I. The dispute and factual background

The dispute involves a claim brought against the Republic of Korea (“respondent”) by Loan Star Funds (LSF)–Korean Exchange Bank (KEB) Holdings SCA (“LSF–KEB”) and group companies (“claimants”) who are affiliates of a Texan investment fund (together, “Lone Star”). Lone Star has a global investment policy of “buying low and selling high,” which has led to it being pejoratively referred to as an “eat-and-run” investor.

The claimants claimed that Korea’s financial regulator, the Financial Services Commission (“FSC”) had delayed in approving LSF–KEB’s sale of its majority shareholding (“Hana Approval”) in KEB. This delay resulted it losing a substantial portion of its control premium. The respondent argued that the claimants´ woes were self-inflicted following LSF–KEB’s conviction in a previous stock manipulation case (“financial crime”). Resultantly, the FSC had a statutory obligation to respond to the financial crime and prevent any fallout on the Korean financial market. It did that by requiring LSF–KEB to dispose of its shareholding in excess of 10% to an approved purchaser by a fixed date and for a reduced sale price via its compliance order dated October 25, 2011, (“compliance order”). The claimants alleged that this had pressured LSF–KEB to sign a new share purchase agreement (“new SPA”) with Hana Financial Group and Hana Bank (“Hana” or “Purchaser”) at a price that was 16% below KEB’s current trading value and losing a value equivalent of USD 433 million.

Additionally, the claimants also alleged a violation of the treaty on avoidance of double taxation and prevention of fiscal evasion with respect to taxes on income (“tax treaty”) due to actions of the Korean National Tax Service (“NTS”) depriving the claimants of a significant portion of the investment profits earned.

In its award dated August 30, 2022, the tribunal held that the FSC had violated the Agreement between the Government of the Republic of Korea and the Belgium–Luxembourg Economic Union for the Reciprocal Promotion and Protection of lnvestments (“2011 BIT”), specifically its obligations of providing FET to the claimants by putting their own self-interest over its statutory mandate to consider fairly and expeditiously the application to acquire LSF–KEB’s controlling interest in KEB (“Hana Application”). However, applying the principle of contributory fault, the tribunal concluded that Lone Star “materially contributed to the damage” by its wilful criminal conduct, without which the FSC would not have had the leverage to engage in its treaty-violating behaviour.

The tribunal therefore passed an order requiring the respondent to pay half of the claimed amount, a total of USD 216.5 million.

II. Dismissal of tax claims

The claimants alleged a violation resulting from the treatment by NTS in respect of sale of the shares owned by the Belgian affiliates of Lone Star using “tax-efficient” structures.

• Waiver objection dismissed

At the onset, the tribunal dismissed the respondent´s objection to the tax claim. It argued that Lone Star had waived its right as per Article 8(3) of the 2011 BIT to initiate international claims, as it had initiated local remedies in the form of domestic litigation. The tribunal agreed with the claimants that Article 8(3) only waived the investor right to initiate “new” proceedings but did not require it to discontinue existing proceedings initiated before an investor’s submission for arbitration.

Lone Star initiated an appeal proceeding from the administrative proceedings before NTS, which in turn was filed before the submission for arbitration. Hence, the appeal was a continuation of existing proceedings.

• Substance or form?

The NTS had applied the “substance over form” doctrine to rule that the Belgian affiliates of Lone Star were not the substantive owners of the investment income and denied claimants the benefit of the tax treaty. The claimants had previously unsuccessfully challenged the “substance over form” doctrine in domestic litigation for not being in compliance with the tax treaty and the 2011 BIT. Similar claims were made before the tribunal.

The tribunal noted that the “substance over form” doctrine informed the factual determination of a tax liability, while the tax treaty determined the tax consequence after the fact-determination stage. The Korean domestic courts, while rejecting Lone Star’s version of facts, had said that the application of the “substance over form” doctrine was not arbitrary. Further, there was Korean judicial precedent on application of the “substance over form” principle, while Lone Star’s own expert witness had stated that the principle was consistent with the tax treaty.

• Standards of protection for tax claims

The tribunal noted that the tax treatment by Korean authorities did not violate any national or international standards. It ruled that there was no discriminatory treatment on facts to support claims of arbitrary and discriminatory treatment; not a violation of full protection and security standard as tax treatment was a routine application of a tax system; nor was it an expropriation or violation of the free transfer obligation.

In relation to claims of breach of the umbrella clause, the respondent argued that the reliance on the tax treaty by the claimants would be an expansion of the umbrella clause. They argue that the tax treaty did not constitute a “written obligation” under the umbrella clause (which rather referred to contractual or private law commitments) nor was it an obligation regarding investments. The tribunal, however, observed (1) the parties had not used enforcement mechanism found within the tax treaty within the scope of the ISDS and (2), even if the tax claim could be brought within the umbrella clause, there was already an impartial litigation into the claimants’ claims without there being any allegation of denial of justice.

