investment arbitration may also arise through the breach of a contract protected by 5.168 an umbrella clause under an international investment agreement, including a BIT, without the necessity to breach an international legal standard, which means that there is not necessarily an international tort. Under the umbrella clause, the injured 172 Hersch Lauterpacht, Private Law Sources and Analogies of Law (Longmans, Green and Co. Ltd. 1927) 6; R.Y. Jennings, ‘State Contracts in International Law’ (1961) 37 British Yearbook of International Law 157–9, 164–9. 173 Compañía de Aguas del Aconquija S.A.  and Vivendi Universal S.A.  v.  Argentine Republic, ICSID Case ARB/97/3, decision on annulment, 3 July 2002 (Vivendi I Decision on Annulment), (2001) 41 ILM 1135. 174 Stanimir Alexandrov, ‘Breach of Treaty Claims and Breach of Contract Claims: Is it Still Unknown Territory’ in Yannaca-Small (ed.), Arbitration under International Investment Agreements (Oxford University Press 2010)  336, with further references and citations (footnotes omitted) (n. 180).

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Chapter 5: Analysing, Framing, and Proving a Claim party may have the option for investment arbitration provided all jurisdictional requirements are met. This would provide the claimant with a highly-specialized forum such as ICSID, the likely application of international law when established under the international investment agreement, and more leverage in case of the execution of the arbitral award. 5.169 The historic function of umbrella clauses after the Second World War was to isolate

concessions and other investment agreements from the domestic law of the host country by applying international law.175 Umbrella clauses served to ‘de-localize’ the concession with the aim to avoid the ‘legal permissibility of a unilateral change [of] the terms of the agreement by the local government’.176 Delocalization also avoided the requirement of exhaustion of local remedies and allowed for international arbitration without years of domestic litigation due to the customary law requirement of the exhaustion of local remedies. Under the traditional understanding of the umbrella clause, ‘a state undertakes not to breach its contracts with nationals of the other state and a breach of the contract ipso facto is held to be a violation of the treaty’. 5.170 In his conference on ‘Some Aspects of International Concession Agreements’

before the Harvard International Law Club in 1959, Professor Hersch Lauterpacht stated that: ‘... it is desirable to have a breach of the agreement straightaway considered to be a violation of international law’.177 The first umbrella clauses were apparently proposed by his son, Elihu Lauterpacht, who advised the Anglo-Iranian Oil Company in connection with the settlement of the Iranian nationalization dispute in 1953–54178 and again in 1956–57 as regards the oil pipeline from Iraq in the Persian Gulf through Syria and Turkey to the Eastern Mediterranean. The reference to such clause may also be found in the Abs-Shawcross draft Convention on Foreign Investment of 1959 and the subsequent OECD draft Conventions on the Protection of Foreign Property of 1962 and 1976 and serve to ‘elevate a contract between an investor and a host state to the level of an inter-state obligation between the host state and the national state of the investor’.179

175 Rudolf Dolzer and Christoph Schreuer, Principles of International Investment Law (Oxford University Press 2008) 154–5, with further references. 176 Hersch Lauterpacht, ‘Some Aspects of International Concession Agreements’ (1959) 1 Bulletin of the Harvard International Law Club 6; George R.  Delaume, ‘State Contracts and Transnational Arbitration’ (1981) 75 American Journal of International Law 796, with further references; Jean-Flavien Lalive, ‘Contracts between States or a State Agency and a Foreign Company, Theory and Practice:  Choice of Law in a New Arbitration Case’ (1964) 13 International and Comparative Law Quarterly 992. 177 (1959) 1 Bulletin of the Harvard International Law Club. 178 Anglo-Iranian Oil Co. Case (Jurisdiction) [1952] ICJ Rep. 93. 179 Anthony C.  Sinclair, ‘The Origins of the Umbrella Clause in the International Law of Investment Protection’ (2004) 20 Arbitration International 411; James Crawford, ‘Treaty and Contract in Investment Arbitration’ (2008) 24 Arbitration International 366–7.

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K. Damages Claims in Investment Arbitration Nowadays, depending on the wording of such clause and its interpretation by the 5.171 arbitral tribunal, the effect of such clauses in investment arbitration is subject to controversy.180 As stated by Katia Yannaca-Small: [A]rbitral tribunals have been called to decide on whether or not and under what circumstances an investor may refer a dispute to investment arbitration by relying on an umbrella clause in a BIT. They have reached different conclusions in particular with respect to the effect of the umbrella clause and its scope, i.e., does it transform all or only certain kinds of contract claims into treaty claims; does it cover obligations only undertaken by the state or also by other entities under state control; and does it cover only specific obligations concerning the investment or include general requirements imposed by law? The results vary, and prudence requires recognition that no general conclusions can be drawn.181

Whether the umbrella clause transforms contracts into international law or not, 5.172 does not seem to be relevant anymore in the light of the protection offered by international investment agreements. What is important is that the contract is protected under an international investment agreement, which provides for investment arbitration. According to Professor James Crawford: In short, under the integrationist view as applied to standard umbrella clauses the claims are still contractual and they are still governed by the own applicable law: The distinction between treaty and contract is maintained. The purpose of the umbrella clause is to allow enforcement without internationalisation and without transforming the character and content of the underlying obligation. . . . What a BIT does is to provide an additional layer of protection for the one transaction: the investment is protected by the BIT but the BIT should not be used as a vehicle to rewrite the investment arrangement.’182

In EDF v. Argentina, the breach of the umbrella clause is additional to the breach 5.173 of international legal standards. In this case, ‘the emergency measures required EDEMSA to abide by its contractual obligations, thereby creating an asymmetry that further exacerbated injury to Claimant’s investment during the thirty-eight (38) months the Renegotiation Process took place’.183 This adds to the outright breach of the currency clause in the concession agreement, which required tariff calculations in US dollars.184 As established by the arbitral tribunal, the respondent’s breach of certain obligations under the applicable umbrella clause ‘operates in tandem with breach of Article 3 of the Argentine-France BIT, providing a duty to accord Fair and Equitable Treatment’.185 180 Crawford, ‘Treaty and Contract in Investment Arbitration’ 351 et seq. (n. 179); Alexandrov, ‘Breach of Treaty Claims and Breach of Contract Claims’ 323 et seq. (n. 184). 181 Katia Yannaca-Small, ‘What About Th is “Umbrella-Clause”?’ in Yannaca-Small (ed.), Arbitration under International Investment Agreements 503, with further references and citations (n. 170). 182 Crawford, ‘Treaty and Contract in Investment Arbitration’ 370, 374 (n. 179). 183 EDF v. Argentina, para. 987 (n. 29). 184 EDF v. Argentina, para. 989 (n. 29). 185 EDF v. Argentina, para. 994 (n. 29).

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Chapter 5: Analysing, Framing, and Proving a Claim 5.174 The breach of contract protected by an umbrella clause does not necessarily imply

international tort or the violation of an international legal standard, which puts into question whether it is correct to use the measure of damages provided by the Chorzów formula in these cases. 2. Chorzów as applicable in international customary damages law a. The relevance of Chorzów for investment arbitration 5.175 The most important judicial decision with respect to international damages law for breach of an international legal standard or obligation is the one related to the Factory at Chorzów case in 1927. This case refers to the illegal expropriation of a German factory in Poland. The Chorzów dictum is considered a general principle of international law186 and even international customary law.187 In this case the PCIJ stated: [R]eparation must, so far as possible, wipe out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed. Restitution in kind, or, if this is not possible, payment of a sum corresponding to the value which a restitution in kind would bear; the award, if need be, of damages for loss sustained which would not be covered by restitution in kind or payment in place of it—such are the principles which should serve to determine the amount of compensation due for an act contrary to international law.188 5.176 The Chorzów standard is particularly relevant as international treaties such as

international investment agreements in the form of BITs and investment protection provisions in free trade agreements only contain obligations with respect to expropriation but are silent as regards damages claims in case of the violation of international legal standards and illegal expropriations. In the absence of a developed international damages law,189 it has been necessary to look at customary law and general principals of law, such as the Chorzów standard, which refers in essence to the measure of damages in international law. 5.177 International customary law and general principles of law are based on private

law. Private law sources and analogies in international law are found, in particular, in the areas of the ‘international law of tort and the problems of State responsibility; the measure of damages; the question of interest, moratory and

186 Marboe, Calculation of Compensation and Damages in International Investment Law 27, with further references (n. 4); Sabahi, ‘Compensation and Restitution in Investor-State Arbitration’ 48 (n. 170). 187 Ripinsky with Williams, Damages in International Investment Law 34–5 (n. 170). 188 1928 PCIJ Series A, No. 17, 47. 189 Kinnaer, ‘Damages in Investment Treaty Arbitration’ 551–2 (n. 170).

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K. Damages Claims in Investment Arbitration compensatory’.190 The notions of causation and mitigation used in international law also derive from private law. International customary law is reflected in Articles 31 to 39 of the Articles on 5.178 State Responsibility (Chapter II: Reparation for Injury).191 The Articles on State Responsibility are the product of the most prominent jurists in international law192 and represent an important tool for identifying the respective international rules of damages law.193 Article 31, paragraph 1 (Reparation) on State Responsibility recognizes the full compensation principle, according to which ‘[t]he responsible State is under an obligation to make full reparation for the injury caused by the internationally wrongful act’. According to Article 36, paragraph 1, (Compensation), ‘[t]he State responsible for an internationally wrongful act is under an obligation to compensate for the damage caused thereby, insofar as such damage is not made good by restitution’. The full compensation principle is reflected in its paragraph 2, which reads: ‘The compensation shall cover any financially assessable damage including loss of profits insofar as it is established’. Both articles refer to the Factory at Chorzów case.194 The importance of the Chorzów case is due to the fact that it contains a comprehen- 5.179 sive damages analysis, based on clear legal principles, which are duly established and shared by many later arbitral tribunals. It also provides guidelines on how to achieve the full compensation principle in international law and the underlying rationale. b. Full compensation under the Chorzów formula The reference to ‘wipe out all consequences of the illegal act’ establishes the full 5.180 compensation principle for damages in international law. Full compensation under

190 Hersch Lauterpacht, Private Law Sources and Analogies of Law 6 (n. 172); see also Hersch Lauterpacht, The Development of International Law by the International Court (Cambridge University Press 1958) 32; Jean-Flavien Lalive, Contracts between a State or a State Agency and a Foreign Company, Theory and Practice (n. 176). 191 Commentaries (7), (9) to (11) to Art. 31 on State Responsibility. 192 The Articles on State Responsibility were ‘commended’ by the International Law Commission ‘to the attention of Governments without prejudice to the question of their future adoption or other appropriate action’, UNGA Res 799 56/83, 12 December 2001, accessed 25 September 2013. 193 It has been observed that ‘the trend to specialized regimes could heighten the importance of general rules that may fill gaps and play a unifying role in international law, particularly given the proliferation of international tribunals, which are likely to be the articles’ primary customers’: Daniel Bodansky and John R. Crook, ‘Symposium: The ILC’s State Responsibility, Introduction and Overview’ (2002) 96 AJIL 774, accessed 25 September 2013. According to Prof. David Caron such articles should not be given unwarranted authority and be scrutinized rigorously, together with all of their associated context and history, as they are not international law: David D. Caron, ‘The ILC Articles on State Responsibility: The Paradoxical Relationship Between Form and Authority’ (2002) 96 AJIL 857, accessed 25 September 2013. 194 Comment (1) to Art. 31, and comments (27) and (30) to Art. 36 on State Responsibility.

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Chapter 5: Analysing, Framing, and Proving a Claim the Chorzów case means awarding the higher of the value of the company at the moment of breach or at the moment of the award. If the moment of valuation is the date of the award, lost profits from the date of the breach to the date of the award have to be added. 5.181 This case was a landmark decision and was commented on by Professor Hersch

Lauterpacht as follows: In the international sphere the principle established in general jurisprudence to the effect that damages must, as a rule, include full restitution in integrum did not at first secure ready acceptance by writers. It was asserted that the responsibility of States must be limited to damages arising directly out of the injurious event, to the exclusion of all indirect and consequential damages. . . . The suggestion of a general limitation of the responsibility of States in this matter was rejected by the Court in the Judgment in the case concerning the Chorzów Factory. The Court declined to agree that the compensation due to the German Government was limited to the value of the undertaking at the moment of dispossession, plus interest to the day of the payment. The Court distinguished between expropriation which was lawful . . . and expropriation which had been resorted to in violation of an international undertaking. In the latter case, . . . [t]he Court laid down in detail the principles governing compensation in these cases: ‘Restitution in kind, or, if this is not possible, payment of a sum corresponding to the value which a restitution in kind would bear; the award, if need be, of damages for loss sustained which cannot be covered by restitution in kind or payment in place of it.’195 5.182 This case was the departure from the rule that damages were limited to the pay-

ment of the value of tangible assets, but should also include lost profits.196 Lost profits play nowadays a particular role in case of the loss of use and enjoyment of income-producing assets, the unlawful taking of income-producing property, and in the context of concessions and other contractually protected interests. In case of contracts it ‘is the future income stream which is compensated, up to the time when the legal recognition of entitlement ends’.197 5.183 The reference to ‘wipe out all consequences of the illegal act’ is similar to Mommsen’s

but-for premise, which aims ‘to place the injured in the position it would be but for the breach’. However, full compensation under Chorzów is achieved by awarding the FMV of the investment that results higher between the date of the breach and the date of the award plus historic losses in the latter. This is different from Mommsen’s differential hypothesis or but-for premise where damages are only the economic difference between the actual and the but-for scenarios at the date of the award.

195 Lauterpacht, Th e Development of International Law by the International Court 315–16, footnotes omitted (n. 190). 196 See comment (27) to Art. 36 on State Responsibility. 197 Comments (28) to (31) to Art. 36 on State Responsibility.

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K. Damages Claims in Investment Arbitration c. Measure of damages under Chorzów and fair market value In the Factory at Chorzów case the objective of the German government acting on 5.184 behalf of the shareholders was to obtain a fair compensation.198 In the context of income producing contracts, the Court held that the value of the factory and its accessories including intangible property was independent from the advantages which each of the companies derived under its contracts.199 The questions posed by the Court to the experts referred to the determination of the value of the undertaking at the date of expropriation or the date of the award. The reference to the ‘value of the undertaking’ under the Factory at Chorzów has been considered to refer to the notion of FMV,200 though the Factory at Chorzów case does not expressly refer to this term. The notion of FMV was first used in American International Group v. The Islamic 5.185 Republic of Iran in 1983, which stated that ‘the valuation should be made on the basis of the FMV of the shares’,201 and Starrett Housing Corporation v. Government of the Islamic Republic of Iran in 1987.202 In Starrett, the expert defined the FMV ‘as the price that a willing buyer would pay to a willing seller in circumstances in which each had good information, each desired to maximize his financial gain and neither was under duress or threat’.203 The reference to duress or threat is particularly important in case of economic crises and where there are normally no willing buyers. The FMV ignores such duress and threat. Apart from that, as the investment is made for a particular project and may often be used only for a particular purpose, there is no actual ‘willing buyer’. The term ‘willing buyer’ is a hypothetical term, which leads to the preponderant use of the income stream as the basis for the calculation of damages, as the value of an asset depends on what the market is willing to pay for that asset or for its generation power of income stream. With respect to the measure of damages for illegal expropriation, according to 5.186 commentaries (21) and (22) to Article 36 on State Responsibility, 204 compensation reflecting the capital value of property taken or destroyed ‘is generally assessed on the basis of the “fair market value” (FMV) of the property lost. The method used to assess “fair market value”, however, depends on the nature of the asset concerned.’ The FMV, as a general measure in investment arbitration determines the value of the company that was lost due to the violation using different valuation approaches such as asset-based, market-based, and income-based valuation methods. Income

198

1928 PCIJ Series A, No. 17, 55. 1928 PCIJ Series A, No. 17, 55–6. 200 Manuel A.  Abdala and Pablo T.  Spiller, ‘Chorzów’s Standard Rejuvenated:  Assessing Damages in Investment Treaty Arbitrations’ (2008) 25(1) Journal of International Arbitration 108. 201 (1983) 4 U.S.C.T.R. 106. 202 (1987) 16 U.S.C.T.R. 112. 203 (1987) 16 U.S.C.T.R. 201. 204 Draft Articles on Responsibility of States for Internationally Wrongful Acts, with commentaries, United Nations, Yearbook of the International Law Commission, Volume II, Part 2 (2001). 199

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Chapter 5: Analysing, Framing, and Proving a Claim producing assets and investments are often valued using income-based valuation methods when applying the notion of the FMV. The calculation of the FMV of projects based on income stream is very similar to the calculation of the expectation interest. The main difference seems to lie in the treatment by the experts of atypical or extraordinary circumstances negatively affecting the injured party when calculating the discount rate. 5.187 The Chorzów formula through the FMV has been applied in several leading cases. 5.188 In ADC v. Hungary, the tribunal decided ‘to put the claimant in the same position

as if the expropriation had not been committed as required by the Chorzów factory standard’.205 According to the arbitral tribunal, the claim for damage under the restitution approach fell into two parts: (a) the estimated value (FMV) of the claimant’s stake in the project company as of the award date; and (b) all unpaid dividends and management fees from the date of the expropriation until the date of the award. Taking 30 September 2006 as the date of the Award, the total amount of damages payable to the claimants by the respondent was US$76.2 million.206 5.189 This case is an excellent example of the application of the Chorzów formula. In this

case, full compensation was obtained by awarding the FMV as of the date of the award, which makes sense as the tribunal recognizes that the value of the investment increased after the expropriation and all the lost profits from the date of the illegal expropriation to the date of the award. 5.190 When there is an illegal measure without expropriation, the measure of damages is

the difference between the without measure FMV and the actual FMV: 5.191 In EDF v. Argentina, damages caused by the illegal measures were calculated as the

difference between two values, the value of claimant’s stake in EDEMSA under a ‘without the measures’ scenario and the value of the same stake under a ‘with the measures’ scenario taking the date of the measure as the valuation date. In this way, overcompensation was avoided, as only the difference and not the whole FMV was compensated. The but-for method or differential hypothesis using the FMV is particularly relevant when the government measure does not lead to a total and permanent interruption of the income stream but only to a partial permanent or temporary interruption of such income stream, such as in case of creeping illegal expropriation and the violation of the fair and equitable treatment standard, which does not lead to a deprivation of the investment as only the difference in value is compensated. 5.192 National Grid vs. Argentina 207 is an UNCITRAL award rendered on 3 November

2008. National Grid commenced proceedings in 2004 alleging that as a result

205

ADC v. Hungary, para. 496 (n. 153). ADC v. Hungary, paras. 518–19 (n. 153). 207 J.D. Cayre, ‘National Grid plc v. Argentina (case comment)’ in Herfried Wöss (ed.), Special Edition on Latin America (2009) 6 TDM 4. 206

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K. Damages Claims in Investment Arbitration of the measures taken to combat the economic crisis in 2002, Argentina had (i) expropriated the investment in the Argentine electrical power industry contrary to undertakings and assurances which were given to it in order to encourage its investment, and in breach of the Treaty between the United Kingdom and Argentina; (ii) breached the standard of ‘fair and equitable treatment’ contained in such treaty by failing to respect the assurances and undertakings relied upon by National Grid in its decision to invest; (iii) breached the duty to provide ‘protection and security’ to National Grid’s investment in contravention of the treaty; and (iv) discriminated against it in comparison to other industry sectors as a result of the measures taken. The tribunal found that neither direct nor indirect expropriation had occurred. 5.193 National Grid had not been deprived of the title to its property, which was central to proving expropriation, and the measures taken by Argentina to deal with the crisis were not tantamount to expropriation in their effect either. The tribunal, however, did find that the standard of ‘fair and equitable treatment’ 5.194 had been breached by Argentina for the following reasons:  (i)  Argentina had fundamentally changed the legal framework put forward to and relied upon by National Grid in making its investment; (ii) it had not meaningfully negotiated with National Grid in between implementing the measure and the disposal of the investment; and (iii) had requested that National Grid renounce its legal remedies in respect of the renegotiation of its investment. It also found that the difficult economic circumstances in which Argentina had implemented the measures at issue had to be taken into account. The claimant alleged that the proper measure of economic compensation for the 5.195 respondent’s breaches of the treaty should be the loss of FMV of the claimant’s investment. The claimant proposed, (1) to calculate the value of the investment as of the date of the breach without the measures, then, (2) subtracting the value of the investment as of the same date with the measures. The arbitral tribunal awarded the FMV but-for difference minus 23 per cent, taking into consideration other business not affected by the measure. d. Relevant date for the determination of damages under the Chorzów formula In order to achieve full compensation, according to the Chorzów standard, the 5.196 higher FMV of the undertaking as of the date of the violation and the date of the award plus the lost profits between the date of the violation and the date of the award is awarded. The purpose of Chorzów is ‘to determine the monetary value, both of the object which should have been restored in kind and of the additional damage, on the basis of the estimated value of the undertaking including stocks at the moment of taking possession by the Polish Government together with any probable profit that would have accrued to the undertaking between the date of taking possession and that of the expert opinion’. As stated by the court 241

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Chapter 5: Analysing, Framing, and Proving a Claim ‘the value of the undertaking at the moment of dispossession does not necessarily indicate the criterion for the fixing of compensation. . . . the difference between the value which the undertaking then had and that which it would have had at present may . . . be very considerable’, due to the economic and monetary crisis at the moment of dispossession.208 5.197 Under the Chorzów formula, the date of valuation is either the date of the breach, or

the date of the award plus historic lost profits, whatever leads to a higher result. The but-for or differential hypothesis as developed by Mommsen refers to the date of the award as the relevant date of damages determination.209 The Chorzow formula follows the but-for premise, but establishes a particular standard for international law.210 5.198 With respect to the date of the determination of damages, the Chorzów formula

may be considered an important example of the reception of private law.211 By awarding damages at the higher amount as of the date of the breach or the date of the award, the Chorzów tribunal seems to have been influenced by the German law damages principle of the hypothetical normal course of events (hypothetischer Normalverlauf ) that would have existed in the absence of breach. The hypothetical course of events only refers to the normal course of events, which excludes extraordinary events, which may reduce the damages.212 The German imperial court (Reichsgericht) already established that events subsequent to the occurrence of the loss (überholende Kausalität), which would also have caused the loss (reserve cause or Reserveursache), should be ignored.213 Extraordinary events such as force majeure, which would have affected the hypothetical normal course of events, will not be taken into consideration as explained in chapter 4.214 5.199 According to the Court, the reference to the value at the date of the award supposes

‘that the factory had remained essentially in the state in which it was on the date of expropriation, and secondly, the factory is to be considered in the state in which it would (hypothetically but probably) have been in the hands of Oberschlesische and Bayerische, if, instead of being taken in 1922 by Poland, it had been able to continue its supposedly normal development from that time onwards’.215 In the Chorzów case, the date of the award left the injured party in a better economic situation, in comparison with the date of the breach; therefore, it was chosen as the relevant date to get full compensation. In a case where the value of the company

208

1928 PCIJ Series A, No. 17, 50, 52. Mommsen, Zur Lehre von dem Interesse 3 (n. 11). 210 Fikentscher and Heinemann, Schuldrecht para. 698 (n. 136). 211 Sabahi, Compensation and Restitution in Investor-State Arbitration 48 (n. 170); Wälde and Sabahi, Compensation, Damages and Valuation 1057 (n. 170). 212 Fikentscher and Heinemann, Schuldrecht para. 669 (n. 136). 213 (1933) 141 RGZ 365; (1951) 169, 117; 78 BGHZ 209. 214 Fikentscher and Heinemann, Schuldrecht para. 701 (n. 136). 215 1928 PCIJ Series A, No. 17, 52. 209

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K. Damages Claims in Investment Arbitration was reduced due to economic circumstances after the breach, the relevant date for valuation would have been the date of the breach. In Amco v.  Indonesia,216 Amco, an American corporation, and PT Wisma, an 5.200 Indonesian company operating under the guidance of the Indonesian government in 1968 entered into a lease and management agreement whereby Amco was to invest in and manage a hotel for the duration of 30 years until 1999. In April 1980, PT Wisma took over the management of the hotel. In July 1980, the Indonesian government revoked Amco’s license. Amco initiated ICSID arbitration claiming compensation for damages incurred due to the unlawful taking of the hotel for the termination of the license. In the first arbitral award in 1994, the tribunal held that Indonesia had breached international law and awarded damages for US$3.2 million. However, that award was annulled in 1986 on the grounds that the tribunal had not reasoned its findings. Amco resubmitted the dispute to ICSID arbitration. The second tribunal found that the takeover and the revocation of the license had 5.201 been internationally unlawful acts and the tribunal decided to apply the principle of restitutio in integrum including profits lost as a result of the license revocation. The arbitral tribunal stated that ‘assessment of the dispossession would not meet the objectives of compensation which is to put the claimant in the position it would be if the contract had been performed’. The tribunal decided to take into account all known data subsequent to the violation but preceding the award, which could be useful for the assessment of damages.217 This is an example of how the Chorzów formula is applied as regards the most 5.202 favourable date for the assessment of damages and as, in this case, it was the date of the award, lost profits between the date of the breach and the date of the award were also granted. By doing this the full compensation principle under the Chorzów formula was applied. e. Rationale of the Chorzów measure of damages In investment arbitration, there are two main differences with respect to commer- 5.203 cial arbitration: (a) the preponderant use of the FMV as the measure of damages; and (b) the use of the higher FMV as of the date of the violation and the date of the award plus the lost profits between the date of violation and the date of the award. These differences aim to establish equilibrium between the parties, as the state may take unilateral decisions that can affect the other party’s economic position. The approach under the Chorzów standard is explained by legal policy reasons such 5.204 as the need to treat international tort differently from a breach of contract. This

216 Amco Asia Corporation, Pan American Development Limited, PT Amco Indonesia v. Republic of Indonesia, ICSID Case 1984–1990. 217 Amco v. Indonesia , para. 186–7 (n. 216).

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Chapter 5: Analysing, Framing, and Proving a Claim rationale was explained in the Factory at Chorzów case when stating that an illegal expropriation is not to be treated as being the same as a legal expropriation:218 It follows that the compensation due to the German government is not necessarily limited to the value of undertaking at the moment of dispossession plus interest to the date of payment. This limitation would only be admissible if the Polish Government had the right to expropriate, and if its wrongful act consisted merely in not having paid to the two Companies the just price of what was expropriated; in the present case such a limitation would result in placing Germany and the interests protected by the Geneva Convention, . . . , in a situation more unfavourable than that in which Germany and these interests would have been if Poland had respected the said Convention. Such a consequence would not only be unjust, but also and above all incompatible with . . . the prohibition, in principle of the liquidation of the property, rights and interests of German nationals and of companies controlled by German nationals in Upper Silesia—since it would be tantamount to rendering lawful liquidation and unlawful dispossession indistinguishable in so far as their financial results are concerned.219 5.205 The choice between the FMV as of the date of the breach or the date of the award

will be explained in detail in chapter 6. As stated by the PCIJ, it aims to avoid the state party taking advantage from the economic situation or the effect of its own measures on the value of the investment: It has already been pointed out . . . that the value of the undertaking at the moment of dispossession does not necessarily indicate the criterion for the fi xing of compensation. Now it is certain that the moment of the contract of sale and that of the negotiations with the Genevese Company belong to a period of serious economic and monetary crisis; the difference between the value which the undertaking then had and that which it would have had at present may therefore be very considerable. And further it must be considered that the price stipulated in the contract of 1919 was determined by circumstances and accompanied by clauses which in reality seem hardly to admit of its being considered as a true indication of the value which the Parties placed on the factory; and that the offer to the Genevese Company is probably to be explained by the fear of measures such as those which the Polish Government in fact adopted afterwards against the Chorzów undertaking, and which the Court has judged not to be in conformity with the Geneva Convention.220 5.206 However, this rationale should not apply to breach of contract cases under umbrella

clauses contained in international investment agreements, where international legal standards such as the fair and equitable treatment standard are not violated and there is no international tort but only a breach of the contract protected by an umbrella clause.

218 219 220

1928 PCIJ Series A, No. 17, 50. 1928 PCIJ Series A, No. 17, 47. 1928 PCIJ Series A, No. 17, 50.

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6 VA LUATION OF DA M AGES IN INTER NATIONA L AR BITR ATION

A. Introduction B. The Economics of Public and Private Contracts 1. Sunk investments 2. Politicization of prices and governmental opportunism 3. Challenges when contracting with public agencies 4. Implications of public contracts for arbitration

C. Principles of Compensation under the Chorzów Formula D. Causality and Completeness: The But-for Premise 1. The construction of but for and actual scenarios 2. Example: CMS v. Argentina

E. Investment vs. Contract Disputes 1. 2. 3. 4.

Fair market value Market value Two investors—two arbitrations Fair market value in commercial arbitrations 5. Application: fair market vs. market discount rates 6. Example: Sempra v. Argentina 7. Example: Enron v. Argentina and LG&E v. Argentina

F. Date of Valuation 1. Historical damages and going-forward damages 2. Date of the award vs. date of the breach 3. Example: El Paso v. Argentina

4. To whom the windfalls 5. Factory at Chorzów ’s three questions 6. Example: ADC et al. v. Hungary

6.01 6.04 6.05 6.07

G. Avoiding Double Counting Damages 1. Double counting sunk costs and lost profits 2. Example: RDC v. Guatemala 3. Avoiding double counting while assessing damages under damnum emergens and lucrum cessans

6.13 6.18 6.24 6.26

H. Loss of Income vs. Loss of Value I. Avoiding Undercompensating 1. The potential misuse of discount rates 2. Discount rate vs. internal rate of return vs. target rates 3. Example: Enron v. Argentina 4. Target rates vs. discount rates 5. Undercompensating via pre-judgment interest 6. Example: ConocoPhillips v. PDVSA 7. Example: Vivendi v. Argentina 8. Compensating for investments not made 9. Example: Siag v. Egypt 10. Example: Occidental Petroleum v. Ecuador 11. Uncertain environments 12. Example: LG&E v. Argentina

6.29 6.34 6.35 6.37 6.40 6.41 6.45 6.48 6.50 6.52 6.53 6.54

J. Valuation of Damages

6.57 6.60

1. Overview 2. Approaches to valuation

6.65 6.71 6.80 6.84 6.85 6.90

6.92 6.93 6.97 6.98 6.100 6.103 6.105 6.107 6.118 6.119 6.121 6.123 6.127 6.129 6.131 6.136 6.136 6.145

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Chapter 6: Valuation of Damages

A. Introduction1 6.01 The calculation of damages in disputes involving complex long-term contracts

must marry two universes: it must rely on an understanding of the facts of each matter under dispute, be consistent with the legal framework and merits of a case, and must also utilize the best-available tools in the fields of economics and valuation theory and practice. This chapter is aimed not as an inventory of such tools, but rather as a study of cases (some based on real examples and some hypothetical) of how the interaction between circumstance and legal theory may inform the approach that a damages evaluator can take, or the prism that a tribunal may use in evaluating the damages submissions by the parties. This chapter builds on prior concepts outlined in this book to provide a consistent economic framework— sprinkled with constructive examples—of how many of the situations described in prior chapters, including but not limited to the concepts of damnum emergens and lucrum cessans, the notion of ‘double counting’ (or ‘undercounting’), the ‘but-for ’ premise and the construction of a ‘but-for ’ framework, the selection of an appropriate date of valuation, and the issue of investments not yet fully disbursed, among other issues, can be analysed and understood systematically in the framework of complex long-term contracts. 6.02 By addressing the valuation and damages issues that are germane to complex

long-term contracts, this chapter seeks to explain the similarities and differences when claiming damages in investment and commercial arbitration. 6.03 This chapter focuses on loss of income arising from the breach of complex long-term

contracts based on income stream or the violation of an international legal standard affecting such contracts. We start with an analysis of the application of the but-for premise under the famous Factory at Chorzów case as the international customary law standard, and compare the differences, where applicable, under commercial arbitration.

B. The Economics of Public and Private Contracts 6.04 This work deals with complex long-term contracts between private parties or

between private and public entities. The latter are referred to in this chapter as public contracts. One feature differentiates complex long-term contracts, whether

1 The authors wish to disclose that one of them served as quantum expert in the following arbitrations mentioned in this chapter: El Paso v. Argentina, EDFI v. Argentina, Sempra v. Argentina, RDC v. Guatemala, ADC Affiliate et al v. Hungary, Enron v. Argentina, EDFI v Argentina, and Siag v. Egypt. The information provided in this chapter is based exclusively on the information presented in the publicly available awards.

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B. The Economics of Public and Private Contracts public or private, from other short term or typical long-term contracts:2 they normally involve large sunk investments or costs incurred by the provider of the service. With respect to public complex long-term contracts, two additional elements are relevant: (a) they are highly affected by politics; and (b) one of the parties is a public entity, which gives rise to particular challenges. Consider a water and sewerage concession. Water and sewerage concessions are often granted for long periods of time, making these long-term contracts. Similarly these contracts are complex in that they normally require substantial upfront investments, which are to be repaid via future tariff revenues. These concession contracts normally stipulate complex pricing adjustment mechanisms, sometimes involving a mixture of temporary adjustments (such as indexation to retail or producer prices), coupled with periodic price reviews, which can be triggered either by the passage of time, or requested by either party. Seldom do these contracts involve simple pricing rules such as, for example, long-term natural gas sales (or other typical synallagmatic contracts) which tie the contract price to an index of observable prices. The reason for this contractual feature arises from the other features of these contracts: in particular their large sunk investments, and when one of the parties is a public entity, the politicization of pricing. 1. Sunk investments Consider sunk investments first. Investments in water and sewerage assets (pipes, 6.05 treatment plants, meters) are highly specific to the area being served and are most often sunk, in the sense that their value in the best alternative use is small compared to the cost of their investments (e.g., it is very expensive to dig out water distribution or sewerage mains, treatment plants, or meters, and move them to an alternative location). Different from other long-term contracts where the investments at hand are not that highly specific (e.g., long-term gas suppliers may redirect their natural gas to the market rather than to the specific buyer facing a contractual breach), an investor in a water concession contract facing a contractual breach cannot take its product and sell it to another buyer in a different location. The sunk nature of its assets means that the supplier has offered its buyer a prime hostage.3 If the buyer behaves opportunistically and reneges on some important dimension of the contract—such as tariff terms, subsidies, quality requirements, and the like— the supplier is exposed to being unable to recover its investment or to repay its debt. As a consequence, the supplier would normally demand complex safeguards so as

2 See, e.g., Pablo T. Spiller, ‘An Institutional Theory of Public Contracts: Regulatory Implications’ in M.  Ghertman and C.  Menard (eds.), Deregulation or Re-regulation:  Institutional and Other Approaches (Edward Elgar Publishing 2009) and Pablo T. Spiller, ‘Transactions Cost Regulation’ (2013) 89 Journal of Economic Behavior and Organization 232–42. 3 See Oliver E. Williamson, ‘Credible Commitments: Using Hostages to Support Exchange’ (1983) 73 American Economic Review 520–40.

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Chapter 6: Valuation of Damages to avoid being exposed to opportunistic breach.4 Complex pricing mechanisms are often designed to provide such safeguards. Similarly, detailed quality specifications are developed to avoid the potential for quality disagreements leading to an opportunistic breach, as well as termination and alternative conflict resolution arrangements, to avoid judicial inadequacies. 6.06 It is the existence of sunk investments that makes opportunism a hazard in com-

plex long-term contracts. The fact that a large component of investments is sunk implies that once the investment is undertaken the operator will be willing to continue operating as long as operating revenues exceed operating costs. Since operating costs do not include a return on investments (but only on the alternative value of these assets), the operating company will be willing to operate even if prices are below total average costs. The fact that the ‘buyer’ in this contract may be a public agency makes a fundamental difference in the hazards, because in this case, opportunism is not only rooted in economics but politics as well. In fact, the potential for opportunistic breach is exacerbated when one of the parties, and in particular, the ‘buyer’ is a public agency. We call this hazard governmental opportunism.5 2. Politicization of prices and governmental opportunism 6.07 Governmental opportunism consists, in the framework of complex long-term con-

tracts, in the ability of governments, and thus, of governmental agencies, to make unilateral changes to the rules of the long-term relation via the standard use of governmental powers in order to extract the rents of the supplier associated with its sunk investments. Changes in the rules of the game can be done in multiple subtle, and not so subtle, ways. Governments may issue legislation making illegal a particular type of conduct, contract or pricing, even one it may have originally encouraged or even formally agreed to in the contract. Consider the history of San Francisco’s hydrant rates in the late 1880s as recently discussed by Masten:6 To overcome the water company’s resistance to new investment . . . , the San Francisco Board of Supervisors agreed to payments of $2.50 per hydrant per month in 1882, increased to $5.00 in 1895, ‘in return for the company making investments in system extension and pipe enlargement for fire protection’. . . Beginning in 1898, however, following investments by the company that achieved an increase in per-capita consumption of more than a third between 1880 and 1890 despite population

4 Williamson defi ned opportunism as ‘self-interest seeking with guile’. See Oliver E. Williamson, ‘Transactions Cost Economics: The Governance of Contractual Relations’ (1979) Journal of Law and Economics 3–61. In this sense, our concept of opportunistic breach appears when, as the US Seventh Circuit Court defined, ‘the promisor wants the benefit of the bargain without bearing the agreed-upon costs, and exploits the inadequacies of purely compensatory remedies’. See Patton v. Mid-Continent Systems, Inc., 841 f.2d 742, 751 (7th Cir. 1988) (Posner, Circ. J.). 5 See Pablo T.  Spiller, ‘A Positive Political Theory of Regulatory Instruments:  Contracts, Administrative Law or Regulatory Specificity?’(1996) 69 Southern California Law Review 477–515. 6 Scott Masten, ‘Public Utility Ownership in 19th-Century America: The ‘Aberrant’ Case of Water’ (2011) 27(3) Journal of Law, Economics, and Organization 604–654.

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B. The Economics of Public and Private Contracts growth of almost 30%, the city undertook a series of rate reductions—characterized as a ‘breach of trust’ by the company—cut[ting] hydrant payments . . . from the previous level of $5.00 per hydrant per month to a rate amounting [to] $1.75 per hydrant per month . . . , despite previous implicit agreements with Spring Valley to maintain existing charges in return for water company investments in system improvements . . .

