Yukos v. Russia and Damages in International Arbitration with respect to Income Generating Assets or Investments

I. INTRODUCTION

This article discusses damages analysis for the interruption of the income stream in income generating assets or investments due to breach of contract or the violation of an international legal standard (international tort), in commercial and investment arbitration, as applicable. As will be shown in the following paragraphs, the methodology of damages analysis with respect to income generating assets in commercial and investment arbitration is similar. The difference lies in the so-called measure of damages.

For income generating assets, the income stream serves to recover the investment and to generate profits. Income generating assets may be electric power plants, hotel resorts, oil and gas exploration projects, toll highways, production plants and other investments. In these cases, damages claims may arise from the breach of contract or international tort, where the damages analysis is about the effect of the breach or the illegal State measure on the income stream.

In complex long-term contracts such as joint venture agreements, concessions for toll roads, BOT (Build-Operate- Transfer) or PPP (Public-Private Partnership) projects, the parties contribute assets of any kind, in order to obtain the income or cash flows, which come from a third party, that is, the market such as the users or consumers of electricity, toll roads or water. This leads to a triangular structure or so called ‘synallagmatic triallagma’.¹ Such situation is different from typical synallagmatic contracts such as sales and construction contracts, where one of the parties receives a good or service in exchange for a price paid by the other party. In this case, the profits for the buyer may be generated through collateral transactions with third parties and are not directly governed by the original contract, but the lost profits under collateral or subsequent transactions are the consequence of the breach of the original contract. These legal differences have implications as regards to causality, foreseeability and mitigation.

Damages analysis with respect to the interruption of income stream is challenging due to the element of uncertainty in the behavior of the market from which the income stream depends. The determination of the reasonable certainty of the income is the key element of damages analysis, together with the determination of the effect of the breach or the illegal State measure on the income stream.

The lost profits with respect to income generating assets may be caused by the breach of a complex long-term contract and resolved through commercial arbitration, by breach of contract under an umbrella clause or by an illegal State measure through investment arbitration. Damages are the amount of compensation for the lost profits, which should place the injured party in the economic position it would be in but for the breach or the illegal State measure. This corresponds to the full compensation principle, which is recognized as a general principle of law² and also as international customary law standard.³

The core of damages analysis is the understanding of the structure of income stream based investments as developed since the 1970s by project finance specialists⁴ and the application by analogy of the corresponding private law legal principles. Correct damages analysis aims at a fairly precise determination of historical losses and a considerable reduction of the element of estimation as regards future lost income stream or profits measured at the moment of the award. A deficient damages analysis leads to erroneous results in damages valuation. Therefore, the understanding of the correct process of damages analysis as regards income generating investments in commercial and investment arbitration is of utmost importance in order to achieve a reasonable and fair determination of damages.

II. THE STANDARD OF COMPENSATION

It is undisputed among legal systems that the injured party is entitled to recover all losses incurred due to the breach of contract or illegal State measure. The principal function of damages law is to compensate for the loss caused by the breach or the illegal State measure, by placing the injured party in the economic position it would be in but for the breach or the

illegal State measure. Full compensation thus requires one to answer the question of what would be the economic position of the injured party but for the breach, or the illegal State measure. The principle of full compensation applied through the but-for premise is, therefore, the guiding principle for any damages claim.

The standard of full compensation is recognized in the Factory at Chorzów case,⁵ which reflected contemporary State practice at the beginning of the 20th century.⁶ Full compensation refers to the expectation interest as defined by Friedrich Mommsen in his Doctrine of Interest in 1855, according to which ‘Interest means, however, damages; and if the expression damages is exclusively understood as full compensation, both terms coincide in their meaning’.⁷

III. TYPICAL AND ATYPICAL SYNALLAGMATIC CONTRACTS AS WELL AS OTHER INCOME GENERATING ASSETS

Before explaining the differences in damages analysis, it is important to understand the structural elements of typical complex long-term contracts such as energy and gas supply contracts or turnkey construction agreements, and atypical long- term contracts based on income stream such as joint venture contracts, BOT and PPP contracts, or any other income generating assets such as hotel resorts or income-generating investments without a contractual relationship with a State entity.⁸

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 (synallagmatic triallagmas), the essential legal elements are the assets of any kind that the parties contribute, but with the income coming from a third party (i.e., the market). This is relevant for the determination of loss and with respect to foreseeability and mitigation.

The difference is that in typical synallagmatic contracts the profits of the buyer derive from collateral transactions or subsequent contracts. In this situation, there is an exchange of goods or services against money, and the buyer may obtain profits from a third party through collateral transactions based on the services or goods received under the original contract. Atypical synallagmatic contracts (triallagmas) are similar to a partnership. In this second situation, both parties contribute assets with the expectation to obtain an income stream or profits from a third party. The contract regulates the way in which the parties must act in order to obtain such profits and the way they would share those profits. The similarity between complex typical synallagmatic and atypical synallagmatic contracts is that in both cases the ultimate economic purpose is the generation of income or profits coming from a third party.