III. Proper application of state attribution?

• “Wait-and-watch” approach an abuse of states’ discretionary authority?

The claimants argued that the FSC delayed its approval of the Hana Application to placate hostile public opinion toward “eat-and-run” investors. This was in contravention of the Korean Banking Act, where the targeted entity is the purchaser of a Korean bank and not the seller, like the claimants.

The respondent argued that it had the responsibility of both approving bank ownership applications and supervising the financial sector, but the governing statutes were silent on which power took precedence in a conflict. The respondent further argued that the soundness of the banking sector and stability of the banking entity could be impacted by seller-driven factors, too. Therefore, the tribunal should not second-guess FSC’s procedural discretion of adopting a “wait-and-watch” approach, especially considering the criminal conviction of claimants in the stock manipulation case.

The tribunal ruled that under Korea’s statutory framework, the FSC was justified in investigating if the claimant’s alleged criminal conduct affected the soundness and efficiency of the banking sector. However, the relevant question was whether the “wait-and-see” approach was taken for prudential reasons or an abuse of its discretion. To determine international state liability, it had to see three elements: (a) who had the burden of proof (b) what was the standard of proof (c) what was the causation.

• Burden of proof and standard of proof

The claimants argued that although they bore the burden of proof, if they could adduce enough evidence to establish a prima facie claim, then the burden shifted to Korea to disprove their position.

The tribunal noted that, under general principles of law, the burden of proof is on the party bringing a proposition, while the standard of proof requires showing that the factual allegation is “more likely than not true.” However, while there was no explicit reference to burden of proof or standard of proof under ICSID Convention or Rules, the tribunal was empowered under Article 34 of ICSID Rules to judge on the admissibility of any evidence adduced and its probative value. The tribunal was, therefore, of the opinion that a prima facie claim did not mean that the burden shifted from the claimants to the respondent but that the tribunal was required to assess all evidence placed before it to determine whether an award could be issued in favour of the claimants. Here, if the claimants’ evidence was unanswered by the respondent, the claimants would prevail.

• Causation

The tribunal next had to consider whether the claimant’s loss was caused by Korea’s conduct or was self-inflicted. Alternatively, if indeed liability could be attributed to Korea, whether such liability could be reduced by operation of the doctrine of contributory fault.

To determine this, the tribunal looked at competing approaches to determine causation. One was the “near” or “proximate” approach” argued by the claimants, according to which, the last “clear chance” to avoid loss was seen. The claimants argued that if the FSC had approved the Hana Application before it signed the new SPA, any loss to Lone Star could have been prevented. Alternatively, under the “efficiency approach,” as argued by the respondent, some underlying misconduct (which, in the present case, was Lone Star’s criminal misconduct) was the cause behind the loss. The respondent also argued that Lone Star had willingly agreed to reduce the price at which it sold KEB shares out of its own commercial interest and that this “free act” broke any chain of causation that could be attributable to it. The claimants argued that this “free act” was made under duress, considering the relentless pressure on it that was exerted through the media and statements made by Hana and FSC.

The tribunal rejected the argument by the claimants that the “free act” was made under duress, as the new SPA was signed under protest and not any duress. The claimants were consistent in their intention of recovering any losses through an ISDS claim. The tribunal stated that international law recognizes contributory fault as a circumstance for reducing the amount of compensation. The contributory fault must, however, be “material and significant,” and in the present case, it constituted a financial crime. It therefore held that although the FSC acted in its own self-interest to orchestrate a price reduction and thus violated the 2011 BIT, “but for” Lone Star’s criminal misconduct, Lone Star would not have been in the position of jeopardy that led to its financial loss.

The tribunal, while deciding on apportionment of damages, held that the loss could not be broken into distinct elements assigned exclusively to either the claimants or the respondent. Rather, there was a single indivisible loss to which both the claimants and the respondent materially contributed, and, therefore, the loss had to be allocated equally between the parties.

• Dissenting opinion: Improper interpretation of facts and application of law

The dissenting opinion issued by Professor Brigitte Stern noted that the majority decision relied on indirect, ambiguous media articles or statements by Hana as evidence of pressure applied by the FSC. At the same time, neither statements from FSC representatives nor any internal document from FSC exhibited any pressure. Therefore, in the absence of an overt act on the part of the FSC, there could be no attribution of international wrong to the respondents. Further, regarding the financial crime, the dissenting arbitrator considered the response of the FSC, a financial regulator, prudential, and opined that this aspect was not given adequate deference by the majority. Further, it rejected the self-interest argument considering the FSC allowed the sale to go through despite domestic criticism instead of ordering a punitive sale.

