CAVALUM V. SPAIN: LEGITIMATE EXPECTATIONS OF AN INVESTOR WITH A FOCUS ON DUE DILIGENCE
- Dr. Yulia Levashova
Keywords- Fair and equitable treatment, ECT, Legitimate expectations, Due diligence, Reasonable rate of return, Margin of appreciation, State’s right to regulate
The decision on jurisdiction, liability and, quantum in Cavalum v. Spain , rendered on 31 August 2020, is yet another case arising out of changes to the renewable energy regime in Spain. I have discussed some of the previous renewable energy cases here and here. In Cavalum v. Spain, a Portuguese company, Cavalum, which operates and develops facilities to produce electricity in renewable energy, invested in photovoltaic (PV) power plants through its subsidiaries and special purpose vehicles. In making its investment decision, Cavalum relied on RD 661/2007 and RD 1578/2008 that, according to the investor, guaranteed that its PV installations would obtain incentive tariffs at fixed amounts for a period of 25 years and 80% of these fixed amounts would be secured for the remaining lives of PV plants. However, as a result of the tariff deficit, between 2010 and 2014 Spain adopted a series of measures (the disputed measures)  that reduced and ultimately reversed the special regime created for producers in the renewable energy sector established by RD 661/2007 and RD 1578/2008. To exemplify, in 2014 the new regulatory regime replaced the system of fixed returns with a non-fixed rate of return, which has to be updated every six months according to prevailing interest rates. Since 2007, interest rates have significantly declined and hence, the latter measure adopted in 2014 had substantially reduced the investors’ profits. 
In 2016, Cavalum (the claimant) initiated an investment claim against Spain under the Energy Charter Treaty (ECT), arguing that the value of its investments had been destroyed because of the State’s modification of the regulatory regime. The claimant alleged that Spain had violated the fair and equitable treatment (FET) standard under Article 10(1) ECT by: (1) frustrating its legitimate expectations; (2) altering the investment framework in a fundamental manner; (3) treating the investor non-transparently, inconsistently and, in bad faith. 
In this blog, I discuss the tribunal’s assessment of the legitimate expectations based on the stability of a regulatory framework with the focus on the role of an investor’s due diligence.
The reasoning of the Tribunal
The majority of the tribunal rejected the principal claim of the investor concerning the violation of its legitimate expectations arising out of a change in a regulatory framework that led to a reversal of the special regime set up by RD 661/2007 and RD 1578/2008. The majority found that the claimant only had the legitimate expectation to receive a ‘reasonable rate of return’ on its investments as guaranteed by the Law 54/1997, which was the material legislation at the moment of investment[LJ1] . The Tribunal supported its position by relying on several judgments of the Spanish Supreme Court that have upheld the principle of the ‘reasonable rate of return’. 
Legitimate expectations arising out of stability and the state’s right to regulate
As a starting point, the Tribunal asserted that the notion of stability is a part of the legitimate expectations of an investor under the FET standard, and not a separate obligation under Article 10 (1) of the ECT. In the words of the tribunal, the obligation of stability has ‘a relatively high threshold’ and only protects against fundamental changes. The latter formulation is consistent with many previous decisions concerning the obligation of stability (discussed here), where there generally is a consensus among Tribunals that only drastic modifications to the regulatory framework may rise to a level that entitles the investor to the protection of legitimate expectations.
Before proceeding to the assessment of the factual claim of the investor, the Tribunal outlined relevant considerations in weighing the legitimate expectations and the state’s right to regulate.  Firstly, the Tribunal stressed that the legitimate expectations are only those that are legally protected and hence, should be not mistaken with ‘reasonable business judgment.’ Secondly, a State is free to amend its legislation, which is a part of the State’s margin of appreciation.  The latter principle, reveals that ‘the State’s right to regulate is subject to a wide latitude, subject to its compliance with its duties under the ECT and customary international law.’  Also, according to the tribunal, the State is entitled to a ‘high measure of deference.’  Thirdly, under the ECT an investor cannot expect protection against any and all changes to the State’s legal framework. Under the FET standard, the expectations of an investor maybe subject to protection only if they are ‘(at least) reasonable and justifiable.’  Fourthly, ‘a reasonable market expectation (…), justified or not, is not a basis for shifting risks to the public sector, i.e., the state budget.’ In the absence of specific commitments provided by the host state, it is for the investor to anticipate and assess the possible risk of change to a regulatory framework. Finally, an investor cannot expect the freezing of the legal and regulatory framework and it would be “inconceivable that a state would make a general commitment never to change its legislation whatever the circumstances, and it would be unreasonable for an investor to rely on such a freeze”, especially upon changing needs, or in a time of crisis. The Tribunal further elaborated that these changing needs result from an evolutionary nature of various circumstances and problems in a host state, e.g. social, environmental, and legal. In order for a state to successfully provide public services, it should have the flexibility to adjust its policies under evolving circumstances. 