In a typical sales or construction agreements, the seller sells goods or services and the buyer pays the price. If the goods or services are deficient, the loss for the buyer is either the cost of cure or the difference in value between a conforming and non- conforming good or service, which is the damnum emergens. This situation is normally regulated in detail under the applicable laws and there are substantial differences between such applicable laws with French law having the highest level of measure of damages, which is the cost of cure⁹ and English law applying the concept of difference in market values.¹⁰ In practice, in case of a defective swimming pool, under French law the constructor would have to reconstruct such swimming pool even when the cost of reparation exceeds the cost of the original works, whereas under English law, no damages would be awarded if the value of the house with the swimming pool would be the same with and without the compliance with the original specifications of the swimming pool.

The situation is different with respect to complex long-term contracts based on the income stream from a concession or from other income generating investments, where the investors receive the income stream from a third party. Here, the breach of contract or the illegal State measure (international tort or violation of an international law standard such as the fair and equitable treatment standard) impairs the income stream. In these cases the damages could only be lost profits, or lucrum cessans,¹¹which would have been obtained but-for the breach or the illegal State measure.

IV. IMPLICATIONS OF THE DIFFERENT LEGAL SITUATIONS ON DAMAGES ANALYSIS

There are three basic legal situations which have to be distinguished for the purpose of damages analysis:

1. (1)  Typical synallagmatic contracts, where the income to be generated is not governed by the original contract, but subject to collateral or subsequent contracts of one of the parties.
2. (2)  Synallagmatic triallagmas mentioned above, where the legal and economic purpose of the contract is to generate income which comes from the market, and where there are detailed rules within the agreement governing such income stream.
3. (3)  Other investments aimed to generate income, where the income stream is interrupted by an illegal State measure, and where the investment is protected under an International Investment Agreement with the State which committed the illegal measure, even if there is no contract with that State.

Loss and causality are the key elements to be analyzed in all three situations. Significant differences may exist with respect to the measure of damages and limitations such as foreseeability/ adequacy and mitigation. If the loss is caused by a breach of contract, it may be subject to commercial arbitration or even investment arbitration in case of an umbrella clause contained in an International Investment Agreement. If it is caused by an illegal State measure in the form of violation of an international legal standard such as the fair and equitable treatment, investment arbitration may proceed if the requirements of jurisdiction are being met. The but-for premise is the framework for the damages analysis in all these situations

V. THE BUT-FOR PREMISE

The but-for premise is based on Friedrich Mommsen’s’ Differenzhypothese as of 1855 which defines the expectation interest, a term developed by Rudolf von Ihering in 1861, referring to tortuous liability under the notion of culpa in contrahendo,¹² and further explained in a seminal article by Lon Fuller with William Perdue in 1936 which lead to the codification of the expectation and reliance interest in US law.¹³

The but-for premise has an important temporal notion and refers to the course of events with and without the breach or the illegal State measure from the moment of such breach or State measure until the end of a project or investment, even if the end of such project or investment occurs after the arbitral award. This poses significant challenges for damages analysis.

The but-for premise is the analytical framework for the determination of loss or lost profits in a damages claim. This premise leads to the reconstruction of the hypothetical economic situation of the injured party but for the breach or the illegal State measure in order to compare it with its actual economic situation after the breach or the illegal State measure.¹⁴

The but-for premise starts by establishing the hypothetical economic performance of a contract or of an investment in the absence of the breach or illegal State measure and seeks to determine in monetary terms the difference with the actual situation as a consequence of the breach or the illegal State measure. Such difference is precisely the loss to be compensated. The experts have to determine whether the but-for economic performance of the claimant would have been superior to the actual performance. In order to do this, each of the relevant contingencies that might affect such performance during the relevant period of time must be analyzed. The reconstruction of the hypothetical course of events requires the expert to isolate the effects of the breach or the illegal State measure from any other factors which may have affected the business or investment. Such reconstruction should be in accordance with the evidence available and would have to prove with reasonable certainty that there would have been income but for the breach or illegal State measure. Therefore, if it cannot be proved with reasonable certainty that there would be income but for the breach or illegal State measure, there are no lost profits. The most important thing when reconstructing the hypothetical situation is that the data are credible. Moreover, the quantification will be weakened if the defendant can show that it is not consistent with the basic economic situation.¹⁵ Lost profits resulting from the difference between the hypothetical and the actual scenarios must be proved with reasonable certainty, which after the application of the limitations results in the ‘actual loss.’

The but-for premise will also help to determine causation. Causation is the test used to determine the connection between the loss and the breach or the illegal State measure. If the economic situation would have been the same for the injured party, there would be no loss. With respect to income generating assets, if the investment would not have been profitable, there would be no lost profits in spite of the breach of contract or the illegal State measure. If the investment would have turned sour because of an economic crisis, there might not be lost profits caused by the breach or the illegal State measure but the failure of the investment would be the result of the economic crisis. Loss of income stream and causality are, therefore, determined through the but-for premise.

