July 2008

Overview

In late 2007 Kazakhstan set down a bold new marker in its bid for greater control over – and profit share in – the country's evolving hydrocarbon project development boom. This came by enactment of a brief set of amendments to Kazakhstan's Subsoil Law (SL) – under which the Government now appears to have the power unilaterally to force re-negotiation/agreement on new terms to a Production Sharing Agreement (PSA) or other subsoil use contract for any designated ‘strategic field’, if the Government believes the contractor has done something that has substantial negative effect on the Kazakh side's interests under the contract – on pain of contract termination/repudiation for the contractor's failure to comply.[1] These amendments are expressly stated to apply retroactively, to pre-existing contracts as well as future ones. (And note the potential application to ‘strategic’ hard minerals fields also – mining also being governed by SL.) See Section 1.

This laser-like legal initiative is generally considered as having been aimed primarily, Damocles-sword style, at the North Caspian (Kashagan) PSA consortium – whose reported development delays and cost overruns have been trumpeted by the Kazakh Government as claimed ground for fundamental re-adjustment of the contract terms (perhaps including profit and/or equity shares) or more, and have become a highest-level and well-publicized political cause célèbre. (This dispute now appears to be headed for settlement.)

The situation is reminiscent of that of four years ago when the Government, by enacting an SL amendment that gave a pre-emptive purchase right to the State, pressed the North Caspian consortium (and specifically, the then-selling shareholder British Gas) to sell a stake to the national oil company KazMunayGas (KMG) rather than per the contract-based pre-emptive right to the remaining shareholders or to other third parties. As in that 2004 case, the consortium members (and similarly situated participants in other pre-existing projects) could well have grounds supporting arbitration under their contract – and Kazakh law-based stabilization protections as well as treaty-based expropriation claims – should the Government seek to utilize its newly legislated sword and the investors choose to resist.[2]

This latest development follows a lesser-noticed but also important packet of amendments (to Kazakhstan's Civil Code, CC and National Security Law, NSL) enacted last August[3] – see Section 2 – which empowers the Government to designate any oil or gas trunk pipeline (among other types of infrastructure facilities) as a ‘strategic object’ and thus trigger basic restrictions on investors' transfers of interests in same that are akin to the restrictions applicable to upstream field interests under existing law. One must further keep an eye on the drafts of a Transport Code and a Trunk Pipeline Law (TPL) – either/both of which, if/when enacted, would dramatically affect the legal ‘lay of the land’ in this realm.

There were also certain other notable ‘technical’ amendments (including some important environmental-related ones) introduced into the SL and the PL earlier in 2007 (see Section 3).

Overall, Kazakhstan's dramatic moves to better control what it views as strategic hydrocarbon-related assets in which foreign companies do or may have a stake can be compared with Russia's long-pending intention to legislate certain controls on foreigners' investments in mineral fields of ‘federal significance’ and in other ‘strategic industries’ – now about to be enacted. Two important differences are: Kazakhstan has swiftly enacted its measures while Russia has taken some years to do so; and Kazakhstan's approach is – at least at the formal level – more heavy-handed than is Russia's impending tack of restricting foreigners to not more than a certain percentage stake (without state approval). Kazakhstan  evidently prefers to have the blunt legislative ‘terminator’ instrument readily at hand, while Russia seems more content to rely on other pressure levers. This difference perhaps is explicable in part by Russia's having a handful of quite experienced, strong and rich national-champion energy companies to help do its asset-consolidation bidding on more ‘market-like’ terms – for example, Gazprom's recent pressured entry into Shell's Sakhalin 2 and British Petroleum's Kovykta projects. (It is also telling in this regard that foreign companies currently are estimated to control nearly 75 per cent of Kazakhstan's hydrocarbon reserves (oil and gas both); the figures for Russia are, of course, vastly lower.)

At the same time, responsible officials have been quoted as assuring along the lines of ‘Kazakhstan  isn't Venezuela or Bolivia , and we're not seeking open confrontation’ with petroleum investors – see KMG News, 3 November 2007. (One may note, though, that Kazakhstan has engaged the same international legal advisory team who have been counseling Venezuela in its recent expropriation-related struggles with various International Oil Companies). Local experts are surmising that the new strategic field termination/repudiation weapon is indeed so powerful that it is unlikely ever actually to be triggered – rather just to be used as effective pressure tool. "There won't be any blood", as one commentator has put it. (And, as far as we are aware, there has not been any such ‘blood’ from application of these new measures in the six months since enactment.)