The dissenting opinion also noted that the majority had not applied Article 34 nor Article 39 of the International Law Commission Articles (“draft articles”). It notes that from the date of its conviction, Lone Star was not entitled by law to more than 10% of shareholding in KEB and, consequently, any share premium. Hence, its position was of a “dead man walking.” The loss of control arose due to the criminal conviction and not due to any illegal pressures from the FSC and that the compliance order allowed Lone Star to lose only a part of its premium and not the whole in totality. Therefore, the proximate cause of Lone Star’s loss was its conviction for financial crime.

The dissenting opinion also notes that the decision to accept the price reduction was made for commercial reasons considering the drop in share value following the conviction. Therefore, any pressure by the FSC did not “break” the chain of any causation.

IV. Breach of treaty standards

The claimants alleged several treaty standard violations, but the tribunal upheld only a breach of the FET standard and thus found it unnecessary to issue a ruling for other breaches. The claimants argued that the respondent breached the claimants’ legitimate expectations and acted in breach of its good faith obligations.

• Breach of legitimate expectations

The claimants argued that the respondent agreed to protect the investors’ legitimate obligations by according it “freedom from coercion or harassment by its own regulatory authorities.” The respondent failed to adhere to these obligations when it (i) failed to adhere to statutory deadlines when delaying its approval of the sale of shares and (b) failed to act in good faith.

The respondent agreed with the “general expectation” that a host state should act in good faith which is inherent in the notion of fairness found in all provisions of the BIT. However, the respondent argued that the general expectation did not add or detract from a specific requirement under the legitimate expectation doctrine that there should be a specific representation by the government which formed the basis upon which an investor decides to invest. Further, the FET analysis required deference to a state’s right-to-regulate responsibilities along with protecting investments.

• Regulatory action in good faith?

Dismissing claims of failure to adhere to statutory deadlines, the tribunal held that the timelines were only hortatory, not mandatory. Rather, the improper motive was the proper consideration.

The claimants had argued that the respondent diverted the domestic pressure it was facing by taking recourse to a “legal uncertainty” argument to delay its approval. The respondent argued that the legal uncertainty surrounding the approval process was self-inflicted due to the financial crime. Further, it argued that the claimants had failed to demonstrate that pressure rather than statutory obligations was the controlling rationale for the respondents’ actions.

The tribunal, while agreeing with the “controlling rationale” argument, nevertheless held that the delay tactics employed by the respondent in respect to the Hana approval were meant to force the claimants to accept a price reduction in relation to the sale of KEB’s shares while placating political opposition to “eat-and-run” investors. The tribunal noted that the FSC manipulated the financial crime to its benefit to pressure Lone Star while withholding its approval of the Hana purchase. This is especially important because the Hana approval had nothing to do with the qualification of Hana as a purchaser. The financial crime did not relieve the FSC’s obligation to act in good faith, and the FSC’s action was rather driven by self-interest.

• Claimant compromised its position by its own conviction

The tribunal noted that the claimants were put in a “Catch-22” situation, whereby they were required to divest their shareholding in KEB within 6 months, while FSC’s delaying approval for sale prevented just that. However, the tribunal noted that this Catch-22 was of the claimants’ own making due to its criminal conviction, which had allowed the FSC to leverage the conviction to orchestrate a price reduction.

• Breach of FET standard

The tribunal therefore held that the FSC’s conduct was arbitrary and unreasonable within the definition the respondent had itself proposed. The tribunal also noted that the FSC had acknowledged in Korea’s National Assembly that the price reduction was not within the FSC’s mandate, the contractual terms being found in a private agreement. The tribunal, therefore, found the respondent guilty of violating its obligations to provide FET to the claimant.

V. Conclusion

The Lone Star case sheds light on interesting dimensions regarding treaty disputes. Firstly, it reveals how the “substance over form” argument relevant in many tax-related claims is a factual determination, while any tax treaty violation determination can happen only after this fact-determining stage. It also highlights how investors’ own contributory actions can lead to a reduction in damages. However, as highlighted by the dissenting opinion, all tribunals need to give due regard to a financial regulator’s prudential responsibility and, to that effect, tribunals should preferably consider the overt actions of the state over any ambiguous or indirect actions. This is, however, a determination that will be based on facts.

Note: The tribunal included Ian Binnie, who was appointed by the parties as the chair, Charles N. Brower, who was appointed by the claimants, and Brigitte Stern, who was appointed by the respondent.

The award, dated August 30, 2022, is available at https://www.iareporter.com/wp-content/uploads/2022/09/LSF-KEB-v.-South-Korea-Award-30-August-2022.pdf

The dissenting opinion dated August 22, 2022, is available at https://www.italaw.com/sites/default/files/case-documents/italaw170699.pdf.

Author

Tathagata Choudhury holds an LLM from The Geneva Graduate Institute and Queen Mary, University of London and is currently associated with The United Nations Conference on Trade and Development.