Some investors are more equal than others

Say you are a foreign investor that invests in a developing country, which is subsequently hit by a deep financial crisis.  As a new government tries to get its house in order, it undertakes a number of emergency measures such as freezing bank deposits, not paying wages and pensions, and freezing some prices.  You happen to have invested in one of those sectors where prices are now frozen, so you are upset. 

But unlike many domestic firms and investors, who have equal reason to be to be aggrieved, you are foreign, which means that you can take your case to an international tribunal (the International Center for the Settlement of Investment Disputes, ICSID). A bunch of lawyers with no expertise in matters of financial crises or economic development meet and "arbitrate" the case, and then award you with a handsome compensation.      

Should you as a government pay up?

Wait, there is more.  It turns out that the initial arbitration panel made "manifest errors of law," according to a review committee subsequently set up by ICSID.  But since there is no formal appeals procedure allowed in these arrangements, the damages still stand.

Now would you pay?

A long piece by Alan Beattie in the FT does great service by bringing these issues to light. (The case in question concerns Argentina.)

The FT article does not mention what is perhaps one of the most outrageous instances to date of foreign companies taking governments to court for changing the terms under which the original investments were made: Three Italian mining companies have filed a case against South Africa challenging the country's affirmative action policies (Black Economic Empowerment, BEE) designed to undo the ugly legacy of apartheid.     

OK, I know that the bilateral investment treaties (BITs) under which these arbitration cases are filed are entered into voluntarily by host governments anxious to attract foreign investors.  And I have nothing against rules that enable investors to take governments to court. It is the the privileged treatment of foreign investors over domestic investors and the patent disregard for due process that I find grating.   

UPDATE: I should have mentioned this paper, which shows that there are scant benefits to BITs in terms of attracting foreign investment.  And do read the long comment below by Jurgen Kurtz which is very interesting.

UPDATE2: See also this interesting paper on this subject.

Comments

[Ricardo Hausmann]

Dani: I think you should relax a bit. Countries voluntarily join ICSID in order to enhance their attractiveness as investment destinations. Infrastructure is very sensitive to hold-up and expropriation risk because investments are sunk at the beginning and require a long repayment period. If governments give a guarantee, they can get a lower price for the investment as they bear the risk. Governments are free to change the rules but they need to compensate investors.

The least significant aspect is the point you make: foreign vs. domestic. Any domestic firm that is big enough to do one of these projects can also domicile it in Amsterdam.

[Dani Rodrik]

Ricardo --

Governments do a whole lot of things voluntarily that is not in the best interest of their societies. If that were not the case, you and I would both have a lot less to do. As for domestic versus foreign, no that is a serious issue. You send out all sorts of wrong signals if you tell your domestics that the only way they can get fair treatment is by acting as if they are foreign.

[Jurgen Kurtz]

I have followed this insightful blog with great interest but, as an international lawyer, have rarely felt qualified to offer meaningful contribution. I will though offer a few thoughts on the network of bilateral investment treaties (BITs) in operation.

It is worth firstly noting that the scope of coverage of most BITs extends far beyond infrastructure or other forms of FDI in a host state. The definition of “investment” typically encompasses more mobile forms of capital including portfolio investment. Secondly, there is no doubt that certain foreign investors (especially in the resources sector) face the risk of a rapidly “obsolescing bargain” as touched on by Ricardo Hausmann in his post (and explored in the work of Ray Vernon in the 1970s). The substantive BIT protections indeed offer protection to the foreign investor for this type of risk. A signatory host state is required to provide compensation for direct expropriation but also where it uses regulatory and tax measures to indirectly deprive the investor of the economic benefit of their holding.

