The US Supreme Court made a lot of headlines in its latest session, from affirming a right to gay sex to allowing affirmative action. But of much more importance for the world of international finance was an almost-unnoticed ruling handed down at the end of April that could change the way that bond contracts have to be written.
In Dole Food Co v Patrickson, a group of farm workers sued Dole for using pesticides that made them sterile. They sued in the Hawaii state court, which, like all state courts, allows jury trials that can result in enormous damages being awarded.
The pesticide was, however, produced in Israel by the Dead Sea Bromine Company, a subsidiary of Israeli Chemicals, a company owned by the Israeli state. Under the Foreign Sovereign Immunities Act (FSIA) of 1976, any company owned by a foreign government has several rights and immunities. These include the right to be tried in a federal rather than a state court, thereby avoiding the risks inherent in a jury trial.
This legislation helps to smooth diplomatic relations between the US and other countries, especially because a sovereign state, unlike a commercial defendant, cannot claim bankruptcy if a jury awards large damages against it.
The case went all the way up to the Supreme Court, which handed down a ruling contrary to the interpretation most lawyers had put on the FSIA for decades. Since Israel did not own Dead Sea Bromine directly, but rather through its ownership of Israeli Chemicals, the court found that the company was not entitled to the protections laid down in the FSIA.
The question is generally referred to as one of tiering: if company A is owned by a sovereign state, then is company A’s subsidiary owned by that sovereign? The Supreme Court decided no, thereby stripping important protection from thousands of companies around the world.
Already, this has had significant effects. An Austrian ski resort operator, a subsidiary of an electricity company owned by the Austrian government, was sued in New York by the families of the victims of a ski train fire. The case was removed to the federal court because the company had immunity under the FSIA; it has now, in the wake of the Supreme Court ruling, been sent back to state court. As a result, says Mark Cymrot, a lawyer at Baker & Hostetler in Washington: “A New York court is deciding how the government of Austria operates its ski facilities.” The upshot, he says, is that “in effect, the US is now going to be doing foreign relations through juries”.
The Supreme Court didn’t stop there. Along with tiering, it decided an equally crucial question: that of timing. When one tries to determine whether or not a company is owned by a sovereign, should one look at the state of affairs when the alleged offence took place, or should one concentrate on the situation when the complaint was filed? The answer, the court decided, is the latter.
What this means is that virtually any contracts made under New York law with a foreign corporation run the risk of being made extremely difficult to try if that corporation is, for whatever reason, bought by its government.
The case before the Supreme Court, like the Austrian ski fire case, was what Boaz Morag, a lawyer at Cleary Gottlieb Steen & Hamilton in New York, calls “a catastrophic mass tort case”, where plaintiffs were suing for potentially huge damages. But the lasting effects of the court ruling are likely to be felt elsewhere, in the world of contract law.
Restricted recovery Consider any lender, whether an investor or a bank, that has lent to a foreign borrower under New York law documentation. If that borrower is taken over by its sovereign state before the lender sues for its contractual rights, the ability of the creditor to recover any assets is severely curtailed. It doesn’t matter if the contract was entered into with a private party that had no idea that the company might ever be nationalized: if that happens (something that is not uncommon, especially in the case of banks that go bust), it automatically gets sovereign immunity.
The ruling, says, Mark Rosenberg, a lawyer at Sullivan & Cromwell in New York, is likely to prompt a change in the way that most bond and loan documentation is written. Even if a borrower has no present connection to its sovereign, it is now likely to have to include either some kind of arbitration clause or a waiver of sovereign immunity. One other option would be to make the acquisition of the company by the sovereign an act of default, unless the sovereign provided an FSIA waiver at the time that it bought the company.
Meanwhile, jury awards in state court in the US can be so enormous that other countries are likely to start seriously considering rejigging their corporate structures, just to prevent the risk that one of the companies they own could find itself owing untold millions of dollars in damages. It’s a serious incentive either to turn all indirect subsidiaries into direct subsidiaries, or otherwise to construct some form of control that means that the company is protected by the FSIA. The cost, of course, says Rosenberg, is that “you lose the benefits of a tiered structure when you move from a vertical to a horizontal structuring”.
Ultimately, however, any unintended consequences of the Dole ruling are a result of the fact that the whole FSIA seems fundamentally misconceived. After all, notes James Kerr, a lawyer at Davis Polk & Wardwell in New York, “generally, worldwide, foreign courts do not provide protection for subsidiaries,” and indeed the US solicitor general’s brief in the Supreme Court argued in favour of the eventual decision. Obviously the US doesn’t greatly fear the effects of this ruling on foreign relations.
Andreas Lowenfeld, a professor at New York University law school who admits to being “the grandfather of the Act, but not the father”, says that one of the problems with the FSIA is that it conflates two issues that should be separate: on the one hand it gives immunity to sovereigns; on the other it gives defendants the option to remove cases from state to federal court. “The British did it much better,” says Lowenfeld. “The US structure mixes up jurisdiction and immunity in a way that’s very hard to understand.”
The result, says Jay Newman, the investor at Elliott Associates who successfully sued Peru for defaulted loans, is that the FSIA, far from being a minefield for the ignorant, is in fact “a minefield for the well informed”. Even after this Supreme Court ruling, there are still many aspects of the FSIA that are far from clear, including the question of how retroactive it is: whether it applies to events that happened before 1976 or maybe 1952, when its predecessor was enacted.
At the moment, however, especially for companies that had thought themselves immune from jury trial and that are being sued in a US state court, the future looks scary. Lowenfeld says: “I don’t think there’ll be a wholesale restructuring of foreign companies, but I do think there’ll be a lot more fear of the US court system.”
