Contracting with governments: pitfalls, arbitration, sovereign immunity and enforcement

Entering into a contract with an entity owned or controlled by the state poses unique challenges not faced when dealing with a private commercial counterparty. Parties should be aware of certain distinctive features of negotiating with a state entity from the start of any commercial relationship. It is particularly important for parties to consider these implications when conducting business in the Middle East given that:

i. state entities play a major role in the procurement of major projects, particularly in GCC countries; and

ii. the reconstruction of infrastructure and the development of natural resources in countries such as Iraq require significant foreign investment in the form of contracts with state-owned entities.

Determining whether or not a commercial party is dealing with a state entity is not always a straightforward process in the Middle East. As such, parties should take extra care and consider the following factors at the outset:

a) the capacity of the entity to enter into an arbitration agreement;

b) the ability of the state in question to raise a defence of sovereign immunity in the future; and

c) the investment treaty protections that a company may be able to utilise.

In this article, we set out the key factors that parties should consider when negotiating with a state entity in order to maximise the protections available should a dispute arise at a later point.

The risks of contracting with a state

The actions of a state may be influenced by political turbulence, swings in public opinion or economic instability. In addition to the risk of expropriation, commercial parties may also suffer from unfavourable treatment by national courts, legislative or regulatory changes which directly affect the contractual relationship itself (of particular concern in infrastructure and energy projects), or a failure of the state to honour a guarantee.

Failure to consider such risks when negotiating a contract may have considerable consequences in practical terms. A party may find itself unable to bring proceedings against the state or to enforce a court judgment or arbitral award against state assets. The terms of the contract should be carefully drafted to minimise these risks and legal advice should be sought in the jurisdiction in which proceedings may be brought and in any jurisdictions in which a judgment or award may need to be enforced.

If a dispute with a state entity does arise, a private commercial counterparty may face jurisdictional challenges if the state itself is not a party to the arbitration clause. Moreover, whether a national court will consider that a party contracted with (or is arbitrating against) a “state” varies by jurisdiction according to local law.

A common hurdle faced by parties attempting to enforce contractual rights against a state is the defence of sovereign immunity. Sovereign immunity protects states from legal proceedings brought before the courts of a foreign jurisdiction and operates on two levels: (i) it can offer protection to a state or state-owned entity from legal proceedings before a court or arbitral tribunal (immunity from suit), and (ii) it can prevent the recognition/enforcement of a court judgment or arbitral award and execution against state-owned assets (immunity from execution).

Commercial counterparties must therefore be particularly careful when contracting with government entities, navigating the potential pitfalls by ensuring that state immunity from both suit and execution is duly waived. It is important to distinguish between jurisdictions where states have total immunity from suit and execution and jurisdictions in which a state is only immune in matters where it is exercising sovereign power (rather than acting in a commercial capacity). A counterparty should pay particular regard to any limitations on such a waiver and the approach of the courts to state immunity in the relevant jurisdiction where a judgment or award may need to be enforced.

Regional considerations

Can the state entity enter into an arbitration agreement?

Importantly, the UAE effectively has a three tier legal system:

i. federal laws that apply to each Emirate,

ii. laws that operate at the specific level of each Emirate

iii. within Dubai and other Emirates, the government has established free zones such as the DIFC in Dubai or the ADGM in Abu Dhabi, which are independent jurisdictions with their own civil and commercial laws and separate courts.

At the federal level, governments in the UAE must obtain approval from the Ministry of Justice before entering into an arbitration agreement (Council of Ministers Decision No. 406/2 2003). It is important that the commercial counterparty ensures that this approval has been granted before entering into the contract.

Additional restrictions apply in the Emirate of Dubai where “departments, institutions, bodies or authorities” are prohibited from entering into:

a) Contracts that include a governing law clause that does not include Dubai law (Dubai Instruction Order of February 6, 1988; Dubai Law No. 6 of 1997, Article 36).

b) Arbitration clauses which specify a seat outside Dubai, unless approval is obtained in writing from the Ruler of Dubai (Dubai Law No. 6 of 1997, Article 36). Without such approval the arbitration clause will be null and void.

c) Contracts that incorporate conditions of international contracts (Dubai Law No. 6 of 1997, Article 37). The entity needs approval of the Ruler of Dubai to agree to any such provisions. This is particularly relevant to parties in the construction sector as incorporating FIDIC provisions by reference is invalid without such approval.

The Abu Dhabi Commercial Conciliation and Arbitration Centre (ADCCAC) is commonly used in disputes concerning contracts with Abu Dhabi government entities and, whilst there is no law proscribing this, the commercial reality may be that counterparties will need to agree to arbitration seated in Abu Dhabi under the ADCCAC rules.