Governmental opportunism, however, does not have to be so drastic as a law or 6.08 Decree, or a municipal decision, cancelling or changing the nature of contracts, pricing or allowable practices, but can be achieved via the subtle works of administrative process. The imposition of fines on a concession operator for alleged quality deficiencies, or a regulatory decision denying a tariff increase could just do the trick. What may seem as innocuous acts of regulatory supervision, may actually be nothing else but governmental opportunism, attempting to extract part of the utility’s quasi-rents. The case of Compañía de Aguas del Aconquija is an interesting example. A water and sewage services concession was granted by the Province of Tucumán, Argentina in 1995 and terminated by the Province just two years later. The process that led to the contract termination, and described in unusual detail by the arbitration panel in its award,7 is a textbook, and probably an extreme, example of what we call governmental opportunism, whereby a government uses its regulatory and executive powers to achieve a tariff reduction not allowed by the regulatory framework. In fact, the Aguas del Aconquija Award shows the multiplicity of instruments governments have at their disposal to attempt to extract a utility’s quasi-rents. In this case, the Provincial Government seems to have used all its formal powers, regulatory decisions, legislative acts, executive decrees, attorney general recommendations, even judicial decisions, and informal powers, press releases, Ombudsman’s letters, public announcements, and the like, to force the company’s hand.8 Investors facing the risk of governmental opportunism will either cease to invest, 6.09 or demand up-front compensation for that risk. Either strategy, however, as the case of Aguas del Aconquija shows, may not alleviate the risk, but rather may, in the end, exacerbate it. It is sunk investments that provide politicians with the opportunity to behave 6.10 opportunistically vis-à-vis the investor. In other words, sunk investments expose the utility to the risk of potential expropriation, which may be indirect and undertaken by subtle means. Politics, by focusing on short-term gains (often at the expense of long-term losses), provide impetus for—and hence the risk of—governmental

7 See Award—‘In the Arbitration between Compañía de Aguas del Aconquija S.A. and Vivendi Universal S.A. Claimants v. Argentine Republic, Respondent, Case No. ARB/97/3’ issued on 20 August 2007. 8 At the end, the company attempted to rescind the contract due to Governmental breach, at which point the Province terminated the concession. The service remained in the company’s hand for another year, at which point it was taken over by ENHOSA, a federal water service entity. See Vivendi Award at 112 (n. 7).

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Chapter 6: Valuation of Damages opportunism. Since politicians can obtain substantial short-term political gains by reducing tariffs or not granting tariff increases, investors in complex long-term contracts involving a public agency will demand further contractual safeguards to be introduced so as to reduce the potential for governmental opportunism. 6.11 These conditions result in contracts that tend to be noticeably different in at least

two fundamental aspects: they are more rigid, and they pay a premium to investors. The increased rigidity results from the tension between the investor (who demands guarantees that prices shall not be lower than a certain threshold, for example), and the government, which wants to maintain control of maximum prices (often through price cap regulation or rate of return regulation) mindful of the social and political implications of price changes in the provision of these services. The premium paid to investors, usually seen in a higher contracting price or required return is the result of the investors’ perceived risks. 6.12 The rigidity of these contracts often implies a higher number of legal conflicts,

especially when a change in the economic environment makes contracts obsolete, unfavorable, or simply politically unviable. The case of the disputes stemming from contracts for the provision of public services (utilities) in Argentina as a result of the macroeconomic crisis in 2001–2002 is a recurring topic throughout this chapter, as it illustrates a dramatic set of circumstances (resulting in a dramatic number of arbitration matters), which tested the economics of complex long-term contracts. 3. Challenges when contracting with public agencies 6.13 When complex long-term contracts involve a public agency, such as in most utility

contracts where a public agency plays the role of the concessionaire or purchaser, the contract faces an additional hazard not present in standard long-term synallagmatic contracts (such as a natural gas sale). This hazard, which Spiller calls ‘third party opportunism,’ consists of interested third parties challenging, when by such action they benefit,9 the ‘probity’ of the contract (or of its performance), thereby affecting directly the perceived probity of the public agency in charge. Such incentives may exist when third parties compete with the public agent in the political market.10 A fundamental feature of interest groups, though, is that they are interested. In other words, they are biased. They provide information only when it is to their advantage. This means that the third party (or parties) may behave opportunistically. Given the inherent informational asymmetries between the interested third party, the courts, and the public in general, the challenge may be exercised even if the action is ethical and/or legal. In fact, the more complex the contractual 9 A successful challenge may involve the eventual displacement of the incumbent (and competing) public agent, or simply the erosion of public support for its political group or party. See Spiller (n. 2). 10 Such would be the case when watchdog groups are highly aligned, or become identified, with particular political parties.

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B. The Economics of Public and Private Contracts relation is, the higher the inherent informational asymmetries, and thus, the higher the probability of ‘third-party opportunism’. The exposure to third-party opportunism creates risks to both the public agent and 6.14 the contracted party. In response, both will have incentives to formalize their relation (i.e., to move away from implicit agreements), and to make it highly specific. Furthermore, to mitigate the risk of third-party opportunism, these regulatory contracts will be designed so as to limit potential challenges, both at the signing and implementation stages. As a consequence, concession contracts will tend to limit high volatility in cash flows to the investor, and set out rigid procedural processes, including formal procedures for renegotiation.11 As in private contracting, though, these adjustments may not fully mitigate third-party opportunism, and government/utility investors’ interactions are likely to experience a higher degree of conflict than contracts among private parties. In other words, the risk of third-party opportunism means that ‘relational’ con- 6.15 tracting is less likely to evolve in utility regulation. Governments, then, will have difficulty entering into close relations with utilities, in which contract adaptation takes place without formal renegotiations, specific administrative processes, and/ or litigation. Furthermore, concession contracts will tend to be complex, involving multiple rules and procedures, and will be subject to substantial litigation. The recent example of Aguas del Tunari (AdT), another failed water concession 6.16 contract, provides an illustration of third-party opportunism. Aguas del Tunari was a 40-year water and sewage services management contract in the City of Cochabamba, granted by the Government of Bolivia, in September 1999, to the AdT consortium led by International Water (Tunary) Ldt, a Cayman company fully owned by Bechtel Enterprise Holdings Inc, a US corporation.12 Operations started in November 1999. In January 2000 a tariff increase was instituted, raising average revenue between 35 per cent and 51 per cent,13 with tariff increases 11 Complex compensation schemes, involving performance bonuses, for example, may not pass public scrutiny and be perceived as consenting to investors’ demands. Similarly, high pay-off volatility must imply instances where investors may receive very high transfers, which may not be easy to explain to the public, and perceived as corrupt. In the same way, flexible procedures may be perceived as granting favours to the investor, and thus increase exposure to third-party opportunism. 12 Aguas del Tunari S.A.  v.  República de Bolivia , ICSID Case No. ARB/02/3, Decision on Respondent’s Objections to Jurisdiction, 21 October 2005, Washington DC, at 13. 13 Bechtel claims the average increase was 35 per cent while the Democracy Center reports a study run by SEMAPA, the public utility that operated the water services prior to AdT, claiming that prices increased by 51 per cent on average. See Bechtel Corporation, ‘Bechtel Perspective on the Aguas del Tunari Water Concession in Cochabamba, Bolivia’, 16 March 2005, available at , and Bechtel Corporation, ‘Cochabamba and the Aguas del Tunari Consortium’, December 2005, available at . Democracy Center, ‘The Water Rate Hikes by Bechtel’s Bolivian Company (Aguas del Tunari): The Real Numbers’ (n.d.), available at .

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Chapter 6: Valuation of Damages ranging, according to Bechtel, from 10 per cent for the poorest segments to more than 100 per cent for the richest segments of Cochabamba.14 Civil protests started right away, initially led by a ‘Civic Committee’, demanding the renegotiation of the contract. The ‘Coalition in Defense of Water and Life’, representing Cochabamba citizens, but also tanqueros,15 coca growers, and industry, started to demand the termination of the contract. Violent protests started in February, which led to the roll-back of the tariff increase. Violence continued and intensified in April 2000, leading to several deaths. After the violence erupted, the Government terminated the contract, and reversed the water privatization efforts. 6.17 The issues surrounding the granting and termination of the AdT contract are

highly complex. A prior privatization attempt in 1998 had failed to attract any bidders. A subsequent bid attracted only a single bidder, the AdT consortium. Under the new contract, the consortium was not required to own facilities nor resources. It was, however, required to invest in what seemed to be an unprofitable dam and aqueduct (Misicuni) project,16 and was required to pay down the public utility’s debt. The contract involved only potable water, not agricultural water, and affected only connected, not private or community wells. Nevertheless, the emphasis of the interest groups was on agricultural and local water rights, fear of appropriation by AdT of privately developed wells, and potentially very high rate hikes for the poor; issues that, in principle, were not to take place. The complexity of the concession contract, the negotiated arrangement—with a claim of lack of transparency17 — rather than a transparent bid, its monopoly nature, as well as the multiplicity of those affected by the granting of the concession (including the tanqueros, urban dwellers, industry, among others) and those who might benefit from the political response (opposition politicians,18 coca growers,19 union leaders, among others) created a highly volatile environment in which claims about corruption and potential appropriation of water pipes and agricultural water rights, exacerbated by the

14

See Bechtel Corporation (n. 13). Tanqueros are water truck operators who distribute water in unserved areas. According to commentators, tanqueros in Bolivia charge those without access 10 times what water distribution companies do. See W. Finnegan, ‘Leasing the Rain’, The New Yorker, 8 April 2002. Walker et al. (1999, see box 2.4) reports similar results for Tegucigalpa, where homes without connection to the water system paid in 1994 L27 per m3, while they would have paid L2 per m3 if they were connected. 16 See Bechtel Corporatino (n. 13). 17 According to the Decision on Jurisdiction (at 13–14), ‘. . . on September 3, 1999. . . was a newspaper article reported that the Defense of Water Committee criticized the negotiations as lacking of transparency and requested that the Bolivian government publicize the true rates that would govern before it concluded the Concession’. 18 For an interesting interview with President Evo Morales, who at the time was a national legislator and leader of the coca growers, about the role of the political opposition in the AdT case, see Democracy Now!, ‘Bolivian President Evo Morales on President Obama: “I Can’t Believe a Black President Can Hold So Much Vengeance Against an Indian President’ ”, 23 April 2010, available at . 19 Coca growers were at the time in conflict with the government because of the Bolivian coca eradication program. See Finnegan, ‘Leasing the Rain’ (n. 15). 15

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B. The Economics of Public and Private Contracts tariff increases, could not be easily countered by either the state or the company.20 The result was widespread protests—in multiple other cities, and many on topics wholly unrelated to the water concession,21 —leading to a military curfew, six deaths, the subsequent termination of the concession in April 2000, and the reversal of the privatization process.22 4. Implications of public contracts for arbitration In sum, the fact that complex long-term contracts have characteristically high lev- 6.18 els of sunk investments leads to particular features of complex long-term contracts that are not present in private-to-private contracting. These hazards are exacerbated when one of the parties is a public entity. These contracts tend to be formalistic, to have complex pricing rules and schemes, and to have detailed operational and quality conditions. When dealing with public entities, furthermore, these contracts are not easily amenable to ‘on the contract’ renegotiation. Instead the public nature of these contracts requires that expected deviations, even if agreed upon by the parties, be formally negotiated, leading to formal amendments, often under public scrutiny. Successful formal renegotiations, however, may be impeded by the fear of third-party opportunistic challenges, leading to conflict between the parties. Would the two parties to the contract be private parties, such conflict could have been mediated through ‘on the contract’ renegotiation (the fundamental of relational contracting), with deviations being agreed upon and implemented with proper compensation, without the need for a formal modification.23 Instead, in complex long-term contracts with public entities formal renegotiations are required, with a higher probability of failure, leading to litigation and arbitration. The arbitral system is fundamental in providing the right incentives for con- 6.19 tract ‘adjustment’ (in advance or in reaction to a change in the environment that affects the relationship). From a risk management and risk allocation perspective, the objective then of conflict resolution should be to mitigate the incentives for opportunistic breach, of both private and public entities, while providing incentives to achieve optimal adaptation (i.e., adjustments to the contract that result in an efficient allocation of risk and rewards), while properly compensating the affected party. 20 According to the Decision on Jurisdiction (at 14), Bolivia, in its Memorial objecting to ICSID jurisdiction, stated ‘In fairness, no one negotiating the concession agreement could have anticipated the intensely hostile reaction that greeted AdT immediately upon the Agreement’s signing’. See also Bechtel Corporation (n. 13). 21 Finnegan, ‘Leasing the Rain’ (n. 15). 22 Finnegan, ‘Leasing the Rain’ (n. 15). A similar group then fought the ‘gas wars’ in 2003 during the presidency of Sanchez de Lozada, this time under the leadership of future president Evo Morales. 23 See Ian R.  Mcneil, ‘Contracts:  Adjustment of Long-Term Economic Relations under Classical, Neoclassical, and Relational Contract Law’ (1978) 72 Northwestern University Law Review 854–905.

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Chapter 6: Valuation of Damages 6.20 The large number of cases involving natural resources fi led under ICSID since the

new century is not surprising given that commodity prices started to recover from their prolonged decline circa 2000. Following governments’ attempts to capture a larger share of the rent associated with the commodity boom, foreign investors turned to arbitration and international dispute resolution. Domestic investors, however, often remain unprotected from unilateral actions including the seizure of large sunk and/or stranded assets. 6.21 Similarly, the difficulties Argentina faced in renegotiating its concession contracts

following the demise of the convertibility currency system in early 2002 reflect the working of the combination of the high level of sunk utility investments— which allowed the utilities to continue supplying utility services even though many entered into substantial financial difficulties—and the high visibility and politicization of utility prices, both diminishing the Government’s incentive to reach agreements with the utilities. On the other hand, the increase in commercial arbitration involving complex long-term contracts arising from the financial crisis of 2008/2009 also shows the important role of arbitration in providing the right incentives to both private and public parties. 6.22 Arbitral tribunals, then, have a major role to play in making complex long-term

contracts with state entities safer from the threat of opportunistic recontracting, whether in private or public complex long-term contracts. 6.23 The question, then, is how to limit opportunism in complex long-term contracts.

A  proper implementation of the fundamental principle of damage compensation—whether to ‘wipe out all the consequences’ as enunciated by the ICJ in its Factory at Chorzów decision for the case of investment arbitration, or the but-for premise ‘to place the injured party in the situation it would be in had the breach not occurred’ would accomplish this feat.24 As we discuss later, in its essential features the Chorzów formula is equivalent to the but-for premise, and hence would apply not only to investment but also in commercial arbitration, and in particular, when dealing with public entities.25

C. Principles of Compensation under the Chorzów Formula 6.24 The key legal principle for damage compensation in the Factory at Chorzów deci-

sion is that compensation should ‘wipe out all the consequences of the illegal act

24 The Factory at Chorzów (Claim for Indemnity) (Th e Merits), Germany v. Poland , PCIJ Series A, No. 17 (1928). 25 Factory at Chorzów (n. 24), however, introduces two features that may not be generally applicable to commercial arbitration—the use of fair market value rather than market value, and the principle that windfalls should go to the affected party. We discuss these differences.

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C. Principles of Compensation under the Chorzów Formula and re-establish the situation which would, in all probability, have existed if that act had not been committed’.26 It is straightforward to see that the Chorzów principle is equivalent to compensa- 6.25 tion for specific performance under a standard synallagmatic contract. Specific performance would wipe out all the consequences of the breach and re-establish the contract to its situation absent the breach. In many complex long-term contracts, however, specific performance is not an option, either because the arbitral tribunal does not have the power to compel specific performance—such as to require a Government to return an expropriated asset to its owner, or because the tribunal cannot fully replicate specific performance over time.27 In such cases, the key issue is how to implement a compensation scheme that fits the three essential features of Factory at Chorzów: • Wipe out all the consequences: This principle refers to the fact that compensation should be complete, and based on causality. That is, all the economic consequences that arise from the breach and not others should be compensated. This has important methodological implications which we discuss later. • Re-establish the situation which would . . . have existed if that act had not been committed— this principle refers to the re-establishment of the economic situation of the injured party. An immediate question, though, is at what point in time? At the time of the breach, at the time of the award, or at some intermediate point? Factory at Chorzów considers two points in time—time of the breach and time of the award. As we discuss later, there are solid reasons for using the latter for long-term complex contracts of the type discussed in this book. • In all probability: With this principle, Factory at Chorzów raises the extent of certainty that is required to compute an award. As we discuss in para. 6.128, the extent of certainty should not be any different than that faced in a putative willing buyer-willing seller transaction where the asset in question (i.e., the performance of a contract) would have been transacted.

26

Factory at Chorzów, Judgment, 27 (n. 24). Some simple synallagmatic contracts, such as long-term commodity supply contracts, may be replicable by the judicious design of particular compensation formulas. One such example is the failure to supply, say, natural gas at a fi xed long-term price under a ship or pay contract. If the tribunal determines that such failure is a compensable breach, it may design a formula whereby on a monthly basis the supplier must contribute the difference between the contract and a benchmark price (as long as the latter exceeds the former) to a fiduciary fund, from which the buyer may withdraw amounts at certain time intervals. If market prices reverse and fall below the contract price, efficient contractual performance would imply no shipment nominations, and hence no need for the supplier to continue compensating the buyer. The authors of this chapter were involved in a contract dispute which stipulated a long-term arrangement of this type. 27

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Chapter 6: Valuation of Damages

D. Causality and Completeness: The But-for Premise 6.26 The Chorzów requirement that compensation ‘wipe out all the consequences’ of

the breach is the investment arbitration parallel of the but-for premise ‘to place the injured party in the situation it would be in had the breach not occurred’ in commercial arbitration. Compensation, then, must make the injured party indifferent between a monetary award and specific performance from the moment of the breach forward. Indifference means that nothing but the economic consequences of the breach should be compensated. This is the gold standard of compensation for breach that we apply throughout this book to complex long-term contracts, whether private or public. 6.27 The difficulty resides, however, in developing a basic framework that allows the

valuation analyst and tribunals to disentangle the differentials in value caused by the alleged breach from actions of the other party as well as from industry and macro-economic changes. Imagine, for example, a dispute involving a long-term contract for the supply of a certain critical raw material, involving a failure to deliver, in which the purchasing entity after some difficulty finds a way to imperfectly substitute (at a less convenient price and after delays causing lost sales). A  basic framework for assessing damages should consider what revenues (and expenses) would have been but for the breach and compare those revenues to the revenues (and expenses) that are generated by that business under the breach. This basic framework allows us to compute a differential in value, which, if properly estimated, can be attributed specifically to the actions in dispute. 6.28 Outlining a reliable construction of what the economics of that specific industry,

market and business would have been but for the breaches may be a straightforward exercise or an extremely complex one. The following section attempts a roadmap into the critical aspects of building a reliable analysis. 1. The construction of but-for and actual scenarios 6.29 The objective is simple: the analyst is faced with the task of building a scenario that

takes into account the world as it is, except for the economic and financial implications that could arise from a hypothetical circumstance where the breach has not taken place. 6.30 The application may not be as simple, in particular because of lack of information

and the inability to disentangle the effects of specific actions from other random forces affecting the business. The analyst and arbitral tribunals must follow the principle of causality: unless the breach had consequences on market prices, the only difference between the scenario with the breach (the actual scenario) and the scenario in the absence of the breach (the but-for scenario) must be the consequence of the breach itself. Thus, for example, in the hypothetical raw material 256

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D. Causality and Completeness: The But-for Premise supply contract discussed in para. 6.27, the macro-economy, global demand and supply for the raw material—and hence its international price, as well as global demand for the buyer’s final product, interest rates, inflation, exchange rates and other macro-economic variables, should be the same across the actual and but-for scenarios. The only factor that must be accounted as different across scenarios is the lack of delivery of the raw material. For example, in El Paso v. Argentina, Argentina contended ‘that there is no causal 6.31 connection between the GOA measures and the damage allegedly suffered by the Claimant since the latter decided to sell at the worst possible time of the financial crisis, the country’s macroeconomic conditions at that time being the cause of the reduced value of its investment’.28 The tribunal, however, upheld the claimants’ experts but-for vs. actual approach stating that it: . . . is satisfied that [the Claimant’s expert] has calculated the Claimant’s damage under its DCF valuation method by considering only damage directly attributable to the GOA measures, to the exclusion of damage which might be attributable to the financial crisis. As explained by [the Claimant’s expert]: ‘In our DCF Approach (both the 2004 and the 2006 update we discuss later), the macroeconomic indicators, as well as all available ex-post company performance information are included in the building of cash flows from January 2002 onwards. Thus, the DCF analysis is based on actual sales volumes and costs that fully reflect all the actual macroeconomic conditions in which the companies have been operating in Argentina since January 2002 to date. This is true for both the but-for and actual scenarios, so as to make the comparison between the two scenarios compatible and avoid attributing damages to factors other than the Government measures. In other words, volumes and costs reflect the impact of the 2002 recession, and of the dramatic economic recovery of 2003 onwards.’29

In some cases, however, the breach has an impact on the purchaser’s final product 6.32 prices. Consider, for example, the construction of a large power plant. Assume that because of particular construction problems, its completion was delayed by a non-trivial period of time, and the tribunal determined that the construction company must compensate the power plant owner for its losses. In this case, the only feature that differentiates the but-for and actual scenarios is the availability of the power plant. On the other hand, the fact that the power plant was not available may have implied that electricity prices were higher during the time the plant opening was delayed. Such higher prices, however, should not be considered in the but-for scenario, as had the plant been opened on time, and available during the

28 See El Paso Energy International Company v.  Th e Argentine Republic, ICSID Case No. ARB/03/15, Award dated 31 October 2011, para. 683. 29 See El Paso v. Argentina , para. 685 (n. 28). The tribunal further explained that the respondent ‘has not disputed the fact that [the Claimant’s expert] has only considered the effect of the GOA measures on the value of the Claimant’s investment when evaluating the latter’s damage’. See also para. 686.

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Chapter 6: Valuation of Damages period of time of the breach, electricity prices would have been lower. Thus, in this example, the but-for scenario has to consider not just a different amount of sales (in terms of KWhs), but also different prices.30 6.33 Often, however, evidence on damages is presented not following the premise of a

but-for scenario, but rather a before vs. after approach. This approach often takes its inspiration from the fact that bilateral investment treaties (BITs) often stipulate that compensation should reflect the value of the asset just prior to the (or any threat of) expropriation. This is often interpreted, wrongly, however, to mean that compensation should be the difference between the value just prior to the measures, and the value after the measures. The difference between the before vs. after approach and the premise of a but-for value, is that in the former, damages most probably would not ‘wipe out all the consequences’ of the breach, while the in the latter they would. The reason is simple: the value of an asset operating under the breaches reflects what willing buyers and sellers would be willing to pay and receive in the presence of the breach, given the particular macro-economy, interest rates, inflation, international prices, and so on, at the moment in which this assessment is performed. The value prior to the measures may reflect, however, a completely different macro-economic scenario. Assume, for example, that the breach was undertaken under normal economic circumstances, while the actual valuation is undertaken five years later, in the middle of an economic boom. The value prior to the breaches, however, could fall short of the value after the measures simply because of the economic boom. Would the tribunal decide, however, that given that the value of the undertaking after the measures falls short to the value prior to the measures, the award would undercompensate for the economic impact of the breaches, as but for the breaches, the value of the company after the breaches would have been substantially above its value under the breaches. Thus, it is important, that in assessing damages the but-for premise should be upheld, whereby the damages are computed as the difference, at a certain date of valuation, between the value absent the breaches to the value with the breaches. 2. Example: CMS v. Argentina 6.34 In CMS v.  Argentina, a case involving the suspension of tariff indexation in

Argentina, prior to and following the financial crisis of late 2001/2002, the claimant’s experts proposed a damage computation based on the before vs. after approach, which separated by three years the before and after valuations. The tribunal reversed the approach applying an appropriate but-for vs. actual approach, concluding that ‘it would be more logical and mathematically correct to assess the value lost by

30 Further complications could arise if the power plant owner also owns multiple other power plants in the same market. In such case, the fact that the new power plant was not available most probably implied higher sales at higher prices its other power plants than it would have had in the absence of the breach.

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E. Investment vs. Contract Disputes shares as of a single date’.31 In order to do so, they looked at the difference between the actual value as of that date, and a but-for value as of the same date. As in many other treaty arbitrations, the tribunal in CMS had no problem in using differences between the fair market valuations in a but-for and actual scenarios to assess damages for the fair and equitable claim.32

E. Investment vs. Contract Disputes Methodologically, the techniques described in Section J will also apply, in most 6.35 cases, equally to both settings. There is, however, a fundamental difference between contract and treaty disputes involving expropriation or unfair treatment provisions. While in contract disputes, losses are to be computed, in general—but not always as we will discuss—at market values, in treaty disputes losses are to be computed at ‘fair market values’. The rationale is straightforward. In private transactions, the potential for contract breach is inherent to the contract, and the parties design the contract to be able to balance such risks, and to avoid one of the parties having excessive leverage.33 On the other hand, treaty disputes naturally involve an unbalanced relation. While a state can unilaterally change laws affecting the performance of the investment, the private party is in an inherently weaker position as, at least in most cases, its ability to unilaterally affect the welfare of the state is extremely limited. As a consequence, transitory market dislocations allow states to attempt to take advantage, directly or indirectly, of the sunk asset nature of certain investments in the country, while granting compensation at less than fair market value.34 While a private party may attempt to take advantage of increased leverage due to changing market conditions to, at least transitorily, appropriate some of the rents of its trading party, when market conditions revert to normal, the balance of power moves to the other party. Unless the changing market conditions made one of the parties prefer to terminate the relationship, the potential for retaliatory behaviour in an otherwise long-term relationship, will keep both parties from misbehaving. In government/private investment disputes, however, the balance of power is always one sided, and private investors have little individual leverage to prevent governmental opportunism. Instead, governmental opportunism is restrained by the nature of the country’s institutions, and by the potential financial penalties associated with such misbehaviour arising from judicial or arbitral awards.

31 See Award, CMS Gas Transmission Company v.  Th e Argentine Republic, ICSID Case No. ARB/01/8, dated 12 May 2005, para. 440. 32 See CMS Gas Transmission Company v. Th e Argentine Republic, paras. 264 and 281 (n. 31). 33 Th is is behind Oliver Williamson’s contention that private contracting almost always involves the mutual trading of ‘hostages’. See Williamson (n. 3). 34 For example, a country may take advantage of a fi nancial crisis to unilaterally terminate crude oil concession, offering to pay book value for such assets, knowing that market values at the time are depressed because of market illiquidity and distress.

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Chapter 6: Valuation of Damages 6.36 The fact that most BITs require compensation to be based on ‘fair market’, rather

than just ‘market’, values, is in fact designed to prevent governments from taking advantage of market crisis to expropriate cheaply. Some treaties, such as the French-Argentine BIT talk about ‘normal conditions’, 35 others about ‘just value’, while others about ‘real value’.36 It is understood, though, that all these refer to the same thing: fair market value. 1. Fair market value 6.37 The fair market value of an asset represents the price at which willing buyers and

sellers, under no compulsion to buy or sell, would have been willing to exchange an asset. The US Supreme Court provided a classic definition of fair market value:37 The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. 6.38 Similarly, fair market value is defined by the American Society of Appraisers as:38

. . . the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. 6.39 Thus, a fair market valuation must assume that neither party to the transaction is

under compulsion to buy or sell. For that reason, it is standard to exclude distress sales when assessing fair market value based on the ‘willing buyer/willing seller’ approach.39 2. Market value 6.40 Market value is the price at which an asset will trade at a given point in time in a

competitive setting. Market value, differing from fair market value, may be influenced by temporary distress conditions. Consider, for example, assessing the market value of a company in late September 2008. Following the Lehman Brothers 35

See Argentina—France BIT, Article 5. Such as the Algeria—Luxemburg BIT. 37 See United States v.  Cartwright, 411 U.S. 546 (1973), (CL-068). See also World Bank, ‘Guidelines on the Treatment of Foreign Direct Investment’ (1992) Foreign Investment Law Journal, Chapter IV ‘Expropriation and unilateral alterations or termination of contracts’, at paras 5 and 6. 38 See American Society of Appraisers, ‘International Glossary of Business Valuation Terms’ (2009), , accessed 22 August 2011, 27. 39 The US Treasury regulations, for example, specifically exclude distress sales from fair market value estimations. For example, in detailing the procedures to estimate the fair market value of real estate, Revenue Procedures 79-24 say: ‘If any sale is a distress sale, a forced sale, or one negotiated with unusual terms provided by the seller, it should be discarded.’ See Revenue Procedure, 79-24, 1979-1, C.B. 565. 36

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E. Investment vs. Contract Disputes bankruptcy in 15 September 2008, the stock market (measured by the Dow Jones Index—DJI) fell more than 3,000 points, from 11,400 as of 9 September 2008 to 8,400 in 9 October 2008. During that period, and subsequent months, the stock market was impacted heavily by a dramatic drop in liquidity, the closing of interbank lending, the increase in the probability of default of banks, and in a dramatic flight for liquidity and safety. This process led to further declines in companies’ valuations, with the DJI reaching 6,500 by early March 2009. During that time, then, it is fair to say that market transactions did not reflect normal trading times. Sellers were either motivated by extreme illiquidity or panic, while buyers were benefitting from ‘bottom feeding’. Thus, while during this period of time stock market prices properly reflected the economic conditions of the period, they did not satisfy the conditions to be called fair market values. 3. Two investors—two arbitrations To highlight the potential differences between treaty and commercial arbi- 6.41 tration consider an example of two foreign investors, both shareholders in a publicly-traded utility. Shareholder A has an agreement in place to sell his shares to a buyer within a certain time frame. Before the sale is executed, the macroeconomic environment dramatically worsens, bringing the value of the utility to a fraction of the price that had been stipulated. At the same time, and in the middle of the crisis, the host country issues regulatory rules, which have the effect ceteris paribus, of further lowering the value of the utility. In this example, the prospective buyer will likely renege on the sales agreement, maybe invoking force majeure or change in conditions to get out of what now would be a bad deal. The prospective seller will likely pursue a claim against him under commercial arbitration for failing to honour the agreement, demanding as compensation the difference between the contractual price and the utility’s stock price at that point in time, which it is reasonable to presume was affected both by the financial crisis and by the new regulations. The second shareholder, who was not involved in the sale, may also have a claim against the host country for the imposition of the regulations. Following the filing of a treaty arbitration, the tribunal determines that the regulations imposed by the regulatory body were in violation of the treaty protecting foreign investments. The question then arises:  how are these two arbitrations similar or different 6.42 with respect to value? In the commercial proceeding, the expert will want to determine the value loss as the difference between the contract price and the price that the shares would have commanded in the market at the time. In the investment proceeding, on the other hand, the valuation will have to satisfy the requirement that the claimant be made whole specifically for the losses that are attributable to measures inflicted by the host country, but considering the macroeconomic environment as is, since the state is not being held liable for economic performance. 261

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Chapter 6: Valuation of Damages 6.43 In this example, while the expert is technically trying to estimate a value of the

company in each of these proceedings, the assumptions that form the basis for each valuation may differ significantly: the commercial dispute will seek a value of the performance of the contract (possibly observable given certain market conditions), and the treaty dispute will seek to find a value based on the hypothesis that certain actions would not have taken place (but not attribute macroeconomic issues to the respondent). Specifically, while in the commercial arbitration damages can be assessed directly as the difference between the contractual price and the stock market price as of the contractual sale date, in the treaty arbitration damages cannot be based on the stock market price at the time of the regulations being imposed, as this price was contaminated by the crisis. Although it is true that if the second shareholder had attempted to sell its shares just prior to the enactment of the regulations it would have had to sell them at the current depressed stock prices, reflecting distress and panic conditions, as the Sempra Tribunal argued,40 this claimant did not invest for ‘trading purposes’. Thus, short-term market fluctuations, and in particular those reflecting an environment of distress and panic, do not represent fair market valuations, and hence should not be considered in assessing damages. 6.44 On the other hand, it is inappropriate to infer from this discussion that fair market

value has no role in commercial arbitrations. In fact, since the purpose of compensation is the same—to place the damaged party in the situation it would have been absent the breach, whether treaty or commercial, there is a role for the fair market value concept in commercial arbitration. 4. Fair market value in commercial arbitrations 6.45 Consider a case of a long-term supply coal contract, say 20 years. Assume, further-

more, that the foreign coal supplier had to undertake substantial specific investments so as to be able to commit to this transaction, and that as a consequence, it demanded some degree of certainty on delivery prices. Thus, the contractual price, while fluctuating over time, may diverge substantially from spot prices. Assume further that a deep financial crisis emerges, leading to a substantial reduction in coal spot prices. The buyer facing reduced demand and not wanting to buy coal at above market prices, unilaterally terminates the contract. The seller files an international arbitration for breach of contract. In this case, the buyer would allege that damages ought to be computed based on discount rates prevalent at the time. Such discount rates reflect both the economic downturn but also the financial panic and distress among investors. The buyer would then probably claim that would the seller try to sell its contract, the market price for such contract would be very low,

40 See Sempra Energy International v.  Th e Argentine Republic, ICSID Case No. ARB/02/16, Award dated 28 September 2007. The award was subsequently annulled on 29 June 2010. Sempra Award at para. 435. For further discussion of this issue, see paras. 6.97 and et seq.

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E. Investment vs. Contract Disputes both because of the reduced demand for coal and because of the prevalent illiquidity and high discount rates. The point here, as well as in the investment arbitration we just discussed, is that 6.46 the coal seller did not want to sell its supply contract. The only reason it is faced with the hypothetical sale of the contract is the contractual breach. Thus, forcing the supplier to accept a substantial diminution in value purely because of current market distress or transitory panic would not place the supplier in the same condition had the breach not taken place.41 These examples are also useful to differentiate damage assessments from pure pro- 6.47 ject valuation. In a standard project valuation the analyst must assess value given all current conditions. Thus, in the middle of a financial crisis, an analyst would value assets according to current and forecasted market prices. An investment advisor when advising a shareholder who wants or needs to sell should advise based on prices that can be obtained at that point in time, rather than at prices that it could obtain should it hold onto the asset for a while until markets stabilize. 5. Application: fair market vs. market discount rates Interest rates are used for discounting and updating. Discounting is used to bring 6.48 to the date of valuation future cash flows, while updating or ‘capitalizing’ is used to bring to the date of valuation losses that took place prior to the date of valuation. When computing lost profits or discounted cash flows, the discount rate, whether used for discounting or updating, becomes one of the essential components of discussion among experts. Tribunals should not shy away from making hard decisions on discount rates. Discount rates are often a significant component of damages and compensation. In general, discount rates should reflect market, industry and contract conditions 6.49 under which the impacted asset operates. As we have discussed,42 however, fair

41 In Himpurna California Energy Ltd (Bermuda) v. PT (Persero) Perusahaan Listruik Negara (Indonesia), Final Award dated 4 May 1999, a commercial dispute resembling, to some extent, this example, the tribunal made a determination which transferred to the supplier most of the risks of the Asian crisis prevalent circa PLN’s breach (1997): it discounted future cash flows at a rate (19%) that may be reflecting the financial crisis at the time; it did not compensate the claimant for the value of further capacity expansions which were specifically contracted upon, so as not to saddle PLN with potential excess supply given the perceived reduction in electricity demand in Indonesia; and forced the claimant to transfer its assets to PLN upon receiving the monetary compensation. In other words, the tribunal may have implemented a ‘forced’ sale, whereby had the claimant wanted to dispose of its assets in the middle of the financial crisis, it would have obtained a price substantially lower than what the value of the assets would have been had PLN not breached its purchase contract, and the claimant would have been able to retain ownership of the assets at least until the Asian crisis subsided. The tribunal was expressly influenced by ‘equity’ considerations in favour of the respondent when setting the discount rate. See Himpurna Award, paras. 19, 315 et seq., 372, and 382. 42 See para. 6.39.

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Chapter 6: Valuation of Damages market valuations ought to be free from distress conditions. Thus, for example, the high discount rates implicit in the middle of financial crises, such as the global financial crisis circa end of 2008/early 2009, which led to deeply depressed asset prices, fundamentally reflect generalized panic conditions, and the need of distressed actors to increase their liquidity, and are, thus, inconsistent with fair market valuations.43 6. Example: Sempra v. Argentina 6.50 In Sempra,44 the tribunal was confronted with two conflicting assessments of the

discount rate, one which relied on a long-term view of the cost of capital, and one which was based on the prevalent market conditions circa end of 2001 in Argentina, the latter assessing the country risk based on the yield of the Government’s debt which was, as of end 2001, heavily discounted because of the impending default.45 The tribunal, however, concluded that:  ‘. . . an unusually high market discount should not be included in the valuation of a long-term investment, on the basis of a serious but temporary economic crisis.’46 In particular, it stated that: In the context of some of the expert reports before the Tribunal, high discount rates were also envisaged as a consequence of the premium on Government bonds being very high at the end of December 2001 because these bonds were in default at that time and as a consequence they could only sell at a deep discount, if at all. However, the Tribunal believes that the case of CGP and CGS is different. In fact, there is first a difference between the Argentine government’s credit risk and the country risk. It has been clearly established before the Tribunal that, even in the latter part of 2001, the country risk premium required by an investor in a private company in Argentina was significantly lower than the Government’s credit risk premium during the same period. The difference was even more significant in the case of energy companies like CGP and CGS, because of their regulated status and their relatively lower business risk.47 6.51 In Sempra, then, the tribunal made a clear differentiation between a government’s

credit risk and the country risk faced by an investor, particularly in an environment

43 When applied for updating, such as in commercial or Treaty cases dealing mostly with historical damages or lost historical income, discount rates should be applied in the same way as would be applied for discounting. For an example of such application, see the discussion of ConocoPhillips v PDVSA (see n. 114) at para. 6.118. 44 The claimant, in Sempra (n. 40), invested, starting in 1996, in two natural gas distribution companies, Camuzzi Gas Pampeana (CGP) and Camuzzi Gas del Sur (CGS) (Sempra Award, para. 88). It alleged that a series of measures by the Government of Argentina adopted by the Government of Argentina in 2000–2002 and thereafter, ‘resulted in the permanent abrogation and repudiation of most of the rights it had under the regulatory framework and the License, and that these rights will not be restored’ (Sempra Award, para. 93). The tribunal held that the alleged measures breached the US-Argentina treaty, and ordered the payment of US$128.5 million. The tribunal, however, did not award post Award interest (Sempra Award, 139). 45 See Sempra Award, para. 432 (n. 40). 46 See Sempra Award, para. 435 (n. 40). 47 See Sempra Award, paras. 432–3 (n. 40).

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F. Date of Valuation in which the government’s sovereign credit is drastically impaired by the potential, or actual default. In those cases, the tribunal understood that the yields of government bonds are not a measure of the relevant country risk as faced by a private investor. 7. Example: Enron v. Argentina and LG&E v. Argentina In Enron, a case arising from the same type of measures as those discussed in 6.52 Sempra, and hence having their origins in the same financial crisis of late 2001, the tribunal made clear that, as it relates to the discount rate, it should reflect neither the risks of the measures themselves,48 nor the financial dislocation that preceded the measures.49 A similar determination was made in LG&E.50

F. Date of Valuation In order to ‘Re-establish the situation which would . . . have existed if that act had 6.53 not been committed’ another critical component of the damages analysis is the date of valuation. Once again borrowing from the legal principles in investment arbitrations, we ask the valuation analyst to consider that the damaged party’s situation should be restored to what it would have been, but the question arises: as of when? There is a natural tendency to use the date of the breach, but contract or treaty disputes are often much more complicated. For example, consider a treaty dispute involving the imposition of a tax on crude oil exports affecting a crude oil producer operating under a concession contract that grants it tax free status. If the tribunal determines that the tax is a breach of the treaty and that the government must compensate the claimant, the question, following the Chorzów principle, is how to compensate so as to re-establish the claimant’s situation which would have existed absent the tax. Assume that, because of the time it takes for the arbitration 48 See Enron Corporation and Ponderosa Assets L.P. v. the Argentine Republic, ICSID Case No. Arb/01/13, Award dated 22 May 2007. The tribunal stated (at para. 378): ‘. . . the Tribunal believes that the “country risk” does not include the risk of freeze and pesification of tariffs, which was separately and specifically protected under the Regulatory Framework.’ See also para. 149. 49 For that reason the tribunal endorsed the used of a WACC that was preliminarily determined by the regulatory agency several months prior to the financial collapse of late 2001/early 2002. See Enron Award, paras. 411–12 (n. 48). 50 See LG&E ENERGY Corp., LG&E Capital Corp., and LG&E International Inc. v. Th e Argentina Republic. ICSID Case No. Arb/02/01, Award dated 25 July 2007, at para. 52 saying: ‘The Tribunal makes a final remark with respect to the allegations on the impact of the country risk premium on compensation. Although this premium was included in the calculation of tariffs, it does not excuse Argentina for the abrogation of the tariff regime. The tariff regime was an essential feature for enticing foreign investors to invest in the gas industry and an express commitment of the Argentine Government. The tariff regime offered additional conditions than those covered by the country risk premium. In addition, acknowledging Respondent’s arguments, as noted by the Claimants, would result in the absurd situation that high-risk borrowers would be excused from their international responsibility.’

