Features of special permits for subsoil use in production sharing agreements

Any investor, as a party to a production sharing agreement, until the moment of signing the production sharing agreement is a regular subsoil user who has acquired the right to a subsoil use permit in a competitive or non-competitive manner.

In the event that the type of subsoil use permit is limited to geological exploration, from the moment of signing the production sharing agreement, the state, as a party to the production sharing agreement, proceeds to the registration of a special permit for mineral extraction.

At first glance, the situation with the acquisition of rights to special permits for the purposes of production sharing agreements seems logical and normal.

However, this situation does not seem so predictable in terms of the termination of the right to a special permit for both the ordinary subsoil user and the investor in particular.

Special permits for overuse in sharing agreements have a dual legal nature as a special permit for mineral extraction (as a permitting document), and as a document that gives the right to conclude a production sharing agreement (a condition of a production sharing agreement).

Let's consider an example regarding Ukraine.

Issues regarding the termination (cancellation) of a permit document are regulated by Clause 7 of Article 4-1 of the Law of Ukraine «On the Permit System in the Sphere of Economic Activity» No. 2806-IV of 06.02.2005, which states that the permitting authority revokes a permit document on the following grounds:

1) the presence in the Unified State Register of Legal Entities, Individual Entrepreneurs and Public Organizations of information on the termination of a legal entity through merger, acquisition, division, transformation and liquidation, unless otherwise established by law;

2) the availability of information in the Unified State Register of Legal Entities, Individual Entrepreneurs and Public Organizations about the termination of the entrepreneurial activity of an individual entrepreneur.

The licensing authority that issued the permitting document may apply response measures regarding:

1) invalidation of a permit document in the event of establishing the fact of providing unreliable information in the application for the issuance of permit documents and the documents attached to it, except for obvious grammatical errors, typos or arithmetic errors that do not affect the content of the information provided;

2) revocation of a permit document in the event that a business entity performs certain actions related to the conduct of economic activity, in respect of which the permitting authority has issued a regulation or other regulatory document, and the business entity fails to comply with this regulation or other regulatory document within the period specified therein.

The law may provide for other grounds for terminating the validity of a permit document. Termination of a permit document for reasons not provided for by law is prohibited.

Additional grounds for terminating the right to use subsoil are determined by Article 26 of the Code of Laws on Subsoil No. 132/94-ВР dated 07/27/1994.

Therefore, a systematic analysis of the above legal norms gives grounds for concluding that the termination (cancellation) of a special permit is possible if the subsoil user has ceased economic activity, it is established that the subsoil user provided false information in the application for the issuance of documents, and the violations that became the basis for the suspension of the permit have not been eliminated.

In addition, the Supreme Court, in its Resolution of November 12, 2020 in case No. 260/943/19, formulated a legal conclusion that the supervisory authority must indicate which violations that have been identified and not eliminated are grounds for terminating the right to use subsoil by canceling a special permit.

The said conclusion is aimed at protecting the interests of subsoil users to prevent restrictions on the powers of government entities, in cases specified by law, to make decisions on termination of the right to use subsoil within the framework of the administrative procedure.

The risk of any error by a public authority lies with the state itself, and errors cannot be corrected at the expense of the persons concerned (case law of the European Court of Human Rights in the cases of Pincova and Pinev. The Czech Republic, application no. 36548/97, paragraph 58, Gashiv. Croatia, application no. 32457/05, paragraph 40, Trgov. Croatia, application no. 35298/04, paragraph 67).

However, in the context of terminating a special permit for subsoil use under a production sharing agreement, the termination of a special permit has a different procedure than the termination of the right to a permit for a regular subsoil user.

In accordance with the requirements of paragraph 3 of part one of Article 17 of the Law of Ukraine «On Production Sharing Agreements», the validity of a special permit for the use of subsoil under the terms of production sharing agreements may be suspended or terminated early exclusively by the Cabinet of Ministers of Ukraine in accordance with the procedure and on the grounds provided for in part two of this article.

At the same time, the right to use subsoil during the execution of a production sharing agreement may be limited, temporarily prohibited (suspended) or terminated by the Cabinet of Ministers of Ukraine in the event of an immediate threat to the life and health of people or the environment in accordance with the procedure provided for by such agreement.

