Centre for Energy, Petroleum and Mineral Law and Policy, Volume 5-3(a)

"Renegotiation and Contract Adaption in the International Investment Projects:

Applicable Legal Principles & Industry Practices"

By Thomas Waelde and Abba Kolo

EXECUTIVE SUMMARY

This study focuses on the law and practice with respect to renegotiation of long-term
international investment agreements - particularly in the natural resources and energy
sector. The study analyses the concept of renegotiation in the context of long-term
international commercial contracts - particularly in the upstream petroleum industry.
It discusses the reasons governments and companies have for insisting on, and
accommodating, renegotiation. It provides a survey of legal issues which are relevant
to renegotiation - first, naturally, the question of what law is applicable, second, how
the major legal systems deal with the issue of renegotiation (including international
law). The survey then concentrates on how in practice, particularly in the natural
resources industry, governments and companies have dealt with the challenge of
renegotiation due to changed circumstances and it concludes with a recommendation
on how reasonable contract partners should accommodate fundamental changes of
circumstance.

Introduction

The long-term nature of the contracts at issue makes them vulnerable to disruption
from unforeseen events or events which the parties - for whatever reason - did not and
perhaps could not deal with in the contract with sufficient time and in sufficient detail.
The longer-term an agreement and the more exposed to geological, commercial and
political risk, the more it becomes vulnerable to external events. Such events can
make the operation of the contract partially impracticable or, from a commercial and
financial perspective, no longer viable for one party. One consequence is for the
parties to terminate the agreement or one party to withdraw.

However, such complete destruction of the contract would then also destroy the
contractual relationship which often would have continuing benefits for both parties.
Parties can also suspend operations under the contract which if the issues are not
solved will in many cases equally result in the destruction of the contract. Finally,
both parties often welcome to be seen as reasonable partners with whom one can do
business with, and salvaging a contractual relationship from the destructive impact of

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unforeseen and unregulated external events tends to contribute to the parties'
reputation as "good to do business with" in the international business community -
here the natural resources industry. Such reputation becomes as a rule known quite
rapidly in the rather narrow community of the international petroleum industry. It is
for this reason that most governments and companies will accede to reasonable
requests for renegotiation by their partners when the contractual and in particular
financial equilibrium was seriously disrupted by external events.

So renegotiation becomes for both parties a way to maintain the benefits of the
contractual relationship by adapting the contractual document. It is also a way to make
negotiations for contracts easier and more acceptable: If one party knows that the
other party will act reasonably when a renegotiation situation arises, it will build in far
less protective and escape clauses into the original contract than it would be forced to
do otherwise.

The study notes that renegotiation is known to all major legal systems. Most major
legal systems (with reservations in particular for the English common law) recognise a
right/duty to renegotiate obligations for on-going performance in a long-term
commercial contract when, due to an unforeseen fundamental change of the major
circumstances underlying an agreement the continuation of on-going performances
under the contract would severely disrupt the originally negotiated contractual
equilibrium and make continuation of performance excessively onerous to one party.
Contracting practice and commercial practice of de-facto renegotiation confirms that
in international business there is an expectation that parties should not be held to
continue in the future a performance which would be excessively onerous due to such
change of fundamental circumstances. Many contracts provide explicitly for such a
renegotiation procedure; in other agreements, parties renegotiate based on such
generally recognised principle and on the basis of contracting freedom. However,
notwithstanding these findings, the paper concludes by suggesting a different
approach towards looking at renegotiation that would reflect current trends in
international economic law. While accepting the fact that there is nothing wrong for
parties to renegotiate their contract which contains a renegotiation clause or where
they both felt the need to do so, it argues that insisting on renegotiation of an existing
agreement by either party to a contract which contains no renegotiation clause, or a
third party intervention to adapt the contract amounts to an undue interference in
contract as a medium of allocating risk. It also argues that a formality of law approach
to contracts is probably the best in transnational/global economy context because of
its certainty and predictability.

Section A: The Legal Issues: Sanctity of Contracts vs Flexibility

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 Renegotiation has entered into the vocabulary of international contract management
over the last 30 years. It is a reflection of the tension between the commercial need to
conclude international commercial and related contracts of a very long duration and
the impossibility to foresee all contingencies and regulate all possible situations in the
future. It also reflects the tension between the binding nature of the legal instrument of
contract - meant to commit the parties for a long time whatever their changing
position, relation and interests, and the practical and commercial difficulties to being
fully and specifically committed to certain obligations and courses of action when the
reasons underlying the contract in the first place have changed drastically.

Normally, before any foreign investor commits his capital into a petroleum
exploration or mining project, he will want to be assured that there shall be stability in
the investment regime. That is to say, the whole or key aspects of the agreement will
be respected by the host state and that the rules of the game will not be changed
unilaterally. The foreign investor needs such an assurance not only as a means of
ensuring that he realises the expected benefits (rate of return) for his shareholders, but
also to convince other sponsors of the project (e.g. banks, insurance agencies and
customers) that the project will generate enough capital to pay off their loans and meet
their supply requirements. These objectives may only be realised (other things being
equal) if the terms of the investment agreement respected by the host state. Hence, for
that reason, the principle of sanctity of contract is regarded as one of the most
important legal concepts in the investment process. On the other hand, the host state
which owns the minerals and enters into an agreement with the foreign investor to
exploit and develop the natural resources at a time when it is not certain as to the
extent, quality, and future prices of the commodity, will want the agreement to be
flexible and amenable to change with changing circumstances in both the domestic
and international political and economic situations. The host state is therefore more
likely (but in rare cases, the foreign investor as well) to view the contract as a
planning document - to be referred to and amended as relationships progress. The
contract is therefore one, but by no means the exclusive guide for post-contractual
bargaining. In that regard, there is a continuos conflict over the stability and flexibility
of a long-term investment agreement.

The concept of sanctity of contract is based on the 19th century classical contract
theory which is founded in the Aristotelian virtue of promise keeping, and liberality.
According to the theory, a contract is an expression of the parties' free will or choice.
It is an exercise of the parties' freedom and autonomy as such, it should honoured and
not be interfered with by the court. The terms of the contract must be implemented to
the letter no matter how onerous or burdensome they may prove to be. The individual
is the best judge of his own interest and if he strikes a bad deal then he should blame
himself and bear the risk. It is neither the duty of the court nor that of the state to

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inquire into the fairness or otherwise of the contract; their role is to enforce what the
parties have agreed to do. After all, enforcing contracts enhances economic efficiency.

As a general principle of contract law, the concept of sanctity of contract is widely

accepted by all modern legal systems and is upheld by international tribunals.
However, it has been argued that, under no legal system (municipal or international)
has the principle of sanctity been found to be absolute. For example, under
international law, the principle is counter-balanced by that of fundamental change of
circumstances as contained in the Vienna Convention on the Law of Treaties. Indeed,
"even under the classic contract law, freedom was not a complete license for laizez-
faire. Victims could be released from their contracts in cases of duress, undue
influence and under the rubric of unconscionability" in "the more extreme instances of
the strong taking advantage of the weak." Other exceptions to the principle include:
public policy, terms implied by law, standard of reasonableness and good faith,
fairness and equity, as well as filling of gaps by courts through contract interpretation.
These principles reflect the inherent conflict in contract law between market-
individualism and consumer welfarism, and in our case, between sanctity of contract
and contractual flexibility.

It has also been noted that the classical contract principle emphsises ‘discreteness' ( a
one-off transaction between the parties) and ‘presentiation' (a detailed contract
stipulating all the parties' expectations and remedies for breach). A discrete contract
applies more to businessmen operating locally in a stable environment. Hence, the
market place paradigm applicable to a ‘one-time', discrete transaction is not applicable
to a long-term (‘relational') or contract which spans over 10-20 years. As we shall see
later, in such a continuos or ‘relational' contract, the signed agreement is basically
viewed as a framework for future cooperation between the parties. And since the
contract hardly deals exhaustively with the parties' rights and obligations, it should be
flexible enough if it is to sail through the storm and waves of the uncertain future.

Moreover, it has also been argued that, where the agreement is between a government
and a foreign investor for the exploitation of the host state's natural resources, the
concept of sanctity of contract is overridden by the principle of permanent sovereignty
over natural resources which allows a host state to unilaterally cancel or amend the
contract. The more so, if the agreement falls within the domain of public or
administrative contracts under the legal system of the host state. Governments see
such agreements not just as simple commercial contracts but as major instruments of
public policy on which the country's socio-economic development depend. While we
accept that this view may reflect the widely popular position of developing countries
in the 1960s and 1970s - when foreign investment was generally viewed with
suspicion, in some cases, hostility, and when governments of newly independent

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states were faced with the urgent need to achieve socio-economic development
through the exploitation of their natural resources on one hand (and in some cases,
having to grapple with contracts signed by former colonial masters or previous
unsophisticated or weak governments) on the other. Such a view can hardly be
defended now with increased globalisation, maturity and sophistication of most host
governments (which may employ independent experts if they wished, to advice them
on negotiations with foreign investors). Furthermore, most investment agreements are
now concluded with privatised state enterprises which place the profit motive over
and above some imprecisely defined ‘public' interest. There is no public or
commercial reason why such enterprises should not be held bound by their contracts.
He who goes to the market place must accept to play by the rules of the game!

Section B: Major Renegotiation Cases from the 1950s-1990s

At this stage, it may be worthwhile to highlight some of the major renegotiation cases
which have taken place in the petroleum and mining industries since the 1960s. Apart
from illustrating the point that renegotiation is a fact of life in any long-term
commercial relationship, the case studies also help in understanding the factors and
forces which trigger renegotiation.

OPEC - Oil Companies in the 1970s

The old oil concession regime granted the oil companies unlimited rights in the
exploitation and disposal of the petroleum resources of the host states. The oil
companies determined the rate of production and set prices at which to sell the
products .Until the 1960s, the host states had little or no say in the exploitation and
management of their petroleum resources. However, the establishment of OPEC in
1960 (which was triggered by the oil companies' unilateral cut in posted oil prices) led
to significant changes in the relationship between host states and oil companies . Not
only did the host states assume an important role in setting prices, they were also able
to secure renegotiation of the concession agreements. Those renegotiations and
subsequent ones were backed by OPEC Resolution XVI in 1968 which formally
called for renegotiation of existing concessions between member states and oil
companies on the basis of changed circumstances. Subsequent declarations by the
Organisation called for an increase in the level of state participation to reach 51% by
the year 1983. By 1974, most OPEC member countries had achieved either full state
control or majority state participation as set out in the resolution.

The Papua New Guinea-Bourgainville Mining Concession 1967

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In 1967, Bourgainville Copper limited, a subsidiary of Conzinc Rio Tinto of
Australia, obtained a mining lease from the Australian government which was then in
charge of the mandated territory of Papua & New Guinea (PNG). Among the key
terms of the Agreement were: the company to pay $1 Australian per hectare as annual
rent; 1.25% of the value of ore sold as royalties; an option for the PNG government to
purchase up to 20% equity in the project; an income tax holiday for the first three
years of operations to be followed by a graduated income tax rate of between 25-50%
on 80% taxable income (thereby guaranteeing the company a non-taxable profit of
20%). The Agreement contained a stabilisation clause which insulated it against any
subsequent legislation that may seek to undermine the contract.

The mine commenced operations in 1972 and proved very profitable. But by 1974, the
government of the newly independent PNG pressured the company into renegotiating
the Agreement on the ground that the fiscal regime was too much in favour of the
company. Although the Agreement contained no renegotiation clause, nonetheless,
common interest of the parties in the survival of the project (on one hand, the
government was dependent on the mine as a source of foreign exchange and did not
want to send wrong signal to other potential foreign investors who had shown interest
in the country, and on the other, the company did not want to lose its sunk capital and
the profit being generated) enabled the parties to reach an amicable settlement that
would strengthen the relationship. As such, the company was ready to forego the tax
holiday period it enjoyed and accepted an increase in the tax rate to 331/3 % as well
as another 70% excess profit tax.