Similar restrictions apply elsewhere in the region. For example, arbitration is prohibited in disputes involving Saudi Arabian government bodies, unless the approval of the Prime Minister has been obtained or arbitration is provided for under a special provision of law (Article 10(2), new Arbitration Law). Similarly, government entities in Qatar can only agree to arbitrate with permission from the Prime Minister, whilst in Iraq approval must be obtained from a special committee at the Secretariat of the Council of Ministers.

Sovereign immunity

There is no concept of state immunity under UAE law per se and federal law does not grant state entities immunity from suit. However, Article 247 of UAE Federal Law No. 11 of 1992 (the Civil Procedures Law) includes a general prohibition on the seizure of “[p]ublic property owned by the state or any of the Emirates” for the purposes of enforcement. Moreover, Dubai law provides that:

a) suits cannot be filed against the Ruler without his approval;

b) suits against a state entity are subject to numerous formalities, including submitting details of the claim to the Government of Dubai Legal Adviser and then waiting for two months before issuing a claim; and

c) no debt or financial obligation against the Ruler or the Government may be collected “by means of detainment, public auction sale or possession by any other legal procedures of the properties and assets of the Ruler or of the Government whether such debt or financial obligation has received a final and conclusive judgment or not” (Dubai Law No. 3 of 1996, Article 3 (BIS) as amended by Dubai Law 10 of 2005, Article 2).

The DIFC Courts have thus far avoided the question of whether or not the law of the DIFC or the UAE includes the concept of sovereign immunity. However, in the recent decision of Pearl Petroleum Company Limited & Others v The Kurdistan Regional Government of Iraq, the Court clarified that it will uphold correctly drafted waivers of sovereign immunity and permit proceedings and enforcement to continue against states seeking to raise the defence contrary to the contract. This decision is helpful for commercial parties contracting with a sovereign entity, given that the DIFC Courts remain a conduit to enforcement in other jurisdictions such as in “onshore” UAE and Iraq.

Elsewhere in the region, immunity from execution will generally apply. In Saudi Arabia, enforcement is not permitted against government assets pursuant to Article 21(1) of the new Enforcement Law. In Iraq, Article 62 of the Enforcement Law and Article 71 of the Iraqi Civil Code provide respectively that assets of the state and “public property” may not be attached. Similarly, Article 87 of the Egyptian Civil Code provides that public assets are immune from enforcement and attachment procedures.

What comfort should a party seek from a state entity when negotiating the contract?

Are you dealing with a state entity?

Commercial parties should ask at the outset whether, as a matter of fact, the state is in fact a party to any arbitration agreement. Consideration of this point during the negotiation of the contract will assist should there be a dispute at a later stage. If the state may have a degree of involvement in the contract itself, or if the entity has links to the state, the commercial counterparty may wish to make the state a party to a future dispute. In such circumstances, the counterparty should ensure that the state is expressly named in the arbitration clause.

Commercial parties should also be wary of potential uncertainty over the legal rights of the state entity in question. For example, uncertainty regarding the status of the government of the semi-autonomous Kurdistan Region of Iraq continues to pose challenges for foreign investors.

Waiver of sovereign immunity

Obtaining a court judgment or arbitral award against a state entity can be somewhat of a pyrrhic victory if the state raises the defence of sovereign immunity in order to prevent enforcement of the award and execution against its assets. Substantial costs may have been incurred by the commercial party over a significant period only to find that damages cannot in fact be recovered. Parties should seek a waiver of sovereign immunity to avoid such a situation and ensure that this constitutes a waiver of immunity as to suit and execution.

An arbitration clause is usually sufficient as a waiver of state immunity from suit and such clause should in theory grant a tribunal jurisdiction. However, an express waiver offers greater protection to the counterparty. An arbitration clause and express waiver of immunity from suit will not assist when it comes to enforcing an arbitral award and as such a commercial party should always seek an express waiver of immunity from execution. The party should also consider whether both the state entity and the state ultimately controlling that entity have consented to the waiver.

A waiver of immunity will only be effective to the extent permitted by national law and consequently local law advice should be sought in respect of the relevant jurisdiction. In the UAE, there is no guarantee that a waiver of immunity from execution would be upheld by national courts.

Stabilisation clauses

After entering into a contract, there is always a risk that the state in question will legislate in a way which effectively changes the terms of the contract. In order to protect against this, a private commercial counterparty should consider incorporating a stabilisation clause into the contract.

A stabilisation clause allows an investor to minimise risk by addressing how legislative or regulatory changes in the country will modify the rights and obligations of the parties under the contract, usually by stating that the applicable domestic legislation shall not apply to the investor (freezing clauses) or that the host government shall indemnify the investor from and against the costs of compliance with such laws (economic equilibrium clauses), or a combination of the two.

