Until recently, it was fair to decry the lack of attention paid to how ISDS tribunals quantify compensation, against evidence of ballooning awards and the sometimes dizzying amounts involved. Today, however, this issue is no longer secluded from public and academic scrutiny: it features prominently in critical scholarship and is probably the most contentious item within UNCITRAL’s Working Group III ongoing reform agenda. That said, most focus has been on the calculation of the principal amount of damages, particularly the contentious use of certain valuation methods. There is another issue that still fails to capture much attention – that of interest.
Interest refers to the financial compensation awarded to investors, in addition to the principal, for the temporary deprivation of that principal amount, from the time from which it should have been paid until the award (pre-award interest) and from the award until effective payment (post-award interest). In ISDS it is almost always awarded and can reach very significant amounts. For instance, in Tethyan Copper v Pakistan, interest accounted for almost 30% of the total $5.9 billion awarded. And yet, interest remains, as nicely put by Yves Derains, the ‘mal aimé’ (‘un-beloved’) of legal analysts. Arbitral tribunals will dedicate little of their reasoning to interest, scholarship continues to be scant, and the issue remains peripheral in ISDS reform efforts.
This relative lack of attention does not mean, however, that ISDS practice has not converged around a certain approach to interest – one that has significantly contributed to the inflation of awards. As explained below, that approach began to develop in the 1980s and consolidated in the 2000s through a combination of case law and scholarship. Moreover, I would also like to suggest that this now widespread (but not unanimous) ISDS approach is flawed, as a matter of law. This is so because of its tendency to rid the issue of interest of legal principle and applicable legal restrictions, treating investors as entitled to market expectations of financial return (comparably to how ISDS tribunals have come to embrace DCF valuation). There is however, as I will conclude, a more legally appropriate way of adjudicating interest – as well as encouraging signs within some scattered awards and recent reform discussions that ISDS practice may be pivoting in that sounder direction.
The evolution of interest
For most of the twentieth century, interest was dealt with in international adjudication pithily and in an apparently unsystematic way. With regards to applicable law, for instance, tribunals turned to customary international law, equity, general principles, and a variety of domestic legal systems – sometimes simultaneously. Nevertheless, adjudicatory practice broadly adhered to three main propositions: interest should be simple rather than compound (i.e. interest should not bear further interest), calculated at a flat rate (usually 5 or 6%), and from the date at which the principal became legally due (the so-called dies a quo, with tribunals disagreeing as to what that meant – some preferring the date of harm, others the start of proceedings, and another group the award itself). Moreover, at a more fundamental level, interest was seen as involving a variety of conflicting considerations, which the tribunal had discretion to consider. While it was perfectly clear that interest served to compensate claimants for the temporary deprivation of due capital, other factors also had to be weighed, such as those related to the debtor State and its society. Thus, the traditional preference for a flat and simple rate could be seen as an equitable (and remarkably stable) compromise, as to how to apportion the profitability arising from the capital amount in dispute during its adjudication.
Two key developments took place in the late 1970s and early 1980s that severely tested this state of affairs. The first was economic: this period saw a sharp increase in interest rates in comparison to previous decades, following the aggressive monetary tightening undertaken in the US to combat the high and persistent inflation of the 1970s. As a result, the flat rate of 5-6% that tribunals had (somewhat mechanically) tended to favour now fell below prevailing rates. The second was legal-institutional, with the establishment in 1981 of the Iran-US Claims Tribunal (IUSCT), which was called upon to adjudicate hundreds of claims for compensation (including interest). In doing so, the IUSCT’s case law evidences a real struggle between remaining loyal to customary approaches of the past and doing justice to claimants in this new context of exceptionally high rates.
The 1986 McCollough award, penned by presiding judge Michel Virally, contains perhaps the most sophisticated – and last – attempt at rationalizing previous legal authority in light of novel economic circumstances. He starts by noting that the issue of interest is governed by two potentially conflicting principles. Whilst claimants must ‘under normal circumstances’ be compensated for the delay in receiving due payment, defendants must not be submitted ‘to an excessive burden’. Mediating between the two thus requires weighing multiple considerations case by case. These include the reality of available market rates, but also the domestically applicable law, ‘the nature of the facts generating the damage’, and ‘the knowledge that the defaulting party could have had of the financial consequences of its default for the other party’. On this basis, the tribunal found a (simple) rate of 10% to be ‘fair’ in the circumstances – a significant bump up from the traditional 5-6%.
