An Economic Analysis of Bilateral Investment Treaties

Jan Peter Sasse An Economic Analysis of Bilateral Investment Treaties

GABLER RESEARCH Ökonomische Analyse des Rechts Herausgegeben von Professor Dr. Peter Behrens Professor Dr. Thomas Eger Professor Dr. Manfred Holler Professor Dr. Claus Ott Professor Dr. Hans-Bernd Schäfer Professor Dr. Stefan Voigt (schriftführend) Universität Hamburg, Fakultät für Rechtswissenschaft und Fakultät für Wirtschafts- und Sozialwissenschaft

Die ökonomische Analyse des Rechts untersucht Rechtsnormen auf ihre gesellschaftlichen Folgewirkungen und bedient sich dabei des methodischen Instrumentariums der Wirtschaftswissenschaften, insbesondere der Mikroökonomie, der Neuen Institutionen- und Konstitutionenökonomie. Sie ist ein interdisziplinäres Forschungsgebiet, in dem sowohl Rechtswissenschaftler als auch Wirtschaftswissenschaftler tätig sind und das zu wesentlichen neuen Erkenntnissen über Funktion und Wirkungen von Rechtsnormen geführt hat. Die Schriftenreihe enthält Monographien zu verschiedenen Rechtsgebieten und Rechtsentwicklungen. Sie behandelt Fragestellungen aus den Bereichen Wirtschaftsrecht, Vertragsrecht, Haftungsrecht, Sachenrecht und verwaltungsrechtliche Regulierung.

Jan Peter Sasse

An Economic Analysis of Bilateral Investment Treaties With a foreword by Prof. Dr. Thomas Eger

RESEARCH

Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

Dissertation Universität Hamburg, 2010

1st Edition 2011 All rights reserved © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011 Editorial Office: Stefanie Brich | Sabine Schöller Gabler Verlag is a brand of Springer Fachmedien. Springer Fachmedien is part of Springer Science+Business Media. www.gabler.de No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. Registered and/or industrial names, trade names, trade descriptions etc. cited in this publication are part of the law for trade-mark protection and may not be used free in any form or by any means even if this is not specifically marked. Cover design: KünkelLopka Medienentwicklung, Heidelberg Printed on acid-free paper Printed in the Netherlands ISBN 978-3-8349-2756-9

Foreword The global economy is characterized not only by a steady increase of international trade, but also by growing flows and stocks of foreign direct investment (FDI). This development has manifested itself especially since the mid-1980s. The importance of FDI in providing foreign markets with goods and services has become comparable to trade. FDI also constitutes a crucial source of external finance for developing countries. An important prerequisite for a high level of FDI is that investors view the political risk of the host country as manageable. Political risk may, for example, comprise the danger of expropriation of the investment without adequate compensation, or more subtle regulatory measures with comparable effects, which are often referred to as indirect expropriation. The most important legal instruments in international investment law that may mitigate this kind of risk are bilateral investment treaties (BITs). Since the first BIT, concluded between Germany and Pakistan in 1959, the number of such treaties has risen to the impressive number of more than 2700 in 2010. Despite the undeniable importance of FDI for the global economy and the growing prominence of BITs, the economic analysis has mainly focussed on international trade law and has thus far neglected the analysis of international investment law. This contribution by Jan Peter Sasse seeks, and succeeds, to fill that gap in the existing literature. Jan Peter Sasse begins his research by providing a comprehensive analysis of the economic and legal tools available to international investors who wish to safeguard their assets abroad. In contrast to the domestic context, international law is generally characterized by the absence of a supranational authority that may enforce legal obligations through coercion. Consequently, investors have to rely on economic devices (the exchange of hostages, for example) or on legal protection through international law and the possibly unfavourable domestic legislation and judiciary of host-states. Especially in the light of the lack of a truly multinational treaty on the protection of FDI, bilateral investment treaties can be considered a cornerstone of international investment law. Consequently, a number of recent empirical studies find a positive relationship between the conclusion of BITs and the amount of FDI flows. The economic analysis of the functioning of BITs must first of all illuminate the relationship between the investor and the host-state. This relationship may be characterized by problems of hold-up and asymmetric information. Based on the rational choice principle as advanced recently by scholars of international law and economics, Jan Peter Sasse shows to what extent the host-state can overcome the hold-

VI

Foreword

up problem through self-commitment. Furthermore, the author convincingly argues that signaling is only of limited value in counteracting the asymmetry of information between investors and host-states. Apart from the relationship between investors and host-states, a thorough analysis of bilateral investment treaties has to take into account the strategic interaction among host-states that may consider BITs as an instrument in the competition for FDI. Jan Peter Sasse analyses this competition in great institutional detail with special attention devoted to the environmental conflicts that have emerged in the context of international arbitration. His results show that BITs, if drafted and interpreted with care, may help capture the beneficial effects of institutional competition and mitigate the potentially detrimental effects. The author then contributes to two ongoing discussions in the area of international investment law. Firstly, Jan Peter Sasse provides an empirical analysis of the impact of BITs on the institutional quality of developing countries. He finds that external effects of BITs on institutional quality cannot be verified. The study thus lends empirical support neither to the optimistic calls for BITs as serving as a positive example for developing countries, nor to the pessimistic accounts that regard BITs as detrimental to domestic institutional quality. Secondly, the author provides a systematic analysis of the issue of transparency vs. confidentiality in international arbitration. Jan Peter Sasse explains why more transparency may be harmful for the parties involved and that, as a consequence, a movement towards more transparency in international investment arbitration will be hard to achieve. This publication in the field of international law and economics makes a valuable contribution to our understanding of the functioning of bilateral investment treaties. Jan Peter Sasse also provides an insightful and well-researched analysis of different aspects of the protection of FDI through BITs, including institutional competition, institutional quality, and transparency.