We proceed to summarize these important Kazakhstan legal developments in turn.[4]

1. The late 2007 Subsoil Law amendments - Re-negotiate or bust?

This new measure is quite a formidable supplement to the Government's existing arsenal of Subsoil Law (SL)-based unilateral termination weapons for potential use against upstream project investors.

These already included the usual provisions (at SL arts 45 and 45-2) allowing State-initiated termination in cases including declaration that the contract is void/invalid for one of various stated reasons – including refusal, failure ‘in sufficient time’ or impossibility to cure violations of the contract that had triggered prior suspension of contract rights; substantial non-fulfillment/violation of the contract or work program (in some such cases perhaps without opportunity to cure); violation of the State's SL art 71 pre-emptive purchase right – and perhaps even simply for being a ‘bad-faith contractor’ in Ministry of Energy and Mineral Resources’ (MEMR’s)view (see PL art 7-1 third-to-last para). True, these weapons have not been employed frequently to date – particularly against any foreign investors.

The basic elements

The new act (by way of additions to SL art 45-2) and its apparent effects may be summarized as follows:

• The general rule is stated (by new SL art 45-2.1): "In the event that actions of the subsoil user in carrying out subsoil use operations with respect to subsoil plots (deposits) having strategic significance lead to substantial change to the economic interests of the Republic of Kazakhstan, creating a threat to national security, the competent body [ie, the RK Ministry of Energy and Mineral Resources (‘MEMR’) – as contract signatory party for the Government] shall be entitled to demand amendment, and/or additions to the terms of the contracts, with the aim of restoration of the economic interests of the Republic of Kazakhstan" (emphasis added).
• This jolting provision (briefly analyzed below) is accompanied by the following new vice-style ‘procedural’ rules in art 45-2(1) – permitting MEMR to initiate unilateral termination in the event that:

                 -    within two months from receipt of an MEMR notice of the need to amend/ supplement the contract terms to restore Kazakhstan's economic interests, the contractor has not given written agreement to (or has refused to hold) such negotiations;

                 -    within four months from receipt of the contractor's agreement to such negotiations, the contractor and MEMR have not reached agreement on appropriate amendment/supplement to the contract for restoration of Kazakhstan's economic interests; or

                 -    within six months from the date of reaching agreed decision for restoration of Kazakhstan  's economic interests, the parties have not executed the corresponding amendments and/or supplements to the contract terms.

(In other words, a contractor appears to have a maximum one-year period under this provision – from the date of MEMR's first notice of required amendment – to sign such amendment agreement with MEMR or face possible contract termination proceedings. But note also the alternative new repudiation provision – discussed just below.)

• Reinforcing this weapon package is no-less-important new SL art 45-3 by which the Government may alternatively instruct MEMR just to unilaterally repudiate (‘withdraw from performance of’) the subsoil use contract – on two-months notice – in the event of actions by a strategic-field contractor deemed to cause the requisite substantial effect on Kazakhstan's economic interests and consequent threat to national security (as introduced above).
• As coup de grâce, art 2 of this Amending Law expressly provides that it ‘extends as well to previously executed contracts for production or combined exploration and production’.
• There is no express provision for compensation of any kind in the event of such termination by the State. (This is one of the many criticisms leveled at the Amending Law in an opposing letter sent to President Nazarbayev by the Kazakhstan Petroleum Association and the other leading foreign investor groups in October 2007, unsuccessfully urging him to veto the bill.)
• There are also some associated ‘housekeeping’ injections into SL arts 7 and 8: giving the Government the power/responsibility to enact a list of such fields having strategic significance[5] and giving MEMR the power/responsibility to carry out unilateral repudiation of subsoil use contracts (along with performance and termination of such contracts) in accordance with the law.

