Occidental: The Most Expensive Contract Termination in History

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The U.S. Company Occidental Petroleum Corporation was expelled from Ecuador in 2006 after the Ecuadorian Minister of Energy and Mines issued a Caducidad [termination]Decree, ending their participation contract to explore and exploit hydrocarbons in Block 15 of the Ecuadorian Amazon. It was, perhaps, this scenario which was the main banner under which Rafael Correa Delgado secured his star position in the electoral model. Correa, who was up until then an economic analysist and had a brief stint as Minister of Finance in Alfredo Palacio’s interim government, became the presidential candidate for Alianza País [Country Alliance], a collection of socialist organizations, civil-society groups and leftist personalities. In a time of social unrest, the collapse of the government and nationalist manifestos, the termination of the contract with Occidental was a victory for a country doomed to relive a century of oil celebrations and to drown its sorrows in contaminated rivers.

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Focus Ecuador

Six years after Occidental brought an application for arbitration to protect their interests, the World Bank’s International Centre for the Settlement of Investment Disputes (ICSID) issued the first arbitration award, ordering Ecuador to pay compensation to the company. Ecuador appealed the ruling and the tribunal is now preparing to make its final decision, which will be heard at the end of October.

The arbitration award ordered Ecuador to pay Occidental the sum of USD 2.535 billion (USD 1.769 billion in damages before interest), which according to several national jurists, violates the country’s legal and economic sovereignty, and evidences once more the World Bank Tribunal’s subservience to the interests of multinational corporations. However, at the same time, it exposes an inconsistent and contradictory defense on the part of Alfredo Palacio and Rafael Correa’s governments.

The Caducidad Decree was used as blackmail
Although the process of Caducidad ended during Alfredo Palacio’s government (May 2006), in reality it was initiated during the presidency of Lucio Gutiérrez (August 2004), after Occidental signed a farm-out agreement transferring 40% of its stake in Ecuador’s Block 15 oil field to EnCana (who have since sold this share to Andes Petroleum Corporation, a joint venture of Chinese petroleum companies). According to Ecuador, Occidental sold this share without ministerial authorization, which violated the Contract of Participation between Occidental and Ecuador. They further claimed that Occidental had violated Ecuador’s Hydrocarbon Law. After the fall of Colonel Gutiérrez, Alfredo Palacio’s interim government took over the battle and on 15 May of 2006 the Ecuadorian Minister of Energy and Mines issued the Caducidad Decree. Ecuador seized Occidental’s oil fields in Block 15 and two days later Occidental filed a claim against Ecuador before the ICSID.

Ecuador recognized the authority of ICSID from the beginning
Ecuador began to prepare its defense as soon as notification of the claim was received. The Ecuadorian Attorney General’s Office hired the renowned lawyer Alberto Wray Espinosa, who sat on the ICSID arbitration panel in the claim that Repsol had brought against Petroecuador. In this case, in 2004 the tribunal, with a unanimous vote, ordered that Ecuador pay Repsol a sum of USD 13.6 million, plus interest.

Despite the fact that Wray, in an official letter to the ICSID, dated 17 August 2006, recognized the obligation to obtain Ecuador’s written consent in order to proceed with the arbitration, on 21 September of 2006, he stated that “the Ecuadorian State gave its consent so that disputes arising from foreign investment could be resolved in a binding arbitration”. In other words, according to Ecuador’s lawyer, Ecuador’s written consent was not lacking, it was implicit in the agreement.

By means of an extensive letter, dated 13 December 2006, the elected President Correa cornered the Attorney General, José María Borja, and ordered him to repudiate the ICSID arbitration and to refuse to appoint an arbitrator on Ecuador’s part, stating: “It is my opinion that the State’s defense has been to join arguments alleging lack of jurisdiction and competence, but the legal and logical response is to allege the inadmissibility of the arbitration process because Ecuador’s consent to same is lacking. A serious issue is that, despite the fact that the State has not expressly consented to the arbitration, the State Attorney General’s Office, and the lawyers they have instructed, have been insisting on the need to appoint an arbitrator on behalf of Ecuador, which supports the legitimacy of an arbitrary and illegal act”.