It is also worth noting that, in accordance with the requirements of part two of Article 27, the investor is not subject to the effects of regulatory legal acts of executive authorities and local self-government bodies if such acts restrict the investor's rights specified in the production sharing agreement.

Regulations of state control and supervision bodies that lead to restrictions, temporary prohibition (suspension) or termination of subsoil use are mandatory for implementation by the investor from the date of adoption of the relevant decision by the Cabinet of Ministers of Ukraine or a local government body.

That is, as we can conclude, the validity of a special permit for an ordinary subsoil user is terminated by a court decision, while the validity of a special permit for subsoil use in the aspect of production sharing agreements is terminated by a decision of the government.

We believe that the procedure for terminating a special permit for subsoil use under production sharing agreements, provided for in the legislation of Ukraine, namely exclusively by decision of the government, is a strong guarantee that investors will not lose the permit.

Rules for interpreting a production sharing agreements

The interpretation of a production sharing agreement should not be chaotic, taken out of context, but should comply with the general rules of interpretation applicable to investment agreements.

Recall that the rules for interpreting production sharing agreements are governed by the rules of interpretation codified in Articles 31–33 of the Vienna Convention on the Law of Treaties.

A production sharing agreement shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the agreement in their context and having regard to its object and purpose.

Article 31 of the Vienna Convention on the Law of Treaties contains four elements of interpretation: good faith, ascertaining the ordinary meaning of the words in the agreement, the context, and the object and purpose of the investment agreement.

These elements are described in detail below:

1) Good faith. Although rarely mentioned in case law, is described as interpreting a treaty in a way that «conforms to the standards of honesty, loyalty and fair dealing» in international conduct, does not result in «gross manipulation», the wording of the contract or did not use ambiguity in the wording to advance an interpretation that could not be the interpretation of the parties;

2) clarifying the ordinary meaning of words in a production sharing agreement includes its preamble and annexes, and with (ii) the definition;

3) the context should not be confused with the «circumstances of the conclusion» of the contract, which refers, for example, to the «political and economic background».

4) the object and purpose of the investment agreement. The object and purpose of the treaty serve to shed light on the ordinary meaning of the terms to be interpreted. «Object and purpose» is usually interpreted as a single phrase, not as a separation of «object» and «purpose», and tribunals are usually wary of using it to achieve a meaning that is contrary to the plain meaning of the text.

The main reason for referring to the context in interpreting a contract (agreement) is to confirm the ordinary meaning given to the terms of the contract or to determine such meaning in cases of doubt.

Theoretically, there is no hierarchy in the application of these four elements, the interpretation focuses on the text of the contract (i.e. the starting point) rather than the intentions of the parties or, as the tribunal put it in Methanex v. United States, the text of the contract «is considered to be the authentic expression of the intentions of the parties».

Having become a party to a production-sharing agreement, participating States retain the right to modify the substantive or procedural aspects of the provisions of the production-sharing agreements.

«The authentic interpretation of a treaty remains the exclusive prerogative of the contracting States themselves, which may interpret the treaty expressly or implicitly by subsequent conduct» (Canadian Cattlement v. United States, (UNCITRAL) NAFTA, Jurisdiction, 28 January 2008).

Authentic interpretation does not change the content of the production sharing agreement and aims to:

1) clarify its meaning, thereby increasing the consistency, coherence and predictability of the interpretation of the agreement;

2) eliminate uncertainties and ambiguities.

The authentic interpretation may actually be a veiled amendment to the production sharing agreement that cannot be retroactive at the expense of foreign investors.

We consider it necessary to supplement the rules for interpreting production sharing agreements with the following paragraph.

The use of the separating conjunction «or» indicates a distinction: one concept from several concepts. When we say: «A or B», using the separating conjunction, we can mean «A and not B», and we can mean «B and not A».

Analysis of arbitration practice in matters of reimbursement of expenses incurred by the investor prior to the conclusion of production sharing agreements

Due to the systematic emergence of controversial issues related to the state's reimbursement of costs to the investor before they conclude a production sharing agreement, there is a need to analyze arbitration practice.

