03 June 2022 - Events
This article is co-authored by Hussein Haeri, the co-head of international arbitration at Withersworldwide, Philip Marcovici and Iraj Ispahani, the CEO of Ispahani Advisory. It was published in two parts by Wealth Briefing on 3 and 13 July 2018.
Political risk, in its many manifestations, is one of the most salient concerns of international investors today, including family offices. Such risks are far from being confined to nationalisations or direct expropriations of international investments. More frequently, family offices investing in foreign countries can over time face materially different regulations and legal frameworks to those which informed – and perhaps even partially motivated – their investments in the first place.
Changes in governments routinely throw up particular challenges for international investors. Such challenges can arise from host government political considerations that seem to bear little relation to the prospects or progress of the underlying investment projects. Issues of favouritism and discrimination frequently pose obstacles for family offices.
The economic prospects of international investments may furthermore be damaged or even destroyed by an array of state actors ranging from ministries and legislatures, to regulators and tax authorities.
Local courts may be unresponsive to legitimate legal claims, and due process issues in foreign courts in proceedings that will frequently be against the host state or other local counterparties can further complicate matters.
Political risk is also a home country reality for many wealth and business owners and this not only in the developing world. Populist governments, confusion about how best to address income and wealth inequality and many other factors have made political risk something that wealthy families internationally need to consider. Often, however, family offices fail to adequately address political risk in their development of asset ownership and succession structures. But they should and must.
Minimising political risk
In simple terms, political risk has to be considered at three levels. First, attention needs to be paid to political risk in the country of the citizenship and/or residence of the family. This may involve dealing with more than one country given that there may be multiple citizenships and places of residence involved. Second, political risk needs to be considered in the location that investment structures are maintained. The family may live onshore in the UK, for example, but there may be trusts, companies, partnerships, investment funds or other holding vehicles located somewhere else. The jurisdiction in which the structure is maintained is also highly relevant to any political risk minimisation strategy. Third, of course, is the country in which an investment is made.
Compared with commercial risks, political risks can be amorphous and hence difficult to predict and manage. Moreover, the political risks in the country of investment are likely to be different to those of the home country. Political risks can manifest in varied and challenging ways. Examples range from circumstances of revolution, civil unrest and civil war to politically charged changes in regimes or governments, or – more prosaically – marked policy and regulatory changes or discrimination. Moreover, recent and wide-ranging international changes to tax and transparency frameworks are related to political risk. As mentioned above, risks can exist in the countries of intermediate structures, such as investment vehicles, partly due to ongoing challenges to traditional offshore centres.
The means for family offices to minimise political risk has historically been limited. A possibility for an aggrieved investor is to sue the host state government, such as for expropriation of investments, in the host country domestic courts. However, the likelihood of successful host country litigation against the host state and local counterparties is often low, frequently leaving investors with inadequate or no compensation, even in cases of expropriation. Local court litigation is therefore rarely the preferred option, not least because the judiciary is part of the host state apparatus. In some circumstances, the problem may indeed have arisen from actions in the host state courts, in which case those courts are particularly unlikely to be receptive to a complaint. A reality is that under international law, it is generally accepted that a country has the sovereign ability to act within its borders, such as would be the case in relation to expropriation.
The (often only theoretical) possibility of securing diplomatic protection from a home country government can be subject to complex political considerations and may not necessarily be forthcoming or effective. It is within the home country government’s discretion as to whether or not to bring a claim on the family’s behalf and the investor is forced to rely on an unpredictable political process. The home country government may have no wish to engage in a dispute with another government for any number of geopolitical or economic reasons unrelated to the family’s claim. Moreover, a state-state legal confrontation can precipitate international tensions beyond the circumstances of a specific investor and investment.
Although political risk insurance can be a potential means of managing certain political risks, such as expropriation risks, its ambit is often narrow and the costs can be high. As experience shows, these historic limitations in managing political risk are far from academic.
Learning from history
But family offices can learn from history, and pay more attention to what has worked and has not worked in the context of political crisis. Wealthy investors can also reflect on steps others have taken in uncertain times.
In and around the Second World War, for example, a number of European companies, including the Philips Electronics group, took steps to isolate their European assets from holdings elsewhere, such as in the US. In the case of Philips, the group’s US assets were held in a trust carefully designed to separate the ownership of US assets in the event of an expropriation or other political risk event in Europe. In the 1980s and early 1990s, many businesses in Hong Kong were restructured in view of perceived political risk associated with the return of Hong Kong to China in 1997. Most common was the undertaking of corporate inversions – the removal of a holding company in the location of risk and its replacement by a holding company elsewhere, isolating the assets in the location of risk. Companies ranging from the Hong Kong and Shanghai Banking Corporation (now HSBC), Jardine Matheson and many others replaced their Hong Kong holding companies with holding companies in other jurisdictions. In the case of HSBC, the choice was the UK; in the case of Jardine Matheson, the choice was Bermuda.