Prof. Dr. Thomas Eger

Acknowledgements This thesis was written while I was a student at the Doctoral College for Law and Economics (Graduiertenkolleg für Recht und Ökonomik) and, subsequently, a research assistant at the Institute of Law and Economics, both at the University of Hamburg. It would not have been successfully finished without the help and support of a number of people. I am especially grateful to Thomas Eger, who supervised the thesis and allowed me to benefit from his helpful comments and advice. Hans-Bernd Schäfer agreed to act as the second reviewer and was of great support to me (and my fellow colleagues) as the Speaker of the Graduiertenkolleg. I am grateful to him, other professors and fellow colleagues, in and around the Graduiertenkolleg, for many inspiring interactions und discussions during my time in Hamburg. Also, I want to thank the chairman of the disputation committee, Manfred Holler, who not only handled the formal dissertation process very efficiently, but also provided helpful comments during the research process. My thanks go to the editors of the scientific series “Ökonomische Analyse des Rechts” for giving me the opportunity to publish my thesis in the series: Peter Behrens, Thomas Eger, Manfred Holler, Claus Ott, HansBernd Schäfer and Stefan Voigt. I had the pleasure of conducting research as a visiting scholar at Columbia University (New York) and my gratitude goes to Avery W. Katz for making this possible. The German Research Foundation (DFG) financially supported my research both in Germany and the United States with generous research grants and I am thankful for that. Additionally, I am indebted to Anne van Aaken, Peter Behrens, Stephania Bonilla, Eberhard Feess, Henning Fräßdorf, Andrew Guzman, Jonathan Klick, Frank MüllerLanger, Jan Matauschek, Susan Russell, Stephan Wittig, Katherine Walker and Tammy de Wright for helpful advice, comments and inspiration during my research process. Focusing on interdisciplinary research may not be the obvious choice for a young student of economics. I owe my passion for the economic analysis of law to two professors who exposed me to this field of research while I was still a graduate student at the Humboldt University in Berlin: Charles B. Blankart and Christian Kirchner. I want to thank them for putting me on the right track. Most importantly, I would like to take this opportunity to thank my father, my sister and Katrin Stägert for their loving support, kind words, patience and encouragement. This book is dedicated to the memory of my mother, Hanne Sasse.

Jan Peter Sasse

Summary Contents FOREWORD...................................................................................................................V ACKNOWLEDGEMENTS ........................................................................................... VII SUMMARY CONTENTS ............................................................................................... IX DETAILED CONTENTS............................................................................................... XI LIST OF FIGURES ..................................................................................................... XIX LIST OF ABBREVIATIONS........................................................................................ XXI LIST OF VARIABLES ..................................................................................................... 1

1

INTRODUCTION ................................................................................................. 1

2

FOREIGN DIRECT INVESTMENT .................................................................... 6

3

ECONOMIC AND LEGAL PROTECTION OF FDI......................................... 17

4

THE ECONOMICS OF BITS ............................................................................. 67

5

BITS AND INSTITUTIONAL COMPETITION ............................................. 124

6

BITS AND INSTITUTIONAL QUALITY....................................................... 155

7

BITS AND TRANSPARENCY ........................................................................ 177

8

SUMMARY AND OUTLOOK......................................................................... 199

APPENDICES............................................................................................................. 205 BIBLIOGRAPHY......................................................................................................... 221

Detailed Contents FOREWORD...................................................................................................................V ACKNOWLEDGEMENTS ........................................................................................... VII SUMMARY CONTENTS ............................................................................................... IX DETAILED CONTENTS............................................................................................... XI LIST OF FIGURES ..................................................................................................... XIX LIST OF ABBREVIATIONS........................................................................................ XXI LIST OF VARIABLES ..................................................................................................... 1

1

INTRODUCTION ............................................................................................... 1 1.1 INTERNATIONAL LAW AND ECONOMICS ............................................................ 2 1.2 STRUCTURE ........................................................................................................ 4

2

FOREIGN DIRECT INVESTMENT ................................................................ 6 2.1 TRENDS AND FIGURES ........................................................................................ 6 2.2 MULTINATIONAL ENTERPRISES AND FDI........................................................... 8 2.3 FDI AND DEVELOPMENT .................................................................................. 12

3

ECONOMIC AND LEGAL PROTECTION OF FDI ................................... 17 3.1 TIME INCONSISTENCY AND EXPROPRIATION RISK ........................................... 17 3.1.1

Time Inconsistency................................................................................... 17

3.1.2

On the Relevance of Expropriation Risk ................................................. 22