The existence of such a clause acts as an indication that the state itself is entering into the contract rather than just a related entity. This may be helpful at a later point if a court or tribunal is asked to conduct a factual and legal analysis of the background to the transaction in order to assess whether or not the entity is in fact an emanation of the state.

What protections are available for investors?

Bilateral Investment treaties

In addition to commencing commercial arbitration proceedings or proceedings in national courts, a party may be able to bring a separate claim against the relevant state pursuant to the investor state dispute settlement (“ISDS“) provisions of an investment treaty. Bilateral investment treaties (“BITs“) are entered into between countries to promote and protect investments made by investors from respective countries in each other’s territory. A state consents to international arbitration proceedings through the ISDS provisions of a BIT and therefore a claim by the party for a breach of the provisions of a BIT would be brought against the state itself.

The commercial party may wish to consider which countries have entered into treaties with the state in question and structure the transaction from the outset to benefit from such treaties. For example, only Kuwait, Japan and Jordan currently have BITs in force with Iraq.

Multilateral investment treaties

Whilst a BIT will generally offer greater protections to qualifying investors, a party could also consider bringing a claim under a regional multilateral investment agreement. The Organisation of Islamic Cooperation Agreement on promotion, protection and guarantee of investments among Member States (the “OIC Agreement“) has been signed by 33 Member States and ratified by 27 countries across the Middle East, Asia and Africa and offers a number of potential advantages. The definition of “investor” is very broad and does not provide for specific requirements as to the nationality of the legal entity. “Investment” is also defined very broadly and was held by a tribunal to encompass “all assets”. Furthermore, the “most-favoured nation” provision under Article 14 of the OIC Agreement allows an investor to import provisions from other investment treaties entered into by the state in question.

A further option for consideration would be to commence proceedings pursuant to the dispute resolution provisions of the Unified Agreement for the Investment of Arab Capital in the Arab States (the “Arab Investment Agreement“). However, the Arab Investment Agreement offers fewer protections than the OIC Agreement as the criteria for an investor are much more limited.

Enforcement

Certain BITs allow investors to commence proceedings under the ICSID Convention, which has its own enforcement mechanism pursuant to which an ICSID award must be recognised as a final judgment of a national court and as such cannot be appealed to national courts. This is worth noting given that the Inter Arab Convention on Judicial Co-Operation (the Riyadh Convention), the most commonly used treaty in the Middle East for the recognition and enforcement of both court judgments and arbitral awards between Arab nations, and the Agreement on the Execution of Rulings, Requests of Legal Assistance and Judicial Notices (the GCC Convention) do not apply to awards against a government.

The option to commence ICSID proceedings may be attractive where the state in question is not a signatory to the New York Convention (“NYC“) and given that the Riyadh Convention does not apply to awards against a government. For example, Iraq is not yet (although it should accede soon) a contracting state in respect of the NYC but did accede to the ICSID Convention in December 2015. However, it is important to note that a state’s consent to ICSID arbitration does not constitute a waiver of its immunity as to execution which remains a matter of domestic law (articles 54(3) and 55).

At the point at which an award is obtained, the commercial party should ensure that the award is made against the state rather than or in addition to the entity to minimise the risk that a national court will question whether or not the award has been made against the state itself at the enforcement stage.

Conclusion

Given the prevalence of state-controlled entities in the Middle East in the infrastructure, energy and construction sectors, commercial parties should be alert to the potential pitfalls of contracting with such an entity. An awareness of the potential risks at the outset should enable the party to draft the contract to minimise risk and maximise protection should a dispute arise in the future. Predicting political and economic crises and the sympathies of future governments towards foreign investors is never an easy task. However, it is possible to anticipate that future regulatory or legislative changes may occur or that a state may be able to raise a defence of sovereign immunity. Addressing such issues in the contract itself may prevent a situation where a party finds that it cannot commence proceedings or enforce an award against state assets. If a dispute does occur, private counterparties should also be fully aware of the options available and the enforcement risks in any relevant jurisdictions.

For further information, please contact Craig Shepherd, Partner, Caroline Kehoe, Partner, Stuart Paterson, Partner, Patrick O’Grady, Associate or your usual Herbert Smith Freehills contact.

Craig Shepherd
Craig Shepherd
Partner Global Head of Contentious Construction
Email | Profile
+97 14 428 6304
Stuart Paterson
Stuart Paterson
Partner
Email | Profile
+97 14 428 6308
Caroline Kehoe
Caroline Kehoe
Partner
Email | Profile
+97 14 428 6302
Patrick O'Grady
Patrick O'Grady
Associate
Email
+97 14 428 6388

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Filed under Advice on State Contracts and Disputes, Arbitration clauses, Middle East, Sovereign Immunity

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