Dispute Perspectives Determining Damages in Cross Border Disputes

October 2012

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From the Editor’s deskDear Friends,

Welcome to our third issue of Dispute Perspectives – a periodic newsletter that will provide you with a focused analysis of ongoing trends in dispute resolution in India and update you with the ongoing events in this regard.

In this issue we will look at what techniques are being used to determine damages in cross border disputes. This article provides an overview of the elements of the discounted cash flow method, commonly used assumptions in estimating cash flows and the discount rate.

We, of course, look forward to hearing from you. I believe that we should be able to assist you or at least guide you in your pursuit of finding the most efficient and effective way to resolve disputes.

Should you have any questions, concerns or suggestions for future topics, please feel free to write to us.

Warm Regards,

Vidya RajaraoNational Leader, Forensic Services

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IntroductionAccelerated globalisation in the last decade has led to an explosion in international trade, cross-border mergers and acquisitions and a host of bilateral and multi-lateral investment treaties. Inevitably, globalisation also has led to increased cross-border disputes between companies as well as against sovereign governments.

Based on a study conducted by PwC and the School of International Arbitration at the Queen Mary University of London, international arbitration has emerged as the preferred choice for resolving cross-border disputes. The study found that 88% of corporate counsels have used arbitration at least once while 44% indicated that they mostly use international arbitration to resolve disputes1.

Between 2005 and 2011, over 21,000 international arbitration cases were administered by major international arbitration institutions2. American Lawyer Magazine’s 2011 Arbitration scorecard highlights a total of 261 eligible disputes. The study highlights that one third of the billion dollar disputes were in the oil and gas sector. Significant amounts are at stake in international arbitrations and dispute claims can reach millions of dollars rather quickly in large scale joint ventures and mergers. The treaty cases have stakes of $100 million and contract cases involve stakes as high as half a billion. The study highlights that one third of the billion dollar disputes were in the oil and gas sector 3.

1. Survey results titled: “International Arbitration: Corporate attitudes and practices 2008” published by PricewaterhouseCoopers LLP. The global study is conducted by PwC every four years to study trends in international arbitration as a dispute resolution mechanism.

2. Compiled from http://www.hkiac.org/index.php/en/hkiac-statistics, http://www.dis-arb.de/scho/39/content/statistics-id51 and http://icsid.worldbank.org/ICSID/FrontServlet?requestType=ICSIDDocRH&actionVal=CaseLoadStatistics. Major arbitration institutions include AAA, CIETAC, DIS, HKIAC, ICC, LCIA, SIAC and ICSID.

3. Michael D. Goldhaber, Focus Europe, High Stakes; Arbitration Scorecard 2011, The American Lawyer (online) July 1, 2011.

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4. Michael D. Goldhaber, Focus Europe, Arbitration Scorecard, The American Lawyer, (Summer 2011) available at http://www.americanlawyer/focuseurope/contracts0605.html. The survey covers arbitrations that were active in the years 2009 and 2010.Disputes are classified as “treaty arbitrations” if they are primarily grounded in a treaty (usually but not always an investment treaty) and classified as “contract arbitrations” if they are primarily grounded in a contract, even if one of the parties is a nation.

5. According to Michael D. Goldhaber, a more precise characterisation of the Lukoil /Petrokazakhstan award would be $ 500 million plus the right for Lukoil to buy out their Chinese partner for $ 800 million. In the end they settled for $ 438 million and let their Chinese partner stay in the joint venture.

Arbitration Type of Dispute Award Date of Award Party receiving the Award Arbitration Institution

RosUkrEnergo v. Naftogaz

Contract disputes 12.1 cubic meters of gas worth about $ 2.1 billion

Jun-2010 RosUkrEnergo SCC/Stockholm

Sonatrach v. Sagane Contract disputes about $ 2.1 billion Jul – 2010 Sonatrach ICC, Geneva

Petrokazakhstan v. Lukoil Overseas

Contract disputes $ 1.3 billion5 Oct – 2009 Lukoil Overseas SCC/Stockholm

Areva v. Siemens Treaty disputes $ 925 million May - 2011 Areva ICC, Geneva

Navy of the Republic of China v. Thales

Contract disputes $ 830 million April – 2010 Navy of the Republic of China

ICC, Paris

Hyundai Heavy Industries v. IPIC

Contract disputes Right to buy joint venture for $750 million under market

Nov-2009 Hyundai Heavy Industries ICC, Singapore

Chevron v. Ecuador Treaty Disputes $698.6 million Mar-2010 Chevron Permanent Court of Arbitration (UNICTRAL)/The Hague