For a family office, the corporate inversion is only part of the political risk minimisation strategy. If the family involved lives in country A and developed their business in that country, it would be quite common to see the progress of the business having involved the establishment of a company in country A. As the business expands cross-border, subsidiaries are established in other locations. A corporate inversion involves the group restructuring such as to establish a new holding company in a “safe” jurisdiction, and ideally one that can benefit from investment protection agreements and otherwise provide political risk minimisation. Now there is no holding company in Country A – only a subsidiary of a holding company elsewhere. While the assets in Country A remain at risk, how those assets are owned can help to ensure compensation payments in the event of expropriation, something elaborated on below. Leveraging the assets in Country A can shift political risk to lenders, depending on the terms of the loans involved.
But if the family office remains a resident of Country A in the example, having a holding company in Country B may be an incomplete approach to political risk minimisation. Country A could take steps to force a repatriation of assets held abroad by the individual involved, and parallels to this can be seen from recent events in Saudi Arabia. To further minimise political risk, a family office can separate itself from the ownership of the assets held abroad, or adopt approaches designed to automatically create such a separation in the event of a political risk event occurring. An example of the first approach could involve having assets overseas held in a single premium life insurance policy over which the family retains no power to have the assets returned to them – the assets pass to the next generation on the death of the family head, and until then are simply owned by the insurance company located, of course, in a safe jurisdiction other than Country A. An example of the second approach could involve ownership by a trust, with provisions that exclude as possible beneficiaries any individual residing in a country that is subject to a political risk event, such as repatriation orders or otherwise. Initially a member of the class of potential beneficiaries, the family members living in Country A are cut out of possible benefit if risk manifests itself in Country A.
Political risk presented by third countries
It is interesting that political risk can also be presented by third countries. The US, for example, has a number of means through which such risk can arise. Freezing or vesting orders can and are used against perceived enemies of the US. A family office in country A may find itself unable to access assets held internationally by virtue of this. Separation of ownership, through one of the approaches described above or otherwise may be designed to minimise the risk of a freezing or vesting order applying to a particular set of assets.
Changing borders and revolutions
History serves as a reminder of the disruption that occurs when revolutions happen, borders are redrawn and wars develop. Some notable examples of geopolitical disruption are the general expropriations which occurred following the Mexican Revolution, the Bolshevik Revolution, the Nazi German invasion of Europe and the Cuban Revolution.
In South West Asia in 1947, we witnessed the partition of India and Pakistan and the creation of a third country Bangladesh in 1971. The Soviet invasion of Afghanistan and the Iranian Revolution both followed in 1979 adding to regional volatility.
In every instance assets, including key industrial and commercial assets and land, were seized from private citizens by governments, in some cases by being declared abandoned property. This taking of private property for supposedly public use is something which wealth owners globally still fear. However there are more options today to diminish the impact of big geopolitical changes via thoughtful asset protection strategies. Precedents are being established though many wealth owners are not aware of the possibilities given that much of the body of law in this area has been developed in the arena of international dispute resolution between sovereign countries.
Managing the downside risk of emerging markets
Emerging and frontier markets represent growth opportunities. They attract cross-border investors looking for returns, including through private or listed equity. It is noteworthy therefore that there are according to the International Committee of the Red Cross (ICRC) 35 conflict zones in the world today, across emerging economies. In emerging markets GDP held by family business owners is often in excess of 80%. For these business owners, geographical diversification from their home country was not historically a priority since in many cases they were operating in relatively new nation states whose independence had been hard won. Today, however, it is very much the case since diversification, and growing beyond ones borders, is generally recognised as a practical business strategy. We are seeing these disruptive events with increased frequency because of the lack of political and economic stability in host sovereigns. These events include direct governmental interference from military takeovers, expropriation, or mandated national ownership of all or part of particular businesses as well as indirect actions such as currency restrictions or punitive income or estate taxes.
For international or cross-border investors, seeking additional levels of protection from geopolitical changes is pragmatic. However, wealth owning families in emerging economies tend to be part of the fabric of the countries where their offices are or were headquartered. For families like these, leaving is not a preferred option and neither is it straightforward for them to challenge their government in the local courts. Often these wealth owners have contributed to societal improvements through education and healthcare and are important local stakeholders by holding governments to account and by encouraging public private partnerships. They often represent the preferred partners international investors seek and take comfort from in these markets. These families should also seek advice on asset protection strategies more proactively.
While political risks will shape some investment decisions and flows, such risks cannot easily be bypassed by international investors. For one thing, political risk is now a fact of life across the world; it isn’t confined to a select few countries that can be avoided. Second, given greater growth prospects and investment opportunities in many emerging markets, investors will continue to make investments there.