3.2 THE ECONOMICS OF FDI PROTECTION ............................................................. 22 3.2.1

Static Devices........................................................................................... 23

3.2.1.1 Hostages................................................................................................ 24 3.2.1.2 Collateral............................................................................................... 27 3.2.1.3 Hands-Tying ......................................................................................... 29 3.2.1.4 Union..................................................................................................... 30

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Detailed Contents

3.2.1.5 Insurance ............................................................................................... 31 3.2.1.6 Devaluation of Assets ........................................................................... 32 3.2.1.7 Lobbying ............................................................................................... 32 3.2.2

Dynamic Devices ..................................................................................... 33

3.2.2.1 Expertise and Time ............................................................................... 33 3.2.2.2 Repetition and Reputation .................................................................... 33 3.2.2.2.1 Repetition...................................................................................... 33 3.2.2.2.2 Reputation..................................................................................... 35 3.2.3

Discussion ................................................................................................ 40

3.3 LEGAL FDI PROTECTION .................................................................................. 40 3.3.1

Domestic Regulation................................................................................ 41

3.3.2

Customary International Law.................................................................. 41

3.3.3

Multilateral Treaties ................................................................................ 43

3.3.3.1 WTO ..................................................................................................... 44 3.3.3.2 Energy Charter Treaty .......................................................................... 44 3.3.3.3 NAFTA ................................................................................................. 45 3.3.4

Investor-State Contracts .......................................................................... 45

3.3.5

Bilateral Investment Treaties................................................................... 45

3.3.5.1 Overview and History........................................................................... 46 3.3.5.2 Treaty Practice and Treaty Interpretation ............................................. 47 3.3.5.3 Preamble and Definitions...................................................................... 48 3.3.5.3.1 Investor ......................................................................................... 48 3.3.5.3.2 Investment..................................................................................... 49 3.3.5.4 Admission ............................................................................................. 50 3.3.5.5 Standards of Treatment......................................................................... 50 3.3.5.5.1 Fair and Equitable Treatment ....................................................... 50 3.3.5.5.2 Most-Favoured-Nation Treatment ................................................ 52 3.3.5.5.3 Additional Standards..................................................................... 53 3.3.5.6 Expropriation and Compensation ......................................................... 54

Detailed Contents

XIII

3.3.5.6.1 Indirect Expropriation................................................................... 55 3.3.5.6.2 Compensation ............................................................................... 56 3.3.5.7 Public Concerns .................................................................................... 57 3.3.5.8 The Settlement of Disputes................................................................... 58 3.3.5.8.1 ICSID ............................................................................................ 59 3.3.5.8.2 Remedies....................................................................................... 61 3.3.5.8.3 Enforcement and Execution of Arbitral Awards .......................... 62 3.3.5.8.4 Costs.............................................................................................. 63 3.3.5.8.5 Empirical Aspects of Arbitration.................................................. 63 3.3.5.9 BITs and Customary International Law ............................................... 64 3.3.5.10 Summary ........................................................................................... 65

4

THE ECONOMICS OF BITS .......................................................................... 67 4.1 THE (PERCEIVED) WEAKNESS OF INTERNATIONAL LAW ................................. 67 4.2 THE EFFECT OF BITS ON FDI ........................................................................... 69 4.2.1

Empirical Studies on the Effect of BITs on FDI ...................................... 69

4.2.2

Discussion ................................................................................................ 72

4.3 LAW AND ECONOMICS OF INTERNATIONAL LAW ............................................. 73 4.3.1

Theories of International Law ................................................................. 74

4.3.2

Rational Choice Approach....................................................................... 74

4.3.3

Methodological Individualism ................................................................. 75

4.3.4

The Three R's: Reputation, Reciprocity and Retaliation ......................... 76

4.4 THE FUNCTIONING OF BITS.............................................................................. 78 4.4.1

The Costs of BITs..................................................................................... 78

4.4.1.1 Concluding BITs................................................................................... 79 4.4.1.2 Breaching BITs: The Three R's Revisited ............................................ 79 4.4.1.2.1 Reciprocity and Retaliation .......................................................... 79 4.4.1.2.2 Reputation vis-à-vis Other States ................................................. 80 4.1.1.2.3 Reputation vis-à-vis Investors ...................................................... 81

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4.4.1.3 Breaching BITs: Non-Reputational Costs ............................................ 83 4.4.1.4 Summary ............................................................................................... 84 4.4.2

Commitment and Signalling..................................................................... 84

4.4.3

Commitment ............................................................................................. 85

4.4.3.1 Repetition Revisited.............................................................................. 86 4.4.3.2 The Commitment Game........................................................................ 86 4.4.3.2.1 The Tribunal's Decision................................................................ 89 4.4.3.2.2 The Arbitration Decision .............................................................. 89 4.4.3.2.3 The Expropriation Decision.......................................................... 90 4.4.3.2.4 The Investment Decision .............................................................. 91 4.4.3.3 Equilibria............................................................................................... 92 4.4.3.4 Hostages and Collateral ........................................................................ 93 4.4.3.5 Extensions............................................................................................. 94 4.4.3.5.1 Compliance and Enforcement in Third Countries ........................ 94 4.4.3.5.2 Settlement vs. Trial ....................................................................... 95 4.4.3.5.3 The Perils of Success .................................................................. 100 4.4.3.6 Summary ............................................................................................. 101 4.4.4