• The initial troubling point: there seems a prospect of the State's trying to apply the new SL art 45-3 provision – against its likely spirit but arguably consistent with its literal wording – to allow the Government/MEMR unilaterally to repudiate a contract, on a claim based on the new art 45-2 substantial change/national security threat ground, without even bothering to go through the art 45-2 year-long negotiation/agreement period (let alone the required judicial termination proceedings for ‘normal’ termination).

                 -    The official Explanatory Note accompanying this SL Amending Law in Parliament indeed clarifies that art 45-3.1 was crafted specifically to skirt around the general RK Civil Code (CC) requirement (for contracts) of applying to court for a ruling before art 45-2 termination may be invoked: ‘[art 45-3.1] will achieve a result analogous to that invoked with art 45-2 … , without requiring that [MEMR] apply to a court or arbitral tribunal’.

                 -    The relevant CC provisions appear to support the Government's general approach on repudiation: CC art 401 provides that unilaterally initiated termination of a contract normally (for material breach or on other grounds under law or contract) requires application to and decision by a court. But CC art 404 (and authoritative commentary thereto) then make clear that unilateral repudiation – as a special case triggering termination – may occur without court decision in the specified cases (some specified at art 404.2 not here relevant, and in cases provided ‘by other legislative acts’). The new SL art 45-3 provision would appear to be such an other targeted act.[6]

                 -    It seems most logical/likely that this art 45-3.1 repudiation provision was conceived to apply only upon running of the newly established sequential art 45-2.2 procedural deadlines – and not simply at the total whim of the Government without even any prior attempt at negotiation/agreement. And there was apparently some (unsuccessful) effort to have the language refined accordingly before enactment. One hopes that at least this small clarifying adjustment still may be accomplished in time.

• The core concern is that Kazakhstan here essentially has enacted for itself a special one-sided ‘frustration of contract’ mechanism – for possible application (or at least threat of same) any time an investor/contractor acts (or refrains from acting) in a way that it believes is consistent with a fair interpretation of the contract but the Government chooses to insist otherwise.

                 -    In other words, there is nothing in the provision to assure it can/will be used only in the event of clear violation of the contract (or law) that triggers the specified substantial change/national security consequences. And it would appear that the Government already had sufficient levers – in law and in each individual contract – to press for and achieve termination in the event of such real violations and failure to cure.[7] (Several Kazakh Government officials quoted in the local press in support of their new SL Amending Law have sidestepped or ignored this basic point.)

                 -    Interestingly (indeed, ironically) in this connection, Kazakhstan  's CC does not even contain a general provision (as does Russia 's Code) permitting either party to a contract to apply to court for revision or termination in the event of proven ‘fundamental change of circumstances’. We understand that Kazakhstan 's Code draftsmen rejected that provision as being vulnerable to abuse.

• The SL Amending Law gives no criteria (in terms of confirmed reserves, stage of development, geographic location or otherwise) to guide the Government's designation of fields as ‘having strategic significance’. As noted above, the Government evidently is on the verge of issuing such a list of fields. Common sense dictates (and statements by officials to date tend to confirm) that at least the North Caspian Production Sharing Agreement (PSA) fields as well as some leading already-producing hydrocarbon project fields such as those connected to Tengizchevroil (and perhaps also those held by the other few leading venture and local producers) would be on it – as well as some key gold, uranium and some other hard minerals fields.
• The express extension of application of these new rules to pre-existing contracts could well run counter to express stabilization-protection provisions of such contracts and Kazakh law. In the event that the new law is triggered against an existing-contract foreign investor, there could also quite likely be strong ground for an expropriation-based claim under one or more bilateral investment treaties or the Energy Charter Treaty. (The absence of any provision for compensation in the new act would not meaningfully hinder such a claim on other available well-recognized bases.)
• It is also worth stressing here again that in the specified circumstances MEMR is given the right (in other words, the discretion) to terminate/repudiate. This is not automatic (self-executing), even at the end of the specified procedural-negotiation road. This being so, where the Government side does exercise the discretion to terminate/repudiate in the context of pre-existing or future contracts that contain a typical clause calling on the Government side to exercise its powers as possible so as to shield the investor from adverse effects of evolving laws, the investor would have yet another contract-based ground for challenge.
• Finally, note the link between this new SL Amending Law package with provisions of Kazakhstan's National Security Law (NSL) as it has been molded/targeted in recent years to date: NSL art 5(10) includes as a specified type of ‘threat to national security’ – ‘the causing of harm to the economic security of the state, including the use of strategic resources’. See also NSL art 18.3 re the national security significance of performance of strategic-resource contracts and the Government's control over same. (This is in addition to the NSL tie-in with the new trunk-pipeline-as-strategic-object restrictions, addressed just below.)

