Principles and practices of full compensation in international arbitration

Introduction

The primary objective for a party seeking arbitration after suffering damages is often to obtain the maximum possible compensation. This goal is rooted in the principle of full compensation, a cornerstone in most legal systems, international standards and international law.^[1]

This chapter explores key issues surrounding the notion of full compensation in both domestic legal systems and international law. For domestic legal systems, the UNIDROIT Principles of International Commercial Contracts (the UNIDROIT Principles)^[2] serve as the starting point, representing a balanced compromise between various national laws. In the context of international law, we focus on the International Law Commission’s (ILC) Articles on Responsibility of States for Internationally Wrongful Acts (ARSIWA)^[3] and then the case law of investment arbitration tribunals, which frequently apply principles of public international law to resolve disputes between private parties and states.

We first examine principles pertinent to commercial arbitrations, following the structure of the UNIDROIT Principles. This section begins with an analysis of causality, a fundamental element in determining compensation in any adjudication. We then address the issue of foreseeability, and finally, within the framework of these two concepts, we analyse the scope of full compensation. These issues are closely tied to the concept of the ‘but-for’ premise, which are referenced throughout these sections.

The discussion then shifts to the principles of full compensation under international law. For this section, the point of departure is ARSIWA, with a particular focus on their application by investment arbitration tribunals. In this section, we first treat the concepts of causality and foreseeability together and then discuss the scope of full compensation. As part of the discussion on the scope of compensation, we also discuss certain relatively more discretionary factors, such as the circumstances surrounding the violation and contributory fault by the investor affecting the determination of a tribunal.

Full compensation in domestic legal systems

The concept of full compensation is a fundamental principle in both domestic legal systems and international law, reflecting the underlying goal of restoring the injured party to its pre-damage state. Therefore, various legal systems, despite their differences, share common principles regarding compensation, especially with regard to foreseeability, causality and the necessity of making the injured party whole.

In civil law countries such as Germany and France, the principle of full compensation is included in the statutory provisions. The German Civil Code specifies that a person who is obliged to pay damages must restore the condition that would exist if the circumstance obliging them to pay damages had not occurred, which includes both actual damage (damnum emergens) and lost profits (lucrum cessans), ensuring comprehensive coverage of losses.^[4] Similarly, the French Civil Code mandates full compensation for the harm suffered, including both material and moral damages, thus emphasising restitution to the pre-damage state while tailoring the amount through pillars of foreseeability and causality.^[5] In contrast, common law systems approach full compensation through a combination of statutory provisions and judicial precedents. The US legal system allows for compensatory damages to cover actual losses and punitive damages in certain cases of gross negligence or intentional misconduct.^[6] Although the UK system is generally more conservative with punitive damages, it also emphasises compensatory damages that cover both economic and non-economic losses, guided by case law and judicial discretion.^[7] In Singapore, another common law jurisdiction, principles of causation and remoteness of damage are recognised in the jurisprudence and are applied meticulously, subject to judicial discretion.^[8]

The aim of the UNIDROIT Principles is to provide a harmonised framework that bridges the gap between different legal traditions and to create a universally acceptable set of guidelines.^[9] They have inspired several national legislatures in reforming their domestic contract laws.^[10] Both arbitrators and domestic courts increasingly reference the UNIDROIT Principles in their decisions, applying them as the governing rules of law,^[11] either because of an explicit choice by the parties or a reference in the contract to ‘general principles of law’, lex mercatoria or similar terms, since arbitrators generally consider the UNIDROIT Principles as a particularly authoritative expression of supra-national or transnational principles and rules of law.^[12] Additionally, the UNIDROIT Principles have been used by domestic courts and arbitral tribunals to interpret international uniform law instruments, such as the United Nations Convention on Contracts for the International Sale of Goods (CISG), and to adopt a more internationally oriented approach under applicable domestic law or to fill gaps in the latter.^[13] Furthermore, the UNIDROIT Principles’ comprehensive approach to the scope of full compensation, encompassing direct and indirect damages while excluding punitive damages in most cases, reflects a balanced view that resonates with various legal systems.^[14] It can also serve as a reliable foundation for arbitration and litigation, guiding decision makers in awarding fair and equitable compensation. As such it constitutes a good point of departure to examine the principles relating to the concept of full compensation because either it is directly applied by arbitral tribunals or it reflects the common approach in the legal systems that frequently serve as the applicable law in commercial arbitrations.