Signalling ............................................................................................... 102

4.4.4.1 Reputation Revisited........................................................................... 102 4.4.4.2 Signalling Theory ............................................................................... 104 4.4.4.3 Rights and Treaties as Signals ............................................................ 105 4.4.4.4 The Signalling Game .......................................................................... 107 4.4.4.5 Equilibria............................................................................................. 110 4.4.4.6 Hidden Characteristics and Hidden Intentions ................................... 114 4.4.4.7 Summary ............................................................................................. 116 4.4.5

Beyond Commitment and Signalling ..................................................... 117

4.4.5.1 Flexibility vs. Commitment ................................................................ 117 4.4.5.2 BITs as Development Aid................................................................... 118 4.4.5.3 Risk Aversion ..................................................................................... 119

Detailed Contents

XV

4.5 EMPIRICAL STUDIES AND THE FUNCTIONING OF BITS ................................... 120 4.6 DISCUSSION AND CONCLUSIONS .................................................................... 121

5

BITS AND INSTITUTIONAL COMPETITION ......................................... 124 5.1 EFFICIENCY AND BITS .................................................................................... 124 5.2 INSTITUTIONAL COMPETITION........................................................................ 127 5.2.1

BITs and the Prisoner’s Dilemma ......................................................... 127

5.2.2

The Economics of Institutional Competition ......................................... 129

5.2.2.1 Tax Competition ................................................................................. 131 5.2.2.2 Environmental Competition................................................................ 133 5.2.3

Discussion .............................................................................................. 135

5.3 BITS IN THE CONTEXT OF INSTITUTIONAL COMPETITION .............................. 136 5.3.1

BITs and Self-Interested Governments .................................................. 137

5.3.1.1 Political Economy and International (Trade) Law ............................. 137 5.3.1.2 Political Economy and International Investment Law........................ 139 5.3.2

BITs and the Prisoner's Dilemma Revisited .......................................... 142

5.3.2.1 BITs and the Underprovision Hypothesis........................................... 142 5.3.2.2 Distribution of the Benefits of FDI..................................................... 144 5.4 PROVISIONS AND EVIDENCE ........................................................................... 145 5.4.1

Non-Discrimination ............................................................................... 145

5.4.2

Fair and Equitable Treatment (FET)..................................................... 146

5.4.3

Indirect Expropriation ........................................................................... 147

5.4.4

Evidence................................................................................................. 148

5.4.4.1 Case Law............................................................................................. 148 5.4.4.2 Analysis............................................................................................... 151 5.5 DISCUSSION AND CONCLUSIONS .................................................................... 152

6

BITS AND INSTITUTIONAL QUALITY.................................................... 155 6.1 THE EFFECT OF BITS ON INSTITUTIONAL QUALITY ....................................... 155

XVI

Detailed Contents

6.1.1

Some Theory........................................................................................... 155

6.1.2 Empirical Literature ............................................................................... 158 6.2 MODEL AND DATA ......................................................................................... 160 6.2.1

Fixed-Effects Model............................................................................... 160

6.2.2

Variables ................................................................................................ 162

6.2.2.1 Dependent Variables........................................................................... 162 6.2.2.2 Independent Variables ........................................................................ 163 6.2.2.3 Overview............................................................................................. 165 6.2.3

Summary Statistics................................................................................. 166

6.2.4

Regulatory Quality and the Rule of Law ............................................... 166

6.2.5

Corruption.............................................................................................. 172

6.2.6

Outliers, Economic Freedom and OECD BITs ..................................... 173

6.3 CAVEATS ........................................................................................................ 173 6.3.1

Selection and Composition of Variables................................................ 174

6.3.2

Perception Based Indicators.................................................................. 174

6.4 DISCUSSION AND CONCLUSIONS .................................................................... 175

7

BITS AND TRANSPARENCY....................................................................... 177 7.1 LEGAL BACKGROUND .................................................................................... 177 7.2 THE CASE FOR TRANSPARENCY ..................................................................... 181 7.2.1

International Law .................................................................................. 181

7.2.2

International Investment Law ................................................................ 183

7.3 THE CASE FOR CONFIDENTIALITY .................................................................. 184 7.3.1

Conventional Arguments for Confidentiality......................................... 185

7.3.2

Structural Arguments for Confidentiality .............................................. 186

7.3.2.1 Informational Ambiguities and the Incentive to Comply ................... 186 7.3.2.2 Efficient Breach and Settlement Problems ......................................... 190 7.3.2.3 The Incentive to Conclude an Agreement .......................................... 194 7.3.3

More Transparency?.............................................................................. 196

Detailed Contents

XVII

7.4 DISCUSSION AND CONCLUSIONS .................................................................... 196

8

SUMMARY AND OUTLOOK....................................................................... 199 8.1 SUMMARY....................................................................................................... 199 8.2 OUTLOOK........................................................................................................ 203

