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Business Law Today

Doing Business with Foreign Sovereign Entities
Who Are They and What Are the Risks?
By Michael L. Morkin, Ethan A. Berghoff, and Richard S. Pike
Doing business internationally is almost a necessity for U.S. companies today. The farther that commerce reaches across borders and oceans, the less our trading partners resemble the domestic companies with whom we have historically done business. When doing business abroad, U.S. companies cannot take for granted that they are transacting business with private corporations who are free to negotiate any contracts or terms that they deem appropriate. Outside the United States, it is commonplace for many industries or organizations to be run by the government or to be government owned, even though it may not be apparent on its face.

Deals involving foreign governments and state-owned entities present unique and often significant consequences and risks that need to be addressed before closing. Otherwise, if foreign sovereignty issues do not surface until a dispute arises, it is often too late to address them and a lack of understanding or foresight may prove to be costly. This article, which results from the experience of several dispute lawyers, identifies many of the issues that dealmakers need to understand and look for at the outset and suggests ways to minimize the related risks so as to avoid learning about them after it is too late.

Are You Dealing with a Sovereign?

A large, sophisticated defense contractor manufacturing aircraft for a foreign military knows very well that it is transacting business with a foreign government. However, U.S. companies with little experience internationally may not be aware that the foreign airline, central bank, shipping line, steel company, insurance company, oil company, hotel, or other commercial entity with whom it is dealing is really owned, directly or indirectly, by the local government. Although often obvious, sovereigns are not always identifiable from their name. Conversely, with the wave of privatizations going on around the world, some formerly state-owned entities have complete independence, although their name or history may still suggest otherwise. To minimize this risk, U.S. companies need a better understanding of how sovereign status is determined and what factors should raise red flags when evaluating a transaction.

There is no universal definition of a sovereign, although the United Nations is attempting to change that. As such, local law, which differs significantly from one country to the next, defines a sovereign's status. The United States defines "sovereign" more broadly than most developed nations. In particular, it is important to note that the definition is not limited to what is commonly recognized as governmental bodies.

In the United States, a "foreign state" for the purposes of the Foreign Sovereign Immunities Act (FSIA) includes all "political subdivisions" as well as "agencies and instrumentalities of the state." The term "political subdivisions" includes all governmental units beneath the central government, including local governments. "Agencies and instrumentalities" of a foreign state, on the other hand, include corporations, associations, or other entities, a majority of whose shares or other ownership interests are owned by the state, even when organized for profit. Even indirect ownership may be relevant when concluding a deal because the sovereignty test is applied at the time when proceedings are commenced. While indirect ownership by a government is likely insufficient to garner treatment as a sovereign, indirect ownership could easily become direct ownership later.

Examples of the broad range of commercial entities that qualify for foreign sovereign status in the United States include a number of national airlines (Aer Lingus, Emirates Airlines, Malaysia Airlines, South African Airlines), insurance companies (Peoples Insurance Company of China), steel companies (Baosteel), oil and energy companies (PEMEX, Pedevesa, Petronas, Sonatrach), shipbuilding (Navantia), hotel chains (Parador Hotels, Pousada Group, and Pan Pacific Sonargaon Hotels), and a passenger rail company (SNCF).

If inquiries reveal any significant state ownership interest or involvement in company decision making, then advice should be sought on the law of any country where legal proceedings may be brought. At a minimum, this should normally include the jurisdictions in which each party is resident. If the deal concerns a project or assets in other jurisdictions, then the law of these jurisdictions often will also be relevant. Finally, it may be advisable to ascertain the position in any jurisdictions where it may be necessary (or possible) to enforce against assets.

Sovereign Immunity

Until the twentieth century, sovereign immunity from the jurisdiction of foreign courts seemed to have no exceptions. However, as governments increasingly engaged in state-trading and various commercial activities, it was urged that the immunity of states engaged in such activities was undesirable and served as a deterrent to global commerce. Immunity deprived private parties that dealt with a state of their judicial remedies and gave states an unfair advantage in competition with private commercial enterprise. As a result, countries began carving out exceptions to sovereign immunity, particularly in the area of commercial activity.

In the United States, if an entity meets the definition of a "foreign state," it cannot be sued in U.S. federal or state courts unless the plaintiff establishes the existence of one of the exceptions listed in the FSIA, section 1605. This places a heavy burden on the plaintiff, as immunity for the sovereign is presumed. Importantly, immunity under the FSIA can be explicitly or implicitly waived under a contract. Implicit waivers are narrowly construed by the U.S. courts and will only be found "when (1) a foreign state has agreed to arbitrate in another country; (2) a foreign state has agreed that the law of a particular country shall govern; or (3) a foreign state has filed a responsive pleading but has failed to raise the defense of sovereign immunity." U.S. companies will be relieved to hear that if no waiver was agreed to, then a suit can still be brought if it relates to commercial activities of the "foreign state" that took place in the United States or had a direct effect here. Proceedings to enforce arbitral awards or to compel arbitration under an agreement are also expressly permitted by the FSIA.