For all its legal sophistication, Virally’s was not an approach that could easily be put to work. It is noticeable that McCollough did not explain how the relevant factors were weighed to produce a specific decision on interest for the case at hand, and later IUSCT decisions appeared to renounce any case-by-case assessment. Moreover, an altogether different – and apparently more workable – approach also emerged in a parallel strand of the Tribunal’s case law, which focused solely on the loss suffered by the claimant, leaving little space for other considerations. This alternative thinking was already visible in Judge Brower’s separate opinion in McCollough, which approved the flat rate but expressed some disagreement as to the majority’s reasoning. ‘Conceptually’, Brower countered, ‘interest is an item of damage’ and, as such, its ‘award is intended as compensation for the temporary withholding of money, and its measure is the cost of such deprivation’.
This reconceptualization of interest – as firmly and exclusively grounded on the principle of full reparation – eventually became dominant in ISDS. It does not, however, explain everything that has followed. A second key development relates to how full reparation came to be understood and implemented – as requiring tribunals to focus on financial expectations of return on capital, or what is often referred to as ‘economic realities’. Such realities have come to provide the sole measure of the investor’s deprivation for the temporary withholding of capital and, crucially, justify ignoring applicable legal principle – leading to an overhaul of how the three main issues regarding interest are adjudicated:
Interest rates
On interest rates, traditional approaches based on flat rates, or relying on statutory rates under the applicable domestic law, suddenly became, when viewed solely through the lens of the investor’s economic deprivation, unfit for purpose if not purely arbitrary. The IUSCT’s Sylvania award was the first to focus instead on concretely available market opportunities: interest rates, it proclaimed, should be based ‘on the amount that the successful claimant would have been in a position to have earned if it had been paid in time and thus had the funds available to invest in a form of commercial investment’. It has now become generally accepted that tribunals ought to focus on available market benchmarks, but disagreement persists as to the relevant one. Sylvania preferred the return offered by six-month certificates of deposit in the US – a relatively low-risk form of investment. More recently, it is common to add a premium (usually 2%) to a near-risk-free base rate, in order to reflect the greater risk, and therefore expected higher return, associated with commercial activity. Another option, popular with multiple scholars and usually pushed for by claimants (since often leading to higher awards) but accepted only by a minority of tribunals, is to base interest rates on the investor’s cost of capital, i.e. the rate of return required by capital providers to invest in the project, taking into account the risk associated with the investment.
Dies a quo
On the dies a quo, the traditional diversity of practice reflected disagreement across national legal systems (which hold different positions as to when an amount owed becomes legally payable) or even within customary international law (e.g. in relation to expropriation, many did not accept that the ‘prompt’ payment of compensation was a universal requirement). As tribunals came to focus solely on the economic reality of the investor’s deprivation, however, the consensus position became that interest should run from the date at which that deprivation took place financially.
Compounding
Finally, in relation to compounding, the IUSCT did not depart from traditional hostility under international law. Soon, however, scholars became practically unanimous in criticizing restrictions as contrary to ‘modern economic conditions’ (where investors do earn compound returns). Tribunals eventually agreed (starting with the 2000 Santa Elena award) and today compounding is the norm in ISDS (despite the restrictions that continue to be found in the applicable national law, which arbitrators will often override, and continuing hostility to compounding elsewhere in international legal practice).
The problem with interest in ISDS
In the current state of affairs, therefore, investors tend to be treated as legally entitled to the returns they would have expected to make on the market, from the capital they were temporarily deprived of, and for the full duration of that deprivation. This thinking has gradually consolidated from an exclusive focus on an abstract principle of full reparation, and an invocation of apparently objective ‘economic realities’.
