New Trade Agreements Don’t Need ISDS

Simon Lester’s lead essay challenges us to be clear as to what specific problems ISDS is intended to address, and to examine thoughtfully ISDS’s potential to effectively address those problems.[1] How we define the relevant problems depends in part on whether we are focusing on the question from the perspective of a developing (capital importing) or developed (capital exporting) state. In the case of the former, the main argument of ISDS proponents is typically that the problem is inadequate flows of foreign investment to the developing world. This shortfall of foreign investment is said to be driven by a lack of legal security for investor property rights, and ISDS is said to provide an especially effective means of securing those rights. Investors are said to recognize ISDS as playing such a role, and to take the presence or absence of ISDS into account in a meaningful way when deciding whether and where to invest.

It is difficult to argue against the notion that many developing countries could benefit from greater access to foreign capital. It is also difficult to argue against the notion that many developing countries have serious rule-of-law type problems. However, there is room to doubt that ISDS has much chance of meaningfully impacting either problem. There are a number of empirical (statistical) studies attempting to identify significant correlations between foreign investment flows and whether a host state has entered into investment treaties. Several of these studies indeed find a positive correlation (controlling for various other factors), but others fail to find a correlation. The empirical literature is, in short, inconclusive on the question of whether investors make investment decisions on the basis of a state’s commitment to ISDS. While proponents of ISDS may argue that more studies find a correlation than do not, or that some studies are better than others, in fact there are very serious methodological and data problems that, in my view, require all of the statistical results, positive and negative, to be taken with a significant grain of salt.  For example, data on foreign investment flows is of notoriously poor quality; existing studies fail to adequately address the fact that many states adopted numerous other investment related reforms at the same time they embraced ISDS (raising a problem of confounding influences); and they fail to account for the fact that investors have access to a number of potential substitutes to treaty-based ISDS, such as contract-based arbitration clauses or political risk insurance. If investors can already use such alternatives to protect against “political risk,” then the addition of treaty-based ISDS is unlikely to substantially change their evaluations of the costs and benefits of making an investment.

And perhaps most importantly—though here too the empirical evidence is admittedly incomplete—there are intriguing suggestions in the literature that foreign investors, like businesses generally, are either ignorant of international investment law, or likely to heavily discount its value and relevance. ISDS supporters may justifiably be accused of holding an unsubstantiated and perhaps unrealistic view of the importance of investment law in the foreign investment decisionmaking process, as well as an exaggerated sense of the actual effectiveness of ISDS at protecting investor interests. On that latter point, as Professor Susan Franck has shown empirically, ISDS is very costly, investors lose most cases they bring, and they rarely win anything close to the amount of damages claimed.[2]

From the perspective of developed (capital exporting) countries, like the United States, Germany, or the United Kingdom, it is implausible to argue that they suffer from a deficit of foreign investment. These economies are almost completely open to foreign investment and receive massive amounts of it. It is also implausible to argue that such economies suffer from systemic rule-of-law problems of the sort that ISDS is meant to address. The United States, for example, has no meaningful practice of discriminating against foreign investors, of seizing their property without full compensation, or of treating them in other grossly arbitrary ways. While there will always be a risk of isolated instances of government mistreatment, even in the United States, in almost all cases the domestic legal system will be more than adequate to address the problem. ISDS proponents often cite the famous Loewen investor-state arbitration, involving a challenge to a highly questionable Alabama jury award, but that case is but a single example of arguable investor mistreatment, and in fact the investor lost its arbitration. Loewen is a highly inadequate and unconvincing argument for the position that there is an objective “problem” as to U.S. treatment of foreign investment, or for the position that ISDS is well suited to solving it.