The agreement was again renegotiated in 1986. Due to unforeseen natural disasters
other natural qualities of the climate/geology unforeseen in the original contract, a 200
Million U.S. $ tailings dam broke. Rebuilding in a form able to sustain the pressures
of the climate in the particular geology of the area would have required considerable
investment which was unforeseen and uncontemplated in the original agreement. Such
investment would have made the project economically unviable for the companies.
The companies indicated their interest to withdraw from the project. As a result and in
view of the government's interest to continue the project, the financial and
environmental conditions were renegotiated in order to make this project of continued
attractiveness to the investors.

However, the mine was forced to close in 1989 due to secessionist attacks and
differences between the parties on whether or not to involve the provincial
government in the renegotiation process.

Chile - Anaconda 1967-71

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Anaconda Copper Mining Company together with Kennecott have dominated the
Chilean copper mining industry since the 1920s. But until after World War Two,
mining companies in Chile (just like in other countries generally) were not heavily
taxed partly because, the country needed to attract more foreign investors and partly
because the country relied less on mining as a major source of government revenue.
But as copper assumed a central place in the economy after the second World, the
Chilean government started becoming more directly involved in the sector by
controlling prices and export of the commodity in 1951. That action set the stage for
more future state intervention in the industry.

A programme of ‘Chileanisation' was introduced in 1964 soon after Frei was elected
as President of the country. Before the end of that year, state participation (ranging
from 25-75%) was negotiated with the mining companies (including Kennecott and
Cerro Corporation, a subsidiary of Anaconda) and terms of the basic Agreements
reached with the companies was passed into law by the Chilean parliament in 1967 in
spite of strong opposition from the left and centre-right parties. Among the reasons
which accounted for the companies equanimity were: firstly, the government's
proposal represented the lesser of the ‘two evils' - either state participation or
nationalisation. Secondly, Anaconda heavily relied on its copper investment in Chile
in its overall global business operations and so it could not afford to resist the
government's demand and risk losing its investment in the country through
nationalisation. On the other hand, Kennecott saw the renegotiation as only one of the
several ways to reduce the political risks confronting foreign investors in the country.
Thirdly, the mining companies obtained good concessions (lower taxes and a twenty
-year tax guarantee) in return for acceding to the government demand. On its part, the
government realised that it had to work with the foreign companies in order to achieve
the desired growth within the industry and the economy generally.

However, in spite of the tax guarantee given to the companies in 1967, further
renegotiation of the Agreements took place in 1969. This time around, the government
obtained 51% in Chuquicamata and El Salvador ( two of Anaconda's principal mining
companies) and the right to purchase the remaining 49% in 1973. The Chilean
government also obtained a review of the tax regime applicable to both Anaconda and
Kennecotts' operations. The new tax regime gave the government 54% of each cent
per pound of copper sold at a price above 40 cents; such tax rising to 70% of each cent
when the price reached 70 cents per pound.

When Anaconda and Kennecott were finally nationalised in 1971 by the Allende
regime, Kennecott's political risk management strategy proved very useful as it was
able to force the government to agree on compensation. Anaconde was not so lucky; it

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had to wait until after a change in government in 1973 before it could obtain
compensation.

The Chilean case study reveals not only the economic and political strategies which
could be pursued by a foreign investor to reduce political risks but also shows that an
ideologically determined regime bent on nationalisation may hardly be persuaded to
act otherwise.

Jamaica - Alcoa 1974

In 1950, Jamaica signed Agreements with a number of mining companies for the
development of bauxite. Although the agreements contained stabilisation clauses, that
did not stop the revision of the fiscal regime three times before 1971. The pressure to
further renegotiate the deals came in 1972 with the coming into power of a new
government (headed by Prime Minister Manley) which was committed to socialist
model of economic development. It felt that the country was not getting much from
the profits being made by the mining companies. More so, as the country was facing
rising import bills for oil brought about as a result of the steep rises in prices of oil in
1973. The country's dependence on bauxite export as a major source of foreign
exchange made the industry the most immediate target added to the fact that the
companies had so much at stake as not to contemplate withdrawing from the country.
Negotiations commenced with the companies.

Failure by the government and the companies to reach agreement on the level of new
impositions led the government to pass the Bauxite Production Levy Act in 1974. The
Law imposed a levy of between 7.5 - 8.5% over a period of two years on all
companies operating in the country. Another law empowered the government to
determine the level of production.

Although the companies protested against the levy and some of them commenced
arbitration proceeding, nonetheless they were all able to reach a compromise with the
government on common principles which allowed the government more revenue and
a majority equity participation in the mining projects. But as the country faced more
and more competition from other countries in the following years and declining
market share, the Jamaican government realised that its comparatively higher bauxite
levy was a further disincentive to companies and so, it agreed to renegotiate the
agreements in 1979 to make the levy more flexible.

One lesson to be derived from this case study is that, resort to international arbitration
or its threat may induce the parties to negotiate under the ‘shadow' of law. In this case,
the likelihood of an adverse award coupled with the bad publicity it would have

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brought, could have weakened the negotiation position of the Jamaican government
and strengthened that of the foreign investors; and that probably influenced the
government towards a compromise. On the other hand, the time and cost and
uncertainty regarding the arbitration could have influenced the companies into
accepting the government's proposal.

United Kingdom, Norway – 1974/75

In Western Europe, the move towards greater government participation in the industry
(now reversed towards privatisation) led, for example, the UK government to
renegotiate existing licenses for offshore petroleum development; as a result,
companies accepted to let the then British National Oil Corporation participate in their
offshore oil operations as an equity partner. This renegotiation was achieved partly by
the likelihood that recalcitrant companies would be excluded from future licenses,
partly by the threat of unilateral legislation. Similar developments took place at this
time in Norway and in the United Kingdom: In 1975, all existing petroleum licenses
were renegotiated on the insistence of government which acquired - against payment
and future participation in investment - a 51% participation interest held by the then
UK state oil company - BNOC/BRITOIL.

Dominican Republic - Falconbrdge 1987/88

Falconbridge Mining company had carried out exploration for nickel in the 1940s and
1950s and concluded agreements granting it the right of exploration and eventual
development. The agreement which was signed in 1969 constituted at that time an
important political step - after the civil war - signaling the economic policies of the
country and its receptiveness to foreign investment. However, negotiations were
difficult and the government and company team did not come to an agreement; the
then president of Falconbridge then went directly to President Balaguer. He took
along a memorandum which outlined Falconbridge's view of the economic prospects
for the DR. Government income of over US$200million over the next 20 years (i n
1970 prices). President Balaguar then overruled his negotiating team and authorised
the signature and ratification of the agreement. The projected revenue was based on
assumptions of a reasonable nickel price and a low petroleum price ($2 per barrel) -
petroleum being a major input for production of ferro nickel out of laterate nickel
ores.

The agreement provided for an operating company - Falcondo - with basically no

equity capital. The total investment expenditures required were funded wholly with
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loan provided by Loma Corporation and the World Bank. The low capitalisation of
the company was explained by the interest of Faconbridge to reduce political risk
exposure and also to obtain OPIC insurance. Falconbgridge and ARMCO, the share
holders controlling Falcondo provided guarantees for the loans. The DR agreed that
all loans including those of the share holders as well as corporate overheads incurred
abroad were to be deducted as costs before tax. Falconbridge guaranteed the working
capital needs of the company for which it was to receive a 2.5% fee on total sales (tax
free) for management and marketing - in addition to full cost reimbursement.

Although the agreement contained a "cooperative clause" according to which the

parties would cooperate all the times to see that the agreement operated fairly for both
parties, it did not contain a submission to any arbitration tribunal. But, it did contain a
stabilisation clause which provided that apart from income tax, the company was
exempt from any other levies (including import duties) for the duration of the
agreement.

The agreement did not generate the expected benefits. In reality, it was estimated that
for shipment of over one billion pounds of nickel between the period 1969-1986 (or a
sale of over US$1billion), the DR received only an amount of about US$5million as
tax payment from the company and nothing in dividends. According to the company,
this was because the project generated losses throughout its life due to the rise in oil
prices by 10 times between 1973 - 81.

On November 20, 1987, the government issued a presidential Decree 578 imposing a
foreign exchange levy ("aporte") on all exports from the country; that would give the
government approximately 20% of the gross sales value of the company's production.
The company refused to comply with the new law on the ground that it was not
subject to the new tax. But attempts by the company to export nickel were stopped by
the Dominican customs until the company came up with some payment to the
government.

Negotiations involving the government, Falconbridge, Falcondo (and behind the scene
consultations with OPIC, UN advisers and, of course, the President) yielded some
results. A final settlement was reached in May 1988, with both sides making
concessions. The over all effect was that the government received US$123million in
additional taxes in that year and Falcondo making a record profit of US$88million.

Apart from illustrating the fact that long-term investment agreements hardly survive
their duration without alteration, this case study also confirms the strong influence of
the markets on the parties' relationship. The rise in prices of nickel and the desire of
both the government and the company to get the best out of it was perhaps the most
important factor which enabled the parties to reach a compromise. Failure to reach
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agreement would not have been in any one's favour, economically and politically.
While the company could not walk away from the project nor take the risk of an all-
out confrontation with the government over the levy, the government could least
afford any long-term disruption to the project with its attendant loss of revenue and
possible effect it might have on other potential investors. The government was not
also prepared to face the political backlash (from the World Bank and possibly, the
U.S. government) that might follow the dispute. Finally, the case does raise an
important question on the use of economic coercion as a lever to obtain a
renegotiation of an existing agreement. Was the Dominican government's blockage of
nickel exports and the threat to raise prices of petroleum products as a way of forcing
the company to renegotiate legally justified or could the renegotiation be said to have
been procured through economic duress or coersion or, was the tactic merely a
negotiating strategy which the company should have resisted and probably invoke the
dispute settlement mechanism to resolve the conflict?

Peru - Belco/Occidental 1985

A closely similar case of renegotiation to that of Falconbridge was that between Peru
and Belco, and Occidental oil companies in 1985. The two oil companies had been
operating in Peru since 1959 and 1971, respectively. Until 1985, Belco had been
operating offshore the northern coast of the country under a Production Sharing
Contract (PSC) with an output at about 24 000 b/d, while Occidental was producing
about 110 000 b/d from jungle fields in the eastern part of the country, also under a
PSC. Together, the two companies were producing almost 2/3 of the country's oil
output and their success led to the emergence of the country as the fifth oil exporting
country in Latin America.

At a time when many Latin American countries were screening and restricting foreign
investors, Peru adopted a more open-door and liberal policy which placed less
restriction on foreign investors wishing to invest in the country. As part of that open-
door policy, a new Petroleum Law (Law No. 232331 and Supreme Decree 005-81-
EM/DGH) was enacted in 1980/81 aimed at increasing foreign investment in
exploration and production. A key feature of the law was a provision for a tax credit
against income reinvested in the country's oil industry (hitherto accorded only to
national oil companies). As a result of the new law, the three major oil companies
(Occidental, Belco and Bridas) operating in the country, reportedly invested about
US£600million to enhance reserves and production, and received a corresponding tax
credit.

However, after assuming office in 1985, the populist government of President Alan
Garcia unilaterally rescinded the tax credit regulations with retrospective effect and
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the companies were required to pay back taxes which the government considered
would have been paid had the tax credit system not been in existence. In addition, the
government also canceled the existing PSCs and by law, required a renegotiation of
the contracts.

