The ISDS controversy: How we got here and where next

1 June 2016

In recent years the debate over investor state dispute settlement (ISDS) has heated up and in Europe is reaching boiling point. European governments were once the main force behind modern investment treaties, but now European citizens are sceptical. As a result the future of ISDS has become somewhat uncertain; reforms have been proposed, but it is not yet clear whether or not they are sufficient to appease critics. This article explores the origins of ISDS, the backlash against it, the shortcomings of the public ISDS debate, proposed reforms, and prospects for its future role in international economic law.

The origins of ISDS, and its discontents

Disputes between foreign investors and host states pre-date the modern investment treaty regime. Early disputes reflected a colonial era approach to foreign investment, with European or American corporations investing in the developing world, often with strong backing from their governments. When problems arose with the treatment of those investments, the governments would frequently step in to support their corporations. In some instances these governments established ad hoc tribunals or claims commissions to resolve the dispute.

After World War II, as colonial arrangements came to an end and assertive, nationalist governments took hold in parts of the developing world, European-based multinational companies experienced continued and increasing problems with their investments including the expropriation of assets.  In reaction, these firms pushed for a treaty-based, international dispute system that would provide neutral arbitrators to hear their legal claims, stemming from a mis-trust of local courts.  This was the beginning of the modern, treaty-based ISDS.

In the early years, there were few disputes reported publicly, and the system remained relatively unknown and uncontroversial. When the obligations were just words on paper, it was difficult to envision exactly what the litigation system would look like. By the 1990s, however, along came a few high-profile claims under the North American Free Trade Agreement (NAFTA) and awareness grew. It became clear that the substantive scope of investment obligations was quite broad. It was not just actual expropriation or nationality-based discrimination that was covered, but also regulatory expropriation and treatment of foreign investors that was considered unfair or unjust in some general sense. As a result, claims could be brought against a wide range of government actions, even in domestic policy areas such as environmental protection and public health. One controversial NAFTA ISDS claim, for example, involved a Californian ban on the gasoline additive MTBE. In essence general public policy measures could be challenged by foreign investors in international courts. As claims against government policies and actions in these areas grew a number of non-governmental organisations (NGOs) took notice and expressed concerns about the impact of investment treaties on regulatory autonomy and domestic policymaking.

Some governments also took notice of the implications of ISDS litigation and began to revisit their participation. Venezuela, Indonesia, South Africa, and India, among others, have all shown a good deal of scepticism, if not outright rejection. Australia was also opposed to ISDS for a few years, although it has since changed its view, and is now willing to sign on to ISDS provisions on a case-by-case basis. Now, however, scepticism has spread to the EU. When the inventors of ISDS are among its critics, the backlash has reached full intensity.

Making sense of the ISDS debate

The ISDS debate taking place today is, however, lacking in many ways. Both the critics and supporters of ISDS get a lot of basic facts wrong. Some supporters portray investment obligations as being solely about nationality-based discrimination or expropriation. That is not the case. Critics, meanwhile, offer up inflammatory rhetoric about how the investment treaty system will undermine national sovereignty and prevent necessary regulations. Frequent reference to investors being able to “sue when their profits go down” is nevertheless a complete mis-characterisation of the rules. Investors can sue when their rights have been violated; if they succeed in that, there will then be a judgement as to the damages.

In the face of misleading rhetoric it is important to set out precisely how investment treaties and ISDS operate. While ISDS provisions vary a bit across thousands of existing bilateral investment treaties (BITs), and investment chapters of trade agreements, generally speaking, they work as follows. Foreign investors can sue host governments in an international tribunal for various actions taken by those governments, the most prominent of which are expropriation, nationality-based discrimination, and treatment that falls below a “minimum standard.” Expropriation is familiar concept in many countries’ domestic law, and in the context of international investment law, the standards are similar. As for the non-discrimination provisions, they prohibit government actions that discriminate against foreign investors as compared with domestic investors, or against investors from one nation as compared to those from another nation. The “minimum standard of treatment” obligation covers a variety of government behaviour. Broadly, it covers government behaviour that is arbitrary, manifestly arbitrary, or outrageous, depending which treaty is at issue and which tribunal is hearing the case. If the foreign investor proves that a host government has violated one of these obligations, there will then be a determination of how much economic harm the investor has suffered as a result. With this background in mind we can take a step back and look at some of the foundational arguments about this system.