Borja Gallegos responded a few days later, saying: “I will abstain from appointing an arbitrator. The Attorney General is the State’s lawyer, but it is the President of the Republic who is responsible and who defines the political guidelines for the actions of the State in the international arena”.

Obviously, in drafting this response, Borja should have cited the legal advice that was addressed to Alfredo Palacio, only one month earlier, which attempted to persuade him that: “The only way in which Ecuador can present its arguments and put forward its defense, including the arguments relating to jurisdiction, competence and the applicable law, is before the Arbitration Tribunal, which it should therefore acquiesce to. To refuse to attend said Tribunal is tantamount to leaving the country in a position where it is unable to defend itself…”.

From May of 2006 up to the date of the award (October of 2012), it is not known if the Attorney General’s Office presented an objection to the arbitration process based on the lack of written consent on the part of the Ecuadorian State, as President Rafael Correa had demanded. On the contrary, Ecuador’s defense continued to argue the points called into question by the president relating to the jurisdiction and competence of the ICSID, alleging that the Tribunal lacked competence to adjudicate on the Caducidad Decree, which was governed by the participation contract, which directed that disputes of this nature be settled before the Administrative Courts in Ecuador.

When the arbitration hearing opened, Occidental brought a motion before the ICSID to dismiss Petroecuador as a defendant, naming the Ecuadorian State as sole defendant, in this way hoping to evade the issue of the Caducidad Decree and instead to focus the dispute on the alleged violation of the Bilateral Investment Treaty (BIT) between Ecuador and the U.S., signed in 1997 and which was valid for ten years, terminating on 11 May of 2007, with one year prior notice.

In other words, the Ecuadorian government should have denounced the BIT at the same time as it issued the Caducidad Decree to Occidental, but neither Alfredo Palacio’s government, let alone that of Rafael Correa, sanctioned its termination. On 8 May of 2007, the then Minister of Foreign Affairs María Fernanda Espinosa announced that Ecuador would not be renewing the BIT but said that, “Ecuador and this government in particular are committed to comply fully with the law, and so will respect the BIT while it remains in force”.

The government changes its stance
Once in office, Correa’s government began to take another stance on the Occidental case. On 21 June of 2007, the Minister of Foreign Affairs María Fernanda Espinosa, with no shame, assured that her government would abide by the decision of the ICSID, “whatever it be”. She stated, “It is a legal process and Ecuador will accept the arbitration process”. On the other hand, the new State Attorney General, Diego García, in a public announcement on 8 December of 2008, declared that Ecuador was willing to pay Occidental “compensation” if the ICSID were to find against the Ecuadorian State. In the “possible case” that the Tribunal finds in favor of Ecuador, “this would be the end of the proceedings” but, “if the Tribunal finds Ecuador responsible in any way, a second phase will begin, in which the sum of any possible compensation awarded to the company will be disputed”, he advised.

After these statements, and having expelled the World Bank representative from Ecuador, the government made preparations to denounce the Bilateral Investment Treaty. In November of 2010, the Constitutional Court delivered a favorable opinion: “We are denouncing and will keep denouncing these Bilateral Investment Treaties, which have been extremely prejudicial to our country”.

In the Tribunal hearing, in June of 2011, Ecuador’s defense claimed that if the Tribunal held the country responsible, the amount of indemnification should be reduced to 60% of the experts’ valuation of Block 15, which was USD 2.359 billion plus interest, so as not to include the 40% transferred to EnCana. It was also claimed that the corresponding amount under Law 042, relating to windfall revenues from the increase in the price of oil, should be debited from the compensation.