Concurrent causation situations such as contributory negligence can reduce the scope of causation and, therefore, reduce the amount of damages. Therefore, causation is not only a requirement for the recovery of damages, but has also implications on the amount of damages to be recovered. Partial causation may lead to a substantial reduction of the damages claim. Therefore, the causation and the quantification of damages cannot be separated. They are intimately related and must be analyzed within the but-for framework.¹⁶

The but-for premise can be applied to determine loss and causation in typical or atypical synallagmatic contracts or in the case of the interruption of income stream caused by an illegal State measure. However, the implications will be different with respect to the measure of damages. The measures of damages are damnum emergens, lucrum cessans, expectation and reliance interest, or the fair market value of an investment.

VI. MEASURE OF DAMAGES FOR TYPICAL SYNALLAGMATIC CONTRACTS

The measure of damages for typical synallagmatic contracts is cost of cure or difference in value of the deficient good or service received, which refers to damnum emergens. There are legal systems such as French law which recognize the cost of cure as the measure of damages even if such cost is not reasonable.¹⁷ For example, in the case of a swimming pool, already mentioned, claimant would have the right to obtain the reconstruction of the swimming pool even if such cost exceeded the original price of such swimming pool. However, cost of cure does not apply to income expectations under complex long-term contracts, payment obligations under take or pay agreement or income generating investments, as this damnum emergens only applies to the non- conforming goods or services that can be repaired or replaced.

On the other hand, in typical synallagmatic contracts another measure of damages that could be applied is the so-called difference in value. This is recognized under English law where the test is whether the non-performance would affect the value of the property. For example, in the case of the swimming pool, the question to ask is whether the value of the property changes because of the difference in depth of the swimming pool. In this renowned case, the court did not find any difference in value¹⁸ and did not award damages, whereas under French law the damages would have theoretically exceeded the construction cost. Both cost of cure and difference in value correspond to damnum emergens, which is the loss to the goods or services received caused by the breach of the contract.

In typical synallagmatic contracts, lucrum cessans are the lost profits that cannot be realized from collateral transactions because of the non-performing good or service received. If the breach of a typical contract affects collateral transactions, there would be lost profits (subject to mitigation) which would correspond to lucrum cessans.¹⁹

VII. MEASURE OF DAMAGES FOR INCOME GENERATING INVESTMENTS UNDER COMPLEX LONG-TERM CONTRACTS

The breach of a complex long-term contract based on income stream, or the interruption of income stream in an investment caused by an illegal State measure, results in lost profits. Therefore, the measure of damages for the interruption of income stream is the expectation interest for lost profits or lucrum cessans and there is no room for damnum emergens, which as we said is the good or services not received or not received in conformity with the contract.

A. Expectation Interest

The expectation interest protects the legitimate expectations of the parties in the performance of the contract or the investment. Under the but-for method, the question is ‘What would have happened in the absence of the breach or illegal State measure?’ To answer this question the but-for premise compares the hypothetical economic situation without the breach or illegal State measure and the actual situation. The result is the expectation interest or lost profits.

With respect to lost profits, there are two main issues: (i) the reasonable certainty of the income stream, (ii) and the effect of the breach or illegal State measure on the income stream. As regards the first, claimant must prove with reasonable certainty that, according to the evidence available, there would have been income in the absence of the breach of contract or the illegal State measure. The reasonable certainty of that income may depend on the existence of a market, and sometimes on the existence of natural resources. As regards the second issue, the effect of the breach or illegal State measure has to be determined based on the evidence available.²⁰

The determination of the reasonable certainty of an income stream is particularly challenging in oil and gas projects.²¹ However, even in such projects there are methods, such as the Monte Carlo method, which may allow the determination of the probability of finding such natural resources and the value of future expected revenues with reasonable certainty,.²²

The expectation interest avoids over- and under-compensation when correctly applied, as it leads to a determination of the economic and financial parameters that changed precisely because of the breach of contract or illegal State measure, both with respect to the past and the future impact on the project.

B. Reliance Interest

This measure of damages is the loss caused by entering into a contract which was not performed due to its breach. 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 expectation interest, the question is ‘what would be the position of the injured party but for the breach?’ Certain rules of law such as the English and German law establish a presumption in favor of recovery which leads to a reversal of the burden of proof, whereby the respondent would have to prove that the claimant would not have recouped its investment in the absence of the breach or illegal State measure. The respondent would have to prove that the income stream was not reasonably certain.²³

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 or illegal State measure. Reliance interest may be justified from a legal policy perspective in a case where the investor enters into a project due to misrepresentations or misleading information provided by the respondent. Similarly, bad faith of the respondent, or the difficulty of obtaining evidence of the reasonable certainty of the income stream, in particular, when such evidence is under the control of respondent, could justify the use of reliance interest. This would be in accordance with the original conception by Rudolf von Ihering as tortious liability.

If the injured party can prove that it invested in reliance on misleading information and misrepresentations provided by the respondent, there should be no need to prove the certainty of the income stream, but only the investment made in reliance on the contract, according to the general principle of law omnia presumuntur contra spoliatorem.²⁴

VIII. THE MEASURE OF DAMAGES IN INTERNATIONAL LAW (FAIR MARKET VALUE)

Damages in investment arbitration may arise from the violation of an international legal standard such as the fair and equitable treatment standard, or the breach of a contract protected under an umbrella clause contained in an international investment agreement with or without the violation of an international legal standard. In these cases the measure of damages is different.

