Arbitration vs. litigation

Wesley J. Heath - Shearman & Sterling LLP, Washington, DC

International arbitration presents compelling advantages over litigation before United States or other national courts for managing specific discovery problems unique to oil and gas controversies. In the coming years, the discovery management problems apparent today in resolving oil and gas controversies before US courts are likely to become even more pronounced if trends in the industry continue. This article addresses the advantages to both national oil companies (NOCs) and private oil companies of using international arbitration over litigation in US courts to manage discovery in the context of national oil companies’ growing power in the market.

The oil and gas industry has undergone radical changes recently and will likely undergo even more profound changes in the next decade. After a decade of liberalized capital movement in the 1990s, the past 5 years has seen a resurgence of national control over petroleum resources. Although this is partially the result of a political environment unfriendly to foreign investment, it is no coincidence that the growing interest of national governments in controlling petroleum resources has accompanied a bull commodities market.1

Despite recent price moderation, growing energy demand in the US, China, and India will likely keep prices high by historical standards and continue the trend of national governments asserting greater control over domestic petroleum resources. Moreover, the 7 largest private oil companies control less than 5% of world reserves, a figure that is declining each year.

While the power of NOCs is certainly nothing new, their ability to control petroleum resources has grown remarkably over the past 5 years as they have been increasingly in a position to dictate the terms on which they will deal with private oil companies. As Daniel Yergin recently observed, current market conditions suggest another historic shift of power from private to NOCs is occurring.2

NOCs operate in a context profoundly different from private ones, a unique environment that makes international arbitration far superior to litigation before US courts as a means of managing discovery.

Unlike their private counterparts, NOCs are instruments of national policy fulfilling sensitive political and diplomatic objectives. Because of the central role that NOCs play in their nations’ economies, they are routinely entrusted with extremely sensitive information. Moreover, for many countries with nationalized petroleum industries, the NOC is the heart of the nation’s economy providing not only the vast bulk of foreign exchange but also supporting an enormous share of the national government’s budget.

Crippling the oil industry in many countries would severely undermine the national government’s ability to maintain internal and external security. As a result, routine production and storage information is of strategic military importance. The Federal Rules of Civil Procedure’s adoption of a one-size-fits-all solution to litigation makes them a poor means of managing discovery involving the diplomatic, political, and sensitive economic issues that arise when an NOC is involved in dispute resolution.

The possession by NOCs of extremely sensitive information makes them vulnerable in litigations, particularly in the US. There is a growing tendency in US litigation for plaintiffs to use discovery to secure a favorable settlement rather than to obtain information to try a case on the merits.3

The Federal Rules of Civil Procedure allow very broad discovery of any information that is relevant or may lead to the discovery of relevant information. Parties suing a NOC have an incentive to make very broad document production requests and demand harsh sanctions if the NOC is unable or refuses to comply.

One example is Lyondell-CITGO Refining, LP v. Petroleos de Venezuela, S.A., 2005 WL 1026461 (S.D.N.Y. May 2, 2005), where PDVSA, the Venezuelan NOC, found itself in the unenviable position of a US court ordering it to allow plaintiff’s counsel wholesale access to minutes of PDVSA’s board of directors, although Venezuelan law prohibited access to those minutes by anyone without appropriate security clearances.

After PDVSA found itself unable to comply with the court’s order because plaintiff’s counsel lacked the security clearances required under Venezuelan law, the plaintiff was able to secure an “adverse inference,” a formal ruling that the evidence not produced was detrimental and that the judge or jury determining the facts may give additional weight to the evidence presented by the plaintiff during trial.

The US system of liberal discovery is inappropriate when it may result in the revelation of foreign governments’ diplomatic or sensitive economic information. One can easily imagine a situation when an NOC would rather default in a case than allow disclosure of such information.

Under US law, the federal government can invoke the state secret privilege, a common law privilege that prevents disclosure of military or diplomatic secrets. Invocation of the state secret privilege requires a personal determination by the department head, usually a cabinet-level official, that the disclosure of the secret information would be detrimental to the US’ military or diplomatic interests.

Even assuming a US judge would recognize an assertion of the state secret privilege by a foreign government, no sovereign state would entrust a foreign government official with the discretion to determine whether that state had met the requirements of the state secret privilege because such discretion would likely allow the foreign judge to examine the very documents the state sought to keep secret.

