Governance Risk in Kazakh Oil and Gas Joint Ventures

01Introduction

An international investor in a Kazakh upstream joint venture project almost never holds the subsoil license into which it ultimately invests. The subsoil use contract sits with a Kazakh JV company. The investor holds an interest in that company and must look for protections to a negotiated shareholders’ agreement, which is usually governed by a foreign law and referred to a foreign arbitral institution.

A disagreement between the joint venture partners may transmute into a license problem. In a deadlocked JV company, where the partners cannot agree, the company cannot approve the licence work programme or budget, nor take other actions required from it under the subsoil use contract. This leads to a breach of the subsoil use contract, and after a few breaches the licensing State may terminate the contract.

The cause of the deadlock does not matter: it can relate to issues of funding, strategy, a change of control, or arise when a partner that simply stops turning up for reasons of its own. The Government cares only about compliance with the subsoil use contract and is indifferent to the JV CO’s reasons for breaching its requirements. Below we follow the route from a stalled general meeting to a government termination notice, and look at where the usual joint venture documents fall short.

02The Asset You Own Is Not the Asset That Matters

In Kazakh practice the status of subsoil user is given to the JV corporate vehicle, not the investor. It is the vehicle that carries the obligations to fund, report, monitor and eventually wind up the use. The investor’s asset is equity in the corporate vehicle, and that asset is only worth what the subsoil use contract and any other assets held by the vehicle are worth.

Deadlock most obviously arises in cases with a 50:50 equity split. Yet it may also arise where a minority partner has a veto over the budget or any number of other key decisions, or where the board of directors goes into a stalemate. The same can happen where a voting partner simply stops coming to meetings. In some projects the split is set by law: where the national hydrocarbons company obtains a large field through direct negotiations, the Kazakhstan Subsoil Code requires it to hold an equity of fifty per cent or more.^[1]

There are two parallel legal realities here. The joint venture reality is private and contractual; relations between co-venturers are usually governed by foreign law and disputes are resolved by private arbitration. The licensing reality exists under the Kazakh public and administrative law. There, the JV company deals with a government ministry which has no reason to take an interest in the intricacies of the JV Co’s corporate governance.

03How a Stalled General Meeting Becomes an Upstream Contract Termination Notice

Under the subsoil use contract, the licensed JV company carries specific obligations in terms of annual work programme and budget, funding and reporting.^[2] Agreed terms of corporate governance may operate to require adoption of decisions by the general meeting or the supervisory board for the JV company to perform those obligations.

Once a decision-making deadlock arises, breaches start piling up. Performing less than thirty per cent of the contract’s financial obligations in a reporting year is a breach under the Subsoil Code.^[3] If the company does not cure the breach in time or fails to cure more than two breaches of other obligations, the competent authority may terminate the contract unilaterally.^[4] Termination takes effect by two months’ notice. The company may challenge the notice in court before expiry of those two months, and the issue of the challenge stops the clock until the judgment takes effect.^[5] But going to court is itself a corporate decision, and a deadlocked company may not be able to take it.

The problem is structural. Only the company can cure the breach, or challenge the termination, and it is the company that is paralyzed by the deadlock.

04The Charter and the Shareholders’ Agreement Are Equally Important

Investors negotiate hard over the terms of the shareholders’ agreement and often treat the corporate charter of the JV company as a filing formality. In Kazakhstan equal attention should be paid to the charter. The points below relate to a joint venture company formed as a limited liability partnership (LLP).

First, choosing a foreign law to govern the shareholders’ agreement may fail to disapply the Kazakh law. Under the Civil Code, the law of Kazakhstan governs the agreement on establishing a Kazakh company with foreign participation. That covers the transfer of interests in the company and other relations between participants about their mutual rights and obligations, including those set out in later agreements.^[6] An investor making a case to before an arbitral tribunal on the basis of English law as a contractual choice made in a shareholders’ agreement in relation to a Kazakh LLP should expect a counter-argument that Kazakh law governs the matter.