The violation of an international legal standard may occur through administrative or fiscal measures or changes in the regulatory framework by the State affecting the income stream of the investment or project. The decisive issue is that the State’s conduct violates international law, 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 favored nation standards and other standards contained in International Investment Agreements and under customary international law. State responsibility arises from international tort.

International damages law has developed through analogy with private law. International Investment Agreements do not contain rules on damages. Therefore, it has been necessary to look at customary international law and general principles of law. Private law sources and analogies in international law are found in areas of the international law of tort and the problems of States responsibility; the measure of damages; and the question of interest, moratory and compensatory. The notions of causation and mitigation used in international law also derive from private law.

Customary international law has been identified in the famous Factory at Chórzow case, which is the most important judicial decision with respect to international damages law for breach of an international legal standard as confirmed by the former Austrian-British judge of the International Court of Justice, Prof. Hersch Lauterpacht:

‘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 Judgement in the case concerning the Chórzow 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 the disposition plus interest to the date 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 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.’²⁵

The oft-cited reference to ‘wipe out all consequences of the illegal act’ establishes the full compensation principle for damages in international law. Full compensation under the Chorzów formula means awarding the higher of the value of the company or investment at the moment of the 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.²⁶

This reference is similar to Mommsen’s but-for premise, which aims to place the injured in the economic position it would be but for the breach. However, full compensation under Chorzów is achieved by awarding the higher of fair market value (FMV) of the investment at the date of the breach and at the date of the award, plus historic losses in the latter case. This is different from Mommsen’s but-for premise, where damages are the economic difference between the actual and but-for scenarios at the date of the award.

In the Factory at Chorzów case the objective of shareholders represented by the German government was to obtain a fair compensation. In the context of income generating investment, 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 their contracts. The question posed by the Court to the experts referred to the determination of the value of the undertaking at the date of the expropriation or the date of the award. The reference to the value of the undertaking under the Chorzów formula has been considered to refer to the concept of fair market value (FMV) even if the Factory at Chorzów case does not refer to it expressly.

The notion of FMV was first used in American International Group v. The Islamic Republic of Iran in 1983, which stated that ‘the valuation should be made on the basis of the FMV of the shares’,²⁷ and reinforced in Starrett Housing Corporation v. Government of Islamic Republic of Iran in 1987. In Starrett, the expert defined 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 maxmise his financial gain and neither was under duress or threat.’²⁸

The reference to duress is particularly important in case of economic crises where there are normally no willing buyers, as the investment is made for a certain project and normally can only be used for a particular purpose. The FMV ignores such duress and threat. The term “willing buyer” is hypothetical and leads to the preponderant use of the income stream as the basis for the calculation of damages, as the value of an assets depends either on what the market is willing to pay for that asset or for its ability to generate an income stream.

With respect to the measure of damages for illegal expropriation, according to commentaries 21 and 22 of the Articles on States Responsibility, compensation reflecting the capital value of property taken or destroyed is generally assessed on the basis of FMV of the property lost. The method used to assess FMV, depends on the nature of the asset. The FMV as a measure in investment arbitration determines the value of the company or investment that was lost due to the violation using different valuations approaches such as asset based, market based and income based valuations. Income producing assets and investments are often valued using income based valuation methods on the same or similar investments.

The Chorzów formula is an important example of the reception of private law – in particular the German law notion of the hypothetical normal course of events (hypothetischer Normalverlauf), which excludes extraordinary events which may reduce the damages. 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. Extraordinary events such as force majeure, which would have affected the course of events, are not to be taken into consideration. This is an important deviation from the but-for premise originally developed by Mommsen, whereby extraordinary events such as economic crises would affect both the actual and the but-for courses of events and would be taken into consideration when calculating damages.²⁹ In the calculation of the FMV, extraordinary events subsequent to the illegal measure negatively affecting the income stream or cash flows are not taken into consideration when calculating damages. This may have important consequences. Therefore, the measure of damages in form of the fair market value (FMV) does not follow precisely the Mommsen but-for premise, but uses the notion of the hypothetical normal course of events under German law, as found in the Factory at Chórzow case between Germany and Poland. The negative effects of a subsequent crisis are likely to be ignored. The notion of the hypothetical course of events is also reflected in the choice between the higher FMV as of the date of the violation or the date of the award, where the possibility of a failure of the investment is being excluded, which as shown in the ADC vs. Hungary or the Yukos cases.³⁰

The implications are the following: In investment arbitration, there are two main differences with respect to commercial arbitration: (a) the preponderant use of the FMV of the investment as the measure of damages; (b) the use of the higher FMV as the date of the violation or the date of the award plus the award of lost profits between of the valuation and the date of the award. The approach under the Chorzów standard is explained by legal policy reasons such as the need to treat international tort differently from the breach of contract and to avoid opportunistic behavior of the State. As stated by the PCIJ, it aims to avoid the State party taking advantage of the economic situation, or the effect of its own measures on the value of the investment.³¹  However, this measure of damages should not apply to breach of contracts protected under umbrella clauses, where there is no violation of an international legal standard such as the fair and equitable treatment standard and, therefore, there is no international tort, but only a breach of the contract.