Key issues

Causality

Every country imposes limits on damages, although these vary from jurisdiction to jurisdiction. Generally, claimants can only recover losses that were directly caused by the breach and were foreseeable as likely consequences of the breach.^[15] Commonly, to obtain damages, a causal link between the breach by the defendant and the loss suffered by the claimant is essential. The conceptual origins of causality trace back to the Roman legal maxim in jure causa proxima non remota inspicitur (the cause of the injury must be proximate, not remote).^[16] The claimant can only recover damages for losses directly caused by the defendant’s actions, not for those arising from independent causes.^[17]

The basic method for understanding causality is the universally recognised ‘but-for’ or condicio sine qua non (a condition without which not) test for causation, a basic principle in legal analysis which asserts that a defendant’s action is a cause of a loss if that loss would not have happened without said action; conversely, if the loss would have occurred regardless of the defendant’s action, then it cannot be considered a cause.^[18]

In common law countries, the theory of ‘proximate cause’ is used, which establishes a legal causal link between two events only if the first event, as a necessary condition for the second, was sufficiently close to be legally significant. Similarly, the ‘substantial factor’ test in the United States and the Anglo-Canadian ‘material contribution to the risk’ test hold defendants liable if their negligence is a significant but-for cause of the claimant’s injury.^[19] In civil law systems, the concept of proximate cause is reflected in the terms ‘direct’ and ‘indirect’, used in France and in jurisdictions influenced by France to determine the recoverability of damages.^[20] Another civil law theory, the adequacy theory, seeks to limit but-for causes by recognising only those factors likely to produce the type of result that actually occurred.^[21]

Foreseeability

Under the foreseeability requirement, a defendant is not liable for a loss that was not reasonably foreseeable as a result of the breach at the time the contract was formed.^[22] French law, which has served as the primary source for other jurisdictions on the foreseeability requirement,^[23] codified this requirement as follows ‘the debtor is only bound for the damages and interest which were foreseen, or which might have been foreseen at the time of the contract, when it is not in consequence of his fraud that the obligation has not been executed’.^[24]

Under English Law, the foreseeability requirement is known as the Hadley v. Baxendale (1854) rule.^[25] In this case, Judge Sir Edward Hall Alderson laid down a rule on damages in breach of contracts as follows:

Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.^[26]

Similarly, the Restatement (Second) of the Law of Contracts, which stipulates the foreseeability rule under US law, excludes damages for losses ‘that the party in breach did not have reason to foresee as a probable result of the breach when the contract was made’.^[27]

Likewise, Article 74 of the CISG limits the award of damages to foreseeable loss.^[28] As such, foreseeability is a crucial factor for any assessment regarding the question of whether there is compensable damage and what should be the extent of the compensation.

Scope of full compensation

Contractual remedies are based on the premise that the injured party should be fully compensated for the breach.^[29] Full compensation is based on ‘the basic philosophy . . . to place the injured party in the same economic position he would have been in if the contract had been performed’.^[30] As noted above, the definition of full compensation in the UNIDROIT Principles covers both direct and indirect damages, and excludes punitive damages, similarly to Article 74 of the CISG.^[31] Likewise, under English law, punitive damages are not awarded for breach of contract.^[32]

The principle of freedom of contract allows the introduction of limitation and exclusion of liability clauses that allow contractual parties to pre-emptively define the extent of the defendant’s liability, limiting the full compensation principle in the event of a breach.^[33] These clauses are valid in most civil and common law jurisdictions except in cases of unlawful intent, gross negligence or contravention of mandatory norms.^[34] Under the UNIDROIT Principles, such clauses are valid except in the case of gross unfairness.^[35]

Contract law balances the principle of full compensation with competing principles through a general causation requirement and limitations on damages, such as foreseeability.^[36] These rules address different aspects of causation, inherently limiting the scope of full compensation to ensure fairness between the parties.

