October 17, 2004
Legal Tool Kit for Government
Mitigation of Regulatory Risk
1.
Proposal for Regulatory Stability Commitments.
Investor concerns about regulatory risk and change in law are major obstacles
to foreign direct investment in infrastructure. While some developing countries with
well-designed regulatory structures may be able to attract foreign direct investment
without expressly addressing these concerns, many will not. The problem is that
sovereign governments are always free to change their own laws, and investors know that
even a friendly regulatory environment is subject to change after an investment has been
made.
To overcome these concerns, governments should be prepared to make legally
binding commitments to maintain regulatory stability (or to pay compensation if
regulatory stability is not maintained). These commitments, which can focus on the
specific regulatory issues that are most important for a particular project, can have real
value to investors. They can also enable multilateral development institutions and
political risk insurers to offer investors regulatory risk protection that would not
otherwise be available.
Governments most commonly make this kind of commitment by entering into a
contract directly with the foreign investor, such as a concession agreement or
implementation agreement, in which the government may make commitments about
issues such as taxation, acquisition of permits and licenses, customs treatment of
imported equipment, project tariffs, and (in some cases) regulatory issues.
These commitments may not fully address investor concerns if contract disputes
will be resolved in the host country. (Investors that have concerns about the host
country’s regulators may have similar concerns about the host country’s courts.) As a
result, it is preferable if the contract provides that disputes will be subject to arbitration
outside the host country. It also can help if the contract is governed by foreign law (or by
domestic law in effect as of the date of the contract), to protect against the effect of host
country changes in law that happen after the contract goes into effect.1
Without explicit government commitments, the ability of political risk insurers
and multilateral institutions to mitigate regulatory risk is limited. In particular,
expropriation insurance and guaranties typically cover regulatory risk only in the most
extreme cases. They typically do not cover investors against losses that are the result of
legitimate regulatory changes that do not discriminate against foreigners.
Countries that are members of the World Bank Group’s International Center for the Settlement of
Investment Disputes (ICSID) can use the alternative approach of adopting laws that contain both
assurances to investors about regulatory stability and a consent by the government to arbitrate any investor
disputes at ICSID.
1
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But a government’s commitments under a contract can be insured. In some cases,
the risk of government breach of contract is covered under expropriation insurance, but it
has not always been clear that expropriation coverage covers this risk in every case. (In
fact, some expropriation coverage normally excludes government breach of contract
risk.) Starting in the late 1990s, however, a separate, stand-alone breach of contract
product has become available, both from traditional political risk insurance providers like
MIGA and OPIC, and from newer entrants like the InterAmerican Development Bank
and the Asian Development Bank.2
In addition, since the early 1990s the World Bank has in some cases provided
comparable coverage to lenders (but not equity investors) in its “partial risk guaranty”
transactions, but this product has not been widely used.
2.
3.
Benefits of Regulatory Stability Commitments.
*
Legally binding government commitments to regulatory stability give
investors a way to claim compensation if key regulatory assumptions of a
project are violated. This gives the government a way to overcome
investor concerns about regulatory risk. (But the government’s
commitments will be less effective in overcoming investor concerns if
disputes are to be resolved in host country courts (or even in host country
arbitration).)
*
In addition, legally binding regulatory stability commitments enable
investors to seek insurance or guaranties from political risk insurers or
multilateral institutions, which provides a mechanism for investors to get
cash when governments are unable or unwilling to pay compensation for
violating their commitments.
Obstacles.
*
Governments may not be aware of the need to provide explicit assurances
about regulatory stability in legally enforceable form.
*
Governments may not have good information about the specific
commitments that will be necessary to attract investors.
*
Governments may resist binding themselves to maintain regulatory
stability over an extended period of time. But it may be easier for
governments to offer these commitments if the commitments are limited to
a few narrow (but crucial) issues.
2
Governments should be aware that coverage may be easier to obtain if the government
undertakings are at the sovereign rather than the sub-sovereign level.
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4.
*
Any ambiguity in the government’s commitments can lead to disputes that
will require courts or arbitrators to resolve. As a result, it is important that
the government’s commitments be as clear as possible.
*
Because disputes about host government obligations are normal, political
risk insurance against government breach of contract often requires the
investor to win an arbitration (or court case) against the host government
before the insurer will pay.
*
If government breach of contract insurance is being used as credit support
for a bond offering, the need for an arbitral award may present an obstacle
to the “timeliness of payment” required by the rating agencies for an
investment grade rating.
*
Some governments may not be legally able to submit to foreign
arbitration. As an example, the Turkish Supreme Court declared
unconstitutional the Turkish Treasury’s agreement to resolve disputes with
foreign investors by international arbitration.
*
In other cases, governments may resist international arbitration for
domestic political reasons.
*
Some host governments may not faithfully enforce foreign arbitral awards
against government parties, despite having a legal obligation to. (In cases
of this kind, political risk insurance backing the government’s
commitments can be particularly valuable.)
*
Governments that do not wish to honor their commitments sometimes
work hard to avoid them, even where the investor has good contractual
rights. And as a practical matter, investors may see a need to renegotiate,
rather than trigger contractual protections. As examples:
*
a new government may take the position that contracts entered into
by the former government are invalid, because the contracts were
awarded corruptly (whether or not there is any evidence of this), as
happened in power projects in Indonesia, Pakistan and India; and
*
a new regulator may seek an injunction in local courts prohibiting
a foreign-owned company from taking the government to
international arbitration (this happened in India).
Because governments can seek to evade their contractual commitments, it
is best if investors supplement the contracts with other features of project
design to minimize the likelihood of renegotiation.
Next Steps.
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Disseminate information about the need for governmental contractual
undertakings regarding regulatory issues, and the advantages that these
commitments have in enabling investors to obtain project support.
*
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The specific government commitments required will be country-specific,
industry-specific and project-specific. They will be derived from the
specific regulatory environment that applies to specific projects. To be
effective in addressing investors’ regulatory risk concerns, host
governments should work to identify the specific areas in which investors
will require regulatory stability commitments for particular projects.
Technical assistance, perhaps from multilateral institutions, could help
governments to identify the specific commitments that may be required.