The main reason why this mainstream position is flawed, from a legal point of view, is not because full reparation should not play a key role here. Instead, the problem lies mainly with how that principle is commonly interpreted and applied. Indeed, even if the purpose of interest is essentially compensatory, this does warrant bypassing applicable law, or entail that brute expectations of financial return should be legally guaranteed. On the contrary, implementing full reparation necessitates consideration of the baseline conditions determined by the applicable law. It also involves a number of accessory doctrines (including compensable harm, causation, contributory fault and proof of harm) that prevent the assessment of interest from focusing solely on protecting creditors. Concretely:
Compensable harm
First, full reparation does not, in the abstract, determine what it is that the claimant must be ‘fully’ compensated for – the question, in other words, of compensable harm. Nor is this a question that can be answered through an exclusive appeal to ‘economic realities’, as is commonly done. On the contrary, it necessarily requires a legal determination, under the applicable law, of which particular expectations are entitled to legal protection through the award of monetary compensation. There is therefore no reason for ISDS tribunals to discard restrictions on compensability found in the host State’s law, whether in relation to compounding or the accrual period. It is that legal system that sets the baseline of the investor’s legitimate expectations, and so it is encouraging to see that some tribunals, against the fallacy of ‘economic realities’, still continue to enforce those restrictions when adjudicating on interest.
Causation
Second, full reparation also involves a careful assessment of causation, so that the claimant is compensated solely for the losses attributable to the State’s breach. To take this idea seriously means, contrary to the widespread position described above, that interest rates should not include a risk premium. As already explained well, the higher returns available for commercial opportunities necessarily reflect the measure of risk inherent in those hypothetical investments, and so to award interest on that basis would compensate investors for risks they never incurred (and thus restore them to a position that, but for the State’s breach, they would not necessarily have occupied). Thus, the correct position is to award only risk-free interest, as some recent awards have established.
Actual proof
Third, full reparation ought not to dispense claimants from providing actual proof of their loss. The UK House of Lords Sempra Metals decision insisted that any claim for compound interest must be sustained by appropriate evidence. And yet, scholars and tribunals in ISDS have allowed for compound losses to be simply presumed, thus creating a more pro-claimant regime for interest than for principal damages. That said, there are again examples of tribunals taking the more legally rigorous approach of requiring concrete proof of loss.
Other considerations
Fourth, full compensation need not focus solely on protecting creditors. A variety of other considerations necessarily feature in the determination of compensable harm under the applicable law – for instance, States may restrict compounding for reasons of morality, sustainability, or a particular understanding of the economic order. This does not mean that tribunals should return to the free-wheeling assessment of McCollough, but equitable judgment can nevertheless play a corrective role, particularly on the dies a quo. For instance, equity may justify granting a ‘grace period’ for the award’s payment, thus delaying the accrual of post-award interest (as done here). For pre-award interest, as suggested here, compensation for expropriation need not be ‘prompt’ where the amounts involved are crippling for the State or its people. A deferral of the dies a quo may also be justified in view of the claimant’s contributory fault (as e.g. here).
Conclusion – returning to legal basics?
I have explained how interest has evolved in ISDS, the problem with the way this issue is typically adjudicated, and what a more legally appropriate approach would look like. Such an approach is already visible in certain scattered cases (as noted above), and there are further signs that international practice may be heading in that sounder direction. The work recently undertaken before the ILC is revealing. After noting comments critical of arbitral tendencies, Special Rapporteur Mārtiņš Paparinskis accepted, in his First Report on compensation for the damage caused by internationally wrongful acts, that ISDS case law on interest should be scrutinized carefully, rather than accepted uncritically. It is however in the context of UNCITRAL WGIII that we find the clearest breakthroughs. The draft rules most recently proposed by the Secretariat establish that interest should be at a ‘risk-free rate’ (a provision that addresses the causation issue identified above) and that the burden lies on claimants to ‘specifically justify’ the award of compound interest (a somewhat vague addition that may nevertheless indicate that compounding ought to be conditional on concrete proof of harm). Additionally, WGIII would do well to follow the lead of the Vietnamese and Nigerian governments, who have further proposed that ‘interest shall not be calculated in ways deemed unlawful under the law of the respondent State at the time of the breach’ – a clear and welcome step in the direction of reclaiming interest as a legal rather than purely financial concern.
Image: George Hodan, CCO 1.0 Universal