Investor-State Arbitration: Financial Debt and Damages

Financial Debt and Damages in Investor-State Arbitration


Chorzow Factory submissions dominate international arbitration cases. They also cite the standard for total compensation under international customary law. Comprehensive support is given to the principle of full payment. However, its implementation is always fraught with controversy. Details are the devil.

Debt financing is one of these details. UNCTAD has recorded many investor-state disputes. These include capital-intensive industries like energy, water, and financial services. Accounting for outstanding debt is essential to quantify the loss in these cases. International claimants are usually shareholders, and damages claimed to reflect shareholder losses. A shareholder can claim damages for the investment that was affected. However, the investor does not have an independent claim. 

This chapter examines the consequences of shareholders pursuing international reflective loss claims. 

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Another consequence is the emergence and spreading of allegations of financial imprudence. Respondent countries usually direct these towards claimant shareholders. Common allegations are that the claimants were negligent in encumbering an investment with excessive credit, resulting in inevitably poor financial performance and financial distress. These claims could be more common after covid-19 due to an increase in debt and bankruptcy. Below is the appropriate economic framework for assessing allegations of financial imprudence.

The second consequence is the size of any shareholder-reflective loss. Because the debt has a priority right to payment, a reliable damages analysis must first assess the impact of the measures on the debtholders of an investment before quantifying any effect on shareholders. We explain that shareholder losses are typically reduced by the presence of large amounts of debt.

The third consequence is the incentives of investors and host states to participate in the events that lead to arbitration. Sometimes, excessive debt can escalate a dispute, and arbitration may be the only option. Analyzing financial incentives can often explain the actions taken by the parties.


Host states often claim that claimant shareholders caused their misfortune. One claimant shareholder made poor investments, resulting in too little equity and too many debts. Counsel may accuse claimants of the state of treating international arbitration as investment insurance. However, the problem was always the claimant’s financing decisions and inherent vulnerabilities.

Evidence might be available to confirm that there is extensive debt financing. Accounting statements could reveal financial problems, significant debt, and high levels of financial leverage. This refers to the percentage of total investment funding that is used for debt financing. This leverage may have caused a restructuring or bankruptcy, or other financial problems.

This evidence is useful and will likely be uncontested. It is not sufficient to prove imprudent financial decisions or excessive debt. These conclusions need to be analyzed for causation. Was the deterioration of economic performance and slide toward financial distress caused by the measures in question? Was it bad luck or a result of excessive risk-taking and under-investment by the claimant?

Causation can only be determined by analyzing the financial impact of the relevant measures. This analysis should reconstruct the financial performance for the investment without (but for) these measures and then compare the reconstructed performance with reality. Depending on the complexity of the investment and the terms of any concessions, reconstructing financial performance may require significant modeling effort. It is essential to track the evolution of critical financial ratios like financial leverage and debt servicing coverage ratios and determine sufficient cash flows to pay off outstanding debt obligations.

If this was the case, the company or project might have avoided bankruptcy if the measures were not in place. The financial problems caused by the measures in question could have been prevented. Regardless of the actions, financial distress was inevitable, even if it was unrelated to the legal claims.

Analyzing claimant imprudence must also consider the original expectations of the claimants and the lenders at the time of the loan. It would be unreasonable to make second guesses in light of hindsight and the changing world after covid-19.

The amount and predictability of cash flows are vital factors determining an investment’s ability to repay debt. Less debt is appropriate for larger, more predictable activities; and less for smaller, volatile activities. A higher level of debt can have significant financial benefits. This includes the ability to impose business discipline and reduce the overall tax bill. 

Debt interest is exempt from tax in most jurisdictions. Business discipline is a commitment to a business and to return any profits to the lenders rather than investing in new projects. The many benefits of debt may come at the cost of financial problems later on.

Financial risk is not a sign of undue risk-taking. Significant finance theories define the optimal level of debt. This theory considers the trade-off between tax savings and potential financial distress. It would not be suitable to eliminate financial risk, as it would unnecessarily sacrifice shareholder and project value.

Third-party lenders have a financial incentive to conduct due diligence on the borrower and design the financing package that will most likely repay. Prudent lenders will usually consider the borrower’s legal rights, analyze major market, technical and business risks, and create a detailed financial model to forecast cash flows for a project to help assess its ability to pay its debt service.

Independent rating agencies and investors may also be interested in public bond offerings. Independent rating agencies and investors may also be interested in public bond offerings.

An analysis of debt issuance and contemporaneous lender expectation is likely to shed light on financial imprudence allegations, as well as but-for analyses. Lender expectations are an independent and important reference point for assessing financing options’ reasonableness and overall expectations.

Losses by Debtholders

The maximum a shareholder can lose in investment is its equity. 

Overleverage claims mainly concern liability. The claimant shareholder is responsible for its downfall and not the host country. Overleverage allegations can also lead to damages. Because the debt has priority rights to payment, more debt means that debtholders must receive a more significant share of the project’s value before any residual value can be passed to shareholders. 