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Chapter 6: Valuation of Damages procedure, the tribunal is to make a determination of damages several years after the imposition of the tax, in a macro-economic and industry environment completely different to that which was prevalent at the time of the tax. By the time the tribunal must make a determination there are two types of damages: historical and going-forward. 1. Historical damages and going-forward damages 6.54 Historical damages are those losses that claimant has already suffered as a con-

sequence of the tax. These losses are as certain as they can be. They can be easily computed as detailed data may allow. Following the example in para. 6.53 and assuming monthly data, these losses can be computed on a monthly basis simply as price times quantity times the statutory tax.51 6.55 Going-forward or future damages (future as of a given date of valuation, which may

or not precede the date of analysis), on the other hand, are losses that the claimant will suffer in the future because of the fact that its revenues are going to be lower than they would have been absent the tax. These losses are not as certain as the historical losses, but are losses nonetheless. To compute these losses the experts would need to forecast crude oil prices, as well as production and export levels, and assess annual future losses, which then would need to be discounted back to the date of the award at a risk-adjusted discount rate (a rate which, by incorporating business risk applicable to the specific industry, will address the issue of uncertainty of forward-looking estimates). In essence, these losses are equivalent to the reduction in the value of the producer’s concession as of the date of the award. If the claimant wishes to sell its concession to a third party as of the date of the award it would receive a price for its concession which would be lower than absent the tax. This difference, again, is the difference between the but-for and actual scenarios as of the date of the award. It is computed using the same macro-economic, industry, and price conditions across the actual and but-for scenarios.52 6.56 Historical losses, then, can be updated to the date of the award using the appropri-

ate pre-judgment interest (PJI) rate. This issue is discussed later in this chapter in paras. 6.107 et seq.

51 Some crude oil taxes are complex, implying particular formulas which depend on the level of crude oil prices (windfall taxes, for example). Such complexity would not enlighten the discussion, and thus we assume it away. Further complexity arises if claimant also sells domestically. In an open market, export and domestic producer prices must be the same. Thus, an export tax leads to a reduction in the domestic price so that producers be indifferent between exporting and selling domestically. With a producer selling domestically as well, its losses would also involve domestic sales at domestic prices. 52 Th is example also helps illustrate why, even in computing apparently simple ‘lost profits’, the analyst may often find it valuable to compute a full fair market value, which can be compared with other contemporaneous valuations, market information (i.e., market multiples). We explore this further in the sections on valuation methods in paras. 6.145 et seq.

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F. Date of Valuation 2. Date of the award vs. date of the breach Often, however, it is proposed that there should be no differentiation between 6.57 losses taking place between the date of the initial breach and the date of valuation (or date of the award), and going-forward losses, and instead, all losses should be computed as of the date of the breach, rather than historical losses being updated to the date of valuation and going forward losses discounted to that same date. For various reasons this is inconsistent with the fundamental principle of ‘wiping out all the consequences’ of the state measure or ‘placing the injured party in the situation it would be but for the breach’. Valuing damages as of the time of the enactment of the first state measure would 6.58 ignore subsequent events that are relevant for damage valuation purposes, and thus would most likely result in inadequate compensation.53 Some of these subsequent events between the imposition of the tax and the time of the award that have direct impact on the amount of taxes to be paid, and thus losses to the crude oil producers are:54 • changes in industry prices; • changes in crude oil production levels; • introduction of compensatory measures by the state, such as granting income tax exemptions or other palliative measures; • further increases or reduction in tax levels; • damage mitigation actions by the investor, if any; • actions within the control of the investor that are unrelated to the measures and that result in an ex-post reduction or increase in the value of the investment. In essence, as of the date of the breach all those subsequent events are uncertain. As 6.59 a consequence, using expectations as of the date of the breach may under or overcompensate claimant for losses which as of the date of the award are certain. Thus, an appropriate implication of the ‘wiping out all the consequences’ principle is that historical losses should be treated as they are, that is, using hindsight, rather than as could have been expected as just prior to the date of the initial breach. 3. Example: El Paso v. Argentina In El Paso v. Argentina, a case involving several breaches of the fair and equitable 6.60 treatment provision of the Treaty involving El Paso’s investments in Argentina’s

53 See Manuel A.  Abdala and Pablo T.  Spiller, ‘Chorzów’s Standard Rejuvenated:  Assessing Damages in Investment Treaty Arbitrations’ (2008) 25(1) Journal of International Arbitration 103– 120. See also Reisman and Sloane (2003) who detected this issue in the context of consequential and creeping expropriation cases. They advocate that ‘. . . as a general principle, the moment of valuation should be the date on which assessing the fair market value of a foreign investment for purposes of calculating compensation will enable a tribunal to give full effect to Chorzów Factory’s imperative’. 54 Abdala and Spiller, ‘Chorzów ’s Standard Rejuvenated’, 19–20 (n. 53).

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Chapter 6: Valuation of Damages energy sector,55 Argentina’s experts proposed to value all damages as of 2002. The tribunal, however, stated, citing Factory at Chorzów: After considering the above dictum in the Chorzów Factory case, the ILC’s Commentary of this Article concludes that ‘the function of compensation is to address the actual losses incurred as a result of the internationally wrongful act.’ The reference to ‘loss of profits’ in Article 36(2) confirms that the value of the property should be determined with reference to a date subsequent to that of the internationally wrongful act, provided the damage is ‘financially assessable’, therefore not speculative. The Tribunal shares this position.56 6.61 Second, discounting historical losses to the date of the breach to bring them for-

ward later to the date of the award runs the risk of what Abdala, Lopez Zadicoff and Spiller call the ‘Invalid Round Trip’, whereby discounting cash flows at a risk-adjusted interest rate to bring them forward later to the date of award, the tribunal may award for historical losses a value which, as of the date of award, can be lower than the value of the historical loss at the time it occurred.57 6.62 Third, as of the date of the award, the tribunal can ascertain going-forward damages

with much higher accuracy than would be assessed by computing them using only information as of the date of the breach. The rationale is clear. There is no need to forecast ‘historical’ losses as of the date of the breach, and both the residual value of the company and its fair market value absent the breach can be better assessed as of the date of award. 6.63 Thus, valuing damages as of the date of the award has the advantage of taking into

account events that have taken place, i.e., using ex-post information (or hindsight) in computing now only historical damages but also going-forward damages much more accurately. 6.64 All this information can only be obtained by the use of hindsight, which would not

be feasible by using as the date of valuation the date of the breach. 55 El Paso v. Argentina (n. 28) involves various El Paso subsidiaries in the energy sector. As the award describes it in para. 49, ‘CAPSA produces oil and, via CAPEX, generates electric power in Argentina; it also markets propane, butane and gasoline. From December 2001 onward, the GOA took a series of measures which, according to the Claimant, caused considerable harm to the latter, breached undertakings assumed by the respondent State when the investments were made, rendered the investments worthless, particularly those in CAPSA and CAPEX, and prevented these companies from functioning independently. These measures were alleged to be in violation of provisions of the 1991 BIT, i.e. those on expropriation, on discriminatory treatment, on fair and equitable treatment, and on full protection and security.’ Other companies affected by the measures were Central Costanera (an electricity generator, Award para. 65), and Servicios El Paso. The latter is described by the award in para. 12 as LPG processing company (‘Pursuant to a ten-year gas processing agreement with CAPEX, SERVICIOS transformed gas produced at CAPEX’s facilities into liquid petroleum gas (LPG) by-products that were sold by CAPEX.’). 56 El Paso v. Argentina, para. 710 (n. 28). The tribunal, however, went on to use post-event information, but used as the date of valuation December 2001, just prior to the initial measures. See El Paso Award, para. 752. 57 See discussion in paras. 6.109 et seq.

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F. Date of Valuation 4. To whom the windfalls Factory at Chorzów, however, brings an exception to this rule. That exception con- 6.65 sists of what would happen if the value of losses, computed as of the date of the breach, but expressed in currency of the date of award, exceeds damages computed as of the date of award. To understand this, think of the following mental exercise: had the claimant sold its asset just prior to the enactment of the breach it would have obtained the fair market value at that time. This is the logic to exclude ex-post information. Any upside or downside in value that takes place after the asset has been subjected to the measures should not be accounted for, since compensation will make the investor indifferent between selling just prior to the measures or being subject to them.58 In fact, however, the investor did not sell. Instead, it held on to the asset, and suf- 6.66 fered the consequences of the tax. Compensation based on a valuation of historical and going-forward damages as of the date of the award is equivalent to the investor selling its asset as of the date of the award but in an environment in which the tax has not been enacted. Assume, now, that because macro-economic or industry conditions deteriorated between the date of the breach and that of the award, damages computed as of the date of the breach are lower, in currency of the date of the award, than historical and going-forward damages computed as of the date of the award. Date of award computation, then, properly grants the claimant the improvement in business conditions that took place post measures. Factory at Chorzów, however, brings another dimension, and considers cases when 6.67 because of macro-economic or industry conditions, the value of the assets fell between the date of the breach and the award. In this situation, the Chorzów principle stipulates that compensation should be based on the date of the breach. This, however, would lead to over compensating the investor, as the investor could have sold at a higher price prior to the measures (or prior to the collapse of prices), but decided not to. Factory at Chorzów, however, talks about outright expropriation, where the inves- 6.68 tor could not have exercised its right to sell so as to avoid the impact of the recession, and instead, it was forced to sell it to the state. In these circumstances, the transfer of the ex-post business risk to the state does not necessarily imply any overcompensation. The Chorzów standard, however, has a powerful economic logic.59 It is equiva- 6.69 lent to transferring to the expropriating state the ex-post risks (up to the time of the award) associated with the expropriated asset. In other words, if the asset has

58

Abdala and Spiller, ‘Chorzów ’s Standard Rejuvenated’ (n. 53). See M.A. Abdala, P.T. Spiller, and S. Zuccon, Chorzów’s Compensation Standard as Applied in ADC v. Hungary’ (2007) 4(3) Transnational Dispute Management 1–9. 59

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Chapter 6: Valuation of Damages increased in value in the absence of the measures, the state ought not to benefit from its expropriating actions, and thus, the windfall ought to belong to the investor. On the other hand, if the asset has lost value in the absence of the expropriation, the state ought not to benefit by paying a lower compensation, and thus, it should absorb the loss in value. The compensation, in this case, ought to be valued as of the date of expropriation.60 6.70 In commercial arbitrations, however, damages often must be valued directly using

the most recent information (i.e., valued at the date of the award, or at a prior date but using all available ex-post information).61 5. Factory at Chorzów’s three questions62 6.71 In Factory at Chorzów the experts were asked to answer three basic questions.

Question IA asked the experts to compute the fair market value of the factory at the time of expropriation, updated to the time of indemnification (i.e., the date of the award).63 Question IA was expressed as follows: What was the value, on July 3rd, 1922, expressed in Reichsmarks current at the present time, of the undertaking for the manufacture of nitrate products of which the factory was situated at Chorzów in Polish Upper Silesia, in the state in which that undertaking (including the lands, buildings, equipment, stocks and processes at its disposal, supply and delivery contracts, goodwill and future prospects) was, on the date indicated, in the hands of the Bayerische and Oberschlesische Stickstoff werke? 6.72 Notice that the tribunal’s instruction was to update the valuation from the date of

expropriation to the date of the award based on the actualized value ‘in Reichsmarks current at the present time’.64 6.73 Question IB asked the experts to value the lucrum cessans between the interim

period between the date of expropriation and the date of indemnification.

60 One could argue that Factory at Chorzów (n. 24) provides a free option to the investor which may lead to increased litigation. Rather than accept fair compensation from the state, the investor, knowing that the Chorzów principle will be applied, will prefer to delay with the expectation that the value of the expropriated assets will increase over time. If they fall, however, Chorzów would require the state to bear the risk of the reduction in value, while the investor would gain the windfall if it takes place. Given the risks of litigation, any reasonable investor would accept a fair market offer from an expropriating state rather than betting on a positive award compensating it for any possible windfall that may, or not, materialize. 61 See Abdala, Spiller, and Zuccon, ‘Chorzów’s Compensation Standard as Applied in ADC v. Hungary’ (n. 59). 62 Th is section is taken directly from Abdala, Spiller, and Zuccon, ‘Chorzów’s Compensation Standard as Applied in ADC v. Hungary’ (n. 59). 63 See Factory at Chorzów, 51 (n. 24). 64 Th is instruction seems to suggest updating the valuation by the loss in value of the currency— i.e., the inflation rate, rather than by time value of money. In high interest rate environments, this particular instruction would discriminate against granting damages based on the valuation as of the date of expropriation.

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F. Date of Valuation Question IB is as follows:

6.74

What would have been the financial results, expressed in Reichsmarks current at the present time (profits or losses), which would probably have been given by the undertaking thus constituted from July 3rd, 1922, to the date of the present judgment, if it had been in the hands of the said Companies? 65

Observe, however, that compensation for [damnun emergens]66 would not apply if 6.75 the standard of valuation were the fair market value as of the date of expropriation. In such case, the fair market value of the affected assets would already include all future lost profits, from the date of expropriation to the end of the project, not just to the date of the award. On the other hand, if the standard of valuation is fair market value as of the date of the award, then [damnun emergens] for the interim period between the date of expropriation and the award ought to be added to the compensation, as otherwise the investor would not be properly compensated. Finally, Question II asked the experts to compute the fair market value of the 6.76 factory as of the date of indemnification (or date of the award). Question II is as follows: What would be the value at the date of the present judgment, expressed in Reichsmarks current at the present time, of the same undertaking (Chorzów) if that undertaking (Including lands, buildings, equipment, stocks, available processes, supply and delivery contracts, goodwill and future prospects) had remained in the hands of the Bayerische and Oberschlesische Stickstoff werke, and had either remained substantially as it was in 1922 or had been developed proportionately on lines similar to those applied in the case of other undertakings of the same kind, controlled by the Bayerische, for instance, the undertaking of which the factory is situated at Piesteritz?67

Question II, then, leaves aside the situation as of the time of expropriation, and 6.77 instead focuses on a valuation of the assets as of the time of the experts’ assessment. Observe, that Question II allows for the reasonable development of the undertaking, not just maintaining the assets as they were as of the time of expropriation, but also including a reasonable investment program.68 In Factory at Chorzów, then, it is clear that wiping out all the effects of the measures 6.78 through monetary compensation can be achieved by two alternative means: 65

See Factory at Chorzów, 51 (n. 24). Abdala, Spiller, and Zuccon, ‘Chorzów’s Compensation Standard as Applied in ADC v. Hungary’ (n. 59), refers to these sums as lucrum cessans. We believe the appropriate way to formalize the distinction between damnun emergens and lucrum cessans under Chorzów is that by lucrum cessans one interprets the loss in value as of the date of valuation (value that is based on date of valuation and/or looking forward from that date), while damnun emergens reflects losses that took place between the date of the measures and the date of valuation. 67 See Factory at Chorzów, 51–2 (n. 59). 68 See Factory at Chorzów, 53 (n. 59): ‘. . . if the normal development presupposed by question II represented an enlargement of the undertaking and an investment of fresh capital, the amount of such sums must be deducted from the value sought for.’ 66

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Chapter 6: Valuation of Damages • granting the fair market value as of the date of the expropriation brought forward and expressed in current currency; or • granting the sum of the fair market value as of the date of the award, plus the profits that the investor would have probably obtained in the interim period, between the date of expropriation and the date of the award. 6.79 Thus, it is reasonable to interpret, from the Chorzów Panel’s questions, damages as

the highest value between the answer to IA and the resulting sum of the answers to questions II and IB.69 6. Example: ADC et al. v. Hungary 6.80 Although Factory at Chorzów is often cited by arbitral tribunals, few tribunals have

taken Chorzów as seriously in assessing damages as the tribunal in ADC Affiliate Ltd et al. v. Hungary.70 The case involved the alleged expropriation, in December 2001, of the rights granted to claimants to renovate, build and operate terminals 2/A and 2/B in Budapest-Ferihegy International Airport. The arbitral tribunal decision is dated 2 October 2006, almost five years to the date of the alleged expropriation. The tribunal determined that an expropriation took place, and that: . . . no case has been made out that the taking was in the public interest. The subsequent privatization of the airport involving BAA and netting Hungary US$ 2.26 billion renders any public interest argument unsustainable.71 6.81 The tribunal determined that in fact, the applicable standard was that of custom-

ary international law as specified in Factory at Chorzów, and given that restitution could not take place, analysed the implications for the case at hand.72 It stated:

69 Lord Finlay’s dissenting opinion in Factory at Chorzów (n. 59) (at 70 and subsequent pages) raised some interesting issues. Lord Finlay said that if the damaged party chose monetary compensation rather than restitutio in integrum, then monetary compensation should be based on the value of the undertaking at the time of expropriation. Indeed, he stated (at 70–1): ‘A Party who has given up his right to restitutio in integrum is not entitled to claim damages on the footing that it is right that he should have the enhanced value, if any: that he would have got if he had pressed his claim for restitution.’ The fact that a party prefers monetary compensation to physical restitution may have nothing to do with the basic principles of Chorzów’s damage assessment methodology but rather be due to the fact that restitution may imply taking over a degraded facility. Indeed, absent this element, the fair market value should represent the true value of the (fully-functional) factory, and thus the damaged party should be indifferent between restitution in kind and monetary compensation. Notice that Lord Finlay’s other methodological concerns are standard staple in damage assessment. In particular, Lord Finlay’s concerns about asset obsolescence, intangibles, creation of new business developments, and uncertainties about future cash flows can be fully controlled for by modelling a but-for scenario in a discounted cash flow exercise, using all available ex-post information. 70 See Award of the Tribunal, ADC Affiliate Ltd and ADC & ADMC Management Ltd v. The Republic of Hungary, ICSID Case No. ARB/03/16, dated 2 October 2006). A detailed analysis of ADC can be found in Abdala, Spiller, and Zuccon, ‘Chorzów’s Compensation Standard as Applied in ADC v. Hungary’ (n. 59). 71 ADC et al. v. Hungary, Award, para. 304 (n. 70). 72 See ADC et al. v. Hungary, para. 494 et seq. (n. 70).

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G. Avoiding Double Counting Damages The present case is almost unique among decided cases concerning the expropriation by States of foreign owned property, since the value of the investment after the date of expropriation (1 January 2002) has risen very considerably while other arbitrations that apply the Chorzów Factory standard all invariably involve scenarios where there has been a decline in the value of the investment after regulatory interference. It is for this reason that application of the restitution standard by various arbitration tribunals has led to use of the date of the expropriation as the date for the valuation of damages. . . . . the application of the Chorzów Factory standard requires that the date of valuation should be the date of the Award and not the date of expropriation, since this is what is necessary to put the Claimants in the same position as if the expropriation had not been committed.73

The tribunal, then, following the historical and going-forward damages approach 6.82 detailed in paras. 6.55 et seq., determined quantum as follows: The claim for damages under the restitution approach fall into two parts: (a) the estimated value of the Claimants’ stake in the Project Company as of the award date;74 and (b) all unpaid dividends and management fees from the date of expropriation until the date of the award.75 Taking September 30, 2006 as the date of the Award, the Tribunal notes that the Supplemental Report of [Claimants’ expert] arrives at a total amount of damages payable to the Claimants by the Respondent in the sum of US$76.2 million. Since the calculation is based on the value of the expropriated investments as of the date of the award, no pre-award interest has accrued.76

In ADC, having computed losses following the three questions, the tribunal then 6.83 awarded compensation based on the higher of damages as of date of expropriation and as of date of the Award.

G. Avoiding Double Counting Damages The but-for premise to ‘place the injured party it would be in but-for the breach’ 6.84 and the Chorzów requirement that compensation should ‘re-establish the situation which would . . . have existed if that act had not been committed’ also requires the tribunal to avoid overcompensating. A particular risk of overcompensation arises from double-counting damages. Such double counting often arises from the confusion between damnum emergens and lucrum cessans which was discussed in Chapter 5. A common case is when claimants request as damnum emergens the actual sunk costs invested in the enterprise (e.g., wasted costs), while requiring also 73

ADC et al. v. Hungary, para. 496–7 (n. 70). This would be the ‘going-forward losses’. 75 Th is component would be the ‘historical losses’. They ought to be expressed in terms of the date of award, by bringing them forward by an appropriate interest rate. The award does not specify the interest rate(s) used. Our understanding, however, is that they were brought forward at a risk-free rate to account for the passage of time, as stipulated in Question IB of Factory at Chorzów (n. 24). 76 See ADC et al. v. Hungary, paras. 518–20 (n. 70). 74

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Chapter 6: Valuation of Damages as lucrum cessans the present value of cash flows associated with the expropriated or lost assets. 1. Double counting sunk costs and lost profits 6.85 In Himpurna v. PLN,77 the tribunal states:

In contractual cases such as this, it is usual that claimants seek recoupment of their entire investment as a discrete element of compensation. . . . In the case of a breach of contract, the wasted cost is what the claimant has spent in reliance on the agreement, without reference to how judicious or providential those expenditures turned out to be. No further explanation is necessary to understand why victims of contractual breaches tend first and foremost to articulate a plea for damnum emergens.78 6.86 Observe, however, that a direct double-counting arises if claimants also require

compensation for the value of loss profits. The Himpurna Tribunal saw potential for such double counting, and stated: On this footing, however, the quantification of lost profits must result in a lower amount to avoid double counting. . . . To ask for the full amount of the future revenue stream when also claiming recoupment of all investments is wanting to have your cake and eat it too. If the DCF method is applied in a contractual scenario to measure nothing but net cash flows (thus excluding the accrual accounting notion of ‘income’ which may cover non-cash items such as depreciation), there is no room for recovery of wasted costs. In other words, when the victim of a breach of contract seeks recovery of sunken costs, confident that it is entitled to its damnum, it may go on to seek lost profits only with the proviso that its computations reduce future net cash flows by allowing a proper measure of amortisation.79, 80 6.87 Himpurna, however, failed to notice the difference between deducting deprecia-

tion of sunk investments from future cash flows and the fact that the net present

77 See Himpurna California Energy Ltd (Bermuda) v. PT (Persero) Perusahaan Listruik Negara (Indonesia), Final Award dated 4 May 1999 (Excerpt), in A.  Jan van den Berg (ed.), Yearbook Commercial Arbitration, Vol. XXV (Kluwer Law International 2000). 78 See Himpurna v. PLN, para. 241 (n. 77). 79 See Himpurna v. PLN, para. 242 (n. 77). 80 An example may help illustrate the extreme double counting involved in requesting as compensation both the investments already sunk and the expected profits from those investments. Consider the case of a bond with a market price today of $100 and which matures in five years. The market price today ($100) is by definition equal to the net present value of future interest and capital repayments, as no buyer will pay more than this amount. If a buyer made the investment today and it was instantly expropriated, compensating the investor for the wasted costs as damnum emergens, i.e., the amount invested in the bond ($100), and lucrum cessans, i.e., the loss of the discounted future cash flows involving interest and capital repayments ($100), would mean compensating the investor for $200. Nothing more nor less than double the value of the expropriated bond. In other words, requesting for both amount invested and the future cash flows associated with that investment double counts damages. As a result, the purchaser of the bond would be in a better position than just before the expropriation happened. The correct compensation that would place the investor back in the position he was just prior to the expropriation consists of either the amount invested, or the present value of the cash flows that the investment would have provided in the absence of the expropriation (also equal to $100 in this example), but not the sum of both.

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G. Avoiding Double Counting Damages value of such deduction is always lower than the sunk investments themselves. The reason is simple. Amortizing sunk costs means spreading the amount invested over a finite period of time, without, however, accounting for the time value of money. Ripinsky and Williams provide a useful example to illustrate this problem:81 To illustrate, spending $100 in one year’s time costs less than spending $100 today. Similarly, to spread $100 for the next five years (say, $20 each year) costs less for an investor than to spend $100 today. The effect of the time value of money is that $100 spent during the next five years possibly costs $85 today (the exact figure will depend on the applied rate of the time value of money). Depreciation does not take into account the time value of money in relation to expenses; it thus distorts the calculation.

In other words, to avoid distorting the calculation one would need to add interest 6.88 (in equivalent nature to the discount rate used to discount cash flows) to the annual depreciations of the sunk investments, so that the net present value of the amortizations be equal to the value of sunk investments. But if the calculation is performed in that fashion, one would be adding (sunk costs) and subtracting (depreciation) values which in net present value as of the date of valuation are identical. For that reason, tribunals should only award either sunk investments or cash flow losses (i.e., losses in value). Since sunk investments have no necessary relationship to cash flow losses (or losses in value), and since granting sunk investments does not necessarily re-establish the situation which would have existed but for the breach, sunk investments do not constitute a proper measure of damages except in particular circumstances.82 As mentioned, Himpurna granted compensation based both on wasted costs, and 6.89 lost profits, after deducting depreciation. Himpurna granted compensation for damnum emergens or wasted costs of US$273 million and for lucrum cessans or lost future profits of US$117 million. Himpurna makes no explanation of how the amortized amounts were considered in reaching to the US$117 million, nor whether the tribunal considered the fact that the net present value of depreciated amounts is lower than the amount of sunk costs. It, instead, stated satisfaction that: The Rebuttal Statement of the claimant’s chief financial officer . . . reflects a proper understanding of this principle. The Arbitral Tribunal is satisfied that what the

81 See Sergey Ripinsky with Kevin Williams, Damages in International Investment Law (British Institute of International Comparative Law 2008) footnote 176. 82 One such circumstance is when the investor was led to invest under the presumption that a particular contractual or regulatory arrangement was in place, but prior to completion of the investment such promises were breached. Since the fair market value of the investment before completion is normally lower than the invested amounts (simply because of completion risks), compensating based on fair market value of the investments would necessarily be unfair to the investor, as the investor was not given the right to complete the project, and to be able to obtain a fair return. In other words, sunk investments may be a proper compensation measure when the investment process was not fully completed prior to the breach, so that compensating the investor by the fair market value of the investment would grant the investor an amount lower than the actual investment, assuming no changes in market conditions.

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Chapter 6: Valuation of Damages claimant presents as the ‘initial project value’ reflects the alleged value of future cash flows, discounted to 31 December 1998, which indeed deducts the alleged value, at the same date, of past investments.83

2. Example: RDC v. Guatemala 84 6.90 Another case where the claimant’s request for compensation included double

counting is RDC v. Guatemala. In RDC, the claimant’s initial request was for the sum of sunk investments (computed based on the net capital contribution approach, whereby investments are brought forward to the date of valuation at the claimant’s cost of capital) and for the losses in future cash flows due to the termination of the railroad usufruct.85 In its reply, however, the claimant introduced a correction to reduce the probability of double counting by amortizing its sunk costs over the life of the concession.86 The respondent’s expert, however, argued, as we do here, that such correction was insufficient as ‘. . . the net present value of the amortizations deducted from future cash flows is substantially lower than the amount computed as lost investment’.87 6.91 The tribunal disregarded the claimant’s double-counting request by granting com-

pensation exclusively for lost profits associated with some existing real estate leases, plus the amounts invested exclusively in improving the railroad stock, 88 so as not to allow Guatemala to recover a railroad stock in better condition than when it had been given without compensation.89 In other words, the tribunal saw the claimant’s expert’s error in claiming both damnun emergens and lucrum cessans even when the expert attempted to reduce the duplication by amortizing over time the wasted costs. 3. Avoiding double counting while assessing damages under damnum emergens and lucrum cessans 90 6.92 It is our view that the legal profession often misapplies the concepts of damnun

emergens and lucrum cessans, concepts which are deeply ingrained in several legal 83

Himpurna, para. 243 (n. 77). See Railroad Development Corporation v. Republic of Guatemala, ICSID Case No. ARB/07/23, Award dated 29 June 2012. The case involved the granting of two ‘usufruct’ contracts, one for the use of railroad assets, and another for the use of real estate. 85 See Railroad Development v. Guatemala , para. 241 (n. 84). Although Guatemala did not terminate the real estate usufruct, it was understood that the claimant would relinquish the real estate usufruct upon compensation. See Railroad Development v. Guatemala, para. 267 (n. 84). 86 See Railroad Development v. Guatemala , para. 244 (n. 84). 87 See Railroad Development v. Guatemala , para. 252 (n. 84). 88 Since the railroad experienced losses throughout its operating history under private management, the tribunal deducted from the amounts invested the amounts used to cover the railroad’s losses. See Railroad Development v. Guatemala, para. 270 (n. 84). 89 See Railroad Development v. Guatemala , para. 270–1 (n. 84). 90 See Chapter 5, paras. 5.86–5.91, with respect to the interpretation of these notions under private law. 84

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H. Loss of Income vs. Loss of Value regimes. Thus, in this section we propose a way to implement such legal concepts while completely eliminating the potential for double counting of damages. To do so, we again apply the Chorzów approach. If, following the three basic questions, the tribunal would determine that damages ought to be considered as of the date of the measures (i.e., relying on the amounts given by Question IA), then, damages should only be based on future lost profits, that is, future lucrum cessans. If, however, the tribunal determines that compensation should be based on a valuation as of date of the award (by relying on the sum of the amounts given by Question IB and II), then, damnum emergens would represent exclusively what we called before ‘historical losses,’ that is, losses incurred between the date of the measures and the date of the award (expressed in currency values as of the date of award). On the other hand, lucrum cessans would represent the lost profits from the date of award on, or as we called them, ‘going-forward losses’. Thus, tribunals could use a simple rule:91 • If compensation is to be determined as of the initial date of the measure, damages should compensate exclusively for lost profits (lucrum cessans). • If compensation is to be determined as of the date of the award, damages should compensate for historical losses (damnum emergens), encompassing losses between the date of the initial measure and the date of the award, and going-forward losses or lost profits (lucrum cessans).

H. Loss of Income vs. Loss of Value A breach, whether contractual or treaty, may lead to losses to the counterparty. 6.93 Losses normally involve loss of income as well as loss of value. In assessing damages, however, tribunals have to be careful not to grant losses twice for the same thing. Consider, for example, a commercial joint venture in which one of the partners stops contributing its share to the venture (say technology transfer). As a consequence, the venture will be less profitable, and should the partners decide to sell it, they would receive, purely as a consequence of the breach, a lower price than they could have obtained had the breaching party continued with the technology transfer. The affected partner, then, could demand compensation for loss of income. The 6.94 partner, furthermore, could demand compensation for the loss in value. It cannot, however, in this case, demand for compensation for both, as the loss in value is exactly the same as the loss in income. Demanding for loss of income and loss of value in this case would be double counting. On the other hand, as we discussed in Section G (paras. 6.84 et seq.), there is no 6.95 double counting in demanding compensation for loss of income prior to the date 91 An equivalent analysis could be performed for commercial arbitration or for fair and equitable treatment claims where the valuation would be applied as of the date of the award.

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Chapter 6: Valuation of Damages of valuation and loss of value as of the date of valuation, as in this case, loss of value reflects the loss in future income. 6.96 Although normally, loss of income leads to loss of value, there may be a loss of value

with no loss of perceived income. Consider, for example, the imposition of governmental restrictions on dividend payments or dividend repatriation. The company’s cash flows would be unaffected, at least in the short run. It would still operate under the same operating conditions, its market share and final prices would still be the same.92 On the other hand, the limitation on dividend payments or repatriation would have a drastic impact on the market price of the company’s shares. Thus, although the company’s performance has not been affected, and in fact there is no perceivable loss of income, at least in the short run, the dividend restrictions led to a loss of value. The loss can be seen in at least two ways: since dividend restrictions make the company’s cash flows less valuable to shareholders, shareholders will be willing to pay less for the company.93 Alternatively, the loss can be understood as an increase in the cost of capital of the company, as the lower willingness to pay by shareholders, implies lower access to equity capital. The increase in the firm’s cost of capital, which would eventually have damaging operating implications,94 naturally implies that future expansion projects would not be economically viable, and that the company’s future cash flows are much less valuable (i.e., are discounted much more heavily). All this leads to a loss in value, even though, at least in the short term, there is no perceived loss of income.

I. Avoiding Undercompensating 6.97 The but-for premise, requesting that the injured party be placed in the position it

would be in but for the breach, and the Chorzów requirement that compensation should ‘re-establish the situation which would . . . have existed if that act had not been committed’ require the tribunal to avoid undercompensating. There are multiple ways by which tribunals may undercompensate: • using too high interest rates to discount future cash flows; • using pre-judgment interest rates when valuing damages as of date of breach which are inconsistent with discount rates used to discount cash flows or not granting pre-judgment interest at all;

92 Eventually, though, shareholders’ willingness to support the company would diminish, and hence the company would find it difficult to source equity capital. In other words, its cost of capital will increase, leading, then, to reduced investments, lower market share, and an eventual loss in sales and net income. 93 Thus, if the company had been publicly traded, the introduction of dividend restrictions would have lowered its market capitalization. 94 See n. 88.

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I. Avoiding Undercompensating • disregarding profitable expansions, or investments not made, that would have been implemented but for the breach; • using ‘equity’ considerations or ad hoc adjustments; • uncertain environments. 1. The potential misuse of discount rates We have already discussed the difference between fair market and market discount 6.98 rates.95 In this section we discuss the potential misuse of measures of country risk discount rates, for both over and undercompensating. When assessing damages based on the income approach, discount rates are a fundamental component of the damage computation, particularly if the breach involves the termination of contract, or losses over a long period of time. As a consequence, these are fundamental in complex long-term contracts. The assessment of a discount rate is a highly technical procedure, and we will not 6.99 develop it here.96 We will discuss here two standard problems faced by tribunals in assessing the relevant discount rate: (a) discount rate vs. internal rate of return vs. target rates; and (b) country risk premium. 2. Discount rate vs. internal rate of return vs. target rates The discount rate for a particular project represents the cost of raising funds for an 6.100 investor in a similar project as that to be valued, as a fundamental tenet of financial economics is that investors will demand similar returns compared to projects with similar systematic risks.97 The value of a project to that investor would be the present value of the cash flows that the investor can obtain from the project when using the discount rate that covers its cost of capital. The internal rate of return (or IRR), on the other hand, is the discount rate that 6.101 would make a project’s discounted present value equal to zero. Thus, the IRR can be useful when determining whether to invest in a project, as projects whose IRRs exceed their cost of capital would grant the investor a positive return. Historical IRRs for similar projects, however, have no relation to the cost of rais- 6.102 ing funds for the project in question. Consider, for example, a tribunal assessing damages for a breach involving crude oil operations. It is well known that crude oil companies with large existing reserves experienced a substantial gain in value

95

See paras. 6.48 et seq. See, for example, A.  Damodaran, ‘Investment Valuation:  Tools and Techniques for Determining the Value of Any Asset’ (2nd edn., John Wiley & Sons 2002); or T.  Copeland, T. Koller, and J. Murrin, ‘Valuation: Measuring and Managing the Value of Companies’ (2nd edn., John Wiley & Sons 1994). 97 Damodaran, ‘Investment Valuation: Tools and Techniques’ (n. 96); or Copeland, Koller, and Murrin, ‘Valuation: Measuring and Managing the Value of Companies’ (n. 96). 96

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Chapter 6: Valuation of Damages when crude oil prices increased substantially, in particular, from 2002 through 2008. Thus, crude oil development projects during that period showed very high internal rates of return.98 Such large IRRs imply that companies with oil reserves experienced high profitability. Those without reserves, however, would be willing to pay per barrel of oil all the way to the point that the IRR, including the price paid for the reserves, falls to their cost of capital. Thus, as long as projects’ IRRs exceed their respective cost of capital, the price per barrel of oil reserve will be bid up by companies attempting to get a hold of such reserves. Thus, not surprisingly, transactions involving crude oil reserves commanded higher prices per barrel of oil as crude oil prices increased (see Figure 1). 160 WTI Spot Price

US$/Barrel (1P BOE)

140

US$/barrel (1P BOE)

120 100 80 60 40 20 0 Jan-00 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Figure 1 Oil Prices and Transaction Prices per Barrel 3. Example: Enron v. Argentina 6.103 In Enron, the arbitral tribunal, in setting the fair market value of the claim-

ants’ stake was confronted with the respondent’s experts claim that ‘compensation [should not be] awarded in this case because the historical return that the claimants obtained on the investment was allegedly significantly higher than that considered in the determination of tariffs in connection with the cost of capital’.99 In other words, the respondent claimed that the investor had already recovered its 98 For example, Goldman Sachs assessed in 2007 that for a group of 170 crude oil projects it examined the average IRR was 15.7%, it had a 1.51 profit/investment ratio and required less than US$30/bbl to deliver a cost of capital return. See The Goldman Sachs Group, Global Energy: 170 projects to change the world, 20 February 2007. 99 See Enron Award, para. 367 (n. 48).

