Fund Structuring and Investment Treaty Protections

November 2021

Not every dispute relating to a foreign investment is suited to court litigation. This is particularly the case when an investor has claims against a foreign government. Suing a state in its courts is unlikely to be appealing for a host of reasons, especially in high risk jurisdictions. Arbitration is often the only alternative.

Investments can be structured so as to be protected under investment treaties. These treaties offer additional substantive protections under international law and enable the resolution of disputes against states in a neutral forum.

The legal structure of private equity funds can complicate access to such investment treaties, but overcoming such complications is possible and can be worth the effort.

What is an investment treaty?

An investment treaty is an agreement made between two or more states aimed at attracting and promoting foreign investments. Investment treaties contain various incentives for investors, including substantive protections for foreign investments. Usually, they also allow the investor to enforce those protections through international arbitration against the host state, which is a valuable alternative to pursuing claims under local law or in local courts.

There are over 2,600 treaties with investment protections currently in place, with more on the horizon. The rise of investment treaty protections has been one of the most significant developments in cross-border dispute resolution over the past 30 years.

When considering an investment treaty, there are three basic variables to consider: who qualifies for protection, what sort of investments qualify, and what the protections entail.  

Who qualifies for protection?

Generally, investment treaties offer protection to investments made by an investor of one contracting state to the treaty (the home state) in the territory of another contracting state (the host state).

Whilst treaties differ, the definition of an investor is normally quite broad. Typically, an investor includes:

a. individuals who are nationals of a home state; and

b. companies with the nationality of the home state.

Many treaties also protect both direct and indirect investors (including minority shareholders), and investors who control, but do not own, the relevant investment.

For a company, treaties may provide that its nationality is determined by its:

a. place of incorporation;

b. principal place of business activities;

c. place of corporate seat; or

d. place of control.

However, some treaties also allow host states to deny the benefits of the treaty to an entity that meets these formal nationality criteria, but is itself owned or controlled by non-qualifying nationals and has insufficient business activities in the state of its putative nationality.

What qualifies for protection?

A qualifying investor also needs to have a qualifying investment to be entitled to protection under an investment treaty.

Again, treaties differ, but most treaties define investments in broad terms as including any kind of asset that an investor owns or controls, directly or indirectly. Some treaties also give examples of covered assets, typically including:

a. shares, stock, and other interests in a company;

b. debt, bonds, and claims to money or performance under a contract;

c. business concessions conferred by law or under contract; and

d. property rights in movable and immovable property.

How are investors and investments protected?

Investment treaties typically include various protections for qualifying investors and investments, such as undertakings by the contracting state:

a. to treat investments fairly and equitably, such as by not frustrating the investors’ reasonable and legitimate expectations; by ensuring due process and protecting against denial of justice; or not impairing the investment through arbitrary or discriminatory conduct;

b. not to expropriate the investment without compensation, or take measures tantamount to such expropriation;

c. to respect any undertakings the state has made with respect to investments; and

d. not to discriminate against foreign investors but to treat them no less favourably than other similarly-situated national and third-party investors.

The impact of fund structures: Cases in point

Where a fund structure has been used to make a particular investment, questions may arise as to which entities, and which investors, are protected by an investment treaty and in respect of what kind of interest. Is it the portfolio company, one or more intermediate holding companies, the general partner, the limited partners, the fund itself, or all of them, that has access to investment treaty protections?

Because treaty protection typically depends on the nationality of the investor, the nature of its investment in the host State, and the manner in which it owns or controls that investment, the specific fund structure can be dispositive. The structure may determine whether the treaty tribunal has jurisdiction over the claims and therefore whether the investor has access to a neutral forum for dispute resolution.

For example, Cayman exempted limited partnerships do not have separate legal personality, which means that the general partner holds the assets of the fund on trust for the limited partners. In contrast, Delaware funds have legal personality, and therefore can also hold assets directly. Other jurisdictions, such as those in the Channel Islands, allow limited partnerships to elect whether or not to have separate legal personality. A key issue for Cayman funds is whether partners could constitute investors under the terms of the treaty on the basis of their beneficial ownership of investments made by the fund. Which entities control an investment for purposes of treaty jurisdiction can also be a highly fact-specific analysis.