Instead, the proponents’ argument from the capital-exporting perspective is that ISDS is intended to solve the problem of the mistreatment of rich-country investors in weak rule-of-law states. This argument is less concerned with demonstrating that ISDS promotes investment to the developing world, and more focused on the question of whether ISDS reduces mistreatment, or provides adequate remedies for it, on the theory that capital-exporting governments are legitimately interested in how their investors are treated overseas. There are of course any number of examples of such mistreatment, some more shocking than others, and of arbitral awards intended to redress it. But we should be careful not to exaggerate the scope of the problem or the effectiveness of ISDS to combat it. As Simon notes, expropriation seems to be historically rare. Most developing states today very much desire foreign investment and have a strong reputational incentive to treat investors well. Moreover, Professor Franck’s work, already cited above, suggests that ISDS is far from a guarantee that an investor who feels he has suffered a wrong at the hands of the state will actually recover anything. Indeed, the more that the scope of ISDS is “reformed” (narrowed) in response to criticisms of the system, the less likely it will be to provide effective redress (just as it will be less likely to actually promote investment).

Another problem that ISDS is frequently said to prevent is the “politicization” of investment disputes. The concept of “politicization” is not well-defined, but a common usage entails the claim that ISDS prevents investor-state disputes from developing into diplomatic crises that may, in the worst cases, involve “gunboat diplomacy”—military intervention by the home state government against the (typically) weaker host state. This claim has not been subject to any serious empirical study. But it seems relatively obvious that there is very little risk of a return to “gunboat diplomacy” in the modern era. Many of the states covered by ISDS have no real ability to project military force in order to protect investments abroad, and those that do, including the United States, are unlikely to find militarized intervention to be in their national interest except in the rarest of circumstances. Nor am I aware of any compelling, contemporary examples of serious diplomatic crises that might plausibly have been avoided by ISDS.

The discussion above has focused on the problems that ISDS is supposed to solve. I have suggested that those problems may not actually be all that great, and (or) that ISDS is not likely to help resolve them. If I am correct on those points, then we might say that ISDS—especially in the context of rich-country relations—promises to offer few “benefits.” But what about costs? Critics argue that ISDS prevents governments from regulating in the public interest. The problem here, though, is that there is not much evidence that “regulatory freeze” has been a serious problem to date, and critics are vulnerable to attacks of the “Chicken Little” variety. Part of the problem may be that it is difficult, for practical reasons, to identify policies that haven’t been adopted because of the threat of ISDS. Another problem is that the critics’ most impressive example—Philip Morris’s arbitration against Australia—remains pending. Should Philip Morris win, the critics will have spectacular evidence in their favor. The challenge for proponents is to either to argue that Philip Morris is likely to lose, or to distinguish tobacco as somehow “unique” in its potential to cause trouble. In that case, a pragmatic if unprincipled solution might be to exclude tobacco from ISDS protections, while maintaining it for everything else.

My own view (admittedly as speculative as anyone else’s at this point) is that Philip Morris will almost certainly lose, in part because those deciding the dispute recognize that a tobacco victory would place in peril the larger ISDS system, which, in its current form, enriches a small group of elite lawyers. But I also don’t think that the tobacco challenge to the right to regulate is particularly unique. Other industries, advised by the same creative lawyers as enjoyed by Philip Morris, can be counted upon to bring innovative ISDS claims that seek to push international investment law in ways that diverge from national standards and practices. It is impossible to predict how many such claims might arise under the Trans-Pacific Partnership (TPP) or Transatlantic Trade and Investment Partnership (TTIP), or how many might be successful. But even if we expect such challenges to rarely succeed, it is worth noting that ISDS in TPP and TTIP would cover a truly massive number of investments, greatly expanding the pool of potential ISDS claims. The “costs” of ISDS for the United States and its treaty partners would certainly rise as compared to the situation today, as the TPP and TTIP governments would find themselves litigating significantly more ISDS claims. And the more claims that are litigated, the greater the chances that at least one will succeed. The United States government prides itself on never losing a NAFTA Chapter 11 arbitration, but that track record is unlikely to hold up under the brave new world of super-FTAs.

In sum, then, a careful examination of the purported problems that ISDS is meant to solve also suggests that including ISDS in TPP or TTIP is unlikely to provide significant benefits. And while ISDS may not cause the litany of regulatory horrors that critics sometimes suggest it will, ISDS “costs” will surely (if perhaps modestly) rise. Should the decision whether to include ISDS in TPP and TTIP be a rational one, I would suggest that the rational way to proceed is to exclude it.