The renegotiation was ordered with a 90 day dateline followed by a 30 days

extension. When negotiations with Belco broke down because of the company's
refusal to make new investment commitments and pay higher taxes as well as refund
the tax credits, the company's assets were nationalised in December 1985 and its
operations transferred to PETROMAR. But an agreement was reached with
Occidental for a period of 22 years effective 30 August 1985. Under the agreement,
Occidental was to invest US$182million in exploration between 1985 and 1991, plus
an additional US$85million over a further four years, if justified by results. The
company was also to refund, in three annual payments to Petroperu - the state oil
company, tax deductions it received from the previous government. In return for the
above concessions, the company acquired a new 2.5 million acre block in the southern
Peruvian jungle under a 30 years risk service contract which will expire in the year
2015.

Here too, the question is: was the agreement with Occidental in this case voluntary or,
could it be regarded as obtained through economic duress therefore not binding, or did
the company act under business compulsion as such it should be held bound by the
agreement?.

Colombia - BP 1996

In 1989, BP signed an agreement with the Colombian government to search for and
develop petroleum resources in the Piedemonte region. Under the Association
Contract, Ecopetrol, the state oil company, has the option to back into 50%
commercial production rising to 78% after the 150million barrel target has been
reached. The company pays 20% royalties, US$1.25 per barrel war tax, a withholding
tax on dividends sent abroad and extra payments to the military for protection.

The discovery of more natural gas than condensate by the company in the contract
area coupled with difficult geological conditions made development of the fields
unprofitable for the company under the contract terms because it was structured for oil
rather than gas. Efforts by the company and the government to renegotiate the contract
started in 1994 and lasted for four years. The negotiations were marred more by
political pressure - brought to bear on the government - than economic factors or lack
of willingness, on part of the government and the company, to find a solution.

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BP wanted the contract to be converted into a risk-sharing contract or a modification
of the terms to match the more favourable terms awarded to other companies after this
agreement had been concluded. But political opposition to the call for renegotiation
was too strong for the government to resist. There was also some concern within the
government that acceding to BP's demands may cause other companies (perhaps as
many as 20) operating under same model contract to also ask for better terms to match
any deal reached with BP, thereby undermining Ecopetrol's earnings, and the
country's legal tradition of inviolability of petroleum contracts. In spite of the
difficulties, efforts to resolve the dispute continued.

By the end of 1997, BP requested Ecopetrol to declare commercial two of the

Piedemonte fields (Pauto and Florena). This move followed a compromise reached
with Ecopetrol under which condensate production is to be counted as gas. The
compromise was made possible after lawyers from both sides concluded that under
Colombian law, parties to a contract cannot be prejudiced by an omission in their
contract. And since there was no provision in the contract that deals with condensate,
BP should not be made to suffer under it. In other words, there was a gap in the
contract - in that, at the time parties were negotiating the contract, they failed to
foresee or consider/agree on the possibility of gas being discovered instead of oil -
which ought to be filled later through renegotiation.

This case study illustrates the unusual situation of where it was the foreign investor
which found itself in the unenviable position of having to request for renegotiation of
an investment contract because the discovery turned out to be something quite
different (and perhaps, of lesser value to the company) from what was assumed and
contracted for at the time of the initial agreement, and the host state insisting on the
principle of sanctity of contract. Therefore, it illustrates the other side of the
obsolescence bargain theory which assumes that it is always the host state which
demands for renegiotiation after the investment has started yielding profits. Does the
case also suggest the liberal conception of contract has started finding disciples
amongst third world leaders or does it only reflect a defense of self-interest on the part
of the Colombian government? For sure, the case study does show how political
pressure within the host state can prevent the parties reaching an agreement even
though both of them wanted to find a quick solution. Finally, it also shows that
political pressure within the country can drive the government to demand too much
from the foreign investor as a result drive it away, probably to the detriment of the
host country.

Renegotiation, however, has not been limited to petroleum/mining investment

agreements. Any long-term contract with fixed financial parameters is likely to come
under stress when these parameters, due to intervening developments, no longer

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produce a mutual balance of benefits. For example, in the 1970s, due to the actions of
the "Uranium Cartel" uranium prices multiplied. As a result, long-term supply
contracts at fixed prices became economically destructive for companies - such as
Westinghouse - which had entered into long-term fixed price supply contracts while
having to purchase uranium from producers. Westinghouse - using the U.S.concept of
"commercial impracticability" - tried to renegotiate the price for these contracts.
While not ultimately successful in litigation, we believe that in the end Westinghouse
was able to renegotiate its long-term fixed-price commitments. It was not in the
interest of its purchasers to see the company fail. As a result of such developments, it
is unusual for long-term contracts to supply commodities to be any longer at a fixed
price - the rule is either periodic price renegotiation or reference to moving price
indices, i.e. automatic adjustment of the contract.

All of these cases have in common is that there has been a significant change in the
assumptions underlying the original contract and that such fundamental change
drastically affects both or one party's original expectations of profit/return from the
operation and in particular the way the benefits from the project ("Financial
equilibrium") have been divided between the parties. One party is typically very
dissatisfied because the contract worked out very differently from what it envisaged
because fundamental circumstances changed and because the division of benefits
originally agreed is distorted because of such intervening changes in the contract's
environment. Renegotiation - if carried out on the basis of some already provided
contractual adaptation mechanism or if fully renegotiated by both parties without such
internal contract mechanism - is typically an attempt to restore the contract's original
equilibrium and to change the contract to let the contractual relationship, i.e. the
commercial partnership and collaboration between both parties, survive and generate
the mutual benefits both parties expect from the relationship. The philosophy behind
renegotiation is that the contractual relationship is more important than the formal
contract document itself and that the parties will make all efforts to let this
relationship survive if and to the extent it is in their interest to let the relationship
survive - and sometimes send a signal to the outside world over the "reasonableness"
of the government or company in dealing with its partners on a long-term basis of
mutual benefit and trust.

Section C: Reasons for Renegotiation

1. Long-Term Investment Agreement as an ‘Incomplete' Contract

Renegotiation is, evidently, particularly relevant in situations where contract need to

be concluded for very long periods with a continuing sequence of performance
contributions by both or at least one party. In the petroleum industry, the commitment
14
of significant capital for exploration and particularly development, and the assumption
of considerable risk, in particular in exploration require contracts of a very long
duration covering up to and over 10 years of exploration and over 20 years of initial
production phases. As long-term contracts are required to make investors assume the
risk (in exploration a risk of failing in most of the projects), these long-term contracts
are then exposed for a long time to developments the occurrence of which and the
impact of which on the contract are often hard to predict. A long-term investment is
usually made based on assumptions about the geology of the area, costs of inputs,
labour and other payments (e.g. taxes and royalties to the government), as well as the
cost of complying with environmental requirements. All these have to be assessed by
the foreign investor against the projected out put from the mine and the expected
price of the commodity on the international market over the estimated life span of the
project. However, these projections and forecasts are uncertain and highly speculative.
If, for instance, the discovery turned out to be more than expected and the mine
started making profit, the host state may feel that it is not benefiting much from the
exploitation of the country's non-renewable natural resources and so demand for
adjustment of the terms of the agreement. On the other hand, the find may turn out to
be marginal, or the geology of the area may prove difficult to exploit the minerals
under the existing fiscal arrangement (as was the case in Colombia-BP discussed
above), prices of inputs may escalate while that of the mineral resources may actually
fall due to over supply, mild weather or changes to alternative sources of raw
materials (such as fuel). New environmental protection standards may be imposed on
the industry by government or other pressure groups which may require the foreign
investor having to spend huge amounts of money to upgrade his equipment, thereby
adding to costs of the project. Such unexpected changes may impact on the economics
of the project and put pressure on the parties to revise the agreement.

Also, since negotiation is very time-consuming and generates considerable cost on

companies, not all issues that might be theoretically predicted are as a rule dealt with
in detail and regulated carefully negotiated contractual provisions - doing so would
mean that negotiations might go on forever, be far too costly to sustain and many
negotiating problems would arise over issues the probability of arising is, or is at least
seen during the negotiations, to be very small. Since parties negotiating such a long-
term contract cannot possibly foresee all the likely future contingencies which may
arise and impact on the project, they could not deal with them exhaustively. The
parties end up having an incomplete contract. Such an agreement therefore, contains
gaps which may have to be filled later either by the parties themselves or by a third
party. In some cases, the agreement may not provide enough guidance on what
happens should gas be discovered instead of oil (as was the case in the Colombia-BP
agreement discussed above). Renegotiation or resort to third party dispute settlement
process could provide the parties with an opportunity to adapt the agreement and fill

15
in the gaps.

2. Investment Risk as Prelude to Renegotiation

The call by one or both parties for renegotiation is therefore a characteristic function
of the long-term nature of such contracts and their exposure to a number of significant
risks and uncertainties. For example:

a) Change in geology and economic fortune of the project: As we have seen from both
the Opec, and Colombia renegotiation case studies, an unexpected rise in prices of the
natural resource product on the international market bringing windfall profits to the
foreign investor, coupled with shift in bargaining power in favour of the host state
were the main reasons which led to the renegotiations in the 1970s. These cases
illustrate the obsolescence bargain theory - with the host governments reassessing
their "relations with [the] foreign investors on the basis of their countries' current
[diminished] need for foreign capital and technology," on one hand, and the foreign
investors "hostage" status on the other. Similarly, an unexpected discovery of large
(‘bonanza'), high grade mineral ore or petroleum deposits, or changes in technology
which reduces cost of developing the project, may also lead the host government to
demand for renegotiation as might the foreign investor following a disappointing find
in a hostile geographical environment.

b) Regulatory Risk: Renegotiation is often necessitated by the unexpected

intervention of government into the contractual relationship. For example, in the US
in the 1980s, US energy regulation led to renegotiation to many if not most contracts
to supply natural gas. If renegotiation - which was often encouraged and sometimes in
fact ordered by the US authorities - had not taken place, companies would have
become the victim of market developments caused by government intervention over
which they had no control. Similarly, with the deregulation of the US and Canadian
energy industry, most long-term contracts for the supply of energy (natural gas,
electricity, pipeline usage) were renegotiated, often at the instigation of the energy
regulatory agencies.

In the 1970s, natural gas supply contracts were entered into on long term take-or-pay
basis, usually at high prices. But economic changes, for example, in the United States
in the 1980s, which resulted in low demand and fall in prices made the agreements
burdensome to the purchasers. The problem was exacerbated by the regulatory policy
of the Federal Energy regulatory Commission aimed at deregulating the natural gas
industry to make it more competitive. By Order 380 issued in 1984 by the
Commission, pipeline customers were allowed to escape their take-or-pay contractual
obligations to purchase minimum quantities of gas from interstate pipelines, and
16
Order 436 of 1985 encouraged pipelines to operate ‘open-access' transportation
systems which allowed pipeline customers to buy gas from parties other than their
traditional pipeline suppliers and have it transported to them by various pielines. The
deregulation had the effect of creating spot-martkets which led to low prices thereby
rendering the take-or-pay contracts not only uneconomical but threatened the
economic survival of many purchasers, some of whom had to reneged on their
contratual commitments. When sued under the take-or-pay contracts, most of them
pleaded force majeure and commercial impracticality but in almost all cases the
defense failed. Regulatory changes introduced by the Commission was also relied
upon by some purchasers as a possible defense but that too did not find favour with
the courts. And a more recent Supreme Court decision in United States v. Winstar
Corp., et al, in which change in the law was also pleaded as a defence to breach of
contract seems to affirm those earlier cases on the point under discussion; that is: that
regulatory changes per se may not constitute a sufficient reason to justify a failure to
honour a contractual obligation which assumed allocated risk of market failure.