Imagine a project worth US$100million, but the measures in question have destroyed the US$70million of economic value, reducing its value to US$30million. Imagine that the project was prudently funded with US$50m in debt and US$50m in equity. Due to state measures, the project would be declared bankrupt, and its value would plummet to  US$30million. Debtholders would then take all the US$30million in project value after the measures. The shareholder suffers a loss of US$50 million, and the debtholders will incur a loss of US$20 million.

Let’s say that a shareholder responds to the claim by initiating international arbitration. However, the debtholders don’t do so. This assumption is based on our experience. We have found that shareholder claims dominate the rnational arbitration. However, debtholder claims are much less common. Project lenders are often domestic banks and are not eligible to claim international investment treaty protection. A shareholder would likely file claims under the applicable treaty and seek damages equal to the total value of its equity lost.

The US $50m claim for shareholder-reflective loss would not be lower than the US $70m of enterprise value destroyed by the measures in question. A damages claim for shareholder-reflective loss must account for the priority right of debtholders to payment and subtract the US$20m in value lost by the debtholders. A state could only file a shareholder claim and not a debtholder claim. In our example, the state would be able to recover US$70million in economic value. It would also owe into the$50million in shareholder damages.

Overleverage can lead to a reduction in the state’s compensation. Imagine a shareholder financing our US$100million project with US$90 million of debt and US$10,000,000 equity. There would be allegations of imprudence and overleverage in the ensuing shareholder arbitration. This could impact liability. The resulting shareholder damages would only be for the shareholder’s US$10million investment after accounting for the US$90 million in outstanding debt. US$10,000,000 is far less than what is available to a similar claimant who used less debt financing (US$50million, for instance) and much less than the economic damage caused by the measures in question (US$70million).

Debtholder losses may occur even before an event of default or insolvency. This happens when the assets’ value falls below the outstanding liabilities. The market value and the book value of debt are different. The amount of outstanding debt at any given time is called the book or face value. Market values are based on the current value for principal and future interest payments. This is dependent on the risk of default, taking into account the returns available elsewhere in the market. Market values are determined by the current value of principal and scheduled interest, which is dependent on the risk of default, taking into account the returns available elsewhere given the prevailing market conditions. 


Extensive debt financing can significantly impact the analysis of liability, damages, and the incentive of investors and host states in the run-up to arbitration. Excessive debt can make it less appealing for both the investor and the state to settle early and force arbitration. 

An in-depth analysis of financial incentives and debt can illuminate the actions and events that led to the dispute and their potential consequences for liability and damages.

The measures in question may have left shareholders with very little or no value. Covid-19 could have dealt a further blow. With little to lose, shareholders might prefer to escalate a dispute to take on the risk of investment arbitration than to continue negotiations through the underlying company. 

Lenders are likely to be involved in negotiations between the underlying company and the host country. Any settlement value that results could flow to them. To get at least some equity returns, it is better to escalate a dispute and seek a response from the host. While shareholder damages in arbitration would have to be considered priority payment of a debt, it is possible to get at least some equity return by escalating a dispute.

However, excessive debt financing can discourage host states from seeking alternative solutions. Imagine a host country willing to negotiate with the company involved and offer compensation, even partial. The state would consider whether the settlement would sufficiently benefit foreign shareholders to avoid arbitration.

The state could see that lenders could take a significant portion of any compensation and leave shareholders with very little. The state could fear that a shareholder arbitration would be held, despite any payment made to the project company. The settlement reached with the project company will not solve the problem and only compensate the debtholders who are unlikely to arbitrate.

These considerations don’t consider the possibility of multiple legal proceedings or the possibility of double recovery. The following table illustrates an example of a situation in which partial compensation is not paid to a project company. This would not affect the shareholder damages claim in any subsequent arbitration. 

The state pays a portion of the damages to shareholders. This is not due to double recovery from shareholders but because the partial payment by the state represents a sufficient payment to debtholders through the project company.

Table: Shareholder damages unaffected by partial compensation to the project company

But for [A] Actual [B] Actual plus partial compensation [C]
Total value [1] [2]+[3] 100 60 70
Equity [2] assumed 20 0 0
Debt [3] see note 80 60 70
Compensation [4] assumed 10
Equity damages [5] [2][A]-[2] 20 20
Notes: [3] [A] and [B]: assumed [3] [C]: [3][B]+[4]


Shareholders can file international claims. This can lead to claims of excessive debt. This analysis includes detailed but-for reconstruction and a review by the claimant and lender of due diligence at the time of significant financing decisions. It is essential to avoid looking back because covid-19 will bring about higher debt and more bankruptcy. 

However, the quantification of shareholder reflective losses must consider whether equity owners have also suffered some economic harm. All things being equal, extensive debt financing decreases the severity of shareholder damages. 

Comprehensive debt financing can also impact shareholder and state incentives, increasing the likelihood of disputes escalating. An in-depth financial analysis can be used to help you understand the motivations and actions that led to a dispute and their potential consequences, including liability and damages.

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