Second, the quorum rules are set out in the statute, and the charter will invariably replicate them. A first general meeting is quorate if attended by participants holding more than half of the votes, or more than two-thirds where by statute the matter needs a qualified majority or unanimity vote. The charter may raise voting thresholds, up to unanimity.^[7] Some matters, such as amending the charter and approving the company’s financial statements, are reserved to the general meeting and cannot be delegated to management.^[8]

Third, a voting boycott is not always as effective as a vote against. If a first meeting has no quorum, it must be called again within forty-five days, and the repeat meeting is quorate whatever the attendance percentage. With less than half of the votes present, the meeting may decide only matters that need a simple majority. But Kazakh Supreme Court guidance confirms that if those present hold at least half of the votes, the repeat meeting may decide even matters that require a qualified majority or unanimity.^[9] In a 50:50 company this may allow one partner to act alone while the other stays away. Much depends on how the charter sets voting thresholds. Whether a boycott should be capable of being overridden in this way is a drafting choice, and it is better made after consideration of all implications.

Fourth, the general director binds the JV company but cannot be replaced. The general director acts for the LLP without a power of attorney, and internal limits on his/her director’s authority do not bind a counterparty unless it is shown to have known of them.^[10] Only the general meeting can appoint or remove the director, and for no more than five years at a time.^[11] In a deadlock, nobody can remove a partisan director, and when the term ends nobody can appoint a successor, so the partisan director stays in office.

Fifth, Kazakh law has no deadlock-breaker, and the courts will not supply one. Under Supreme Court guidance, where participants cannot reach the required majority, a court may only review whether a decision actually taken was lawful. It may not decide the questions the meeting left open, because they are not a matter for the courts; participants must resolve the conflict themselves.^[12] Nor is deadlock a ground for liquidation of the company by order of the court under the Civil Code.^[13]

The one statutory tool is compulsory buy-out of a participant’s interest. To make the order, the court requires evidence of substantial harm caused by that participant, and the price of the buy-out is set at the market value of the interest, as determined by an independent valuer.^[14]

Staying away from meetings may or may not cause substantial harm. According to the Supreme Court, it may be enough if the charter makes taking part in management a duty of the participant, and the failure to do so blocks adoption of necessary decisions which causes the company substantial harm.^[15] Reported cases go both ways. In one, a court ordered the buy-out of a one-third interest from a participant who had not attended meetings and, for fifteen years, had mired the company in litigation that led banks to refuse loans. In another, a court refused to make an order on the basis that taking part in general meetings is a participant’s right, not an obligation.^[16]

05Resolution of a Corporate Dispute May Come after the Loss of Licence

A well-negotiated shareholders agreement in a deadlocked JV company will include deadlock provisions. Those will typically require notice of deadlock, a referral to senior executives, a negotiation period, and possible arbitration. Resolution of a deadlock may take time. Sometimes the deadlock may not be resolved at all, since arbitration typically decides legal disputes, not purely commercial disagreements.

Performance of subsoil license obligations is subject to strict deadlines set by the government. Termination of a subsoil use contract takes effect two months after notice. By the time the dispute clause produces a result (if it does), the contract may already have been terminated.

06Exit Is Not a Private Transaction

An equity interests in a subsoil user company, and in any parent company which determines its decisions, directly or indirectly, is an “object related to the subsoil use right”.^[17] A transfer of the equity interest transfer requires permission of the competent governmental authority, and the authority may apply to the court for an order to set aside a transfer made without permission.^[18] On strategic subsoil plots the State also has an overarching priority right to buy the interest, which will override contractual pre-emption rights.^[19]

So, in the case of a strategic subsoil plot a put option, an agreed deadlock buy-out or an arbitral award for a sale may be overridden by the State’s statutory right to acquire the interest.

Enforcement of private transfer is another issue. Kazakhstan has been a party to the New York Convention since 1996,^[20] and recognizing an award is usually the easy part. Turning it into a share transfer is harder. Kazakh procedure has no means of effecting a transfer over the transferor’s refusal.^[21] Nor is there an equivalent of the French astreinte, a court-ordered penalty payable to the claimant for each day of non-compliance. The enforcement officer can ask the court for a daily penalty, but it is payable to the State and capped by statute; persistent refusal can lead to administrative fines and, after six months, criminal liability of the defendant (which is rare in practice).^[22] This pressure may eventually result in your partner signing a transfer document, but you will not recover compensation for the delay.

07What Is Left When the Contract Goes

From the date of licence termination, the subsoil plot reverts to the State.^[23] The competent authority then chooses one of three options: liquidating the consequences of subsoil use, conserving the plot for a later award to someone else, or transferring it into trust management of the national hydrocarbons company.^[24]

In every case the joint venture company keeps its liabilities for liquidation obligations, loans from the partners, and creditors. The equity is usually worthless while the obligations survive.