In this case, the U.S. government, through the Federal Home Loan Bank Board,
encouraged healthy thrifts and outside investors to take over ailing thrifts in a series of
‘supervisory mergers' in the 1980s because the Federal Savings and Loan Insurance
Corporation lacked the funds to liquidate all of the then failing thrifts. As an
inducement, the Bank Board agreed to permit acquiring entities to use goodwill and
capital credits in computing their regulatory capital reserves. Subsequently, Congress
passed the Financial Institutions Reform Recovery, and Enforcement Act of 1989
which forbade thrifts from counting goodwill and capital credits in computing the
required reserves. As a result, two of the respondents were seized and liquidated by
federal regulators for failure to meet the 1989 Act's capital requirements. The
respondents then sued the government for breach of contract. The government pleaded
among others, the defense of legal impossibility due to unforeseen regulatory changes.
In affirming the lower courts findings, the Supreme court held that the Bank Board
had by contract, assumed the risk of such regulatory change and the contract would
not be rendered nugatory by a change in the regulatory law.

The binding nature of take-or-pay contract which has become onerous to one of the
parties following regulatory change has also been emphasised by UK courts in
actions brought before them by some contractual partners to enforce take-or-pay
obligations against Enron and Teeside Gas Transportation Ltd, a subsidiary of Enron.
In one of the cases, contracts were signed in 1993 between the North Sea J-Block
partners and Enron agreed to purchase all the gas produced from the J-Block until the
year 2011. Under the agreements (which were signed prior to the liberalisation of the
UK gas industry), Enron was to pay around 20 pence per therm. Delivery was to
commence after the commissioning (not later than September 1996) of the parties'

17
respective facilities. The Agreements required the parties to use "reasonable
endeavours" to agree on a commissioning date. Although construction of the facilities
were completed in February 1996, the parties could not agree on the commissioning
date. One of the main reasons was the relunctance by Enron to proceed with the
contract as prices of gas had fallen to about 9-10 pence per therm on the spot market
(as against the 20 pence under the contract) as a result of deregulation. Enron failed to
persuade the parties to renegotiate the contracts as a result of which the parties went to
court. The High court held that Enron could not refuse to agree a commissioning date
simply because it did not suit its commercial objectives. In other words, the decision
seems to suggest that allowing the subjective commercial interest of Enron to prevail
over the parties agrements might amount to indirect renegotiation of the contracts.

Although the J-Block partners did lodge an appeal to the House of Lords, they were
able to reach a settlement with Enrol under which they agreed to cut prices under the
take or pay contract to reflect prevailing market conditions (though quantity remains
unchanged), in return for a US$440million cash payment from Enron.

In the other case involving Teeside Gas Transportation Ltd (TGTL), a subsidiary of
Enron, the High Court held TGTL bound to pay all the monies it owed the Central
Area Gas Transmission System (CATS) owners under a 15 year Capacity Reservation
and Transportation Agreement (CRTA) relating to the transportation of natural gas
from Central North Sea to Teeside. Beginning April 1993 until the end of 1994,
TGTL had been paying the CATS owners reservation fees under the agreement even
though no gas had been transported. But following the collapse of gas prices on the
UK spot market in 1995, TGTL withheld payment claiming the CATS owners had
failed to comply with some technical aspects of the CRTA. The CATS owners went to
court and it was held that the CATs owners had been capable of transporting the
300million cf/d of gas from the J-Block fields under the CRTA and that they were
capable of fulfilling their obligations. Therefore, TGTL was bound to honour its own
side of the bargain.

These cases illustrate how changes in the regulatory regime of an industry might
affect existing contracts between third parties. They also illustrate the relunctance of
English courts to allow parties to commercial agreements to escape from their
contractual undertakings which have turned sour, even though changes in the market
were brought about by an unexpected change in law in the industry or sector. Thus,
under Anglo-American laws, the formality of law approach to contracts seems to be
preferred over court induced modification of same.

Perhaps, the "shadow" of these cases did hover over the much-publicised British Gas
take or pay dispute with some other North Sea gas producers which also ended in
settlements consisting of cash payments by British Gas to the producers in exchange
18
for reduction in both the quantity and prices of the gas being supplied British Gas. The
facts of the dispute reveal the conflicting arguments surrounding sanctity of contracts
and re bus sic stantibus in relation to long-term agreements and the sort of
compromises which businessmen could achieve under those circumstances. For that
reason, we think it worthwhile to summarise the facts and dispute and its outcome.

Following the liberalisation of the UK gas industry and the resulting collapse in prices
on the spot market, British Gas found itself in 1995 having to cope with more than
US$61 billion worth of high-priced take or pay contracts - over the next 20 years -
most of which were signed in the 1980s with North Sea producers (including BG's
own subsidiaries). In view of its difficulties, BG called on the producers and the
government to bail it out by renegotiating the contracts. Basically, BG argued that the
contracts were a legacy of the monopoly era and therefore not suitable in a
competitive market, that it could not have foreseen the speed with which the
government intended to open-up the market, nor the extent of the competition it will
face and loss of significant market share, or the build-up of gas surplus and the price
collapse, or the mild weather which reduced demand, or delays in construction of new
gas-fired power stations. To further buttress its arguments BG cited as an example,
other companies such as Enron which had signed similar contracts well after the
government's publication of the liberalisation time table in 1993.

But the idea of contract renegotiation was fiercely criticised by BG's contractual
partners. Among the reasons they advanced were that the principle of sanctity of
contracts was regarded as "one of the most important things in the industry," the more
so as such contracts were freely negotiated, signed and approved by experts and senior
officials from both sides, that the producers owed their share holders a duty to protect
the value of the contracts, that renegotiation with BG was likely to lead to demands
from other purchasers for similar readjustment of their contracts, that if BG was in a
more favourable position, they could not alter the contracts without its consent, and
that the market is so unpredictable and no one could tell what the position would be in
2 or 3 years time. Some producers were concerned that renegotiating the contracts
would give BG a competitive advantage both at home and in the European market.
Others blamed BG for the excess capacity because in the 1990s, it deliberately
produced more than it required from some of its fields in order to reduce competition.
Above all, the critics sought to downplay the relevance of the fall in prices by
emphasising that the spot market accounts for only 5 per cent of the pricing system in
the gas market as such it had less impact on the over all market structure than it was
assumed.

Although the government did not want to intervene directly (purely on ideological and
self-interest reasons) nonetheless, it did indicate its preference for renegotiation by the

19
parties. While stating that the "government has neither the power nor the desire to
impose a solution", the then Energy Minister did express the government's believe that
a "sensible commercial renegotiation among the interested parties will result in a far
better outcome for all."

In spite of the seemingly opposing position of the parties, renegotitions did finally
take place between BG and many producers. Among the factors which led to
agreement by the parties' were: the quid pro quo; possibly, the desire to maintain
commercial relationships; the uncertainties surrounding the market - a seller's market
today could be a buyer's market tomorrow; and perhaps, the feeling that the
government might, in some way, penalise some non-cooperating producers.

Another closely related factor which may lead to renegotiation of an investment

agreement is what one may call the ‘legal risks' associated with jurisdictional/title
security issues. In many parts of the world where there have been jurisdictional
disputes over ownership of a territory bordering two or more countries, development
of mineral resources, particularly oil, located in such disputed area may have to be
delayed until some form of settlement is reached between the states concerned. Part of
the settlement may involve sharing the mineral resources with third party which may
affect the foreign investor's expected returns from the project.

c) The Environmental risk: As the Egoth case reveals, concern over the environment
may pose a serious risk to a long-term investment project. Pressure from
environmentalists may force a cancellation or suspension of a project which is
perceived as likely to cause serious damage to the environment, to the detriment of
parties to the agreement who might have invested a substantial amount of money into
the project. Compliance with a new national or international environmental standards
(e.g. on gas flaring, mine construction or disposal of tailings, etc.) may add cost to a
project which was not contemplated by the parties at the time of the agreement. This
happens more often in developing countries where environmental regulations are not
well developed and quite often, they are issued in reaction to one environmental
disaster or another which is publicised and taken up by some powerful environmental
pressure groups (local or international). The usually centralised political set up of
many developing countries (with important decisions being taken by government
beauracrats with no input from members of the public) means that the impact of large
development projects on the environment are not subjected to critical analysis until
when a disaster occurs or the impact of the project on the environment became
apparent - when capital have already been sunk into the project. Salvaging the project
may involve revisiting the agreement by the parties so as to address those
environmental concerns.

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d) Change in Government: Although change in government per se may not provide
any legal basis for renegotiating an agreement entered into by the previous
government, nonetheless, in international business, a regime change (especially if
brought about through a coup, revolution or other drastic measures) does put pressure
on contractual relations and more often than not, used by the new government as one
of the reasons for seeking to renegotiate an agreement signed by its predecessor
especially if circumstances surrounding the initial agreement are tainted by allegations
of corruption, improper procedure or abuse of office by the previous regime.

3. Why Governments and companies ask for Renegotiation

It may be helpful to highlight some reasons why governments - and companies - have
chosen to ask for renegotiation in the past:

Renegotiation, in particular of fiscal terms, either by contract or by exercise of

taxation powers, has been a feature of the natural resources industry throughout the
last 20 years. In times of suddenly upwards exploding prices, all governments have,
by renegotiation or imposition of higher or additional taxes, increased their share. In
times of low prices or of difficult and marginal projects, most governments have
reduced the fiscal burden to continue to make such low-return oil fields still
financially attractive and seek and maintain investment in them. The general tendency
since the oil price collapse of 1985 has been to emphasise tax regimes which focus on
profit (or profitability) and not on total revenues. Fiscal regimes which do not take the
major part of government income from company profit tend to make projects marginal
or economically not viable in a situation of low oil prices. Such system need to be
modified by incentives (as in Malaysia or Indonesia, usually for "frontier" areas) they
are totally replaced by profit-based tax regimes (as in Australia, the UK and Norway).
Governments often have asked for renegotiation of the fiscal regime (taxes, royalties,
government participation) when external events disrupted the original equilibrium and
when companies have made a much higher return from an operation due to external
events such as a significant increase in petroleum prices. Also, the example of other
governments - e.g. the negotiation or imposition of government participation in
ownership in the 1970s - and recommendations by international organisations (e.g.
OPEC in the 1970s) often prompt governments to seek arrangeents which are similar
to those obtained by other governments ("leapfrogging"). Technical standards for
certain areas - e.g. environment and safety - tend to evolve and are often incorporated
in recommendations, guidelines and codes by international organisations.
Governments often have requested that such evolving technical standards be
incorporated into contracts - or they enact them by legislation. Governments have the
significant advantage over companies in that they can execute desired changes in

21
contractual terms by their sovereign power of legislation - though this is as a rule not
appreciated by companies who often build in "stabilisation clauses" into agreements to
protect them from the exercise of unilateral government regulation powers with a
detrimental effect on the economic equilibrium and viability of the project.

It was at one time thought that renegotiation is primarily an interest for governments.
This concept was much influenced by the fact that in the 1970s governments tended to
enforce their notion of permanent sovereignty over natural resources largely through
either nationalisation or renegotiation - often under considerable pressure and
sometimes amounting to outright coercion - of long-term investment agreements.
However, a survey of international practice demonstrates that Companies equally try
to obtain renegotiation of a long-term agreement when it no longer suits their interest.
One reason why company-requested renegotiation may not be so prominent is that
companies can often, even under the terms of the contract, terminate the agreement
and withdraw from projects when they are no longer viable. However, companies tend
to request renegotiation mainly in the case when they want in principle to continue a
project, particularly in view of already made considerable capital investment, but feel
that such continuation is no longer economically viable given the impact of
unforeseen and unregulated external events - such as realisation of significant
geological or commercial risk in particular. Companies will also want to renegotiate if
the imposition of obligations (e.g. environment, minimum investment, infrastructure
investment) becomes so onerous - and much more onerous than originally envisaged -
that the minimum financial return from the project can no longer be realised. The
company's financial minimum return - required to make continuation more attractive
to a company than simple withdrawal - can also be imperiled by government policies
which make operations much more costly (e.g. high import tariffs) or which
drastically reduce revenues - e.g. an obligation to sell production at below market
prices domestically. Renegotiation at the behest of companies is also less often
publicly reported: Host states as a rule wish to keep such downwards renegotiation of
in particular the fiscal regime and investment obligations secret to avoid setting a
precedent. This applies in particular when fiscal terms applied to exploration do not
work once development is considered - in particular in the case of difficult offshore
environments. However, we know of several cases where governments prefer to
quietly adjust fiscal terms as compared to the otherwise likely breakdown of a project
with significant, industry-wide unfavourable publicity.