The BIT protections though extend beyond a simple guarantee for compensation against expropriation. They include a range of undefined legal standards, most notably an amorphous obligation on the host state to accord the foreign investor “fair and equitable treatment”. (This was, in fact, the treaty obligation that Argentina was found to have breached in the cases referred to by Dani.) It is also worth bearing in mind the unique form of investor-state dispute settlement that applies in this field. Unlike traditional mechanisms of state-to-state dispute settlement at international law (as applied in the WTO or the International Court of Justice), investors are accorded rights to sue host states for breach of treaty obligations. There is no basis whatsoever for host state to bring action against investors for breach of particular standards. Consider the impact on the incentives to litigate under this system. The rough discipline of reciprocity of action implicit in state-state systems of dispute settlement is absent; an investor can bring legal action without retaliation under the treaty forum (although there are a myriad of other ways in which the state can retaliate against a foreigner). The investor rationally only considers the commercial imperative for bringing the legal suit.

These factors have led to an explosion in the numbers of cases initiated by investors. Up until 1998, there were only 14 BIT-related cases that had been brought before the ICSID. Since the late 1990s, the growth in cases has been exponential with the cumulative number rising to 259 by the end of 2006. Enterprising legal firms and advisers have realized the opportunities implicit in the BIT system for their clients operating abroad. This was particularly the case for the investment chapter 11 of the NAFTA, where a range of (often plainly adventurous) cases has been initiated against the thick regulatory apparatus of Canada and the United States.

The cases involving Argentina and the particular experience of the U.S under the NAFTA has led to increasing calls for reform to this system. Indeed, the Financial Times article noted above, traces Hilary Clinton’s plan to review NAFTA if elected to the Presidency and in particular her plan to “take out the ability of foreign companies to sue us because of what we do to protect our workers”. It is however important to note that attempts to recalibrate this system are already in place. For example, the U.S has significantly changed the substance of its desired treaty commitments on investment. The investment chapters of FTAs negotiated by the U.S typically include (i) substantive exceptions for host state conduct that far exceed those under the old BIT system; (ii) attempts to carefully delineate the protection afforded under standards such as “fair and equitable treatment”; and (iii) a commitment to consider the possibility of building an investment appellate mechanism. These are all prospective measures that will have little effect on the vast network of existing BITs in operation. Even here though, there may be some cause for a degree of optimism. We are seeing a gradual shift in legal reasoning in the cases to emerge from this system. There is a movement away from reading BITs simply as legal instruments of protection to a nuanced understanding that offers some balance between the interests of the foreign investor, its home and host state. The reasoning adopted by the ICSID Annulment Committee (noted by Dani above) in one of the Argentinean cases is perhaps the starkest reflection of this shift. That committee elected to step beyond its strict legal mandate to offer sharp and compelling criticisms of the overly pro-investor readings adopted by the initial panel.

For those interested in these developments, they may wish to review the recent column of Jose Alvarez, President of the American Society of International Law entitled “The Evolving Foreign Investment Regime”; http://www.asil.org/ilpost/president/pres080229.html

I have provided detailed analysis of the shift implicit in the ICSID Annulment Committee’s decision in a recent note that can also be found on the ASIL web-site; http://www.asil.org/insights/2007/12/insights071220.html.

[dale]

NAFTA, Chapter 11, I believe, included similar priveledges for foreign corporations.

[gallagher]

Here is a piece I had in the FT on this. I also have an article in the Journal of World Investment and Trade from October 2007 that shows that BITS in Latin America have no independent effect on attracting FDI from the US:

Investment rules in Cafta should make possible signatories wary
By Kevin P Gallagher, Financial Times
Published: May 02, 2005

From Mr Kevin P. Gallagher.

Sir, According to the US government, the Central America Free Trade Agreement (Cafta) will benefit the US economy by just .01 per cent after it is fully implemented. That means the best way for Cafta to benefit the US is to ensure that central American countries expand their economies such that they can import US products in the future. Without good investment that growth will not happen, and recent evidence shows that Cafta may not fulfil the promise of increasing investment.

Cafta's investment agreement restricts the ability of member countries to stipulate that foreign companies adhere to performance requirements, measures that have traditionally been used to create links between foreign companies and the domestic economy to spur broad economic growth.

