Damages in the Middle East and Africa: Trends from recent cases and some challenges

In summary

The Middle East and Africa (MEA) region is particularly active in international arbitration. Among recent cases, three main characteristics stand out. First, the majority of cases in the region are linked to large infrastructure-related disputes. Second, among recent cases, investor-state disputes appear to be more frequent in the region than commercial disputes. Third, the most frequent allegations for arbitration are expropriation and breach of contract, including breach of shareholders’ agreements. Despite some similarities in the issues and the sectors affected by the cases mentioned above, from a quantum perspective, each displays features that need to be assessed in the specific context in which they arise. In this context, a correct understanding of the role of country risk, foreign exchange (FX) rates and fiscal regimes is key to the proper calculation and discounting of cash flows.

Discussion points

• Recent cases in the MEA
• Country risk and its impact on valuation
• Treatment of FX rates regimes and capital controls
• Fiscal regimes, transfer pricing and shareholder disputes

Recent cases in the region

The MEA region is particularly active in international arbitration. Out of the 2,507 parties involved in cases filed with the ICC in 2020, 19 per cent were from the Middle East and Africa.^[2] Countries such as the United Arab Emirates, Saudi Arabia and Qatar are among the most frequent nationalities among parties, representing respectively 3.59 per cent, 2.55 per cent, and 1.87 per cent of the total number of parties in 2020 filings (the United States being the number one country with 9.25 per cent share).^[3] Among these cases, three main characteristics stand out. First, according to data collected from GAR covering the past four years, the majority of cases in the region are linked to large infrastructure-related disputes, in particular in the energy and mining sectors, with an average award value that exceeds US$800 million.^[4] Table 1 on page 5 illustrates some of the recent cases involving the MEA region.

Second, among recent cases, investor-state disputes appear to be more frequent in the region than commercial disputes (around 70 per cent of investor-state cases versus 30 per cent commercial cases). Investor-state disputes in the MENA (Middle East and North Africa) region have, in fact, increased from 5 per cent to 9 per cent of ICSID’s new caseload in the past years (while sub-Saharan new caseload decreased from 21 per cent to 14 per cent).^[5] Also, within the set of ICSID cases, most are related to energy and infrastructure.^[6]

Third, the most frequent allegations for arbitration are expropriation and breach of contract, including breach of shareholders’ agreement. In investor-state disputes, expropriation is generally related to project cancellations. The Mohamed Abdel Raouf Bahgat v Egypt dispute related to a businessman’s loss of his iron and steel business and his imprisonment.^[7] The Nile Douma Holding Co. WLL v Arab Republic of Egypt dispute concerned difficulties encountered by Nile Douma at a riverside development known as the Shaza Nile Douma Hotel in the Rod El Farag area in central Cairo. The subsidiary held the rights to use a plot of land that was approved by the Egyptian authorities for the project, but the state allegedly refused to register the land for the project in its name.^[8] The Güneş Tekstil Konfeksiyon Sanayi ve Ticaret Limited Şirketi and others v Republic of Uzbekistan dispute involves the expropriation of Turkish investors in one of Tashkent’s largest shopping centres.^[9]

Breach of contract is also a recurring theme in the region. In GPGC Limited v The Government of the Republic of Ghana, the tribunal held Ghana liable for cancelling an emergency power purchase agreement with GPGC amid an electricity supply crisis. Under this agreement, GPGC would relocate two gas turbine power plants from Italy to Ghana, which would supply electricity to the state for four years.^[10] In Prombati SPA v Bilyap Insaat Enerji Ve Turizm Sanayi Ticaret AS, Kayi Insaat Sanayi Ve Ticaret AS and Kayi Uluslararası İnşaat Sanayi ve Ticaret AS, the dispute related to disruptions and delays in the construction of a Marriott hotel, mall and related facilities in the eastern Algerian city of Sétif.^[11] In Lebanese Broadcasting Corporation International (LBCI) v Lebanese Media Holdings (LMH) and Rotana Holding, the dispute involved several breaches of obligations under a cooperation and service agreement with a local broadcasting company, and an arbitrary and unlawful termination.^[12] In CSE v Guinea, the dispute arose after four years of requests for payment sent by the engineering and infrastructure company CSE to the Minister of Public Works and the Minister of Finance. The Dakar-based company had been awarded two procurement contracts by Guinea to upgrade roads to Gbessia international airport on the country’s Atlantic coast.^[13] In Strabag SE v Libya, the tribunal found Libya liable over infrastructure projects managed by the Austrian infrastructure and energy company Strabag, that were disrupted by the country’s civil war.^[14] In Global Voice Group v Guinea and the Guinean Postal and Telecommunications Regulatory Authority, the Seychelles-based telecoms group won an ICC claim against Guinea over a contract to provide technical resources for the taxing of international phone calls, after the state failed to substantiate allegations of corruption.^[15]