Furthermore, many family offices are giving greater focus to direct investments(1). Family office investments are often international and increasingly include direct investments (whether by way of a controlling interest, minority shareholding, joint venture structure or otherwise) into foreign companies and foreign assets. While this capital moves across borders in search of greater rewards, it also brings risks. It is axiomatic that direct investments into other countries carry direct risks to those investments, particularly in times of increasing instability and uncertainty. Emerging or frontier economies carry risks which are often political and can be difficult to predict (such as sudden changes in attitudes to foreign investment or radical changes following government transitions).
Protectionism and political volatility are also on the rise more generally with the rise of populism and potential antecedents of trade wars. These threats can affect economic fundamentals, but they can also affect the very integrity of international investments.
Investment protection agreements
Into this challenging context comes a very significant international legal instrument which is all too often overlooked by family offices: the investment treaty. Investment treaties are international agreements between sovereign states that aim to promote and encourage investments between them. Investment treaties can be multilateral (such as the Energy Charter Treaty), but bilateral investment treaties between two states (often referred to as BITs) are the most common form. There are over 3,000 investment treaties worldwide.
Although these investment treaties are entered into by sovereign states and operate on the public international law plane (rather than being contracts governed by a designated national law, such as English law), they provide direct rights for international investors which qualify for protection under their terms.
For example, the bilateral investment treaty between the UK and Nigeria gives UK investors in Nigeria the following rights:
These substantive rights are wide-ranging and protect UK investors vis-à-vis the State of Nigeria, which includes the Nigerian government, legislature, courts and regulatory authorities. However, perhaps the most important aspect of investment treaties is one of procedure: the right for investors (in the example given, UK investors) to bring direct international arbitration claims against the host country government (in this case, the Nigerian government) for breaching the substantive investment treaty obligations set out above.
The majority (but not all) investment treaties provide for the resolution of disputes directly between foreign investors and host states through international arbitration. If an investment treaty contains arbitration rights for investor-state disputes, an investor does not need to have a contract with the state providing for arbitration to be able to refer its dispute to international arbitration. The investor needs to follow the procedures set out under the dispute resolution clause of the relevant investment treaty.
Arbitration under investment treaties is often conducted under the auspices of the International Centre for Settlement of Investment Disputes (ICSID), a branch of the World Bank. This framework and the World Bank’s involvement is generally perceived to enhance state compliance with ICSID arbitration proceedings and Arbitral Awards. ICSID has specific rules and procedures for international investment dispute settlement, including by way of investor-state arbitration and a powerful enforcement mechanism.
Given the value of investment treaties to manage political risk, they are routinely considered and utilised by the world’s largest multinationals and private equity companies in making and protecting international investments. Sophisticated international investors also increasingly structure their investments through holding companies and special purpose vehicles established in specific jurisdictions to take advantage of particular investment treaties, alongside other considerations.
To determine whether an investor has the protection of one or more investment treaties, the first stage is to identify whether there is an applicable treaty between the investor’s home state and the host state of the investment. However, the question of whether an investor can rely on a specific treaty, and the arbitration provisions contained in it, depends on the scope and application of the treaty in question. In order to benefit from the standards of protection under a treaty, both the investor and the investment need to qualify under the terms of the investment treaty (which will be defined in the treaty itself). This is where specialist investment treaty protection advice must be sought since every treaty is unique (notwithstanding certain seeming similarities).
The importance of dovetailing investment protection with other considerations in investment structures, including taxation, corporate efficacy and disclosure, can be considerable. An investment structure that takes a holistic approach to all factors that are relevant to the specific circumstances is likely to be optimal.
Diversification of ownership structures is also an important element of political risk minimization planning. In the investment world, diversification is almost always recommended to reduce investment risk. But family offices sometimes fail to consider diversification at the ownership level. Having everything held in a single trust or holding company means that a political risk event can affect the totality of the family’s assets. Safer might be to use multiple structures, and in different locations and of different kinds. Some assets could be held in trusts, and perhaps some in trusts that are designed to limit distributions that can give rise to information exchange. Other assets could be held in insurance arrangements or in other structures. And diversification can also include having different family members owning assets rather than concentrating ownership in one family member.
Location of residence of family members (and their citizenship) also comes into the picture. A family that is diversified in terms of where they live can take advantage of considerable political risk reduction and, in a world of mobility, this is more and more realistic. The UK has, among others, attracted families seeking a safer place to live, albeit that they continue to own and manage businesses in their home countries.
While this requires careful consideration and calibration of different legal specialisms, the net effect can be meaningful: the difference between losing the entire value of an investment or securing market compensation if political risks manifest that would otherwise damage or destroy the value of investments.