The sky is not falling: Dispute resolution and investor protection under Mexico’s Shallow Offshore Model Production Sharing Contract

Michael P. Lennon, Jr., Alejandro López Ortiz, Soledad G. O’Donnell, Mayer Brown

It is widely believed that one of the reasons for low participation in Mexico’s Round 1 first call for bids for Production Sharing Contract (PSC) in shallow waters (qualifying bids were made on only two of the 14 shallow-water blocks made available, with some of the main oil companies worldwide refusing to participate) was the lack of investor confidence in the dispute resolution mechanism of the contracts proposed to bidders. As a consequence, on August 4 and 25, 2015, Mexico released revised versions of its Model PSC (MPSC), in an attempt to provide investors more certainty for the second call for Round 1 bids.

This article summarizes the key dispute resolution provisions of the August 25, 2015 version of the MPSC for shallow offshore operations. It also outlines foreign-investor protections afforded by international treaties with Mexico that could be accessible to protect investments under the PSC through investor-state arbitration. This article is necessarily general given the early stage of the PSC bidding processes; investment planning and potential disputes must be analyzed on a case-by-case basis, taking into account the circumstances surrounding each unique situation.

Arbitration is the preferred mechanism for dispute resolution
Arbitration is the preferred dispute resolution mechanism in the post-reform oil and gas sectors. Article 21 of the Hydrocarbons Law explicitly permits arbitration of disputes except in cases of administrative rescission. Consistent with the law, the MPSC makes arbitration mandatory (with the exceptions described in the following section), if a three-month conciliation period fails to resolve the dispute.  In the event of an arbitration under the MPSC, United Nations Commission on International Trade Law (UNCITRAL) Rules apply, Mexican Law governs, Spanish is the language of the arbitration, the seat is The Hague in The Netherlands, and three arbitrators, one appointed by each party and the third selected by the other arbitrators, comprise the tribunal. One of the latest modifications of the MPSC is that the Secretary General of the Permanent Court of Arbitration (and not, as previously assigned in the MPSC, the President of the International Court of Justice, a body with no competence in international arbitration) is the appointing authority to ensure constitution of the tribunal.

The propriety of administrative rescission is reserved to the Mexican Federal Courts
Potential investors have expressed concern with Sections 22.3 and 25.4 of the MPSC, which largely adhere to Articles 20 and 21 of the Hydrocarbons Law, and reserve jurisdiction over disputes arising out of or related to administrative rescission to the Mexican federal courts. Article 20 of the Hydrocarbons Law provides that the National Hydrocarbons Commission (CNH) may administratively rescind Exploration and Extraction Contracts and recover the Contractual Area only when "serious cause[] is present." Mirroring the Hydrocarbons Law, Section 22.1 of the MPSC lists grounds for an administrative rescission, including failing to start or carry out work obligations, unauthorized transfer of interests, false reporting, missed payments or oil deliveries, and serious accidents involving significant suspension of operations, loss of production or fatalities.

The ramifications of an administrative rescission are significant. If the PSC is terminated administratively, the Contractor loses the PSC and all related infrastructure and other investment made to the date of rescission, with no payment of any kind from Mexico (unless the administrative rescission is found improper). Contractor also may be subject to paying penalties and damages to Mexico.

The CNH has attempted to mollify these concerns in the latest version of the MPSC. First, the CNH introduced wording in Article 22.1 aimed at clarifying some of the grounds for administrative rescission and making them more objective. Concepts such as "serious accident," "lack of justified cause" or "fault" are now defined.

Second, the Contractor now has the option, in the context of the CNH's investigation of potential grounds for administrative termination, to request the appointment of an independent, impartial and neutral expert with at least five years of experience in the subject matter of the investigation. The proposed expert must disclose any interest or obligation that is substantially in conflict with their designation and/or likely to impair the performance of their duty. This procedure appears to be aimed at reducing the number of administrative rescission cases that actually proceed to Mexican federal courts.

