Full Compensation, Full Reparation and the But-For Premise

Introduction

The notions of ‘full compensation’ and ‘full reparation for damages’ have been used synonymously throughout history. Nowadays, the notion of full compensation is expressly recognised in many important jurisdictions. The full reparation principle applies in international law and may lead to higher compensation through the Chorzów principle, which uses the principle of fair market value (FMV), as is explained later in this chapter (see section titled ‘Full reparation, Chorzów and fair market value’). The application of the but-for premise under different rules of law, including international law, will give different results owing to the different levels of interest, which means that the amount of damages would change under different applicable laws.

Origins of full compensation principle

The full compensation principle is recognised in most of the important jurisdictions for international arbitration. In 1848, the leading English case, Robinson v. Harman, established that the aim of damages is to give the injured party the necessary amount of money to put it ‘so far as money can do it, in the same position as he would have been in had the contract been performed’.^[2] The US Second Restatement of Contracts establishes that ‘[t]he initial assumption is that the injured party is entitled to full compensation for his actual loss’.^[3] To achieve this purpose, US courts award the expectation interest, which aims to put the injured party in the economic position he or she would be in but for the breach.^[4]

French law recognises the principle of full compensation or reparation intégrale. Full compensation is the objective and has to be in accordance with the loss suffered. The essence of the full compensation principle is to return the victim as closely ‘as monetarily possible to the position in which he would have been had the wrong not been done’.^[5] German damages law is based on the principle of full reparation leading to the situation that would have existed if the damaging event had not occurred.^[6] Article 7.4.2 (Full compensation) of the UNIDROIT (International Institute for the Unification of Private Law) Principles of International Commercial Contracts reads:

The aggrieved party is entitled to full compensation for harm sustained as the result of the non-performance. Such harm includes both any loss which it suffered and any gain of which it was deprived taking into account any gain to the aggrieved party resulting from its avoidance of cost or harm.

Finally, Article 74 of the United Nations Convention on Contracts for the International Sale of Goods reads: ‘Damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach.’

According to these rules of law, the payment of an amount of money should place the injured party in the economic position it would have been in had the damaging act not occurred, which refers to the full compensation principle. Nowadays, the principle of full compensation is a general principle of law.^[7]

With respect to international law, under the famous Factory at Chorzów principle, ‘reparation must, as far as possible wipe out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed’.^[8] According to Professor Irmgard Marboe: ‘The principle of full reparation has been recognized in international judicial practice not only in the context of international investment but also in cases of other violations of international law.’^[9]

Role of differential hypothesis or but-for premise

But-for premise as means to achieve full compensation

The but-for premise considers the question of what would have happened in the absence of the breach and was developed by Friedrich Mommsen in 1855 in his Doctrine of Interest.^[10] To find an answer, the but-for premise compares the hypothetical situation without the breach and the actual situation with the breach. However, limitations under the applicable law – such as causality, culpability, foreseeability, the duty of mitigation and contributory negligence – have to be considered.^[11] Once the liability has been proven and the differential hypothesis together with the limitations have been applied, the result is the actual loss or expectation interest, which has to be compensated to achieve full compensation.

The application of the but-for premise may lead to different results depending on the interest protected under the applicable law. It makes a difference if the applicable law protects the performance principle, that is the equivalent to specific performance, or the economic benefit leading to a difference in value. For example, in Ruxley Electronics & Construction v. Forsyth,^[12] a case in which a swimming pool had been constructed with less depth than specified in the contract, the House of Lords of the UK Parliament held that the cost of cure has to be in proportion to the benefit that would accrue to the claimant. The respondent argued that he was liable only for the difference in value between the pool as promised and as delivered, which was zero, as the pool could be used for the purposes intended. Under French law, the performance principle is protected and granted even if the cost of cure would be unreasonable. Therefore, the claimant could demand the rebuilding of the swimming pool in accordance with specifications. This example shows how the damages resulting from the application of the but-for premise depend on the interest protected under the applicable law.