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I. Avoiding Undercompensating investment, based on the project’s discount rate as determined by the regulator. The arbitral tribunal, however, rejected that argument as the claimant’s: claims refer to the impact of the measures on the value of their investments. The calculation of such value is based on reasonable estimates of future demand, revenue and expenditures and excludes consideration of past performance or returns. Historical return on investment is therefore irrelevant for determining damages.100

A tribunal, thus, should not confuse historical IRRs for similar projects, or even 6.104 for the same project, with the project’s cost of capital for discounting cash flows.101 4. Target rates vs. discount rates Corporations’ investment decisions are normally guided by internal overall invest- 6.105 ment budgets. When corporations face situations where there are more available potential projects than the company wants to invest in overall, they normally introduce ‘internal capital markets’,102 often via setting target rates of return which are normally above their cost of capital for typical projects. By setting target rate of return above its cost of capital, management screens out the less desirable, although still profitable, projects in favour of the most profitable potential projects. Thus, target rates of return used by corporations to allocate capital among potential 6.106 projects should not be confused with the relevant cost of capital of the projects.103 5. Undercompensating via pre-judgment interest104 Despite all the warnings in the literature, PJI still ranks last in tribunals’ pecking 6.107 order of decisions.105 The longer the time between the breach and the final award, the more crucial PJI becomes. The complexities and uniqueness of international 100

See Enron Award, para. 369 (n. 48). In Mobil v. PDVSA, a commercial arbitration involving alleged discriminatory measures related to OPEC output restrictions, the tribunal awarded damages using an 18% discount rate based, fundamentally, on historical rates of return in the industry (Mobil Award, paras. 774–777). The claimants’ expert in this case proposed the use of a risk-free tax adjusted discount rate for damage computation (Mobil Award, para. 697) See Mobil Cerro Negro, Ltd. v. Petróleos de Venezuela, S.A. and PDVSA Cerro Negro, S.A., ICC Case No. 15416/JRF/CA, Final Award dated 23 December 2011. Contrast this decision with that of the tribunal in ConocoPhillips v PDVSA (see n. 114) discussed at para. 6.118, setting the cost of capital based on the capital asset pricing model. 102 See, for example, J. Stein, ‘Internal Capital Markets and the Competition for Corporate Resources’ (1997) 52 Journal of Financial Economics 111–33. 103 The tribunal in Mobil seems also to have used target rates of return when setting its discount rate. See Mobil Award (n. 101), para. 777 stating ‘The Tribunal also notes that Gaff ney, Cline & Associates has stated that an 18% return for large projects would be acceptable’ (emphasis added). 104 Th is section relies heavily on M.A. Abdala, P.D. López Zadicoff, and P.T. Spiller, ‘Invalid Round Trips in Setting Pre Judgment Interest in International Arbitration’ (2011) 5(1) W.A.M.R. 105 See James M. Patell, Roman L. Weil, and Mark A. Wolfson, ‘Accumulating Damages in Litigation: The Roles of Uncertainty and Interest Rates’ (1982) 11 Journal of Legal Studies 341; Michael S. Knoll, ‘A Primer on Prejudgment Interest’ (1996) 75(2) Texas Law Review 293; John Y.  Gotanda, ‘Awarding Interest in International Arbitration’ (1996) 90 American Journal of International Law 40. See also Jeffrey M. Colon & Michael S. Knoll, ‘Prejudgment Interest’ in 101

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Chapter 6: Valuation of Damages arbitration cases often call for extended proceedings. For example, as of September 2010, of the 124 treaty cases in progress under ICSID jurisdiction, roughly half were started before 2008, and 30 before 2005. Adding the fact that disputes arise from events that occurred well before the date of filing, if awards are calculated following the date of the breach approach,106 PJI may accrue for a period of several years, ending up being an important component of the overall compensation amount. 6.108 There is, however, little consensus among arbitrators on the appropriate PJI. Table 1

provides a sample.107 Table 1 Selected Pre-judgment Interest Awards Matter

Award date

PJI period (years)

PJI rate

Comment

Compañia del Desarrollo de Santa Elena SA v. Republic of Costa Rica, ICSID Case No. ARB/96/1 (17 February 2000)

2000

22

6.40%

compounded

Compañía de Aguas del Aconquija SA and Vivendi Universal SA v. Argentina, Award, ICSID Case No ARB/97/3 (20 August 2007)

2007

10 years

6%

compounded

Metalclad Corporation v. United Mexican States, ICSID Case No. ARB(AF)/97/1 (30 August 2000)

2000

7

6%

Archer Daniels Midland Company and Tate & Lyle Ingredients Americas, Inc. v. United Mexican States, ICSID Case No. ARB(AF)/04/5 (Award redacted version dated 21 November 2007)*

2007

3

1 month T-Bill

In Desert Line Projects v. Yemen 2007

5%

Sempra Energy International v. Argentinae Republic, ICSID Case No. ARB/02/16 (28 September 2007)

6 month libor+2%

(Continued) Roman S. Weil et al. (eds), Litigation Services Handbook: The Role of the Financial Expert (2007), Ch 9; John Y. Gotanda and Th ierry J. Sénéchal, ‘Interest as Damages’ (2009) 47(3) Columbia Journal of Transnational Law 491; Chapter 7, paras. 3–5. 106 Th is assumes awards that are based on damage calculation as of the date of the breach. In some cases the valuation date could be set as of the date of the award, in which case the issue of PJI becomes moot. The present chapter, however, does not focus on this latter situation. 107 For a comprehensive survey, see John Gotanda, ‘A Study of Interest’, Villanova University School of Law Working Paper Series, Paper 83 (2007).

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I. Avoiding Undercompensating Table 1 (Continued) Matter

Award date

PSEG Global Inc. and Konya Ilgin Elektrik Üretim vs Ticaret Limited Sirketi v. Republic of Turkey, ICSID Case No. ARB/02/5 (19 January 2007)

PJI period (years)

PJI rate

Comment

6 month libor+2%

* US 1-month T-bills’ rate available at .

Each of these decisions differs substantially in its underlying rationale for choosing 6.109 PJIs. While some rule in favor of ad hoc rates, others link PJI to market variables of dissimilar nature. Whatever the method, though, a key concern is the practice of awarding damages computed as discounting cash flows at risk-adjusted rates to the date of valuation, and then re-expressing those back to the date of award at substantially lower (risk-free or similar) rates. Abdala, López, and Spiller call this practice an ‘invalid round-trip’ (IRT). In CMS v. Argentina, for example, the tribunal considered a discount rate ranging from 14.5 to 18.0 per cent to calculate damages as of year 2000, but granted PJI up to 2005, the time of the award, at simple interest ‘. . . at the annualized average rate of 2.51% of the United States Treasury Bills’.108 An IRT may take place when a tribunal, deciding to assess damages as of the date 6.110 of the breach uses a discount rate to discount cash flows to the date of the breach (trip one), and a lower interest (or discount) rate as PJI to bring those damages from the date of the breach to the date of the award (the round trip). Observe that there are no IRTs if tribunals use as the date of valuation the date of the award, because, as in ADC, the tribunal does not need to set a PJI.109 An IRT, however, has the consequence that compensation for a loss that took place 6.111 at a date after the date of the breach may be lower by the date of the award than the loss itself. Consider as an example, a case of breach which, at year 0 involves damages over a 6.112 certain discrete period of time—say from year 1 to year 10, with year 10 being also the date of the award. Say that part of the damages is given by the deprived cash flows as of the end of year 10 (say $100 worth of damages in currency of year 10, as illustrated). Under an IRT, this $100 of damages as of year 10 is discounted back to the date of valuation (i.e., at year 0) at a certain cost of capital (say 15 per cent), and then compounded back to year 10 at a risk-free interest rate (say 5 per cent). 108 See CMS Gas Transmission Company v. Argentine Republic, paras. 450–5, and para. 6 of the Decision and Award (n. 31). 109 It will have to set a post-judgment interest rate, but such interest reflects a completely different risk: the risk of collection.

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Chapter 6: Valuation of Damages Following this methodology, the amount to compensate the claimant for the $100 damages that took place in year 10 is lowered to $24.7 as of year 0 by the power of discounting at 15 per cent, and then brought forward to year 10 (date of award) at 5 per cent to a value of $40.3. This value, as of year 10, is much lower than the nominal value of the actual year 10 damages incurred ($100). Claimants, then, would instantaneously lose almost 60 per cent of their actual damage value, an absurd result. Thus, this methodology does not provide for the fundamental principle of ‘full compensation’. This is illustrated in Figure 2.

Step 1: discount @ WACC

Negative PJI Step 2: update @ Risk Free Actual Damage Discounted Initial Date of Measure

Actual Damage (US$ 100)

Actual Damage Updated Date of Award

Figure 2 The Workings of IRT 6.113 Tribunals can avoid IRTs, and hence avoid granting undercompensation in

two ways: • By valuing damages as of the date of the award. This means that IRTs are prevented by definition as no PJI needs to be determined, and the only interest-related risk of undercompensation is whether the interest rate used to bring forward historical losses to the date of award properly compensate the claimants for the risks they took. We submit that such risk, while non-trivial, is orders of magnitude smaller than the risk of first discounting at a risk-adjusted rate to a far back date of the breach, only for the amount to be brought forward at a risk-free rate to the date of the award. • By using as PJI from the date of valuation to the date of the award, the same rate that the tribunal used to discount cash flows to the date of valuation. 6.114 There are, however, various misconceptions about its use of the cost of capital as

a PJI. It has been argued, for example, in Vivendi v. Argentina,110 that compensating at the cost of capital of the affected enterprise would have been excessive as the 110 See for instance the award rendered in Vivendi v. Argentina (n. 7) where the tribunal stated that it ‘. . . was not convinced that claimants would have managed to obtain a 9.7% compounded interest on the award had it been collected at the time of expropriation’.

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I. Avoiding Undercompensating company would have been unable to obtain an equivalent return. Alternatively, others have claimed that awarding PJI at cost of capital compensates for risks that are not there,111 recommending, instead, the use of a risk-free/banking PJI. These authors assert that since claimants ought to have been compensated at the time of the breach, they should have cashed out the value of their investment at that point in time, relieving them from the part (or the totality) of the project’s risks going forward. Parties, however, cannot cash out at the time of the breach. In fact, the only way the parties can cash out at the time of the breach is in raising funds equivalent to the expected award. Since the risk of repaying a loan—or paying dividends to compensate for equity contributions—is given by the risk of the affected company, lenders would not lend at a rate lower than the company’s cost of raising funds. Similarly, since equity contributions would be compensated based on the company’s overall performance, the relevant cost of raising those funds is the cost of capital of the affected enterprise.112 A particular instance where the application of the cost of capital as PJI is limited 6.115 relates to businesses that ceased operations for reasons unrelated to the matter under dispute, relieving claimant from the business risk of the damaged business. For instance, consider a voluntary exit of the industry, for reasons unrelated to the damaging actions. In this case, it would be appropriate to recognize PJI at the company’s cost of capital only up to the time of the sale, and at a different rate thereon. Note that this does not violate the principle of full compensation as the claimant could have not reasonably expected the recognition of the business’ cost of capital beyond the voluntary exit, which would have occurred, at the same date, even if the damaging act never occurred. Similarly, this PJI structure does not generate an IRT as the award is granted at a point in time where no future cash flows related to the affected business exist.113 Note, though, that this exception applies exclusively to cases where the affected 6.116 business ceased to operate for reasons completely separate from the breach, and should not be applied to cases in which the respondent’s actions directly or indirectly caused the business termination, sale or early exit of the business.

111 See F.F. Fischer, and R.C. Romaine, ‘Janis Joplin’s Yearbook and the Theory of Damages’ (1990) 5(1) Journal of Accounting, Auditing & Finance 145–57. 112 Th is would not be the case, however, had the company’s exclusive asset been the potential award as could be the situation of an investor whose only major asset was expropriated. In that case, the investor’s cost of capital is undefined, and lenders would lend only based on the probability of winning. The current trend in third party funders taking equity stakes in arbitration arises, precisely, because of the need of individual investors or bankrupt companies to fund their existing litigation. Given the risks associated in litigation, third party funders are the equivalent of venture capitalists or hedge funds, demanding substantial ex-ante returns. See B.M. Cremades, Jr, ‘Third Party Litigation Funding: Investing in Arbitration’ (2011) 8(4) Transnational Dispute Management 1–41. 113 PJI at the cost of capital should still be employed while the business was still active and suffering the damages from the breach.

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Chapter 6: Valuation of Damages 6.117 In sum, there is a fundamental link between PJI and full compensation which is

broken by tribunals which while selecting date of breach as the date of valuation use, as PJI, rates substantially lower than that used for discounting cash flows. The break-down of the full compensation principle can be achieved by either using the date of the award as the date of valuation or by using as PJI the cost of capital of the affected business. 6. Example: ConocoPhillips v. PDVSA114 6.118 In ConocoPhillips v. PDVSA, a commercial dispute, the parties offered reasons for

both a risk-free rate (respondent), and for the cost of equity (claimant). The tribunal determined that to satisfy the principle of full compensation, PJI must be set at the cost of equity of the affected business (ConocoPhillips Award, para. 295): . . . while interest rates may serve different purposes, the purpose of such rates with regard to compensation of damages for contractual breach is generally to ensure full compensation of a claimant by restoring it to the position it would have enjoyed if the contractual breach he suffered had not occurred. In the present case, Claimant 2 is a supplier of capital for a project from which it expected to receive certain cash flows, from which it also expected to obtain a rate of return. Under such circumstances, the interest rate to be applied should measure the opportunity cost of capital, i.e., the cash flows Claimant 2 was deprived of as a result of Respondent’s contractual breach which, had they been timely received by Claimant 2, it would have had the opportunity to apply them to the Project or some alternative productive use. On the contrary, the principle of full compensation would not be satisfied. Third, relying on the cost of equity as well as the ‘Discounted Cash Flow’ method and the CAPM methods is a widely recognized method of determining the opportunity cost of the lost cash flow or incomes. Finally, while Respondent has criticized [Claimants’ expert]’s reliance on the cost of equity method, it has not challenged or otherwise provided alternatives to [Claimants’ expert]’s bases for the calculation of the 10.55% interest rate . . . 115

7. Example: Vivendi v. Argentina116 6.119 In Vivendi,117 claimants sought compound interest at their cost of capital of 9.7 per

cent.118 The tribunal, however, stated that if the award was collected at the time of the breach, the company would probably not have produced a return equal to the cost of capital since the company was likely unable to actually earn a return 114 See Phillips Petroleum Company Venezuela Limited, ConocoPhillips Petrozuata B.V. v. Petróleos de Venezuela, S.A., ICC Case No. 16848/JRF/CA (C-16849/JRF), Final Award, 17 September 2012. 115 The CAPM refers to the Capital Asset Pricing Model, probably the most commonly used method to assess the cost of equity of a project or company. For cost of capital, see references in n. 97. The cost of equity and the cost of debt are the two fundamental ingredients in the computation of the weighted average cost of capital, or WACC. 116 See Vivendi v. Argentina (n. 7). 117 Vivendi involved investment in a water and sewerage company in the Province of Tucumán, Argentina. See discussion in para. 6.08 et seq. 118 See Vivendi Award, para. 9.2.7 (n. 7).

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I. Avoiding Undercompensating at its level prior to Argentina’s breaches.119 Thus, in Vivendi, the tribunal, as in ConocoPhillips, endorsed the use of cost of capital as PJI as a way to satisfy the full compensation principle, although in this case, it was reduced by what the tribunal perceived to be the potential inefficiencies in Vivendi’s operations. While probably appropriate from an ‘equity’ perspective, from an economic per- 6.120 spective such rationale is incorrect. The fact that a company may normally obtain, in the extant or other projects, higher returns than its cost of capital should not imply that PJI ought to accommodate such high returns. In fact, for full compensation PJI ought to compensate for the cost of capital of the company, which could be higher or lower than the internal rate of return that it expected from the project at hand.120 8. Compensating for investments not made The but-for premise and Chorzow’s ‘In all probability . . . ’ set a standard of causality 6.121 which contemplates the reality of business: that the business is dynamic, and that the variables that drive business performance, as well as their link with performance, are uncertain. In the next section we discuss uncertainty, and in this section we discuss investments not made. Projects do not take place all at once. Some projects have multiple stages and investments are undertaken in succession. Some projects require success in the initial stages to undertake further development. Often contract breaches take place prior to a subsequent stage being developed, or even worse, just prior to the main investments. Although some tribunals see problems in granting compensation for investments not made (e.g. Himpurna), others, such as Siag,121 considered investments not yet made as part of the opportunity involved in the contract. The fundamental issue in investments not made, is not whether it is equitable to compensate a party for investments not made, but rather what is the value of an investment not made. In other words, would the owner of the project sell the project to a third party, absent any breach from the breaching party, what price would it be able to assess. In most projects, the value of a project is not in the project itself, but in the pro- 6.122 ject’s idea and generation. Such intangible often has no substantial direct monetary component. In such circumstances, while the implementation still carries operational risks, the ex-post returns could be substantial, as these returns are nothing but compensation for the scarce resource—namely the project’s conceptualization and idea. Thus, tribunals that refuse to grant compensation for investments not

119

See Vivendi Award, para. 9.2.8 (n. 7). For a discussion of the lack of relation between cost of capital and internal rates of return, see para. 6.100 et seq. 121 See Waguih Elie George Siag and Clorinda Vecchi v. The Arab Republic of Egypt, ICSID Case No. ARB/05/15 (1 June 2009). 120

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Chapter 6: Valuation of Damages made are implicitly assuming that the returns for that project would just compensate for its risks—or in other words, would be equivalent to the project’s cost of capital. Although in certain projects such an assumption is correct, it fails in multiple circumstances, particularly in those cases where the project is unique. 9. Example: Siag v. Egypt 6.123 Siag involves the alleged expropriation by Egypt of the claimants’ investments in a

real estate development project in the Taba area, in Egypt’s Red Sea.122 The claimants were investors in two Egyptian companies which in 1989 acquired from the Ministry of Tourism a seafront property for the purpose of developing a tourist resort complex composed of three main components: two hotels, time share, and a casino.123 The claimants alleged that in 1995 Egypt expropriated their investment. At the time of the alleged expropriation, the amount invested in construction and financing costs was around US$15.6 million,124 while the project was worth, according to the tribunal’s assessment, based on a comparable sales valuation, approximately US$181 million.125 Although the award does not specify the expected total construction costs, it is reasonable to assume that was is several multiples of the amounts invested up to the expropriation. 6.124 In Siag, however, the tribunal recognized the fundamental fact that the main

return in these types of projects is to the idea generator. Thus, the tribunal stated:126 ‘The Tribunal is persuaded that the opportunity which was identified by Mr. Siag was a very promising one and that the Project appeared to be moving forward successfully, albeit that it was still at an early stage.’ 6.125 After implementing a 20 per cent discount over the claimants’ comparable sales

valuation because of the difficulties inherent in computing a comparable sales valuation in this particular case,127 and applying a 50 per cent reduction because of contractual requirements to share with Egypt the proceeds of any sale,128 and adjusting for the claimants’ share interest in the project, the tribunal awarded the claimants US$69.1 million. The tribunal further stated that because of being a promising opportunity: The Tribunal has no hesitation in concluding that this value far exceeded the sum which was paid by Siag Touristic under the Sale Contract and the sums which had been expended on construction by 23 May 1996 and on other work undertaken in relation to developing and progressing the Project.129 122 123 124 125 126 127 128 129

See Siag v. Egypt, para. 2 (n. 121). See Siag v. Egypt, para. 549 (n. 121). See Siag v. Egypt, para. 585 (n. 121). See Siag v. Egypt, para. 584 (n. 121). See Siag v. Egypt, para. 542 (n. 121). See Siag v. Egypt, para. 576 (n. 121). See Siag v. Egypt, para. 579 (n. 121). See Siag v. Egypt (n. 121).

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I. Avoiding Undercompensating Thus, Siag shows a case where the tribunal recognized that investments not made 6.126 have value, and that the value originates in the opportunity. 10. Example: Occidental Petroleum v. Ecuador 130 Occidental involves the ‘termination of a 1999 Participation Contract between 6.127 OEPC and PetroEcuador for the exploration and exploitation of hydrocarbons in Block 15 of the Ecuadorian Amazon region’. The area in question is located in the Oriente Basin and covers approximately 200,000 hectares.131 OEPC’s involvement in Block 15 dates back to 1985, when it started providing services related to exploration and production under a service contract.132 OEPC started production in 1993 under the service contract. In May 1999 the parties signed a participation contract.133 ‘In return for accepting the obligation to explore, develop and exploit Block 15, and being responsible for all the associated expenditures, OEPC received a share of the oil produced from Block 15, referred to as OEPC’s “participation”.’ ‘At the end of 2005, OEPC’s participation was approximately 70 per cent of the oil produced from Block 15.’134 Following a tumultuous political and electoral period, involving strikes and resignations by various ministers and PetroEcuador executives, on 15 May 2006, Ecuador issued a decree terminating OEPC’s participation contract.135 Conventional crude oil projects’ value resides in the barrels of oil that can be com- 6.128 mercially extracted, or what in industry lexicon is called their ‘reserves.’ Reserves are often categorized into three types, proven, probable, and possible according to the uncertainty in the recovery from that specific project.136 These reserves, however, would not be extracted all within the near term, but instead, will involve a path of investment and production over a long period of time. Thus, as in any other case of crude oil contracts or concessions that are terminated or expropriated, there is substantial amount of investments still to be made, and substantial uncertainties about the amounts to be recovered. Conventional crude oil or natural gas fields, however, are sold and traded based fundamentally on reserves.137 While fields whose reserves are mostly probable or possible command, per unit of reserves, a lower price than developed fields, undeveloped reserves (whether in the proven, probable, or possible regions) are valuable assets, as the potential for 130 See Occidental Petroleum Corporation and Occidental Exploration and Production Company v. The Republic of Ecuador. ICSID Case No. ARB/06/11, dated 5 October 2012. 131 Occidental v. Ecuador, para. 109 (n. 130). 132 Occidental v. Ecuador, para. 111 (n. 130). 133 Occidental v. Ecuador, para. 115 (n. 130). 134 Occidental v. Ecuador, para. 117 (n. 130). 135 Occidental v. Ecuador, para. 199 (n. 130). 136 See Guidelines for Application of the Petroleum Resources Management System, November 2011, p 13. 137 Non-conventional (e.g., shale oil or shale gas) areas, however, are sold mostly on a per-acre basis, as their resources will be certified into reserves only when drilling starts.

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Chapter 6: Valuation of Damages substantial profit exists. It is standard, for that reason, to discount probable and possible reserves against proven reserves. In valuing the losses to the claimant, the Occidental Tribunal used a reserve adjustment factor (RAF) to combine the different types of reserves into a single metric for production purposes,138 by summing them according to the formula of 100 per cent proved + 50 per cent probable + 25 per cent possible. Thus, the tribunal granted an award of US$1.8 billion based on oil in the ground which was not only categorized as proven and producing, but also as probable and possible—for which drilling may also have not yet started. In other words, the tribunal applied the standard fair market value approach, and assessed the value of Occidental as a willing buyer would have done absent the termination of the participation contract. 11. Uncertain environments 6.129 As we discussed in the previous section and taking into consideration the notion

of ‘reasonable certainty of income’ discussed in Chapter 5, the variables that drive business performance, as well as their link with performance, are uncertain. Can we be absolutely certain that, for example, an ill-conceived publicity campaign has reduced sales of a competing product? Analysts will try to use the best available tools to determine the causal relationships between measures or breaches and business performance. And what about the future: can we say for certain what income a business plan would have yielded had it been put in motion? We cannot, but reasonable business projections (i.e., those that are grounded in realistic premises) and the use of a market discount rate which represents the risks of the industry in question, can together inform a discounted cash flow analysis that estimates the value of a new business prospect. 6.130 Tribunals must then make determinations in the same way as a buyer or seller

would do, which is by looking at the reasonableness of the business projections vis-à-vis the market in which they are being made. Buyer and sellers transact on business opportunities, not just existing cash flows. Tribunals must do the same. Tribunals, if properly informed by the evidence (factual, expert, or both), will face the prospect of error about the future, in the same way that a board of directors risks being wrong about business decisions. A risk-adjusted discount rate for a given industry should reflect the prospects of the average project in that industry at a certain given maturity, thereby incorporating the whole range of success rates from very successful to unsuccessful ventures. Excessive prudency, as much as treating future cash flows are certain, will violate the principle of full compensation. Following this framework will enable tribunals to avoid systematic downward or upward bias in awards. 138 See Guidelines for Application of the Petroleum Resources Management System , November 2011, at para. 748. The SPEE Annual Survey of Parameters provides annual risk adjustment factors used by practitioners for purpose of acquisition and lending.

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I. Avoiding Undercompensating 12. Example: LG&E v. Argentina In LG&E, a case which originates in the same type of measures as alleged in Sempra 6.131 and Enron, among others, the claimants alleged that Argentina’s treaty violations eliminated the value of their investments in three natural gas distribution companies,139 and asked that compensation be based on full reparation as set out in Chorzow. The tribunal agreed to the principle.140 The claimants further requested that compensation be based on the fair market value of their loss,141 which they assessed as the difference in the companies’ but-for and residual values.142 The tribunal, differing from the tribunals in Enron and Sempra, determined that ‘compensation in this case cannot be determined by the impact on the asset value; it does not reflect the actual damage incurred by Claimants’.143 The tribunal, then, asked itself what was the ‘ “actual loss” suffered by the investor “as a result” of Argentina’s conduct. The question is one of “causation”: what did the investor lose by reason of the unlawful acts?’144 The tribunal concluded that there was loss in income (dividends to shareholders) 6.132 from the time of the breach until the date of the last procedural hearing,145 but there was no loss in value.146 The tribunal, however, rejected as premature that the measures led to a loss in value.147 Although the LG&E Tribunal is correct to say that had LG&E divested—at least 6.133 part of—its investments, it could have had a concrete measure of value,148 the tribunal, however, could have assessed, as the Sempra Tribunal did, the loss in value directly—simply by looking at the value that a willing buyer would have paid for LG&E’s investments in the presence of the treaty breaches, as we discuss in detail later in this chapter. Thus, the LG&E Tribunal’s inability to forecast the value of the company under 6.134 the measures led to it assessing damages only for ‘historical’ damages, without 139 The companies involved were Distribuidora de Gas del Centro (‘Centro’), Distribuidora de Gas Cuyana S.A. (‘Cuyana’), and Gas Natural BAN S.A. (‘GasBan’). See LG&E Award, para. 10 (n. 50). 140 LG&E Award, para. 31 (n. 50). 141 LG&E Award, para. 32 (n. 50). 142 LG&E Award, para. 34 (n. 50). 143 LG&E Award, para. 36 (n. 50). 144 LG&E Award, para. 45 (n. 50). 145 Th at is, 28 February 2005. The Award, however, is dated 25 July 2007. 146 LG&E Award, para. 48 (n. 50): ‘In the Tribunal’s view, the measures—in particular, the abolition of calculation of tariffs in dollars before conversion into pesos, and the abolition of the PPI and five-year adjustments—have resulted in a significant decrease in the Licensees’ revenues that, in turn, has produced a decrease of dividends distributed to shareholders.’ 147 LG&E Award, para. 47 (n. 50): ‘Had LG&E sold its investment, as did other foreign investors, for a depressed value resulting from the measures, capital value would become a practicable basis for determining compensation. The Tribunal believes that the claim for the loss in capital value is, as noted by Respondent, premature and therefore rejects it as basis for compensation.’ 148 See discussion of the use of transactions to value assets in para. 6.191.

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Chapter 6: Valuation of Damages taking into consideration the fact that the measures had a long time effect on the value of the investment.149 6.135 The LG&E’s decision responded, as mentioned, to the concern of double recov-

ery: ‘the compensation which the investor would receive as a result of arbitration and, on the other hand, the compensation which the company would receive in the context of a renegotiated adjustment of tariffs or some other mechanism’.150 The Sempra Tribunal responded to that concern by stating: ‘The Tribunal believes that this is actually not likely to since Government negotiators will make sure that any recovery obtained from one source is not duplicated by means of a separate recovery from another source.’151 The Enron Tribunal made a similar statement.152

J. Valuation of Damages 1. Overview 6.136 The determination of damages in both commercial and investment arbitration

requires, in most circumstances, the valuation of the asset, contract or interest in dispute. We refer to valuation broadly as the determination of quantum of a claim. There are a number of valuation techniques which vary in their use according to information available, state of the assets, industry customs, and specifically in the context of damages analysis, in how they can be adapted to account for special considerations, instructions, and hypotheticals (i.e., but-for scenarios). 6.137 A fundamental consideration about damages determination and valuation meth-

ods, however, is that it is not possible, or desirable, to try to generate a set of rigid rules that would dictate when each method should be applied. Neither are we attempting to replace or summarize in this chapter the vast body of literature on valuation techniques. Instead, the objective of this section is to serve as a roadmap of how the concepts outlined in prior sections are applied in practice in damages assessments. 6.138 As we discussed, when assessing lost income or lost value, the but-for premise as

applied to both treaty and commercial arbitrations would require that the effect of any events that would have affected the value that are attributable to the breaches

149 On an ex-post perspective, the measures complained by LG&E started in early 2002, and they are still in place at the time of writing (October 2013). The award was issued with damages computed between 2003 and 2005. 150 See Sempra Award, para. 395 (n. 40). 151 The tribunal further elaborated: ‘Th is interpretation proved to be correct as the 2007 agreements with the Licensees, as explained, expressly envisage that the Respondent shall be kept free of any adverse consequences arising from compensation that the Claimant might obtain in this arbitration or other proceedings.’ Sempra Award, para. 395 (n. 40). 152 See Enron Award, paras. 211–12 (n. 48).

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J. Valuation of Damages in dispute must be neutralized from the assessment of value. This is, in very simple terms, why economists and damages evaluators often have to develop a scenario that contemplates what the business would have been but for the actions of a given party. It is the construction of this ‘but-for framework’ that involves the great effort in a damages setting. The concept is also referred to in appraisal practice as ‘hypothetical conditions’. We prefer to define them simply as the but-for conditions— that is, the circumstances that would have existed but for the breaches. While in commercial arbitration, the measure is the expectation interest, which 6.139 may be calculated as loss of income stream or loss of value of the company or investment, compensation in international arbitration is usually based upon a measure of fair market value as stipulated by investment treaties, contracts and other standards. For example, Article IV.1 of the U.S./Argentina BIT, states that ‘compensation shall be equivalent to the fair market value of the expropriated investment immediately before the expropriatory action was taken or became known’.153 While the definition of fair market value is generally agreed upon, this does not imply the same for valuation methodology, the choice of which depends on the nature and context of each case. Furthermore, although they are often used interchangeably, fair market value and 6.140 fair value can be used in distinctive manners; fair value can be used in accounting and in certain types of appraisal, whereas fair market value is used in valuation in terms of a hypothetical buyer and seller that form a mutual arms-length agreement under no compulsion to buy or sell.154 A compelling example is provided by the decision in the Sempra v.  Argentina 6.141 ICSID case.155 As mentioned, Sempra’s claim related to the value of its investments in Argentina as of 2002 (as well as certain measures affecting the value of those investments), a time in which Argentina had fallen into a massive default on its sovereign debt and was therefore largely isolated from access to financial markets. Furthermore, the country was in the midst of a financial crisis that affected not only access to financing but the real economy as well.

153 See M.  Abdala and P.T. Spiller, ‘Damage Valuation of Indirect Expropriation in Public Services’ (2003) 14(1) The American Review of International Arbitration 9. 154 Mark Kantor references the IVSC, which notes: ‘The expression Market Value and the term Fair Value as it commonly appears in accounting standards are generally compatible, if not in every instance exactly equivalent concepts. Fair value, an accounting concept, is defined in [IFRS] and other accounting standards as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction. Fair Value is generally used for reporting both Market and Non-Market Values in the financial statements. Where the Market Value of an asset can be established, this value will equate to Fair Value.’ See Mark Kantor, IVSC Concepts Fundamental to Generally Accepted Valuation Principles (GAYP) (8th edn., International Valuation Standards 2007). See also Mark Kantor, Valuation for Arbitration:  Compensation Standards, Valuation Methods and Expert Evidence (Kluwer Law International 2008), 16. 155 For further discussion on fair market value and discount rates, see Section E, 4 and 5.

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Chapter 6: Valuation of Damages 6.142 As discussed in para 6.50, the parties in Sempra disputed the appropriate discount

rate that would apply to discount the expected future cash flows. While the claimant’s experts proposed a rate that was based on longer-term performance of the industry, Argentina’s expert proposed a rate that was based on the spot observation of rates as of 2002 in the midst of the Argentine financial crisis. In assessing damages, the tribunal stipulated that it ought to be rooted in the concept of fair market value. The Tribunal is of the view that fair market value would be the most appropriate standard to apply in this case to establish the value of the losses, if any, suffered by the Claimant as a result of the Treaty breaches which occurred, by comparing the fair market value of the companies concerned with and without the measures adopted by Argentina in January 2002.156 6.143 Based, then, on the concept of fair market value, the tribunal held that the appro-

priate discount rate was the cost of capital proposed by the claimant’s experts, recognizing the difference between fair market value, and the market value at which Sempra may have been able to dispose of its Argentina assets as of 2002 in the context of what might have been characterized as a distress sale. 6.144 In fact, the tribunal stated:

Had CGP and CGS (or Sodigas) hypothetically decided, at the end of 2001, to sell their shares on the Argentine exchange (in fact, none of them were listed), they might very well have suffered from the adverse reactions engendered by the state of economic and political difficulties. In other words, investors might very well have applied an extremely high discount rate and undervalued the equity. But the Claimant had originally not invested in CGP and CGS for trading purposes. It invested for the long term. Therefore, an unusually high market discount should not be included in the valuation of a long-term investment, on the basis of a serious but temporary economic crisis. 157

2. Approaches to valuation 6.145 A multiplicity of valuation methods are often grouped into three approaches that

share some common characteristics, these are: the income approach, the market approach, and the cost approach.158 The choice of approach depends on the nature of the asset being valued, as well as the micro and macro-economic circumstances surrounding the valuation. Furthermore, in determining damages, the technique (and approach) may be determined by which method or set of methods most appropriately allows the analyst to construct a but-for scenario (if necessary) or in general to account for specific assumptions that are necessary for an assessment of damages.159 156

See Sempra Award, para. 404 (n. 40). See Sempra Award, para. 435 (n. 40). 158 See IVSC, International Valuation Standards (8th edn., IVSC 2007), 32–33. 159 The application of valuation methods in valuation of public utilities is also explored in Abdala and Spiller, ‘Damage Valuation of Indirect Expropriation in Public Services’ (n. 153). 157

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J. Valuation of Damages a. The Income Approach The International Valuation Standards Council (IVSC) characterizes the income 6.146 approach as follows: The income capitalisation approach estimates the value of a business, business ownership interest or security by calculating the present value of anticipated benefits. The two most common income approach methods are capitalization of income and discounted cash flow or dividends method . . . 160

Methods within the income approach include the discounted cash flow (DCF) 6.147 method, the adjusted present value (APV) method, and the capitalized cash flow (CCF) method.161 In the following sections we seek to provide an overview of only the key elements 6.148 of each valuation method, in particular as they relate to the determination of fair market value or to their application in estimating discrete damages. i. Discounted cash flow (DCF) The DCF method is one of the most funda- 6.149 mental tools of financial valuation; as a tool, it is used in conducting business decisions on a daily basis at companies and by individuals, as well as by analysts and investors in various fields.162 It relies on a basic and intuitive premise that businesses and assets have value because they are expected to produce net cash flows at some point over time—the DCF method measures that value by assessing the cash flows that the asset is expected to generate over time, and re-expresses those cash flows as of a particular date. The DCF method is one of the most common methodologies used in valuation 6.150 analyses. Most investors and property owners rely on a DCF analysis to determine whether to undertake a project. It is widely supported in the professional literature,163 and is widely used by economists, industry practitioners, companies, investors, and regulatory agencies alike. It is also an accepted tool for the computation of claims for damages; it is recommended by international agencies, such as the World Bank, as a valid method to estimate fair market value in international disputes.164 160 See IVSC, Guidance Note No. 6—Business Valuation in International Valuation Standards (n. 158). 161 See Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies (5th edn., McKinsey & Company / John Wiley & Sons 2010) Ch. 6. See also Kantor (n. 154). 162 See R. Brealey, S. Myers, and F. Allen, Principles of Corporate Finance (8th edn, McGraw-Hill 2006) Chs. 2 and 3. See also Damodaran, ‘Investment Valuation: Tools and Techniques’ 11 (n. 96). See also Koller, Goedhart, and Wessels, Valuation: Measuring and Managing the Value of Companies Ch. 6 (n. 161). 163 See Brealey, Myers, and Allen, Principles of Corporate Finance Chs 2 and 3 (n. 162). See also Damodaran, ‘Investment Valuation: Tools and Techniques’ 11 (n. 96). See also Koller, Goedhart, and Wessels, Valuation: Measuring and Managing the Value of Companies Ch 6 (n. 161). 164 See World Bank, ‘Guidelines on the Treatment of Foreign Direct Investment’ paras. 5 and 6 (n. 37). The DCF method has also been used in several international arbitration cases. See, for

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Chapter 6: Valuation of Damages 6.151 The DCF method is a forward-looking method, based on fundamental principles

of financial economics; it considers a company’s ability to generate future cash flows rather than simply looking at historical profitability. It generally relies on four main drivers: (i) revenues, (ii) operating expenses (including sales, general, and administrative expenses), (iii) capital expenses, and (iv) the discount rate. Revenues provide cash inflows, while operating and capital expenses (as well as taxes) produce cash outflows; cash flows are computed by netting the cash inflows against the cash outflows. 6.152 In a DCF model, each year’s cash flows must be discounted by the appropriate

risk-adjusted discount rate before the cash flows can be aggregated or ‘re-expressed’ as of a particular date, which is generally referred to as the ‘date of valuation’. For the purposes of discounting future cash flows as of the date of valuation, it is widely accepted that the appropriate risk-adjusted discount factor is the weighted average cost of capital (WACC)165 of an efficiently managed firm under a similar market, contractual, and institutional environment.166 6.153 Because the DCF method makes explicit and transparent all of the determinants

of value—it details revenues, operating costs, capital expenditures, and taxes—it is capable of determining how changes in these determinants affect the overall value, while also accounting for the prevailing economic conditions affecting the business being valued. In the context of an arbitration, a DCF model can be laid out transparently as part of a damages assessment to provide visibility into each of the key parameters selected or assumed as part of valuation scenario. The DCF should be, when properly implemented, the opposite of a ‘black box’; the analyst should specify the parameters and assumptions relied on in the DCF, as well as the implications of his or her modeling. example, Iran-US Claims Tribunal, Starrett Housing Corp. v. Iran, 16 Iran-U.S.C.T.R., at paras. 279 and 280; ICSID Award, AMCO Asia Corp. et al. v. The Republic of Indonesia, YCA 1992, at paras. 105–7; ADC et al. v. Hungary, para. 502 (n. 70); and ICSID Award, CMS Gas Transmission Company v. The Argentine Republic, para. 416 (n. 31). 165 The WACC represents a fi rm’s cost of raising funds from both shareholders and lenders in an efficient proportion, called the optimal capital structure. The cost of raising funds from shareholders is measured by the cost of equity, which represents the expected rate of return on equity contributions. The cost of raising funds from lenders is given by the interest rate that an efficiently managed firm would have to pay for its long-term debt. It is measured by the firm’s own cost of debt or by a proxy such as the average yield to maturity of the debt of firms of comparable credit risk that are operating in the same location. The cost of debt is used on an after-tax basis. Thus, it is adjusted to reflect the tax benefits to the enterprise of the deductibility of interest payments. The WACC is the weighted average cost of the cost of equity and the cost of debt, with the weightings (which sum to 100%) determined by the optimal capital structure in the industry. See nn. 96 and 97 for standard references on how to assess cost of capital to a typical project or asset. 166 Mathematically, the DCF method provides the value of an enterprise by computing is the present value (as of the date of valuation) of future cash flows discounted at the WACC. The value to its shareholders, however, can be inferred from such discounted value by deducting the value of the debt, or alternatively, by computing directly the net present value of cash flows to equity, by deducting from the firm’s cash flows payments to creditors and additions to reserves, and discounting the cash flow to equity at the cost of equity, which is a component of the WACC.