Shareholder disputes are also observed in the region. In Société Nationale d’Opérations Pétrolières de la Côte d’Ivoire (Petroci) v MRS Holdings Ltd, the dispute related to an agreement between the parties under which they would jointly acquire and operate Chevron’s downstream distribution assets in East and West Africa through a joint venture.^[16] The contractual breaches included alleged misappropriation of Chevron’s subsidiary’s assets and blocking access to the joint venture. In SCF Holdings II v Manhattan Coffee Investment Holding, the dispute, which involved a fraud claim, is part of a long-running dispute over Tatu City, a 5,000-acre residential and industrial development being built on former coffee estates in the northeast of the Kenyan capital. At issue in the arbitration was Manhattan’s failure to pay a deposit to the Belgian sellers of the land on which Tatu City is being built.^[17]

Challenges for the common valuation approaches

Despite some similarities in the issues and the sectors affected by the cases mentioned above, from a quantum perspective, each displays features that need to be assessed in the specific context in which they arise. The quantification of the damage usually requires the valuation of the companies or projects affected by the liable actions. The three main approaches commonly relied upon to value a business or an asset (the market approach^[18], the income approach^[19] and the asset approach^[20]) are often difficult to apply (see Table 2):

• The market approach is often impractical in countries with underdeveloped or illiquid financial markets. Data might simply not be available, and whenever available, might not be reliable.
• The asset approach could be deemed subjective whenever based on historical costs that depend on management decisions taken at a certain time, and that might not be optimal from the perspective of a rational investor at the time the damage was suffered. In addition, often historical costs are not helpful in estimating the replacement value of an asset or a business.
• The income approach, also known as the discounted cash flow (DCF) method, remains the most widely relied upon method, but it also faces challenges. It requires calculation of the cash flows associated with the project both in the actual scenario, namely after the liable action, and in the counter-factual scenario (ie, but for the liable action). Besides data availability and reliability of prior forecasts, the calculation of cash flows in both scenarios requires appropriate consideration of:
  • the country’s uncertain business environment that may make it difficult to estimate future performance and expected cash flows; the associated risks are generally referred to as country risk and the results of most valuation exercises are sensitive to how it is treated;
  • the fact that cash flows are obtained in a currency different than the one in which the valuation is performed and this requires converting future cash flows into the currency of the valuation, often in countries with multiple FX rates and capital controls; and
  • the applicable fiscal regime, either because it is specific to the country or project in question, or due to the international tax implications on the value of intercompany transactions.

A correct understanding of the role of country risk, FX rates and fiscal regimes is key to the proper calculation and discounting of cash flows. The rest of this article is devoted to explaining some of the issues that must be taken into account when dealing with these factors in quantum exercises.

Country risk

In the DCF approach, the discount rate represents the opportunity cost of the capital employed to finance a business or a project. Calculating an appropriate discount rate for use in DCF calculations requires a logical support for the specific risks affecting the project. Different risk factors stemming from the specific jurisdiction where the project takes place generally imply different risk profiles and activities deployed in jurisdictions with risk factors that can enlarge the variability of potential outcomes for the project (such as changing its future costs or delaying its development) command inherently higher discount rates, reducing – all other things being equal – the present value of such projects.

Two key issues to the consideration of country risk relate to: how to consider it in DCF methods; and how to derive a numerical value to quantify the risk.

In relation to the approach to include country risk in the DCF method, many analysts generally add a country risk premium to the discount rate. In addition, analysts often also structure the cash-flow projections by modelling scenarios that reflect materialisations of the country uncertainties. It may then appear that country risk is accounted for twice: in the discount rate and in the (undiscounted) cash flows.

The discount rate reflects the time value of money, namely the correction to the current value that investors would attach to a monetary value in the future. The larger the uncertainties that can make such future value vary, the less will be the current value for risk-averse investors, given the same expected future value. As a result, if the conditions in a country A make the expected future value of a project more variable than in country B, even if on average the expected value of the projects is the same, then investors will rationally view the project in country A as less valuable today.