Petrobras America v. Astra Oil Trading

Contract Disputes $639.2 million Apr-2009 Astra Oil Trading Ad Hoc, Houston

RosUkrEnergo v. Emfesz

Contract Disputes $527 million Mar-2011 RosUkrEnergo SCC/Stockholm

Danish-Polish Telecommunications v. Telekomunikacja Polska

Contract Disputes $365 million (for phase 1)

Aug-2011 Danish-Polish Telecommunications

Adhoc (UNICTRAL), Vienna

International Arbitration: Top 10 Monetary Awards4

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The selection and application of damage methods for cross border disputes can be complex and subjective, involving widely diverging views resulting in numerous approaches to determine damages. Often international arbitrations and investment treaty disputes involve deter-mination of damages based on fair market value. There are three widely used valuation methods to determine fair market value.

1. Economic valuation method The economic valuation method is also known as the income based method of valuation using the tools of capitalisation and discounting to obtain a fair market value of the business. As the name suggests, it determines the value of the business based on its ability to generate an economic benefit for its owners. Under this method the value of the business acts as a function of economic benefit. Since it is an expectation of economic benefit in the future, practitioners also take into account the risk at-tached to the future cash flows. Accounting for such risks is critical owing to uncertainty in receiving the economic

benefit. The risks in determination of the discount rate will be explained in detail further in this article. The capitalisaltion method of valuing business divides the expected earnings of business by the capitalisation rate. While the discounted cash flow method determines the present value of business by projecting the future rev-enue flows and determining the discount rate. Economic valuation method provides more accurate valuation as the discount rate accounts for the risks of receiving the economic benefit on time.

2. Market comparables method The market based approach of valuing business is de-pendent on the value of comparable companies or assets in the market. In order to value the business, accountants will look at the value of competitor’s business. Under this method, the valuation is a function of competition. The concept of fair market value is understood by what the market is willing to pay for the business, when attempted to sell the business.

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3. Intrinsic value or asset based methodAssets and liabilities constitute business operations and a business valuation based on the assets is simply the difference between the value of assets and the liabilities. However, the challenge for an accounting expert lies in determining the set of assets and liabilities to be used in calculating the value of the business. The business value is reflective of the sum of the assets or their replacement cost to the business.

In this article, we will discuss the discounted cash flow method which is commonly used to determine damages in cross border disputes. A thorough understanding of the elements of the DCF as well as its underlying limita-tions is of immense value to international arbitration practitioners. The theory underlying the DCF does not differ in international arbitration; however, as discussed below, there are additional complexities in the estimation of the cash flows and the determination of the discount rate in international transactions. This article provides an overview of the elements of the DCF method, com-monly used assumptions in estimating cash flows and the discount rate.

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Overview of Discounted Cash Flow method The DCF method is a well known, universally accepted method and is commonly used for determining fair value of assets and liabilities including investments, restricted stock and pension liabilities, calculating lost profits or damages in breach of contract and antitrust matters. In addition, various arbitration tribunals have held that DCF techniques are an appropriate method for valuing business assets.

Barron’s Dictionary of Finance and Investment Terms defines Discounted Cash Flow as: “value of future expected cash receipts and expenditures at a common date, which is calculated using Net Present Value or Internal Rate of Return and is a factor in analyses of both capital investments and securities investments. The Net Present Value (NPV) method applies a rate of discount (interest rate) based on the marginal cost of capital to future cash flows to bring them back to the present. The internal rate of return (IRR) method finds the average

return on investment earned through the life of the investment. It determines the discount rate that equates the present value of future cash flows to the cost of the investment.”6

Simply stated, in the DCF method, future cash flows for a specified period of time are discounted back to present value using a discount rate. The DCF method employs cash flows instead of profits and these future cash flows are discounted at the so called Weighted Average Cost of Capital (“WACC”) of equity and debt providers.

The DCF method allows for incorporation of specific business circumstances in estimating cash flows and underlying assumptions can be made at a very “granular” level of detail. Similarly, the discount rate applied can be tailored to match the uncertainty, variability and riskiness of the specific cash flows. These estimations (of cash flows and discount rates) involve considerable elements of judgment and hence subjectivity. As a result, the DCF method is often “mistrusted” due to the sheer number of assumptions and may also lead to illogical results if assumptions are not well balanced.

6. Barron’s Dictionary of Finance and Investment Terms - 2nd Edition (page 99)

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Estimation of cash flows

Cash flows are typically estimated for two time frames –

1. An explicit or defined period (e.g., 5 years) terminating with the time at which the cash flows reach a steady state and

2. An implicit period that represents the remainder of the investment’s productive life (representing residual or terminal value). In some instances, cash flows cannot be reliably estimated if significant uncertainties exist (for example, if there are uncertainties regarding the viability of the project due to geopolitical constraints or if forecasted investments in the project are not undertaken).