Full compensation in public international law

In international investment arbitration, public international law principles are fundamental in resolving disputes between private parties and states. For instance, most investment treaties do not contain a provision dealing with compensation save for expropriation provisions or clauses regarding damages resulting from war, armed conflict or national emergencies.^[37] Therefore, it has been widely accepted that tribunals should apply international law principles on reparation for wrongful acts when determining compensation for breaches.^[38]

Central to these principles is the concept of full compensation, emphasising the restoration of the injured party to its original position had the breach not occurred. The seminal Permanent Court of International Justice case of Factory at Chorzów^[39] established the doctrine that reparation must ‘wipe out all the consequences of the illegal act and reestablish the situation which would, in all probability, have existed if that act had not been committed’.^[40] The Chorzów requirement that compensation must ‘wipe out all the consequences’ of the breach is akin to the ‘but-for’ premise in commercial arbitration, which aims to place the injured party in the situation they would have been in if the breach had not occurred.^[41] Therefore, from the moment the breach occurs, compensation should place the injured party in a position such that there is no difference between receiving a monetary award and obtaining specific performance, compensating for the economic consequences of the breach.^[42] In practice, tribunals usually ask what the financial position of the injured party would be, in all probability, if the unlawful act or omission by the respondent had not been committed; the difference between this hypothetical position and the actual financial situation in which the claimant finds itself following the breach is equal to the damage caused, which, according to the principle of full reparation, must be compensated in its entirety.^[43]

The Chorzów principle has guided the assessment of damages and was later codified by the ILC under the ARSIWA, particularly Article 31, which provides critical guidelines for reparation, including restitution and compensation.^[44] The ARSIWA outline the general obligation of reparation as a direct consequence of a state’s responsibility, stemming from the breach itself rather than being a right of the injured state, which arises automatically upon committing an internationally wrongful act and is not dependent on a demand from any state.^[45] The term ‘injury’ includes both material and moral damage caused by the wrongful act, excluding abstract concerns or general state interests where the provision emphasises the need for a causal link between the wrongful act and the injury, specifying that reparation is owed only for injuries directly resulting from the wrongful act.^[46] This excludes injuries that are too remote or consequential, with criteria such as directness, foreseeability or proximity being applied variably depending on the breach. The requirement for a sufficient causal link is embedded in Article 31, mandating that the injury must be a consequence of the wrongful act without specifying a particular qualifying phrase.^[47]

Although both the UNIDROIT Principles and Article 31 of the ARSIWA address the notion of full compensation, they differ in scope and application. The UNIDROIT Principles are designed for international commercial contracts and aim to restore the injured party to the position it would have been in had the contract been performed correctly. The framework of the UNIDROIT Principles emphasises a direct causal link between the breach and the damage, often using the ‘but-for’ test, and limits compensation to foreseeable losses at the contract’s formation. In contrast, the ARSIWA deal with state responsibility for internationally wrongful acts, requiring full reparation to ‘wipe out all the consequences’ of the breach, which include restitution, compensation and satisfaction, addressing both material and moral damages. The ARSIWA approach to causality focuses on comprehensive reparation, without explicitly limiting compensation to foreseeable damages, aiming to fully restore the injured party as if the wrongful act had not occurred. Although the UNIDROIT Principles are commercially oriented, ensuring fairness in contractual relationships, Article 31 of the ARSIWA provides a broader, more inclusive approach to state responsibility and reparation.

The primary medium of application for the law of responsibility relating to the full compensation principle, not surprisingly, is investment arbitration cases, given the role of monetary damages in these cases. Although such cases involve both elements of public international law and commercial contracts whose applicable law is usually a particular domestic law, more often than not principles of state responsibility govern the issue of damages both in terms of methodology and quantum. Therefore, the following sections provide explanations regarding the concepts of causality, foreseeability and the scope of compensation from the lens of the law of state responsibility as applied by the investment arbitration tribunals.

Frequently, causation is a focal point of contention between investors and host states. The latter frequently assert that there is no causal link between their actions and the investor’s claimed injury or damage, blaming external factors instead. The causality discussions are often critical in investment arbitration cases because investment disputes often arise in contexts with global consequences for businesses, such as economic crises, armed conflicts or political upheavals. These situations typically involve state actions, creating fertile ground for causality contention.