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J. Valuation of Damages Under the DCF method, it is possible to test the sensitivity of various inputs, indi- 6.154 vidually or sequentially, to the overall value. For example, if one was using a DCF analysis to value an oil field, one can increase and/or decrease the assumed oil price profile to quantify the effect on the valuation of the field. If one were valuing a contract for the provision of road-toll services, one might consider the rate of inflation that might affect operating costs, labour, and other key determinants of value. This flexibility makes the DCF method particularly useful for assessing the value of an asset and/or business in a counterfactual or but-for scenario. The DCF method necessitates an estimation of future cash inflows (revenues) and 6.155 outflows (costs and taxes). This method is therefore suited for assessing the value of an income-generating asset where it is possible to reasonably estimate future revenues and costs. There are various ways of forecasting revenues and costs, and the appropriate method depends on the asset being valued, along with the measures composing the contract or treaty breach (or breaches) and the assumptions of the but-for scenario. One way to forecast future cash flows is to base them on the historical performance of the company. This, of course, requires that the business being valued has a history of operational performance. If, however, the asset under consideration does not have such a history of performance, or if the history is not complete enough to allow for a projection of cash flows,167 it is still feasible to estimate future cash flows based on business plans, feasibility studies, or analyst reports that contain analysis of projected costs and revenues, and any of these, where possible, should be validated with market indicators and industry forecasts. Additionally, if there are measures that have affected the historical performance of the asset or business being valued, then it would be inappropriate to use the historical performance as a basis for valuing the asset or business but for the expropriatory measures. ii. Example: Siag v. Egypt In Siag v. Egypt, the claimants provided three alter- 6.156 native valuation methods: a DCF which was based on the assessment of damages as an ongoing concern;168 a residual land value approach which was an hybrid relying partially on the DCF and partially on the comparable sales valuation approach,169 and a third approach relying purely on comparable sales.170 While recognizing that the claimants were deprived of a substantial investment, the 167 Th is may be the case for assets that have just started operating (for example, a mine that has just moved from the development stage, where the infrastructure of the mine is being constructed, to the production stage). 168 Although the Siag Award (n. 121) does not stipulate it so, it is possible to infer such assumption from the fact that the DCF was based on a discount rate of 12.79%, which does not account for the pre-operational risks associated with assessing cash flows. In particular, the tribunal says ‘Mr. Abdala [the Claimant’s expert] very candidly acknowledged that there is one particular difference and this is that “. . . in the [case] that you have a track record of profitability you could say that you have a higher degree of certainty as to what to expect of the performance of the business in the future.” ’ See Siag Award, para. 567. 169 See Siag Award, para. 552 (n. 121). 170 See Siag Award, para. 551 (n. 121).

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Chapter 6: Valuation of Damages tribunal concluded that it ‘[was] not satisfied that it was an investment that lends itself to a robust DCF’.171 In doing so, the tribunal emphasized that for a case such this, there were ‘numerous moving parts’.172 Instead, it determined that the comparable sales valuation approach was appropriate for the case at hand. From an economic perspective, the tribunal decision not to consider the DCF can be understood as implying that given that the claimants’ DCF valuation was rooted on ‘an ongoing concern’ assumption, it did not reflect the pre-operational risks associated with a venture such as this. In Section 6 we discuss how to incorporate pre-operational risks when assessing the value of businesses without operational history. 6.157 iii. Adjusted present value (APV)

The APV method is very similar to the DCF method, in that both assess the value of an asset or business by calculating the present value of net future cash flows that the asset of business is expected to generate. The two methods differ in how the present value of such expected cash flows is calculated. While under the DCF method all future cash flows are discounted at a constant WACC, the APV method values the cash flows associated with the capital structure separately from the cost of capital. Thus, the DCF method is appropriate when the asset or company under consideration is expected to maintain a relatively stable capital structure. If, however, the capital structure is expected to change significantly, then the APV method is more appropriate.

6.158 The APV method separates the calculation of the value of an asset or company

into two components: (i) the value of the asset or company as if the company was financed solely by equity; and (ii) the value of tax shields that arise from debt financing. In this way the APV method explicitly measures and values the effects of financing separately from the value of the business’s ability to generate cash flows. To value an asset or company under the APV method, discount the expected future net cash flows by the unlevered cost of equity (i.e., what the cost of equity would be if the company had no debt) and then add to this value the value created by the company’s use of debt. The value of the use of debt can be calculated by forecasting and discounting capital structure side effects such as tax shields, security issue costs, and distress costs.173 6.159 The advantage of the APV method is that it gives an explicit view of the factors

that add or subtract from the value of the company or asset; a financial manager using the APV method can explore the implications of different financing strategies without locking into a fixed debt ratio or having to calculate a new WACC for

171

Siag Award, para. 566 (n. 121). See Siag Award, para. 568 (n. 121). 173 See also Koller, Goedhart, and Wessels, Valuation: Measuring and Managing the Value of Companies 123 (n. 161). 172

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J. Valuation of Damages every scenario. The APV method can be useful when the debt for a project or business depends on book value or has to be repaid on fixed schedules (e.g., for valuing a leveraged buyout, which are financed almost entirely by debt that is not intended to be permanent). The APV is also useful in instances where the effects of financing and capital structure are significant. Large international investments, for example, are well suited for the APV method, as they typically involve project-specific financing and special contracts with suppliers, customers, and governments.174 Even though, in principle, the DCF and the APV ought to provide equivalent 6.160 answers when the capital structure is assumed to be relatively constant,175 the APV has its own detractors,176 as the need to incorporate bankruptcy risks, the impact of which on valuation often exceeds the tax benefit, and the mechanical application of its formulas to separate firm value into its unlevered and debt value components may make the method unreliable. Thus, as with international agencies,177 regulatory agencies,178 academics,179 and 6.161 practitioners, arbitration tribunals have increasingly endorsed the use of the DCF as a valuation method.180 iv. Capitalized cash flow (CCF) The CCF, also known as the capitalization of 6.162 earnings, method is another income-based method. A valuation under the CCF method entails identifying a historical income amount (e.g., last year’s EBITDA or a historical average EBITDA), multiplying the identified historical income amount by an expected future growth rate, and then dividing the resulting

174

See Brealey, Myers, and Allen, Principles of Corporate Finance 524–5 (n. 162). See Copeland, Koller, and Murrin ‘Valuation:  Measuring and Managing the Value of Companies’ (n. 96) and P. Fernarndez, ‘Equivalence of the APV, WACC, and Flows to Equity Approaches to Firm Valuation’ (1997) Working Paper IESE Business School, Spain. 176 See, e.g., A.  Damodaran, ‘The Adjusted Present Value Approach’ (n. d.), available at . See also L. Booth, ‘Finding Value Where None Exists: Pitfalls in Using Adjusted Present Value’ (2002) 15(1) Journal of Applied Corporate Finance 95–104. 177 See World Bank, ‘Guidelines on the Treatment of Foreign Direct Investment’ (n. 37). 178 See J.  Makholm, ‘In Defense of the Gold Standard’ (2003) Public Utilities Fortnightly, 15 May. 179 See, among many others, Copeland, Koller, and Murrin, ‘Valuation, Measuring and Managing the Value of the Companies’ (n. 96). 180 See, for example, Occidental (n. 130), which at para. 708 states: ‘The Tribunal is of the view that, in this case, the standard economic approach to measuring the fair market value today of a stream of net revenues (i.e., gross revenues minus attendant costs) that can be earned from the operation of a multi-year project such as OEPC’s development of Block 15 is the calculation of the present value, as of 16 May 2006, of the net benefits, or “discounted cash flows”.’ Among the Awards not yet discussed in this chapter, see also Iran-US Claims Tribunal, Starrett Housing Corp. v. Iran, 16 IRAN-U.S. C.T.R., at paras. 279 and 280; AMCO Asia v. Indonesia , paras. 105–7 (n. 164); and CMS Gas Transmission Company v. Argentina, para. 416 (n. 31) where the Panel states that: ‘Th is leaves the Tribunal with the DCF method and it has no hesitation in endorsing it as the one which is the most appropriate in this case.(. . . ) DCF techniques have been universally adopted, including by numerous arbitral tribunals, as an appropriate method for valuing business assets;. . . ’ 175

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Chapter 6: Valuation of Damages amount by a discount rate minus the same expected growth rate.181 Unlike the DCF and APV methods, which both involve projecting each future increment of cash flows and dividing it by a discount rate compounded for some number of years into the future, the CCF method selects a single expected number and simply divides that number by a rate of return, called the capitalization rate. 6.163 Because there are only a few inputs into a valuation under the CCF method, the

reliability of the valuation relies heavily on the reliability of the inputs, namely the historical income amount, the discount rate, and the growth rate. If, for example, the historical income amount is misstated, the resulting valuation will be wrong. It is therefore important to review, and potentially adjust, revenue and expense numbers for factors such as normalization adjustment, nonrecurring revenue and expense items, taxes, capital structure and financing costs, appropriate capital investments, noncash items, qualitative judgments for rules used to compute discount and capitalization rates, and expected changes in future benefits.182 6.164 Equally important is the selection of the historical time period for selecting the

historical income amount. To normalize historical cash flows, some analysts use a multi-year historical cash flows (e.g., a 3-year or 5-year average); however, if the company had been experiencing significant growth, declines, or extraordinary events, using a longer period, without adjustment, may be inappropriate. The appropriate time period to use will depend on the company- and case-specific characteristics, but in any event, the historical income amount should reflect a reasonable expectation of the company’s future earning power. 6.165 The other essential component of the CCF method is the capitalization rate, which

includes the expected future growth rate and the discount rate. The appropriate discount rate to use in the CCF method is the same discount rate used in the DCF method, the WACC.183 The expected future growth rate is typically the expected annualized rate for the life of the investment.184 The expected future growth rate can be measured in several ways: based on historical trends in the company’s performance, historical trends in the industry, or estimates from industry analysts or government agencies.185 While there is a level of uncertainty in selecting a reasonable growth rate, such uncertainty is also captured in the risk embedded in the discount rate. Note that the capitalization rate used in a CCF valuation must be consistent with the cash flow with regards to a pre-tax or post-tax basis. 181 See Kantor, Valuation for Arbitration: Compensation Standards, Valuation Methods and Expert Evidence 215 (n. 154). 182 See also Kantor, Valuation for Arbitration: Compensation Standards, Valuation Methods and Expert Evidence 219 (n. 154). 183 See para. 6.152. 184 If the discount rate is nominal terms (i.e. including inflation) than the expected growth rate should include inflation, and vice-versa. 185 The appropriate source will depend on the industry under consideration, but it is prudent to check for all sources as a check on whichever source you select.

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J. Valuation of Damages The CCF method is often used to value companies with significant intangible 6.166 assets relative to tangible or fixed assets. While inherently attractive due to its simplicity, it is almost only relevant when future performance is expected to resemble the past. For this reason, it is very rarely used in the valuation of complex long-term contracts where specific business projections based on contract terms tend to provide a lot more detail and scenarios can be outlined more credibly in a fully-fledged out DCF model. v. Risks in the cash flow or in the discount rate One of the most contentious 6.167 issues in the determination of damages via DCF valuations, is the application of the discount rate. While reference has been made at para. 6.98 regarding the tendencies to over or undercompensate via the use of inappropriate discount rates, the main issue that tribunals often face is the need to determine whether risks are or are not captured in either of the cash flows as well as the discount rate. To the extent that cash flows are realistically forecasted (based on a contract’s tariff structure, on mainstream business projections, or on industry-specific methods that may apply), then an equivalently mainstream (i.e., market-based) discount rate is appropriate. There are models which are designed to incorporate all risks in the cash flows and then discount by risk free rates, and while these models are often used in models in which the probabilities of occurrence of various outcomes can be reasonably estimated, it is seldom the case that one can apply all risks in the cash flows in standard DCF valuations. A particular consideration, though, is on projects that are in their infancy, or that have not yet even broken ground—a topic we discuss in the following section. Yet another alternative, used only in certain industries, is to compute a ‘net asset 6.168 value’ (NAV) at standard ‘template’ or ‘yardstick’ rates (0%, 5%, 10% are some examples) and then compare the results with the ratio of market-to-NAV valuations observable in the market (also referred to as price-to-NAV or PNAV). Thus, in applying the PNAV variation of the income approach, one computes the NAV and then multiplies the NAV by a multiple observed in listed peers in the market.186 This approach allows the analyst to compare value across projects on an undiscounted basis (or discounted in a standard way), and then to apply market information into the income approach, not via the discount rate, but as a multiple that can either augment or reduce the value as a function of information from listed market peers. vi. Incorporating pre-operational risks Often complex long-term con- 6.169 tracts fail even before substantial sums have been invested in the project,187 or before planned expansions took place. Affected parties, naturally, want to be 186 A multiple above 1 means the market peers are trading at values above their net asset value, which in turn implies that the market overall believes that the rate used to derive those NAVs is too high. A multiple below 1 implies a discount beyond that in the discount rate, thereby applying an overall discount larger than that in the discount rate. 187 See Section H for a discussion of compensating for investments not made.

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Chapter 6: Valuation of Damages compensated for their lost future profits. When such investments are not unique, or are standard expansions, the computation of lost profits, while never a simple task, is simpler than if the project is one of a kind. In that case, the project has a level of risk that needs to be addressed, as mentioned previously, either via cash flows or through the discount rate. The uncertainty about the operational performance of such a venture is often difficult to introduce into the cash flows, as precisely because the project is one of a kind, its potential operational hiccups cannot be assessed with enough certainty. It is in that case when introducing a differential discount rate for pre-operational status may be appropriate. 6.170 This is a standard problem faced by venture capital (VC) firms, who deal with

companies and projects which, because of their nature, do not have access to credit or formal equity markets. Although VCs devote substantial time to learning the ins and outs of their potential investment targets, at the moment of investment VCs still have substantial uncertainty about whether these projects will make a return at all. A fundamental determinant of that uncertainty, however—apart from the nature of the project itself—is the stage the project is at at the moment of funding. VCs then, demand a much higher return for projects which are in their earlier stage of development, than for projects which are later in their implementation. Damodaran,188 for example, presents ranges of target rate of returns that VCs demand for start-up projects depending on their stage in development. He shows that the rate of return that VCs demand to fund projects fall with the project’s life cycle. Thus, for a project which is still not operational, but which has clients (‘first’ stage), VCs demand between 15 per cent and 20 per cent higher return than for projects that already have commercial manufacturing and sales (‘second’ stage).189 b. The market approach 6.171 The IVSC describes the market approach as follows:190 ‘The market approach compares the subject to similar business, business ownership interest, and securities that have been sold in the market . . . ’ 6.172 Methods within the market approach include:

• publicly-traded multiples; • transaction multiples; • stock prices.

188 See A. Damodaran, Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges (Stern School of Business, New York University 2009). 189 Others report slightly higher pre-operational premiums. See, for example, J.C. Ruhnka and J. E. Young, ‘Some Hypotheses about Risk in Venture Capital Investing’ (1991) 6(2) Journal of Business Venturing 115–33; W.E. Wetzel, ‘Informal Risk Capital in New England’ in K.H. Vesper (ed.), Frontiers of Entrepreneurial Research (Babson College 1981). 190 See IVSC, Guidance Note No 6—Business Valuation (n. 158).

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J. Valuation of Damages These methods rely on the notion that the value of a firm or asset may be assessed 6.173 by looking at valuations arising from transactions involving comparable firms, businesses, or assets, and, if necessary, adjusting relative to a standard measure. The standard measure can either be a financial metric or an operational metric. One common measure to value a firm is Enterprise Value/EBITDA; EBITDA is a measurement of the company’s earnings independent of the company’s financing and accounting decisions (i.e., it excludes consideration of taxes and depreciation).191 Possible operational metrics that are sometimes used include units of production (such as barrels of oil reserves in oil and gas valuations or ounces of a given mineral in mining), units of capacity (such as capability to produce a given product or service, which may be passenger traffic in airlines, square feet in real estate, etc.), and industry specific units (such as unique page views or clicks in valuations of website and certain technology companies). Regardless of whether one is using a financial or operational metric, the metric must be a reasonable predictor of future value creation; in this regard, some financial literature cautions against use of a non-financial metric, arguing that if the company cannot translate the operational metric (e.g., page views, subscribers, web traffic) into profits, then that metric is meaningless as a valuation metric.192 The fundamental principle underlying the market approach is that transactions 6.174 between willing buyers and willing sellers provide a measure of value for the assets subject to valuation. The validity of using this approach to draw inferences as to the value of an asset depends on a number of factors: • The transaction must be voluntary. A transaction concluded under duress provides no indication of intrinsic value. Such a transaction price would not be considered to represent fair market value, and cannot be used as a benchmark to infer the value of comparable assets. • The market must be reasonably well-functioning. While there is no set definition of what a well-functioning market is, some of the characteristics include price transparency and liquidity. Price transparency means that buyers and sellers are able to ascertain accurate prices of other relevant transactions. Liquidity means that there should by many potential buyers for the particular asset at stake, and that there should be other potential sellers for assets of that kind. If the market is illiquid, the price may not reflect intrinsic value. • There should be sufficient, reasonably contemporaneous transactions so that price information from a sale/purchase reflects contemporaneous cost and demand conditions and expectations. • The set of benchmark businesses should have reasonably similar characteristics to the business being valued. To the extent that there are differences, 191

EBITDA refers to earnings before interest, taxes, depreciation, and amortization. See Koller, Goedhart, and Wessels, Valuation:  Measuring and Managing the Value of Companies 321–2 (n. 161). 192

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Chapter 6: Valuation of Damages adjustments to value may have to be made; although such adjustments may introduce a source of error or subjectivity. 6.175 There are two types of transactions providing information on comparable valua-

tions: those arising in formal exchanges and those arising from one to one transactions. There are fundamental differences across the two types. First, transactions in formal exchanges are most often for fractional ownership of companies. One-toone transactions, however, are for fractional or whole ownership of companies or assets. To see the difference consider the stock price of a traded company. This represents the result of a transaction for a marginal share in a company. On the other hand, would that company be subject to a takeover, the transaction would reflect a controlling stake, and hence would be valued differently.193 Productive assets, such as production plants (e.g., refineries), oil fields, pipelines, wireless licenses, and so on, are, on the other hand, normally sold in one-to-one transactions as these are too specific to be able to trade in formal exchanges. Such transactions are most often not for marginal stakes in the companies or assets, but rather for non-marginal stakes. 6.176 i. Market multiples from publicly-traded companies

The market multiples method is a standard valuation technique that estimates the value of an asset or company by examining the market valuation of publicly-traded companies of similar characteristics. This method, therefore, derives a measure of value for the asset subject to valuation by inference from the value of peer companies. The market capitalization of peer publicly-traded companies can be used to infer the value of the asset of the company subject to valuation by expressing the value of the peer companies as a ratio or multiple of some metric.

6.177 a. The metric

The term ‘multiple’ in valuation refers to the use of some measure of market value divided, or scaled, by some measure of performance. The market value is typically either market capitalization, the equity valuation of a firm, which can be calculated as the company’s trading share price multiplied by the number of shares it has outstanding, or enterprise value, which is equal to the value of the firm’s debt plus the value of its equity, less cash. In other words, the enterprise value of a company is the sum of all of the claims of the company’s debt and equity security-holders. The measure of performance can be either some type of financial metric, such as EBITDA, or an operational metric, such as barrels of oil reserves or square acreage.

6.178 b. Peer companies

The essential component of a valuation based on market multiples of publicly-traded companies is the set of peer companies, as the valuation will be derived directly from the multiples of these companies. Building a set of peer companies begins with determining what constitutes a ‘peer’ company.

193

See discussion on control premium at para. 6.182 onwards.

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J. Valuation of Damages The literature on valuation through multiples varies on the specific characteristics that determine comparability, but the general consensus is that the peer companies should operate in the same industry and face a similar risk profile: • Damodaran, for example, stresses that peer firms should have similar cash flow, growth potential, and risk. He concedes that most analysts limit comparables to similar industries and sectors, and that within the same industry, the comparison is stronger.194 • Koller, Goedhart, and Wessels argue that one must choose peers with similar prospects, emphasizing that once the peer companies are selected, the analyst must understand what products they sell, how they generate revenues and profits, and how they grow.195 • Benninga and Sarig outline the criteria that are most often used for the selection of comparable firms:  industry classification, technology, clientele, size, and leverage.196 • The American Society of Appraisers states that the appraiser must also keep in mind the underlying similarities of the companies in terms of markets and products, growth, and cyclical variability in order to fully assess the value of the subject company.197 • The IVSC states that ‘similar businesses should be in the same industry as the subject or in an industry that responds to the same economic variables’.198 There are multiple ways to search for and gather companies when building the 6.179 set of peer companies. There are several classification systems that assign industry codes based on the type of business that a company conducts; examples include the Standard Industrial Classification (SIC) system, the Global Industry Classification Standard (GICS), and the North American Industry Classification System (NAICS). Industry reports and investment banking research reports will often contain groupings of comparable companies. For example, a research report on IBM will likely contain an analysis of IBM’s competitors. It is generally a good idea to start with as large a sample of companies as possible, 6.180 and then to filter the sample of peer companies to assess comparability. Ideally, as the sample is filtered the comparability of the group of peer companies will increase. Note, however, that there is a trade-off between sample size and comparability. One way to check whether the sample of peer companies is robust is to assess the relationship between the valuation multiple and various company

194

Aswath Damodaran, Damodaran on Valuation (John Wiley and Sons 1994), Ch. 7. Koller, Goedhart, and Wessels, Valuation: Measuring and Managing the Value of Companies (n. 161). 196 S. Benninga and O. Sarig, Corporate Finance A Valuation Approach (1st edn., McGraw-Hill/ Irwin 1996). 197 ASA Business Valuation Standards, section SBVS-2 ‘Guidelines Transactions Method’. 198 Guidance Note No. 6—Business Valuation, Section 5.14.3.3. 195

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Chapter 6: Valuation of Damages characteristics. If, for example, valuation multiples are strongly and directly correlated with company size (often measured by capacity, employees, reserves, or market capitalization), not filtering appropriately for market capitalization may introduce bias into the sample. A good check that the sample of companies is robust is to look at the standard deviation of the valuation multiple of the sample; a low standard deviation can suggest that the companies are similar, or are at least valued similarly by the market. 6.181 Once the analyst has identified the set of peer companies, and have selected the rel-

evant multiple, the final step is applying either the average or median (or a weighted average) multiple to the relevant metric of the asset or company under consideration. For example, if you are valuing a company that achieved an EBITDA of US$50 million and its peer companies are valued by the market at 15 x EBITDA, then valuation using this method is US$750 million. c. The use of control premium 6.182 Enterprise value and market capitalization, the numerator of the multiple, is derived from a company’s share price. The share price represents the marginal cost of acquiring a fractional minority interest in a firm. Investors place value on controlling the operation of the company. By holding a majority of the company’s shares, the shareowner has the potential ability to influence the business and future of the company, and ultimately, its cash flow and value. Therefore, in transactions where entire companies are acquired or when an acquisition results in a shareholder holding a controlling interest, it is well documented that the transaction tends to occur at a price higher than the price in which minority interests are transacted, all else remaining the same.199 6.183 The market multiples from publicly-traded companies method considers the share

price to be a fair indicator of the fractional value represented by that share. Since such trading prices represent only minority interest transactions, while offers to buy the entire company on a controlling interest basis often take place at significant premiums, analysts often add a ‘control premium’ to the publicly-traded share price to derive a valuation of companies on a controlling interest basis. The value of the control premium will vary depending on the industry, and potentially

199 J. Pearl and J. Rosenbaum, Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions (John Wiley and Sons 2009), Ch. 2, p. 71 state: ‘[u]nder normal market conditions, transaction comps tend to provide a higher multiple range than trading comps for two principal reasons. First, buyers generally pay a “control premium” when purchasing another company. In return for this premium, the acquirer receives the right to control decisions regarding the target’s business and its underlying cash flows. Second, strategic buyers often have the opportunity to realize synergies, which supports the ability to pay higher purchase prices. Synergies refer to the expected cost savings, growth opportunities, and other financial benefits that occur as a result of the combination of two businesses.’

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J. Valuation of Damages by location.200 Note that the control premium is only applicable when valuing a majority stake in the asset or company under consideration. The market multiples from publicly-traded companies method has several advan- 6.184 tages: it is market-based, it requires making fewer assumptions than other valuation methods, it allows for quick comparison of value across several companies, and, thus, it is relevant for valuing companies in a damages setting. This method, however, also has certain disadvantages, namely that the contributions to value are not as transparent as under the income approach, and that the valuation relies heavily on the comparability of the peer companies. When valuing specific niche assets or companies that operate in a niche industry, it may not be possible to find enough similar publicly-traded companies to build a robust sample to allow for an inference of value.201 ii. Market multiples from comparable transactions By examining the eco- 6.185 nomic terms of arm’s-length transactions involving comparable assets, one can obtain standard multiples of value that can be used to estimate the value of the asset or company under consideration. The comparable transactions method is based on observing the value of comparable assets or companies that have been recently sold in the marketplace, and expressing the value of these comparable transactions as a multiple of a particular metric to allow for a comparison the value of these assets on the same basis. The valuation methodology of the comparable

200 Damodaran (2005), for example, reports that practitioners apply control premiums that range between 15 and 20%. Damodaran refers to the work of Hanouna, Sarin, and Shapiro (2001) which report minority discounts (the inverse of control premium) of 20–30% in ‘market oriented’ economies, Barclay and Holderness (1989, 1991) reporting premiums in excess of 10% for large negotiated block transactions in the United States and Nicodano and Sembenelli (2000) finding an average control premium for Italy of 27%. Rudenno (2009) provide a similar range (15–30%) in the natural resource sector. Finally, Holderness (2003) reports findings by Barclay and Holderness’ (1989) of a 20% premium, Nicodano and Sembenelli’s (2000) of a 27% premium, Mikkelson and Regassa (1991) of an average premium of 9.2% for 37 analysed trades between 1978 and 1987 and Chang and Mayers (1995) an average premium of 13.6%. Finally, Dyck and Zingales (2004) report an average premium of 25.1% for a large set of countries. See A. Damodaran, ‘The Value of Control: Implications for Control Premia, Minority Discounts and Voting Share Differentials’ (2005) Stern School of Business; P. Hanouna, A. Sarin, and A.C. Shapiro, ‘Value of Corporate Control: Some International Evidence’ (2001) Working Paper, USC Working paper series; M.J. Barclay and C. Holderness, ‘Private Benefits from Control of Public Corporations’ (1989) 25 Journal of Financial Economics, 371–95; M.J. Barclay and C. Holderness, ‘Negotiated Block Trades and Corporate Control’ (1991) 56(3) Journal of Finance, 861–878; G. Nicodano and A. Sembenelli, ‘Private Benefits, Block Transaction Premiums and Ownership Structure’ (2000) Working Paper, SSRN; V. Rudenno, The Mining Valuation Handbook (3rd edn., John Wiley & Sons, 2010); C. G. Holderness, ‘A Survey of Blockholders and Corporate Control’ (2003) FRBNY Economic Policy Review, 51–64; W. Mikkelson and H. Regassa, ‘Premiums Paid in Block Transactions’ (1991) 12 Managerial and Decision Economics, 511–17; S. Chang and D. Mayers, ‘Who Benefits in a Negotiated Block Trade?’ (1995) Unpublished paper, University of California at Riverside; A. Dyck and L. Zingales, ‘Private Benefits of Control: An International Comparison’ (2004) 59(2) Journal of Finance 537–600. 201 See para. 6.195 et seq. for a discussion of the reasonableness of using comparables in Occidental (n. 130).

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Chapter 6: Valuation of Damages transactions method is similar to that of the multiples from publicly-traded companies, but instead of looking at the value based on a company’s trading share price, the value is taken directly from actual acquisition prices. 6.186 As with the multiples from publicly-traded companies, the challenge in applying the

comparable transactions method is finding appropriate comparable transactions. The criteria for determining comparability is largely as with the publicly-traded companies method, but for certain industries it may be difficult to find transactions involving a comparable asset. 6.187 Another challenge with this method is finding transactions that occur within a

contemporaneous time range as the date of valuation. This is rarely an issue with the multiples from publicly-traded companies, as in that method transactions take place at all times. With the comparable transactions method, ideally one needs a sufficient volume of transactions occurring within a reasonable time range of the date of valuation. While there are no set criteria for how contemporaneous the transaction must be, the transaction should take place under relatively similar market conditions as the date of valuation. Furthermore, some metrics are more influenced by market conditions than others. For example, physical metrics, such as EV per plant processing capacity or EV per barrel of crude oil, are directly affected by market movements, as these will impact on, say, the company’s EV but will not affect, say, its crude oil reserves. Thus, one can observe that metrics such as EV/crude oil reserves move quite closely with the price of crude oil, as discussed earlier. 6.188 On the other hand, EV to EBITDA ratios are less affected by market movements, as

for example, a recession will reduce EV but will also reduce the company’s revenues and hence its EBITDA. Thus, the EV to EBITDA ratio will tend to be more stable over time than physical ratios, making EBITDA ratios less sensitive to timing. 6.189 In applying this method one must be careful to exclude transactions with peculiar

features. In particular, unless value under distress is a component of the claim, distress transactions should be included. Similarly, transactions that were not at arm-length, such as transactions between related companies, or transactions limited by shareholding agreements, or governmental interference. Thus, when considering a transaction for use in a comparable transactions valuation, one must review any relevant press releases and/or regulatory filings to verify that the transaction is at arm length and does not represent either a distress or file sale transaction. Situations where a company is financially distressed, or is otherwise obligated to sell (or similarly, if a company is obligated to acquire another company) would not reflect a fair market valuation. Additionally, transactions that include significant government involvement would not reflect a fair market valuation (e.g., if a government stepped in to facilitate a transaction or provided tax incentives for a certain transaction to transpire). 308

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J. Valuation of Damages Similar to the market multiples from publicly-traded companies method, the 6.190 advantage of using the comparable transactions method is that it may require (when there are true comparables in the market) fewer assumptions than a cash flow-based valuation. The method’s drawbacks, as discussed, are the potential difficulties in finding appropriate comparables,202 and that the contributions to value are not as transparent as under the income approach. At times, however, comparables may provide the tribunal comfort about value. a. Use of transactions prices in awards:  Siag, Enron, Occidental , and  EDFI 6.191 Tribunals use transactions both to assess value under both the actual and but-for scenarios. As discussed, 203 in Siag the tribunal awarded damages by valuing the asset in the absence of the expropriation, based on a sales comparison valuation (a type of comparable transactions analysis often applied in real estate valuations) over an income approach analysis. Tribunals in ADC and in Siag also found comfort in that subsequent transactions reflected the assessed value but for the measures. For example, in ADC, the tribunal explained that: . . . [the Claimants’ expert’s] valuation is fully validated by the amount of the acquisition by BAA of Budapest Airport Rt. on December 22, 2005, being US$ 2.23 billion (£1.26 billion) for 75% minus one share and a 75-year assets management contract plus moveable assets. 204

Similarly, in Siag, the tribunal stated:

6.192

It has already been noted above that Egypt itself has recently commenced construction of a very substantial resort development in roughly the same location known as ‘the Riviera Centre.’ It is precisely this desirability of the Property, confirmed as it is by the development of the Riviera Centre, which supports the substantial valuation accorded to the Property by [the Claimants’ expert]. 205

In Enron, on the other hand, because of lack of liquidity considerations, the 6.193 Tribunal rejected the use of TGS’ own stock market valuation for the purpose of assessing its but-for valuation, relying instead in the income approach (DCF) for the primary method.206 While relying on the income (DCF) approach for the but-for valuation,207 the Enron Tribunal found that transactions that took place after the measures are a better representation of the actual value of the asset under the Measures than a DCF, stating:208

202 The SPEE cautions about the use of comparables. See SPEE Perspectives on the Fair Market Value of Oil and Gas Interests (2002) 43. 203 See para. 6.123 et seq. 204 See ADC et al. v. Hungary, para. 516 (n. 70). 205 See Siag Award, para. 574 (n. 121). 206 The tribunal determined, however, that stock market capitalization over longer periods of time can still be used so ‘so as to determine relevant averages’. See Enron Award, para. 383 (n. 48). 207 See Enron Award, para. 386 (n. 48). 208 See Enron Award, para. 387 (n. 48).

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Chapter 6: Valuation of Damages ‘Market transactions have taken place in respect of the Claimants’ participation in TGS. . . . Willing sellers and willing buyers in this case are thus no longer hypothetical but real enough, a situation that has turned to be meaningful in the Tribunal’s findings. In fact, these transactions and in particular the sale of the Claimants’ 15.2% stake in TGS to D.E. Shaw and the option to purchase the remaining 4.3% participation in TGS are an accurate reflection of the current market value of the company.’ 6.194 Thus, the Enron Tribunal stated:

. . . the Tribunal will apply DCF to estimate the value of TGS and of Claimants’ investment (i.e., their equity participation in TGS) before the measures were adopted, in particular, before pesification took place. To estimate the current value of TGS and of Claimants’ investment, the Tribunal will use the sale transaction with D.E. Shaw. Both results would then be contrasted with the stock market value. Next, the Tribunal will establish the difference between these two values to calculate the damages suffered by the Claimants as shareholders of TGS. 209 6.195 On the other hand, some assets are harder to assess by comparables. Occidental is

one such example. As discussed, in Occidental,210 the tribunal had to assess damages to the claimants arising, among other claims, from the termination of a participation contract. The tribunal, however, found it difficult to compare a particular participation contract with the set of seven transactions offered by the respondent.211 The tribunal further rejected the comparison to a transaction involving a participation contract, which while directly comparable to Occidental, was undertaken under the threat of termination, and as such, could not reflect the value absent the measures.212 In our view, however, Occidental does not mean that comparable transactions cannot be used as references of value, but rather that in assessing value through comparable transactions, small number of comparables may not be particularly useful if the asset in question has particular contractual features that affect value. This applies, in particular to standard physical metrics, such as EV per barrel of reserves. On the other hand, metrics based on financial data, such as EV to EBITDA may be more informative, as the ratio reflects the value that investors in the sector demand for trading assets with particular income potential, independently of whether the income’s origin is in a contract or ownership. 6.196 In EDFI, 213 however, the tribunal rejected the use of a transaction by which the

claimants divested their assets in the operating company to assess the actual value 209

See Enron Award, para. 389 (n. 48). For a discussion of the nature of Occidental v Ecuador (n. 130), see para. 6.127 et seq. 211 See Occidental Award, para. 787 (n. 130). 212 See Occidental Award, para. 786 (n. 130). 213 The claimants in EDFI v.  Argentina invested in an electricity distribution company (EDEMSA) in the Province of Mendoza. They claimed that measures undertaken by Argentine following the enactment of the Emergency Act in early 2002 essentially destroyed their investment in EDEMSA. See EDF International S.A., SAUR International S.A., and León Participaciones Argentinas S.A. v The Argentine Republic, ICSID Case No. Arb/03/23, Award dated 11 June 2012, para. 199. 210

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J. Valuation of Damages of the claimants’ investments.214,215 The tribunal rejected the use of the divestiture transaction as the transaction was undertaken in the middle of a tariff renegotiation, and subsequent events substantially increased the value of the operating company. In particular, the divestiture closed one week prior to the signing of a memorandum of understanding between the operating company and the provincial government, and two years later, the purchaser resold its stake at a price almost 30 times higher than the acquisition price.216 By not including any contingencies linked to the outcome of the tariff renegotiation, the tribunal determined that the claimants contributed to their loss.217 The tribunal then determined, that the claimants should have negotiated a sharing agreement with the purchaser so that the claimants and the purchaser would have received an equal share of the increase in value had the renegotiation been successful.218 Thus, the tribunal deducted from the award, after discounting to the date of valuation and taking into account the claimants’ shareholding, 50 per cent of the corresponding value of the second transaction.219 iii. Stock market study and event studies One useful source for determining 6.197 the value of a publicly-traded company is its traded share price value, and by extension, its market capitalization (calculated as the product of its share price and number of shares outstanding). The market capitalization for a publicly-traded company reflects the market value of the company’s future cash flows, appropriately discounted to the present, as determined by the market participants (i.e., market participants purchase company stock when they perceive that the share price of the company is undervalued, and sell when they believe it to be overvalued; overall, then, the market price in a well-functioning market represents an amalgam of all expectations). A well-functioning market and liquidity is a necessary prerequisite for the market 6.198 price of a stock to represent fair market value. By contrast, the market price of an illiquid stock does not guarantee that prices are built in a manner that incorporates a multiplicity of sources of information, coverage of analysis, and bid and ask price revelations that are present in well-functioning, efficient markets. As a market-based source of valuation, the stock price, or market capitaliza- 6.199 tion, of a company can be used to value damages. In its simplest form, one can utilize the observed market capitalization of a company just prior to an

214

See EDFI Award, para. 1301 (n. 213). Recall that in LG&E the tribunal would have granted damages for lost value if the claimants had divested their investments as EDFI did. See para. 6.131 et seq. 216 See EDFI Award, para. 1286 et seq. (n. 213). 217 See EDFI Award, para. 1301 et seq. (n. 213). 218 See EDFI Award, para. 1311 (n. 213). 219 See EDFI Award, para. 1317 (n. 213). 215

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Chapter 6: Valuation of Damages expropriatory event, for example, to provide the market’s assessment of value prior to expropriation.220 6.200 Informational efficiency is a necessary precondition. One is able to infer value

when markets are informationally efficient: this means they quasi-instantaneously interpret and incorporate new information into their assessment of company value. For instance, if a government announced that it was considering expropriating a certain company, the stock market would immediately incorporate the risk of such an expropriatory event into its assessment of the share price, and the share price would decrease to reflect this. Thus, share prices from after the first rumour of expropriation would include that assessment of expropriation risk, and would not be an indication of the market’s valuation of the company that does not include expropriation risk.221 6.201 A stock market study can also be used to determine what the growth in value of a

certain company would have been, but for certain actions that are in dispute. Take for example an alleged breach of contract that has stalled a project’s development while its industry was booming; while its peers have been reaping profits from a favorable economic climate, this company has lost an opportunity (i.e., a number of ‘good’ years) to do the same. If one is tasked with assessing the value of this company today but for the measures that caused the company to stall (and granted that legally or otherwise causality has been established), one can use a stock market study to do so.222 This is possible by establishing the relationship between the stock price of the company in question by applying an index of comparable companies that have not had to deal with the same alleged actions, but have been able to operate under normal business conditions. The basis of this methodology is the assumption that comparable publicly-traded companies, on average, grow at similar rates. One can either use a general index (there are many such indices that exist for certain industries), or one can calculate a custom index based on selected companies subject to similar market forces. 6.202 Following our example, in simplified terms, if the share price of the company in

question was US$20 just prior to the expropriatory announcement, and the index of comparable companies had grown by 60 per cent between the alleged actions and the date of valuation, then the stock market study would conclude that the company would have been valued at US$24 per share, but for the breach.

220 In such an exercise, however, it is paramount that no prior rumours or announcements of expropriation exist which would have already seeped into prices and therefore devalue the fair market value that should be clean of threats of expropriation. 221 Similarly, transactions involving impaired assets because of a similar breach should not be used for assessing but-for valuations, but could be used for actual valuations. See discussion on Occidental (n. 130) and Enron (n. 48) at paras. 6.193 et seq. 222 A stock market can also be used to assist in determining causality. See para. 6.30.

