Focus: Abuse of process in investment treaty arbitration
4 December 2009
In brief: A recent decision of an arbitral Tribunal convened under the auspices of the International Centre for the Settlement of Investment Disputes contributes to the emerging notion of abuse of process in the jurisprudence of investment treaty arbitration. This line of authority has implications for treaty shoppers, insofar as it may limit investors' ability to change or acquire nationality for the purposes of Bilateral Investment Treaty claims by selling or assigning their claims to entities incorporated in other countries. Partner Stephen McComish (view CV) and Lawyer Dr Sam Luttrell report.
How does it affect you?
The decision in Phoenix Action:
- identifies some of the limitations on 'treaty shopping' insofar as it deals with a jurisdictional challenge made by a host state in defending a claim brought against it under a Bilateral Investment Treaty (BIT) by its own citizen who was behind, or was interested in, the claimant entity; and
- confirms that foreign investment activities and BIT claims must be conducted in good faith.
In Phoenix Action Ltd v Czech Republic, the Tribunal held that it did not have jurisdiction to hear a claim brought under the Israel-Czech Republic BIT because the claimant was a 'sham' company set up by a Czech national in Israel for the sole purpose of bringing to international arbitration a domestic dispute. The Tribunal characterised the claim as an abuse of the International Centre for the Settlement of Investment Disputes (ICSID) arbitration process and ordered costs against the claimant.
Besides its contribution to the case law of abuse of process in BIT claims, Phoenix Action provides useful guidance as to the circumstances in which an investor can legitimately claim under a BIT, having recently acquired the investment.
The claim in Phoenix Action arose out of an Israeli company's acquisition of two metal Czech companies, Benet Praha (BP) and Benet Group (BG). BG and BP were controlled by the same person, Czech citizen Vladimir Beno. BP and BG became involved in proceedings before Czech courts, BG in relation to the ownership of three other Czech companies (one of which was insolvent); and BP in a public prosecution for tax and custom duty evasions in which assets of BP had been frozen and seized. Mr Beno sold BP and BG to Phoenix Action Ltd (Phoenix), a company incorporated under the laws of Israel and controlled by other members of Mr Beno's family. Two months later, Phoenix gave its host state notice of the existence of an investment dispute.
Eleven months after giving notice of dispute, in February 2004, Phoenix commenced arbitration against the Czech Republic under the Israel-Czech Republic BIT (1997), alleging that the Czech courts' failure to resolve promptly the actions involving BP and BG was a measure equivalent to expropriation of Phoenix's assets, and a breach of the Fair & Equitable Treatment (FET) and Full Protection & Security (FPS) standards of the BIT. After some resistance from ICSID – due largely to the timing of the events and the investment – a three-member Tribunal was formed. Phoenix appointed Professor Andreas Bucher as its arbitrator, and the Czech Republic appointed Professor Juan Fernandez-Armesto. French arbitrator Professor Brigitte Stern was appointed President of the Tribunal.
A hearing on jurisdiction took place on 1 September 2008 in Paris. At the Paris hearing, the Czech Republic argued that the Tribunal lacked jurisdiction because the claimant company was:
[N]othing more than an ex post facto creation of a sham Israeli entity created by a Czech fugitive from justice, Vladimir Beno, to create diversity of nationality.
The state described the claim as 'one of the most egregious cases of treaty shopping that the investment arbitration community has seen'. Appealing to the Tribunal's sense of history, counsel for the state pointed out that the Tribunal would be:
[T]he first Tribunal to decide whether a foreign entity can be created for the sole purpose of creating diversity of nationality and hence to achieve ICSID jurisdiction.
The state argued that the Tribunal had no jurisdiction ratione temporis because the acts said to constitute a violation of the BIT took place before Phoenix acquired BP and BG, thereby making its investment in the host state.1 The Czech Republic put it that, in light of this chronology, the action could be characterised as an abuse of the process of the Washington Convention.