Finally, both parties tend to have an interest in renegotiation if events both did not
contemplate seriously during the original negotiations make the current system
politically, financially and technically unviable or unattractive, but both parties wish
to continue the project - both for reasons of the project's intrinsic benefits and for the
sake of the reputation of both government and company. A failure of an investment

22
project usually is detrimental to the good-will and reputation of both parties - a
government will see its investment climate deteriorate and its political risk rating rise,
a company may find it gets criticised by the industry and financial press and
confidence in its management capability diminishes, with a negative impact on its
ability to raise capital and its share price. So as a rule, both parties have a very strong
interest to renegotiate a contract if such renegotiation is likely to make an otherwise
conspicuously failing project become successful. Nobody likes conspicuous failure
and it is likely to make government agencies and companies lose face; even if a
company withdraws, it will often be difficult to re-attract another company even if it
would enter the project on more advantageous terms since the reputation of the
previous failure will taint the project in the eyes of other companies as well - they will
look at a government's inability to come to a renegotiated deal as sign of the
government's difficulty in managing its relation with foreign investors and they will
be wary over "hidden" defects in the project. To sum up: Renegotiation is the sensible
way out for both government and company to salvage the risk of an otherwise failing
project - with serious negative repercussions for both sides - if the project can, by
suitable adaptation, be salvaged.

Section D: The Applicable Law

As a rule, the original contract will be the determining factor in the choice of law to
apply to the contract and thereby any renegotiation. If parties choose national law,
then national law is - exclusively - applicable - though questions of nationalisation
and compensation might fall under the rules of international law regarding state
responsibility for property of aliens. If parties choose - often done in financial
agreements, rarely in petroleum agreements - the law of another state, this law is
applicable. If the parties choose international law only, then one has to identify which
rules in the international law of treaties and the law regarding foreign investment are
applicable - a difficult task since international law is basically law governing inter-
state relations and does not fit easily to contracts concluded between a government
and a private foreign company. The question of what law is applicable becomes
relevant and will be decided in particular in cases of international arbitration over
disputes arising between the parties. However, negotiations over adaptation requests -
which can, if not settled, constitute a dispute in the sense of the contract's dispute
settlement mechanism and therefore subject to the arbitration mechanism provided -
usually take into account the principles of law which are, or might be considered by
arbitrators, to be applicable. Renegotiation hence is in general conducted "under the
shadow" of the applicable law.

The question of applicable law becomes particularly difficult when - as a typical

negotiation compromise - the parties could not agree on one particular system of law

23
to govern the contract, but only on a combination solution - such as, for example, a
combination of national law, international law and "generally recognised principles of
law", perhaps also with a reference to the "practices in the international petroleum
industry". In this case, arbitrators would normally try to identify how the various
systems of law and commercial usages deal with a particular issue and they would
tend to apply concepts and principles which are common to the various systems
mentioned. In other words, if the various systems of law chosen would come to a
divergent result, arbitrators will tend to give lower weight to solutions which are not
generally shared, but they would tend to highlight and apply principles which are
common among all of the systems chosen. The "common core" would hence have
most weight, while solutions not shared by all or most relevant legal and commercial
systems would have least influence. Arbitrators have a natural tendency to select those
principles which are international and are seen as a reflection of an international
consensus, while they are likely to disregard principles of national law which are
inconsistent with generally recognised principles. This preference reflects the natural
preference of international arbitration tribunals for internationally recognised
principles and the usages of the international business community. In considering
renegotiation, both parties would therefore do well in taking into account how a
hypothetical arbitration tribunal would try to identify and apply applicable law.

1. The Comparative Law Approach

"Comparative law" is not a particular set of rules, but a method to compare how the
major legal systems deal with a particular issue, such as in particular the question of
renegotiability of long-term commercial contracts with a government. It is relevant
because, first, it provides negotiators with an idea of what kind of conditions are
relevant in major legal systems to trigger renegotiability, but second and in particular,
because the method of comparative law is required to establish the substantive content
of "generally recognised legal practices" referred to often in international petroleum
agreements. Comparative law is particularly useful when contracts are made between
parties from different legal systems and not exclusively subject to one specific
national law since it helps to interpret the concepts and principles which the parties
have employed in drafting the agreements. Parties who could not agree to a specific
national legal system as the exclusive foundation for an agreement are likely to be
intended that they be governed by what is common among major legal systems - and
comparative law is the method to establish such a common content - or to delineate
where there is a difference among major legal system and where the method to refer
to "generally recognised legal principles" will not lead to an absolutely clear and
straightforward result.

24
A - quite general - survey of the major legal systems is likely to reach the following
result:

a) Common Law Systems - in particular English law with its emphasis on detailed
legal drafting with a claim for comprehensive and very detailed regulation by contract
- tend to give less of a scope to a claim by one party to renegotiability of a long-term
contract.

As noted above, one of the implications of the American and English take-or-pay
cases is this: The general principle is that if contract parties wished to build an escape
and adaptation clauses into the agreement, they should do so specifically by
negotiating and drafting escape/hardship/ indexation and adaptation clauses. The cases
also confirm the view that common law judges, in particular English ones, tend to
uphold the validity of an agreement and show particular restraint in intervening into
the negotiated terms.

Nevertheless, there is some case law under the concept of "frustration" which allows
parties to escape from contractual obligations if the very purpose underlying a
contract can no longer be achieved. While US law recognises the relatively narrow
grounds for escape from unexpectedly onerous contractual commitment, it is fair to
say that in the law of the United States courts have at times allowed contractors to
escape from unexpectedly onerous contractual commitments and even at times
adjusted contractual terms in response to such changes, if the change related to a
circumstance which was fundamental to the contract's financial balance, if the change
was in essence unexpected at the time of conclusion of the original agreement and if
holding the party to continued operation of the contract would make the project
economically damaging to this party and possibly drive the project or contractor into
bankruptcy. In the United States, contracting parties can withdraw from an agreement
or request renegotiation if the contract is considered "commercially impracticable."
While US law - as reflected in some, not all court opinions - recognises renegotiability
of long-term contracts in case of extreme, unforeseen onerousness to one party to a
larger extent than English law, the criteria for renegotiability are still relatively strict
and narrow.

From the above discussion, one may conclude that, the Anglo-American court
decisions not only reaffirm the principle of sanctityt of contract but also, seem to
suggest that in the absence of a renegotiation clause in their agreements, contracting
parties they should not expect to obtain relief from the courts against bad bargains or
simply because they turned out to be onerous. Thus as one commentator has noted:
the take or pay cases show that "protection against hardship arising from changed
circumstances does not lie in assuming relief will be found [in the courts]. Protection
lies in ensuring appropriate clauses are contained in the contract itself."
25
b) Civil Law: Civil law is in principle more open to renegotiability of long-term
contracts than common law in the English tradition and shape. Civil law was
influenced by Roman law and mediaeval Canon law which included the maxim of
"rebus sic stantibus" meaning that contracts were valid as long as the underlying
circumstances which were essential in the conclusion of the agreement continued to
exist. No civil law system will, therefore, provide an easy exit out of contractual
obligations. Nevertheless, there are principles and a series of court cases available
which allow lawyers to argue for the renegotiability of long-term contracts and
judges/arbitrators to accept an escape from contractual obligations. The question of
adaptation/escape has been applied in two cases: The German "Wegfall der
Geschaeftsgrundlage" (under Art. 242 of the German Civil Code) and the French
doctrine of "imprevision" especially in the case of the "contrat administratif"
(administrative contract/concession contract).

The German practice has developed under the impact of several severe economic and
national crises. Courts have allowed termination or carried out judicial adaptation of
long-term contracts when due to a drastic change in essential circumstances
underlying the original deal the equilibrium of rights and obligations between the
parties' to the contract were severely disrupted so that the contract had no real value
any longer to the affected party. A mere change in risk or onerousness of the contract,
however, would not give rise to intervention by courts into the balance of freely
negotiated deals.

In French law, the concept of "imprevision" similarly allows an escape from

contractual obligations if a significant, unforeseen change affected the foundation
upon which both parties have negotiated the original agreements and results in a
severe imbalance in the contract's distribution of benefits. French law - as the law of
most other Civil Law countries - has also developed the notion of "administrative
contract". Contracts - such as very likely a concession agreement covering the
development of mineral resources owned by and under the sovereignty of the state -
are more accessible to renegotiation and termination by the government than normal
commercial contracts, though against compensation.

Most other civil law systems (e.g. in Scandinavia, the 1994 new Russian Civil Code
or the many civil codes introduced on the model of the French, German or Swiss civil
codes in Arab countries or in Japan) embody a - restricted - version of the "rebus sic
stantibus" concept. In cases of a severe disruption of the balance of obligations
between both parties caused by a drastic change in essential circumstances which
were essential for the parties in constructing their original contract, the law opens a
way for termination and renegotiation and courts can possess the power to adapt the
agreement. Nevertheless, these very open-ended civil code articles are usually applied

26
by the courts in a very restricted way and do now allow an easy escape from
contractual obligations freely assumed - apart from cases of deception and
mistake/error over the legal implication of the contract concluded. Traditional Muslim
Sharia law emphasises the fidelity with respect to agreements, though the more
modern civil codes in many Arab countries have imported European civil law notions
of "rebus sic stantibus".

If we turn towards Asia, we find that formal laws are as a rule imported from
European civil law (e.g. Vietnam from France; Japan from Germany, France and
Switzerland). In so far, from the mere texts of legislation, the civil law tradition is
likely to apply. It is said, however, that in Asian culture formal law is less important
for regulating commercial transactions than a cultural tradition of collaboration with
continuous adaptation of contractual terms to changing circumstances and the need for
both parties to prosper out of the contractual relationship. Application of formal law
seems to be much less significant in countries in Asia than, for example, in the United
States. It is reported that the "Confucian cultural tradition" in Asia discourages a too
legalistic insistence on contractual terms and requires accommodation of both parties'
major interests to a change in the contractual environment to ensure that both parties
benefit from the ongoing relationship and take all steps to ensure that the relationship
endures - rather than the specific initial contractual terms. But as will be shown below,
the formality of law approach is probably more suitable in transnational commercial
transactions in which people from different cultural and legal traditions wished to
cooperate.

If we sum up the contribution of comparative law to the definition of what "generally

recognised legal principles" means for the question of contract renegotiation, we
would find that in all legal systems contracts lose their legally binding effect when the
core purpose no longer exists. There is, however, a difference of approach in
situations where the contract still can be executed, but due to a drastic change in
essential circumstances such continued execution has become extremely onerous to
one party. In strict common law of the English tradition judges are reluctant to
intervene in such cases on behalf of the aggrieved party. In the United States, for
example, one will find precedents and a legal reasoning to help the disadvantaged
party, in particular if there is a continuation of performances, if the balance between
both parties' performances has been severely distorted and if the change of
circumstance was both essential for the original balance of the contract and
unforeseen at the time of conclusion of the original contract. This concept is more
strongly supported in all countries with a civil law tradition, and in particular in cases
where contracts are with a government agency and embody not only commercial, but
also administrative, state-related elements. It would seem that such concepts should be
applied even more stronger in countries in Asia where the cultural tradition would

27
seem to emphasise even more a continuing accommodation of both parties' main
interests irrespective of initial contract terms. We would suggest that under almost all
systems of law a legitimate cause for renegotiation is much more likely to exist when
there is a long-term contract with parties having to continue to perform under
drastically changed and excessively onerous new conditions. Renegotiability is much
less likely to be acceptable if a contract is to be performed by a one-off exchange of
contributions even if such a contribution has become much more onerous to one party.