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J. Valuation of Damages a. The event study approach Another variation of the stock market analysis is 6.203 the event study method. Take, for example, a publicly-traded company whose business is allegedly affected by a breach by a contracting party. If investors trading the stock of the allegedly-damaged company are well informed and the measures are substantial, one would expect to see an effect on its stock price. On any given day, however, the stock price movement responds to multiple effects, some firm specific, but others are general market and sector events. Thus, to isolate the impact of the contract breach on the value of the affected company is a more involved task, normally called an ‘event study’. An event study utilizes tools of applied finance to assess the stock market’s reaction to an announcement (or a series of announcements) on the stock market capitalization of a company, separating it from industry and market general events. This method, furthermore, does not depend on subjective assessments about the evolution of future prices, production and costs, nor on discussions about discount rates, thus providing a market-based and objective view of damages assessments. The objective of an event study is to identify how much of the stock price movement 6.204 observed around a particular event can be attributed to the news contained in that announcement rather than to contemporaneous market-wide or industry-wide events that are unrelated to the event in question. This approach has the advantage of being powerful and easy to interpret. On the other hand, it requires that the event or events under consideration be unexpected. If the events are expected, then the efficiency of stock prices implies that their impact would already be incorporated in the price of the stock at the time the event takes place. Thus, it is important to capture early announcements to detect the full impact of the event. The fundamental principle underlying event studies is the assumption that mar- 6.205 kets behave efficiently and rationally. As news pertaining to the event in question becomes known to the public, market participants update their expectations such that the price of the company’s stock is consistent with current information available to the market as a whole. The key considerations in applying event studies to arbitration disputes have been explored by Abrantes and Dellepiane.223 A standard event study is implemented in three stages:224

6.206

• First, multiple news sources are reviewed to identify key disclosure dates when news of the allegation first reached the market.

223 Rosa M.  Abrantes-Metz and Santiago Dellepiane, ‘Using an event study methodology to compute damages in international arbitration cases’ (2011) 28(4) Journal of International Arbitration 327–42. 224 See D.I. Tabak and Dunbar, F.C., ‘Materiality and Magnitude:  Event Studies in the Courtroom’ in Roman L. Weil, Peter B. Frank, Michael J. Wagner, Litigation Services Handbook: The Role of the Financial Expert (3rd edn., John Wiley & Sons Inc 2001). See also Abrantes-Metz and Dellepiane, ‘Using an event study methodology to compute damages in international arbitration cases’ (n. 223).

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Chapter 6: Valuation of Damages • Second, a statistical (regression) model is specified to predict the return on a firm’s daily stock price as a function of the returns on a broad market index and a more focused industry index. The model is estimated using historical data from a period either prior to the allegation period (known as the ‘pre-period’), after the allegation period (known as the ‘post-period’), or using a combination of pre- and post-period data. The difference between the model’s predicted return and the firm’s actual return is called the ‘excess return’, and represents the fraction of the firm’s returns that cannot be explained by market and industry events. • Third, excess returns are computed on the key disclosure dates when news concerning the potential event reaches the market. If the cumulative excess returns across all disclosure dates is statistically significant (i.e., that it is unlikely to occur normally given the variability inherent in the relationship between firm returns and index returns), this is evidence that the disclosures taken together materially impacted the firm’s actual return on those dates. The damages are estimated by multiplying the excess return by the stock price and the total number of shares outstanding. Assuming the cumulative excess return across all disclosure dates is statistically significant, total damages are then the sum of excess returns across all disclosure dates. 6.207 In sum, the following prerequisites must be fulfilled for an event study to be

robust: (i) the event or events need to be well identified and defined in the news or public record; (ii) the event or events time(s) is (are) known to the market; (iii) the market did not anticipate the news; and (iv) the analysis tells us that the effect from that event or events can be isolated from other market, industry, and economy-wide events which may have had other influences on a company’s stock price. 6.208 As mentioned, one of the main advantages of the event study approach is its objec-

tivity and transparency as well as its reliance on publicly available data. In other words, purely with data in the public record, one should be able to undertake an analysis of what publicly-known events have or have not caused increases or decreases in the value of a company. The second advantage, and perhaps more appealing in a damages analysis setting, is the ability of an event study to disentangle effects caused by particular actions from other forces affecting markets in general. 6.209 Like any method, event studies are limited in certain ways. Financial markets must

be liquid and transparent. In undeveloped financial markets, such as those suffering from low liquidity or insider trading, the analysis will be of limited value. This warning extends to markets operating at times of distress, where normal trading patterns may be temporarily disrupted, and where a market model’s predictive power may fail. Finally, it is often acknowledged that event studies may have a downward bias on damages estimates for a corporation. There are two fundamental reasons for this. The first is the anticipation of events, meaning that in some 314

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J. Valuation of Damages cases, the market may have ‘discounted’ or at least assigned a certain probability that a particular event that is being evaluated could take place in the future. A second reason for a downward-bias in event studies is the market’s inference of the probability of recovery through the court or arbitration mechanisms. When a particular contractual or treaty breach takes place, the market capitalization should decrease only as much as the market believes the net loss to be suffered by shareholders to be, which could be less than the full value of the damage, with the difference being the expected recovery. b. Example:  Rompetrol N.V.  v.  Romania225 In a 2013 award, the tribunal in 6.210 Rompetrol N.V. v. Romania was presented with an event study aimed at identifying the losses suffered by Rompetrol due to certain actions by the Romanian government. At the heart of the application of the event study method is the determination of which dates should or should not be evaluated to capture the effects of measures undertaken by the damaging party. The claimants put forth a selection of dates to assess the impact of the measures. 6.211 The tribunal, however, found the selection of dates was arbitrary, as experts had contemplated repeated announcements (related to the same event), included events which were not part of the measures, and excluded other relevant announcements which tended to mitigate (some even completely) the impact of the alleged measures as observed in other dates. Assuming that the same event or announcement can have effects over a long period of time is problematic, since it contradicts a basic premise in financial economics that informationally efficient markets incorporate information within minutes (or less), rather than over the course of various days. In Rompetrol, the respondent’s experts asserted that including all 32 days would have rendered the damages sum statistically insignificant, with a margin of error of US$0 to 280 million. The tribunal was not persuaded to grant damages under such degree of uncertainty. This case shows that it is important, in order to understand the overall evolution 6.212 of company performance vis-à-vis the market, to confirm that the chronology is complete and that it accounts for all matters, generic or specific, which may have impacted stock price performance. The case also highlights an issue that limits the value of this methodology, with 6.213 the claimant’s expert acknowledging that ‘. . . over long periods of time, the lack of news could be regarded by the market as news in itself, with the effect, for example, of progressively correcting for discounts earlier applied in the wake of bad news’.226

225 See Th e Rompetrol Group N.V. v. Romania , ICSID Case No. ARB/06/03, Award dated 6 May 2013. 226 See Rompetrol v. Romania (n. 225).

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Chapter 6: Valuation of Damages 6.214 c. The asset or cost approach

follows:

The IVSC characterizes the cost approach as

227

In business valuation the asset-based approach may be similar to the cost approach used by Valuers of different types of assets. . . . [it] is founded on the Principle of Substitution, i.e., an asset is worth no more than it would cost to replace all of its constituent parts. 6.215 The IVSC notes that the asset approach is similar to valuation on a cost basis, but

the balance sheet is replaced by one that ‘reports all assets, tangible and intangible, and all liabilities at Market Value or some other appropriate current value’. 6.216 Methods within the asset approach include the book value and adjusted book value

(ABV) method. 6.217 iv. Book value and adjusted book value

Book value, as the name suggests, is the value of an asset or business according to the company’s balance sheets (i.e., the company’s ‘books’). As defined by the IVSC, the book value of a business is simply the difference between a company’s total assets (net of depreciation, depletion, and amortization) and its total liabilities, as they appear on its balance sheet.228 The book value of an asset is the capitalized cost of the asset less accumulated depreciation, depletion, or amortization, again as it appears on the balance sheet.229 The ABV is the book value of an asset or business that results when one or more asset or liability amounts are added, subtracted, or changed from the reported amounts on the balance sheet (hence, ‘adjusted’).230

6.218 Because the book value is based on the balance sheets, it is an accounting valua-

tion, i.e., it is a valuation based on accounting rules. For this reason, the book value of an asset or a business will frequently differ from a market valuation. Whereas the market value of a business is determined by that business’s ability to generate future cash flows for its owner, the book value of a business is based on the purchase price or a capital expenditure value on fixed assets, and is thus backward looking in nature. Additionally, accounting values are often based on rules that do not necessarily reflect economic reality, but are instead used for practical and comparative purposes, such as inventory and depreciation rules. For these reasons, book value is not always well-suited for determining the value of an on-going business, i.e., a business that is expected to generate cash flows for an indeterminate amount of time into the future. At the time of an acquisition, book values may or may not 227 See IVSC, Guidance Note No. 6—Business Valuation, Section 5.14.3.1 and IVSC, Guidance Note No. 4 Intangible Assets, Section 5.8.3.1 in International Valuation Standards (n. 158). 228 In other words, Assets – Liabilities = Book Value. Other terms for this include net book value, net worth, and shareholder’s equity. See IVSC GN6,, Guidance Note No. 6—Business Valuation/ Definitions, Section 3.3.2. in International Valuation Standards (n. 158). 229 See IVSC, Guidance Note No. 6—Business Valuation/Defi nitions, Section 3.3.1 in International Valuation Standards (n. 158). 230 See IVSC, Guidance Note No. 6—Business Valuation/Defi nitions, Section 3.1 in International Valuation Standards (n. 158).

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J. Valuation of Damages reflect the value paid for assets, depending on accounting rules, or where amounts may be recognized as goodwill, for example. While balance sheet (and in general, accounting records) information is often 6.219 appropriately used in the determination of certain components in damages determinations, the use of book value of assets to determine the value of a business may or may not be appropriate depending on the circumstances at hand. The valuation analyst must determine (and advise the courts or tribunals) as to whether the method is appropriately suited to reflect the premise of value that the analyst is seeking to estimate. Where an asset is capable of generating a net present value of future profits greater than the value of their assets on the balance sheet, that asset or company will trade in the market at values above book value (i.e., at multiples of book value greater than 1). Conversely, book values lower than 1 imply that the market value of an asset is lower than what the company has it recorded for in its books. While accounting records often provide a common measuring stick for certain 6.220 indicators such as profits, profit margins, and others, their use as indicators of fair market value is quite limited. a. Liquidation value The liquidation value of a company is the value that can 6.221 be obtained by selling the assets of the company individually on the marketplace, as opposed to operating the assets as an ongoing concern, net of outstanding liabilities and net of transactions and legal costs. There are two ways in which one can estimate the liquidation value of a company. The first is based directly from the book value of the assets, adjusted for any inflation. The limitation of this approach lies in the fact that book values are often based on acquisition cost minus depreciations which may or may not reflect the evolution of the value of those assets in the marketplace. Also, this measure, as discussed in para. 6.220, neglects the earning power of the assets. Assessing a company’s value by the liquidation value of its assets, however, ignores 6.222 the investments the company may have undertaken over its life time in developing an organization able to generate sustainable value as a going concern over and beyond its liquidation value. This is normally called ‘organization capital’, reflecting the creation and storage of knowledge in organizations, which allow for higher productivity and profits, different from its physical capital.231 The second way to estimate liquidation value is to, instead, base the value of sell- 6.223 ing the assets on their earning power (or the prices that these assets can fetch in 231 See, e.g., Andrew Atkenson and Patrick J. Kehoe, ‘Modeling and Measuring Organization Capital’ (2005) 113(5) Journal of Political Economy 1026–1053; Sandra E.  Black and Lisa M.  Lynch, ‘Measuring Organizational Capital in the New Economy’ in Carol Corrado, John Haltiwanger, and Dan Sichel (eds.), Measuring Capital in the New Economy (University of Chicago Press 2005).

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Chapter 6: Valuation of Damages the market). To do so, one would estimate the net cash flows that each asset is expected to generate, and then discount those cash flows back to the present using a risk-adjusted discount rate. In this way, this approach is similar to an income approach valuation, except that each asset is treated as a separate valuation (as opposed to valuing the business as a whole). 6.224 b. Choosing the right approach

We have discussed each of the main methods that valuation analysts consider applying in determining damages. The actual application, especially in arbitration, is always case and fact specific. The principles of compensation outlined in prior sections should inform the basis under which the valuation analyst computes damages. For example: the determination of damages due to a breach of contract involving the lack of supply of raw materials will likely involve some variation of a DCF analysis. If, however, either the actual or but-for values can be resembled by comparison to market indicators such as a recent transaction in a peer comparable or a direct competitor, the market approach may shed useful light on at least one of the scenarios, allowing the tribunal to assess the reasonableness of the parameters of the DCF model.

6.225 If a damages determination, whether treaty or contractual based, involves a signifi-

cant breach for a traded company, the stock market and/or event study methods may provide useful guidance on the size of the loss, as reflected by changes in market capitalization adjusted for other effects where necessary.

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7 INTER EST, CUR R ENCY AND EXCH ANGE R ATE FLUCTUATIONS, AND COST OF AR BITR ATION

A. Interest as Damages 1. Pre-award interest 2. Post-award interest

7.02 7.09 7.34

B. Currency of the Award and Exchange Rate Fluctuations C. Cost of Arbitration

7.42 7.49

This chapter will analyse interest, currency losses, and cost of arbitration related to 7.01 damages claims in order to make the injured party whole.

A. Interest as Damages Interest is particularly relevant in international arbitration with respect to complex 7.02 long-term contracts where significant time may elapse between the date of the contract, the investment made, the breach of contract, the award, and the actual payment of the damages. It is generally acknowledged that interest is payable in international arbitrations.1 Interest may be legal, contractual, or compensatory:

7.03

Legal interest refers to the statutory rate of interest for the delay in payments and is 7.04 found in all the rules of law analysed in this work.2 This is the minimum interest rate, which the injured party should be entitled to receive from the moment of the determination of the damages to their actual payment. This kind of interest was originally 1

Gary Born, International Commercial Arbitration (Wolters Kluwer 2009) 2502 et seq.; Jean François Poudret and Sebastién Iasso, Comparative Law of International Arbitration (Schulthess 2002) 744; Mauro Rubino-Sammartano, International Arbitration: Law and Practice (2nd edn., Kluwer Law International 2001) 811 et seq.; amongst many others. 2 See chapter 4.

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration limited due to public policy reasons to avoid usury.3 Nowadays, the award of interest for the deprivation of the use of money is universally accepted except in countries with the Sharia legal system.4 7.05 The determination of the applicable legal interest rate in international arbitration

may give rise to complications. In particular, problems arise with respect to the applicable rules of law on interest when the currency of the payment is different from the currency of the applicable law of the contract. However, legal interest does not refer to damages and, therefore, will not be further analysed. 7.06 Contractual interest rates for delayed payment are not necessarily applicable to the

payment of damages, and require a careful examination of the respective contractual provisions as well as of any limitations under mandatory law. 7.07 Interest as damages or compensatory interest, on the other hand, aims to make the

injured party whole for the time lapsed between the moment of the determination of the damages and their actual payment. The aim of interest is to compensate the injured party for the loss of the use of money.5 Therefore, interest for breach of long-term contracts arise in damages claims (i) as pre-award interest, if applicable, or (ii) as post-award interest. Interest as damages and not only delay or legal interest are admissible under the different rules of law analysed, as shown in the following: • In England, according to a study by the Law Commission, courts typically award pre-judgment interest at a rate of 8 per cent.6 The English Arbitration Act gives arbitrators the authority to award simple or compound interest at such dates and rates that it considers meet the justice of the case.7 • In the USA, the recovery of interest is subject to state or federal law depending on the matter in question. Statutory interest ranges from 6 to 15 per cent. Some federal courts award pre-judgment interest at the same rate as the post-judgment interest. Other federal courts apply state statutes or rely on the principle of reasonableness and fairness, which gives them a wide margin of discretion.8 As stated by Professor Gotanda:  ‘When federal courts approach

3 Udo Reifner, Sebastien Clerc-Renaud and Michael Knobloch, Study on Interest Rate Restrictions in the EU, final report (Institut für Finanzdienstleistungen e.V. 2009). 4 Tarek Fouad A. Riad, ‘The Issue of Interest in Middle East laws and Islamic Law’, Homayoon Arfazadeh, ‘A Practitioner’s Approach to Interest Claims under Sharia Law in International Arbitration’; both in Filip de Ly and Laurent Lévy (eds.), Interest, Auxiliary and Alternative Remedies in International Arbitration, Dossiers of the ICC Institute of World Business Law (2008) 203–9, 211–18. 5 John Y. Gotanda, ‘A Study of Interest’ in Filip de Ly and Laurent Lévy (eds.), Interest, Auxiliary and Alternative Remedies in International Arbitration 170 (n. 4). 6 The Law Commission, Pre-judgment Interest on Debts and Damages, No. 287 Law Com 21 (2004). 7 Arbitration Act 1996, c. 23 § 49 (Eng.). 8 John Y.  Gotanda, ‘Damages in Private International Law’ (2007) 326 Recueil des cours 209–12.

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A. Interest as Damages

•

•

•

•

compensatory interest issues without consulting state law, district courts exercise broad discretion in resolving claims for compensatory interest.’9 Under French law, article 1153 of the Civil Code provides for interest at the statutory rate in case of obligations restricted to the payment of a certain sum, without the creditor having to prove any loss. The statutory annual rate is 0.04 per cent in 2013.10 Such provision further establishes that in case of delays caused by bad faith, the injured party may recover additional interest as damages independent from the interest accruing on overdue payments. French law also allows the injured party to obtain interest as damages. The right to recover interest as damages follows the rule established by the Cour de cassation, which is in line with the but-for premise: ‘The nature of liability is to re-establish as exactly as possible the equilibrium that the damages destroyed and to have the aggrieved party into the same situation that would have been if the damaging event had not occurred.’11 In Mexico, according to Article 362 of the Mexican Commercial Code, the commercial interest rate is 6 per cent per annum. Compound interest is prohibited unless agreed upon in the contract. This, however, does not exclude additional interest as damages. In Germany, under §288 (2) BGB, delay interest is in the amount of 8 per cent above the applicable ‘base rate’.12 Compound interest is not admissible (§289, first sentence, BGB), however, this may be asked for as damages according to §§280 (1) and (2), and 286 BGB.13 §288 BGB states that an injured party ‘may claim higher interest on a different legal basis’. Compound interest may be claimed as damages when the injured party has paid compound interest to its bank or if the claimant would have received compound interest had he invested the principal sum claimed.14 Article 78 CISG provides: ‘If either party fails to pay the price or any other sum that is in arrears, the other party is entitled to interest on it, without prejudice to any claim for damages recoverable under Article 74.’ Article 78 is silent with respect to the interest rate but allows for interest as damages.15 According to Professor Gotanda: ‘The general principles most often applied to the issue of interest under CISG are: full compensation to the aggrieved party for the loss 9

Gotanda, ‘Damages in Private International Law’ 214 (footnotes omitted) (n. 8). accessed 25 September 2013. 11 ‘Le propre de la responsabilité civile est de replacer la victime ans la situation oú elle se serait trouvée si l’acte dommageable ne s’était pas produit’, Cour de cassation, Deuxième chambre civile, 9 July 1981, Bull civ II, p. 1561. 12 . 13 Wolfgang Fikentscher and Andreas Heinemann, Schuldrecht, 10. Aufl age (De Gruyter 2006) 473. 14 Gotanda, ‘Damages in Private International Law’ 203–4 (n. 8); Martin Hunter and Volker Triebel, ‘Awarding Interest in International Arbitration’ (1989) 6 Journal of International Arbitration 18–19. 15 Peter Schlechtriem and Ingeborg Schwenzer, Commentary on the UN Convention on the International Sale of Goods (CISG) (2nd (English) edn., Oxford University Press 2005) para. 46.06. 10

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration they have endured, reasonableness, and restitution to the aggrieved party for unjust enrichment gained by the defendant.’16 • Article 7.4.10 PICC (Interest on Damages) expressly states that interest on damages accrues from the date of non-performance. Paragraph (3)  of Article 7.4.9 (Interest for failure to pay money) establishes that the aggrieved party is entitled to additional damages if the non-payment caused it a greater harm. According to official comment 3 to that article, such additional damages have to be proved as regards the certainty of loss and foreseeability. As interest on damages is an accessory claim to the principal damages, foreseeability should not play a role, as the damages have already been considered foreseeable otherwise they would not have been awarded. Mitigation might only play a role if the company is able to reduce its cost of capital, which it would do anyway, when that is possible as it is in its own benefit. • According to article 38 of the ILC Articles on State Responsibility:17 1. Interest on any principal sum payable under this Chapter shall be payable when necessary in order to ensure full reparation. The interest rate and mode of calculation shall be set as to achieve that result; 2. Interest runs from the date when the principal sum should have been paid until the date the obligation to pay is fulfilled.

• Commentary 7 to such article notes that there is a trend of international decisions and practice towards ‘greater availability of interest and an aspect of full reparation’, which ‘depends on the circumstances of each case; in particular, on whether an award of interest is necessary in order to ensure full reparation’. 7.08 Under all rules of law analysed interest as damages or compensatory interest as

pre-judgment or pre-award interest is admissible. It may therefore be concluded that, ‘the relevant statutes typically envisage that the court may grant interest on damages for any period between the time when the cause of action arose and the judgment’,18 which should aim at full compensation. 1. Pre-award interest 7.09 The notion of interest has been developed since the fifteenth century and refers to loss,

damages, and interest as a universal concept of the doctrine of interest.19 As already observed by Mommsen, the creditor may ask for higher interest than the legal interest. In case of delay, the creditor may claim all benefits it would have had in the absence of the delay. However, interest exceeding the legal interest has to be proved.20

16

Gotanda, ‘Damages in Private International Law’ 241–2 (n. 8). Chapter 5, para. 5.178. 18 Ingeborg Schwenzer, Pascal Hachem, and Christopher Kee, Global Sales and Contract Law (Oxford University Press 2012) 693–4. 19 Christian Schieder, Interesse und Sachwert: Zur Konkurrenz zweier Grundbegriff e des Römischen Rechts (Wallstein Verlag 2011) 49. 20 Friedrich Mommsen, Beiträge zum Obligationenrecht, Dritte und letzte Abtheilung. Die Lehre von der Mora (E.U. Schwetschke und Sohn 1855) 246–7: ‘... so kann [der Gläubiger], wenn die 17

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A. Interest as Damages It is recognized by leading authors that compensation should be the primary 7.10 function of interest.21 As stated by Professor John Y. Gotanda: (i) the payment of interest furthers the principle of full compensation, because it helps restore the claimant to the position it would have had if the breach had not occurred; (ii) an award of interest prevents unjust enrichment of the respondent by requiring it to pay compensation to the claimant for the benefit that the respondent received by using the money it wrongfully withheld; and (iii) the payment of interest promotes efficiency, as it would not be necessary for the parties to take excessive measures to avoid litigation.22 Additionally, money loses value in time through inflation, which has to be compensated through interest. According to the full compensation principle, the appropriate interest rate and 7.11 interest period is the one which would place the injured party in the position it would be but for the breach at the moment of the award. As stated by leading economists and experts in international arbitration, ‘[w]hen a valuation date is chosen at a date that is far apart in time from the date of the award, the selection of the pre-judgment [interest] plays a central role in the amount of compensation. A wrong interest rate could result in a monetary award that does not fully restore the position of the damaged party in the absence of the measures’ or the absence of breach.23 In most cases, the injured party who is awarded damages has operated a business, 7.12 which has been deprived of some or all of its cash flows. Any company borrows money at any time to operate, either from the shareholders or from the bank. Money is never provided for free. This means that the injured party has a financing cost equivalent to the cost of capital of the affected business or WACC, explained in chapter 6, which has to be compensated in order to make the injured party whole. The date of damages valuation and the pre-award interest are intimately related. 7.13 In this context, the initial question under the but-for premise is ‘Which is the relevant date for the determination of damages in order to place the injured party in the position he would be in but for the breach?’ The date from which to calculate pre-award interest, and whether such interest is applicable, depends on the answer to such question. The effect of the but-for method with respect to the date from which pre-award interest accrues depends on whether the reliance interest Mora auf eine Geldschuld sich bezieht, diejenigen Vortheile in Anspruch nehmen, welche er ohne die Dazwischenkunft der Mora aus dem Gelde gezogen hätte. . . . Der Gläubiger hat aber dann den Beweis zu führen, daß die fraglichen Vortheile durch die Mora des Schuldners ihm entgangen sind.’ 21 F.A. Mann, ‘Compound Interest as an Item of Damage in International Law’ (1987–1988) 21 UC Davis School of Law Review 577 et seq.; Thierry J. Sénéchal and John Y. Gotanda, ‘Interest as Damages’ (2008–2009) 47 Columbia Journal of Transnational Law 491 et seq; Schwenzer, Hachem, and Kee, Global Sales and Contract Law 680 (n. 18). 22 Gotanda, ‘A Study of Interest’ 170–1 (n. 5). 23 Manuel A.  Abdala, ‘Key Damages Compensation Issues in Oil and Gas International Arbitration Cases’ (2009) American University International Law Review 562.

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration or the expectation interest is being sought. The following examples show what to take into consideration either in reliance or expectation interest, when awarding pre-award interest, in order to avoid additional losses to the injured party through what Abdala, López, and Spiller call the ‘invalid round trip’, 24 explained in detail in chapter 6, or unjust enrichment in form of windfall profits of the party in breach, and to achieve full compensation. As already explained in chapter 5, under- or overcompensation are avoided through the proper application of the differential hypothesis or but-for premise leading to the expectation interest. The reliance interest should be an exceptional measure of interest when the injured party was induced to make an investment through misrepresentation or bad faith, or when the applicable rules expressly provide for such interest. a. Pre-award interest under the reliance interest 7.14 As regards the reliance interest, the relevant date for the determination of damages in order to place the injured party in the position it would be in if it had not entered into the contract, is the date when it made the investment. This must be brought forward to the date of the award, at the interest rate which the economic and financial experts have determined to be adequate in the light of the injured party’s cost of capital. If interest is not recoverable from that date onwards, the injured party would incur an additional loss due to inflation, cost of opportunity, the financing cost associated with the delay and in general, the injured party would be affected by the cost of capital of the business until the date of the award and further to the date of the payment of the damages. 7.15 The right to pre-award interest as damages has been recognized in, amongst oth-

ers, the Vivendi v. Argentina cases, where the arbitral tribunal acknowledged a pre-award interest rate in the form of a ‘reasonable proxy for the return claimants could otherwise have earned on the amounts invested and lost in the Tucumán concession’.25 The arbitral tribunal applied the but-for method assuming that the claimant would have invested the money. However, the claimants asked for a 9.7 per cent interest rate, equal to the cost of capital at which cash flows were discounted in their DCF valuation analysis. The arbitral tribunal granted only 6 per cent interest, arguing that it was ‘not persuaded that claimants would have earned 9.7%’.26 Nevertheless, the arbitral tribunal when granting the pre-award interest referred to the interest earned when the money is invested but not to the cost of money of the injured party for operating a business deprived of its cash flows due to the breach, which are two different things. Another issue in this case is that

24 Manuel A. Abdala, Pablo D. López Zadicoff, and Pablo T. Spiller, ‘Invalid Round Trips in Setting Pre-Judgment Interest in International Arbitration’ (2011) 5(1) World Arbitration and Mediation Review 1–21. 25 Compañía de Aguas del Aconquija S.A. v. Argentina , ICSID Case No. ARB/97/3, award, 20 August 2007, para. 9.2.8. 26 Compañía de Aguas del Aconquija S.A. v. Argentina , paras. 9.2.7–9.2.8 (n. 25).

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A. Interest as Damages the discount rate was higher than the pre-award interest rate, which results in an invalid round trip (IRT) that leads to undercompensation as already explained in chapter 6. b. Pre-award interest under the expectation interest With respect to the expectation interest, there could be different scenarios. The 7.16 following examples will be presented for illustrative purposes only, without prejudice to the date of the award as the relevant date for the determination of damages according to the rule already presented in chapters 5 and 6 in order to avoid the IRT. i. Example A The expected income of a company is based on the business plan 7.17 of a project. The business plan started in the year 2000 and the project should be finished in 2010. The breach occurred in 2002 and the award was rendered in 2006. The relevant question with respect to the but-for method is what would be the position of the injured party but for the breach at the end of the project. Once the experts have determined the lost profits arising from the difference between the ‘but-for the breach’ situation and the actual situation, in order to answer the question two approaches could be applied:  (1)  to discount the lost profits accrued at the end of the business plan in 2010 to the date of the award in 2006 using a discount rate calculated by the economic and financial experts; or (2) to discount the lost profits accrued at the end of the project in 2010 to the date of the breach in 2002 and to bring them forward to the date of the award in 2006 using the same interest rate used as the discount rate. ii. Example B In the next example, the business plan starts in year 2000 and 7.18 ends in year 2005. The breach was in the year 2002 and the award was rendered in 2005, the same year when the business plan ends. Under the but-for method, in the absence of breach, the injured party would have received its share of the income in 2005 and there would be no need to discount the damages. If the award is rendered in 2005, and the business plan terminates in 2005, and 7.19 the reality corresponds to the business plan or even exceeds it, there is no need to discount the cash flows of the business plan back to the date of the breach and to discuss risks that did not verify. In this case, calculating damages at the moment of breach and not updating them to the date of the award leads to ‘double counting of risk’. This results in discounting cash flows in excess and, therefore, in undercompensation. In the automotive joint venture case, the arbitral tribunal discounted the lost profits 7.20 accrued from 2010 to 2005 (date of the breach) at a rate of 13 per cent, in spite of the date of the award and the end of the business plan, being 2010, and did not award pre-award interest from the date of the breach to the date of the award in 2010. This is an extreme example of an IRT, which merits several comments: (1) the date of the calculation of damages should have been 2010, which is the termination date of the 325

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration business plan and the date of the award; (2) if the date of the award and the date of the end of the business plan is the same, there is no need of a discount rate; (3) by applying a discount rate of 13 per cent the arbitral tribunal was taking into consideration risks alleged by the respondent that did not verify; on the contrary, public information presented by the claimant showed that the sales of the car models using the automotive parts in question exceeded the numbers projected in the business plan; (4) applying a 13 per cent discount rate and not awarding any pre-judgment interest (PJI) resulted in a magnifying discounting effect that seriously reduced the remaining amount of damages. This is not in accordance with the full compensation principle and the but-for method, as it resulted in undercompensation for the injured party and windfall profits for the respondent. These situations severely affect the efficiency of transactions and provoke opportunistic behaviour. 7.21 Pre-award interests were denied based on an academic article written in 1993, which

argued that there was not enough evidence that pre-award interests were granted.27 Nowadays, pre-award interest as damages are increasingly recognized, as shown throughout this book. On the other hand, pre-award interest is a matter of full compensation, which can only be achieved, as explained in chapter 6, by assessing damages at the date of the award and if not, by expressing the damages from the date of the breach to the date of the award at the same rate used to discount the future cash flows of the project. It was stated in the award in the automotive joint venture case that pre-award interest only applies for the delay in payment, which shows confusion with the legal interest. The determination of pre-award interest for the breach of complex long-term contracts is an integral part of the damages analysis as this aims at recognizing the time value of money and the financing cost of the injured party equivalent to the cost of capital (WACC) as explained in chapter 6. Apart from that, the arbitral tribunal stated that there was nothing in the joint venture agreement that ruled pre-award interest or compensatory interest, which shows that some arbitral tribunals confuse pre-award interest with contractual interest and sometimes have difficulties in understanding that pre-award interest is necessary to make the injured party whole, as stated by Professor Gotanda and mentioned earlier, in para. 7.10. 7.22 iii. Example C

The third example is based on a business plan covering the period from 2000 to 2005. The breach occurred in 2002 and the award was rendered in 2007. According to the business plan, the injured party would have received its share of the revenues under the business plan in 2005. Therefore, the amount due under the but-for method corresponding to the damages in 2005 should be updated to the moment of the award in 2007, at the proper pre-award interest rate calculated by the economic and financial experts. 27 Pierre Karrer, ‘Transnational Law of Interest in International Arbitration’ in Emmanuel Gaillard (ed.), Transnational Rules in International Commercial Arbitration, ICC Publication No. 480 (1993) 223–31, at 230: ‘[T]here is little evidence in arbitral practice of a transnational rule according to which interest should be awarded from an early date onward, namely the date when the damage occurred, to the date of payment.’

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A. Interest as Damages In the following cases the arbitral tribunal only granted interest on the basis of 7.23 commercial interest rates and in some cases denied the cost of equity or capital (WACC) as it confused this concept with the rate of return of an investment or because the claimant did not ask for the but-for interest rate in form of the cost of capital: In Sempra Energy v. Argentina, the arbitral tribunal awarded interest as from the 7.24 date of the determination of the damages on 1 January 2002 until the date of the award at the successive 6-month LIBOR rates, plus a 2 per cent annualized premium or portion thereof compounded semi-annually.28 In National Grid v. Argentina,29 the claimants asked for:

7.25

. . . compensation for the lack of use of the money owed to Claimant from August 18, 2004 to the date of payment by the Respondent, the above amount should be augmented by a factor representing the time value of money. According to Claimant, the appropriate rate should reflect the historical return on equity which the Claimant has demonstrated that it could have earned if it had invested the above amount in its own business. Claimant seeks to demonstrate that the Claimant’s rate of return on equity (as confirmed by U.K. regulators) is 10.9 per cent per annum.30

However, the arbitral tribunal only awarded the average six-month dollar LIBOR rate from 2002, which was 1.8 per cent, to the date of the award compounded semi-annually. In EDF v. Argentina,31 the claimants contended that ‘the applicable interest rate 7.26 should be the WACC because this rate is equivalent to Claimant’s opportunity cost for their invested amount during their operation of the concession’. Th is refers to the period from 2001 to 2005 before the sale of EDESMA.32 Apart from that, the claimants noted that ‘from an economic standpoint compound interest is necessary to compensate Claimants fully’.33 However, in this case, the arbitral tribunal, did not find the WACC rate ‘appropriate in this context. No evidence has been presented that claimants could or would have earned the high-risk WACC rate.’34 This shows that the arbitral tribunal confused the WACC, which is the cost of capital of a company, with the rate of return of an investment. In Siemens AG v. Argentina,35 the arbitral tribunal stated that,

7.27

28 Sempra Energy International v. Argentine Republic, ICSID Case No. ARB/02/16, 28 September 2007, paras. 485–6. 29 National Grid Plc v. Argentine Republic, award, 3 November 2008 under the UNCITRAL Rules. 30 National Grid v. Argentina , para. 265 (n. 29). 31 EDF International S.A., SAUR International S.A.  and Leon Participaciones Argentinas S.A. v. Argentine Republic, ICSID Case No. ARB/03/23. 32 EDF v. Argentina , para. 1329 (n. 31). 33 EDF v. Argentina , para. 1332 (n. 31). 34 EDF v. Argentina , para. 1336 (n. 31). 35 Siemens AG v.  Argentina , award ICSID Case No. ARB/02/8, IIC (2007) .

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration in determining the applicable interest rate, the guiding principle is to ensure ‘full reparation for the injury suffered as a result of the internationally wrongful act.’ The Tribunal considers that the rate of interest to be taken into account is not the rate associated with corporate borrowing but the interest rate that the injured party would have earned on the compensation amount had it been paid after the expropriation. Since the awarded compensation is in dollars, the Tribunal considers that the average rate of interest applicable to US six-month certificates of deposit is an appropriate rate of interest. The average of such rate from May 18, 2001 to September 30, 2006, is 2.66%.36

The tribunal continued: As regards compounding of interest, the question is not as argued by Argentina, whether Siemens had paid compound interest on borrowed funds during the relevant period but whether, had compensation been paid following the expropriation, Siemens would have earned interest on interest paid on the amount of compensation. It is in this sense that tribunals have ruled that compound interest is a closer measure of the actual value lost by an investor.37 7.28 Though the arbitral tribunal awarded reliance interest in spite of its recognition of

the income being speculative and the claimants sought for double counting, this case is interesting as it shows the reasoning of the arbitral tribunal when awarding pre-award interest. The arbitral tribunal refers to the hypothetical situation of the claimant investing the amount awarded at a commercial interest rate. This case shows that pre-award interest rates are misunderstood with commercial rates, when in fact the pre-award interest should correspond to the cost of equity or capital (WACC) of the injured party as explained in chapter 6. 7.29 In Occidental v. Ecuador,38 the claimants asked for a simple interest rate in order

to update the damages determined at the moment of the breach to their actual payment in the amount of the monthly rate paid on U.S. government T-bills compounded on a monthly basis, which at the date of the filing was 4.188 per cent and would reflect a prudent, risk-free and conservative re-investment practice.39 The tribunal cited the Chorzów principle in favour of compound interest as this ‘will usually reflect the actual damages suffered’,40 and awarded interest at the rate of 4.188 per cent, however, compounded on a semi-annual basis. According to the arbitral tribunal: . . . granting monthly compounding would be unduly favourable to the Claimants in view of recent trends in investment arbitration. It may be argued that, given this decision, semi-annual compounding would be appropriate as the interest adopted

36

Siemens v. Argentina, para. 396 (n. 35). Siemens v. Argentina, para. 399 (n. 35). 38 Occidental Petroleum Corporation, Occidental Exploration and Production Company v.  Th e Republic of Ecuador (Occidental v. Ecuador II), ICSID Case No. ARB/06/11, award, 5 October 2012, . 39 Occidental v. Ecuador, paras. 828, 830, 842 (n. 38). 40 Occidental v. Ecuador, para. 832 (n. 38). 37

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A. Interest as Damages by the Tribunal is not high. However, not without hesitation, the Tribunal has decided, in its discretion, that annual compounding is appropriate, given the large amount of the Award and the number of years that have passed since the violation.41

The only case where damages are valuated at the date of the award is ADC 7.30 v. Hungary. This is a leading investment arbitration case that followed the Chorzów formula precisely. The total breach of contract was considered an illegal expropriation under the respective bilateral investment treaty, and therefore under the Chorzów formula the higher FMV, which was at the date of the award, was granted. The arbitral tribunal stated that ‘[s]ince the calculation is based on the value of the expropriated investments as of the date of the award, no pre-award interest has accrued’.42 The determination of interest as damages forms part of the overall damages calcu- 7.31 lation and should be taken into consideration when making the damages assessment and not as a separate issue. In commercial arbitration, the but-for premise aims to place the injured party economically speaking in the same position but for the breach, which means full compensation. The best way to achieve this is to take the date of the award as the relevant date as it is the date where the injured party is actually awarded the damages. By calculating the damages at the moment of the award, conflicts regarding the determination of the pre-award interest rate are avoided. The use of the date of the breach as the relevant date for the calculation of damages imposes additional and unnecessary difficulties when calculating damages, while the result may be achieved fairly straightforward by directing the calculation to the likely date of the award. However if the date of the breach is chosen, pre-award interest corresponding to the cost of capital of the injured party should be awarded until the date of the award. If future cash flows are discounted to the date of the breach, the same discount rate should be used to update them to the date of the award in order to avoid undercompensation. In investment arbitration the higher of the FMV between the date of the breach 7.32 and the date of the award is granted. If the higher FMV corresponds to the date of the breach, it must be updated to the date of the award at the proper pre-award interest determined by the experts, which as explained in chapter 6 should normally correspond to the cost of capital of the injured party. On the other hand, the question is not whether interest is awarded as simple or com- 7.33 pound or compounded on a monthly or quarterly basis, but whether they comply with fundamental principles of justice and fairness, that is to provide full compensation and avoid windfall profits to either party.

