Protecting EU Sanctions by Invoking the Denial of Benefits Clause of the Energy Charter Treaty

Introduction

Recently, on 24 September 2024, the Secretariat of the Energy Charter Treaty (ECT), received a communication from the EU and all its member states, except Hungary. According to the notification, they are exercising their right under the ECT to deny the benefits of investment protection under the ECT to Russian-owned/controlled and Belarusian-owned/controlled investors and investments. The ECT is a multilateral treaty primarily aimed at the protection of energy investments in Eurasia and granting investors access to investor-state dispute settlement (ISDS). Neither Russia nor Belarus is party to the ECT, but their investors could attempt to benefit from the ECT via corporate restructuring. For instance, the ECT has been invoked in the case Nord Stream 2 v. EU, in which the Swiss company Nord Stream 2 AG has initiated arbitration following an amendment to the EU’s Gas Directive. As is well known, Nord Stream 2 is fully owned by the Russian energy company Gazprom, which in turn is majority state-owned. The EU and its members are concerned that more cases are being brought by energy companies indirectly owned by Russians, particularly in the context of sanctions imposed on Russian businessmen linked to the Russian government. According to the EU Commission, the denial of benefits has indeed been invoked ‘as a matter of caution [….] in order to reinforce the application of EU sanctions’.

The communication to the ECT Secretariat follows the adoption of two Council decisions (EU, Euratom) in June 2024 to deny benefits to Russian and Belarusian owned or controlled entities/investments. Already in August 2022 Ukraine and in March 2023 Germany had exercised their right to deny benefits under the ECT vis-à-vis Russian owned investors and investments.

This blogpost outlines what the EU’s and its member states’ decision to deny benefits pursuant to Article 17 ECT means in practice. It starts with a brief overview of denial of benefits clauses in general, before addressing the specific clause in the ECT, how and when it can be invoked.

Denial of Benefits Clauses

Denial of benefits (DOB) clauses allow States to exclude the applicability of investment protection standards to foreign investors and investments that would otherwise be protected by an investment treaty. In general, DOB clauses can be invoked in certain situations to deny the benefits of the investment treaty to entities or investments owned or controlled by a third country investor. Thus, DOB clauses are essentially intended to counter restructuring of companies of third States, which may attempt to benefit from an investment treaty and have access to ISDS (treaty shopping). Two situations are typically covered by DOBs: first, an investor from a third State restructured an investment to benefit from a particular investment treaty without having substantial business activities in the new home State (so-called letterbox or shell companies). In that case the treaty probably never intended to offer protection because no reciprocal treaty relationship exists between host State and the third State. Secondly, the investor from a third State restructured their investment to benefit from a particular treaty but the third State and the host State have no diplomatic relations, or the host State has adopted sanctions, economic embargoes or the like to prevent economic relations with the third State and its investors (for a detailed overview of DOBs see e.g. Mitselis/Baltag).

Article 17 ECT and Its Invocation By the EU

Article 17 ECT is a traditional DOB clause insofar as it covers both scenarios. It provides the following:

Each Contracting Party reserves the right to deny the advantages of this Part to:

(1) a legal entity if citizens or nationals of a third state own or control such entity and if that entity has no substantial business activities in the Area of the Contracting Party in which it is organised; or

(2) an Investment, if the denying Contracting Party establishes that such Investment is an Investment of an Investor of a third state with or as to which the denying Contracting Party:

(a) does not maintain a diplomatic relationship; or

(b) adopts or maintains measures that:

(i) prohibit transactions with Investors of that state; or

(ii) would be violated or circumvented if the benefits of this Part were accorded to Investors of that state or to their Investments.

Paragraph 1 applies to situations where a company was restructured so that the home State of the company is a contracting party of the ECT, but it is in fact owned or controlled by investors of a non-contracting party. Moreover, the company does not have any substantial business activities in the home state. An entity will have ‘substantial business activities’ e.g. if it is involved in commercial activities in the home state, pays taxes, rents offices in the home state, employs staff in the home state, etc. (see e.g. 9REN v. Spain, paras. 180-182).

