Caspian Business Journal

Legal Developments in the Caspian Region

AzPetrol v. Azerbaijan: When is an “Agreement in Principle” a Binding Contract?

The first rule of contracts is that not all agreements are contracts. Under common law, a contract exists only where the parties intend to legally bind themselves on all material terms [1].

That rule was painfully re-learned recently in AzPetrol International Holdings B.V. AzPetrol Group B.V. AzPetrol Oil Services Group B.V. v. the Republic of Azerbaijan (ICSID Case No. ARB/06/15) (AzPetrol) [2]. In that case, an arbitral tribunal concluded that a binding contract had been created where parties had agreed that they had reached “an in principle settlement” in the case. The AzPetrol companies (“Azpetrol”), represented by McDermott Will & Emery UK LLC, disputed that the settlement was binding. The Republic of Azerbaijan (“Azerbaijan”), represented by Allen & Overy LLP, sought confirmation of what it alleged was a binding agreement. The tribunal sided with Azerbaijan.

AzPetrol brought the case to ICSID alleging a violation of the Energy Charter Treaty, an international agreement that prohibits countries from discriminating against foreign investors and in favor of domestic investors in the energy sector. The parties agreed to settlement negotiations when Azerbaijan moved to dismiss the case on the basis of international public policy after allegations of bribery surfaced. Six months later, the parties reported that they had reached “an in principle settlement.” Azerbaijan applied for an order confirming the settlement.

It all boiled down to an exchange of e-mails: Counsel for Azerbaijan had sent an e-mail with a counteroffer, and Azpetrol accepted it. Offer and acceptance are steps one and two in contract formation. But was the agreement really a binding contract that settled the case or was it, as AzPetrol argued, merely an agreement to a “standstill,” a hold on further action before the tribunal?

Both parties did agree that English law was applicable. AzPetrol, for its part, stated that it was not bound to the settlement, arguing that there was no intent to be legally bound, no “meeting of the minds” on key material terms. In essence, AzPetrol took the position that having an agreement in principle identified a lack of agreement on material terms, and thus there could be no contract.

The tribunal found otherwise. According to the tribunal, the plain language of the e-mails, as read objectively – that is, from the perspective of a third-party observer – showed that Azpetrol clearly accepted Azerbaijan’s “offer of settlement.” Azpetrol’s e-mail accepting Azerbaijan’s offer read: “I refer to your email dated 16 December 2008 containing your without prejudice offer of settlement on both the Fondel and Azpetrol arbitrations. I can now confirm that we hereby accept the offer set out in your 16 December 2008 email.” These two sentences made all the difference.

Andrew Newcombe, writing in the Kluwer Arbitration Blog, identified three lessons to take away from the tribunal’s decision:

“Counsel need to ensure it is clear which law applies to any settlement offers. Second, the award demonstrates the ambiguity of the term agreement in principle. It is perhaps better avoided. Third, the award demonstrates the importance of clarity in any conditions [3].”

The law firms involved here – McDermott Will & Emery UK LLP and Allen & Overy LLP – are both megafirms: large, prestigious international firms staffed with lawyers highly ranked in the Martindale Hubbard indexes. That top counsel would have signed a settlement agreement without recognizing that it was legally binding for its client shows how it is possible to lose sight of the forest for the trees.

Caspian Sea Status: What kind of contract could exist for a pipeline if there was no final agreement on territory?

The Turkmenistan International Oil and Gas Conference wrapped up on November 19, but analysts are likely still chewing through some of the developments. Perhaps without realizing it, a U.S. State Department official offered up a legal puzzle when he suggested that a pipeline from Turkmenistan across the Caspian Sea to Azerbaijan would be possible regardless of whether the Caspian Sea’s status was finalized. “We actually believe that it is possible to have agreement to move gas across the Caspian without reaching a final agreement on delimitation,” said Daniel Stein, senior assistant to the U.S. special envoy for Eurasian energy.

The U.S. has made it clear that it is intensely interested in Turkmenistan’s gas and, moreover, just as interested in preventing any gas pipeline from going through Iran. The seabed between Turkmenistan and Azerbaijan is therefore the route. The history of those two countries’ Caspian Sea territorial disputes is well-known [4]. Iran, too, has stated for years that no pipeline could be built on seabed without final delimitation yet Stein’s bold statement suggests that such disagreement would not hinder construction of a pipeline. Contracts to build pipelines, however, have to overcome thorny legal problems and are necessarily comprehensive: the contractual documents for the Baku-Tbilisi-Ceyhan pipeline, for example, could fit a library shelf.