Key issues

Causality and foreseeability

Causality has several functions in international law, including establishing the liability of a state and determining the compensation owed by a state.^[48] According to Article 31 of the ARSIWA, the establishment of a causal link is essential to the definition of ‘injury’ in international law as it must be shown that the damages claimed are part of the ‘injury caused by’ the internationally wrongful act of a state.^[49] The ILC noted that the standard of causation may vary between different primary rules of conduct and decided not to define a specific causal link as a general principle.^[50]

Investment arbitration tribunals have held that if an investor cannot prove that an injury was caused by the alleged breach of an investment treaty, the result may be a finding of liability without any award of damages.^[51] In Biwater v. Tanzania, for instance, the tribunal found that Tanzania had breached the bilateral investment treaty (BIT), but ruled that the claimant was not entitled to monetary damages because the investment had already lost value as a result of actions, some of which the investor itself had taken, prior to Tanzania’s breaches, and that therefore there was no causal link for the damages claimed.^[52]

Although investment tribunals use a variety of standards and methodologies to address the causality requirement, states rarely provide specific guidance on this issue in their investment treaties.^[53] Treaties containing such provisions usually emphasise that the damages claimed must be causally linked to the breach of the investment treaty.^[54] For illustration, the China–Korea BIT defines the investment dispute as ‘a dispute between one Contracting Party and an investor of the other Contracting Party that has incurred loss or damage by reason of, or arising out of, an alleged breach of this Agreement with respect to an investment of an investor of that other Contracting Party’.^[55]

The test used most frequently for factual causality by the investment tribunals is the ‘but-for’ test; for example, the Chevron v. Ecuador tribunal noted that ‘[c]laimants must prove the element of causation – i.e., that they would have received judgments in their favor as they allege “but for” the breach by the Respondent’.^[56] The Clayton/Bilcon v. Canada tribunal stated that:

the test is whether the Tribunal is ‘able to conclude from the case as a whole and with a sufficient degree of certainty’ that the damage or losses of the Investors ‘would in fact have been averted if the Respondent had acted in compliance with its legal obligations’ under NAFTA.^[57]

In establishing the causal link between the conduct of the privatisation agency and the bankruptcy of the investors, the majority of the tribunal in Rand Investments v. Serbia found a clear causal link between the breach of the contract and the damage suffered by referring to Article 31 of the ARSIWA.^[58] In investment arbitration cases, claimed losses can result not only from specific acts but also from broader administrative and legislative actions. Tribunals often assess whether there is a causal link in such cases as well. For instance, in Glencore v. Bolivia, the tribunal identified a causal link between the decrees nationalising the investor’s assets and the alleged damages and awarded compensation to the claimant.^[59]

On the other hand, under both the ARSIWA and investment arbitration case law, foreseeability is not treated as a separate component in the assessment of compensation,^[60] which contrasts with the approach of the UNIDROIT Principles and most domestic legal systems. Instead, it is evaluated alongside causality as a criterion for establishing legal causation.^[61] For instance, the tribunal in CME v. Czech Republic concluded that causality can be established only if the damage to the investment ‘is foreseeable and occurs in a normal sequence of events’.^[62] Similarly, the tribunal in Olin v. Libya considered foreseeability as part of the proximate cause assessment.^[63] It is also possible to observe that some tribunals expressly rejected inquiries based on the foreseeability criterion to establish causation.^[64] The tribunal in Myers v. Canada rejected an argument based on foreseeability, stating that it is a concept of contract law and it may not be applicable for a measure taken by a state because states may not individually foresee the losses by an investor but they can nevertheless be held liable for their conduct affecting an investor if there is sufficient proximity.^[65]

Scope of full compensation

The Chorzów principle of full compensation requires that compensation must fully eliminate all consequences of an unlawful act and restore the situation to what it would probably have been had the act not taken place. This principle is generally included in the expropriation clauses of investment treaties,^[66] which also apply to other standards of protection.^[67] The Amco v. Indonesia tribunal also established that the scope of full compensation includes both actual losses (damnum emergens) and lost profits (lucrum cessans).^[68]

Moral damages are also compensable, as stated in Article 31(2) of the ARSIWA: ‘[I]injury includes any damage, whether material or moral, caused by the internationally wrongful act of a State.’^[69] The Desert Line v. Yemen tribunal observed that whereas investment treaties mainly protect property and economic interests, they do not exclude the possibility of claiming compensation for moral damages in exceptional cases and confirmed that many legal systems allow moral damages to be recovered in addition to material damages.^[70] However, the ‘threshold to award moral damages is high’ and ‘moral damages are an exceptional remedy’.^[71] Although it is an exceptional remedy, some arbitral tribunals have awarded moral damages to investors.^[72] On the other hand, punitive damages are not awarded by arbitral awards.^[73] The award of interest is also intended to ensure the injured party is fully compensated^[74] and also compound interest may be ordered if necessary to ensure full compensation.^[75]