The EU and its member states have invoked Article 17(1), which implies that any Russian shell company or letterbox company in the energy sector in the EU or its member states, cannot rely on the ECT investment protection standards if owned or controlled by Russians or Belarusians. If an investment arbitration case is initiated by such a company, an investment tribunal would have to determine whether the ultimate owner is not Russian or Belarusian or whether ultimately not controlled by Russians or Belarusians.

Paragraphs 2 applies to situations where an investment, such as an enterprise or shares in an enterprise (see the definition of ‘investment’ in Article 1(6)ECT), are ultimately owned by an investor of a third State with whom the host State has no diplomatic relations (a) or if the host State had adopted sanctions against the third State and its investors (b) (see e.g. Hobér [2020] p. 343).

The EU and its member states have invoked Article 17(2)(b) and have adopted various sanctions (restrictive measures in EU jargon) against Russian and Belarusian individuals and entities. In connection with the Russian war in Ukraine the EU has adopted sanctions, first after the annexation of Crimea, and subsequently following Russian invasion starting in 2022. The sanctions have been expanded to Belarus as well due to its involvement in the Russian war against Ukraine. In addition to the sanctions, the EU Commission also adopted a screening guidance for foreign direct investment from Russia and Belarus in 2022, which should also help member states in implementing EU sanctions.

How and When to Invoke Article 17 ECT

The questions of how and when to invoke the Article 17 ECT have proven contentious. Most arbitral tribunals established under the ECT have held that the DOB clause must be actively triggered, i.e. the DOB does not apply automatically if the requirements under Article 17 are fulfilled (see e.g. Plama v. Bulgaria, para. 155-157). For instance, in the seminal case Plama v. Bulgaria the tribunal held that the right to deny benefits must be actively exercised giving reasonable notice of the exercise of the right to investors, for instance through

a general declaration in a Contracting State’s official gazette […]; or a statutory provision in a Contracting State’s investment or other laws; or even an exchange of letters with a particular investor or class of investors (Plama v. Bulgaria, para. 157).

Most tribunals have held that such an active exercise of the right must occur prior to the initiation of an investment dispute against the host State (see e.g. ACF v. Bulgaria, para. 1469), whereas other tribunals have required express invocation even prior to making of an investment (Plama v. Bulgaria, para. 161). However, in one ECT case, it was accepted that Article 17 could be invoked retrospectively, namely after the commencement of arbitration within a reasonable period of time (Littop v. Ukraine, paras. 592-608).

Overall, there is a trend towards requiring prospective invocation under the ECT prior to the commencement of arbitral proceedings. In particular, already pending arbitrations such as Nord Stream 2 v. EU will not be affected by the recent exercise of the right to deny benefits. However, the EU's invocation will be sufficient for any future disputes related to ‘(Belo)Russian investments’. By the time the EU decisions of 25 June 2024 were published in the Official Journal of the EU on 2 July 2024, the DOB clause has arguably been actively invoked. The notification to the ECT Secretariat in September 2024 should be seen as an additional step. It cannot have a constitutive effect, as the ECT does not provide for it. Similarly, the circulation of the declaration in the Energy Charter Conference, which is explicitly provided for in Article 2 of the EU Decision, is probably only declaratory, notwithstanding the terms used ("The Commission shall, on behalf of the Union, give effect to this Decision by circulating the declaration in the Annex within the Energy Charter Conference"). From that moment on, potential claimants have been put on notice that the EU and its member states will deny them benefits under the ECT. The fact that other states are informed of this decision in the Energy Charter Conference does not provide investors from third states with any more direct information than the publication in the EU’s ‘official gazette’.

Conclusion

The EU and its member states, except Hungary, have invoked the DOB clause under the ECT to prevent investors from Russia and Belarus to challenge EU’s sanction under the ECT through restructuring investments to benefit from investment protection standards under the ECT. The active invocation of the DOB clause is well ahead of any future disputes and thus can be considered an effective invocation of the DOB clause.