2. Trunk pipelines as strategic objects - Restrictions on interest transfers

The basic elements

The relevant new CC and NSL amendments, enacted in August 2007, do the following:

• First, the concept of ‘strategic object’ is introduced (at new CC art 193-1.1) and defined as ‘property having socio-economic significance for the stable development of Kazakhstan  society, the possession and (or) use and (or) disposition of which will have impact on the national security of Kazakhstan ’.
• Second, the sphere of property types eligible for strategic-object designation is drawn (at art 193-1.2) to include trunk oil pipelines and trunk gas pipelines – among various other types (such as international sea ports and airports, main highway and railway lines, the national power grid and main communications lines, nuclear power plants and other infrastructure having typical natural-monopoly or similar public importance sensitivity. (This category is also extended to cover ‘stockholdings (participation interests, shares) in legal entities that own strategic objects, and … in legal entities that have the possibility directly or indirectly to determine decisions or exert influence on legal entities that own strategic objects’.)
• Third, the new CC provision confirms that strategic objects may be held either in State or private ownership in accordance with law (which is consistent with existing law). But a series of restrictions on transfers of such property is introduced (by new CC art 193-1.3-.5), as follows:

                 -    Encumbrance or transfer is permitted only by permission of the Government, pursuant to a newly-published set of rules.[8]

                 -    In the event a private owner of such object wants to sell, the Government has a pre-emptive right to purchase it at ‘market price’ – to be determined in accordance with Kazakhstan law on valuation – pursuant to another newly published set of rules.[9]

                 -    Any encumbrance or transfer transaction involving interests in strategic objects conducted without the requisite Government consent (and/or waiver of priority right, as the case may be) is considered void/invalid.

• There are also various technical amendments to the CC and the NSL to help implement the above – and appropriate additions to the Government's authority under the NSL (to establish lists of strategic objects that are in State and in private ownership – which list currently exists in still-unpublished draft form), to establish a Commission on Strategic Objects, and to take decisions on proposed encumbrances/transfers of private-property interests in strategic objects on the basis of Commission recommendations – see new NSL arts 11(3-1) through 11(3-3)).[10]
• This new regime is not to be confused with the similar sounding (and somewhat overlapping) one already existing pursuant to the Law on State Monitoring of Property in Sectors of Economy Having Strategic Importance of 2003 and the list of strategic objects/enterprises that exists thereunder per decree of 2004. That other regime currently is undergoing its own amendment/updating process (in part to bring it to take account of the new CC and NSL amendments relating to strategic objects). Readers should be aware of the distinction but partial overlap.

Here again, (as with the new SL amendments regime for fields of strategic significance), the real importance of these new ‘strategic-object’ rules for trunk pipelines (and sea ports – also relevant for some large hydrocarbons projects) will have to await application. For now we may note the following:

• The whole subject of private ownership of trunk oil and gas pipelines, and the mandatory role of the state (through KazMunayGas (KMG) and its affiliates), is complex and evolving – and of real importance for investors in some of the large upstream projects needing their own new export line outlets. We only touch the various aspects of this subject here:

                 -    There is a preliminary issue – and some uncertainty – about which present/future pipelines are to be considered as trunk, versus collector/gathering/connecting lines.

                 -    Current law (PL art 42) expressly permits private ownership and operation of trunk pipelines. Practice to date (specific existing private lines, and common understanding) also supports this. And the evolving draft Trunk Pipeline Law (TPL) would preserve this principle.[11]

                 -    KMG and its affiliates (on behalf of the State) have: (i) direct ownership/control over the existing State-owned trunk pipeline system and additions thereto – but do not have such control (at least, in law) over new or existing privately financed/owned trunk, export or other pipelines); (ii) the operator/management role for export of all oil and gas to/through Russia on all pipeline routes except Caspian Pipeline Consortium (CPC) (whose monopoly role does not now extend by law to trunk/export lines other than those to Russia);[12] and (iii) arguable mandatory participation right, under current law, in all domestic and international hydrocarbon transport projects – and under the current draft TPL (art 7.2) would have a pre-emptive right of not less than 50 per cent ownership participation in all ‘newly established’ trunk lines.[13]

                 -    The new CC/NSL strategic-objects regime will not in itself supersede any of this, but does inject the important new layer of encumbrance/transfer/pre-emptive right restrictions as the State seeks to tighten its overall management/control over this vital sector.