But-for premise as means to prove causality and loss

Under the but-for premise, the question to be asked is what would have happened in the absence of the breach. If the claimant would be in the same economic situation had the breach not happened, there would be no causation. If the claimant would be in a better economic situation had the breach not occurred, there would be causation. Whether this situation refers to a monetary difference or the injured party’s exact, concrete position, which is the cost of cure measure of damages, depends on the measure of damages applicable or available under the relevant rules of law. The loss must be properly attributable to the breach. Liability is determined to the extent that losses would have been avoided in the absence of the breach. If the damage would have occurred even in the absence of the breach, then there is no loss caused by the breach.^[13]

Causation is not only a requirement for the recovery of damages but also has implications on the amount or extent of damages to be recovered. If through the application of the but-for premise only partial causation is proved, this may lead to a substantial reduction of the damages. This situation is intimately related to contributory negligence of the injured party, where the respondent has to pose hypothetical situations to reduce the scope of causation. For example, in the case of the violation of a non-competition obligation, the defendant may argue that the joint venture company would not have won the project even in the absence of the breach or that the company was badly managed by the managing partner that caused the loss.^[14]

Once the hypothetical situation has been posited and compared with the actual situation, if there is an economic difference, there is a loss. That is why the but-for premise serves as a means to determine whether there is actually loss.

But-for premise and quantification

The objective of the but-for method is to build a situation taking into account the world as it is except for the economic and financial implications that could arise from a hypothetical circumstance in which the breach had not occurred. However, the application may not be that simple, in particular because of a lack of information and the inability to disentangle the effects of specific actions from other forces affecting the business.^[15] Time is also an essential part of long-term contracts and investments.

There are different valuation methods that can be applied in the context of the but-for premise and can be grouped as follows:

• income approach: discounted cash flow method, adjusted present value and capitalised cash flow;
• market approach: publicly traded multiples, transaction multiples and stock prices; and
• the asset or cost approach: liquidated value, book value and adjusted book value.

The choice of the approach depends on the nature of the asset being valued and the microeconomic and macroeconomic circumstances surrounding the valuation.^[16] What is calculated is, in essence, the effect of the breach or violation on the income stream or the difference in value of the business or investment caused by the breach or violation.

In the income approach, the negative effect on the income stream caused by the breach or violation equals a loss of value of the contract, business or investment. In the case of lost income stream, one may either reconstruct the income stream that the company or investment would have had in the absence of the breach or violation, or refer to the income stream of similar companies, and then compare it with the actual situation, which leads to the expectation interest. In jurisdictions where lost profits may be difficult to claim, the loss of value of the contract, business or investment may be the preferable approach. This means that damages may be claimed in different forms and the applicable law and the available evidence determine how a damages claim has to be framed.

Full reparation, Chorzów and fair market value

The full reparation principle as we know it today has its origins in the Permanent Court of International Justice case, Factory at Chorzów. As Professor Hersch Lauterpacht observed:

states were originally reluctant to provide full compensation; however, at the beginning of the twentieth century, both the award of lost profits and the full compensation principle were already duly recognized, as shown by the well-known Factory at Chorzów case, which reflected contemporary state practice in 1928.^[17]

However, full reparation according to Chorzów has additional elements, such as the right of the claimant to ask for the FMV at the date of the violation or the date of the award, whichever results in the higher amount, plus the lost profits between the date of the violation and the date of the award, in the case of the latter. Nowadays, Article 31. Reparation, Commentary (1) and Article 36. Compensation, Commentary (5) of the United Nations draft articles on Responsibility of States for Internationally Wrongful Acts expressly refer to the obligation of the responsible state to provide full reparation of the wrongful act and both refer to the Factory at Chorzów case. This refers to compensation for the violation of international investment law standards, which are in essence international tort law standards.^[18]

The key legal principle for damages compensation in the Factory at Chorzów case is that compensation ‘should wipe out all the consequences of the illegal act and re-establish the situation which would, in all probability, have existed if that act had not been committed’.^[19] To achieve this purpose, the Chorzów formulation uses the higher FMV at the date of either the violation or illegal expropriation or the date of the award. In the case of the latter, lost profits between the date of the illegal act and the date of the award have to be added, as shown by the questions posed by the arbitral tribunal to the experts that reflect the measure of damages determined by the arbitral tribunal.^[20]