In July of 2011, in response to an inquiry carried out by assembly member Cléver Jiménez of the Pachakutik party, the Attorney General García admitted: “The ICSID agreement and their arbitration rules provide that in the event that one of the parties does not appear before the Tribunal, the party will be deemed to have defaulted, the practical effect being that the arguments on the part of the absent party will not be heard, and a binding award will be issued which must be fulfilled”.

If there was no way out of the arbitration, why cause an antiimperialist commotion, creating false expectations? Why did they refuse to name one of the three arbitrators? Why did they not demand that the arbitration be held in Ecuador? And, why did they not prepare an organized and effective legal defense?

The cost of the defeat
Despite ruling that Occidental violated the Hydrocarbon Law and the Contract of Participation when it transferred 40% of its interest to EnCana, the Tribunal considered that the sanction of terminating the participation contract was disproportionate. However, the Hydrocarbon Law, which recognizes the ICSID, did not provide for any other sanction apart from termination, it was termination or nothing, and Article 75 of the same Law provides that if a Caducidad Decree is issued, there will be no indemnification.

In the text of the award a central concern arose on a technical and economic level: the comprehensive assessment of the economic value of Block 15 incorporated the percentage of reserves in the Edén Yuturi and Limoncocha fields, of which 67% and 80% respectively were the property of Petroecuador, pursuant to a joint field operation contract, separate from the participation contract. In other words, Petroecuador’s reserves were used to calculate the economic value of Block 15 in order to indemnify Occidental with a much higher figure. It is, therefore, worrying that the Attorney General’s Office did not inform the expert who was hired to assess the economic value of the Block of this fact and did not request that he present a report questioning the method of calculation carried out by Occidental’s expert.

In this case, the defense facilitated the provision of an unrealistic and prejudicial valuation on behalf of the country. Also, according to the terms of the participation contract, it was not recognized that the oil reserves were the inalienable property of the State and that they only pertained to Occidental once extracted. In the worst case scenario, if the award was in favor of Occidental, the indemnification should be reduced to only cover the investments not recovered, but in no way should the indemnification be calculated based on an economic model which uses the residual reserves of the Ecuadorian State’s property.

Applying the participation percentages of the block as set out in the contract (80/20), and the distribution of reserves in the shared fields, the actual volume of proven reserves which corresponded to Occidental’s participation were almost 106.6 million barrels, and not 227 million as established in the report.

A defense aimed at reducing the amount of the compensation award
Once the claims that the ICSID lacked jurisdiction and competence were rejected, Ecuador’s defense concentrated on reducing the amount of indemnification, claiming that the award should only pertain to the 60% that corresponds to Occidental, in that they transferred a 40% stake to EnCana in the void farm-out agreement in 2000. This argument was rejected by the Tribunal.

On 13 September of 2005, while the Caducidad process against Occidental was ongoing, its partner, the Canadian company EnCana, transferred its contractual interests in Ecuador, formalizing this fact in a statement to the Toronto Stock Exchange, and by signing an agreement transferring its rights and selling its shares for USD 1.42 billion to the Chinese company Andes Petroleum.

The sum of USD 1.42 billion included the Blocks Tarapoa, 14 and 17; the fields Fanny 18-B and Marian 4A; along with the 40% of Block 15, Occidental’s joint fields Edén Yuturi y Limoncocha; together with their shares in the Heavy Crude Oil Duct (OCP). The agreement was reached and concluded as the previous agreement was, without receiving the prior authorization of the State, committing the same offence for which Occidental was subjected to a contractual termination process. In other words, the Canadian EnCana used the Chinese Andes Petroleum as a shield in order to evade contractual obligations.

Discriminatory treatment which benefited EnCana
An important aspect highlighted by the Tribunal was Ecuador’s discriminatory treatment of Occidental, as it previously acted in a different manner, condoning the actions and not terminating contracts with Petrobras and other foreign companies who had found themselves in similar situations. The Tribunal held that Ecuador should have sought to negotiate a solution with Occidental in order to improve the financial participation for the country, and should not have acted in the way it did.

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