Production sharing agreements are a type of investment agreement, and therefore any conclusions from arbitration awards on investment agreements have practical implications for the application of production sharing agreements.

To prepare this analysis, we referred to a number of the following tribunal decisions: «Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan», «The Patel Engineering Limited v. Republic of Mozambique», «Mihaly International Corporation v. Democratic Socialist Republic of Sri Lanka», «Zhinvali v George», «Mytilineos v. Serbia and Montenegro», «Duke Energy v. Peru», «Union Fenosa Gas v. Egypt», «PSEG v. Turkey», «Bear Greek Mining v. Peru», «ADS v Hungary».

From the content of the arbitration decisions, it is apparent that the main factor influencing the amount of compensation to the investor is based on the universal principle that the investor's income from the transaction must be protected throughout the entire life cycle of the investment agreement.

The most common assessment of the above cycle is using a method such as Discount Cash Flow (DCF).

However, the application of this method causes discrepancies between the assessment of the value of the investor's investment and the value of the costs incurred by investors, especially when investment agreements are concluded for long terms and are valid for up to 50 years or more.

Mmaintaining a balance between the cost of investments and the cost of expenses incurred by the investor, and to protect the national economies of states from monetary collapse, arbitration practice has developed 3 postulates in its work:

1) enhanced public interest of the state is a rational argument in disputes with the investor.

2) investor misconduct is subject to a limited exception (for example, signs of corruption in the case of «Union Fenosa Gas v. Egypt», the investor received gas supplies under the influence of the decision of the director of the Egyptian Petroleum Group company. The gas supply was not included in the list of compensating costs to the investor).

3) the state-receiver of the investment can pay the costs.

As a rule, investors incur expenses before the stage of signing investment agreements.

World arbitration practice is consistent in that the following are always subject to compensation to the investor without any conditions:

a) the investor's expenses for environmental impact assessment.

b) scientific research and development.

c) payment for financial advice.

Arbitration tribunals (arbitration courts/commercial arbitration panels) in disputes regarding reimbursement of costs to the investor incurred by him before the conclusion of the investment agreement are resolved based on an individual understanding of the concept of «investment».

Arbitral tribunals/courts agree that costs incurred before the signing of an investment agreement may not have an economic effect, but they are subject to protection.

The source of this conclusion was the inaccuracy of Article 25 of the Convention on the Settlement of Investment Disputes between States (hereinafter referred to as the Convention), which reserves flexibility in determining the essence of an «investment agreement» and «pre-investment preparations» for it.

The commentary to the Convention does not specify a list of «pre-investment preparations, nor their start dates, nor their end dates.

The answer to what exactly should be considered «pre-investment preparations» lies in the content of the investment agreement, which has been analyzed by international commercial arbitrations/tribunals.

Article 10(2) of the Energy Charter Treaty obliges the parties to the agreements to facilitate the pursuit of investment. Such investment shall be provided with the greatest possible permanent protection and security for the investor.

Similar concepts are also found in interparliamentary agreements on mutual investment protection and intergovernmental free trade agreements, which are also arbitration instruments in settling disputes with investors. For reference, as of today, Ukraine has concluded over 3,000 agreements on mutual investment protection and 19 free trade agreements.

The investment theory remains unchanged and conservative today.

The conclusions in the decisions in the cases of «PSEG v. Turkey», «Bear Greek Mining v. Peru» are formulated on the unity of the investment theory, which means that the investor's expenses are included in the limits of the investment that he made.

For example, in the case of Mytilineos v. Serbia and Montenegro, the tribunal held: «where there is doubt that the agreements prior to the investment agreement are taken separately and in isolation, it becomes clear that the combined cumulative nature of such agreements affects the investment agreement».

Despite the unitary nature of the perceived fact of the advantage of the «investor» over nation-states, there are arbitration precedents in arbitration practice in which investors were denied compensation (cases «Mihaly International Corporation v. Democratic Socialist Republic of Sri Lanka», «Zhinvali v George») under concession agreements, commercial transaction agreements and contracts for the construction of energy facilities.