IX. LIMITATIONS

The following limitations are important when framing a damages claim: (a) foreseeability, (b) mitigation, and (c) contributory negligence.

A. Foreseeability

In essence, the test of foreseeability refers to whether the respondent was aware that the breach could cause lost profits. The timing of that awareness, however, may be important. 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.<

In complex long-term contracts, either typical or atypical, considerable investments are made in order to generate income. In case of the construction of a plant or an infrastructure project, the aim is to obtain profits. Those profits may be interrupted by the breach of the contract by the other party. The issue of foreseeability of lost profits is apparently complicated from a legal perspective under typical synallagmatic contracts, as the collateral transactions are not expressly governed in the original contract, and they are not the legal object of the contract. However, even under those contracts the lost profits of the plant owner arising from a defective plant are normally foreseeable and the issue in these cases is the one of mitigation, as will be shown below.

For example, in case of typical synallagmatic contracts such as construction agreements, the situation is as follows: First, payment derives from the buyer or owner and not from a third party. Second, the loss is caused by deficient characteristic performance, such as a plant not meeting performance requirements. Third, the lost profits may derive from collateral transactions that are not directly contemplated in the construction agreement. Therefore, the only situation which gives raise to damages in the form of lost profits is when the breach causes the interruption of income deriving from collateral transactions. This leads to the test of foreseeability, where the question is whether the party in breach would have known at the moment of the signing of the contract or at the moment of the breach that by breaching the contract it could have caused lost profits. In this transaction, it is rather unlikely that the lost profits due to the breach are not foreseeable. However, that does not mean that lost profits must be awarded, as mitigation is of essence. The question is whether the injured party would have been able to mitigate and therefore, the actual loss would be the difference in cost with or without mitigation. Under most applicable laws, there are fairly precise rules regulating damages claims for synallagmatic contracts with an emphasis on the compensation of loss and restrictions as regards lost profits which have to be observed.

With respect to damages in the synallagmatic triallagmas the breach must affect or interrupt the income stream and therefore causes a loss, in the form of lost profits. The essential element in damages analysis is causality which aims to determine the effect of the breach of an agreement on the income stream of an investment. Lost profits in these cases are foreseeable, as they are expressly governed under the contract, and it is not relevant whether they were foreseeable by the respondent at the moment of the breach or at the moment of the execution of the contract. In this case, the test of foreseeability is quite straightforward, as the legal and economic purpose of the contract is the generation of income stream and the effect of the breach is normally foreseeable. Therefore, the test of foreseeability should hardly play a role due to the express assumption of risk under the contract.³²

In situations where the income of the project is interrupted by an illegal State measure, even if there is no contract between the owner of the project and the State, the income stream in the absence of the illegal State measure is protected under the applicable international law standard. The international law standard precisely protects against the undue interference of the State in its investment, and the only relevant consequence for which the investor may be compensated is precisely for the lost profits. If the State had known or could have known that the illegal State measure would cause the lost profits, then the lost profits were foreseeable. Every investment is made to obtain profits, so the State may hardly argue that the lost profits caused by the illegal measure were not foreseeable.

The question of foreseeability does not refer to the certainty of the amount of lost profits and the fact that lost profits are foreseeable does not mean that damages should be awarded as, for example, risk allocation may bar a damages claim.³³

B. Mitigation

In general, mitigation is a limitation that applies under most of the rules of law, where the reasonable expenditures in order to mitigate the losses are recoverable even if such efforts were not successful. The duty of mitigation does not apply under French law and countries based on French law, however, a similar result is achieved through the application of the causality test.³⁴

If the claimant has taken reasonable measures to mitigate the consequences of the breach, the result of the but-for situation vs. the actual situation calculation must incorporate the benefit and cost of mitigation. What is important to mention is that in collateral transactions of typical synallagmatic contracts, replacement of goods or services is often feasible, which may lead to an increase in costs due to mitigation. For example, in case of a deficient freezing plant, the products may be frozen in another plant, which would allow the claimant to maintain sales, but at a lower income, as the costs of freezing in another plant are higher than the costs of freezing as originally planned. Therefore, the difference between the cost of internal production and the external cost of processing could be claimed.

With regards to atypical synallagmatic contracts, mitigation might not be possible, as the effect on the income stream of increased taxes, lack of permits, the non-fulfillment of the delivery of technology by a joint venture partner, often cannot be mitigated. In the case of an illegal State measure such as an illegal expropriation, mitigation is not feasible. However, this has to be examined on a case by case basis. Even if lost profits cannot be mitigated, still the issue is to prove with reasonable certainty that there would have been income but for the breach or the illegal State measure.

The test of mitigation is whether it was reasonable for the claimant to take a certain mitigation action, not whether that action was the best alternative available. When quantifying the effect of failing to mitigate, 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. The recoverable damages would then be the difference between the claimant’s hypothetical situation but for the breach and the claimant’s hypothetical situation if it had mitigated from the breach onwards.³⁵

C. Contributory Negligence

Contributory negligence as regards lost profits is normally a matter of causality, save where the applicable law establishes a different category. Income not received due to the fault of the injured party cannot be considered a consequence of the other party’s breach. The question is what would be the effect of the breach on the income stream. If the income stream is affected by the actions or omissions of the injured party, such an effect was not caused by the other party’s breach.