• There are equal-access and set-tariff rules tied to designation as a trunk pipeline, based on Kazakhstan  's National Monopoly Law and rules issued thereunder. There are also certain recognized exceptions that could apply to particular newly developed trunk lines. The draft TPL and Transportation Code each would further develop/reinforce the general rule as well as the possible exceptions from it.
• The transfer/encumbrance (and pre-emptive right waiver) approval processes for ‘strategic objects’ may end up being similar to those now established/applied for in the analogous PL art 53 and SL art 71 upstream field direct/indirect interest transfers and pre-emptive right waivers. Those latter processes are handled through a special Interagency Commission administered by MEMR.

                 -    On the other hand, it is true that there could well be some differences given that the new process of strategic-objects approvals/waivers (to be considered by the newly established Commission as cases arise after the required initial list of objects is issued) arises now from the NSL – unlike the PL/SL basis in the upstream context. Also, while MEMR may well come to play a lead role under the Government and new Commission for strategic trunk pipeline interest transfer approval/waiver matters, other ministries surely will take the lead role with regard to other types of (non-energy-sector) strategic objects.

                 -    Further, it seems to us that certain specific difficulties/burdens may arise from the literal language of the Strategic-Objects Act, absent helpful subsequent legislative adjustment and/or authoritative interpretation/application. Namely: first, in this strategic-objects context, the approval/waiver requirement might be read to extend to proposed share transfers in almost any situation up a corporate chain outside of Kazakhstan – whereas in the upstream field approval/waiver context the relevant analogous SL art 71 wording, while itself far from ideal, at least (as far as the State pre-emptive right is concerned, and usually/de facto interpreted to apply to the general SL/PL transfer consent right as well) limits the application to share sales in up-the-line companies whose primary activity is connected with Kazakhstan subsoil use. The strategic-objects consent requirement is not expressly so limited in scope. Second, the SL-based pre-emptive right is exercisable by the State only/simply ‘on terms not worse than those proposed by other buyers’ – and has been exercised a few times objectively in this fashion, as far as we are aware. The new CC-based strategic-objects pre-emptive right, on the other hand, per the NSL language is tied only to Kazakhstan 's ‘legislation on valuation’ as noted above – which seems potentially vulnerable to attempted abuse by the Government.

• Unlike the SL Amendments Law (and the earlier 2004 and 2005 SL amendments introducing and then stiffening the State's upstream interest sale pre-emptive right per SL art 71), this CC-based Strategic Objects Act is not expressly made to apply retroactively. Thus, there would be a very strong argument in favor of investors in pre-existing wholly/partly private trunk pipelines (eg, CPC, the Karachaganak–Atyrau CPC tie-in line, PetroKazakhstan's Kumkol–Aryskum–Maibulak line, the CNPC–Kaz Trans Oil (KTO) Kenkiyak–Atyrau line, the China National Oil and Gas Exploration and Development Corp (CNODC)–KTO cross-border Atasu–Alashankou line, and the pending CNODC–KTO Kenkiyak–Kumkol line) that they are not subject to these new restrictions (see CC art 383.2). There could be some ongoing debate about this, however, in law and/or practice (and see the above-mentioned draft TPL provision that more clearly expresses an intended retroactive force).