First, the defenders of the system are correct when they suggest there is nothing scary about the legal principles involved. They are all established concepts derived from domestic constitutional law or administrative law or firmly embedded in international economic law. Second, it is easy to see how this system could provide stability and predictability for foreign investment in countries with a weak judicial branch or rule of law more generally. If domestic courts are not available to enforce contracts, for example, companies will be reluctant to invest. Investment treaties provide an assurance in this context. And finally, beyond the specific impact on investment flows, ISDS can help spread the rule of law as a concept more generally.

The critics also have a number of other points on their side.  First, while there may have been many egregious cases of governments expropriating and otherwise mistreating foreign investment in the 1950s through 1970s, the world of today is very different. Foreign investors are more likely now to be enticed in with subsidies rather than kicked out for reasons of economic nationalism. Second, as noted, one of the arguments for investment treaties is that they encourage foreign investment by offering investors assurance of security. The actual evidence, however, in support of this point is weak. Third, there are a number of alternative methods by which foreign investors can protect against the risk of bad treatment. Many foreign investments involve signing a contract with the host government, and private arbitration can be included in that contract, rather than established as an open-ended international law obligation. In addition, political risk insurance can be purchased in case there are real concerns in a particular country. Fourth, domestic courts are a good avenue for asserting property rights and due process rights in most countries. While there is still progress to be made, the rule of law has spread in recent years, and many countries do a fairly good job providing fair and effective domestic judicial oversight of government actions. Finally, while investment treaties and ISDS are often characterised as relating to foreign investment, that is mis-leading. To a great extent, these obligations take domestic constitutional or administrative law procedures, and apply them internationally. In other words, this creates an international individual right, with an effective remedy. But when you think about all of the individuals who are treated badly by governments and do not have such rights, it seems strange and unfair to provide a remedy for those who are fairly well-off financially and in a good position to assert their rights in domestic courts.

Efforts at reform

With all of this criticism and debate in mind governments have made various attempts over the years to improve the system. Some attempts have been more helpful than others. In response to concerns about the scope of the minimum standard of treatment NAFTA parties issued an “interpretation” in 2001 noting among other things that the concepts of “fair and equitable treatment” and “full protection and security” – usually the two core aspects of minimum standard of treatment – “do not require treatment in addition to or beyond that which is required by the customary international law minimum standard of treatment of aliens.” But debate about the precise nature of this customary standard undermines the usefulness of this clarification.

In addition, the US tried to rein in the problem of regulations being characterised as “regulatory expropriation,” through the following language (this quote is from the 2004 model BIT:  “Except in rare circumstances, non-discriminatory regulatory actions by a Party that are designed and applied to protect legitimate public welfare objectives, such as public health, safety, and the environment, do not constitute indirect expropriations.” This language helps in narrowing the scope of this obligation, by curbing its use against ordinary regulations.

Over in Europe, efforts at reform came later. Originally, investment policy was negotiated by EU member states, but after the 2009 Treaty of Lisbon, the European Commission took responsibility for this area. It did so at a time when there was concern about a number of cases filed against member state governments and part of the Commission’s takeover involved reform of the substance of investment obligations.

One area where the Commission tried very hard to improve on the existing texts was the minimum standard of treatment. The EU has replaced the brief and vague existing provisions with some very detailed obligations. In the Comprehensive Economic and Trade Agreement (CETA) between Canada and the EU that has been negotiated but not yet ratified, for example, treatment that is not “fair and equitable” includes the following specific actions: “Denial of justice in criminal, civil or administrative proceedings; fundamental breach of due process, including a fundamental breach of transparency, in judicial and administrative proceedings; manifest arbitrariness; targeted discrimination on manifestly wrongful grounds, such as gender, race or religious belief.”

