Herfried Wöss
Wöss & Partners
View from the Top

CNH Must Take Crash Course in Contract Law

Wed, 01/21/2015 - 11:59

Q: What are the main legal issues Mexico must tackle to satisfy international oil and gas players?

A: In Latin America, it is common to see contractual interference because of political changes, which are a form of unavoidable political risk in the region. The French legal system is a good point of origin for the Mexican legal system but Mexico has its own particularities. For contracts in the oil and gas sector, all parties have to be sure risks are properly dealt with and that there is a clear avenue to arbitrate any conflicts. Mexico has excellent tribunals but it does not have highly specialized judges that understand infrastructure projects, such as those found in the oil and gas industry. However, Mexico has abandoned the administrative contract regime, with the exception of the administrative rescission of project agreements under the PPP and the Hydrocarbons Law, as well as public works and acquisition contracts. This means everything is now based on commercial law. This grants far more commercial freedom for contracts but, in order to make these agreements work, they must carefully fit international best practice contract models. There are strong models for such contracts for the upstream and downstream segments that have worked in the Anglo-American legal system, which must now be adapted to the challenges of the French-Mexican-Latin American system. The next phase is to ensure proper contract management, including dispute prevention and resolution through dispute boards consisting of one lawyer and two engineers or project experts. Mexico has already successfully used dispute boards to resolve such disputes in the healthcare field, for example. Finally, the oil and gas industry will require a sophisticated dispute resolution process to handle complex arbitration issues. Without these issues being clearly resolved, a significant percentage of potential investors will not come to Mexico.

Q: What could the Mexican government do to reduce risk, political or otherwise, in order to make Round One more attractive?

A: The preparation of the Hydrocarbons Law is crucial. For example, certain elements of the French legal system should be incorporated to allow the state to interfere into the contractual equilibrium against the payment of a fair indemnification. If the state has the power to interfere in contracts, the law should include reasonable compensation formulas, particularly in the case of administrative rescission in order to eliminate political risk. The state or public company should always be able to terminate the contract. Perhaps the state runs out of money or oil prices go down and a project is no longer viable or needed. In that scenario, the state can stop the project but must pay an indemnity determined by reasonable compensation formulas. There are good models for this in the UK and France. Next, the state can choose to terminate a contract or to expropriate a project in the name of public interest. However, such an action must be backed up by the determination of the indemnification or compensation through an independent arbitration tribunal. This happened in Lima, Peru, where the airport was too close to the sea to be expanded without expropriating restaurants that were in the way. After a decade of failing to do so, the government made the unilateral decision to expropriate the restaurants through acts of authority but stated that the proper indemnity would be determined by an independent arbitration tribunal. The indemnities were sorted out in a year and the new runway is being built. This is a fine example of combining the government’s right to expropriate with a reasonable compensation formula. Using such an arbitration model in Mexico would go a long way toward reducing risk. There are major political and historical reasons for why the Mexican state should retain control over natural resources but, in this case, the secondary laws must make issues related to rescission and compensation very clear. This may be the most essential issue of the entire Energy Reform.

Q: Given its relative inexperience, how should CNH prepare to properly administer all the contracts with very experienced oil and gas companies?

A: This is a concern which CNH can mitigate by putting together legal teams from the top law firms and ensuring a transfer of knowhow. The government entities and the new productive enterprise of the state must ensure that their legal teams include a synergy of international experience and local knowledge. The origins of the Mexican legal system date back to the French legal system, which means that certain concepts of Anglo-American law simply do not work under Mexican law, so model contracts have to be carefully adapted. The US$300 million Commisa v. PEMEX case is a clear example of how systemic aspects may lead to rather unwanted results, such as the annulment of an award due to the violation of ordre public caused by parallel litigation. This means the authorities will have to work extra hard to get the legal advice they need. However, there is little time for CNH to build up its own capacity. It must therefore hire the right legal teams that understand Mexican and international petroleum law, that have experience in major law suits, that have faced environmental problems, and understand intellectual property rights for technology protection. Because of this change from a protective legal environment where the administrative contract states how an oil exploration contract has to be formulated, CNH suddenly faces a background where operators have legal experts in international contract models, or even experts who are specialized in particular clauses of a contract. It will now have to be very quick in assembling the right legal teams to deal with this.

Q: If you were hired as a legal consultant for CNH, how would you advise it to build up this legal capacity?

A: In such a scenario, we would team up with another highly specialized boutique firm and tailor-make a team with enough authority to handle negotiations, contracts, and regulatory work. We have an outside the box philosophy as we do not seek to become a massive law firm. For the last 20 years, we have formed agile teams consisting of the best lawyers for the topic at hand. This is very different from the old model where PEMEX would hire huge firms to work on contracts and would end up paying very high fees in exchange for standard services which did not address subtleties.

Q: How much time does a company interested in participating in Round One have to prepare itself legally, and what mistakes can you help them avoid?

A: Companies should have started preparing for Round One at least one year in advance but this is difficult since the information they needed was not available that far ahead of time. They should also get a good lawyer to identify the main risks and how to control them. Although they cannot control elements that might change over the timeframe of the contract, they can add state-of-the-art stabilization clauses. For these clauses to work, companies must identify the factors that may change over the lifespan of the contract and assign the risk of change to one of the parties. Thus, when such a change happens, the parties are properly compensated to keep the project bankable. Such stabilization clauses for key issues mean that companies know the risks and participate in projects. To keep its contracts alive, CNH must ensure they include good adjustment mechanisms made up of state-ofthe-art clauses.

Q: Companies might want to customize their contracts while CNH will seek to keep them standardized. Where should the balance be set between these two options?

A: The most important issue here is the standardization of contracts, which must be done according to international models. These models show whether the risk should be more on the side of the contractor or of the government. A successful project must have a balanced contract so it cannot be tipped too far either way. Furthermore, an adjustment mechanism is needed within the contract to anticipate any possible changes. These contracts are almost living entities; one cannot predict what they will look like in 30 years, meaning the adjustment mechanism must be very well done. For example, a good contract must take into account technological changes that will occur throughout the life of the contract. Other elements must also be accounted for, such as the tendering party carrying out a thorough risk analysis of the contract or the inclusion of a claims management section. In Mexico, many claims have been sorted out through time extensions. This would happen, for example, if a right of way was not granted in time, which means the contract’s timeframe would be extended to account for that. All these elements mean a good contract takes at least a year to make. Related to this, we need highly efficient and competitive tender procedures. A recent tender put forward by CONAGUA for its informatics system involved a 1,000- page document whereas the average World Bank tender document is only 40 pages. Mexico must understand state-of-the-art tender procedures are about quality, not quantity, and involve a completely transparent attitude from the authorities. As for hydrocarbons, the authorities are not highly experienced and must get the right procedures from international standards, especially given the limited timeframe. They must create a working group of international experts, lawyers, and academics that can guide the Mexican government through the pitfalls that lie in its way as it implements the Energy Reform.

Q: Do you see the drop in the oil price as a challenge or an opportunity for the Mexican oil and gas industry?

A: While many are afraid of the drop in oil prices, we should seize this opportunity to begin producing oil derivatives. If selling oil is not as profitable, why not build up industries such as chemicals, pharmaceutical, and others whose products derive from oil? The development of the Mexican automotive industry, which was far from easy, should be replicated for industries that use oil derivatives. Mexico is the ideal location to do this but it has not capitalized on the opportunity. Instead of selling oil, Mexico could then develop new labor intensive value chains. We may have a prolonged slump if oil prices do not go up, but this strategy could be the future in Mexico.