Further, multi-year estimation of cash flows should properly factor in the nature of fixed costs and semi-variable costs and make necessary adjustments to ensure that such costs are consistent with the forecasted level of output.

The following guidelines should be adhered to while estimating cash flows7:

1. Only incremental cash flow should be considered i.e., cash inflows and outflows that are directly or indirectly related to the project in question and would not occur if the project in question did not

7. Baker and Powell, 2005, “Understanding Financial Management,” Blackwell Publishing Ltd, USA

exist. An effective way to assess incremental cash flows is to answer the question: What will happen to a particular item of cash flow if this specific project is not undertaken?

2. Cash flows should be after tax cash flows and as such, items that affect taxes including non-cash charges should be considered;

3. Cash flows should be adjusted to reflect changes in working capital requirements over time and in particular, seasonal working capital needs based on the nature of the industry should be carefully considered; and

4. Cash flows and discount rates should be consistent e.g., nominal cash flows should be discounted using nominal discount rates and real cash flows should be discounted using real discount rate. Since financial statements are stated in nominal dollars (i.e., including the impact of inflation) and interest rates are generally quoted nominally, estimation of nominal cash flows is preferable.

5. The assumption underlying the estimates for a new project must be spelt out clearly as estimating the cash flows for any new project involves a great deal of uncertainty.

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6. While estimating cash flows care must be taken to include only operating and investment cash flows and not cash flows associated with the financing of the project as the financing costs are also included in the project’s required rate of return.

7. The decision to adopt a project or not is based on the potential future cash flows and hence the sunk costs must not be included in the estimation.

Determination of discount rate

The discount rate is the interest rate used in calculating the present value of future cash flows8. Future cash flows are not as valuable as current cash flows because of the time value of money and the risk that future circumstances might change in a way that would reduce or eliminate the anticipated future cash flows. The discount rate is calculated as the sum of the risk-free rate plus an equity risk premium. The risk-free rate is the basic interest rate assuming no uncertainty about future cash flows.

In high-risk emerging economies or hyperinflationary economies (e.g., Democratic Republic of Congo, Myanmar and Venezuela) or during periods of increased uncertainty and volatility in capital markets (e.g., the recent Euro crisis and possible break-up of the Euro), special attention should be devoted to consideration of

Sources of Risk

Description

Business Risk Uncertainty of income flows caused by the nature of the firm’s business e.g., automotive, airlines, etc

Financial Risk Uncertainty introduced by the method in which the firm finances its investment e.g., debt, equity, etc

Liquidity Risk Uncertainty introduced by the secondary market for an investment e.g., whether the investment can be easily saleable to someone else., United States Treasury bill has almost no liquidity risk since it can be bought and sold easily and quickly.

Exchange Rate Risk

Uncertainty of returns to an investor who acquires securities or makes investments in a currency different from his or her own currency. More volatile the exchanges rate between the countries, greater the exchange rate risk.

Country Risk or Political Risk

Uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. Analysis of country risk is much more subjective as it is based on the history and current environment of a country.

8. Barron’s Dictionary of Finance and Investment Terms - 2nd Edition (page 100)

Source: Investment Analysis and Portfolio Management (5thEdition) by Frank K. Reilly and Keith C. Brown

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exchange rate risk and country risk in the discount rate. As such, based on the underlying circumstances and to the extent possible, consider the following guidelines:

1. To the extent possible and before making adjustments for country risk be sure that a) you can describe the risk; b) the risk is plausibly systematic and c) you can determine whether the risk may be hedged (and how);

2. Whenever possible, treat country considerations or political risks and discrete “event” risks (e.g., risk of a change in the tax regulations, risk of expropriation, risk of a renegotiation of a contract, etc.) in the cash flow projections, not the discount rate. If the political situation of the country in which the entities whose cash flows are being considered is likely to turn adverse, estimate the probability of this event occurring and multiply your cash flows by one minus this probability to get an estimate of your expected cash flows;

3. Be wary of assumptions regarding fixed exchange rates since such assumptions are inherently wrong due to possible significant currency volatility. Changes in real exchange rates tend to be accompanied by changes in relative interest rates and exchange rates and interest rates can move in

the same or opposite directions. If Currency A is appreciating relative to currency B, then A’s real interest rate tends to decline relative to B’s. Also, while foreign cash flows converted to domestic currency may be decreasing due to appreciation in the home currency, there will also be a decrease in the home discount rate; and

4. Any residual systematic country risk probably should be treated in the discount rate, but there is no fool-proof way to estimate the premium.