In Compagnie Francaise d’Assurance pour le Commerce Exterieur v. Phillips Petroleum Co., 105 F.R.D. 16, 24-26 (S.D.N.Y. 1984), the court seemed to recognize the right of the French government to invoke the state secret privilege but found that in that particular case its requirements had not been met because the documents were not military or diplomatic secrets. The case also demonstrates that state secret determinations would likely be made not under the law of the country designating the material as a state secret but rather under US law.

International arbitration provides parties much better options for avoiding the disclosure of highly sensitive information. The International Bar Association Rules on the Taking of Evidence in International Commercial Arbitration (“IBA Rules”) for instance require that requests to produce documents describe not only why the documents are relevant but also “material to the outcome of the case.” The IBA Rules’ materiality standard does not allow the broad requests for documents common in US litigation and hence limits the ability of a plaintiff to secure a tactical advantage by requesting information that an NOC may refuse or be unable to produce because of security concerns.

Moreover, the IBA Rules allow appointment of an impartial expert to review a document to determine the propriety of an objection to production if the arbitral panel believes review by the panel is inappropriate. Theoretically, the panel could use this procedure to select an impartial expert with appropriate security clearances to rule on objections to production.

Even if selecting an expert with appropriate clearances and impartiality may prove difficult in practice, the IBA Rules still provide greater flexibility than corresponding procedures available in US courts. Although US courts have procedures for using special masters to resolve discovery disputes, US judges generally use special masters when particular substantive expertise is needed rather than as a means of shielding judges from sensitive information.

More importantly, Article 9 of the IBA Rules explicitly recognizes the exclusion of evidence of “special political or institutional sensitivity (including evidence that has been classified as secret by a government or a public international institution) that the Arbitral Tribunal determines to be compelling.” While this provision may confer an advantage on parties seeking to avoid production of documents, the IBA Rules guard against abuse by requiring that the arbitral tribunal determine the need to withhold the documents “compelling.”4

The IBA Rules also mandate exclusion of evidence in compelling cases of commercial or technical confidentiality. Unlike the IBA Rules, the US judicial system only allows parties to withhold evidence on the basis of common law privileges like the attorney-client privilege that do not recognize political or institutional sensitivity. Moreover, even if US judges are willing to allow withholding of foreign state secrets, the state secret privilege can only be asserted by a government and hence any assertion would probably have to be made not by the national oil company but rather by the foreign government whose state secret was to be revealed.

A US court might even require the foreign government to undertake the burden of intervening in the case to assert the state secret privilege. In contrast, the IBA Rules specifically allow a party in receipt of sensitive information standing to raise the issue to the arbitral tribunal.

By creating party autonomy to fashion procedural rules, international arbitration gives the parties additional flexibility to craft their own solution to the state secret problem. One of the most important advantages of international arbitration is that it allows the parties to create a procedure where state secret determinations are made by the arbitral panel according to the law of the country classifying the material as secret even if the agreement were governed by another country’s law. Parties drafting new arbitration agreements could include this procedure in the arbitration agreement while those with existing agreements could adopt this solution when agreeing on the terms of the arbitration.

If parties with existing agreements are not able to agree on a procedure for making state secret determinations, Article 9 of the IBA Rules, by referencing withholding information based on classification, seems to resolve state secret determinations under the law of the country declaring the information to be a state secret.

Even though Article 9 requires the party withholding the information to meet the high standard of “compelling,” the IBA default procedure under Article 9 is far more protective of sensitive information in possession of NOCs than the corresponding state secret privilege available in US courts. As discussed, the suggested procedure for making state secret determinations under the law of the country deciding the information to be a state secret is probably unavailable in US courts where judges will likely decide the issue under US law.

International arbitration is a wise choice not only for NOCs but for private ones as well. Even though private oil companies may have been able to insist on dispute resolution before US courts in the 1990s, those days have passed. Private oil companies would be wise to encourage the use of international arbitration because the alternative is likely to be litigation before the NOCs’ home courts.

Many governments have suggested that controversies over future agreements will be decided by their national courts. Although some dismiss this as nationalist rhetoric, the possibility should be taken seriously given the recent moves towards nationalization of foreign investment in the Bolivian natural gas industry.

Moreover, as privately owned reserves are depleted, the leverage of NOCs to demand litigation before home courts will only increase. Litigation before NOCs’ home courts, however, may ultimately prove to be a risk private oil companies and international investors are unwilling to endure.