Restrictions on investor activities under production sharing agreements

Plots under production sharing agreements that are provided for use by the investor, or their parts may cover wetlands, fertile black soils, and the boundaries of the field may approach settlements.

For the most part, states make a move to meet investors as a concession to the latter's compliance with environmental legislation.

However, despite environmental liberalism, investors are still obliged to at least minimally consider environmental standards and rules in the field of natural resource protection.

In terms of compliance with restrictions and prohibitions that are not included in the package obligation of investors, three regime environmental burdens should be distinguished in the form of regimes that the investor must comply with, namely:

1) the regime of the nature reserve fund.

2) the water protection regime.

3) the sanitary and protective regime.

Any activity that may negatively affect the state of natural and historical and cultural complexes is prohibited on the lands of the nature reserve fund and lands of historical and cultural significance.

Given that the state is in one ecosystem; to simplify the conclusion of production sharing agreements, the state establishes a limited regime for the nature reserve fund, limiting obligation of the investors narrowing to obey the law of the protection of the lands of reserves, sanctuaries, and natural parks.

That is, the use of land plots or part thereof within the nature reserve fund may be established to the extent of separating the above-mentioned objects from residential development areas.

Therefore, we recommend that investors consider the need to preserve natural habitats and species of natural fauna and flora in the long term when planning or implementing activities.

Sometimes the coordinates of the corner points of the sections are located within the boundaries of river sections.

Water protection zones are areas of economic activity where the use of persistent, potent pesticides, the establishment of cemeteries, animal burial grounds, landfills, and the discharge of untreated wastewater using lowland relief, as well as in streams, is prohibited.

In some cases, sand and gravel extraction is permitted outside the water fund lands in the dry part of the floodplain, in the ancient riverbeds.

The boundaries of water protection zones are determined by specially developed projects; therefore, we recommend that investors consider financing developed water protection zone projects.

Within sanitary protection zones, the construction of residential buildings, social infrastructure facilities associated with the constant presence of people around facilities that are sources of the release of harmful substances, odors, increased noise levels, vibration, ultrasonic and electromagnetic waves is prohibited to limit economic activity.

As an exception to the rules (sanitary protection zones), within the boundaries of the deposit area, it is allowed to locate depots, baths, laundries, garages, warehouses (except public and specialized food warehouses), buildings, departments, design bureaus, educational institutions, industrial and technical schools, premises for emergency personnel on duty, parking lots for transport, and local communications.

Jurisdictional distinction in production sharing agreements

In production sharing agreements, the parties agree on procedures for arbitration and judicial review of disputed issues.

Moreover, pre-arbitration discussions can manifest themselves both in the form of claim settlement, provided for by the terms of production sharing agreements, and in the right of the parties to choose an institution or person as an expert, whose decision can be appealed by one of the parties to an arbitration court, as an appeal to the form of an independent arbitration appeal.

However, production sharing agreements may contain provisions for some kind of (combined) national and arbitration court appeal substrate, both for the state and the investor.

We believe that the specified dispute resolution model is justified in terms of initiating a lawsuit by any party to challenge the rules of jurisdiction established by the production sharing agreement itself.

Options for submitting a dispute to a national court of the state as a party to the production sharing agreement:

1) an investor’s appeal for the assessment of value added tax amounts in connection with the purchase or production of goods/works/services.

2) an investor’s appeal of the state’s refusal to recognize a tax credit.

3) an investor’s appeal of the state’s refusal to recognize income from sources originating in the state.

4) claims of third parties against the investor to challenge intentional unlawful actions in relation to measures to eliminate extraordinary circumstances.

5) claims of third parties against the investor to recover any losses and damage caused to the environment, if it has been proven that such losses or damage were caused by the investor's intent.

6) claims of the state for violation by the investor of any legislation of the state.

7) claims or actions of third parties arising from losses or damage, if it has been proven that such losses or damage were caused by the investor's intent.

8) a claim by the state regarding the transferee's violation of legislation in the field of legalization (laundering) of proceeds from crime, or financing of terrorism or financing of the proliferation of weapons of mass destruction.

The transfer of a dispute for resolution by a national court of the state, as a party to the production sharing agreement, may be preceded by an administrative appeal on the initiative and at the request of the investor.