The reference to the ‘value of the undertaking’ in Factory at Chorzów ^[21] has been considered to refer to the notion of FMV,^[22] although the case does not expressly refer to this term. The court referred to the value at the date of the award and stated that this supposes:

that the factory had remained essentially in the state in which it was on the date of the expropriation, and secondly, the factory is to be considered in the state in which it would (hypothetically but probably) have been in the hands of Oberschlesische and Bayerische if instead of being taken in 1922 by Poland, it had been able to continue its supposedly normal development from that time onwards.^[23]

This corresponds to the notion of the ‘hypothetical normal course of events’ originally developed under German private law, whereby extraordinary circumstances or economic crises are being discarded. Therefore, it may be seen clearly that the FMV measure of damages appears in the Chorzów principle.

The German notion of the hypothetical normal course of events is reflected in the FMV rule developed in the United States, when referring to situations without duress or threat. The US Supreme Court has provided a classic definition of FMV: ‘The Fair Market Value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.’^[24] This formulation is also referred to in the World Bank ‘Guidelines on the Treatment of Foreign Direct Investment’ 1992. Commentary (22) of Article 36 of the United Nations draft articles on Responsibility of States for Internationally Wrongful Acts states: ‘Compensation reflecting the capital value of property taken or destroyed . . . is generally assessed on the basis of the “fair market value” of the property lost.’ A fair market valuation must assume that neither party to the transaction is under any compulsion to buy or sell, therefore it is standard to exclude distress when assessing fair market value.^[25]

The FMV and the hypothetical normal course of events ignore duress or threat or special economic circumstances, thereby removing potential issues of alternative causation. Applying the FMV may increase compensation as compared with market value, where the actual economic circumstances are being taken into consideration even if they represent duress or threat. However, in investment arbitration practice, economic crises are considered temporary and reflected in cash flows but not normally in the discount rate.^[26]

With respect to the date of the valuation of damages, the rationale behind using the higher of the FMV at the date of the illegal act and the date of the award is that the state should not obtain windfall profits from the illegal expropriation. As stated by Professor Pablo Spiller and Santiago Dellepiane:

The Chorzów standard, however, has a powerful economic logic. It is equivalent to transferring to the expropriating state the ex-post risks (up to the time of the award) associated with the expropriated asset. In other words, if the asset has increased in value in the absence of the measures, the state ought not to benefit from its expropriating actions, and thus, the windfall ought to belong to the investor.^[27]

Factory at Chorzów showed that wiping out all effects of the measures through monetary compensation can be achieved by two alternative means: granting the FMV as at the date of the expropriation brought forward to the date of the award and expressed in current currency; or granting the sum of the FMV as at the date of the award plus the profits that the investor would have probably obtained in the period between the date of expropriation and the date of the award.^[28]

If there is total destruction or deprivation of the investment because of an illegal act, the calculation of the FMV of the whole investment suffices. However, if the investment is not totally destroyed, the but-for premise is the tool to calculate the effect of the illegal act on the income stream or the value of the investment in order to achieve full reparation.

Is Chorzów and FMV measure of damages always applied?

The application of the FMV through the Chorzów principle leads to full reparation in investment arbitration, which may be higher than the market value corresponding to full compensation in commercial arbitration, as under the hypothetical normal course of events formula used under the FMV measure of damages, extraordinary events such as economic crises that would have contributed to the damages are being ignored. For example, during the 2008 financial crisis, an apartment in Manhattan might have a market value of US$2 million because of the effect of the crisis, whereas its FMV was still at US$8 million, as the FMV formula ignores the ‘distress’ and effects of the economic crisis.

