Arbitrability Of Issues Arising from Contracts For The Exploration And Extraction Of Hydrocarbons: Convenience And Needed Amendments To The Mexican Law

Gabriela Cosio, Associate – Guarrigues

At the end of 2013, Mexico’s ambitious Energy Reform, core objective of President Enrique Peña Nieto’s political agenda, was passed, ending the days in which key areas of the Mexican energy sector, such as the exploration and extraction of hydrocarbons, were closed for the private sector. On 11 August 2014 the new Hydrocarbons Act was published on the Official Gazette setting forth the legal grounds governing the Exploration and Extraction Contracts (“E&E Contracts”). While this unprecedented opportunity incentivizes foreign companies to invest in Mexico by contracting with the National Hydrocarbons Commission (“CNH”) to develop promising energy projects, the new contracting scheme, as set forth by the Hydrocarbons Act, by banning the parties from submitting to arbitration any dispute regarding the government termination of E&E Contracts, may be problematic for investors.

1. Dispute Resolution Mechanisms in Accordance with the New Hydrocarbons Act

The Federal Government, through the CNH, may enter into E&E Contracts, in which it shall invariably be established that the hydrocarbons in the subsoil are the property of the Nation. For this matter, the selection of contractors will derive from a public bidding process. While opening up to private investors, the new Hydrocarbons Act contains a widely criticized provision regarding the dispute resolution methods included in E&E Contracts. The referred provision states that, while E&E contracts can contain dispute resolution clauses, the parties must select Mexican Federal Laws as the applicable law, and specify that the proceedings shall be held in Spanish (article 21). There is more. Article 22 of the Act further states that any dispute related to government termination of E&E contracts cannot be subject to arbitration.

The latter provision mainly derives from the famous COMMISA case in which the mismanagement of a the case by the Mexican courts, recently ended in the 2nd U.S. Circuit Court of Appeals in New York confirming an award of $300 million dollars against Mexico’s National oil company, PEMEX, –even though a Mexican court had nullified it— and upholding a lower court ruling that added $106 million dollars to the judgment.

2. General Terms and Conditions of Public Bids

Despite the harsh provisions of the Hydrocarbons Act, the Mexican Federal Government has made several modifications to the terms and conditions of the contracts as the first, second, third and fourth public bids of Round 1 have been developing. The pending bid (fourth bid), has implemented the following provisions:

26.4 Federal Courts. All disputes between the Parties in any way arising from or related to the events of administrative rescission provided in Article 23.1, without prejudice of the provisions set in Clause 23.6, first paragraph, shall be resolved exclusively by the Federal Courts of Mexico. The Contractor may initiate proceedings before an arbitration tribunal in terms of Article 26.5, only for the determination of the existence of damages, and in such case, their quantification, that result in a cause or causes of administrative rescission considered as unfounded by the Federal Courts in a definite manner.

26.5 Arbitration. Subject to Article 26.4, any dispute arising from or relating to this Contract that has not been resolved within three (3) Months after the commencement of the conciliation period or that it would have been rejected by any Party in terms of Article 26.2, it shall be resolved by arbitration pursuant to the UNCITRAL Regulations. The Parties agree that the Secretary General of the Permanent Court of Arbitration at The Hague shall be the nominating authority for the arbitration proceeding. The applicable substantive law shall be as provided in Article 26.1 [“This Contract shall be governed by and construed in accordance with the laws of Mexico.”], and disputes shall be resolved strictly according to law. The arbitral tribunal shall consist of three members, one named by CNH, another named jointly by the Operator and the Participating Companies and the third (who shall be the president of the tribunal) named in accordance with the UNCITRAL Regulations … The arbitration proceeding will be conducted in Spanish and the seat of the arbitration shall be the City of The Hague in the Kingdom of the Netherlands.

In light of the above, there are three scenarios in which the parties may submit their disputes to commercial arbitration:

(i) When there is a dispute not related to the government termination;

(ii) If, after submitting the dispute to Federal Courts, it has been finally determined that the government termination was unfounded, in order to recover damages;

(iii) If, within a 6 month period following government termination, the parties are unable to reach an agreement in regards to the corresponding compensations.

It becomes apparent that, as the E&E Contracts have been negotiated, there has been an evolution towards extending the scope of matters that are able to be subject to commercial arbitration. This is not surprising considering the suitability of commercial arbitration to this type of disputes that require extensive technical knowledge and an international, confidential and flexible perspective. The main outstanding issue, however, revolves around the multiplicity of procedures in case of government termination.

3. Arguments Supporting Arbitration of Government Termination Disputes

Even though the government termination of E&E Contracts has been legally excluded from arbitration, in accordance with articles 20 and 21 of the Hydrocarbons Act, there are several arguments that suggest that such limitation is not ideal to ensure procedural efficiency.

Intact Sovereignty

Some may argue that the submission to arbitration of disputes related to the government termination constitutes a violation of Mexico’s sovereignty. This argument can only be construed around a crippled conception of sovereignty. As sustained by Francisco González de Cossío, “sovereignty, properly understood, does not mean freedom to do what the government wants, but freedom to do what the law authorizes”.  With that in mind, the Mexican State exercises its sovereignty by determining in the Hydrocarbons Act which are the causes for a government termination and thus the examination of the government termination by an arbitral tribunal through the application of the Hydrocarbons Act does not constitute a violation of Mexico’s sovereignty.

Technical Expertise

Nowadays in Mexico there are no courts or tribunals specialized in the energy sector. In fact, Mexico has been seeking help from other States in order to train its officials in such field. This scenario evidences that (i) Mexican courts, at the moment, may be overwhelmed with disputes arising from energy contracts and that (ii) this sector requires sufficient technical knowledge. Hence, by submitting even government termination disputes to commercial arbitration in which the arbitral tribunal may be selected in accordance with their expertise (engineering, energy contracts, oil and gas, etc.), any dispute can arrive to a viable and expedite resolution.

4th Public Bid: Terms and Conditions

The terms and conditions negotiated and ultimately included in the contract base of the 4th public bid, to be adjudicated in the following months, are the result and reflection of the conciliation of investors’ interest and the need for flexibility of the Mexican government. The latter is relevant and necessary in order to ensure the investment in hydrocarbons projects that will trigger economic growth and eventually economic development in our country. The proposed contract now contemplates 3 scenarios for commercial arbitration and incorporates experts and conciliators in the process showing that the investors are comfortable with selecting alternative dispute mechanisms over federal procedures. By providing for such decisions to be made through arbitral awards, the probabilities of the parties being subject to arbitration increases and the inclusion of a ‘necessary’ court procedure lacks procedural efficiency and will offset the benefits that commercial arbitration may carry to these contractual relationships.

Conclusion

Mexico’s decision shall not set a precedent in the arbitration field and the expanding scope of arbitrability shall prevail when dealing with these kind of contracts in any other forum. Moreover, Mexico should embrace the arbitrability expansion not only because it contemplates a homogeneous international law, but also because from a practical perspective it will help avoid multiple procedures and ensure procedural efficiency. These considerations, therefore, suggest that the Hydrocarbons Act should be amended to allow the arbitration of any disputes arising from E&E Contracts. The elimination of this limitation will translate in benefits for both the Mexican State and investors, ensuring an efficient procedure for the resolution of disputes and ultimately ensuring economic development in Mexico.

Gabriela Cosio, Associate – Guarrigues