Entities that only qualify as "foreign states" under the "instrumentality or agency" limb of the test receive less generous treatment under the FSIA than "core" sovereign entities such as government departments. For example, service of process can be accomplished more easily and punitive damages can be awarded against entities that only qualify as an instrumentality or agency though they are not available against foreign states generally.

Even if the FSIA allows suit to be brought, substantive immunity may still be available to a foreign state by virtue of the "act of state" doctrine. This relatively narrow doctrine prohibits any U.S. court from considering the validity of public acts conducted by a sovereign within its own borders. Since it is restricted to public acts and not commercial acts of the type that could be undertaken by any business, it is unlikely to be a factor in most commercial disputes. However, on the rare occasion that it is a factor, such as in expropriations through armed force or a program of nationalization, it could have disastrous consequences. For example, a U.S. plaintiff that established a factory in Taiwan had no remedy when the Taiwanese government radically changed the importation duties that had allegedly been promised to it, causing the factory to fail. Importantly, entitlement to protection of the "act of state" immunity can be waived by a foreign state. It also should be noted that nationalization and similar acts may give rise to remedies under bilateral investment treaties (BITs), but such actions are outside the scope of this article.

A similar approach to jurisdictional and "act of state" immunity is followed in the United Kingdom and many other European, Commonwealth, and former Commonwealth jurisdictions. In these common law legal systems, separate commercial entities are not entitled to any form of sovereign immunity, unless and to the extent they exercise governmental powers unavailable to private entities. A comparable approach is adopted in the recently drafted United Nations Convention. Historically, though, even common law legal systems granted much broader immunity and this approach is still followed in some jurisdictions such as the former Soviet states. In these states, the fact that the dispute is commercial may not prevent immunity being successfully claimed.

In other states, particularly developing nations, there is simply no established law on sovereign immunity. If it is necessary to sue in such a jurisdiction, then the results will be, at best, unpredictable. Ultimately, the United Nations Convention may remedy this problem, but until that time, business opportunities with state-owned entities in developing nations should be met with great caution.

Immunity from Enforcement

As with other aspects of state immunity, the extent of any state immunity from the enforcement of judgments or arbitration awards depends on the local law and varies significantly among jurisdictions. However, in most countries, the scope of immunity against enforcement is more expansive than the immunity from being sued. This continuing broad protection against enforcement has been described as the last bastion of old-style sovereign immunity. Many jurisdictions view enforcement against a state entity differently depending on what is being enforced: a court judgment or an arbitration award. Moreover, if the sovereign has state-owned assets outside of its own jurisdiction, the scope of sovereign immunity available in those jurisdictions becomes part of the analysis for U.S. companies when negotiating the dispute clause. For example, the broad protection against enforcement afforded by the sovereign's local law becomes less relevant if the sovereign owns assets in other jurisdictions that afford less protection against enforcement.

Enforcement of an arbitral award, as opposed to a court judgment, should be relatively straightforward in any of the more than 140 states that are party to the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards of June 10, 1958 ( the New York Convention). However, the New York Convention permits states to decline enforcement on public policy grounds or if the dispute is not considered arbitrable under the law of the state where enforcement is sought. While U.S. courts have taken a broad approach to arbitrability, many nations have taken a much more restrictive view.

For example, the Thai courts rejected the attempted enforcement of a foreign arbitration award against a Thai state entity because the dispute was of a type deemed not arbitrable. Similarly, Brazil, Finland, France, India, Ireland, Israel, Italy, Japan, South Africa, South Korea, and Spain all have national laws that generally disfavor or limit the arbitration of intellectual property disputes. National self-interest alone can make it difficult to enforce arbitral awards in the courts of the state against which judgment has been obtained. In Argentina, for example, the government has recently sought to avoid enforcement of awards on public policy grounds claiming that payment would force the state into bankruptcy.

The position will often be worse still if the award to be enforced is a judgment issued by a foreign court. There is no United Nations Convention on the enforcement of foreign judgments. Judgments rendered by European courts are readily enforced throughout Europe pursuant to the Brussels Regulation (in all EU States except Denmark), the Brussels Convention (in Denmark), and the Lugano Convention (in Switzerland and Iceland). Outside of Europe, however, the approach to enforcement of foreign court judgments varies significantly as there are relatively few treaties regarding enforcement. Russian courts, for example, tend to have little or no regard for foreign judgments. Kuwaiti courts only enforce foreign judgments if it is shown that there would be reciprocal enforcement of a Kuwaiti judgment in the same circumstances. English and U.S. courts generally enforce each other's money judgments, although English courts are prohibited from enforcing multiple damages awards.