A standoff between NOCs insisting on litigation before their home courts and private oil companies and international investors insisting on an environment they see as less politically charged would likely have extremely negative effects on oil and gas production by greatly reducing the flow of capital and expertise needed to expand future output.

Producers looking to expand output, particularly NOCs whose governments rely on exports to provide foreign exchange and finance the national budget, are not likely to benefit from such a standoff. Moreover, use of a producing country’s home courts risks encouraging foreign investors, who may believe those courts biased in favor of the government, to seek the protections of foreign judicial forums.

In today’s global capital markets, court orders have the ability to affect transactions in other countries. This problem was recently demonstrated by the bankruptcy litigation in Texas involving Yukos, formerly Russia’s largest private oil company before the Russian government seized its core assets.

When the Russian government sought to sell Yukos’ assets, the company filed for bankruptcy in Texas and was able to obtain an injunction against the sale. While the injunction could not stop the sale, Deutsche Bank refused to provide Gazprom, the assumed purchaser, with financing while the injunction remained in place, and Gazprom was unable to participate in the sale.

To avoid disrupting global capital markets and impairing the ability of domestic corporations to engage in transactions, national oil companies and their governments should press for favorable commercial and contractual terms but adopt international arbitration rather than their home courts as the means of settling controversies.

The changing environment in which private oil companies operate also suggests that they are in need of a means of managing discovery. Despite the shift of power towards NOCs, the private oil industry is facing enormous scrutiny. In the US, record profits have led to a public outcry against the major oil companies and discussions of a windfall profits tax. Pay packages of oil executives have come under increasing criticism, and the major private producers are constantly accused of aiding less than democratic regimes and of providing little economic benefit to the countries where they produce oil and gas.

International arbitration provides private oil companies with a means of resolving disputes while keeping their affairs more confidential and providing less ammunition to their critics. As easily recoverable conventional oil becomes scarcer, private oil companies will be subjected to even greater scrutiny at home as they search for petroleum in geographic and political environments that are even more challenging than the ones with which they are currently engaged.

However, one should note that confidentiality itself has become a target in recent proceedings before the International Centre for Settlement of Investment Disputes. In Aguas del Tunari v. Republic of Bolivia, critics of confidentiality have argued that investment disputes in industries that affect the livelihood of entire nations should be subject to public scrutiny, a powerful argument with which the international arbitration community continues to struggle. National and private oil companies should weigh confidentiality issues carefully in crafting dispute resolution provisions.

The most important advantage of international arbitration is that it offers a form of dispute resolution with less potential than US-style litigation to destroy the business relationship between the parties. Due to the petroleum industry’s capital-intensive nature and limited number of major players, most companies desire to develop long-term business relationships. Maintaining long-term business relationships will become even more important, especially for private oil companies, as conventional oil becomes scarcer.

US-style discovery is a powerful tool in resolving disputes and improving a party’s settlement position against its adversary in part because it serves as an escalator both financially and emotionally. Although US-style discovery has always been burdensome and expensive, the system’s escalating nature has increased rapidly over the past decade as e-mail has vastly expanded the number of discoverable documents.

It is precisely the escalating nature of US-style discovery, however, that makes it a very dangerous device if the parties are in an ongoing business relationship because a small dispute may transform itself into a potentially relationship ending one.

Often when drafting contracts, the dispute resolution provision is more of an afterthought than a carefully considered provision that will be invoked when the relationship between the parties is already severely strained.

Companies should deal judiciously with the dispute resolution provision to ensure its appropriateness to the relationship envisioned and to avoid unnecessary escalation. Because international arbitration provides party autonomy to limit the scope and methods of discovery, the parties can craft an agreement that allows for resolution of differences while preserving the ongoing business relationship.

Although international arbitration has long been a means of resolving international oil and gas disputes, the practice has not been universal, and the specific advantages that forum provides for managing the unique problems associated with oil and gas controversies has not been fully appreciated.

During the past few years, producing countries have become more interested in placing these disputes before national courts. The contentiousness of oil and gas controversies is only likely to increase in the coming years as easily recoverable conventional oil reserves decline and become increasingly concentrated in the hands of NOCs.

Due to the unique discovery management problems associated with oil and gas controversies, both national and private oil companies should adopt international arbitration as the standard method of resolving disputes before this more contentious period arrives.

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