Options for submitting a dispute for resolution by a national court of the state, as a party to the production sharing agreement, to an arbitration/arbitration institution:

1) claims for the collection of penalties or claims for compensation for damage caused by the investor to third parties caused by the investor’s intentional breach of its contractual obligations.

2) claims for damage caused by the Investor to the environment, if it was caused of the investor’s intent.

3) claims by third parties for compensation for breach of confidentiality.

Options for submitting a dispute to arbitration/arbitration institution/arbitral tribunal:

1) appeal of the actions or inaction of the investor by the state.

2) claims by the state or the investor for the recovery of costs incurred in resolving the dispute.

3) the state's challenge of the investor's intentional unlawful actions in relation to measures to eliminate extraordinary circumstances.

4) claims of the state against the investor regarding measures to protect life, health, the environment and property to eliminate emergency situations, if it has been proven that such emergency situations were the result of the investor's intent.

5) state claims compensation for breach of confidentiality.

6) investor claims to challenge refusal to grant consent to the investor's transfer of rights and obligations under a production sharing agreement.

 

Confidentiality of the provisions of the production sharing agreement

When information is exchanged between different government agencies of a country as parties to an agreement, there is a concern about maintaining the full confidentiality of the provisions of production sharing agreements, even if disclosure is required by law.

 Let's consider the situation using the example of Ukrainian legislation.

Ukraine has undertaken international obligations in connection with joining the Extractive Industries Transparency Initiative, as well as implementing European Union legislation on increasing the transparency of economic activities in the extractive industries, namely Directive 2013/34/EU of the European Parliament and of the Council on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings.

The mechanism for implementing the Law of Ukraine No. 2545-VIII consists in providing the Ministry of Energy of Ukraine, as the central executive body, which ensures the formation and implementation of state policy in the fuel and energy complex, exclusively by business entities operating in the extractive industries and parent companies in the extractive industries of payment reports, information on the essential terms of contracts (agreements) for the use of subsoil, as well as information on amendments made to them.

However, production sharing agreements contain a high standard of confidentiality, as no information regarding the contractual areas, the content of the production sharing agreements themselves, including any documents, information, data and reports of any nature, any discussions or any decisions, are subject to disclosure.

Given the above, information about production sharing agreements is not published even in open sources.

At the same time, Law No. 2545 – VIII (the law as the will of the party to the agreement represented by the state) requires the investor to provide data on the payment report, in particular, data on the volume of products subject to transfer to the state for the reporting period, information on the cost of products excluding value added tax, information on the volume of the state share of profitable products, the cost of the state share of profitable products), as well as information on the form of obtaining the state share.

That is, there is a controversial dilemma according to which the investor is subject to additional obligations to provide new reporting forms to those specified in the production sharing agreement and the state's public commitments in international obligations to demonstrate transparency in the extractive industries.

From the point of view of the expediency of obtaining reporting information as part of production sharing agreements, it is not so important, since the disclosure of information in payment reports and consolidated payment reports only duplicates the information that the state already possesses.

We believe that in production sharing agreements, private interest should prevail over the public obligations of the state, as a party to the production sharing agreement.

Audit evidence in production sharing agreements

The start of the review of the joint accounting account for production sharing agreements is to conduct an independent audit to determine whether the costs reflected in the joint accounting account comply with the material aspects of the production sharing agreement.

Typically, auditors prepare 2 copies of the report (one detailed) for the investor and the other (less informative) for the government body of the party to the production sharing agreement.

As a rule, the auditor's formal conclusion on the compliance of the joint account and the correctness of the reflection of expenses does not provide a complete picture of the investor's activities, which makes it impossible for the inspecting authorities of the parties to the production sharing agreement to attach the audit report to the list of references in the report on the verification of the oil and gas activity account.

The international audit report contains the basic skeleton of the study, which eliminates the basis for its appeal. The general conclusion that there is no fraud in the investor's activities cannot be relevant to the concept of maintaining a joint account for oil and gas management expenses in strict accordance with the production sharing agreements.

A solution to this problem may be for the state to recommend to the investor to indicate in contracts for organizing and conducting an international audit a list of audit evidence used.