3. Earlier technicak amendments of note - SL and PL terms tightened in January 2007

Kazakhstan  also introduced a series of lesser-noticed but also important technical-type (including environmental-related) amendments to the SL and PL – by three amending laws enacted in succession during January–February 2007. We provide only brief bullet-point notes on these items and no formal citation to the implementing acts here – and will be glad to provide further detail to those interested on request:

• The core SL art 14 subsoil use interest transfer/sale rules were further adjusted – in a way that is in itself not very clear – with regard to scope of coverage of share transactions – see art 14.1. (This ties into the whole above-noted approval/waiver process for proposed upstream field interest stakes, regulated under SL art 14 and PL art 53 together with SL art 71 – in which we have considerable experience but do not pause further on here.) A two-year freeze has also been imposed – on rights transfers (at least at the direct level – and conceivably also considered as extending at least to second-tier company shareholdings by reference to SL art 14.1), with certain narrow exceptions (including an important one for KMG and its affiliates), for the first two years following a subsoil use contract's entry into force (see new SL art 14.10).
• The role of and guidelines for suspension (as opposed to termination) of subsoil use rights has been somewhat clouded – by elimination of former SL art 45-1 and the vagueness of what is left in art 45-2.2 and elsewhere in the law.
• The State's priority right to purchase oil from contractors has been expanded to include State-owned entity contractors (including KMG) – and the price for such purchase has been softened to read ‘must not exceed world prices’. There is also some adjustment in the way such purchase terms are to be agreed (now by separate contract rather than in the subsoil use contract itself). Both of these adjustments could possibly open the door to more pressure/mischief from the State toward investors.
• Per injections at SL arts 7 and 8 and PL art 31 and then a Government decree of May 2007, MEMR is to take the lead in developing/issuing during 2007–08 various technical/safety regulations governing a wide range of hydrocarbons operations – including for offshore production, wells, pipelines, related industrial facilities and equipment. These are reported to be still in progress.
• Per new SL art 41-5.2(3-1), all Kazakhstan subsoil users (with only insignificant exceptions not practically relevant for foreign investors) must join the so-called Memorandum of Understanding (MOU) on the Initiative of Transparency in Activities in Extractive   Industries in the Republic of Kazakhstan before Signing of Subsoil Use Contract, dated 5 October 2005 (the ‘Transparency MOU’). This document is aimed at helping assure the transparency of payments made by subsoil users to the Government – in line with the   global Extractive Industries Transparency Initiative. (There is some history of non-transparent/improper payments allegations in Kazakhstan's energy sector, as is well known.) Most of the major hydrocarbons producers (or consortium members) in Kazakhstan have already signed on to the Transparency MOU.   According to paras 4 and 5 of this MOU, subsoil users are required to submit annual reports on payments made to the Government. The report must be submitted each year, by 1 May, to the designated audit firm chosen from among the Big Four firms by the group of Transparency MOU parties.
• Kazakhstan also enacted an all-embracing new Ecological Code in January 2007 – which attempts to codify into one act the spectrum of environmental regulations previously reflected in various laws and lesser normative acts. Not surprisingly, a number of its provisions impact petroleum operations and entailed introduction of SL amendments. Here again there are many relevant details for the E&P industry in this key area (including some aimed specifically at the Caspian offshore ‘protected zone’), on which space does not permit elaboration here.
• The local content and labor rules were stiffened, in essence as follows: introduction of a new certification requirement (administered by a committee within the Ministry of Trade and Industry) for ‘goods of Kazakhstan origin’; extension of local content requirements to subcontractors (SL art 63-2.1); new reporting requirements (SL art 63.1.13); and provision for equalization of foreign/local work force conditions and salaries, including subcontracted personnel (SL art 42.2-4 – this evidently not enforceable retroactively).
• Considerable elaboration and stiffening of the rules and requirements applying to SL tenders for exploration, production and combined E&P subsoil use rights/contracts. (See SL ch 4-1, arts 41-1 through 41-7.) The additions focus mainly on new transparency requirements for applicants (including required disclosure of applicants' indirect shareholders/participants, and an undertaking to join the Transparency MOU), and several procedural clarifications. Recall that there remains an important exception to the general tender requirement for new E&P rights – covering rights/contracts issued to the national company (KMG and its affiliates) on direct-negotiation basis, and including foreign companies entering a project as ‘strategic partner’ along with KMG on basic terms as reflected in the PL (per 2004 amendments) and currently being applied in the various KMG/foreign company negotiations ongoing for new offshore Caspian E&P blocks.[14] There is another recognized tender exception for conversion of an exploration contract user's right to production contract upon State-confirmed commercial discovery (SL art 13).