APPENDICES............................................................................................................. 205 APPENDIX A ............................................................................................................. 205 APPENDIX B ............................................................................................................. 207 APPENDIX C ............................................................................................................. 211 APPENDIX D ............................................................................................................. 216 BIBLIOGRAPHY......................................................................................................... 221

List of Figures Figure 2.1: FDI Flows (Inward) 1970-2009 ................................................................... 7 Figure 2.2: FDI Flows (Inward) – Selected Countries and Regions............................... 8 Figure 3.1: Time Inconsistency .................................................................................... 19 Figure 3.2: Hostage-Mechanism................................................................................... 26 Figure 3.3: Collateral .................................................................................................... 28 Figure 3.4: Hands-Tying............................................................................................... 29 Figure 3.5: Time Inconsistency and the Good Host Country (HCgood)......................... 37 Figure 4.1: The Commitment Game ............................................................................. 88 Figure 4.2: The Signalling Game................................................................................ 109

List of Abbreviations BIT

Bilateral Investment Treaty

CIEL

The Center for International Environmental Law

CIL

Customary International Law

DCF

Discounted Cash Flows

DSB

Dispute Settlement Body (World Trade Organization)

EBIT

Earnings Before Interest and Taxes

ECT

Energy Charter Treaty

EU

European Union

FCN

Treaty of Friendship, Commerce and Navigation

FDI

Foreign Direct Investment

FET

Fair and Equitable Treatment

FMV

Fair Market Value

FPI

Foreign Portfolio Investment

FTC

Free Trade Commission

GATS

General Agreement on Trade in Services

GATT

General Agreement on Tariffs and Trade

GDP

Gross Domestic Product

GNI

Gross National Income

HC

Host Country

ICC

International Chamber of Commerce

ICJ

International Court of Justice

ICSID

International Centre for the Settlement of Investment Disputes

IISD

International Institute for Sustainable Development

IMF

International Monetary Fund

LDC

Least Developed Countries

M&A

Mergers and Acquisitions

MAI

Multilateral Agreement on Investment

XXII

List of Abbrevations

MIGA

Multilateral Investment Guarantee Agency

MFN

Most Favoured Nation

MNE

Multinational Enterprise

NAFTA

North American Free Trade Agreement

NE

Nash Equilibrium

NGO

Non-Governmental Organisation

OAS

Organization of American States

OECD

Organisation for Economic Cooperation and Development

OPIC

Overseas Private Investment Corporation

PBE

Perfect Bayesian Equilibrium

PCA

Permanent Court of Arbitration

PD

Prisoner's Dilemma

SCC

Stockholm Chamber of Commerce

TRIMS

Trade-Related Investment Measures

TRIPS

Agreement on Trade-Related Aspects of Intellectual Property Rights

UN

United Nations

UNCITRAL

United Nations Commission on International Trade Law

UNCTAD

United Nations Conference on Trade and Development

USD

US-Dollar

VCLT

Vienna Convention on the Law of Treaties

WGI

World Governance Indicators

WTO

World Trade Organization

List of Variables CM

=

Cooperation gain for the MNE (profit)

CH

=

Cooperation gain for the host country (taxes, spillover etc.)

LM

=

Loss for the MNE in case of expropriation (Loser's payoff)

WH

=

Value of the assets to the host country if expropriated (Winner's payoff)



=

Discount rate of the host country

X

=

Collateral/Hostage

D

=

Damages/Compensation



=

Probability that the host country is reliable

q2

=

Probability that the host country is reliable as assessed by the MNE in period two

z

=

Probability that the bad type will play accommodation in the first period

v

=

Probability that MNE plays invest

y

=

Probability of error

T

=

Litigation costs

R

=

Reputational loss

S

=

Settlement costs

A

=

Costs of concluding the BIT

BR

=

Compliance costs of the BIT for the reliable type (arbitration risk)

BU

=

Compliance costs of the BIT for the unreliable type (arbitration risk)

1

Introduction

Foreign direct investment (FDI) flows amounted to 1,697 billion USD in 2008, while global FDI stocks reached a level of more than 16,205 billion USD.1 These figures underline the fact that FDI has gained an importance that is comparable to trade in providing foreign markets with goods and services.2 In addition, FDI constitutes the largest source of external finance for developing countries.3 Nevertheless, the global financial crisis had a significant impact on FDI at the end of 2008, reducing flows by approximately 14.2% compared to the all-time high of 1,978 billion USD in 2007. The downward trend continued in 2009. Flows declined to 1,114 billion USD, but are expected to rise in the next 3 years to about 1,600 - 2,000 billion USD in 2012.4 In any case, the relative importance of FDI flows in the global economy remains unchanged. However, FDI is prone to risk. In addition to the operational risk inherent in any business activity, FDI suffers from political risk. Investors need to be concerned with the protection of their investment from expropriation, be it direct or indirect, and any other derogation of their assets by governmental actions. Several institutions on both the domestic and international level have developed to mitigate this kind of risk. The most important development in international law in this regard is the emergence of Bilateral Investment Treaties (BITs). While the number of these treaties has been steadily growing since the first treaty in 1959, the number of arbitrations based on BITs and the controversies surrounding the content and impact of BITs has been notably increasing in the last decade. Unlike international trade law, the functioning and consequences of international investment law in general and BITs in particular have not yet been analysed thoroughly from an economic point of view. Indeed, there is a gap in the literature regarding the economic analysis of Bilateral Investment Treaties that is worth addressing. Developing a better understanding of the legal structure surrounding the protection of FDI is an important enterprise, especially because FDI can substantially contribute to the economic development of poor countries. The legal protection of FDI does not only have important implications regarding the integration of the global economy, but also with regard to issues of domestic public policy as BITs limit the sovereignty of governments. The approach of law and economics is well-suited to