2. Renegotiation Under International Law

It is disputed if international law as such is applicable to petroleum investment

agreements between a foreign company and a government per se, but there is no doubt
that international law needs to be referred to when the choice of law provision in an
agreement explicitly refers to international law. If it refers to international law in
addition to national law and generally recognised principles, then we have to look into
international law to see if it supports the identification of principles which are
common to comparative law, national law and international law. The problem with
international law is that it is basically applicable only for inter-state relationships and
it has been created expressly only for such relations between governments, and not for
relationships between governments and foreign private companies. Nevertheless, there
is a certain part of international law which relates to foreign investment and
agreements between governments and private companies. We will look both towards
principles of general international law of treaties and towards principles of
international foreign investment law. If we survey international law, we need to look
at generally recognised principles (classical international law), at general treaties and
multilateral conventions, at bilateral treaties and state practice, at opinions express in
international arbitral awards and at the writings of recognised scholars with special
experience in the field of "state contracts" - the name for foreign
company/government contracts relating to investment.

International treaty law - governed mainly by the Vienna Convention on the Law of
Treaties of 1969 in force since 1980 - is governed both by the principle of sanctity of
contracts (Art. 26) and its counterpart, the change of circumstance/rebus sic stantibus
doctrine (Art. 62). In interpreting this section, the ICJ has taken a very restrictive
approach on what amounts to a fundamental change of circumstance. This is
illustrated by the recent Gabcikovo-Nagymaros Case, in which Hungary sought to rely
on, among others, the principles of impossibility of performance and the occurrence of
a fundamental change of circumstance as grounds to withdraw from its treaty
obligations. These included political changes in both Hungary and Slovakia (i.e.
collapse of socialism and independence of Slovakia), the project's diminishing

28
economic viability, and the progress in knowledge on the environment, and
development of new norms of international environmental law. In its decision, the
court acknowledged that new norms and standards have been developed since the
treaty was signed in 1977. Nonetheless, it did:
"not consider that new developments in the state of environmental knowledge and
environmental law can be said to have been completely unforeseen. .... The changed
circumstances advanced by Hungary are, in the court's view, not of such a nature,
either individually or collectively, that their effect would radically transform the
extent of the obligations still to be performed in order to accomplish the project. A
fundamental change of circumstances must have been unforeseen; the existence of
circumstance at the time of the Treaty's conclusion must have constituted an essential
basis of the consent of the parties to be bound of the Treaty. The negative and
conditional wording of Article 62 of the Vienna Convention on the Law of Treaties is
a clear indication moreover that the ability of treaty relations requires that the plea of
fundamental change of circumstances be applied only in exceptional cases,"
(emphasis added).

Whilst re-inforcing the principle of pact sunt servanda, this decision also suggests that
an unforeseen fundamental change which affects the basis of an agreement could be a
ground for renegotiating the agreement. This is confirmed by the court's observation
that newly developed norms of environmental law had to be taken into consideration
by the parties in implementing the treaty. It therefore, called on the parties to enter
into good faith negotiation to re-examine the effects of the project on the environment,
and to reach a satisfactory solution that takes account of the objectives of the treaty
(i.e. economic development). Towards that end, it recommended to the parties, the use
of the expertise of a third party.

Although the case involved two states, nonetheless, it provides a perfect analogy: the
nature of the project in dispute (a long-term development of natural resources) is
typical of the type of agreements between host states and private foreign investors
which we have been discussing in this paper; and the issues involved are also very
common (e.g. case between SPP and the Egyptian government). In that regard lies the
importance of the reasoning of the court to us.

The authoritative view on current international law is that the principle of rebus sic
stantibus/ change of circumstance is an "objective rule of law" which applies
irrespective of the inclusion of a change of circumstance clause in the agreement
itself. The change of fundamental circumstances underlying an international treaty can
therefore give rise to a - carefully circumscribed and exceptional - right of the
disadvantaged party to request withdrawal or renegotiation of its treaty obligation.

29
International investment law was mostly concerned over the last 25 years with
questions of state sovereignty versus security of foreign investment. Developing
countries with majority in the United Nations' fora have called, mainly in the 1970s,
frequently for a revision of previously concluded investment agreements. The UN
Group of Eminent Persons in their report on Multinational Companies, recommended
including renegotiation clauses in long-term agreements as did, at the time, the
General Counsel of the World Bank, as well as the UN-ECSOC, Draft Code of
Conduct on Transnational Corporations. Legal and political declarations of this period
often support renegotiation by long-term concession agreements which have become
obsolete and no longer represented the aspirations of developing countries.
International codes of conduct were meant in this context to facilitate renegotiation
towards more appropriate terms and conditions. OPEC, the oil producers' association,
has made in 1969 an explicit declaration calling for, and supporting the legitimacy, of
renegotiating such long-term concession agreements, a legal claim followed up in the
following 10 years by renegotiation of most previous petroleum investment
agreements. Western countries have in this context resisted claims for such
renegotiability on the insistence of governments and supported the "sanctity of
contract" and the protection of foreign investment which would be imperiled if
governments could, by regulation, nationalisation or forced-upon renegotiation,
change or revoke contractual commitments which they assumed freely. The
1994Energy Charter Treaty (Art. 10, 1) reaffirms this view - subject to sovereignty
rights. This discussion, however, has to be seen in the light of the debate of national
sovereignty versus foreign ownership of investment. The insistence by Western
countries on "sanctity of contract" did at no point explicitly or implicitly reject the
application of contract law concepts such as "change of circumstance", but it reject the
developing countries' claim to a right to unilaterally change, revoke or coerce the
renegotiation of contract on the grounds of sovereignty and new economic policy
alone.

In our opinion, this perspective seems to reflect the emerging international law on the
subject since these treaties together with national laws and contractual practice form
the basis of legal authority.

3. Arbitral Awards

The three significant Libyan cases in the 1970s and several arbitral cases before the
World Bank ICSID-arbitration tribunal, have to be seen before the context of the
debate of state sovereignty versus sanctity of contract. Some arbitral tribunals (Texaco
v. Libya) upheld the absolute sanctity of contract; most other tribunals recognised a
government's right to abrogate/nationalise an agreement, but required compensation.

30
The important Kuwait v. Aminoil award did raise the issue of "change of
circumstance" and balanced a contractual stabilisation clause against renegotiability of
such long-term concession contracts to bring them in line with current standards.
Kuwait v. Aminoil can be considered as a recognition of the "rebus sic stantibus"
principle in the case of international petroleum investment agreements.

The reasoning in the Aminoil case seems to have been endorsed by the Iran-U.S.
Claims Tribunal. For instance, in Mobil oil v. Iran, the Tribunal held that the duties
and obligations of the parties under the Agreement in dispute "must be construed not
only pursuant to its initial terms, but also as to the manner in which it was performed
and the de facto or de jure amendment during its life;" accordingly, it found the
agreement still valid in spite of the informal changes to the initial agreement.

These cases seem to suggest, in our view, that informal or de facto renegotiation of
long-term investment agreements might be given effect to even though it was
achieved through a manner not provided for by the contract. In other words, it is not
the duty of the arbitrator to tell the parties how renegotiation should be carried out.
These cases therefore, provide an authority on contract interpretation by using the
behaviour of the parties both before and after conclusion of the agreement.

If we sum up the contribution of international law, we will find that most of

international law is not really concerned nor has specific rules on renegotiability of
long-term contracts since it is mostly deals with government nationalisation and
revocation of concession agreements and the therefrom resulting compensation.
Nevertheless, the existence of Art. 62 of the Vienna Convention, the widespread
recognition of government's right to nationalise such contracts against compensation
and several references to the principle of "rebus sic stantibus" in international arbitral
awards would suggest that while international law does not have very specific rules
for petroleum investment agreements, it would support the view according to which
the principle of change of circumstance should apply to long-term petroleum
investment agreements. International law, however, contributes very little on how to
define the conditions for triggering a right to request renegotiation and on the
procedure of how to reach a contract adaptation - except perhaps that it should be
done in good faith and without coercion.

Section E: Contracting Practice in International Commercial Transactions

International contracting practice has developed considerably in the field of

renegotiation and contract adaptation - partly due to the fact that neither national law
nor international law provided sufficiently specific and appropriate mechanisms of
contract adaptation and partly due to the fact that international business has developed
31
a number of long-term international types of transaction (investment contracts; joint
venture; production sharing contracts;transfer of technology; licensing; turnkey;
management; project finance; franchising contracts) which are exposed to many
technical, commercial, regulatory, environmental and political risks and where
contract parties have tried to develop sophisticated mechanisms and procedures of
contract adaptation within the contract itself. While this practice may not necessarily
be indicative of the state of law applicable, they reflect the practices and culture of the
international business community and its need to balance the binding nature of long-
term contracts with the flexibility required and the need to maintain a balance of
mutual benefits from the operations of the agreement throughout its life. The
widespread contract drafting practice in our view thereby indicates that international
business practices include and assume that contracts need some sort of adaptation
mechanism to facilitate the smooth functioning of a long-term business relationship.
International commercial institutions and associations have recognised this need for a
regulated procedure of contract adaptation by providing special rules for conciliation
and contract adaptation - such as the World Bank's Centre for the Settlement of
Investment Disputes ("Additional Facility") or the Contract Adaptation Rules of the
International Chamber of Commerce or the UNCITRAL Conciliation Rules. Both the
ICC and UNCITRAL have recommended adaptation and adjustment of international
commercial agreements in the event of fundamental change in circumstances under
which the parties' contractual relationship was based. The two institutions have also
formulated rules for the adaptation of contracts by arbitral tribunals, conciliators and
other third parties dispute settlement mechanism.

Current international investment agreements in the petroleum and mineral sector

sometimes include general "cooperation" or "review" clauses by which the parties
promise to review the satisfactory operation of the agreement from time to time. If
such a review does not result in an adaptation of the contract if one party feels
substantially disadvantaged, then arguably the contract's mechanism for dispute
settlement can be invoked and the request for contract adaptation can become the
object of arbitration. Sometimes, though more rarely, the contract may include a
formal renegotiation clause allowing each party to request a renegotiation to restore
the contract's original financial equilibrium. More frequently, a stabilisation clause is
combined with a renegotiation clause: In that case, a change of circumstances -
particularly government, legislative and fiscal action - which affects a contract's
financial equilibrium results in the right of the aggrieved party to request renegotiation
or contract adaptation to restore the disrupted balance of the contract. Such clauses are
becoming particularly frequent when companies are concerned over a government's
disruption of the contract's fiscal regime by subsequent enactment of additional taxes
not envisaged in the agreement. Petroleum investment agreements, moreover, are
nowadays replete with many specific renegotiation, new negotiation and contract

32
adaptation mechanisms dealing with special issues. For example, the discovery of gas
often leads to a review of the contract's fiscal regime and its development obligation,
often by explicitly ordered renegotiation in good-faith between the parties.

Thus in the Wintershall, A.G. et al v. Government of Qatar case, one of the questions
which the arbitration tribunal had to decide was: whether by refusing to an agreement,
the Qatari government was in breach of the contractual provision under which the
parties had undertaken to "enter into further arrangements" for the utilisation of non-
associated natural gas should commercial quantity be discovered in the contract area?
The Tribunal held that the government was not in breach because it (the government)
had not agreed to participate in development according to an agreed utilisation plan
nor had it agreed that the utilisation of the gas discovered was economical. And on the
claimants contention that under the applicable law to the agreement, the government
had a duty to negotiate in good faith, the tribunal ruled that there was no violation of
the principle because, "it is clear that such a duty does not include an obligation on
the part of respondent to reach agreement with respect to the proposals made by
claimants.". The government's refusal to accept such proposals was made in good
faith and was justified by "normal commercial judgment." However, the tribunal
extended the original agreement for a period of 8 years so as to enable the parties to
further explore the possibility of agreeing on the natural gas utilisation.