When assessing lost profits, there is an overlap between causality, mitigation and contributory negligence. Causality and contributory negligence refer back to the breach or the implementation of the illegal State measure, while mitigation refers from the moment of the breach onwards.

X. THE RELEVANT DATE FOR THE VALUATION OF DAMAGES AND INTEREST AS DAMAGES

The selection of the date of damages and to what extent the damages expert should use ex-post information in his assessment is of particular relevance in damages valuation. The date of valuation has to be the most appropriate in the light of the full compensation principle, which means that compensation has to restore the economic position that the injured party would have had at the date of the award.

As already examined by Friedrich Mommsen in his seminal work on “The Doctrine of Interest” as of 1855, which establishes the notion of the expectation interest, the date for the assessment of damages is the ‘time of the judgement’, which is ‘the only determination of the time which truly corresponds to the essence of [expectation] interest’.³⁶

Under the but-for method, the difference between the but-for and the actual economic situation could be assessed at the date of the breach or at the date of the award. However, in order to fulfil the full compensation principle, the assessment of damages should correspond to the date of the award, which is the date in which the injured party should receive the damages.

If the date of the breach is taken for the damages valuation, in order to meet the full compensation principle, the lost profits should be updated from the date of the breach or the illegal State measure to the date of the award. Similarly, 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 rate must be the same in order to avoid over- or under-compensation. But this difficulty can be avoided if damages are measured as of the date of award in the first instance.

The primary function of damages is compensation, as recognized by leading authors, because it helps to restore the claimant’s economic position it would have had if the breach or illegal State measure would not have happened. Money loses value over time through inflation, which has to be compensated by updating the damages to the moment of the award. This updating of damages from the date of the breach to the date of the award is necessary to make the party whole, and it prevents or avoids unjust enrichment of the respondent.³⁷

According to the full compensation principle, the appropriate interest rate is the one which would place the injured party in the economic position it would be but for the breach, at the moment of the award. Generally, this will be the same rate used to discount the cash flows. 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 the breach.³⁸

Companies obtain financing for their operations from the shareholders or lenders. That money is never provided for free. The injured party has a financing cost equivalent to its cost of capital (WACC). ‘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) of an efficiently managed firm under a similar market, contractual, and institutional environment.’ ‘The WACC represents the firm’s cost of raising funds from both shareholders and lenders in an efficient proportion…, called the optimal capital structure’.³⁹ Tribunals can avoid under- compensation by updating the damages from the date of the breach till the date of the award at the WACC or in any case at the same rate used to discount the cash flows.

The date of damages valuation and the rate used to discount and update the damages are very important in order to award damages properly. For illustrative purposes only, an example is presented to show how to avoid under-compensation:

Example. A company expects an income based on a business plan of a project. The plan started in 2000 and it ends in 2010. The breach occurred in 2002 and the award was rendered in 2006. The relevant question under the but-for premise is “What would be the economic position of the injured party at the date of the award?” To determine the lost profits arising from the difference between the but-for situation and the actual situation of the injured party at the date of the award, there can be two approaches: (a) to discount the lost profits to be obtained at the end of the business plan in 2010 to the date of the award in 2006, or (b) to discount the lost profits to be obtained at the end of the business plan in 2010 to the date of the breach in 2002, and to then update them to the date of the award in 2006. If the latter approach is chosen, the same rate should be used to discount the lost profits or cash flows and to subsequently bring them forward. If they are not updated at the same rate used to discount the cash flows (or not updated at all), there would be a violation to the full compensation principle causing significant under-compensation to the injured party and unjustified enrichment of the party in breach.⁴⁰

Under the but-for premise, the aim is to place the injured party in the economic position it would be but for the breach or the illegal measure, which means full compensation. The most straightforward way to achieve this is to take the date of the award as the relevant date for the assessment of damages, as this is the date when the injured party is actually awarded the damages. By assessing damages at the moment of the award, problems related to the updating of damages or the determination of pre-award interest are avoided. This approach was followed in the case of ADC v. Hungary, which was considered an illegal expropriation under the respective bilateral investment treaty.⁴¹

The use of the date of the breach as the relevant date for the determination of damages imposes additional and unnecessary difficulties when valuating damages. However, if the date of the breach is chosen, damages should be updated till the date of the award at the same rate used to discount the cash flows. Cash flows that are expected to occur after the date of the award should be discounted to the date of the award, preferably using the WACC. If such 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 under-compensation. In order to avoid under-compensation arbitral tribunals can also award pre-award interest rate at the same rate used to discount the cash flows.

In the Yukos cases, the arbitral tribunal confirmed that the claimant was entitled to the higher of the damages calculated on the date of expropriation as of 19 December 2004 and the anticipated date of the award as of 30 June 2014,⁴² which follows the rationale of the Chorzów case.