41

Occidental v. Ecuador, para. 845 (n. 38). ADC Affiliate Ltd and ADC & ADMC Management Ltd v. The Republic of Hungary, ICSID Case No. ARB/03/16, 98, para. 520; see chapter 5, para. 5.120. 42

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration 2. Post-award interest 7.34 Under Roman law, post-judgment interest was at a rate of 12 per cent. However, as

observed by Friedrich Karl von Savigny, the economic effect of the delay is not interrupted by the judgment, and, therefore, the interest rate applied to the delay should be the same before and after the judgment.43 Post-award interest is considered interest governed by procedural rules under many rules of law. In international arbitration, local rules of procedure are not applied but substituted by the rules of arbitration. 7.35 In the USA, 28 U.S.C.A. §1961 governs the recovery of interest in civil litigation

in federal courts. The rate used to calculate post-judgment interest is the weekly average 1-year constant maturity Treasury yield, as published by the Board of Governors of the Federal Reserve System, for the calendar week preceding the date of the judgment. Under German law, post-judgment interest is in the same level as delay interest (§291 BGB). In France the post-judgment interest rate is 5 per cent higher than the normal rate, which was 5.04 per cent in 2013. 7.36 In Amco Asia v. Indonesia, ‘interest thus awarded for the period elapsed between

the said date and the date of payment of the sum awarded, should be considered as part of the compensation granted to Claimants, in order for the same to come as close as possible to the full compensation prescribed by international law’.44 This practice can also be seen in Asian Agricultural Products v. Sri Lanka,45 Fedax v. Venezuela,46 Antoine Goetz v. Burundi,47 Técnicas Medioambientales v. Mexico,48 Autopista Concesionada v. Venezuela,49 MTD v. Chile,50 CSOB v. Slovak Republic,51 S.D. Myers v. Canada,52 and CME v. Czech Republic.53 7.37 As noted in Occidental v. Ecuador :

. . . the Claimants did not specifically distinguish between pre-award and post-award interest requesting that interest be awarded on the basis proposed by the claimants up to the date of full and effective payment. It is not uncommon for tribunals to 43 L. 1 §. 2 D. de usuris (22. 1). L. 13 C. eodem (4. 32). L. 2. 3 C. de usuris rei jud. (7. 54), cited in Friedrich Mommsen, Die Lehre von der Mora 247 (n. 20). 44 Amco Asia Corp. v. Indonesia (Amco I), award, 20 November 1984 (1993) 1 ICSID Reports 413, para. 281. 45 Asian Agricultural Products v. Sri Lanka , award, 27 June 1990 (1997) 4 ICSID Reports 4 246, para. 115. 46 Fedax NV v. Venezuela , award, 9 March 1998 (1998) 37 ILM 1391, para 33. 47 Antoine Goetz et al. v. Burundi, award, 10 February 1999 (2000) 15 ICSID Review 457, 517. 48 Técnicas Medioambientales SA v. Mexico, award, 29 May 2003 (2004) 19 ICSID Review 158, para. 197. 49 Autopista Concesionada de Venezuela v. Venezuela , award, 23 September 2003. 50 MTD Equity v. et al. v. Chile, 24 May 2004 (2005) 44 ILM 91, para. 250. 51 Ceskoslovenska Obchodni Banka, a s (CSOB) v. Slovak Republic, award, 29 December 2004, , para. 352. 52 S.D. Myers v. Canada, second partial award, 21 October 2002, para. 306. 53 CME Czech Republic BV v. Czech Republic, final award on damages, 14 March 2003 (2005) 8 ICSID Reports 246, para. 641.

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A. Interest as Damages distinguish between pre- and post-award interest and in the present case it seems appropriate to do so, given the current LIBOR interest rates, used as a base rate by banks and other financial institutions, are very low; but, of course, the rates will fluctuate before the Award is settled. In the circumstances, and since the Tribunal cannot predict when the Respondent will settle the sums which it has been ordered to pay to the Claimants, the Tribunal considers that it would be fair to order that post-award interest should accrue in favour of the Claimants at the U.S. 6 month LIBOR rate compounded on a monthly basis.54

In Phillips Conoco v. PDVSA, the arbitral tribunal awarded the same post-award 7.38 interest as the pre-award interest, which was 10.55 per cent, however post-award was compounded on a quarterly basis.55 In Sempra Energy v. Argentina, the arbitral tribunal did not award post-award interest, arguing that such interest was not expressly requested.56 However, according to the dissenting opinion of Marc Lalonde, the claimant had the right to post-award interest because the pre-award interest was made for the purpose of the actualization of damages to the date of the award, but ‘the petitium itself did not mention a time-limit for the award of interest, this matter being implicitly left to the discretion of the tribunal’. The dissenting arbitrator stated that ‘interest should run until full payment of the compensation awarded’: Acting otherwise, . . . , is ignoring the basic characteristic of interest which is the recognition of the time value of money and of the lost opportunity to earn a reasonable rate of return. In addition, it is giving a strong incentive to the party at fault, to delay indefinitely and with impunity the payment of the sums due. The arbitral system should not encourage that kind of behaviour.57

This argument is in accordance with the but-for formula and the Chorzów prin- 7.39 ciple, which is that in order to fully compensate a claimant for the loss of use of money, a tribunal should grant interest until the date of the full payment of compensation. Different rates may be used to calculate post-award interest and pre-award inter- 7.40 est. In several cases post-award rates are higher as compared to pre-award interest granted in the same cases. In Metalclad v. Mexico58 the frequency of compound interest was changed from annual for pre-award interest to monthly for post-award interest. The same happened in Maff ezini v. Spain.59 In Occidental v. Ecuador,60 the interest rate increased from 4.188 per cent per annum compounded annually from 16 May 2006 to the date of the award, to post-award interest at the U.S. 6 per cent 54

Occidental v. Ecuador, para. 849 (n. 38). Phillips Petroleum Company Venezuela Limited, ConocoPhillips Petrozuata B.V. v. Petroleos de Venezuela, S.A., ICC Case 16848/JRF/CA, 17 September 2012, p. 101. 56 Sempra v. Argentina , para. 485 (n. 28). 57 Sempra v. Argentina , partial dissenting opinion of The Hon Marc Lalonde, 18 December 2007 (n. 28). 58 Metalclad Corporation v. Th e United Mexican States, ICSID Case No. ARB(AF)/97/1. 59 Maff ezini v. Spain , ICSID Case ARB/97/7, award, 13 November 2000, para. 96. 60 Occidental v. Ecuador, para. 326 (n. 38). 55

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration month LIBOR rate compounded on a monthly basis. In CMS v. Argentina simple pre-award interest and compound post-award interest were ordered.61 In ADC v. Hungary the arbitral tribunal applied post-award interest at the rate of 6 per cent per annum compounded at monthly rests until payment.62 7.41 The point is not the distinction between simple and compound interest, but whether

the interest awarded makes the injured party whole. In accordance with the full compensation principle and but-for premise, in order to place the injured party in the position it would be at the moment of the actual payment, the post-award interest should be the same as the pre-award interest or the rate used to discount future cash flows to the date of the award. The reason for the increase in post-award interest is to make the respondent pay promptly by adding a preventive and even a punitive element.63

B. Currency of the Award and Exchange Rate Fluctuations 7.42 The award will only place the injured party in the situation it would be in but for

the breach or the illegal measure if made in the currency which most closely reflects the claimant’s loss. According to this premise, the most suitable currency is the currency in which the investment has been made. 7.43 With respect to international law, according to Professor Georg Schwarzenberger,

standards of reasonableness and good faith apply with regards to the currency of compensation, as there are no specific rules.64 According to international law, awards have to be expressed in freely convertible, transferable currencies. This means that the currency must be in a form usable by the injured party.65 Sometimes the investment is made in different currencies and that may require different parts of compensation to be awarded in different currencies.66 The key issue is that the currency has to be convertible because this facilitates the computation of the damages. Discount rates may be difficult to compute in unstable currencies. 7.44 In The Folias, the court stated that damages should be determined and awarded in

the currency that truly expresses the loss of the injured party. In order to identify the relevant currency, the court must ask what is the currency which compensates

61

CMS v. Argentina, ICSID Case ARB/01/8, final award, 12 May 2005, para. 471. ADC v. Hungary, para. 521 (n. 42). 63 Irmgard Marboe, Calculation of Compensation and Damages in International Investment Law (Oxford University Press 2009) 378, para. 6.246; Sergey Ripinsky with Kevin Williams, Damages in International Investment Law (British Institute of International and Comparative Law 2008) 389. 64 Georg Schwarzenberger, International Law as Applied by International Courts and Tribunals vol. 1 (3rd edn., Stevens & Sons Ltd 1957) 681. 65 Ripinsky with Williams, Damages in International Investment Law 395 (n. 63). 66 Biloune v. Ghana , award, 30 June 1990, 95 ILR 211, 229. 62

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B. Currency of the Award and Exchange Rate Fluctuations the injured party in accordance with the principle of restitution.67 In other words, compensation should be awarded in the currency that would place the injured party in the situation it would have been but for the breach. If the currency in which the damages are determined depreciates prior to the 7.45 award, the tribunal has to decide which party bears the adverse effects of such devaluation. The United Nations Compensation Commission states that the aim of a judgment is to restore an injured party to the position in which it would be in had the injury not occurred. This means, in the context of currency conversions, that such conversions have to be made at a rate ‘to make the injured party whole and avoid a windfall to the wrongdoer’.68 International tribunals have generally ruled that the respondent has to take the risk 7.46 of currency depreciation between the date of the loss and the date of the award. This is confirmed in the Lighthouse arbitration in 1957, where the arbitral tribunal found that ‘the injured [party] has the right to receive the equivalent at the date of the award of the loss suffered as a result of an illegal act and ought not to be prejudiced by the effects of the devaluation which took place between the date at which the wrongful act occurred and the determinations of the amounts of compensation’.69 According to the Chorzów formula and the corresponding provisions of German 7.47 law referring to the hypothetical normal course of events, extraordinary circumstances between the moment of the breach and the date of the award negatively affecting the injured party are not to be taken into consideration.70 This means that the negative effect of the devaluation should not be imposed upon the injured party. On the other hand, in commercial arbitration and under the but-for premise the aim is to place the injured party in the position it would be in but for the breach. In this sense, the devaluation should be taken into consideration if it takes place after the breach but before the end of the project and only for the time that it affected the cash flows. If the project ended before the award and the devaluation took place between the end of the project and the award, the devaluation should not be considered for the damages compensation. In the investment arbitration Siemens v. Argentina, the arbitral tribunal acknowl- 7.48 edged that the currency risk should be born by the party in breach and stated: Argentina has argued that the Contract is denominated in pesos and that it had not guaranteed to Siemens the parity of the peso in effect at the time it entered 67 Charles Proctor, ‘Changes in Monetary Values and the Assessment of Damages’ in Djakhongir Saidov and Ralph Cunnington (eds.), Contract Damages, Domestic and International Perspectives (Hart Publishing 2008) 476. 68 Ripinsky with Williams, Damages in International Investment Law 396, with further references (n. 63). 69 Ripinsky with Williams, Damages in International Investment Law 396 (n. 63). 70 Chapter 4, para. 4.297; chapter 5, paras. 5.198–5.199.

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Chapter 7: Interest, Currency and Exchange Rate Fluctuations, and Cost of Arbitration into the Contract. This assertion is correct but it has to be considered in the context of the requirement that the consequences of the illegal act be wiped out. It would be hardly so if the parity of the currency would be added as yet another risk to be taken by the investor after it has been expropriated. In the instant case, the Claimant has pleaded that the Tribunal accept May 18, 2001 as the date of expropriation. . . . On May 18, 2001, the peso was at par with the dollar. If such obligation would have been met, the Claimant would have been compensated in pesos convertible at that rate. Therefore, the Tribunal concludes that compensation shall be paid in dollars.71

C. Cost of Arbitration 7.49 In most institutional rules of arbitration, the award on cost is at the discretion of

the arbitral tribunal. There is a tendency in commercial arbitration towards the principle that the successful party should have its costs paid by the unsuccessful party. The same tendency can also be seen in investment arbitrations.72 7.50 The following paragraphs are limited to the question whether the cost of arbitra-

tion may be considered damages, and, if applicable, how they should be assigned to the parties. As the arbitral tribunal stated in ADC v. Hungary: In the present case, the Tribunal can find no reason to depart from the starting point that the successful party should receive reimbursement from the unsuccessful party. This was a complex, difficult, important and lengthy arbitration which clearly justified experienced and expert legal representation as well as the engagement of top quality experts on quantum. The Tribunal is not surprised at the total of the cost incurred by the Claimants. Members of the Tribunal have considerable experience of substantial ICSID cases as well as commercial cases and the amount expended is certainly within the expected range. Were the Claimants not to be reimbursed their costs in justifying what they alleged to be egregious conduct on the part of Hungary it could not be said they were being made whole.73 7.51 According to Professor Peter Schlechtriem, cost of arbitration may be claimed as

part of the damages. In such a case, only the reasonable and necessary cost may be recovered due to the obligation of mitigation.74 The cost of arbitration would not have occurred if the other party had performed the contract. Therefore, under the but-for premise, the recoverable costs should be considered as damages suffered due

71

Siemens v. Argentina, para 361 (n. 35). Bernard Hanotiau, ‘The Parties’ Costs of Arbitration’ in Yves Derains and Richard H. Kreindler (eds.), Evaluation of Damages in International Arbitration, Dossiers (ICC Institute of World Business Law 2006) 213–24; M. Weiniger and M. Page, ‘Treaty Arbitration and Investment Disputes: Adding up the Costs’ (2006) 44 Global Arbitration Review. 73 ADC v. Hungary, para. 533 (n. 42). 74 Peter Schlechtriem, ‘Attorneys’ Fees as Part of Recoverable Damages’ (2002) 14 Pace International Law Review 208. 72

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C. Cost of Arbitration to the breach of contract,75 subject to proof. The principle in international arbitration acquiring importance is that ‘costs should follow the event’, which originally derives from English law. The emerging trend is to order the losing party to pay for both the procedural and the legal cost of the other party.76 The principle that the costs should follow the event is established in the rules of arbitration of UNCITRAL and of the Stockholm Chamber of Commerce and is in accordance with the full compensation principle.

75 José Rosell, ‘Arbitration Costs as Relief and/or Damages’ (2011) 28 Journal of International Arbitration 2. 76 Mauro Rubino-Sammartano, ‘Costs Awards in Arbitration’ (2011) 28 Journal of International Arbitration 113–14.

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8 CONCLUSIONS

The function of compensation in damages law where the aggrieved party is entitled 8.01 to recover all losses incurred due to the breach of contract is undisputed amongst legal systems, and leads to the full compensation principle. Damages law aims to provide legal certainty of the protection of the legitimate expectation of the injured party to obtain what it was promised. There are different levels of protection of the underlying interest under the different rules of law, such as the protection of the economic benefit or of the underlying performance. However, the relevant issue is that by not protecting the legitimate expectations of the parties or by not honouring the principle of full compensation, economies are harmed. When one of the parties obtains any benefit by breaching the contract at the expense of the other party, the effect is not only that one of the parties will be unjustly enriched by the injury caused to the other, but also that this leads to legal uncertainty and, therefore, an increase in transaction costs. Protection to the private property, including contractual rights through the rule of law provides legal certainty, which in turn promotes investment and welfare. Damages law plays a major role in this context. If, for example, damages are not 8.02 properly awarded leading to less than full compensation, the risk increases with the corresponding higher financing costs. The higher the risk, the higher the price. This leads to waste of resources, and this is called inefficiency. On the other hand, any legal system which is not perceived to be fair is considered illegitimate and, therefore, is vulnerable. The adequate and fair compensation of damages is a fundamental element of 8.03 any legal system, where damages law has an important economic and social role. Damages law is an important tool to achieve equilibrium in contractual relationships and avoid opportunistic behaviour in order to provide legal certainty and predictability in contractual relationships. This results in an efficient economy. The fundamental principle in damages law is full compensation of the actual loss 8.04 caused by the breach or illegal measure. The actual loss may vary according to normative requirements under the different applicable rules of law, however, it is 337

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Chapter 8: Conclusions generally recognized that avoiding over- and undercompensation is fundamental for the stability of any legal and economic system. 8.05 In order to arrive at the proper compensation of damages in complex long-term

contracts, it is important to understand their structure. Complex long-term contracts may be typical synallagmatic contracts such as long-term sales and construction agreements, or atypical synallagmatic contracts, referred to in this work as complex long-term contracts based on income stream, such as joint venture agreements, public-private partnerships, build-operate transfer concessions and similar agreements. The similarity between complex typical synallagmatic and complex long-term contracts based on income stream (atypical synallagmatic contracts) is that in both the purpose is the generation of income or profits coming from a third party or the market. The difference is that in typical synallagmatic contracts, the profits derive from collateral transactions, while in atypical complex long-term contracts based on income stream, the income stream or profits arising from a third party are expressly regulated under the contract. In typical synallagmatic contracts the essential legal elements are, on one hand, the delivery of goods or services and, on the other, the payment of the price. In complex long-term contracts based on income stream the essential legal elements are the assets of any kind that the parties contribute, on one side, and the income coming from a third party, which is the market, on the other.1 This is relevant for the determination of loss, foreseeability, and mitigation. 8.06 The analysis of different rules of law on damages is necessary in order to analyse,

frame, and award damages properly. The different rules of law examined in this book provide different solutions, which provide for the determination of damages related to sales transactions and commodities trade, but not for the particularities of damages under complex long-term contracts, especially with respect to lost profits arising therefrom. 8.07 However, even if they do not specifically refer to complex long-term contract situa-

tions, each of the rules of law examined presents useful tools that can be applied when analysing, assessing and awarding damages under complex long-term contracts: 8.08 The differential hypothesis or but-for method, for example, was originally devel-

oped by Professor Mommsen in Germany in 1855. Nowadays, Germany applies the hypothetical normal course of events under the but-for method, which means not considering extraordinary circumstances negatively affecting the injured party in its but-for situation. There is considerable experience with the application of the but-for premise under UK and US law of damages, where this method is applied in its original form and extraordinary events are taken into consideration and may

1 Scott L. Hoff man, The Law and Business of International Project Finance (3rd edn., Cambridge University Press 2008) §18.01, §18.02.

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Conclusions lead to intervening or concurring causality for the respective period of time and income stream. The severity and temporality of extraordinary events have to be determined by the experts. Additionally, UK and US courts frequently hear damages claims resulting from breach of complex long-term contracts, and provide case law using the but-for premise. On the other hand, the US notion of reasonable certainty of loss has been adopted by the PICC and is frequently used in international arbitrations. Germany has developed the theory of the protective effect of the norm (Schutzzweck 8.09 der Norm), which best explains the relationship between risk allocation, foreseeability, and breach of complex long-term contracts. The French notion of cost of cure provides the highest protection of the interest of 8.10 the injured party equivalent to specific performance. Cost of cure does not apply to income expectations under complex long-term contracts or payment obligations under take-or-pay agreements. This measure only applies to the party that receives a non-conforming good or service that can be cured or replaced. The PICC provide modern notions of risk allocation techniques and their effect on 8.11 breach of contract and damages, which are particularly relevant with respect to the determination of liability when awarding damages. Rules of private law influence international law and the practice of investment arbi- 8.12 tration tribunals. This can be clearly seen in the Chorzów formula, which is based, on one hand, on the Mommsen differential hypothesis when it states that damages must wipe out all the consequences of the illegal act and, on the other hand, seems to be influenced by the German law hypothetical normal course of events as reflected in the particular measure of damages consisting in the higher fair market value (FMV) as of the date of the breach and the date of the award plus any lost profits between the date of the breach and the date of the award if the latter is chosen, which means not taking into consideration negative extraordinary circumstances affecting the injured party, as explained in chapter 5. Transnational law such as CISG and the PICC are often referred to in investment arbitration awards in order to fill in gaps in international law such as, for example, with respect to causality or foreseeability. Private rules of law turn into public international customary rules when complying with the requirements of opinio juris sive necessitatis and the corresponding state practice, or may be considered to be general principles of law. The principal function of damages law is the compensation of the loss caused 8.13 by a breach of contract or an illegal act affecting a complex long-term contract. The payment of an amount of money which would place the injured party in the financial position it would be in had the damaging act not occurred, that is to wipe out all the consequences of the measure, leads to full compensation, which is the general principle of damages law applied both in commercial and investment arbitration. 339

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Chapter 8: Conclusions 8.14 The starting point in a damages claim is to establish the breach, which may

lead to considerable difficulty in case of exemption and justification clauses or re-negotiations. In case there is no obligation to renegotiate, a hypothetical renegotiation scenario cannot be used as a substitute for the but-for scenario, as this would imply the denial of the underlying contractual obligations. For the purpose of damages analysis, what matters is whether there was a breach or not and not whether the breach could have been eliminated or cured by renegotiation, justification, or exemption clauses. 8.15 Once the breach has been established, the but-for premise has an essential role when

analysing, framing, and quantifying a damages claim and is particularly adequate for the assessment of lost profits arising from the breach of complex long-term contracts. It is recognized as a legal principle as well as a measure of damages in order to achieve full compensation. It also provides the analytical framework in order to determine loss and causality, and is the method used to obtain the economic difference between the but-for and actual situations of the injured party, which is the quantum. 8.16 In international arbitration, full compensation is for the loss suffered or the actual

loss, which is the loss caused by the breach, after the applicable limitations and proved with reasonable certainty. This means that full compensation is achieved by placing the injured party in the situation it would be in but for the breach, which corresponds to the but-for principle. 8.17 The but-for premise is the framework for determining loss and causality. In complex

long-term contracts, where the purpose is the generation of income, the loss is the effect of the breach on the income stream; there may only be loss if there is a reasonable certainty of income stream; if the loss would occur for other reasons than the breach of the contract or the measure, there would be no causality. Another issue is concurring or interrupting causality where the loss would also have occurred due to an ex-post event with the same effect after the breach, such as a war or economic crisis affecting a business or investment. Concurring and interrupting causality may bar the damages claim. Such extraordinary events, however, are not to be taken into consideration under the German law notion of the hypothetical normal course of events. Different rules of law with respect to causality may, therefore, have a significant impact on the damages claim. 8.18 The but-for method is the most adequate tool for determining lost profits. It starts

by establishing the hypothetical economic performance of the contract absent the breach, and its actual situation due to the breach, where it seeks to determine in money terms the difference between these two situations. Such difference is precisely the expectation interest. This is what Mommsen had in mind when he refers to the difference in balance or assets of the injured party. In case of lost income stream arising as a consequence of the breach of a complex long-term contract, the effect 340

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Conclusions of the breach or international tort on the income stream is the loss that equals the expectation interest. The lost profits or lost income stream are only lucrum cessans. Therefore, the measure of damages of damnum emergens and lucrum cessans cannot be applied together in its original form. In arbitral practice, for the purpose of the calculation of damages, damnum emergens has been considered as historical lost profits and lucrum cessans as future lost profits, in order to avoid double counting. Loss and expectation interest are two different sides of the same coin in a case of 8.19 lost profits, where causality is the determining factor. Expectation interest depends on the income stream or profits that can be proved with reasonable certainty. Discrepancies between the amount sought and the evidence available undermine certainty and weaken the claim. The difference between the but-for and the actual scenarios corresponds to the lost profits and the expectation interest that could have been obtained but for the breach, where the injured party may or may not recover its investment and may or may not obtain a profit margin, as that depends on the outcome of the business in the absence of the breach. This leads to two main issues to be examined when dealing with lost profits arising 8.20 from the breach of complex long-term contracts: (1) the reasonable certainty of income, and (2) the effect of the breach on the income stream. Both the determination of the reasonable certainty of income and the analysis of the effect of the breach on the income stream require the economic and financial experts to prepare financial models based on assumptions that have to correspond to the economic background. The reasonable certainty of income is obtained through the reconstruction of the hypothetical course of events including the analysis of contingencies using statistics and econometric methods. Certainty of income stream should not be confused with the foreseeability of the loss. Whereas the first depends on the evidence available, the second is a matter of the scope of protection of the contract. Lost profits based on contingencies should not be considered loss of a chance as they arise out of a contractual framework and do not involve alea or a game of a chance. Future lost profits are always a matter of probabilities and estimation and should not be confused with loss of a chance. Damages should only be awarded if the injured party can prove with reasonable 8.21 certainty that there would be income or profits but for the breach. This means that the claimant should not recover investments it would not have recovered even without the breach, as there would not be causality. Therefore reliance interest should only be considered in case of misleading behaviour or bad faith on the respondent’s side. However this interest is specifically recognized, inter alia, in the UK and the USA and is used when the arbitral tribunal is not sure that there is reasonable certainty of income. For example, under UK law once the injured party has shown the possibility of profits or income without reaching the evidentiary threshold for the expectation interest required by the arbitral tribunal, the respondent has to prove that there would be no profits in the absence of the breach in order to avoid 341

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Chapter 8: Conclusions the award of the reliance interest. German law requires the proof of profitability for the award of the reliance interest. However, the burden of proof against the injured party is handled liberally as it may not be presumed that an investor would invest a significant amount of money if it did not expect the project to be profitable. 8.22 Once the reasonable certainty of income has been established, it is necessary to

isolate the effects of the breach on such income stream. The effect of extraordinary situations such as economic crises, war, and distress of a joint venture partner, have to be examined on a case-by-case basis and under the applicable rules of law. Th is is particularly true in case of the measure of damages of FMV where the effect of crises or distress is not necessarily considered in the valuation. 8.23 The following situations have to be distinguished when analysing the effect of the

breach or violation on the income stream: (1) a total and permanent interruption of the income stream; (2) a total but temporary interruption of the income stream; (3) a partial and permanent interruption of the income stream; and (4) a partial and temporary interruption of the income stream. These situations require different approaches. The first one would exist in an illegal termination of a public works contract by a state entity that could also be considered an illegal expropriation of the investment or the contract. The second one might be the lack of a price increase in violation of a contractual price adjustment clause in case of a tax increase, where even future adjustments would never lead to the but-for situation. In this respect it is important to mention that the but-for situation is not the situation before the breach (before and after method), but the situation of the injured party without such breach at any time in the future. The third one is in the form of a permanent effect of the breach on the income stream that cannot be cured and there is always a difference between the but-for and the actual situation. As regards the fourth situation in form of a partial and temporary interruption of the income stream, this could be the temporary interruption of payment under a power purchase agreement, without any effect on any future payments. 8.24 Under the different rules of law analysed, foreseeability has to be established when

determining the actual loss. The test of foreseeability refers to whether the claimant could have known that the breach of the contract could cause a loss at the moment of the breach or at the moment of its execution. With respect to typical synallagmatic complex long-term contracts, two kinds of losses may arise: those with respect to the non-performing good, which is the difference in value or the cost of cure depending on the rules of law applicable, and the lost profits resulting from collateral transactions that did not verify because of the breach. In atypical synallagmatic or income stream based contracts, lost profits are the only losses that can arise. In both cases considerable investment is made with the only purpose of obtaining profits, therefore the lost profits arising from the breach are deemed to be foreseeable. However, in atypical contracts, where the loss of income stream is

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Conclusions due to risk properly assumed by the party in breach, the limitation of foreseeability does not even seem to arise. Mitigation may apply in case of typical synallagmatic contracts and the losses 8.25 would only be the difference in costs with and without mitigation. However, mitigation may not be possible in atypical synallagmatic contracts based income stream, where a license, a concession, the good illegally expropriated, or even the technology cannot be replaced. The respondent has the burden of proof with respect to hypothetical mitigation scenarios. With respect to the date for the damages determination, under the expectation 8.26 interest the date of the award is the date that corresponds to the full compensation principle, as this is the date when the injured party is supposed to receive the damages and, therefore, it is the only date which would put the injured party in the economic position it would be but for the breach. This date is also correct as it allows taking into consideration important ex-post information for the determination of the effect of the breach on the performance of the contract and it is accepted in all rules of law analysed. If the damages are determined at the date of the breach or any other date before the date of the award, these must be expressed at the date of the award at the same rate used to discount the future cash flows in order to avoid the so-called invalid round trip (IRT), which would lead to undercompensation and windfall profits for the party in breach. With respect to pre-award interest, the injured party has financed the operation of 8.27 the business at a cost equivalent to the cost of capital of the affected business, which has to be compensated in order to make the injured party whole. The danger of undercompensation often appears, amongst others, when arbitral 8.28 tribunals (a) use interest rates which are unreasonably high to discount future cash flows; (b) apply pre-award interest rates when valuing damages as of the date of the breach, which are lower than the discount rates used to discount the future cash flows; (c) do not award pre-award interest rates at the cost of capital; and (d) do not award pre-award interest at all, which is an extreme case of undercompensation. Overcompensation mainly arises from double counting either by awarding the investments together with the expectation interest or by not making the proper adjustments when awarding damnum emergens and lucrum cessans at the same time. In the light of the multiple legal and evidentiary requirements and limitations in 8.29 order to arrive at the actual loss to be compensated, the risk of undercompensation is higher than the risk of overcompensation. Arbitral tribunals have an eminent responsibility when awarding damages and should deal with uncertainty and not skimp efforts when analysing the reasonable certainty of income, the effect of the breach on such income, and the determination of discount and pre-award interest rates. They should apply principles of procedural equity in order to allow the 343

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Chapter 8: Conclusions injured party to arrive at a reasonable estimate of the income stream, for example by liberally admitting requests for the production of relevant documents. Excessive burden of proof requirements imposed on the claimant may result in the impossibility of recovering damages. The Roman law maxim ‘omnia praesumuntur contra spoliatorem’, according to which ‘all things have to be presumed against the wrongdoer’ should be reasonably applied in any damages claim for lost income. 8.30 Damages analysis is fairly similar in investment arbitration as international dam-

ages law derives in essence from private law. In investment arbitration a violation of an international legal standard or international tort in the form of an illegal expropriation, the violation of the fair and equitable treatment standard, discrimination through the violation of the national treatment and most favoured nation standards and other standards contained in bilateral investment treaties and under customary international law is normally required, save in the case of the application of an umbrella clause contained in an international investment agreement. The existence of international tort has an effect on the measure of damages through the application of the FMV using a kind of hypothetical normal course of events as established in the Factory at Chorzów case. This measure of damages does not appear to be justified in investment arbitrations under umbrella clauses in the absence of international tort. 8.31 Jurisdiction and state responsibility in investment arbitration is outside the scope

of this book. However, contractual risk allocation plays a role in establishing liability even in investment arbitration as shown in several recent investment arbitration cases. A state measure may give rise to contractual non-performance of the state party. Such party may try to excuse its non-performance on the ground of force majeure or hardship. However, when the state measure is within the risk sphere of the state party, the respondent may not avoid liability and the underlying contractual relationship will play a role in investment arbitration. On the other hand, when an investor takes the risk of contract termination when illegally disposing of the natural resources of a developing country, which represent a significant percentage of that country’s GDP, for example in Occidental v. Ecuador, risk allocation should also be respected. The ‘legitimate expectations’ in investment arbitrations related to complex long-term contracts is nothing else than the expectations provided under the contractual risk allocation as admitted under the applicable law. 8.32 Compensation in investment arbitration is based on the Chorzów standard, where

the full compensation principle is also recognized. When a business is illegally taken or its value destroyed by an illegal act of a government, the measure of damages is the FMV. When a business is not taken or only partially destroyed, the difference between the but-for and the actual FMV is the measure of damages. Therefore the but-for premise applies, albeit in a different form. This is shown in a series of recent cases where there is no expropriation but a violation of the fair and equitable treatment principle which leads to a total or partial interruption of the income stream for a certain period of time or forever. 344

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Conclusions The Chorzów case applies the FMV as a measure of damages without expressly 8.33 referring to this term, which was first introduced in American International Group v. The Islamic Republic of Iran in 1983, and Starrett Housing Corporation v. Government of the Islamic Republic of Iran in 1987. In Starrett, the expert defined the FMV ‘as the price that a willing buyer would pay to a willing seller in circumstances in which each had good information, each desired to maximize his financial gain and neither was under duress or threat’. This has an effect on damages assessment, as examined in detail in chapter 6, together with the techniques that are often used to compute it. Income stream producing assets are most likely valued using income-stream based methods taking into consideration what such assets would generate under normal circumstances. The Chorzów standard shares the but-for premise when it states that compensa- 8.34 tion must wipe out all consequences of the illegal act or measure. However, the Chorzów measure of damages takes the highest value of the investment between the date of the breach and the date of the award plus lost profits from the date of the breach to the date of the award if the latter date is chosen. It is influenced by German law with respect to the normal hypothetical course of events, which means that atypical events negatively affecting the injured party after the measure may be ignored through the choice of date of the higher valuation at the date of the violation or the award. The rationale for this measure is that the illegal expropriation or the illegal act 8.35 amounts to international tort. Apart from that, the Chorzów measure of damages aims to avoid windfall profits being gained by the state by expropriating investments during times of crises in order to avoid the corresponding compensation. In international arbitrations the award will only place the injured party in the 8.36 situation it would be in but for the breach or the illegal measure if made in the currency which most closely reflects the claimant’s loss. According to international law, awards have to be expressed in freely convertible, transferable currencies as this facilitates the computation of the damages. For example, discount rates may be difficult to compute in unstable currencies. If the currency in which the damages are determined depreciates prior to the award, 8.37 the tribunal has to decide which party bears the adverse effects of such devaluation. Under the but-for premise, the aim of the award is to restore an injured party to the position in which it would be in had the injury not occurred. This means that currency conversions have to be made at a rate ‘to make the injured party whole and avoid a windfall to the wrongdoer’.2 International tribunals have generally ruled that the respondent has to take the risk of currency depreciation between the date of the violation and the date of the award. However, according to the 2 Sergey Ripinsky with Kevin Williams, Damages in International Investment Law (British Institute of International and Comparative Law 2008) 396, with further references.

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Chapter 8: Conclusions but-for method the devaluation between the breach and the end of the project has to be taken into consideration, but the devaluation between the end of the project and the award should not be considered. In the case of reliance interest, damages should be calculated in the currency the investment was made at date of the investment and in the case of expectation interest, damages should be calculated in the currency of the profits to be received, provided that in both cases the currency is convertible. 8.38 There is a tendency in international arbitration towards the principle that the suc-

cessful party should have its costs paid by the unsuccessful party, as the cost of arbitration would not have occurred in case the other party had performed the contract. This is in accordance with the but-for premise, where the recoverable costs should be considered as damages. The trend is to order the losing party to pay for both the procedural and the legal cost of the other party. The principle in international arbitration acquiring importance is that ‘costs should follow the event’. This principle is established in the rules of arbitration of UNCITRAL and of the Stockholm Chamber of Commerce and is in accordance with the full compensation and the but-for principles. 8.39 Arbitral tribunals should aim at full compensation of the actual loss, as this would

avoid under- and overcompensation, as well as windfall profits to either party, which would give incentives to breach the contract every time it is convenient. This would also provide legal certainty and foreseeability in contractual relations, which would reduce transaction costs and bring efficiency to the economy, while not wasting resources. 8.40 Damages claims for lost profits under complex long-term contracts based on

income stream should be subject to fewer limitations. In particular, foreseeability and mitigation do not seem to play a major role. However, the difficulty lies in the determination of the proper assumptions for the reconstruction of the historical course of events without the breach to be compared with the historical actual course of events, as well as to reconstruct the future without the breach and the actual courses of events in order to calculate their monetary difference, which explains the important role of the economic experts in the analysis and valuation of lost profits. What is important is that there is congruence between the application of the legal principles and the financial and economic considerations in the arbitral award leading to a proper reasoning, which would allow the replication of the results and the further development of an international damages law with respect to income producing assets, corresponding to the principle of fairness as analysed, described, and established in this book.