Contracts as a rule contain some automatic variation in response to external factors -

e.g. indices (for prices, for inflation/interest rates). If certain indices used (for oil &
gas sale price valuation or relating to inflation) disappear or become unsuitable, there
is often a provision according to which the parties will negotiate to determine a new
index - when no agreement ensues, usually a third-party is empowered to determine
the disputed issue. Many clauses in contracts dealing with possibilities not envisaged
directly and in the immediate future are often very open-ended - they require in
essence the parties to negotiate a specific regime for this issue - e.g. the regime for
abandonment of obsolete offshore facilities, the restoration of areas after exploration
and extraction, the development of oil fields under joint development programmes and
unitisation arrangements or specific training and economic development
contributions. In fact, since it is practically not feasible to regulate every possible
issue in comprehensive detail, most long-term contracts entrust a large number of
issues to future negotiation between the parties in the expectation that they will find a
proper solution in the sentiment of trust and continued collaboration for continued
mutual benefit which is essential for any long-term agreement. This is particularly so
where no detailed ‘modern' regulatory framework exists such as, in some of the ex-
communist countries of Central Asia and Eastern Europe where regulation are still in
their infancy.

33
In our experience, long-term contracts as a rule are - frequently - renegotiated. Most
of such renegotiation may not refer to major issues, but is likely to provide a periodic
adjustment to external developments, the parties' changing interests, resources and
capabilities. Such renegotiation in general involves a give-and-take: One party's
interest in renegotiation of some issues will meet the other party's interest in
(re-)negotiating other issues. Such renegotiation is generally carried out without
reference to a formal renegotiation clause in the agreement. Both parties usually have
something to give in such renegotiations; the context of such renegotiation is entirely
voluntary.

When governments and international petroleum companies are involved, the

government usually can bring into the renegotiation issues not settled by the contract -
its ability to extend the scope of the company's operations and to facilitate them; the
company can bring into negotiations its management and investment resources: it may
extend its operations, reinvest "revenues", look at new investment opportunities,
extend training, local business development and infrastructure contributions. Such
renegotiation is a - daily - fact of life and does not need to be analysed in depth.

The renegotiations may be more formal, involve higher levels of government and
require a formal amendment to the contract - or they may be less formal, involve the
local company management and its output may be reflected in an exchange of (side)
letters, be minuted as a record of a meeting or be reflected merely in a change of
behaviour. It is hard to come across a long-term investment project where such
renegotiation has not taken place frequently over the years.

In other fields of international commercial transactions, special "hardship" clauses

have developed which enable a party to request an adaptation of contract terms if
continued performance would become unduly and excessively onerous. Hardship
situations may be due to various causes, natural (earthquake, flood) or economic
(price fluctuations). The idea again is that a contract should not, because of a major
change in important circumstances, force a party to continue to operate at a loss since
this would destroy the benefit both parties should expect from the continued operation
of a long-term contract. Another closely related concept is "force majeure" which may
result from events similar to those causing hardship. Although the two concepts are
different in theory (in that force majeure may result in termination or suspension of
performance of the contract), in practice they are rarely distinguishable. On the
occurrence of force majeure event, parties to a long-term contractual relationship
would rather "seek to maintain the contractual relationship but to implement the term
in a modified form, adapted to the new circumstances."

Although, the legal effect of such clauses depends on the law applicable to the
contract, yet an effective hardship clause must not only contain an obligation on the
34
parties to negotiate in good faith. It must also provide for third party resolution of the
dispute should the parties fail to reach an agreement since an obligation to negotiate in
"good faith" does not impose a duty on the parties to reach an agreement. At most, a
stipulation in a contract for parties to negotiate in good faith could be said to impose a
moral obligation on the parties to use their best endeavour with a view to finding a
solution, failing which, the dispute settlement mechanism of the agreement may be
triggered. The use of such clauses illustrates the point that: while in short-term
contracts parties may often have to carry out an obligation which became
unexpectedly onerous, this risk should not be imposed on parties in a long-term
relationship.

To sum up: International contracting practice and the development of special

institutional facilities suggests that the international business community regards
adaptation of terms in a long-term agreement as a natural, unavoidable feature of
business. It indicates that there is a quite general attitude that parties should not be
required to comply with unexpectedly and unduly onerous terms in a long-term
business relationship based on a continuation of performance contributions since this
would destroy the basis of the relationship - continuity of mutual advantage. Parties
are expected to shoulder the losses arising from unexpected events in short-term, but
not in long-term relationships. This discussion of general and specific adaptation
clauses should, however, not be seen to suggest that every contract nowadays contains
such clauses. We have surveyed, in 1976, the incidence of general renegotiation
clauses and have found that a significant number, but not a majority, of international
petroleum and mining investment agreements contains a general renegotiation clause.

There are good reasons: A renegotiation clause tends to undermine the expectation of
stability of the contractual arrangement; it invites spurious claims for renegotiation at
any moment. Also, it is very difficult to formulate a general renegotiation clause
which defines specifically when a change of circumstance and its impact is serious
enough to trigger a renegotiation. For this reason, and perhaps with some confidence
in the application of general legal principles and business practicalities, negotiators on
both the government and the company side in most cases do not focus on including a
general renegotiation clause in the agreement. In fact, a review of most recent
agreements indicates that very few have a general renegotiation provision.

Section F: Policy-Oriented Analysis of Current Legal Position of Renegotiation

of Long-Term Transnational Investment Agreements in Light of Globalisation

To start with, it should be pointed out that, the 1960s and 1970s renegotiations (some
of which we have highlighted above) ought to be viewed from their historical (both
economic and political) contexts. In the 1960s and 1970s , the debate over foreign
35
investment centred on questions over economic decolonisation and developing
countries quest for permanent sovereignty over their natural resources as reflected in
the various UN Resolutions. It was a period marked by economic nationalism, the
main thrust of which was, (at least) to control and regulate foreign investment and (at
most), to take over it or keep it at bay. Thus renegotiation and in some cases,
nationalisation, was seen as a normal progression in host state -foreign investor
relationships - expressed through the concept of the New International Economic
Order. That concept had more political rather than economic content. It was, as one
commentator puts it, a "political programme which [sought] to reorder international
economic relations along politically determined lines." It was therefore, "a grand
manifesto for a social democratic system of world economic order". But those events
and debate have run their course and died down. The current paradigm is globalisation
- brought about by the end of the Cold War, the opening up of markets to competition
following the completion of the Uragua Round and the establishment of the World
Trade Organisation, the progress in information technology (satellite TV and the
internet); which have all combined to make the world a global ‘village' in which
interdependence through trade and investment (rather than isolationism and
nationalism) have become the main features of international relations.

However, this truimph of liberal capitalism or the ‘end of history', as Fukuyama calls
it, does not mean an end in differences in attitude towards economic and political
issues between nations. Rather, it only suggests the prevalence of liberal democracy
and market based capitalism as a political and economic system over other hitherto
competing ideologies. Although it may be argued that the convergence of political and
economic paradigms now taking place may lead to the development of some uniform
standards and practices in commerce and law, nevertheless cultural and ethical or
moral attitudes will continue to shape and influence how people and nations interact
with each other in economic matters, especially international trade and investment.

Globalisation is characterised by liberalisation, privatisation, deregulation, free

enterprise and competition. The concept of globalisation has been embraced generally
by most countries of the world (perhaps, with the exception of Burma and North
Korea) including the hitherto socialist countries. With globalisation, the role of the
state in the economic field has, to a large extent, changed from that of an active
participant in economic activities to that of a ‘facilitator' whose main role is to create a
level playing field for private entrepreneurs. And for globalisation to function
properly, the system "requires self-discipline on the part of states, ... in the form
resisting the manifold temptations of protectionism and other forms of economic
nationalism." That means not just liberalisation by countries of their foreign
investment regimes but also adopting and implementing a legal system that protects
property rights and enforce contracts, including those between the state and private

36
parties. A move towards that direction could be discerned if one examine the
numerous national investment laws enacted by most countries within the past ten to
fifteen years, multilateral instruments (the e.g. the Energy Charter Treaty, NAFTA,
Lome Convention, etc.) and bilateral investment treaties. It could be argued that these
instruments (viewed along with the practice of major players in the international
investment process) indicate the current international investment law. The main
concepts common to most of these instruments are: free enterprise, non-discrimination
and respect for agreements. These are, in our view, some of the main policy
objectives of the instruments. The hope is that, this liberal policy would promote
international trade and investment, seen as the engines of economic growth. From this
policy perspective, one could argue that, international investment law should be read
and interpreted so as to meet these policy objectives. In other words, we are
suggesting that: "International investment law must be viewed within the process
which currently accelerate a globalisation of economic relations ... a development that
requires the parallel. development of a more effective system of economic and
commercial law as one of the necessary pillars of a global society."

In that regard, any free and voluntary agreement - be it a treaty or an investment

contract - must be respected. Any unilateral cancellation, amendment or coerced
renegotiation runs counter to these policy objectives because a violation of an
agreement acts as a disincentive to contracting and risk taking through long-term
investment. Furthermore, coerced renegotiation or unilateral amendment of an
investment agreement taints the reputation of the violating party in the sight of other
players in the market. They will be reluctant to enter into agreements with any party
which does not respect its commercial commitments. In the case of a host state,
violation of contracts with foreign investors heightens the political risk rating of the
host state thereby diminishing the rate of foreign investment flow into the country
(unless in a situation where the expected rate of return is viewed by the foreign
investor as high enough to justify taking the risk). Thus, the most potent sanction
against violation of the rules of the markets is, the loss of reputation and credibility,
not the threat of legal sanctions (which does matter a lot). The fear of being
ostracised, isolated and boycotted by other players may not only have a psychological
effect but may influence in a practical and positive way, respect for contracts.

From this policy angle therefore, it seems clear the fact that, "the global economy
requires to be working well, a global society, and a global society requires an effective
system of global law and order. Transactions must be based on legal instruments
which facilitate reliability and trust." For as Fukuyama has argued, in a culturally
diverse global market place in which players come from what he terms ‘high trust' and
‘low trust' societies, the best legal mechanism through which they can cooperate is
contract based on formal rules which are clear and unambiguous, and which are not

37
subject to manipulation by any party nor to the interpretative idiosyncracy of a judge
or arbitrator. According to Fukuyam, transaction costs are reduced when people who
are culturally homogeneous and trust one another, come together to cooperate for a
common economic objective. But it costs more for culturally diverse individuals or
organisations who have less or no trust in each other to work together because, as he
puts it, they will "end up cooperating only under a system of formal rules and
regulation, which have to be negotiated, agreed to, litigated and enforced; sometimes
by coercive means." Thus, trust in one another among members of the first group
(‘high trust society') obviates the need for a detailed contract and regulation of the
parties relationship because "prior moral consensus gives members of the group a
basis for mutual trust." But where trust is in short supply, as amongst members of the
second group (‘low trust society'), detailed contract and formal rules provide the best
trust. It could be argued that, this point is more relevant in the context of
transnational/global economy law where you have economic operators from both
‘high trust' and ‘low trust' societies coming together to cooperate in a transnational
investment project.