08Investment Treaty Claims: What the Caratube Cases Show

Investment treaties protect foreign investors against the host State, not against their own commercial partners. A deadlock between private partners is not a treaty matter. A treaty becomes relevant when the State acts unlawfully – typically, when it terminates the contract or refuses a transfer. The two Caratube arbitrations against Kazakhstan show how that protection works in practice.

Who can claim. In the first Caratube case, a Kazakh company holding an exploration and production contract brought a claim under the US–Kazakhstan bilateral investment treaty. The tribunal declined jurisdiction. The US shareholder in the claimant had bought 92 per cent of its equity for a nominal price, and there was no evidence that he actually controlled the company or had contributed anything or taken any risk.^[25] An annulment committee upheld the award.^[26] A joint venture company, whose control is shared by design, may find it even harder to show foreign control, so the foreign partner should expect to have to bring its own claim in its own name. Tribunals generally allow that: shareholders, including minority shareholders, may claim for State-imposed measures that damage the investment vehicle company and thereby reduce the value of their shares.^[27]

In the second case the same company succeeded by a different route. Its subsoil use contract contained an ICSID arbitration clause, which the tribunal treated as an agreement that the company would be regarded as a foreign national. The US shareholder’s own claim failed, because the statute he relied on had been repealed before he bought his shares.^[28]

Which entity is protected, under which instrument and from when is a question to be considered on entry, not after termination.

Termination for breach. The majority in the second Caratube case held that a breach of contract is not enough; the State must have used its sovereign powers. It found that the ministry had acted on a prosecutor’s “recommendation” as if it were an instruction to terminate, and that Kazakhstan had not shown a material breach by the company. The termination was an unlawful expropriation, even though the tribunal accepted that the company’s performance had been sub-standard.^[29] One arbitrator dissented, finding that the State had acted as an ordinary contracting party.^[30] For a deadlocked joint venture the lesson is uncomfortable. If the company has in fact stopped performing and the ministry terminates through the ordinary contractual procedure, then it will likely be seen as a contracting party enforcing its contract, which is no basis for a treaty claim.

If your partner is the national company. Its conduct is not automatically attributable to the State. State ownership and control are not enough; the investor must show that the company exercised governmental authority or acted on the State’s instructions or under its direction or control.^[31] Tribunals have refused attribution where a state-owned company acted in its own commercial interests.^[32]

How much. In the second Caratube case, the company claimed about USD 941 million. The majority rejected the claim for lost profits, because there had been no commercial discovery and the reserves reports rested on an inadequate seismic study. An award was made for sunk costs of USD 39.2 million, with interest.^[33] Compensation for loss of a project before commercial discovery is usually limited to compensation for sunk costs.

09Practical Actions

1. Map out every material obligation under the subsoil use contract opposite the corporate decision that its performance requires and make a list of those which cannot be taken without the other partner’s vote. That list is your exposure.

2. Put governance mechanics in the corporate charter to replicate the shareholders’ agreement: an annual budget that rolls over to the next year if no new one is approved, rules for repeat corporate meetings, alternate signatories, and standing authority for making statutory filings and corresponding with the regulator.

3. Make taking part in management a duty of each participant under the charter. That gives access to the remedy of a forced buy-out in case of corporate sabotage.

4. Create fast track decision mechanics, with timeframes measured in days, for anything that must meet a statutory deadline, and align deadlock escalation timetable with the shortest regulatory deadline it may have to meet.

5. Keep the regulator apprised of any developments. Early engagement and a documented plan to cure breaches carry real weight.

6. Design exit mechanics to complete without the partner’s cooperation and mind the need for transfer permission and the State’s priority acquisition right.

7. At entry, decide which entity holds the investment, and which treaty or contract protections will be available. Keep evidence of actual control, contributions and assurances given by the State when the project was awarded.

10Conclusion

An unresolved private disagreement between partners may trigger regulatory consequences. Contractual and treaty investor protections will not assist when the subsoil licence is lost for breach of regulatory obligations.

The answer is the use of joint venture governance mechanics that can keep the joint venture company compliant with the licence regulations while the partners sort out their disagreements.

The law is stated as at the date of publication and by reference to publicly available sources. This document is provided for general informational purposes only and does not constitute legal advice. Neither Akta FZC nor any of its employees accepts responsibility for any action taken or not taken in reliance on it. For considered advice tailored to your specific circumstances, please contact Akta FZC.