Conclusion

In summary, valuation methods vary considerably and the assumptions underlying the valuation methods should be carefully evaluated. Valuation methods are useful as long as the underlying assumptions are valid and relevant to the items in dispute. Relevance of a particular valuation method should be evaluated and a range of valuation approaches should be considered while determining damages as this can add credibility to the amount of damages claimed.

One should expect to be challenged about their valuation methodology, assumptions and calculations and should be prepared to explain and support the logic, rationale and assumptions in their calculations. In addition, one should ask for and obtain support if they review other experts’ calculations.

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In the News• Indian legal system will no longer be a road

block for enforcing international arbitration awardsA recent Supreme Court ruling in the case of Bhatia International v.s Bulk Trading stated that “in a foreign-seated international commercial arbitration, no application for interim relief would be maintainable under Section 9 or any other provision.”

This judgment has come as a relief for business opting for arbitration as a dispute resolution mechanism. The losing parties in a dispute can no longer seek a stay on international arbitration award that is adverse. The judgment has reinstated faith in the Indian legal system and will aim to stop abuse of the system.

Related article was published in the Economic Times on September 8, 2012 under the heading “Supreme Court ruling on international arbitration order a relief for PE firms.” accessed on August September 8, 2012 on the following link: http://articles.economictimes.indiatimes.com/2012-09-08/news/33696697_1_arbitration-awards-arbitration-agreements-arbitration-act

• The Jury is out – why arbitration as a dispute resolution mechanism is becoming popular with India Inc.Large disputes in the corporate world are being battled out through arbitration proceedings. These disputes go over and above the consumer disputes. There is plethora of reasons for popularity of arbitration as a dispute resolution mechanism. One the reasons being that arbitration in India is being viewed as a panacea to the costs of proceeding through the normal judicial system, especially in disputes involving parties from different countries.

Related article was published in the Businessworld on August 25, 2012 under the heading “The Jury is out,” accessed on August 25, 2012 on the following link: http://www.businessworld.in/en/storypage/-/bw/the-jury-is-out/498958.0/page/0

• Arbitration proceedings are not governed by Indian Law of Arbitration if the disputes have to be decided in accordance with Indian lawThe Calcutta High Court has pointed out that if the parties under an arbitration agreement go into a dispute then the arbitration proceedings would

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not automatically be governed by arbitration law in India. In an ongoing arbitration case, the Court pointed out that when the seat of arbitration as stated in the contract is a place other than India, then the Courts of that country are empowered to address any weaknesses in the award. However, the arbitration proceedings can be conducted in accordance to the Indian law.

Related article was published in the Hindu Business Line on April 19, 2012 under the heading “Disputes may be decided according to the Indian Law, but not the arbitration proceedings: says Court” accessed on April 19, 2012 on the following link: http://www.thehindubusinessline.com/opinion/columns/s-murlidharan/article3332793.ece?homepage=true&ref=wl_home

• Taking arbitration proceedings to the next levelIn construction sector, the delay in completing a project gives rise to disputes between the parties and the project generally remains unfinished till a satisfactory resolution is arrived at. Claims that may arise on account of delay in a construction

project could be because of reasons like cost of idle labour and machinery, unabsorbed overheads, increased material prices, and so on. Consequentially, it means locking-up of substantial funds as well as loss to the Government/corporate. More and more parties to dispute are looking at the calculation of damages more proactively in the initial phases of the case to administer the arbitration proceeding more effectively and efficiently.

The fundamental reason for such a change is that a robust damage calculation helps the arbitrator to understand the value of claim as well the assumptions used in the calculation of the claim amount.

Related article was published in the Hindu Business Line on April 8, 2012 under the heading “Taking Arbitration to the next level,” accessed on April 8, 2012 on the following link: http://www.thehindubusinessline.com/industry-and-economy/taxation-and-accounts/article3293940.ece.

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Upcoming Events 31st Australasian Forum for International Arbitration (AFIA) Symposium, New Delhi.

Date: Thursday, October 11 2012Time: 3:00 pm to 6:00 pmLocation: Habitat World, India Habitat Centre, Lodhi Road, New Delhi – 110003

Seasoned international arbitration professional, Mark Kantor (Arbitrator, Washington D.C.) will be the guest speaker of the symposium. Vidya Rajarao (Leader, Forensic Services) and Kunal Gupta (Associate Director, Forensic Services) will be a part of two different panel discussions.

For more information and registration, please mail Ms. Prerna Gulati at prerna.gulati@in.pwc.com or call at + 91 9971424420.

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This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwCPL, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of PwCPL, this publication may not be quoted in whole or in part or otherwise referred to in any documents.

© 2012 PricewaterhouseCoopers Private Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Private Limited (a limited liability company in India), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

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