However, in many investment arbitration awards, the only reference to Chorzów is to the ‘wipe-out’ rule, but in fact what is used is the market value.^[29] Furthermore, in certain cases, arbitral tribunals have questioned the usefulness of calculating the FMV through an income approach using the scenario of a hypothetical willing buyer and a hypothetical willing seller. Determining the causal effect of the illegal act on the income stream of an investment through the but-for premise is likely to provide a more direct and realistic result.

In the landmark case Burlington v. Ecuador,^[30] Ecuador illegally expropriated certain oil exploration and development blocks, which was preceded by tax increases on profits from the proceeds of the sale of oil to 50 per cent and to 99 per cent. The arbitral tribunal found that the standard of compensation was full reparation as set out in Article 31 of the International Law Commission Articles, which it applied by analogy. This led to the application of the Chorzów formula.^[31]

According to the arbitral tribunal, ‘the value of Burlington’s investment should be quantified by reference to the profit-making capacity of the PSCs [product sharing contracts]’.^[32]

According to the arbitral tribunal, ‘[i]n the majority’s view, the full reparation standard requires that the damages resulting from the unlawful act be valued on the date of the award, using information available at that point in time’, which ‘derives from the Chorzów case’, according to which ‘wip[ing] out all the consequences of the illegal act . . . involves the obligation to restore the undertaking and, if this be not possible, to be its value at the time of the indemnification, which value is designed to take the place of restitution which has become impossible’.^[33] The majority of the arbitral tribunal stated that its task is to place Burlington in the situation it would have been in had Ecuador not expropriated the PSCs. For this, the tribunal assessed what the PSCs’ value would have been on the date of the award.

With respect to quantification, the arbitral tribunal found that:

its task is to place Burlington in the position in which it would have been but for the expropriation. The question here is whether, when assessing the value of PSCs’ revenue stream, the Tribunal should assume that extraordinary revenues are taxed at 99 per cent (as mandated by Law 42) or that Ecuador absorbs the impact of this tax.^[34]

When building the counterfactual situation in which the expropriation has not occurred, the majority assumed that Burlington holds the rights that made up the expropriated assets and that those rights are respected.^[35]

The arbitral tribunal found: ‘When quantifying the value of a going concern, the Tribunal must disregard the effects of value-depressing measures taken by the State related to the investment.’^[36] Under the standard of full reparation, ‘the Tribunal must value what Burlington lost as a result of the expropriation’. When determining the FMV, ‘the Tribunal is not bound by the “willing buyer-willing seller” analogy’. What Burlington lost was a contract with a full set of rights, each of which must be given its value. Burlington did not lose an opportunity to sell its contract rights, ‘it lost an opportunity to exercise them. The relevant question is thus not whether a hypothetical buyer would have paid full value for the PSCs, it is what value Burlington would have derived from exercising the rights under the PSCs, but for their expropriation’.^[37]

The rationale behind the Chorzów principle is to avoid opportunistic behaviour by the state. However, there are cases such as Burlington v. Ecuador in which the FMV element of the Chorzów principle referring to a willing buyer and a willing seller was not considered adequate. The arbitral tribunal in Burlington v. Ecuador considered the contract as an income-generating investment. It calculated the effect of the illegal expropriation on the income stream using the but-for premise and arrived at the market value, applying the date of the award under the Chorzów principle to arrive at full reparation.

Conclusions

The differential hypothesis, or but-for premise, is the tool to determine loss and causality when framing and analysing damages claims. Its application leads to full compensation in the form of the expectation interest in commercial arbitration, which varies according to the applicable rules of law. To achieve full reparation in investment arbitration, this tool is to be used under the Chorzów principle in combination with the hypothetical course of events that is used to assess the FMV.

The difference between FMV and market value may be significant. Market value is the result of the application of the but-for premise considering the prevailing economic circumstances affecting the business in both the actual and but-for situations, including situations of distress and economic crises, while the FMV is the result of applying the but-for premise without considering distress, threat or economic crises for their duration. Therefore, the FMV is likely to be higher than the market value, which is justified by the rationale behind the full reparation principle under the Chorzów principle, which is to avoid opportunistic behaviour by the state. When opportunistic behaviour of the state is not involved, market value may be considered fair and adequate compensation.

Notes