The same country risk premium should, however, not apply to all types of projects in a particular country. Some countries have a more developed and stable regulation and legal environment in some sectors than in others. Often, activities in sectors of strategic importance for the country (such as agriculture and extraction of natural resources) may be subject to more frequent interference by public authorities and more subject to political risk.

For this reason, an accepted principle in DCF analysis is that cash-flow projections should reflect the characteristics of the project at hand. They will therefore reflect features of the sector where the project operates, the contracting arrangements it has signed to sell its production, the labour contracts in place for its workforce; many of these features may be sector-specific or project-specific, particularly when the project is one of a kind. The cash flows the project delivers may then be more or less subject to change as compared to those in the average sector in the country. As long as the cash-flow projections reflect the project characteristics, they must consider all the likely scenarios for the project in the future, which reflect all the uncertainties related to the project, including those related to the country where it operates. Such scenarios would reflect the practical consequences on the specific project of the interaction between all risk factors, project-specific and country-specific. The scenarios are then weighted according to their probability of occurrence and the resulting average values reflect the expected stream of cash flows going forward.

While cash-flow projections reflect all risks affecting the project, the inclusion of country risk in the discount rate must consider only the systematic (or non-diversifiable) part of country risk. Standard asset valuation models such as the capital asset pricing model (CAPM) attach a premium related only to the part of the risk that investors cannot avoid with diversification. The degree of diversification of the relevant investors must be analysed case by case as often global investors are well diversified and local investors are not, particularly in relation to investments in real assets and if restrictions to access capital markets exist. Moreover, beta estimates may not be reliable, as local industry stocks are often not very liquid or have a short history of public trading. These conditions are common in many emerging markets.

Often country risk premiums are derived by comparing US dollar-denominated bond yields in the local country with those in reference countries (such as the United States or Germany) for the same maturities.^[21] Adding such a premium to the risk-free rate implicitly assumes that: all country risk is systematic, and the risks related to the local government defaulting on its bonds is a relevant risk for the project under valuation. These assumptions do not hold in many cases and not correcting for these factors may lead to using country risk premiums that are unrealistically high for the project in question.

When country risk premiums are derived from bond rates, the question arises as to whether further adjustments are necessary to account for the greater risk inherent in equities than in debt. Often such equity risk differentials are reflected in the determination of equity discount rates, for instance, by using market risk premiums that are then multiplied by the relative volatilities (the betas) of specific samples of companies with similar risk profiles relative to the overall market.^[22] Attempts to use data from companies with comparable risk (such as multinational companies with a similar percentage of activity in countries with similar risk assessments) with equity-to bond country risk adjustments may lead to double counting country risk.

In sum, the assessment of country risk must be tailored to each particular environment. Cash flow projections need to include realistic assumption about all risks on a project if such risks exists at the time of valuation.^[23] This includes political risk, such as expropriation risk.^[24] However, it should avoid the temptation to excessively weigh bad outcomes to ‘illustrate’ how certain elements of country risk would impact the project if they were to materialise. Once expected cash flows reflect the market expec-tations at the valuation date, they need to be discounted with a rate that includes the systematic component of country risk and considers the effects of potentially illiquid local equity markets on the volatilities of companies used as benchmarks for risk pur- poses. This is because, in emerging markets, country risk is project-specific and not fully systematic, and it may not correlate well with the spread of government bonds of the country concerned.

Foreign exchange rates

In many cases project cash flows are earned in a currency that is different from the currency of the valuation. The question then arises as to whether it is preferable to:

• discount the cash flows using foreign discount rates and convert the resulting discounted value using the spot exchange rate; or
• convert the future cash flows into domestic currency values using expected future exchange rates and then discount using a domestic discount rate.

The two methods may seem equivalent and, in fact, they generally provide the same answer as this equivalence is the well-known interest rate parity result. The results might not, however, be exactly the same and there are many reasons why this may be, ranging from slight imperfections in market prices to theoretical issues.^[25]

However, the valuation issues we address below go beyond questions related to the accuracy of interest rate parity. Rather, we consider how the non-existence of foreign exchange markets or the existence of currency controls affects the valuation of cash flows. These are significant concerns and apply to valuation in many countries around the world, including in the MEA region. In the MEA region, there are a variety of FX regimes, with pegged currencies, floating currencies and a variety of arrangements that seek to approximate a fixed exchange rate (see Table 3).

