King's X in Mexico's Round One

The term "administrative rescission" in the law makes the Mexican National Hydrocarbons Commission (CNH) effectively the judge and jury. A foreign investor would normally expect the exploration and extraction agreement to provide for international arbitration as a mechanism for mitigating Mexico's home-court advantage. But the Hydrocarbons Law prohibits international arbitration of administrative rescission. Even so, US or Canadian companies might also expect that the investment-protection chapter of the North American Free Trade Agreement (NAFTA) offers some protection. However, fine print deep within the NAFTA might surprise them.

The 50-plus companies that have expressed interest in Mexico's Round One have expected Mexico to sweeten fiscal terms in light of lower oil prices and "now constrained investment budgets." Acknowledging this new reality, recent clarifications and amendments to the draft Exploration and Extraction Contracts (PSCs) have apparently accommodated industry comments. But political risks remain.

ADMINISTRATIVE RESCISSION: GAME OVER

Two little-explored provisions in the Hydrocarbons Law present a potentially devastating risk. Hydrocarbons Law Article 20 gives the Mexican government's Comisión Nacional de Hidrocarburos (CNH) the power to administratively rescind exploration and extraction contracts. This contract-between the Mexican state (through CNH) and a foreign or Mexican contractor-permits a company to engage in hydrocarbon production and exploration in a given block for a given period of time.

In short, the Hydrocarbons Law gives the Mexican state the power to rescind its own contract, with profound effect. After the CNH administratively rescinds the contract, the contractor "shall transfer" the contract area to the Mexican state, "free of charge, payment, or indemnity whatsoever." Once an administrative rescission is declared, the parties will enter into a corresponding settlement in accordance with the PSC and the applicable legal provisions.

Administrative rescission does not exempt the contractor from a claim for damages by the CNH.

The contractor does have the right to plead its case against administrative rescission, to the CNH. The Hydrocarbons Law requires CNH to declare an administrative rescission and state the cause or causes. The contractor has up to 30 days to "express what it deems legally significant" about the administrative rescission and to submit evidence. The CNH then has 90 days to "issue a ['duly grounded'] resolution."

The "serious causes" for which the Hydrocarbons Law provides that the CNH may administratively rescind the contract are, in the words of one observer, "broad enough to drive a truck through." The wording comprises factual scenarios that range from routine, garden-variety infractions to material breaches. Here are some examples:

Failure to comply with the contract's minimum work requirement "without cause." Even though the contract may set out those requirements in some detail, "without cause" leaves CNH with the discretion as to whether or not to apply them.

Severe accident "as a result of willful misconduct or fault of the contractor that causes damages to the facilities, death, and a loss of production."

False or incomplete reports to enumerated public authorities "without cause" concerning "production, costs, or any other relevant aspect of the contract. It is not difficult to imagine a report concerning a relevant aspect of a contract that was mistaken, but which gives leeway to CNH to decide that it was "without cause."

The contractor fails, without cause, to make any payment to the state, or delivery of hydrocarbons to it, pursuant to the timeframes and terms set forth in the exploration and extraction contract." The complexities of tax regimes, for example, can require significant time to determine compliance, procedures, and to document. Corrections in the light of these complexities can turn a technical mistake or legitimate difference of interpretation on such obligations into a ground for administrative rescission.

The text of the grounds on which CNH may rescind is broad. But new trends of protection of human rights by Mexican federal courts have incorporated some legal principles that may serve to advance the argument that CNH should act proportionally while rescinding a contract, (i.e. administrative rescission is applied restrictively and interpreted in a manner favorable to the investor).

ADMINISTRATIVE RESCISSION: GAME OVER PLUS HOME-COURT ADVANTAGE

The second significant political risk is in an exception to Hydrocarbons Law Article 21, which does allow for international arbitration. Foreign parties frequently look to international arbitration outside of the state party's territory, to ensure neutrality. PSCs routinely provide for international arbitration. Article 21 requires arbitration, under Mexican law, in Mexico.

More importantly, however, an administrative rescission cannot be arbitrated at all. An aggrieved contractor would have to turn to the Mexican courts for relief. In this regard, and although there is a new trend in the Mexican legal system of protecting human rights against the abusive exercise of powers by authorities , a strong resistance persists in the manner in which Mexican courts perceive and interpret public policy. It is, therefore, questionable if Mexican courts would be more inclined to confirm the validity of a rescission based on a broad interpretation of public policy, than to overturn it based on the violation of human rights.

Taken together, Article 20's broad grounds for administrative rescission, giving discretion to CNH and Article 21's prohibition of arbitration, leave a foreign contractor no choice but to litigate in Mexican federal courts.

ADMINISTRATIVE RESCISSION IN THE UPSTREAM: A CAUTIONARY TALE

The long and continuing attempt to enforce an arbitration award by a Mexican subsidiary of KBR in the face of an administrative rescission by Pemex's E&P subsidiary illustrates some difficulties that investors into Mexico's upstream may face.