After laying down the framework for balancing the legitimate expectations of an investor and the State’s right to regulate, the Tribunal proceeded with the analysis of the legal and regulatory situation at the time of the investment and the disputed measures. In establishing whether the investor was entitled to the legitimate expectations based on the stability of the regulatory framework, the tribunal assessed the investor’s due diligence that is discussed below.
In Cavalum, the appraisal of the investor’s due diligence is a central factor in assessing the investor’s legitimate expectations based on the stability of the regulatory framework. In line with several recent renewable energy decisions (Charanne v. Spain, Isolux v. Spain, Stadtwerke München and others v. Spain, Antaris v. Czech Republic, Belenergia v. Italy, Hydro Energy v. Spain), the tribunal underlined that in “determining an investor’s legitimate expectations at the time of investment, the legal and commercial environment has to be considered in the light of the due diligence which an investor can be expected to undertake.” 
As I discussed here, Tribunals have different views on the extent of the required investor’s due diligence. However, in determining whether the investor has exercised sufficient due diligence, Tribunals generally evaluate the following factors: (1) the form and the content of the conducted due diligence; and (2) the foreseeability of changes in a host state that could be predicted by a diligent investor with the information available to him/them.
(1) The form and the content of due diligence
In Cavalum, the tribunal has evaluated the form and the content of the performed due diligence. The Tribunal asserted that the existence of legitimate expectations has to be examined in light of the information that the investor ‘knew or should reasonably have known’ at the time of making the investment.  The latter threshold implies that the investor is expected not only to conduct a basic commercial due diligence, but also obtain ‘a detailed knowledge of the legal system.’  This ‘detailed knowledge’, is expected to be obtained by an investor from qualified legal advisers. The claimant argued that he conducted sufficient due diligence by getting qualified advice from a Spanish consultant and through three law firms, two of which had advised the claimant’s bank. According to the claimant, none of these sources had warned him about the possible future changes in the regulatory framework. The tribunal disagreed with the investor that the changes were unforeseeable. Firstly, the tribunal pointed out that the Spanish consultant had never practiced law and therefore was not authorized to give legal advice. Furthermore, the claimant had not inquired legal advice on the stability of the regulatory framework. Secondly, the scope of the legal due diligence provided to the claimant by the law firms was limited to specific issues, e.g. legal compliance, urban planning and, real estate.  These firms were not asked to provide advice on the wider issue of stability of the regulatory framework relied on by the investor.
The formulation of what a due diligence should entail in Cavalum is in line with the decisions in Hydro Energy v. Spain,  Belenergia v. Italy, Charanne v. Spain, Stadtwerke München and others v. Spain, where the tribunals required an appraisal of the risks related to the applicable regulatory framework as a part of an investor’s due diligence. For example, in the recent decision in Hydro Energy v Spain (2020), similar to Cavalum, the claimants that relied on the advice of law firms argued that none of their advisers predicted the possibility of changes to the regulatory framework. The tribunal in Hydro Energy v Spain was not convinced by the claimants’ arguments. The tribunal pointed out that despite the fact that an investor was relying on the legal expertise of three prominent law firms, the ‘claimants never sought, nor received, advice on regulatory risk.’ According to the tribunal, the ‘Claimants deliberately avoided being advised that regulatory changes could be made.’ Using the same threshold as in Cavalum, the tribunal in Hydro Energy emphasized that in determining the extent of an investor’s due diligence, it is essential to asses “in particular whether, for example, (1) the investor investigated or took advice on the host State’s applicable law (…).”
(2) The foreseeability of changes in a host state
The Cavalum tribunal elaborated on the type of information about the regulatory framework that should have been taken into account by the investor when making the investment decision.
The tribunal relies on several decisions of the Spanish Supreme Court,  as justification for the foreseeability of the changes to the state’s regulatory framework. By taking the Supreme court judgments into account, the tribunal emphasized that under Spanish law the Supreme court determined that at the time the investor made their investments, the alterations to the special regime regulating incentives were lawful in the event they were made within the framework of Law 54/1997. 
By placing importance on the national law and in particular the national judgments, Cavalum follows several previous Spanish investment cases (Isolux v. Spain, Charanne v. Spain, Hydro Energy v. Spain) in asserting the relevance of inquiry into the national law in predicting regulatory changes. This contrasts with SolEs v. Spain, OperaFund v. Spain and Cube v. Spain, in which the tribunals took a restrictive approach to the relevance of the Supreme Court judgments. In SolEs v. Spain, the Tribunal was of the view that the Spanish judgments should be approached with caution, as they were based on Spanish law and not the ECT. 