The Caspian Sea from above. Photo courtesy of NASA.

This begs the question: what kind of legal obstacles would have to be overcome for a pipeline that traversed disputed territory? One lawyer well-versed in international law and who has closely followed the proposed pipelines of the Caspian Sea region says that the legal obstacles cannot be addressed until the political ones are. Stein’s proposal is, in his opinion, impossible. “This is because it is a political question, not a legal question,” he says. If, without a final territorial agreement, pipeline construction begins and Russia and Iran are not pacified, the former will pull strings to halt the pipeline and the latter may engage in more “gunboat” diplomacy.

It seems highly unlikely that any consortium of European and U.S. companies would, therefore, start construction on such a pipeline. But Stein’s very point is that such political questions could be resolved short of a final territorial agreement. Hypothetically speaking, therefore, what would the consortium and its individual members demand before overturning the first ceremonial shovel?

The answer may lie in the “stabilization clause.” Stabilization clauses are contractual terms which freeze in time the political, economic, and regulatory conditions as they exist. Alternatively, they can limit the extent to which governments can change those conditions. They are extremely useful in countries with a high risk that such country’s laws may fluctuate rapidly or even wildly with changes in government or political mood, and especially may change to the detriment of long-term foreign investors. They are used even in countries with low political risk, however, to fix the rate of taxation or, more broadly, the economic burden (measured in a variety of ways) applied to an investor. A study done for the IFC on stabilization clauses showed how widely they are used in developing countries [5].

Assuming that any political objections by Iran and Russia could be mollified, therefore, the consortium could potentially use stabilization clauses to address the risks inherent in building a pipeline without a final territorial agreement. Pipelines are multi-decade affairs, and the five littoral states will likely delineate the underwater boundaries before the last cubic foot of gas passes from Turkmenistan to Azerbaijan. To eliminate the risk that the final territorial agreement will negatively affect the consortium’s expected return, stabilization clauses could be included in the contracts signed with the governments of Turkmenistan and Azerbaijan. These clauses could require that any rent owed to, say, Iran, by virtue of the seabed pipeline location, would have a ceiling. Anything above that ceiling would be paid by the sovereign governments (Turkmenistan, Azerbaijan) to Iran. Potential changes in rent owed to Turkmenistan and Azerbaijan because of the final territorial agreement could be dealt with in the same way.

Thus, although a stabilization clause generally binds a country from extracting more than a certain amount of rent regardless of changes in that country’s own laws and regulations, stabilization clauses for the proposed seabed pipeline could be modified to bind the governments of Turkmenistan and Azerbaijan from extracting more than a certain amount of rent, regardless of who finally owns what piece of seabed. In effect, stabilization clauses could allow risk to be “absorbed” by Turkmenistan and Azerbaijan, or by other stakeholders anxious for gas to flow westward.

Footnotes:

[1] The element of “consideration” – that something of value be given by a party – remains a formal element of a contract, although courts will presume consideration of almost any form.

[2] AzPetrol International Holdings B.V. AzPetrol Group B.V. AzPetrol Oil Services Group B.V. v. the Republic of Azerbaijan (ICSID Case No. ARB/06/15) (AzPetrol). See: http://ita.law.uvic.ca/documents/Azpetrolaward.pdf

[3] Newcombe, A (2009), “A cautionary tale of settlement negotiations: Azpetrol v. Azerbaijan”. See: http://kluwerarbitrationblog.com/blog/2009/09/29/a-cautionary-tale-of-settlement-negotiations-azpetrol-v-azerbaijan/

[4] Weaver, K.S. (2009), “Turkmenistan’s ‘mixed’ signals,” in Azerbaijan in the world. See: http://ada.edu.az/biweekly/issues/vol2no20/20091021031606573.html

[5]  Shemberg, A (2008), “Stabilization Clauses and Human Rights”. See: http://www.reports-and-materials.org/Stabilization-Clauses-and-Human-Rights-11-Mar-2008.pdf