Even if a sovereign is subject to an enforcement action, the assets available to satisfy that judgment or arbitral award may be limited under local sovereign immunity law. In the United States, "core" sovereign entities sued under the commercial activity exception can only be the subject of an enforcement action in the United States to the extent that there are available assets that were used for the commercial activity on which the claim was based. However, the property of any entity that only qualifies as a "foreign state" through the "instrumentality or agency" limb of the FSIA (i.e., a state-owned business) is generally available for execution of a judgment. Notwithstanding the above, certain types of property such as any owned by a central bank have complete immunity, unless waived.

The United Kingdom applies very much the same approach in its State Immunity Act. A commercial enterprise is not entitled to any immunity from enforcement, even if state-owned, unless the litigation concerned the exercise of governmental powers. As in the United States, the UK-based property of a central bank is given complete immunity from execution. Other sovereign entities have complete immunity from execution, unless waived, except in respect of property used or intended for use commercially (a notably broader exception than that in the United States). The commercial or noncommercial status of any state-owned property located in the United Kingdom is typically determined by a certificate from the foreign state's ambassador or equivalent. Additionally, specific performance and injunctions cannot be obtained against a foreign state in the United Kingdom.

Limits on the Ability to Contract

Most governments place restrictions on the agreements that their public bodies can conclude with commercial entities. Such restrictions are not always readily apparent nor are such restrictions necessarily disclosed by the sovereign during negotiations. Thus, once a potential trading partner has been identified as a sovereign and the scope of immunity is understood, additional research or legal assistance is advisable regarding local restrictions.

In Saudi Arabia, for example, public bodies are not allowed to agree to foreign arbitrations and all arbitrators must be of the Islamic faith. Similarly, the Thai government will not agree to foreign arbitrations and, while arbitrators can be foreigners, lawyers appearing in the arbitration must be locally qualified. Violations of such provisions have been punished with fines and imprisonment.

There also may be other restrictions that are not readily apparent without specialist advice. In England, for example, many modern public bodies are established by statutes that limit their powers and functions. Contracts that are ultra vires will be void. A few years ago, a number of English local authorities were able to successfully avoid loss-making speculative interest rate swap investment contracts with domestic and international banks, and to recover their initial investments, by pleading their own incapacity.

Becoming educated about local restrictions on sovereigns is not just a defensive measure. A well-informed U.S. company will be better positioned in a negotiation with a foreign sovereign to call its bluff when the sovereign raises a purported limitation. For example, it is not uncommon for a state-owned entity to insist that all disputes be resolved in local courts and in accordance with local law, asserting that it is required by the law governing state entities. While many countries do mandate such restrictions, some claim such a restriction or policy simply to extract advantageous terms. A U.S. company aware of the scope of or limits to any local restrictions will be better positioned to push back when the sovereign asserts a position claimed to be nonnegotiable because of the local law governing state-owned entities.

When negotiating with foreign entities, U.S. companies also should inform themselves of other major restrictions under local law and procedures, and whether such restrictions are limited to sovereigns or not. For example, many civil law countries including France, Germany, and Switzerland impose strict limitations on the ability to take discovery within their territory in support of local or foreign proceedings. In Switzerland, for example, trying to serve process or obtain information other than through the proper channels can amount to a criminal offense because such tasks are understood as reserved to the government. While uninformed violations of such restrictions often may go unnoticed or unreported, when dealing with sovereigns, such violations would certainly be understood and, likely, pursued by the sovereign entity.

Issues on Forum

Due to the complications discussed above, U.S. companies must evaluate at the outset where and how any future disputes will be resolved, always taking into account any limitations set by the local law of the sovereign. While this is true in any international transaction, it is even more critical when dealing with foreign sovereigns. The separation of powers at the heart of our government is often taken for granted. However, many countries lack a meaningful line between the judicial and executive branches. This lack of independence from other governmental branches raises significant concerns when suing a sovereign entity.

Insistence by the counterparty on using the local courts may not be a problem in jurisdictions with an independent and well-respected court system. Indeed, it may be a good option if that is the locale where most company assets are located. However, it is important to do your research. Local bias and corruption are real problems in many countries. Organizations such as Transparency International do regular surveys, but there is no substitute for local knowledge.