Third, Article 22.6 now allows disputes over the financial consequences of the administrative rescission to be arbitrated (and therefore, excluding them from the exclusive competence of the federal courts), in cases where parties cannot settle on this point within six months from termination. This seems to include the determination of any damages to be claimed by the investor should the administrative rescission be found to be improper.

Conflicts may arise in cases where the ground for administrative rescission under Section 22.1 of the MPSC overlaps with an express ground for contractual termination in Section 22.4, or where administrative rescission coexists with other breaches or disputes.  Although this must be analyzed on a case-by-case basis, the manner in which Sections 22.1, 25.4 and 25.5 of the MPSC are drafted suggests that the competence of the Mexican federal courts has precedence when the matter is arguably related to administrative rescission, and that only disputes clearly unrelated to administrative rescissions—save the required settlement—can be submitted to arbitration.

In a pre-Hydrocarbons Law scenario, the reservation of administrative rescission proved to be a fertile ground for conflicts. The Corporación Mexicana de Mantenimiento Integral, S. de R.L. de C.V. (COMMISA) obtained a favorable ICC arbitration award against PEMEX in respect to two contracts for building and installing natural gas platforms in the Gulf of Mexico. PEMEX managed to annul the award before the Mexican federal courts on the grounds that the matter related to the administrative rescission, and that it fell under the exclusive jurisdiction of the Mexican courts due to a statute that was not in existence when the contract was entered into by the parties. Enforcement of this ICC award was nevertheless granted by New York courts. It has been reported that COMMISA's parent company's (KBR Inc.) NAFTA proceeding against Mexico, alleging the annulment of the ICC award by the Mexican courts breached the Treaty, has been dismissed for non-compliance with NAFTA's requirement to waive any other remedies.

Investor protections under NAFTA and Bilateral Investment Treaties and Free Trade Agreements
Foreign investors may wish to consider protections against administrative rescission provided by bilateral investment treaties (BITs) and trade agreements under international law. Generally, these BITs and trade agreements can protect foreign investors in Mexico, and would allow those investors to assert claims against Mexico for breaches of international law, including breaches involving administrative rescission (termination) in the context of a PSC. Section 25.9, which is a new addition to the MPSC, specifically acknowledges that investors (the Contractor) shall have the rights recognized in international treaties to which Mexico is a party; a clear reference to these investment protection and free trade agreements and the arbitration mechanisms contained therein.

The most well-known free trade agreement to which Mexico is a party is the North American Free Trade Agreement (NAFTA).  When NAFTA entered into force, Mexico reserved investment and provision of services in the energy sector (including exploration and exploitation of crude oil and natural gas) for itself under the treaty, which effectively excluded the application of Chapter 11 investment protections to the energy sector, and reflected existing Mexican law by excluding foreign investment in that sector.

Although untested, it is our view that the amendments to the Hydrocarbons Law have made investment protections (including arbitration) available for NAFTA investors and their investments in the oil and gas sector, so long as there is a Mexican government act authorizing the investment (for example, an oil and gas license or contract). In short, the recent reforms effectively withdraw Mexico’s reservation of the energy sector for State-only investment and renders the protections afforded by NAFTA Chapter 11 available.

NAFTA Chapter 11 contains provisions designed to protect cross-border investors and facilitate the settlement of investment disputes.  For example, each NAFTA Party must accord investors from the other NAFTA Parties a minimum standard of treatment and may not expropriate investments of those investors except in accordance with international law. In order to initiate an arbitration under NAFTA, a party must waive its right to initiate or continue other proceedings before any administrative tribunal or court and comply with other procedural requirements such as a ninety-day cooling-off period.

Mexico is also a party to 28 BITs in force and to a number of other Free Trade Agreements (FTAs) that protect foreign investors in Mexico, and allow those investors to bring claims against Mexico for breaches of international law, including situations related to administrative termination of a PSC. Further, a new FTA between the European Union and Mexico is currently being negotiated.  Generally, these treaties also afford broad investor protections and access to dispute resolution through arbitration. BITs and FTAs have procedural requirements similar to NAFTA, such as cooling-off periods and waiver of actions or fork-in-the-road provisions.