European civil society nonetheless remains very concerned by the idea of an investment chapter in the Transatlantic Trade and Investment Partnership (TTIP) deal between the EU and the US. Consultation processes by the Commission on ISDS have resulted in a major, structural reform – an Investment Court System (ICS) – that has now been incorporated into CETA. This proposal does not alter the substance of investment law very much, but it does move it from an “arbitration” process to a more traditional “court” process in terms of how judges are appointed, in order to address the criticism that the existing system of arbitration is too corporation-friendly. The United States has seemed sceptical of this proposal so far. It recently spent several years on an internal review of its own model BIT, and is not eager to re-open that domestic debate. Early reports indicated that Canada was alsowary of the idea in the EU’s efforts to update CETA, although Ottawa agreed to the EU’s proposal in late February, as part of a “legal scrub” of the deal. The Trans-Pacific Partnership (TPP), which includes both the US and Canada along with 12 other Pacific Rim nations, outlines some minor tweaks to the substantive obligations and the process but it does not appear that these changes will have a significant impact.

Beyond the major Western powers, many other governments also use investments treaties and ISDS and their approaches should not be ignored. As China has expanded its investment abroad, it has become a supporter of ISDS, although its agreements are sometimes more limited than those of traditional capital-exporting countries.

Overall the reforms offered so far are somewhat of an improvement in terms of reining in foreign investors’ use of the system to sue governments. But it is not yet clear that critics will be satisfied. To fully respond to the controversy over investment treaties and ISDS governments may need to address some more fundamental questions.

First, international law is for the most part about the relationship between and among nations. Granting individual remedies to protect individual rights is rare. ISDS is an anomaly in this regard, and it is worth asking how it looks for international law to provide such a remedy only to the wealthy, bearing in mind most ISDS cases to date have been brought by relatively well-off firms and individuals.

Second, a standard part of most trade agreements is to have exceptions for other policy purposes, such as for the environment or public health. Some investment agreements have such exceptions, but most do not, and in particular the US and EU agreements rarely do. In CETA, there is an exception, but it does not apply to the minimum standard of treatment or expropriation provisions; the TPP has no such general exception related to ISDS. Perhaps making exceptions a part of investment obligations could help carve out policy space for governments to regulate. (The CETA does note, in Article 8.9, that the parties “reaffirm their right to regulate,” but this is not the same as an exception, and its impact is unclear.)

Third, while the EU efforts to narrow the minimum standard of treatment make some progress, even the reformed provisions give wide latitude to investors to bring claims. It is worth thinking carefully about the idea of including such an obligation in investment treaties. A requirement that governments not discriminate based on nationality is a narrow one; governments rarely do this. By contrast, there is quite often a credible argument that domestic regulatory actions are arbitrary, or manifestly arbitrary, or even outrageous, all of which are various articulations of the minimum standard of treatment. As long as that obligation remains in some form, governments have opened themselves up to litigation on just about any regulatory policy.

More broadly, though, the system as it exists today lacks an evidentiary basis. At its formation, the world was full of expropriation, and having an international system designed to address that problem made some sense. Today, by contrast, expropriation is rare. The bigger problem with foreign investment is probably the lavish financial subsidies that governments offer to corporations to convince them to invest. Thus, instead of copying and pasting the concepts from 1950s era thinking about foreign investment, governments should take some time to evaluate what, if any, are the problems with foreign investment today, and then construct their international investment agreements accordingly.

The future of ISDS

The future of ISDS is uncertain. In large part this is due to the EU reform efforts. If the US rejects the new ICS, it is not clear how ISDS can be part of the TTIP. The problem is that the EU seems to have promised ICS to some of its domestic constituents, it is not clear that a trade and investment agreement with old-style ISDS will be approved by the European Parliament, and it even remains to be seen whether agreements with the new ICS will be approved.

The US for its part seems comfortable with its existing model. ISDS will be part of the TPP debate, but only as one small factor. The standard defence of ISDS by supporters in the US is that Washington has never lost a case. As long as that perfect record continues, no deep engagement with the ISDS controversy is likely to occur. It is worth noting, however, that recently a case was filed that could change all this. TransCanada challenged the US rejection of the Keystone XL pipeline in a NAFTA Chapter 11 lawsuit. This appears to be one of the stronger cases filed against the US, and if it is required by a NAFTA tribunal to pay out several billion dollars as a result of a regulatory decision motivated at least ostensibly by environmental concerns, this could prompt some new thinking about US participation in such a system.

Simon Lester is a Trade Policy Analyst at Cato Institute.