1 2

3 4

UNCTAD (2009a), p.xix and p. 251. Comparing FDI stocks and trade flows for the year 2006, Sauvant (2008) argues that FDI "has become the most important vehicle to bring goods and services to foreign markets." See Sauvant (2008), p.1. World Bank (2007), p.314. See UNCTAD (2010), p. xvii.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_1, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

2

Introduction

unite the legal and economic aspects of FDI protection and to advance our understanding of these important issues. 1.1

International Law and Economics

The economic analysis of law is by now an integral part of many if not most areas of law. It is virtually undisputed that – in addition to classical fields like antitrust law economic theories and methods have also improved the understanding of contract law, property law and tort law. The application of economic models has also been expanded to criminal law and family law. Yet, while the field of international law has always received considerable attention by legal scholars, it has traditionally been ignored by scholars with a law and economics background.5 Leading law and economics textbooks do not or only very shortly deal with issues of international law.6 Further, international legal scholars have mainly abstained from the use of economic methods.7 Nevertheless, for about the last decade, there has been a small but growing literature on international legal issues. In 1997, Ronald A. Cass denoted international law and economics scholarship as the "new kid on the block."8 Dunoff and Trachtman (1999) provide one of the first systematic overviews on the economic analyses of international law. The authors identify a number of issue areas where the insights of law and economics can be fruitfully applied. The recent overview article by Sykes (2007) illustrates that, while the bulk of work still analyses international trade law, a number of contributions have now been made in various areas of international law, such as security issues and international investment law. Nevertheless, most fields of international law remain underdeveloped in this respect. But what are the defining characteristics of the law and economics of international law? Three aspects appear especially noteworthy when answering this question. First, the core principle of economics is the rational choice principle. Consequently, rational choice theory is a cornerstone of law and economics. Its application to international law has been the subject of controversial discussion.9 The differences of the rational choice approach as compared to other common approaches to the analysis of international law and international relations can be found in Guzman (2002) and Guzman (2008a). Similar to Guzman (2008a), this book takes a rationalistinstitutionalist approach. In particular, it is not assumed - unlike the "managerial model" laid out by Chayes and Chayes (1995) - that states have a propensity to comply 5 6

7 8 9

A notable exception is international trade law. See e.g., Cooter and Ulen (2004), Shavell (2004) or, for a short comparison of contracts and treaties, Posner (2003), p.136ff. Dunoff and Trachtman (1999), p.2. Cass (1997), p.2. See e.g., Snidal (2002) or Keohane (2002) for the main points of the discussion.

Introduction

3

with international obligations.10 The standard rationalist assumptions encompass that states "are assumed to be rational, self-interested, and able to identify and pursue their interests. Those interests are a function of state preferences, which are assumed to be exogenous and fixed. States do not concern themselves with the welfare of other states, but instead seek to maximise their own gains or payoffs."11 An implicit part of these assumptions about the state is that it acts as a unitary actor. This assumption of the unitary state is very useful for the analysis of many aspects of international law, such as questions of compliance. This approach, although a deviation from the methodological individualism paradigm of economic theory, has also been applied in other areas of economics. With regard to corporate behaviour, Posner (2007) argues: "Economics made much progress in modelling the interactions of business forms without peeking inside them but instead treating them as if they were individuals."12 Therefore and in line with the relevant literature, the arguments in this book will in large part be based on this assumption. Nevertheless, at some points, it will be necessary to deviate from this assumption as some aspects of bilateral investment treaties may be better understood when assuming - in the public choice tradition - that the interests of political leaders and citizens do not align.13 Please note this is not a repudiation of the rational choice principle. Relevant actors are still assumed to be rational. The public choice approach in the context of international relations simply opens the "black box" of the state and allows different actors within the state to have diverging, yet rational interests that influence international lawmaking. However, in analyzing many aspects of international law, it is simply not necessary to open this black box. A second feature of law and economics as compared to other branches of legal theory is its emphasis on the use of certain, often rather formal methodologies, most prominently econometrics and game theory.14 Nevertheless, it should be noted that, while these methods are characteristic to international law and economics, they are not essential to the rational choice approach. For example, quantitative and statistical methods can obviously also be employed to test hypotheses derived from theories not applying the rational choice approach, while a verbal analysis may very well be based on the rational choice approach. A third important aspect is the distinction between the positive analysis and the normative analysis usually employed in economics. While the positive analysis 10 11 12 13 14

Chayes and Chayes (1995), p.3. Guzman (2008a), p.17. Posner (2007), p.136. Namely, in chapter 5 of this book. See e.g. Elkins, Guzman et al. (2006) and Goldsmith and Posner (2005). For a literature overview on economics applied to international law, see Sykes (2007).