Cafta would allow new social and environmental regulations to be interpreted as being "indirect expropriation" by clever legal teams working for investors. The companies themselves can file suit for massive compensation. For example, in 2004, the US company Occidental Petroleum took advantage of a US-Ecuador investment agreement to challenge the cancellation of value-added tax rebates by Ecuador. Occidental was awarded $71m, plus interest.

One could argue that agreeing to such measures is the price central American governments have to pay for receiving more investment. The problem is that the investment may not come. Numerous studies looking at the determinants of foreign investment conclude that investment agreements such as Cafta do not independently attract foreign investment. They include a 1998 study by the United Nations Conference on Trade and Development. The study concludes that the impact of these agreements is small and secondary to the effects of other determinants, especially market size.

A 2003 World Bank study found that the agreements themselves did not stimulate additional investment. More recent studies indicate that the promise of Cafta may be overrated. In the most recent issue of the Latin American Research Review, two authors found no independent correlation between trade or investment agreements and increases in foreign investment. My own study, due out later this year, comes to similar findings - and in fact shows a negative correlation between US agreements and the flow of US investment, as does a recent study by researchers at Yale University.

These studies indicate that the additional benefits of an investment treaty may be outweighed by the costs of lifting performance requirements and of adopting expropriation rules that can be broadly interpreted to pertain to new laws for economic development. Central American nations should think twice about signing on to the investment rules in Cafta. The US Congress should carefully consider this as well.

[Ricardo Hausmann]

Dani:

Having ICSID available creates an opportunity to complete an insurance market. I am not sure that you have made a good case for governments not availing themselves of this possibility. You make two points. 1) Governments often change their minds. 2) The current arrangmenet discriminates between domestic and foreign firms.
On the first point, if a government is not willing to give a guarantee that it will not change some policy then it should not do so. But if it wants to give a guarantee, ICSID makes that guarantee credible.
2)I am not sure that it excludes domestic firms, but if it does, I would be all in favor for expanding ICSID to include them, rather than shutting it down.
I do believe that expropriation risk is real and important and it limits investment while making everything more expensive. I have no doubt that Argentine firms that bought the insurance were expropriated in economic terms.
BITs are a broader issue of which I have no strong views. Promising not to impose exchange controls is a bad idea, as the Chileans have probably come to regret these days.

[Gallagher]

Domestic firms do not have the same rights under BITS and US RTAS. What's more, the foreign investor itself has the power to directly sue a developing country government and go through dispute resolution--rather than in the WTO where the firm has to convince their state that the claim is valid and then the firm's state has to approach the trading partner state for a dispute (investor state versus state to state dispute). Under NAFTA and Ecuador BITS, new environmental regulations have been interpreted as "tantamount to expropriation" because the costs of compliance wasn't incorporated into the firms' plans when they located in the host developing country. Developing countries have paid millions back to these investors--effectively paying the foreign firms not to comply (or subsidizing their ability to comply) and the domestic firms take the hit.

[Gallagher]

If investment agreements and the investment portions of RTAs fail to bring "market access" in terms of new FDI, they may not be worth surrendering the policy space to develop linkages with domestic firms (which is also forbidden in these agreements).

Agosin has shown(in a recent Journal of Development Studies paper but here is the web downloadable version http://ideas.repec.org/p/unc/dispap/146.html)
that in Latin America FDI has "crowded out domestic investment" ie. wiped out local firms. THis has led in a decrease of total investment (was 25 percent of GDP in the 70s and is now 19 percent, compared with China's 40 percent). This is part of the reason why growth has been slow.

These agreements raise the rights over those of domestic firms, have a highly questionable dispute resolution system, and rob developing countries of the ability to foster linkages.

[shahryar]

well I think you may find a similar situation in Iran. The value of Dollar in Rial is frozen during the last decade despite the 2 digits inflation . There is no official explanation but it is said that the administration tries to satisfy foreign investors and also common consumers (who import goods by spending oil money)