In his comparative analysis of the role of culture in fostering economic cooperation

between members of a society and invariably, between people from different cultures,
Fukuyama identified Japan, Korea, Germany and the United States as among the high
trust societies endowed with healthy social capital which enables people from each of
these societies to identify and trust one another and in some cases, cooperate with
strangers from outside the immediate family unit based on trust rather than formal
rules. As trust and moral obligations complement basic legal commitments in the
parties relationship, transaction costs are lower as the long-term business relationship
between the parties is considered more important than short-term gain or the need to
maximise profits. Hence, parties are less likely to waste time haggling over a deal as
they are more likely to compromise over most of the important issues of the
agreement. This mighht be so because, "[i]f one party feels it got a less than optimal
price or even suffered a loss in the short run, it knows that its partners will be willing
to make this up at a latter point." In other words, the individual interest is
subordinated to the long-term collective interest. On the other hand, in low trust
societies such as the Chinese societies (China, Hong Kong, Taiwan and Singapore),
Italy, Spain and France, there is an inclination to trust one's family members and a
tendency to distrust outsiders beyond the family and kinship. As such, it is rarer for
strangers to cooperate with one another to run an organisation. Where people did
manage to come together under one organisation, "[t]he contract and its associated
system of obligations and penalties, enforced through a legal system, could fill in the
gap" which exists in place of trust, which is restricted to family members or kinship.
Furthermore, in contrast to the long-term, group-oriented view of economic operators
from a high trust society, "when faced with the need for collective action," each

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member of an organisation from a low trust society "would try to figure out how to
exploit [the group] for its own advantage and would suspect the others of scheming to
do the same."

However, this is not to suggest that economic actors from all the high trust societies
are trusting towards outsiders nor are they all group-oriented. Far from that! For
instance, according to Fukuyama, Americas growing individualism has had the
economic effect of "reduc[ing] the ability of individuals to work with outsiders and
diversity lowers trust and creates new barrier to cooperation." Although the Anglo-
Saxon society is more indidualistic, nonetheless, it should be noted that individualism
and rationalism have been the hallmark of western society since times of the Roman
Empire. In an individualistic society, self –interest (objectively determined) as
opposed to the collective well-being is very much accepted as a normal and rational
course of behaviour. The individual is allowed to pursue and perhaps, insist on the
protection of his legitimate self-interest as against the secondary societal or group
interest. Thus when faced with the problem of renegotiating a deal which benefits the
group as a whole but at the expense of his self-interest, the typical westerner is most
likely to resist the urge or accept it grudgingly. He is also less likely to trust a third
party (e.g. an arbitrator or judge- who probably knows nothing about the
circumstances of the initial agreement) to adjust the agreement on behalf of the
contracting parties that negotiated and agreed upon it hoping that it would be binding
on them. On the other hand, a non-westerner, perhaps an Asian, is more likely to
foresake his personal interest and accede to renegotiation if that would benefit the
group in the medium or long-term because the individual interset is regarded in the
Asian society as subject to the overriding collective or group interest to which the
individual is a member. However, that concession may not apply where other
members of the group share different cultures to the Asian member(s) because as
Fukuyama noted, the "Japanese sense of nationalism and procrivity to trust one
another is their lack of trust for people who are not Japanes."

To apply Fukuyama's thesis to transnational investment agreement in general, and to

renegotiation of such an agreement in particular, one may observe that a typical
natural resources development agreement would probably bring together economic
operators from both high trust and low trust societies with a view to developing the
project. All the parties involved in the project have an interest, in one way or another,
in the stability of the investment agreement. Any change in the terms of the agreement
that would affect the interests and expectations of any of the parties might require its
express or tacit approval. And in view of the cultural differences between the parties
and the level of trust between them, it might be difficult and expensive to renegotiate
the deal. Therefore, in such a situation, the formal approach to contract is probably the
best solution. This rule-based approach will not only provide certainty and stability in

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a complex transnational relationship but also reduce transaction costs in a global
competitive economic environment in which, stability and economic efficiency are
prerequisites for any successful commercial undertaking.

To turn to the economic basis on why renegotiation of an investment agreement

should only be allowed in exceptional circumstances (e.g. where the parties provided
for it in their contract or where they agreed on it at a later stage of the agreement) in
the present global economy, one may find a ready answer in the economic analysis of
law approach. According to this theory, a contract is an instrument of "reciprocal
allocation of specified risks, and an efficient system contract law should facilitate
risk-sharing by upholding the allocation of risks made by the contract." Thus, parties
to a contract should, at all times bear their allocated risks except in an unusual event
"beyond the scope of the normal risks contemplated by the parties." Applying this
economic analysis of contract to long-term investment agreement in the mineral
industry, one may argue that, since both the foreign investor and the host state usually
make their independent calculations of the various risks and rewards associated with a
project before appending their signatures on the agreement, each party should bear its
allocated risks. Moreover, in making such calculations, each party relies on expert
opinion and advice from its own (a times independent outside consultants) geologists,
engineers, economists and lawyers. Any decision then taken after such consultations
could be said to be an informed one based on the party's over-riding interest and
should therefore, be implemented.

Although a counter argument could be made to the effect that, the expert's opinion or
advice which is usually based on currently available information (such as geological
surveys, state of technology and their cost, and current economic indicators and likely
future trends) which may turn out to be either insufficient or wrong. In such a case,
the parties could not be said to have assumed the risks allocated to them in the
contract or new ones which might arise in the future. Our answer to that argument is
to say: that is precisely what contract is aimed at - the allocation of risks and reward.
He who takes risks expecting to derive benefits from them should bear those risks or
their likely occurrence instead of trying to shift them to the other party who did not
assume them nor expect to be benefit from them. In any case, since the risk "whether
great or small, must generally fall on one party or the other," it should fall where it
lies i.e. with the party who ought to have guarded against it (the obligor). Allowing
parties to renege on their contractual commitments creates uncertainty and
discourages long-term investment. A prudent foreign investor will only undertake to
risk his share holders money into a risky petroleum or mining project if he is assured
that the fiscal and legal regime under which the investment is made would not be
changed unilaterally in a manner which adversely affects his financial calculations.
On the same note, a host state will be reluctant to grant and maintaina long mining

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lease to a foreign investor who will be free to abandon, delay or scale down the
project, or insist on renegotiating the contract simply because the project no longer
meets the foreign investor's expected rate of return. That would dampen the host
state's expectations (which might have budgeted its expenditure partly based on the
revenue it expects from the exploitation of the country's natural resources) and make it
loss faith in foreign investors who only want to make huge profits out of their
investments; the more so if there are no other investors who are willing to take over
the project.

An argument which is usually raised to justify calls for renegotiation is the issue of
"fairness" of the agreement. That, when a long-term agreement seises to be seen as
‘fair' by either of the parties then it should be renegotiated. But, on the other hand, it
could be argued that the term ‘fair' is relative in meaning; which varies from one
jurisdiction to another, from one culture to another or even from one individual person
to another, as well as with time and circumstances. An agreement which is perceived
as fair by the foreign investor may be viewed as exploitative by the host state. Indeed,
even within the host state, an agreement which is viewed as fair by the ministry of
energy (which has the responsibility of signing natural resources development
contracts with foreign investors) may be regarded by the ministry of finance or
treasury department (which is in charge of government revenue) as giving-away the
country's natural resources for pittance. Thus, in our view, inquiring into the fairness
of an agreement as a basis for renegotiation is probably unwarranted. It amounts to
looking for ‘substantive' rather than ‘formal' reasons (which we prefer) for enforcing
an agreement. To seek to rely on substantive reason (which takes into the moral,
economic and social basis of the contract) creates uncertainty and unpredictability in
the system. Parties to an agreement are never sure as to whether or not the contract
may be declared unfair by a judge or arbitrator should either of them complained that
the agreement had become onerous for him. The judge or arbitrator will then rewrite
the contract for the parties using his own discretion and sense of justice or fairness.
Apart from interfering with a freely bargained agreement, that would not lead to
efficiency in economic activities and application of the law. On the other hand, a more
formal approach to contract law (i.e. interpreting the agreement as ‘it is' rather than as
‘it ought to be') ensures that the parties honour their commitments thereby enabling
them to plan based on the contract, in particular in transnational context.

Furthermore, it may be argued that, enforcing free and voluntary bargains is cost-
effective and will encourage businessmen to be more careful and scrupulous in their
assessment of projects thereby reducing speculative bids and the likelihood of
conflicts over such agreements. Consequently, that reduces transaction costs in the
international investment process. The now more readily available information on
recently negotiated agreements (e.g. from publications by the Barrows company,

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Petroconsultants, and the financial and economic press) from different countries and
the availability of private independent consultants enhance the knowledge and skills
of business negotiators, and assist them in taking informed (and possibly competitive)
decisions. Price volatility and political upheavals are now matters of common
knowledge which are duly taken into consideration by businessmen in their economic
and political risk assessment of long-term investment projects. The boom and burst
cycle in the global economy and the possibility of regime change are now the norm
rather than the exception in international trade and investment. Businessmen have
since learned to live with them and so should governments. This point should
therefore counter the argument (usually made in support of host states' call for
renegotiations of investment agreements) that governments in the developing
countries and those emerging from socialism negotiate under weak position vis-à-vis
multinational corporations and so are usually taken advantage of due to their
unsophistication and perilous political and economic circumstances.

Whilst it may be true to say that the crave for foreign investment (seen as a panacea to
these countries economic woes and predicament) and competition among countries to
attract same do combine with other factors, to reduce a developing country's
bargaining power, it is difficult to accept the view that these countries are taken
advantage of (largely because they lack adequate information, professional knowledge
and skills on how to exploit their natural resource) by foreign investors. Instead, one
may argue that, the competitive (or what others may regard as ‘low' or ‘give-away')
and favourable terms being offered by these countries are a reflection of the global
competition over scarce investment capital rather than a sign of the exercise of undue
bargaining strength by multinational companies (thereby providing ammunition to
attack such agreements later in the future) who are out to take massive financial risks
in unpredictable economic climates.

Of course, one cannot rule out the possibility of some corrupt state officials conniving
with some unscrupulous foreign investors in the award of mineral licenses to the
detriment of the host state. Agreements procured through corrupt means are in no
doubt, invalid under most national laws and international law and should, where
proven, be impeached or at least renegotiated. However, many a times, it could be
daunting to distinguish corrupt practices from legitimate business objectives.

Conclusion

Our survey has shown that renegotiation - in whatever form - is a way of life in long-
term business relationships, especially where the joint project and both parties depend
on a series of continuing performances by both sides to maintain the mutually
advantageous project and their relationship. International and generally recognised
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legal principles identified by the method of comparative law have a tendency to
recognise - in narrow confines - the right of a party whose participation in a contract
has become ruinous through no fault of its own, but through the collapse of the basic
circumstances underlying the deal with a major disruptive effect on the balance of
benefits - to seek renegotiation or escape from such contractual commitments. The
practice of international business, particularly where Asian culture influences prevail,
is to recognise that the relationship is more important the precise terms of the initial
contract. In response to the recognition of such needs, and of the insufficient help
provided by international law in structuring renegotiation, the nternational business
community has developed numerous contractual methods to provide for adaptation
and renegotiation. Where such methods of contractual adaptation have not been
negotiated, reliance on general principles, on general practice and on commercial
reason will tend to suggest mutual accommodation by renegotiation.

The essence of renegotiation should be to conduct the process in good-faith, without

coercion, without mutual recrimination and accusations over responsibility for past
failures and with the view that both parties are likely to benefit most from a solution
which restores the balance of the agreement and allows the relationship to prosper for
both parties. There must be renewed quid-pro-quo, and the party which gives up its
secured contractual position to accommodate the other's request for adaptation of the
contract should get some concessions so it can show to its constituency success in
renegotiation. These, we believe, are quite normal and perfectly acceptable even in the
current globalised economy. However, we did point out that most of the renegotiation
of the 1960s and 1970s must be viewed from their historical (economic and political)
contexts. As such, it is questionable whether unilateral or coerced renegotiation could
be justified on either policy or legal grounds in the present day globalising and
liberalised economic environment.

Under current conditions, the formality of law approach would be more suitable as it
reduces uncertainty and chances of opportunistic behaviour in transnational
commercial transactions. Above all, it is probasbly the most convenient
contractual/legal mechanism to regulate the relationship of economic operators from
different cultural and legal backgrounds. Thus, the formality in law approach makes
more economic and legal sense than the renegotiability approach.

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