Several pending cases illustrate the kinds of issues that can arise when funds and investment vehicles bring claims under investment treaties.

For example, in the twin cases of Mason Capital L.P. and Mason Management LLC v. Republic of Korea, PCA Case No. 2018-55 and Elliott Associates L.P. v. Republic of Korea, PCA Case No. 2018-51, the claimants are pursuing claims under the South Korea-U.S. free trade agreement. The claims relate to the South Korean government’s purported intervention in a 2015 merger between Cheil Industries and Samsung C&T Corporation, in which the claimants were shareholders. Claimants allege that the controlling family of Samsung bribed former Korean President Park Geun-Hye to intervene in the merger via the state-run National Pension Service, causing losses for the Samsung shareholders.

In Mason, South Korea objected to the tribunal’s jurisdiction under the South Korea-US free trade agreement on grounds relating to the ownership structure of the investment. The claimants in Mason are a Cayman exempted limited partnership (“Mason Fund”) and its general partner, a Delaware limited liability company (“Mason GP”).

First, South Korea alleged that Mason GP, the Delaware entity, did not either “make” or “own or control” the investment. In dismissing this objection, the tribunal observed that although the investments were registered in Mason Fund’s name, as a Cayman exempted limited partnership, Mason Fund lacked legal personality and could not hold property. Instead, the tribunal determined that Mason GP held legal ownership to the investment on trust for Mason Fund.

Second, South Korea argued that Mason GP did not beneficially own the investment. The tribunal also dismissed this objection, and determined that Mason GP’s entitlement to carried interest in the investments constituted a beneficial interest in Mason Fund’s assets that was protected under the treaty.

In Elliott, where the sole claimant is a Delaware limited partnership, South Korea objected that the LP did not itself “make” the investment, because another Elliott entity provided the capital for more than half of the shares.

In The Carlyle Group L.P. and others v Kingdom of Morocco, ICSID Case No. ARB/18/29, Carlyle Group L.P. and six of its affiliates (all of which are US entities, including two other Delaware limited partnerships) are pursuing claims against Morocco under the US-Morocco FTA in relation to investments made in a Moroccan oil company, which has since gone into liquidation. Morocco has challenged the jurisdiction of the tribunal on various grounds, including that the claimants lack standing because their investments were made through Cayman special purpose vehicles.

Similarly, in Gramercy Funds Management LLC and Gramercy Peru Holdings LLC v. Republic of Peru, ICSID Case No. UNCT/18/2, Debevoise represents two Delaware entities who invested in Peruvian agrarian bonds. Peru has objected to the jurisdiction of the tribunal under the US-Peru FTA on various grounds, including relating to the claimants’ ownership and control of the investment.

Decisions on jurisdiction are still pending in Carlyle, Elliott and Gramercy, and will be of special interest to the funds industry.

Structuring for protection from the start

Investments can be structured at the outset to maximize treaty protections, especially in high-risk jurisdictions or politically sensitive sectors. In certain situations, it may also be possible to restructure the investment to create such coverage on a prospective basis. For example, it may be possible to insert a holding company into the chain of ownership below the fund level that would be protected under an investment treaty with the host state of the ultimate portfolio investment.

Any restructuring may, however, affect the availability of treaty protections. For example, in Elliott, South Korea has argued that the claims should be dismissed as an abuse of process because the investor allegedly restructured its investment to gain treaty protections at a time when the dispute was foreseeable. In November 2021, it was also reported that the tribunal in CSP Equity Investment Sàrl v. Spain (SCC Case No. 094/2013) declined jurisdiction over claims brought by a Luxembourg company on the basis that the dispute was foreseeable at the time of a corporate restructuring.

In light of these risks, any restructuring should be carefully considered with counsel at the earliest opportunity.