Moreover, capital controls (ie, restrictions on the ability to access FX) can lead to ‘black market’ exchange transactions, whereby participants exchange currency at rates other than the official rates. Capital controls can coexist with managed and stabilised currency regimes. For example, Iran has a black-market FX rate, an official FX rate, and another FX rate called the NIMA rate, which is the rate at which exporters are required to transact (when converting foreign currency into domestic currency). This is a complicated structure that has features of a floating exchange rate regime along with a controlled currency regime where conversion is restricted. Valuation of an asset in a home country such as Iran would require considering not only these FX rules at present but how they are expected to evolve as well.

Differences in the FX regimes and in the rules specific to any asset may affect the best way to approach the valuation. To illustrate the challenges that arise, we refer to a numerical example below. An asset generates foreign currency (FC) cash flows and the aim is to derive its value in terms of the domestic currency (DC). Specifically, an asset generates a FC cash flow of FC 20 one year in the future. The FC risk-free rate is 2 per cent and the DC risk-free rate is 10 per cent (including country risk of the domestic country), and the spot FC/DC exchange rate is five (ie, one unit of FC is valued at five units of DC). For simplicity the cash flows are assumed to be risk-free.

Data on expected future FX rates are often not available and, even when they are, the reliability of such data may be questionable. While it depends on the specifics of why future FX rates are not available, a straightforward approach that can be appropriate would be to discount the FC cash flows of the asset using FC risk-free rates and then convert the result to DC units using the spot exchange rate. In the example, that results in FC 19.6, which is the result of dividing FC 20 by (1 + 2 per cent). When converted using the spot exchange rate, this is equal to DC 98.0. The domestic risk-free rate of 10 per cent does not enter this computation. This is because the cash flows are earned in the future in FC.

When valuing an asset in a country with currency controls like Iran, the rules that apply to the cash flows of the asset must be considered. As a stylised example, again consider the valuation of an asset with FC flows of FC 20. The black-market FX rate remains 5 DC = 1 FC. If the expectation is to be allowed to convert FC into DC at the black-market rate, then the valuation remains the same as in the example above, that is, the value of the asset is DC 98. However, if the FC cash flows must be converted at a less favourable rate, the valuation in DC would be lower.

Each valuation must assess the rules that are expected to apply to the asset in question. In addition, what is important are the rules that are expected to apply when the cash flows are realised. While current rules can serve as guidance, what is relevant is the rules that are expected to apply in the future for conversion of FC into DC. If in a year all FC cash flows are expected to be converted at a less advantageous rate, then such a fact should be incorporated into the valuation.

In the example, if FC earned by the asset in one year is forced to convert at the official rate and by then the official rate is such that each unit of FC gets 20 per cent less DC than the black-market rate, then an expectation of a discount to the value of the asset should be built into the valuation. This is because 20 per cent of the value is diverted due to the use of the official exchange rate. If covered interest parity holds for black market rates, the value of the asset is worth exactly 20 per cent less than the value without the forced use of the official exchange rate.^[27] In this case, the forced use of the official exchange rate had a meaningful impact on the valuation.

Naturally there may not be easy answers for every situation. Market data on domestic assets that are expected to generate FC cash flows may provide some guidance. Analyst and market commentary may also help to understand what expectations are about conversion of FC into DC.

Under other FX regimes the valuation may require other approaches. Some countries operate with an exchange rate that is allowed to adjust only slowly. Other countries have a currency that is pegged to either the euro or the US dollar. What is important for valuation of future cash flows is the expectations for these regimes in the future, whether the peg will remain in place, or what FX regime will be adopted if the peg collapses. These are not necessarily easy questions to answer, but a proper valuation should consider them.

As an extreme example, since 2019 Lebanon has placed unofficial^[28] restrictions on the withdrawal of currency from the country.^[29] This makes it challenging to value an asset that generates cash flows in Lebanese pounds for a US investor. One approach could be to shift cash flows into future periods when the restrictions on transfers are expected to cease. Such an estimate is, however, difficult to make and might be highly subjective. In addition, several different currency exchange rates emerged in the country:^[30] the Lebanese pound remains officially pegged at 1,517 to US$1, banks allow cash withdrawal at a rate closer to 3,900, the black-market rate at the time of writing stands more than 20,000, and is subject to fluctuation, and businesses randomly apply their own exchange rate, which depends on the payment means (cash, foreign or local credit cards, etc). In such circumstances, a careful examination of the factors that are relevant to the project cash flows and to the valuation is necessary to decide on the most appropriate approach.