4

Introduction

attempts to explain legal rules and outcomes as they are (given the rationality assumption), the normative analysis rather asks how the law should be. The normative criterion employed in law and economics is the efficiency criterion. Economists differentiate between Pareto efficiency and Kaldor-Hicks efficiency.15 A situation where it is impossible to make changes that make at least one person better off without making another person worse off is called Pareto efficient. Put differently, a change that makes one person better off without making anybody worse off is called a Pareto improvement. A less restricted notion of efficiency is the Kaldor-Hicks efficiency. Here, a change is already considered efficient when the winners gain more than the losers lose. In theory, the winners could compensate the losers for the loss and still be better off. This compensation, though, does not actually have to take place. Therefore, Kaldor-Hicks efficient changes are often also referred to as potential Pareto improvements. While the positive analysis of international law based on the rational choice principle is now widely used16, the application of the efficiency principle to international (public) law is rare and not unproblematic. As Van Aaken (2008b) points out, the problems with the use of the efficiency criterion in international law bears a resemblance to problems with its use in constitutional law.17 Here, one of the fundamental problems is that certain constitutional principles may be equally or even more important than efficiency. Another problem related to efficiency and social welfare concerns the level of analysis. From a normative perspective, it makes a huge difference if only the contracting parties are taken into account or if global welfare is taken as the benchmark. Given these considerations, the book at hand is mainly of a positive nature with the notable exception of chapter 5. Where normative conclusions are put forward, the difficulties with the efficiency criterion in international law will be made explicit. 1.2

Structure

The book will proceed as follows: chapter 2 will provide an overview on the underlying causes, effects and trends concerning foreign direct investment. By using a simple game theoretic example, chapter 3 explains why FDI suffers from expropriation risk and discusses the economic strategies and mechanisms that may help to diminish this risk. In addition, this chapter outlines the legal landscape regarding the protection of international investment, with a special focus on the nature and contents of BITs. Chapters 4 and 5 are both devoted to the understanding of the functioning of Bilateral Investment Treaties from different perspectives. Chapter 4 focuses on the relationship

15 16 17

See e.g. Cooter and Ulen (2004), p.16f and p.48. Although the rational choice principle is - as mentioned before - not undisputed. Van Aaken (2008b), p.659.

Introduction

5

between the countries trying to attract FDI and the multinational enterprises (MNEs) providing FDI. At the core of the chapter lies the question of why BITs function despite the (perceived) weakness of international law. The potential commitment and signalling properties of BITs will be analysed and discussed. It will be argued that the scope for a signalling function is rather limited. In addition, the commitment function is structurally similar to the exchange of hostages or collateral and therefore suffers from the same incentive problems. In turn, chapter 5 examines the competition dynamic between developing countries trying to attract FDI. While BITs are certainly part of the institutional competition for FDI, a controversy exists regarding the (welfare) implications of this institutional competition. BITs will be discussed in the context of this controversy. The relevant question is whether BITs are either a manifestation of the detrimental or of the beneficial aspects of this competition. The analysis shows that BITs contain elements of both aspects. Furthermore, the findings of this chapter underline the importance of the consideration of public policy concerns in investment arbitrations. The following two chapters focus on specific issues relating to bilateral investment treaties. More precisely, chapter 6 analyses the impact that BITs may have on domestic institutional quality using panel data in a fixed-effects model. A positive effect can be excluded while rather weak evidence points in the direction of a negative effect. Moreover, the results emphasize the importance of domestic reform for institutional quality. Chapter 7 is concerned with the issue of transparency in international investment arbitration. A lack of transparency has been criticised by a number of observers. Without contradicting the arguments for transparency, this chapter will discuss some structural implications of increased transparency compared to confidentiality and aims to add new arguments to the discussion. Special attention will be paid to the question of who would actually profit from increased transparency, arguing that the benefits of transparency are widespread, while the benefits of confidentiality directly accrue to the parties of a dispute. This explains the persistence of confidentiality in international investment law. Chapter 8 summarises the main results and identifies areas for further research.

2

Foreign Direct Investment

2.1

Trends and Figures

According to the OECD, foreign direct investment "reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘‘direct investor’’) in an entity resident in an economy other than that of the investor (‘‘direct investment enterprise’’). The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated."18 As a practical matter, an equity share of more than 10% is usually considered the threshold for the control of an asset.19 In contrast to FDI, investment that does not aim at the exercise of control is usually referred to as Foreign Portfolio Investment (FPI). To be classified as FDI, it does not matter if the direct investment enterprise is incorporated in the foreign country, and is thus a subsidiary or associate company, or not incorporated and is thus a branch.20 A frequent distinction with regard to FDI is between flows and stocks. Obviously, FDI stocks denote the value of FDI in a given country at a given point of time, while FDI flows denote the amount of FDI flowing to a given country in given period of time. Another important differentiation regarding the nature of FDI is between Mergers and Acquisitions (M&As) and Greenfield investment. While the notion of M&A is self-explanatory, Greenfield investment refers to investment that includes the establishment of new production facilities such as offices, buildings and factories.21 The last few years have seen a considerable growth of FDI. In 2006, FDI flows reached $1,306 billion USD while total FDI stocks amounted to roughly $12,000 billion USD.22 Compared to 2005, this constitutes a growth in FDI flows of about 38%. As Figure 2.1 indicates, FDI has been on a growth path since the mid-1980s, reaching a peak in the year 2000 and an all-time high in 2007. However, recent figures for 2008 and 2009 evidence the negative consequences of the financial crisis and have caused FDI to fall to 1,114 billion USD in 2009.23