The dispute, between KBR subsidiary Corporación Mexicana de Mantenimiento Integral (Commisa) and a Pemex subsidiary (PEP), arose out of two contracts, in 1997 and 2003, to build and install two offshore natural gas platforms in the Bay of Campeche. The two contracts were governed by Mexican law, provided for international commercial arbitration in Mexico, and allowed PEP to rescind the contracts.

Disputes arose. PEP administratively rescinded the contracts in March 2004. Commisa brought its claims in international arbitration, as the contracts provided. Court litigation in Mexico ensued over the propriety of PEP's administrative rescission.

Meanwhile, the arbitration progressed, and, in December 2009, the arbitrators issued a US$286 million award in favor of Commisa. In 2010, Commisa sought to enforce the arbitration award in New York under a treaty allowing for such enforcement. The federal court in New York allowed the award to be enforced.

PEP sought to nullify the award in Mexican courts, which rejected PEP's first two attempts. The third time, PEP succeeded.

The nullifying courts relied on a 2009 law, i.e. after the date of the contracts and after Commisa brought arbitration, barring the arbitration of administrative rescission. The 2009 law, according to the Mexican courts, was not being applied retroactively. Moreover, according to the Mexican court, another change in Mexican law also effectively barred Commisa from litigating the propriety of the administrative rescission in Mexican courts, too.

In later chapters of the Commisa saga, Commisa has tried to enforce the arbitration award, despite the Mexican court annulment of the award. After Commisa enjoyed a first-round success, the United States Court of Appeals reversed the New York award-enforcement lawsuit. The appeals court sent the case back to the lower court to decide whether to enforce the arbitral award or the Mexican nullification judgment.

The New York court upheld the award, again, because it was unjust for Mexican courts to retroactively apply the 2009 law, to favor a state enterprise that had agreed to arbitrate. The injustice was compounded because Commisa was left without any forum to litigate administrative rescission. PEP has again appealed, and that appeal remains pending.

The twists and turns of Commisa's continuing, six-year award-enforcement story make some simple points clear. First, Mexican governmental bodies can administratively rescind a contract, thus nullifying it, at the state party's say-so. Second, Mexico via Pemex has already done so in the oil and gas upstream. Third, the legal circumstances under which Mexican courts nullified the Commisa award were new then.

Now, however, the ban on arbitrating administrative rescission is firmly anchored in Hydrocarbons Law Article 21. Fourth, any right to commercial arbitration in the Hydrocarbons Law or in the model PSC has less value in circumstances of "serious breach," when the CNH can simply rescind the contract administratively. CNH can override it by declaring administrative rescission. Fifth, this is a political, not a commercial, risk to the extent that Mexican authorities may choose to exercise the broad discretion given to them in the Hydrocarbons Law.

CAN NAFTA'S INVESTMENT PROTECTIONS MITIGATE THIS POLITICAL RISK?

KBR, Commisa's parent company, is pursuing another line of attack via NAFTA, which protects investments made by investors from one NAFTA country into the territory of another. In contrast to Commisa's case, which relied on the contracts at issue, KBR's case relies on the treaty.

In its NAFTA arbitration, KBR has argued that the Mexican award-annulling courts allowed PEP to act as the judge of its own case and unilaterally nullify an arbitration award. As KBR framed its case, the annulling court decision was designed to protect PEP against an adverse award favoring a US company, in violation of several NAFTA provisions. KBR's NAFTA arbitration case is ongoing.

If the CNH administratively rescinded a PSC because a US (or Canadian) company's Mexican subsidiary violated Hydrocarbons Law Article 20, could the US or Canadian company pursue the same course? Of course, each case would turn on factual questions, the most important of which would answer whether the CNH's rescission was basically well founded or not.

But the text of the NAFTA trade pact leaves some important questions unanswered. When Mexico originally signed on to NAFTA, in 1994, the country was allowed to bar the door to foreign investment hydrocarbon exploration and production. But now Mexico has changed its laws, allowing foreign investment. So, does the change in Mexico's own laws effect a change in NAFTA?

A US or Canadian investor/NAFTA claimant would argue that the change in Mexican law does have that effect. The claimant would argue that Mexico had been allowed to bar the door, but once Mexico opened it, foreign investors have to be given the same treatment as NAFTA investments in other sectors.

However, Mexico might argue a point from NAFTA's fine print: "[i]f Mexican law is amended to allow private equity investment in [hydrocarbons], Mexico may impose restrictions on foreign investment participation ... and describe them." Administrative rescission is just such a restriction, Mexico might contend. Interesting and nice arguments about international law versus Mexican law would then be tested in arbitration.