Accepting the universality of good faith in international trade ('this caveat is fundamental'2), the Tribunal laid down four considerations to be taken into account in evaluating whether or not the investor had a bona fide intention to engage in economic activities in the host state:
- Timing of the investment: was the asset or investment already distressed, and was the incoming investor aware of these difficulties when it bought in? The Tribunal noted that 'Phoenix bought an "investment" that was already burdened with the civil litigation as well as the problems with the [Czech] tax and customs authorities'.3
- Timing of the claim: how long after the investment was made did the claimant bring its ICSID claim, and are pre-investment violations and damages really at the heart of the claim? In this case, the vast majority of the facts underlying the alleged breaches of the FET and FPS standards dated from the period before the investment. The Tribunal noted that Phoenix notified the host state of the existence of an investment dispute even before the registration of its ownership of BP and BD with the Czech authorities.
- Substance of the transaction: what was the substance of the transaction, and how was the transaction carried out? In this case, the investment was the purchase of shares in Czech companies BP and BN. In the case of BP, the amount Phoenix paid for the shares was handed on to a company Mr Beno's family controlled. All of the transfers of interest were done within Mr Beno's family, and, at the hearing, counsel for Phoenix conceded that the dealings were not at arm's length.
- True nature of the operation: was any economic activity performed or genuinely intended by the investor? Here, Phoenix had no business plan, no program of refinancing the Czech entities, and no economic objectives.
The Tribunal concluded that, on an analysis of the post-investment facts, it was clear that 'what was really at stake were indeed the pre-investment violations and damages.' 4 The Tribunal found that there was no investment in the Czech Republic, but simply 'a rearrangement of assets within a family, to gain access to ICSID jurisdiction to which the initial investor was not entitled'.5 The person who controlled the claimant company was alleged to have committed customs and tax offences in the Czech Republic, and all of the transfers of interest that affected the assignment of the right to sue were done within a group of companies his family controlled. The claim itself was also very weak, relating to delays in Czech courts and the actions of Czech customs authorities. The Tribunal went on to state that:
The manifest purpose behind its purchase of the Benet Companies was an attempt to render their purely domestic disputes subject to the protections of the BIT rather than to conduct business.6
The Tribunal concluded that because the 'investment' was made for the sole purpose of bringing international litigation against the Czech Republic, the transaction
is not a bone fide transaction and cannot be a protected investment under the ICSID system ... All elements analysed lead to the same conclusion of an abuse of rights. The abuse here could be called a 'détournement de procedure', consisting in the Claimant's creation of a legal fiction in order to gain access to an international arbitration procedure to which it was not entitled.
On these grounds, the Tribunal determined that it lacked jurisdiction to hear the merits of Phoenix's BIT claim.
Significantly for the international investment community, the Tribunal in Phoenix Action accepted that 'the fact of buying a bankrupt or inactive company must not necessarily be disqualified as an investment, as the intent of the investor can precisely be to make the company profitable again'.7 The Tribunal found that the claimant in this case had no such intent, and so its claim was not legitimate.
Phoenix Action involved a clear abuse of the investment treaty arbitration process. In the Tribunal's view, the claimant was attempting to internationalise what were, in reality, domestic matters in order to access the more favourable dispute resolution framework of the Israel-Czech Republic BIT. The future persuasive value of the decision may, as such, be limited by the extremity of its facts, and it is unlikely that the decision will function as a barrier to treaty shopping in the future. The broader value of the decision lies, it seems, in its confirmation of the universality of the obligation of good faith, and its elucidation of the way this fundamental caveat informs the definition of 'investment' in an investment treaty dispute.
- The respondent's final argument was that Phoenix's acquisition of BP and BG is not an 'investment' within the meaning of Article 25 of the ICSID Convention.
- Phoenix Action v The Czech Republic, ICSID Case No. ARB/06/5 (Award on Jurisdiction, 15 April 2009) para 133.
- Ibid. para 136.
- Ibid. para. 138.
- Ibid. para. 140.
- Ibid. para. 141.
- Ibid. para. 140.
- Peter O'DonahooPartner,
Ph: +61 3 9613 8742
- Andrea MartignoniPartner,
Ph: +61 2 9230 4485
- Tracey HarripPartner,
Ph: +61 7 3334 3215
- Stephen McComishPartner,
Ph: +61 8 9488 3767