Fiscal regimes and transfer pricing

The applicable tax regime is a third potential driver of project or business value in both the actual and ‘but for’ scenarios.

In many cases involving joint ventures between local (often state-owned) entities and international companies, damage claims refer to the difference between the actual project value, which was reduced by the liable actions, and the continuation value of the project for the claimant. In these cases, the ability to restructure the project by the local entity or by the state after expropriation or after the cancellation of the concession contracts with the international investor may lead to substantial value being diverted to the state in the form of fiscal revenues. If the possibility of these alternative arrangements is not considered, the continuation value of the project may appear low, when in fact the distribution of profits between the local entity and the state implicit in the original project structuring does not need to apply after cancellation of the concession. Post-cancellation values would be affected by changes in the fiscal treatment of the project and treatment does not necessarily remain the same after cancellation of the contract with the original investor or partner.

Many projects in the energy and infrastructure sectors span several segments of the value chain. Because different activities in different segments may face different effective tax rates, different project structures may imply differences in value. When, for example, upstream production is sold to a downstream affiliate at a transfer price, the distribution of profits along the value chain is affected. Often such transfer pricing rules are designed to: abide with international tax regulation; guarantee sound resource allocation decisions within the company, which maximise profits; and provide objective divisional performance measures for management purposes. By increasing the transfer price, the upstream affiliate would increase its post-tax profits and its net present value (NPV). Of course, if upstream activities face lower taxes, the profits and NPV of the downstream business would be reduced but by less than the increase in the upstream value because of differences in tax rates. The calculation of future cash flows must therefore assume the expected fiscal regime and consider any expected change that could affect the optimal structuring of an integrated project.

A second set of disputes in relation to transfer pricing relates to shareholder disputes about internal transactions among entities within the same multinational company. These include post-M&A disputes, breach of shareholder agreements, financial instruments valuation, compensation differences and dividend-related disputes.

In commercial arbitration, transfer pricing issues may arise in the context of shareholder disputes, whereby shareholders disagree on the level of profit made by the entities they own, as a result of intercompany transactions. This can, for example, be the case when an entity controlled by one shareholder sells products or charges service fees or intangible related fees to an affiliate it co-owns with other shareholders.

In investor-state arbitration, transfer pricing issues may be linked to the current wave of regulations aiming at countering tax avoidance and tax optimisation schemes following the Base Erosion and Profit Shifting initiative led by OECD. While measures taken by tax authorities are legitimate, parties can call upon investment treaties to challenge fiscal measures.

A common topic of recent disputes in commercial arbitration relates to minority shareholders viewing the level of management fees paid by the entity they own to the majority shareholder as abusive.^[31] Subsidiaries pay management fees to their parent company in return for centrally performed activities. The latter can be administrative and of low value, as well as strategic or operational and of high value. Moreover, such activities can lead to the development of intangibles, which need to be taken into consideration in assessing the right remuneration of the parent company at arm’s length.^[32] The diversity of headquarter activities and organisation structure translates into a diversity of transaction structure. Management fees can thus be charged on a cost-plus basis, on a revenue basis (royalty), on a lump-sum basis or following other mechanisms.

Minority shareholders are not indifferent to the level of management fees paid by the entity they own shares in, since those fees have an influence on the profit level of the entity, and in turn on dividends paid.

To assess the correct level of management fees, the OECD guidelines on transfer pricing clearly refer to the arm’s-length principle and suggest the remuneration must be in line with what independent third parties would have agreed upon in similar circumstances. In this context, the assessment of the level of management fees that should be paid at arm’s length – and that should satisfy both the minority and majority shareholders’ interests – would likely account for the following factors:

• the roles and responsibilities of the parent company in performing centralised activities and of the subsidiary, in line with the functions they perform, the risks they assume and the assets they own, within the overall framework of the group’s value creation;
• the actual benefits obtained by the subsidiary from the centralised activities, relative to its next best alternative;
• the contractual arrangements governing the overall relationship between the parent company and the subsidiary (this is not necessarily limited to the management services agreement between the parent company and the subsidiary, but could include other agreements that could have an impact on pricing); and
• a comparison with similar market practices, and a specific pricing analysis, notably in cases where comparability is limited.

The last factor is often the case in the MEA region, where data availability can be an issue. In this case, whenever transactions among unrelated parties are not available to serve as a point of reference, it might possible, under certain conditions, to rely on similar transactions with other parties with different ownership interests. Such analysis requires, however, a careful review of the facts and circumstances surrounding each transaction.

Notes