The tension between the state’s right to regulate and the legitimate expectations of the investor tends to arise when the stability of an investor’s investment is undermined by a state’s measures (further elaboration here). The Cavlalum tribunal has resolved this tension by first clarifying, and then, weighing the various considerations relevant for the assessment of the legitimate expectations and the state’s right to regulate. Following previous cases, the tribunal has compiled and clarified the definition of the state’s right to regulate under the FET standard. It provided that the state has the right to amend its laws that constitutes a part of the state’s margin of appreciation and that the state in its regulatory actions is entitled to a high measure of deference. The tribunal does not really elaborate on these doctrines, except an observation that the state’s margin of appreciation conveys a ‘wide latitude’ of the state’s regulatory powers, which however is subject to the compliance under the ECT and customary international law.  This leaves the question of what type of measures fall under the margin of appreciation and are still in compliance with the FET under the ECT open. As follows from the Tribunal’s analysis, the Spanish measures that amounted to a replacement of an incentive system were taken in public interest  and fell under the state’s margin of appreciation. An explicit reference to both: the margin of appreciation and a high measure of deference demonstrates the weight placed on the state’s right to regulate by the tribunal while balancing of the commercial interests of an investor under the ECT.
A noteworthy part of the Cavalum decision concerns the investor’s due diligence. The decision contributes to the further clarification of the due diligence obligation of a foreign investor, to which arbitral tribunals have been increasingly referring in the latest cases.
Firstly, the decision affirms that the existence of an investor’s duty to conduct due diligence as a part of a balancing exercise in assessing the legitimate expectations of an investor and the state’s right to regulate. Secondly, the tribunal articulates that the investor’s due diligence should constitute a legal due diligence that also includes an appraisal of the regulatory framework relied on by the investor. The latter threshold for the required due diligence is higher in comparison to several other renewable energy decisions e.g. Watkins v. Spain, SolEs Badajoz v. Spain, Cube Infrastructure v. Spain and Novenergia v. Spain, where tribunals have not posed any specific requirements to the form of due diligence and the necessity to obtain legal advice on the risk of modifications to a regulatory framework relied on by the investor. Thirdly, the Cavalum decision reaffirms the relevance of the domestic judicial decisions pertaining to forecast the predictability of modifications of the regulatory framework. As the Cavalum Tribunal puts it “‘Business people will not necessarily be expected to know about such judicial decisions, but their lawyers, especially well-known experts in international commercial law and Spanish energy and administrative law, can properly be held to a standard of knowledge in respect of such decisions.” 
Dr. Yulia Levashova (Assistant Professor, Nyenrode Business University, Associate Research Fellow, Utrecht University)
Preferred Method of Citation – Julia Yevashova, ‘Cavalum v. Spain: Legitimate Expectations of an Investor with a Focus on Due Diligence’ (ICAR, 24 September 2020) <https://www.investmentandcommercialarbitrationreview.com/post/cavalum-v-spain-legitimate-expectations-of-an-investor-with-a-focus-on-due-diligence>.
 Cavalum SGPS, S.A. v. Spain, ICSID Case No. ARB/15/34 (Decision on Jurisdiction, Liability and Directions on Quantum, 31 August 2020).
 Cavalum v. Spain (2020), ¶ 84.
 Cavalum v. Spain (2020), ¶ 457.
 Cavalum v. Spain (2020), ¶ 459.
 Cavalum v. Spain (2020), ¶ 459 (8).
 Cavalum v. Spain (2020), ¶ 216.
 Cavalum v. Spain (2020), ¶ 601.
 Cavalum v. Spain (2020), ¶ 405.
 Ibid, ¶ 406.
 Ibid, ¶ ¶ 418 – 430.
 Ibid, ¶ 418.
 Ibid, ¶ 419.
 Ibid, ¶ 430.
 Ibid, ¶ 424.
 Ibid, ¶ 420.
 Ibid, ¶ 422.
 Ibid, ¶ 428.
 Cavalum v. Spain (2020), ¶ 470.
 Cavalum v. Spain (2020), ¶ 538.
 Cavalum v. Spain, ¶ ¶ 471-472.
 Cavalum v. Spain (2020), ¶ 520; ¶ ¶ 523-527.
 Hydro Energy 1 S.ÀR.L. Andhydroxana Sweden AB v. Spain, ICSID Case No. ARB/15/42 (Decision on Jurisdiction, Liability and Direction on Quantum, 9 March 2020).
 Hydro Energy v Spain, ¶ 616.
 Hydro Energy v Spain, ¶ 617.
 Hydro Energy v Spain, ¶ 601.
 Cavalum v. Spain, ¶ ¶ 510-515.
 Cavalum v. Spain, ¶ 530.
 SolEs Badajoz GmbH v. Kingdom of Spain, ICSID Case No. ARB/15/38, Award, 31 July 2019, ¶ 430.
 It should be noted that almost an identical framework for the assessment of the legitimate expectations and the state’s right to regulate has been included in the Hydro Energy v. Span, a decision published a few months earlier than Cavalum v. Spain. In both cases, Lord Collins of Mapesbury was a presiding arbitrator.
 Cavalum v. Spain, ¶ 430.
 Cavalum v. Spain, ¶ 615 and ¶ 620.
 Cavalum, ¶ 531.
The views and opinions expressed in the article are those of the author(s) solely and do not reflect the of official position of the institution(s) with which the author(s) is /are affiliated. Further, the statements of the author(s) produced herein should not be construed as legal advice.