Whether viewed as a positive or not, most jurisdictions outside the United States provide no juries in civil trials. Absence of a jury may avoid some prejudices, in part because a judge will generally have to provide reasons for his or her decision. However, because most judges are appointed by government officials, judicial bias or government influence presents serious concerns.

As discussed above, a foreign state entity may not be permitted or willing to litigate in the United States. Multimillion-dollar punitive damages awards in the United States make headlines all over the world and represent a major disincentive to litigate here, even if the reality is that they are unlikely to be awarded in most commercial disputes. The scale of U.S. discovery and the seemingly high costs of conducting litigation in the United States (fees often being recoverable by successful parties in foreign proceedings) also discourage potential foreign litigants.

While local biases and other concerns can be avoided through the selection of a neutral forum (i.e., the courts of a third country), the resulting judgments may often not be sufficiently portable to be of value. As noted above, outside of Europe there is no international convention on the recognition and enforcement of foreign court judgments. Further, some foreign courts may not accept jurisdiction if all parties and significant events are foreign, even if there is an express contractual submission to the jurisdiction of the relevant courts (though New York and English courts are notable examples of ones that commonly will). Some Swiss, Swedish, and Danish courts have refused jurisdiction on this basis. Equally, in some Australian states, a choice of forum clause is insufficient in itself to permit service of proceedings outside the jurisdiction.

In light of these considerations, arbitration offers an excellent compromise for dispute resolution in international contracts. However, before opting for it, verify that an award will be enforceable in the places where enforcement might be sought. Subject to the comments above on public policy issues, enforcement should be straightforward in nearly every country in the world under the New York Convention. Where arbitration is permissible and desirable, selection of the arbitral institution often raises additional issues. The most common and widely accepted international arbitration rules include those of the International Chamber of Commerce in Paris (ICC), the London Court of International Arbitration (LCIA), the international arm of the American Arbitration Association, the International Centre for Dispute Resolution (ICDR), the Singapore International Arbitration Centre (SIAC), and those of the United Nations Commission on International Trade Law (UNCITRAL). While these rules differ in some respects, the more relevant differences tend to be the level of administration and cost, as well as perceived national orientation. Perceived national orientation may cause a sovereign entity to lean toward or away from one or more of these entities. However, given the United Nations' promulgation of the UNCITRAL rules, governments that are out of favor with the United Nations often forbid their state-owned entities from arbitrating under the UNCITRAL rules.

Some Practice Pointers

Sometimes, sovereign status may have little impact on a transaction. Other times, it should cause a party to question the viability or structure of the entire transaction. Most often, however, the potential added risk of dealing with sovereigns, while not taken lightly, need not prevent commercial parties from doing business with them. Several steps can be taken to reduce some of the risks described above.

Just as with any counterparty, there is no substitute for research. A company search will usually reveal enough information to determine if the entity is state-owned or controlled, but a news or Internet search is also advisable. If there is nothing to suggest state ownership or control, then the entity probably is not a sovereign entitled to any special immunities.

If the body is a sovereign entity, then early inquiries should be made about any restrictions on its powers to enter into the proposed transaction or relationship. Efforts should be made to obtain a copy of any establishing statute or constitution, as well as standing orders currently in force. If the body's powers appear limited in any significant respect, then specialist advice may be required and possibly some kind of third-party guarantee for the body's obligations. For example, central government departments may be willing to take on guarantor responsibilities for subsidiary agencies. Alternatively, though generally offering limited comfort, the body may be prepared to provide an independent legal opinion on its capacity.

Where the body is likely to have the benefit of sovereign immunities, the best course is to seek contractual waivers, though confirmation should be obtained that these will be effective in any relevant jurisdictions. Letters of credit or other security arrangements, when available, also will short-circuit the inevitable immunity questions.

In drafting the dispute resolution clause, the guiding principle should be to seek the fairest mutually acceptable process that will result in an award enforceable in a location (or locations) where there will be sufficient assets available, both physically available and not immune from execution. Similarly, difficulties with service of process may be avoided by appointing agents for that purpose under the contract (often an official of the sovereign that is resident in the United States).

As in all business transactions, compromises will likely be necessary and a business decision will ultimately have to be made as to whether the benefits outweigh the risks. The key is to ensure that before deciding to enter the contract or relationship with a sovereign, you have full knowledge of the risks and everything possible has been done to eliminate or minimize those risks.
Morkin is a principal and Berghoff is a partner in the Litigation Department of the Chicago office of Baker & McKenzie LLP. Pike is an associate in the Litigation Department of the firm's London office. Their e-mails are michael.l.morkin@bakernet.com, ethan.a.berghoff@bakernet.com, and atprichard.pike@bakernet.com.

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