In order to arrive at the value of Yukos at the relevant valuation dates, the arbitral tribunal adjusted the Yukos value calculated as of November 2007 ‘on the basis of the development of a relevant index’ (the RTS Oil and Gas Index), which refers to the prices of trades executed in securities admitted to the trading on the Moscow Stock Exchange and includes preferred or common shares of nine Russian oil and gas companies. Such index represents the value of comparable companies.⁴³

The value calculated as of 19 December 2004 applying the aforementioned index was updated to the date of the award at an annual interest rate in the amount of 3.389% per annum, which actually corresponds to the compensation for a legal expropriation as analyzed in the Factory at Chorzów case.⁴⁴ This value was considerably lower than the value of Claimant’s Shares in Yukos as of 30 June 2014, which was also calculated applying the aforementioned index between 21 November 2007 and 30 June 2014.⁴⁵ Dividends and interest on dividends were added until that moment in accordance with the Chorzów formula, as Claimant would have received such dividends in the absence of the expropriation. By correctly applying the Chorzów formula in the award of damages, the Yukos arbitral tribunal calculated damages at the moment of the award and the issue of pre-award interest did not arise. The effect of ‘bringing forward’ or ‘backwards’ the amount of damages using the same index corresponds in essence to the application of the same discount and interest rates in order to avoid over- and under-compensation.

In that case, the arbitral tribunal did not base its valuation on the generation of income stream as proposed by Claimant but on what the market pays for the investment which was the determined through the relevant stock exchange index.

XI. CONCLUSIONS

Damages analysis requires an understanding of the notion of income generating assets either in form of income-based complex long-term contacts or non contract-related investments. Damages analysis with respect to such assets is similar in commercial and investment arbitration. However, whereas in commercial arbitration, the Mommsen but-for premise provides the analytical method for damages analysis of the lost income stream or lost profits, there are certain differences in investment arbitration such as the determination of the loss of the FMV, the treatment of economic distress under the notion of the FMV and the choice between the higher value as of the date of the State measure or the date of the award plus the award of lost profits between the date of the State measure and the date of the award in case of the latter.

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* International Arbitrator, partner, Wöss & Partners, Arbitration & Trade, Mexico, D.F. – Washington DC – Lima, International Who’s Who of Commercial Arbitration, Founder of the Investment Arbitration Forum, former visiting scholar of the Georgetown University Law Center.

** Partner, Wöss & Partners, Arbitration & Trade, Mexico, D.F. – Washington DC – Lima, attorney at law and financial analyst, M.A. in Finance & Investment (Exeter), passed first level of the Chartered Financial Analyst exam, New York.

¹ 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 Ingeborg Schwenzer, Pascal Hachem and Christopher Kee, Global Sales and Contract Law (Oxford University Press 2012), para. 44.19.

³ Irmgard Marboe, Calculation of Compensation and Damages in International Investment Law (Oxford University Press 2009) para. 2.72, with futher references.

⁴ Scott L. Hoffman, The Law and Business of International Project Finance (3rd edn., Cambridge University Press 2008) §1.01.

⁵ 1928 PCIJ Series A, No. 17, 50.

⁶ Hersch Lauterpacht, The Development of International Law by the International Court (London, Stevens & Sons 1958) 315-16.

⁷Friedrich Mommsen, Beiträge zum Obligationenrecht: Abth. Zur Lehre von dem Interesse [Contributions to the Law of Obligations: Section The Doctrine of Interest] (E.U. Schwetschke und Sohn 1855), 27.

⁸Herfried Wöss, Adriana San Román Rivera, Pablo T. Spiller, Santiago Dellepiane, Damages in International Arbitration under Complex Long-term Contracts (Oxford University Press 2014), para. 3.42, 5.03-4.

⁹Solène Rowan, Remedies for Breach of Contract: A Comparative Analysis of the Protection of Performance (Oxford University Press 2012), 117-8, with further references.

¹⁰Guenther Treitel, The Law of Contract (11th edn., Thomson, Sweet & Maxwell 2003) 937-8, 940, 944.

¹¹John Y. Gotanda, ‘Recovering Lost Profits in International Disputes’, 36 Georgia Journal of International Law (2004-5) 61-112; Robert L. Dunn, Recovery of Damages for Lost Profits, Vol. 1 (6th edn. Lawpress 2005); American Bar Association (ABA), Proving Antitrust Damages: Legal and Economic Issues (2nd edn., American Bar Association 2010) 4, 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; Comments (28) to (31) to Art. 36 of the Articles on State Responsibility.

¹²Rudolf von Ihering, Culpa in contrahendo oder Schadensersatz bei nichtigen oder nicht zur Perfektion gelangten Berträgen, Jahrbücher für die Dogmatik des heutigen römischen und deutschen Privatrechts IV (1861) 1 et seq.; Christian Schieder, Interesse und Sachwert, Zur Konkurrenz zweier Grundbegriffe des Römischen Rechts (Wallstein Verlag 2011) 45-53.

¹³Lon L. Fuller and William R. Perdue, ‘The Reliance Interest in Contract Damages’ (Pt. 1) (1936) 52 Yale Law Journal 52-96; §344(a) and (b) of the Restatement Second) of Contracts.