According to paragraph 7 of the International Auditing Standard 200. The overall objectives of the independent auditor and the conduct of an audit in accordance with international auditing standards (hereinafter referred to as the International Auditing Standard 200): «international auditing reporting standards require that the auditor, throughout the planning and performance of the audit, and, among other things, detect and evaluate errors, based on an understanding of the entity and its environment, including the entity's internal control system, formed an opinion on the financial statements based on the conclusions drawn from the audit evidence obtained».

The International Standard on Auditing 200 includes as audit evidence both information contained in the accounting records underlying the financial statements and other information that supports management's assertions and any information that contradicts such assertions (Article 13(b), paragraph A. 30).

At the same time, the disclosures in the auditor's report should include explanatory or descriptive information, set out as required, expressly permitted or otherwise permitted by the applicable financial reporting framework, either in the notes or included therein by cross-reference.

For examples of financial statement disclosures in the notes, the International Standard on Auditing 200 provides for the following mandatory references: «Balance Sheet», «Income Statement or Statement of Operations», «Statement of Retained Earnings», «Cash Flow Statement», «Statement of Assets and Liabilities excluding Equity», «Statement of Changes in Equity», «Statement of Income and Expenses», «Statement of Operations by Product Line».

The term «financial statements» usually refers to a complete set of financial statements as defined by the requirements of the applicable financial reporting framework but may also refer to a single financial statement (A8, A29 of ISA 200).

In addition, ISA 200 recognizes that in some jurisdictions, applicable law or regulation may require auditors to express opinions on other specific matters, such as the effectiveness of internal control or the consistency of a separate management report with the financial statements (A1).

The theoretical problem of applying international auditing standards and international financial reporting standards remains unresolved, because the quasi-character of the joint accounting account is devoid of a financial basis, but is exclusively a source of generalizations of the investor's accounting and management actions.

Legal nature of a joint account in oil and gas activities

Production sharing agreements, as investment agreements, are usually registered with the tax authorities of the states in order to carry out separate accounting of investors' expenses, different from the regime and tax accounting for their ordinary business transactions.

Separate accounting is necessary so that authorized state bodies responsible for monitoring and controlling production sharing agreements can calculate the costs incurred by investors and include them in future compensation at the stage of settlement with them for the extracted hydrocarbon raw materials.

Therefore, in production sharing agreements, you can sometimes find the concept of a «joint accounting account».

The legal nature of a joint accounting account is interesting, because on the one hand, it contains a financial basis, but has not acquired the status of an accounting account, and on the other hand, it is a management account for expenses. That is, a kind of synthetic quasi-sub-account.

However, during the verification of the costs incurred by the investor, disputes arise regarding the correctness of the accrual of costs for this quasi-account, since production sharing agreements fragmentarily regulate the procedure for maintaining a joint accounting account, and the law applicable to the agreements omits this issue.

Sometimes production sharing agreements contain references to the accrual method.

Unfortunately, there is currently no arbitration practice on the issue raised.

In the aspect of the above, I propose to use, at the discretion of the states, the following.

The purpose of the «accrual principle» is that income and expenses are recorded in the accounts at the time they arise, regardless of the date of receipt or payment of funds.

Accruals are reflected in accounting registers and are usually reported in reports and in the periods to which they relate.

The appropriateness of the charge for expenses should be assessed on the basis of facts that the investor knew or could reasonably be expected to have known at the time the expenses were incurred.

The accrual method is largely a question of fact.

Thus, the investor bears the burden of proving the correctness of the accrual in accordance with the expense item of the joint accounting account.

Tax practice follows from the position that in investment agreements, focusing on the decision to comply with the accrual principle seems appropriate as opposed to other principles (most favored nation, equity, etc.).

The accrual method alone provides a fair representation of an investor's performance.

A more important aspect for the formation of accounting rules was the need to limit the investor's power to control the time when receipts should be included in income or when deductions from expenses should be made.

If accounting is conducted on a commercial basis, income and expenses are credited although they are not actually has realized, and the entries thus made do not actually show anything other than the accrual or occurrence of the said income or expense at the relevant point in time.