Lone Star is back in town, armed with the investor-state dispute system

The Hankyoreh

Lone Star is back in town, armed with the investor-state dispute system

2 June 2012

International investor preparing case to seek compensation for investors’ losses from South Korean government

By Jung Eun-joo, Hankyoreh 21 staff reporter

In a May 31 press release, the US private equity fund Lone Star said it was planning to request investor state dispute (ISD) arbitration for losses suffered due to "unlawful" interference by the South Korean government.

The ISD system allows a foreign investor to request international arbitration against a government that has caused them to lose money by violating investment treaty obligations. Last year, President Lee Myung-bak pledged to renegotiate ISD provisions in the South Korea-United States Free Trade Agreement (KORUS FTA) after a controversy erupted over them ahead of National Assembly ratification. 

Lone Star is claiming two kinds of losses. First, it is arguing that a capital gains tax levied by the National Tax Service (NTS) was "arbitrary and unlawful." In February, the company agreed to sell its share in Korea Exchange Bank to the Hana Financial Group for 3.9 trillion won (about US$33 billion). This figure exceeds the 2.2 trillion won invested in KEB during its 2003 acquisition and represents a return on investment of 239% when the 2.9 trillion won received in dividends over the past nine years is factored in.

The NTS demanded 10% of the stock transfer value, or 391.5 billion won, as a capital gains tax. Hana paid this amount and delivered the remaining stock payment to Lone Star.

But Lone Star countered that there was no reason it should pay taxes in South Korea. Because the seller of KEB is LSF-KEB Holdings, a corporation in Belgium, and Belgium has a tax treaty with South Korea, it has taxation authority for any of its corporations that earn returns from investments in South Korea. 

Belgium does not tax income from overseas equity investments, so Lone Star may not have to pay taxes anywhere. This is the reason the company, which is based in Texas, set up a corporation in Belgium before investing in South Korea. On May 9, it filed a correction request with the NTS asking for the return of the 391.5 billion won in capital gains taxes.

The second claim is that the company suffered losses when the South Korean government delayed its approval for attempted sales to the KB Financial Group in 2006 and HSBC in 2007-2008. In Sept. 2007, Lone Star signed a contract to sell 51% of KEB to HSBC for 18,045 won a share, or a total of 5.9 trillion won.

But South Korean financial authorities delayed approval for close to a year, and HSBC ended up pulling out of the contract in Sept. 2008 after the global financial crisis hit.

Lone Star said that since it received 3.9 trillion won for the February sale to Hana, it lost roughly 2 trillion won in the lost opportunity to sell to HSBC due to the delayed approval, if dividend earnings are not counted.

A letter of intent to initiate arbitration of its claim was sent to the South Korean embassy in Belgium on May 22 containing these claims. The agreement purportedly violated by Seoul was a bilateral investment treaty signed with Belgium in 1976 and amended in March 2011. The Agreement between the Government of the Republic of Korea and the Belgium-Luxembourg Economic Union for the Reciprocal Promotion and Protection of Investments protects investors against unlawful government interference with their property rights

The agreement in question took effect without being ratified by the National Assembly. Article 8 states that in cases of investor-state disputes, the parties are to provide written notification. If the matter is not resolved within six months of the notification date, the matter is to be referred to the International Centre for Settlement of Investment Disputes (ICSID), a Washington institution in the World Bank group.

Lone Star’s letter of intent served as the opening salvo for South Korea’s first ISD case. The company also said the May 31 press release that it plans to submit an arbitration request with ICSID in November after the six-month cooling-off period in the investment treaty expires. 

Meanwhile, Seoul failed to provide adequate notification after receiving its first ISD case, an issue that caused a major controversy last year. The Financial Services Commission issued a press release at around 6 pm on May 28, the Buddha’s Birthday holiday in South Korea, stating that Lone Star had "delivered a document to the South Korean government requesting discussions."

The response stood in stark contrast with the approach of the United States and Canada, which post the text of ISD letters of intent on their official websites.

Lone Star is confident about its chances in arbitration. The company’s chairman John Grayken said he had consulted with legal experts in South Korea and other countries and been advised that he had a convincing case for an ISD request.

Grayken said he felt certain the ICSID, with its objective arbitration panel, would rule for Seoul to compensate investor losses. The reason for this confidence is the favorable treatment foreign investors get in international arbitration. To begin with, the position of arbitrator is not an official title like a judge. The disputants each elect one person, with both sides agreeing on a third to serve as chairperson. In essence, Lone Star potentially has a 50% influence over the makeup of the panel that will be hearing its own arbitration case - a right it would never enjoy in a South Korean court.

This means that at least half the panel, which has authority to invalidate the South Korean’s taxation and finance policies, will go to an overseas jurist who primarily works as counsel for multinational corporations and is heavily influenced by US law.

Indeed, the ICSID had 144 Americans with arbitration experience as of December 2011, and no Koreans. The arbitrators also do not consider the justification or motivation for state policies as South Korean judges do when handling administrative cases.

After selling off its shares in Gangnam’s Star Tower Building (Gangnam Finance Center) in Dec. 2004, Lone Star filed an administrative suit in South Korean court to avoid paying capital gains and corporate taxes. The Supreme Court ultimately ruled in January that the South Korea-Belgium tax treaty did not apply because the Belgian corporation was a "paper company" established by Lone Star to avoid paying taxes. In so doing, it opened the way for the NTS to levy taxes on the company. Lone Star’s goal now is to use the ISD to overturn the Supreme Court verdict.

But a loss for the South Korean government would mean the invalidation of its tax and finance policies and a Supreme Court ruling. Even if it wins, it would have to pay large arbitration and legal fees out of taxpayer money.