¹⁴Wöss et al., Damages in International Arbtitration under Complex Long- term Contracts, para. 5.08.

¹⁵ABA, Proving Antitrust Damages 57, 61.

¹⁶Leonardo Giacchino and Richard E. Walck, ‘Damages Models to Accommodate the Necessity Defense’ 27 (1) (2010) The International Litigation Quarterly, 1, 3-6.

¹⁷Rowan, Remedies for Breach of Contract, 118.

¹⁸Ruxley Electronics & Construction v.Forsyth, [1996] 1AC344.

¹⁹Tractebel Energy Marketing v. AEP Power Marketing, Inc.,487 F.3d 89, 109-10 (2dn Circuit 2007).

²⁰ABA, Proving Antitrust Damages 61.

²¹Manuel A. Abdala, ‘Key Damages Compensation Issues in Oil and Gas International Arbitration Cases’ (2009) American University International Law Review 547-8.

²²Joint 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, final award, 18 May 2000, para. 88.

²³Wolfgang Fikentscher and Andreas Heinemann, Schuldrecht, Zehnte Auflage (De Gruyter 2006) para. 439; Bridas v. Turkmenistan, final award, para. 62.

²⁴Bridas v.Turkmenistan, final award, paras.365,369.

²⁵Hersch Lauterpacht, Private Law Sources and Analogies of Law (Longmans, Greens & Co. Ltd. 1927), p. 6; Hersch Lauterpacht, The Development of International Law by the International Court, 32; Jean-Flavien Lalive, Contracts between a State 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 p. 992.

²⁶Manuel A. Abdala and Pablo T. Spiller, ‘Chorzow’s Standard Rejuvenated: Assessing Damages in Investment Treaty Arbitrations’ (2008) 25 (1) Journal of International Arbitration 108.

²⁷(1983) 4 U.S.C.T.R. 106.

²⁸(1987) 16 U.S.C.T.R. 201.

²⁹Fikentscher and Heinemann, Schuldrecht, para. 669, 701, 698.

³⁰ADC Affiliate Ltd and ADC & ADC & ADMC Management Ltd v. The Republic of Hungary, ICSID Case No. ARB/03/16, paras. 496, 518-19; for example, Yukos Universal Limited (Isle of Man) and the Russian Federation, final award, PCA Case No. AA 227, 18 July 2014 paras. 1821-1822.

³¹1928 PCIJ Series A, No. 17, 47, 50.

³²Adam Kramer, ‘An Agreement-Centred Approach to Remoteness and Contract Damages’ in Nili Cohen and Ewan McKendrick (eds.), Comparative Remedies for Breach of Contract (Hart Publishing 2005) 250. Adam Kramer, ‘Remoteness: New Problems with the Old Test’ in Djakhongir Saidov and Ralph Cunnington (eds.), Contract Damages: Domestic and International Perspectives (Hart Publishing 2008) 277-8.

³³Christoph Brunner, Force Majeure and Hardship under General Contract Principles: Exemption for Non-Performance in International Arbitration (Wolters Kluwer 2009) 145-6; Stefan Vogenauer, Art. 5.1.3, paras. 1-4, Harriet Schelhaas, Art. 7.1.2 paras. 6-7, 11, Jan Kleinheisterkamp, Art. 7.1.7, para. 6, all in Stefan Vogenauer and Jan Kleinheisterkamp (eds.) Commentary on the UNIDROIT Principles of International Commercial Contracts (PICC) (Oxford University Press 2009).

³⁴Yves-Marie Laithier, ‘Comparative Reflections on the French Law of Remedies for Breach of Contract’ Damages’ in Nili Cohen and Ewan McKendrick (eds.), Comparative Remedies for Breach of Contract (Hart Publishing 2005) 114-16.

³⁵Djakhongir Saidov, The Law of Damages in International Sales: The CISG and Other International Legal Instruments (Hart Publishing 2008), 125-132.

³⁶Mommsen, Zur Lehre von dem Interesse, 3.

³⁷John Y. Gotanda, ‘A Study of Interest’ in Filip de Ly and Laurent Lévy (eds.), Interest, Auxiliary and Alternative Remedies in International Arbitrtion, Dossiers of the ICC Institute of World Business Law (2008) 170-1.

³⁸Manuel A. Abdala, ‘Key Damages Compensation Issues in Oil and Gas International Arbitration Cases’ 562.

³⁹Spiller and Dellepiane in Wöss et al.: Damages in International Arbitration under Complex Long-term Contracts, para. 6.152.

⁴⁰Manuel A. Abdala, Pablo D. 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.

⁴¹ADC v. Hungary, para. 496, 518-19.

⁴²Yukos Universal Limited (Isle of Man) and the Russian Federation, final award, PCA Case No. AA 227, 18 July 2014 paras. 1763-1769, 1826-27.

⁴³Yukos Universal Limited (Isle of Man) and the Russian Federation, final award, 18 July 2014 paras. 1887-88.

⁴⁴1928 PCIJ Series A, No. 17, 50.

⁴⁵Yukos Universal Limited (Isle of Man) and the Russian Federation, final award, 18 July 2014, para. 1821.