In principle, Mexico could be held internationally responsible should it exercise discretionary legal power—such as termination by administrative rescission of a PSC—if it acts in an arbitrary, discriminatory, unreasonable, disproportionate, or abusive manner. It should be noted, however, that this international remedy is not available in cases of mere disagreement with the decisions of the CNH or mere issues of domestic illegality, but only when there has been a breach of the international protections afforded by the applicable treaties.

The case of Occidental Petroleum Corporation and Occidental Exploration and Production Company v. Republic of Ecuador, ICSID Case No. ARB/06/11, Award (October 5, 2012) illuminates a potential basis for an international law challenge to administrative rescission.  The Hydrocarbons Law and Occidental’s participation contract prohibited a transfer of rights and obligations without prior governmental approval, and permitted termination in the event of such a transfer. Occidental farmed-out a 40% economic interest in return for certain capital contributions without obtaining prior approval. Upon learning of the farm-out agreement, Ecuador terminated its participation contract with Occidental on the ground that it was in violation of the Hydrocarbons Law.

Although the farm-out agreement violated Ecuadorian law, the tribunal nevertheless held that the termination of the participation contract was a disproportionate response to Occidental's assignment of rights under the agreement. Therefore, the tribunal concluded, Ecuador breached Ecuadorian law—which was the applicable law to the contract and recognizes the principle of proportionality—customary international law, as well as Ecuador's obligation under the BIT to accord fair and equitable treatment to Occidental's investment, and found the administrative sanction to be a measure tantamount to expropriation.

According to the tribunal, "the overriding principle of proportionality requires that any...administrative goal must be balanced against [the investor's] own interests and against the true nature and effect of the conduct being censured." In finding the termination was in breach of the principle of proportionality, the tribunal took into account that: (1) the Minister's termination order was discretionary, not mandatory; (2) alternatives to termination were available; (3) the termination decision may have been, in part, retaliation for a prior arbitral award in Occidental's favor; and (4) the farm-out caused no economic harm to Ecuador. In upholding the obligation of proportionality, the tribunal relied on, among other cases, Técnicas Medioambientales Tecmed, S.A. v. United Mexican States, ICSID Case No. ARB (AF)/00/2, Award (May 29, 2003).

Administrative rescission presents a potential risk to foreign investors and the exclusive competence of the Mexican federal courts is seen with concern. It is too early to tell whether CNH’s recent changes to the MPSC will mitigate the concern. Therefore, companies investing in Mexico should carefully structure their investments, taking into account available investment protection treaties, in addition to the classic tax considerations, because those treaties may provide a foreign investor access to international arbitration in cases of administrative rescission. A case-by-case study of the available treaties is critical to harmonize these twin objectives.

About the authors
Michael P. Lennon, Jr. is a partner in the Houston office of Mayer Brown LLP and a member of Litigation & Dispute Resolution and International Arbitration practices. His practice encompasses a wide variety of arbitration and litigation matters, particularly in the energy, natural resources and construction sectors, and covers both international commercial and investment treaty disputes. Alejandro López Ortiz is a partner in the Paris office of Mayer Brown LLP and a member of Litigation & Dispute Resolution, International Arbitration and Latin America practices. He represents companies and States in commercial and investment arbitrations in complex disputes arising of engineering and construction projects, energy, telecommunications, mergers and acquisitions, commercial contracts and financial transactions. Soledad G. O'Donnell is an associate in the Chicago and Houston offices of Mayer Brown LLP and a member of Litigation & Dispute Resolution and International Arbitration practices. She routinely represents clients in international disputes arising out of the energy and natural resource sectors.

Michael P. Lennon, Mayer Brown

Alejandro López Ortiz, Mayer Brown

Soledad G. O'Donnell, Mayer Brown


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