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INDEX

Abdala, Manuel A. 6.61, 6.109 Abrantes-Metz, Rosa M. 6.205 adequacy 1.20, 4.316–4.317 adjusted book value (ABV) 6.217–6.220 adjusted present value (APV) 6.157–6.161 affermage 3.109 Alexandrov, Stanimir 5.166 American Society of Appraisers 6.178 anticipatory breach 4.19, 5.28 Aquinas, Thomas 2.17, 2.18 arbitration 3.59, 3.155, 3.156 case law 3.77–3.78, 3.172 CANACO 4.422–4.431 gas exploration and exploitation joint venture in Turkmenistan 3.201–3.213, 5.47–5.56 joint venture in the automotive industry 3.214–3.225, 5.65, 5.90, 5.100, 5.146 oil platform construction contract 3.185–3.200 processing plant turnkey construction project 3.180–3.184, 5.89, 5.102 turnkey construction contracts of power plant projects 3.173–3.179 cost of 7.49–7.51, 8.38 importance of PICC 4.375 public contracts, implications of 6.18–6.23 Argentinian economic crisis 5.19–5.22, 5.192, 6.12, 6.21, 6.34, 6.50–6.52, 6.141–6.144 Aristotle 1.04, 2.02, 2.17 asset-based valuation 6.214–6.216 book value and adjusted book value 6.217–6.220 liquidation value 6.221–6.223 assumption of responsibility 4.57–4.63 atypical events 5.67 atypical synallagmatic complex long-term contracts 1.23, 3.45, 4.456, 8.05 see also income stream-based complex long-term contracts calculation of the loss 5.42, 5.45 Australian Competition Tribunal 5.158 automotive industry: joint venture agreement 3.214–3.225, 5.65, 5.90, 5.100, 5.146, 7.20 avoidance of damages 4.131–4.132, 4.159–4.161 see also mitigation bank defaults 6.40 Benninga, S. 6.178 BLT (Build-Lease-Transfer) 3.15

Bonell, Michael Joachim 4.377, 4.378 bonuses 3.50 BOO (Build-Own-Operate) 3.15 book value 6.217–6.220 BOOT (Build-Own-Operate-Transfer) 3.15 BOT (Build-Operate-Transfer) 1.05, 3.12–3.15, 3.44, 3.109 see also UNIDO: BOT Guidelines breach of contract 5.10 burden of proof 5.127 CISG 4.347 effect of termination on the damages claim 5.23–5.33 English law 4.13–4.19 evidence and 5.127 French law 4.187–4.188 gain-based relief for 4.50 German law 4.264–4.267 Mexican law 4.232–4.235 opportunism governmental 6.05–6.12, 6.35 third party 6.13–6.15, 6.18 PICC 4.385–4.388 principal difficulties when determining the breach 5.11–5.22 protected by an umbrella clause 5.168–5.174 US law 4.99 breach of duty 4.274–4.286 bridge trusts 3.07 Build-Lease-Transfer (BLT) 3.15 Build-Operate-Transfer (BOT) 1.05, 3.12–3.15, 3.44, 3.109 see also UNIDO: BOT Guidelines Build-Own-Operate (BOO) 3.15 Build-Own-Operate-Transfer (BOOT) 3.15 burden of proof 1.25, 1.27, 4.447–4.450, 8.29 CISG 4.370–4.371 English law 4.74 French law 4.217–4.219 full compensation and 2.14 German law 4.327–4.335 Mexican law 4.247–4.249 PICC 4.416 US law 4.105, 4.145, 4.147, 4.163–4.165 business plans and projections 5.147–5.150 but-for premise 1.03, 1.16, 1.20, 1.29, 2.07, 4.338, 4.440, 4.459, 5.08–5.09, 8.08, 8.15, 8.17–8.18 avoiding overcompensation 5.126

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Index but-for premise (cont.): avoiding undercompensation 6.97 business plans and projections as evidence 5.147–5.150 calculation of the loss 5.37, 5.40, 5.45, 5.121, 6.136, 6.138 causality and valuation of damages 6.26–6.28 CMS v. Argentina 6.34 construction of but-for and actual scenarios 6.29–6.33 causality test 5.62, 5.66 comparison with Chorzów formula 5.183, 5.197, 6.23, 6.26 double-counting 6.84 future damages and 6.55 measure of damages 5.68 damnum emergens and lucrum cessans 5.91 expectation interest 5.69, 5.74 reliance interest 5.78 see also measure of damages quantum and evidence 5.131–5.132 relevant date for valuation of damages 5.120 buyout price 3.158 calculation of damages see valuation of damages CANACO case 4.422–4.431 capitalized cash flow (CCF) valuation method 6.162–6.166 causality 5.61–5.67 atypical events 5.67 but-for premise and 6.26–6.28 CMS v. Argentina 6.34 construction of but-for and actual scenario 6.29–6.33 CISG 4.360 English law 1.25, 4.32–4.35 evidence and 5.128–5.130 French law 1.18, 4.197 German law 4.288–4.289 Mexican law 4.238–4.243 partial causation 5.64 PICC 4.396 US law 4.155–4.122 CERN (European Organization for Nuclear Research) 3.75 certainty see reasonable certainty of income stream; reasonable certainty of loss chance, loss of 4.122, 4.210, 4.287, 4.397–4.395, 5.122–5.124 change of circumstances 5.18 Channel Tunnel 3.73–3.74 Chorzów formula 2.04, 2.06, 4.461, 5.02, 5.163, 8.12, 8.32–8.35 avoiding double-counting damages 6.84, 6.92 avoiding undercompensating 6.97, 6.121 comparison with but-for premise 5.188, 5.197, 6.23, 6.26 currency of the award 7.47

date of valuation 6.53, 6.60, 6.65–6.81 determination of interest as damages and 7.29, 7.30 full compensation under the formula 5.180–5.183 measure of damages and fair market value (FMV) 5.184–5.195 principles of compensation 6.24–6.28 rationale 5.203–5.206 relevance of the Chorzów case for investment arbitration 5.175–5.179 relevant date for determination of damages 5.196–5.202 CISG (United Nations Convention on Contracts for the International Sale of Goods) 1.21, 4.341–4.344, 8.12 considerations 4.372 date of determination of the damages 4.369, 5.119 interest as damages 7.07 level of evidence required and burden of proof 4.370–4.371 limitation of damages foreseeability 4.363–4.365, 5.98 mitigation 4.366–4.367 prohibition of enrichment 4.368 measure of damages expectation interest 4.361 reliance interest 4.362 principles for damages claims 4.345–4.346 requisites of a damages claim breach of contract 4.347 causation 4.360 existence and classification of losses 4.348–4.359 claims see damages claims commutative justice 1.04, 2.02 comparative law 4.01–4.03 compensatory interest 7.07–7.08 compensatory principle 2.01–2.20, 4.05, 4.07 complex long-term contracts 1.06, 1.08, 1.23, 3.01–3.03, 3.04 based on income stream see income stream-based complex long-term contracts cases and arbitrations 3.172 gas exploration and exploitation joint venture agreement in Turkmenistan 3.201–3.213, 5.47–5.56 joint venture agreement in the automotive industry 3.214–3.225, 5.65, 5.90, 5.100, 5.146, 7.20 oil platform construction contract 3.185–3.200 processing plant turnkey construction project 3.180–3.184, 5.89, 5.012 turnkey construction contracts of power plant projects 3.173–3.179 characteristics relevant to damages claims 5.03–5.04 classification 1.10, 3.62–3.78 contract guidelines and recovery of damages 3.157–3.171

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Index damages claims in investment arbitration see investment arbitration guidelines and models 3.26–3.36 historic overview 3.05–3.25 nature of 3.41–3.61, 4.463 regulation 1.11 risk see risk role of project finance 3.37–3.40 typical project structures 3.106–3.108, 3.156 joint venture agreements 3.145–3.155 off-take sales agreements 3.127–3.144 operation and maintenance agreements 3.124– 3.126 PPP contracts see PPPs turnkey construction 3.111–3.123 concession agreements 3.94, 3.98, 3.109, 5.21, 5.139, 5.142 water and sewerage 6.04, 6.05, 6.08, 6.16–6.17 concrete valuation 4.359 conditions 4.13, 4.15 consequential losses/damages CISG 4.354 English law 4.12, 4.22–4.28 German law 4.302–4.309 US law 4.102, 4.135, 4.136, 4.141, 4.145, 4.146, 4.147 considerations CISG 4.372 French law 4.223–4.225 German law 4.337–4.340 Mexican law 4.251 PICC 4.419–4.421 US law 4.172–4.173 construction and completion risks 3.83 construction contracts English law 4.79–4.85 US law 4.168–4.171 consumer surplus 4.48 contingencies, analysis of 5.46–5.60 contractual interest rate 7.06 contractual risk 3.87 contributory negligence 4.35, 5.111–5.115 English law 4.71 French law 4.214–4.215 German law 4.318–4.322 Mexican law 4.244–4.245 controlling interest basis of valuation 6.182–6.184 corrective justice or commutative justice 1.04, 2.02. 2.17–2.18 cost-adjustment clauses 5.22 cost avoided 4.131 cost of arbitration 7.49–7.51, 8.38 cost of capital 6.96, 7.100–6.106, 6.112, 6.114–6.115, 6.117, 6.119–6.120 weighted average cost of capital (WACC) 6.152, 6.165, 7.21, 7.23, 7.26, 7.28 cost of cure 1.18, 4.436, 4.439, 4.455, 5.95 English law 4.44–4.46 French law 4.203–4.206, 4.224, 8.10

cost overruns 3.88, 3.92 country risks 3.82 Crawford, James 5.172 critical path method 3.121–3.122 currency clauses 5.22 currency of the award 7.42–7.48, 8.36–8.37 damages assessment see valuation of damages damages claims 5.01–5.02 adjustment avoiding overcompensation 5.126 breach as the starting point 5.10 effect of termination on the damages claim 5.23–5.33 principal difficulties when determining the breach 5.11–5.22, 8.14 burden of proof see burden of proof but-for premise see but-for premise determination of loss 5.34–5.45 difference between lost income and loss of a chance 5.122–5.124 effect of income taxes 5.125 evidence see evidentiary rules experts, role of 5.152–5.162 full compensation as the guiding principle 5.05–5.07 investment arbitration see Investment arbitration limitations see limitations to damages claims lost profits and lost value see loss of profits; loss of value measure of damages see measure of damages relevant characteristics of complex long-term contracts 5.03–5.04 relevant date for valuation of damages see date for valuation of damages damages law economic and social role 2.28–2.34, 4.462, 8.02–8.03 function of 1.04, 8.01, 8.13 compensatory function 2.01–2.20 legal certainty and protection of legitimate expectations 2.21–2.26 preventive function 2.26 punitive function 2.27 historic development 1.04 importance of 1.04 rules of law 1.12–1.20, 8.06–8.07 damnum emergens 1.18, 1.26, 4.456, 5.68, 5.86–5.94, 8.18 Chorzów case 6.75 CISG 4.346 double-counting 6.84, 6.85, 6.86, 6.89, 6.91, 6.92 French law 4.190, 4.225 PICC 4.389–4.390, 4.419 Damodaran, Aswath 6.178 date for valuation of damages 1.29, 4.451, 5.116–5.120, 6.53, 8.26 ADC et al. v. Hungary 6.80–6.83

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Index date for valuation of damages (cont.): Chorzów formula 5.196–5.202, 6.53, 6.60, 6.65–6.81 CISG 4.369, 5.119 date of the award vs. date of the breach 6.57–6.59 El Paso v. Argentina 6.60–6.64 English law 4.72–4.73, 5.119 French law 4.216, 5.119 German law 4.325–4.326, 5.116 historical damages and going-forward damages 6.54–6.56, 6.61–6.63 Mexican law 4.246 PICC 4.414–4.415, 5.119 pre-award interest and 7.13 US law 4.162, 5.119 DBO (Design-Build-Operate) 3.15 defects liability guarantees 3.96 delay 4.274, 4.276–4.277 Dellepiane, Santiago 6.205 demand risk 3.82, 3.97 Design-Build-Operate (DBO) 3.15 determination of loss see valuation of damages development risks 3.83 difference in value 4.207–4.209, 4.437, 4.439 business plans and projections 5.147–5.150 causality test 5.62, 5.66 differential hypothesis 1.03, 1.19, 1.24, 2.06, 4.294, 4.338, 4.440, 4.459, 4.461, 8.08 calculation of the loss 5.38, 5.45 comparison with Chorzów formula 5.183, 5.197 discounted cash flow (DCF) valuation method 6.149–6.156, 6.167, 6.193 discount rates 6.48–6.49 discount rate vs. internal rate of return vs. target rates 6.100–6.102 potential misuse of 6.98–6.99 target rates vs. discount rates 6.105–6.106 discrete damages 5.36 disgorgement of the defendant’s profit 4.50 disputes 3.56–3.60 resolution 3.99 distress conditions 6.40, 6.49, 6.143 distributive justice 1.04, 4.94 domestic contracts 3.63 double-counting damages 1.29, 5.93, 6.84 damnum emergens 6.84, 6.85, 6.86, 6.89, 6.91, 6.92 lucrum cessans 6.84, 6.89, 6.91, 6.92 RDC v. Guatemala 6.90–6.91 sunk costs and lost profits 6.85–6.89 double jeopardy 4.12 down payment guaranties 3.96 due diligence 3.97 due process: full compensation 2.14 Dunn, Robert L. 4.121 duration of contracts 3.52 duty of care 4.17

EBITBA 6.173, 6.181, 6.188, 6.195 Economic Analysis of Law 1.14, 1.17, 2.19, 2.23, 4.95, 4.98 economic benefit principle 2.22–2.23 economic experts: role in damages claims 5.152–5.162 Economic-Financial-Equilibrium (EFE) 5.139 Economic-Financial Plan (EFP) 5.139, 5.142 economic role of damages law 2.28–2.34 efficient breach of contract 1.14, 1.17, 2.19, 4.95–4.98 English law see UK law enrichment, prohibition of 4.50, 4.323–4.324, 4.368, 4.413, 4.446 Enterprise Value (EV) 6.173, 6.188, 6.195 epistemic asymmetry 5.155 equity investors 3.89 European Organization for Nuclear Research (CERN) 3.75 event studies 6.203–6.213 evidentiary rules 1.27, 4.447–4.450 breach and evidence 5.127 business plans and projections 5.147–5.150 causation and evidence 5.128–5.130 CISG 4.370–4.371 English law 4.74 French law 4.217 German law 4.327–4.335 Mexican law 4.247–4.249 negative inference 5.151 PICC 4.416 quantum and evidence 5.131–5.132 reasonable certainty of income 5.133–5.145 reasonable certainty of loss 4.104–4.114, 4.392, 4.459, 5.39, 5.40, 5.42, 5.145–5.146 US law 4.163–4.165 exaggerated claims 5.132 excess returns 6.206 exchange rate fluctuations 7.42–7.48, 8.36–8.37 exemption clauses 5.11, 5.14 exit clauses 3.151–3.152 expectation interest 1.03, 1.16, 1.17, 1.18, 1.24, 5.69–5.75, 6.139, 8.19 CISG 4.361 difference between lost income and loss of a chance 5.122–5.124 English law 4.37–4.38 German law consequential damages and lost profits 4.302–4.309 definition of the interest 4.297–4.299 value of the promised performance 4.300–4.301 lost profits and lost value 5.121 pre-award interest 7.16–7.33 US law 4.124, 4.128–4.149 experts: role in damages claims 5.152–5.162 export credit agencies (ECAs) 3.102

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Index failure to satisfy: performance guarantees 3.92 fair market value (FMV) 1.28, 1.29, 5.184–5.195, 6.139, 6.140, 7.30, 7.32, 8.33 commercial arbitrations 6.45–6.47 Enron v. Argentina 6.103 investment vs. contract disputes 6.35, 6.36–6.39 vs. market discount rates 6.48–6.49 fairness 1.04, 2.32 US law 4.90–4.94 fair value 6.140 Farnsworth, Edward Allan 4.96, 4.377 fault principle 4.198–4.201, 4.290–4.292, 4.339, 4.445 FIDIC (International Federation of Consulting Engineers) 1.07, 3.30–3.31 financial crises 6.40, 6.49 financial risk 3.89 flexibility 3.53–3.54 force majeure 3.82, 3.97, 3.121 breach due to 5.11, 5.14 foreseeability of loss 1.18, 1.25, 4.151–4.158, 4.443–4.444, 5.97–5.105, 8.24 CISG 4.363–4.365, 5.98 English law 4.23, 5.98 French law 4.201, 4.211–4.213, 5.98 German law 4.317, 5.98 PICC 4.407, 4.410–4.411, 5.98 US law 4.105, 4.136, 4.147, 4.151–4.158 Franck, Thomas M. 2.32 French law 1.18, 2.03 burden of proof 4.217–4.219 considerations 4.223–4.225 damages caused to a third party 4.195–4.196 date of determination of the damages 4.216, 5.119 faculté de remplacement 4.184–4.185 interest as damages 7.07 law reform 4.221–4.222, 4.462 level of evidence required 4.217 limitations to damages claims contributory negligence 4.214–4.215 foreseeability 4.211–4.213, 5.98 measure of damages 4.202 cost of cure 4.203–4.206, 4.224, 8.10 difference in value 4.207–4.209 loss of a chance 4.210 penalties and liquidated damages 4.220 principles for damages claims 4.174 full compensation or principle de reparation intégrale 4.178–4.186, 4.202, 4.223, 5.07, 5.40 pacta sunt servanda 4.174, 4.175–4.177, 4.186, 4.223 requisites for a damages claim 4.187 breach of contract 4.187–4.188 causality 4.197 existence and classification of losses 4.189–4.196 fault 4.198–4.201

Friedmann, Daniel 4.48, 4.97 full compensation principle 1.02–1.03, 1.14, 1.18, 2.06–2.11, 8.04, 8.16, 8.39 French law 4.178–4.186, 4.202, 4.223, 5.40 German law 4.259 guiding principle in damages 5.05–5.07 interest as damages 7.11 legal issues 2.12 Mexican law 4.229 not an aim under English law 1.16, 4.10 PICC 4.383–4.384 procedural issues 2.14 quantification issues 2.13 US law 4.89, 5.40 Fuller, Lon L. 1.03, 1.13, 1.17, 4.123 future damages 6.54–6.56, 6.62–6.63, 6.66 gain-based relief for breach of contract 4.50 Gantt chart 3.122 gas exploration and exploitation 3.201–3.213, 5.47–5.56 reasonable certainty of the income strand 5.71 German law 1.20, 2.03, 4.252 categories of damages 4.274–4.286 causality test: atypical events and 5.67 considerations 4.337–4.340 date of determination of the damages 4.325–4.326, 5.119 interest as damages 7.07 law reform 4.253–4.255, 4.462 level of evidence required and burden of proof 4.327–4.335 limitations to damages adequacy 4.316–4.317, 5.98 contributory negligence and mitigation of damages 4.318–4.322 prohibition of enrichment 4.323–4.324 measure of damages 4.293–4.296 expectation or performance interest 4.297–4.309 see also expectation interest; performance interest reliance or negative interest 4.310–4.315 penalties and liquidated damages 4.336 principles for damages claims pacta sunt servanda 4.256–4.258 scope of protection of the norm 4.261–4.262, 8.09 total reparation and full compensation 4.259, 5.07 unitary approach to non-performance 4.260 requisites of a damages claim 4.263 breach of contract 4.264–4.267 causation 4.288–4.289 existence and classification of losses 4.268–4.287 fault 4.290–4.292 Global Industry Classification Standard (GICS) 6.179 Goedhart, Marc 6.178

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Index going-forward damages 6.54–6.56, 6.62–6.63, 6.66 Gotanda, John Y. 7.07, 7.10 governmental opportunism 6.07–6.12, 6.35 government procurement rules 3.70, 3.71 guaranties 3.96 Hayek, Friedrich August 2.30 Heldring, Otto 2.29 historical damages 6.54–6.56, 6.61 ‘hot tub’ procedure 5.157–5.158 hypothetical course of events, reconstruction of 5.46–5.60 ICC (International Chamber of Commerce) 1.07 Model Turnkey Contract for Major Projects 3.32, 3.46 id quod interest 4.293 impossibility of performance 4.283 incentives 3.50, 3.51 incidental losses 4.103, 4.352–4.353 income, loss of 5.122–5.124, 6.93–6.96 income expectations 5.122–5.124 income stream: reasonable certainty of 1.25, 5.47, 5.69–5.71, 5.133–5.145, 8.20, 8.21 income stream-based complex long-term contracts 1.23, 1.27, 3.42, 8.40 expectation interest 5.74 foreseeability of lost profits 5.101 interruption of income stream 1.26, 1.28, 4.455, 4.456, 5.42, 8,22–8.23 income taxes 5.125 industry codes 6.179 informational asymmetries 6.13 infrastructure projects see privately financed infrastructure projects innominate terms 4.13, 4.16 insurances 3.96, 3.97, 4.112 intangible benefits 4.43, 4.47 interest 4.293–4.296 see also expectation interest; performance interest; reliance interest interest, pre-judgment (PJI) 6.55, 6.107–6.120 interest rates 1.30, 4.431, 7.02–7.03 contractual interest 7.06 interest as damages/compensatory interest 7.07–7.08 legal interest 7.04–7.05 post-award interest 7.34–7.41 pre-award interest 7.09–7.13, 8.27 under the expectation interest 7.16–7.33 under the reliance interest 7.14–7.15 internal rate of return (IRR) 6.100–6.102, 6.103 international contracts 3.63, 4.376 International Finance Corporation 3.102 international investment agreements 3.76 international law 1.28, 2.04–2.05 see also investment arbitration international organizations 3.75

international tort 5.165–5.167 international treaties 3.73 invalid round trip (IRT) 5.118, 6.61, 6.109–6.115, 7.13, 7.15 investment arbitration 1.28, 1.29, 5.16, 5.18, 5.163, 8.30–8.31 Chorzów formula 8.32–8.35 full compensation under the formula 5.180–5.183 measure of damages and fair market value (FMV) 5.184–5.195 rationale 5.203–5.206 relevance of the Chorzów case 5.175–5.179 relevant date for the determination of damages 5.196–5.202 claims arising under complex long-term contracts 5.164 breach of contract protected by an umbrella clause 5.168–5.174 violation amounting to international tort 5.165–5.167 compared with contract disputes 6.35–6.36 Enron v. Argentina/LG&E v. Argentina 6.52 fair market value 6.35, 6.36–6.39 fair market value in commercial arbitrations 6.45–6.47 fair market vs. market discount rates 6.48–6.49 market value 6.40 Sempra v. Argentina 6.50–6.51 two investors–two arbitrations 6.41–6.44 investment risk 3.89 investments not made, compensation for 6.121–6.128 joint venture agreements 3.145–3.155 automotive industry 3.214–3.225, 5.65, 5.90, 5.100, 5.146, 7.20 effect of termination on the damages claim 5.25–5.27 gas exploration and exploitation in Turkmenistan 3.201–3.213, 5.47–5.56 justification clauses 5.11, 5.14 Kantor, Mark 5.41 Koller, Tim 6.178 Kleinheisterkamp, Jan 4.378, 4.406 Lauterpacht, Hersch 1.02, 5.170, 5.181 leases 3.109 legal certainty 2.21–2.26 legal interest rate 7.04–7.05 legitimate expectations 2.21–2.26 limitations to damages claims 4.150, 4.442–4.446 adequacy 4.316–4.317 causality 4.241–4.243 contributory negligence 4.71, 4.214–4.215, 4.244–4.245, 4.318–4.322, 5.111–5.115 foreseeability see foreseeability of loss

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Index mitigation see mitigation prohibition of enrichment 4.368, 4.413 remoteness 1.16, 4.23, 4.53–5.63 risk spheres 4.399–4.409 liquidated damages 3.96, 3.113, 3.114, 3.115, 3.157, 3.164, 3.167 English law 4.75–4.78 French law 4.220 German law 4.336 Mexican law 4.250 PICC 4.417–4.418 US law 4.166–4.167 liquidated value 6.221–6.223 liquidity crisis 6.40, 6.49 litigation 3.100, 3.157 López Zadicoff, Pablo D. 6.61, 6.109 loss avoided 4.132 loss causation (US law) 4.116–4.119 see also causality losses analysis of contingencies to reconstruct the hypothetical course of events 5.46–5.60 causation see causality classification of CISG 4.348–4.359 English law 4.22–4.31 French law 4.189–4.196 German law 4.268–4.287 Mexican law 4.236–4.237 PICC 4.389–4.395 US law 4.100–4.103 determination of loss 5.34–5.45 loss of a chance 4.31, 4.210, 4.287, 4.394–4.395, 5.122–5.124 loss of amenity 4.47 loss of profits 5.93, 5.121 CISG 4.356–4.358 double-counting 6.85–6.89 foreseeability 5.101–5.105 German law 4.270, 4.302–4.309, 4.335 new businesses 4.148–4.149, 5.141 reasonable certainty of income 1.25, 5.47, 5.69–5.71, 5.133–5.145 relevant date for valuation of damages 5.118 US law 4.134–4.136, 4.141, 4.148–4.149 loss of value 4.129, 5.121, 6.93–6.96 lost income 5.122–5.124, 6.93–6.96 lost opportunities 4.112 lucrum cessans 1.18, 1.26, 4.456, 5.68, 5.86–5.94, 8.18 Chorzów case 6.73 CISG 4.346 double-counting 6.84, 6.89, 6.91, 6.92 French law 4.190, 4.225 PICC 4.389, 4.391, 4.419 management contracts 3.109 management risks 3.82, 3.97 market discount rates 6.48–6.49

market value 6.40 material non-performance 3.99 McNamara, John J. 4.168 measure of damages 4.433–4.441, 5.68 Chorzów formula 5.184–5.195 CISG see CISG: measure of damages cost of cure 5.95 see also cost of cure damnum emergens and lucrum cessans 5.86–5.94 see also damnum emergens; lucrum cessans English law see UK law: measure of damages expectation interest 5.69–5.75 see also expectation interest French law see French law: measure of damages German law see German law: measure of damages PICC 4.397–4.398 reliance interest 5.76–5.85 see also reliance interest US law see US law: measure of damages ‘measured mile’ calculation 3.123 Mexican law 1.19, 4.226–4.228 burden of proof 4.247–4.249 considerations 4.251 date of determination of the damages 4.246 interest as damages 7.07 level of evidence required 4.247–4.249 limitations to damages claims causality 4.241–4.243 contributory negligence 4.244–4.245 penalties and liquidated damages 4.250 principles of damages claims 4.229–4.231, 4.426 requisites for a damages claim breach of contract 4.232–4.235 causality 4.238–4.240 existence and classification of losses 4.236–4.237 milestone payments 3.96, 3.112 mitigate, duty to 1.18, 4.65, 4.443 mitigation 3.96–3.105, 5.106–5.110, 8.25 CISG 4.366–4.367 English law 4.64–4.71, 4.85 German law 4.318–4.322 PICC 4.408, 4.412 US law 4.159–4.161 Mommsen, Friedrich 1.03, 2.06, 4.294, 4.461, 5.09, 5.88, 5.183, 5.197, 7.09, 8.08, 8.18 monetary equivalent of performance 1.14 Monte Carlo model 5.47, 5.51 Multilateral Investment Guarantee Agency (MIGA) 3.102 multiple contracts 3.43 nationalization 1.05 negative inference 5.151 negative interest 4.310–4.315 see also reliance interest net asset value (NAV) 6.168 non-competition clauses 3.151, 3.219, 3.221, 5.100

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Index non-monetary losses 4.272 North American Industry Classification Standard (GICS) 6.179 off-take sales agreements 3.127–3.144, 5.91 oil exploration and exploitation: reasonable certainty of the income stream 5.71 oil platform construction: arbitration case 3.185–3.200 oil prices 6.102 omnia praesumuntur contra spoliatorem 5.81, 5.83 operating risks 3.82, 3.97 operation and maintenance (O&M) agreements 3.124–3.126 opportunistic breach governmental 6.05–6.12, 6.35 third-party 6.13–6.15, 6.18 overcompensation 1.16, 2.15–2.20, 4.10, 4.438, 5.78, 5.126, 8.28, 8.29 double-counting see double-counting damages exaggerated claims 5.132 Özal, Turgut 3.12 pacta sunt servanda 1.17, 4.434 French law 4.174, 4.175–4.177, 4.186, 4.223 German law 4.256–4.258 Mexican law 4.230, 4.231, 4.426 not an aspect of English law 4.07 PICC 4.380–4.382 participation contracts 5.16–5.17 Paulsson, Jan 2.28 peer companies 6.178–6.181 penalties 3.50 English law 4.75–4.78 French law 4.220 German law 4.336 Mexican law 4.250 PICC 4.417–4.418 US law 4.166–4.167 Perdue, William 1.03, 1.13, 1.17, 4.123 performance guarantees 3.96, 3.114 failure to satisfy 3.92 performance interest English law 4.39–4.42 increasing the protection of the interest 4.43–4.52 failure to satisfy 3.92 German law consequential damages and lost profits 4.302–4.309 definition of the interest 4.297–4.299 value of the promised performance 4.300–4.301 performance-monitoring mechanisms 3.50–3.51 performance principle 1.14, 2.24–2.25 PFI (Private Finance Initiative) 3.16–3.17, 3.26, 3.33–3.34

PICC (Principles of International Commercial Contracts) 1.11, 1.22, 2.03, 4.373–4.379, 4.459, 4.460, 8.11, 8.12 CANACO Case 144 4.422–4.431 considerations 4.419–4.421 date of determination of the damages 4.414–4.415, 5.119 interest as damages 7.07 level of evidence required and burden of proof 4.416 limitations of damages foreseeability 4.407, 4.410–4.411, 5.98 mitigation of harm 4.408, 4.412 no enrichment 4.413 risk spheres 4.399–4.409 measure of damages 4.397–4.398 penalties and liquidated damages 4.417–4.418 principles for damages claims full compensation 4.383–4.384, 5.07 pacta sunt servanda 4.380–4.382 requisites of a damages claim breach of contract 4.385–4.388 causation 4.396 existence and classification of damages 4.389–4.395 ‘piggy-back’ clauses 3.153 Pinna, Andrea 5.87 political risks 3.82, 3.101, 3.102 governmental opportunism 6.07–6.12, 6.35 Popper, Sir Karl 1.31 post-award interest 7.34–7.41 power plant projects: cases and arbitrations 3.173–3.179 power purchase agreements 3.129, 3.132–3.144, 5.91 PPPs (Public Private Partnerships) 1.05, 3.16–3.25, 3.109–3.110 operation and maintenance (O&M) agreements 3.124–3.126 pre-award interest 7.09–7.13, 8.27 under the expectation interest 7.16–7.33 under the reliance interest 7.14–7.15 pre-judgment interest (PJI) rate 6.55, 6.107–6.120 preventive function 2.26 price-to-NAV 6.168 Private Finance Initiative (PFI) 1.05, 3.16–3.17, 3.26, 3.33–3.34 private law 3.67, 8.12 privately-financed infrastructure projects 1.05, 1.06, 3.105–3.11 guidelines for 1.07 procedural equity 2.14 Proctor, Charles 5.117 productivity losses 3.123 profits, loss of see loss of profits project finance 1.08 role in structuring complex long-term contracts 3.37–3.40

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Index property rights 2.30 projected interest see measure of damages protection of legitimate expectations 2.21–2.26 protective effect of the norm 4.261–4.262, 4.452–4.453 proximate cause 4.115–4.122 public contracts 3.66, 3.67, 3.68–3.71, 3.98 challenges when contracting with public agreements 6.13–6.17 implications for arbitration 6.18–6.23 Public Private Partnerships (PPPs) 1.05, 3.16–3.25, 3.109–3.110 HM Treasury’s Standardisation of PFI Contracts (UK) 1.07 public procurement provisions 3.70, 3.71 punitive function 2.27 ‘put and call’ options 3.152 quantification 5.38 full compensation 2.13 quantum and evidence 5.131–5.132 reasonable certainty of income stream 1.25, 5.47, 5.69–5.71, 5.133–5.145, 8.20, 8.21 reasonable certainty of loss 4.104–4.114, 4.392, 4.459, 5.39, 5.40, 5.42, 5.145–5.146 relational contracts 1.11, 3.45, 6.18 relevant date see date for valuation of damages reliance interest 5.76–5.85, 8.21 CISG 4.362 English law 4.41 German law 4.310–4.315 pre-award interest 7.14–7.15 US law 4.120, 4.125 remoteness of losses 1.16, 4.23, 5.98 renegotiation 5.15, 5.18, 5.19, 6.18 reparation 4.229–4.230, 4.259, 4.337 repudiation 4.19 responsibility, assumption of 4.57–4.63 restitution 5.23 restitution interest 4.126–4.127 retentions 3.96 Ripinsky, Sergey 6.87 risk 1.08, 1.09, 3.55 allocation 3.84–3.95, 3.171, 5.14, 5.18, 5.22 take-or-pay agreements 3.140–3.144 identification 3.79–3.83 mitigation 3.96–3.105 pre-operational 6.169–6.170 risk matrix 3.91–3.92 risk-reward equation 3.93 risk spheres 4.399–4.409, 4.452–4.453 Rowan, Solène 4.70 rule of law 2.30 Sarig, O. 6.178 Schlechtriem, Peter 7.51 Schwartzkopf, William 4.168

Schwarzenberger, Georg 7.43 self-contained systems 3.46–3.47 self-enforcing agreements 3.49–3.50 shadow tolls 3.130–3.131, 5.30 share price 6.182–6.183 share sales 3.154 ‘shot gun’ clauses 3.152 social role of damages law 2.28–2.34 specific performance 1.14, 1.17, 4.07, 4.09, 4.174, 4.176 compensation for 6.25 specific risk 3.82 Spiller, Pablo T. 3.70, 6.13, 6.61, 6.109 Standard Industrial Classification (SIC) system 6.179 Standardisation of PFI Contracts (SoPC) 3.161, 3.167, 3.168, 3.169 standardized contracts 3.46–3.47 state entities 3.67, 3.68, 3.70 state responsibility 5.165, 7.07 Stockholm Chamber of Commerce: rules of arbitration 7.51 stock market prices 6.40, 6.43 stock market study 6.197–6.202 strict obligation 4.17 sunk costs 6.85–6.89 sunk investments 6.05–6.06, 6.10, 6.18 supply risks 3.82, 3.97 symbiotic contracts 3.48 synallagmatic contracts see atypical synallagmatic contracts; typical synallagmatic contracts synallagmatic triallagma 3.48, 4.340, 4,432 take-and-pay agreements 3.138–3.144 take-or-pay agreements 3.138–3.139, 5.91 target rates 6.100–6.102, 6.105–6.106 taxes 5.125, 6.53–6.55 technical risks 3.82, 3.97 termination of contract 4.306–4.307, 4.441 effect on the damages claim 5.23–5.33 third-party losses 4.49, 4.195–4.196, 4.355 third-party opportunism 6.13–6.15, 6.18 toll road contracts 3.130–3.131, 5.30, 5.45, 5.57–5.60, 5.72 transaction causation (US law) 4.117, 4.118 transactions prices 6.191–6.196 transparent bids 6.17 treaty disputes see investment arbitration Turkmenistan: gas exploration and exploitation 3.201–3.213, 5.47–5.56 turnkey construction contracts 3.111–3.123 cases and arbitrations 3.173–3.184 typical synallagmatic complex long-term contracts 1.23, 3.42, 4.456, 5.102, 8.05 calculation of the loss 5.43, 6.04, 6.13 compensation for specific performance 6.25 expectation interest 5.74

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Index UK law 1.16, 2.03 burden of proof 4.74 case management system 5.157 causality test: atypical events and 5.67 compensatory principle 4.05, 4.07 considerations 4.86–4.87 construction contracts 4.79–4.85 date of determination of the damages 4.72–4.73, 5.119 interest as damages 7.07 level of evidence required 4.74 limitations to damages claims mitigation 4.64–4.71 remoteness 1.16, 4.23, 4.53–4.63, 5.98 liquidated damages 4.75–4.78 measure of damages 4.36 expectation interest 4.37–4.38 increasing the protection of performance interest 4.43–4.52 performance interest 4.39–4.42 penalties 4.75–4.78 principles for damages claims 4.04–4.14, 4.462, 5.07 requisites for a damages claim breach of contract 4.13–4.19 causation 4.32–4.35 classification of losses 4.22–4.31 existence of losses 4.20–4.22 umbrella clauses 3.76, 3.77, 5.16, 5.19, 5.168–5.174 uncertainty 1.31, 5.81 undercompensation and 6.129–6.135 UNCITRAL (United Nations Commission on International Trade Law) Contracts Guide 3.28–3.29, 3.161, 3.163 Legislative Guide 1.05, 1.08, 3.35, 3.54, 3.80, 3.165 Model Legislative Provisions 3.36, 3.53, 3.166 rules of arbitration 7.51 undercompensation 2.15–2.20, 4.438, 6.97, 8.28, 8.29 compensating for investments not made 6.121–6.128 ConocoPhillips v. PDVSA 6.118 discount rate vs. internal rate of return vs. target rates 6.100–6.102 Enron v. Argentina 6.103 invalid round trip (IRT) 6.61, 6.109–6.115 LG&E v. Argentina 6.131–6.135 Occidental Petroleum v. Ecuador 6.127–6.128 potential misuse of discount rates 6.98–6.99 Siag v. Egypt 6.123–6.126 target rates vs. discount rates 6.105–6.106 uncertain environments 6.129–6.135 undercompensating via pre-judgment interest (PJI) 6.55, 6.107–6.120 Vivendi v. Argentina 6.119–6.120 UNIDO (United Nations Industrial Development Organization) 3.27

BOT Guidelines 1.05, 1.08, 3.13–3.14, 3.39, 3.81–3.82, 3.161–3.162, 3.164 UNIDROIT (International Institute for the Unification of Private Law): Principles of International Commercial Contracts (PICC) see PICC United Nations Compensation Commission 7.45 United Nations Convention on Contracts for the International Sale of Goods see CISG US law 1.14, 1.17, 2.03, 4.88 burden of proof 4.105, 4.145, 4.147, 4.163–4.165 considerations 4.172–4.173 construction contracts 4.168–4.171 date of the determination of the damages 4.162, 5.119 interest as damages 7.07 level of evidence required 4.163–4.165 limitations to damages claims 4.150 avoidance or mitigation of damages 4.159–4.161 foreseeability 4.151–4.158, 5.98 liquidated damages 4.166–4.167 measure of damages 4.123 expectation interest 4.124 measure of expectation interest 4.129–4.149 reliance interest 4.125 restitution interest 4.126–4.127 penalties 4.166–4.167 principles of damages claims efficient breach 1.14, 1.17, 2.19, 4.95–4.98 fairness 4.90–4.94 full compensation from the actual loss 4.89, 5.07, 5.40 requisites for a damages claim breach of contract 4.99 causation or proximate cause 4.115–4.122 existence and classification of loss 4.100–4.103 reasonable certainty of loss 4.104–4.114, 4.392, 4.459, 5.39, 5.40, 5.42 valuation of damages 1.29, 5.34–5.45, 6.01–6.03, 6.136–6.145 asset or cost approach 6.214–6.216 book value and adjusted book value 6.217–6.220 liquidation value 6.221–6.223 avoiding double-counting see double-counting damages avoiding undercompensation see undercompensation but-for premise and causality 6.26–6.28 CMS v. Argentina 6.34 construction of but-for and actual scenarios 6.29–6.33 choosing the right approach 6.224–6.225 Chorzów formula see Chorzów formula date of see date for valuation of damages economics of public and private contracts 6.04 challenges when contracting with public agencies 6.13–6.17

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Index implications of public contracts for arbitration 6.18–6.23 politicization of prices and governmental opportunism 6.07–6.12 sunk investments 6.05–6.06, 6.10, 6.18 income approach 6.146–6.148 adjusted present value (APV) 6.157–6.161 capitalized cost flow (CCF) 6.162–6.166 discounted cash flow (DCF) 6.149–6.156, 6.167, 6.193 incorporating pre-operational risks 6.169– 6.170 net asset value (NAV) 6.168 risks in the cash flow or in the discount rate 6.167–6.168 Siag v. Egypt 6.156–6.157 investment vs. contract disputes 6.35–6.36 Enron v. Argentina/LG&E v. Argentina 6.52 fair market value (FMV) 6.35, 6.36–6.39 fair market value in commercial arbitrations 6.45–6.47 fair market vs. market discount rates 6.48–6.49 market value 6.40 Sempra v. Argentina 6.50–6.51 two investors–two arbitrations 6.41–6.44 loss of income vs. loss of value 6.93–6.96 market approach 6.171–6.175 EBITBA 6.173, 6.181, 6.188, 6.195 EDFI 6.191, 6.196 Enron 6.191, 6.193 Enterprise Value 6.173, 6.188, 6.195 event study 6.203–6.213

Occidental 6.191, 6.195 Rompetrol N.V. v. Romania 6.210–6.213 Siag 6.191–6.192 stock market study 6.197–6.202 market multiples from comparable transactions 6.185–6.190 use of transactions prices in awards 6.191–6.196 market multiples from publicly-traded companies 6.176 metric 6.177 peer companies 6.178–6.181 use of control premium 6.182–6.184 value, loss of 4.129, 5.121, 6.93–6.96 venture capital (VC) firms 6.170 Vogenauer, Stefan 4.378 Von Jhering, Rudolf 1.03, 1.13, 1.20, 4.295, 4.435 Von Mises, Ludwig 2.30 Wallace, Don Jr 1.05, 3.25 warranties 4.13, 4.14, 5.19 water and sewerage concessions 6.04, 6.05, 6.08, 6.16–6.17 weighted average cost of capital (WACC) 6.152, 6.165, 7.21, 7.23, 7.26, 7.28 Wendell Holmes, Oliver 1.17 Wessels, David 6.178 Williams, Kevin 6.87 World Bank 1.05, 1.07, 3.18, 3.23, 3.31, 3.102 Yannaca-Small, Katia 5.171

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