Handicapping the legal merit of these intricacies is the investment-lawyer's stock in trade, and management is accustomed to adjusting its investments decisions accordingly. But there is another thumb on the scale. NAFTA allows the representatives of the countries that signed NAFTA to have the final word on interpreting NAFTA's text.

Specifically, imagine a NAFTA arbitration, brought by a US investor claiming that administrative rescission violated the NAFTA treaty. A defense by Mexico such as the ones cited above involves a reservation or exception to NAFTA. In that case, the NAFTA arbitrators must request a "binding" interpretation of the NAFTA Free Trade Commission. If the commission does not issue its interpretation in 60 days, the arbitrators can decide.

Importantly, the commission consists of ministerial-level representatives from the three NAFTA member countries. The interests of the states may not align with the interests of their investors. This is not surprising, as states are most often the respondents in investor-state arbitrations.

Indeed, this point of view was reflected when the commission interpreted the so-called "fair and equitable" treatment standard in 2001. The result of that interpretation of the fair and equitable cause of action was that NAFTA investors have to show treatment that is arguably more unfair than an investor under another treaty with exactly the same words. In sum, the decision-maker risk, again a political risk, ought to give the investor pause.

MITIGATING THE RISK?

Mitigation strategies might involve looking to the terms of other treaties, to see if Mexico's investment-protection treaties with other treaty partners, of which there are over 40, offer greater protection than NAFTA. This requires detailed analysis of each potential investment protection treaty, which could include, for example, another treaty with a fair and equitable treatment standard that is not burdened with the commission's interpretation, as NAFTA is.

ABOUT THE AUTHORS

Timothy J. Tyler is a counsel in the International Dispute Resolution practice at Vinson & Elkins LLP and practices international commercial arbitration, investor-state arbitration under treaties and state contracts, and associated US litigation. He represents clients in many industries, drafts international dispute-resolution clauses and procedures, and counsels clients on how to structure investment holdings into emerging markets to maximize investment-treaty protection.

James L. Loftis is a partner and heads the International Dispute Resolution practice at Vinson & Elkins LLP. He focuses his practice on the arbitration and litigation of international commercial and investor-state disputes, and counseling in matters involving public international law and treaties. His practice includes disputes involving all aspects of energy, construction, and infrastructure development; disputes under investment laws and treaties; and boundary disputes, cross-border technology disputes, and sovereign debt.

Claus von Wobeser is managing partner of Von Wobeser y Sierra Mexico City. With experience acting in over 100 arbitrations as either counsel or arbitrator under the rules of the ICC, AAA, Inter-American Commercial Arbitration Commission, NAFTA and ICSID. He serves as arbitrator on the ICSID Panel as designee of the chairman of the Administrative Council. Furthermore, he is vice chairman of the ICC International Court of Arbitration, former co-chair of the Arbitration Committee of the International Bar Association and former president of the Mexican Bar Association.

Marco Tulio Venegas is a partner at Von Wobeser y Sierra Mexico City, with 18 years of international experience both on a professional and educational level. He has saved his clients billions of US dollars and has protected and resolved several of the most complex and consequential litigation and arbitration matters for both multinational clients and governments around the world. His expertise includes international commercial arbitration and investment arbitration. He serves as vice-chair of the Controversy Dispute Committee of the Mexican Chapter of the ICC and is a member of ICDR Young and International and the Mexican Bar Association.

Know this before investing

What is "investment treaty planning?"

It is structuring the ownership chain of investments into an investment-receiving country, the "host state." This is one tool to reduce political risk.

What is an investment protection treaty?

BITs, or bilateral investment treaties, are between two sovereign states and protect each state's investors' investments in the territory of the other state. So, a US investor's investment in a host state enjoys protection, and the other state's investor enjoys the same protection in the US. NAFTA, although a free trade agreement (FTA), has the same type of protection as a BIT. There are thousands of these investment-protection agreements.

What do BITs or FTAs protect?

The protections found in each treaty differ, so each requires special attention. Typically, host governments are required to give investors of the other state: fair and equitable treatment (e.g., protection from arbitrary treatment and from fundamental changes to the legal or tax regimes), treatment at least as good as a host-state company would receive restrictions on expropriation and require paying investors when expropriation occurs, and more.

These protections typically extend to in-country investments in the "host" country such as: locally incorporated entities; rights in minerals; licenses; contractual rights; shareholdings; and IP rights.

How can treaty planning protect investments?

If a state breaches its investment protection obligations, most BITs and FTAs give investors a direct cause of action to recover damages against the state itself through international arbitration. Claims are typically brought by a qualified holder of an investment. To ensure an investment qualifies for protection, an appropriately qualified national must hold the investment. A rule of thumb is that the national must be established in, and in a few instances must, operate from a jurisdiction that has a treaty with the host state. When investing in higher-risk countries, a company may have several holding companies in the ownership chain.