There are several factors that can affect or limit claims for full compensation. Contributory fault, country risk and the degree of fault all play a certain role in the assessment of compensation. Article 31 of the ARSIWA commentary indicates that international practice and tribunal decisions generally do not reduce reparation for concurrent causes, ‘except in cases of contributory fault’.^[76] Similarly, Article 39 of the ARSIWA specifies that reparation must consider the injured party’s wilful or negligent actions contributing to the injury.^[77] Investment tribunals have held investors accountable for damages following decisions that increased business risks^[78] or their role in events leading to a loss.^[79] However, not every contribution by the injured party triggers a finding of contributory negligence; the contribution must be substantial and significant, with tribunals having broad discretion in assigning fault.^[80]

Further, the CME v. Czech Republic tribunal noted: ‘One of the established general principles in arbitral case law is the duty of the party to mitigate its losses.’^[81] This principle implies that the ‘Claimant cannot claim compensation from the Respondent to the extent that the Claimant has failed unreasonably to mitigate its loss in accordance with international law’.^[82] According to the Unión Fenosa v. Egypt tribunal, the applicable legal test ‘is based upon a reasonable and not an absolute standard, as confirmed by Comment (11) to Article 31 of the ILC Articles and Article 39 of the ILC Articles’ and further clarified that the ‘legal burden of proving such unreasonableness in this arbitration rests upon the Respondent’.^[83] The conditions under which the mitigation requirement applies are as follows: ‘(i) a claimant is unreasonably inactive following a breach of treaty; or (ii) a claimant engages in unreasonable conduct following a breach of treaty’.^[84]

Tribunals also tend to limit the scope of full compensation when there is a country prone to less stability or that did not have a good prior reputation in terms of security.^[85] For instance, in AMT v. Zaire, the tribunal found liability but rejected the award of loss of profit.^[86] In doing so, it stated that an investor making an investment in Zaire should not expect a degree of security that could have existed in Switzerland or Germany.^[87] As mentioned above, in the sections titled ‘Foreseeability’ and ‘Causality and foreseeability’, foreseeability on the part of the respondent can play a role in limiting the extent of compensation. In investment arbitration cases, it is possible to observe that foreseeability on the part of the investor may play a similar role in determining the extent of the compensation even when the tribunals find liability.^[88] In Pantechniki, a similar approach resulted in the sole arbitrator not finding liability.^[89] In other cases, however, these concerns have not prevented tribunals from finding liability but they approach the issue of compensation with a more restrictive approach to strike a balance between finding liability in favour of the investor and the circumstances that make protection of investment relatively more difficult for the host state. Therefore, it is important for the parties to be aware of such a potential balancing approach by the tribunals and raise their arguments in a pre-emptive nature in this regard.

Conclusion

In concluding this comparative and international analysis on the principles and practices of full compensation in arbitration, it is evident that the concept of full compensation is fundamental in both domestic legal systems and international law. Whether dealing with commercial arbitration or public international law, the primary goal is to restore the injured party to its pre-damage state.

Domestic legal systems, such as those in Germany, France, the United States and the United Kingdom, enforce full compensation through a blend of statutory provisions and judicial precedents. These systems focus on causality and foreseeability to determine compensation, with the UNIDROIT Principles offering a harmonised framework that bridges different legal traditions.

Under international law, the principle of full compensation is clearly articulated in the ARSIWA and has been significantly influenced by landmark cases such as Factory at Chorzów. Investment arbitration tribunals apply these principles to resolve disputes between private parties and states, aiming for comprehensive reparation that seeks to ‘wipe out all the consequences’ of a wrongful act.

Factors such as contributory fault, country risk and the degree of fault by the respondent can affect the scope of compensation. Investment tribunals often evaluate causality and foreseeability together, using the ‘but-for’ test and considering other factors that might limit compensation.

Although the principle of full compensation remains a guiding principle, its application involves balancng various legal principles. The decisions of arbitration tribunals highlight the context-dependent nature of tribunals’ approach in making their decisions on the compensation to be awarded.

Endnotes