18 19 20 21 22 23

OECD (1996), 7f. UNCTAD (2007a), p.245. OECD (1996), p.9. UNCTAD (2006), p.15. UNCTAD (2007a), p.9. UNCTAD (2010), p.xix.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_2, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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7

Figure 2.1: FDI Flows (Inward) 1970-2009

Source: Own diagram based on UNCTAD Data (http://stats.unctad.org/FDI/)

Foreign Direct Investment now constitutes the largest source of external finance for developing countries.24 Nevertheless, the bulk of FDI in 2006, namely more than 60%, went to developed countries.25 As figure 2.2 indicates, the countries of Western Europe experienced the highest FDI inflows. Among the emerging and developing regions, Asia appears to be the most attractive FDI location.

24 25

World Bank (2007), p.314. Kekic and Sauvant (2007), p.6.

8

Foreign Direct Investment

Figure 2.2: FDI Flows (Inward) – Selected Countries and Regions

Source: Own diagram based on UNCTAD Data (http://stats.unctad.org/FDI/)

It is remarkable that, as Sauvant (2008) notes, FDI "has become the most important vehicle to bring goods and services to foreign markets and to integrate national production systems".26 More specifically, in 2006 there were more than 78,000 parent companies with more than 780,000 foreign affiliates.27 Another noteworthy trend is the growing importance of south-south flows (meaning flows between developing countries) since the mid-1980s. Starting from about 4 billion USD in 1985, southsouth flows rose to almost 60 billion USD in 2004.28 Regarding the sectoral distribution of FDI, a relative shift from manufacturing to services can be observed. Of the global FDI stocks in 2005, 61% were in the service sector, compared to 49% in 1990.29 Manufacturing accounted for 30%, leaving the remaining 9% to the primary sector. 2.2

Multinational Enterprises and FDI

Why do enterprises find it worthwhile to invest in foreign countries at all? Goods and, to a growing degree, services could be produced in the home country of the investor and simply be exported to the foreign markets. A number of theories of foreign direct 26 27 28 29

Sauvant (2008), p.3. UNCTAD (2007a), p.12. UNCTAD (2006), p.117. UNCTAD (2007a), p.22.

Foreign Direct Investment

9

investment have been developed. This section will focus on transaction cost/internalisation theories of FDI as developed by scholars like Buckley, Casson, Hennart and Rugman.30 The following summary is based on Hennart (2001). The transaction cost theory of FDI has its foundations in the writings of Coase (1937), Alchian and Demsetz (1972) and Williamson (1985).31 As Hennart (2001) points out, classical trade theorists explained FDI mainly as a result of differences in real interest rates. However, this theory proved to be unable to explain the major flow and growth patterns of FDI. Theories based on transaction cost economics revealed more explanatory power in the context of FDI. In general, transaction cost economics focuses on the costs of cooperation between economic agents as a result of cognitive limitations and opportunism, namely information, enforcement, and bargaining costs.32 The specific question transaction cost theories of FDI seek to answer is why interdependencies across national boundaries are organised through multinational enterprises (and thus through FDI) that could also be organised through markets. Interdependencies, in this context, arise when a "firm located in country X has some assets which have potential value in country Y if successfully combined with some country Y factors."33 The obvious answer is that multinational enterprises (MNEs) will arise when they can organise these interdependencies more efficiently than markets. As Hennart (2001) notes, this implies three conditions for the existence of MNEs: "(1) interdependent agents must be located in different countries (otherwise we would have a domestic firm), (2) the MNE must be the most efficient way to organize these interdependencies (otherwise we would have international market transactions), and (3) given condition (2) the costs incurred by MNEs to organize these interdependencies are lower than the benefits of doing so."34 These conditions are likely to be met where know-how, reputation, raw materials and components, distributions and marketing and, finally, financial capital is involved. Why should MNEs in these areas work more efficiently than markets? It is, for example, well-known, that the market for know-how suffers from information asymmetries. The dynamic is similar to the market for lemons as described by Akerlof (1970). Potential buyers of know-how cannot assess the quality of the product. Obviously, the seller cannot reveal the know-how (if he did, he would give away his

30

31

32 33 34

Hennart (2001), p.131. A competing theory of FDI that nevertheless shares many features with transaction cost theories is the eclectic paradigm. See Dunning and Lundan (2008). Dunning and Lundan (2008), chapter 4. Hennart (2001), on the other hand, emphasises that the transaction cost theories of FDI was developed independently of the writings of Williamson. See Hennart (2001), p.132. Hennart (2001), p.133. Hennart (2001), p.145. Hennart (2001), p.136.

10

Foreign Direct Investment

product for free). If patent systems cannot guarantee the property rights of the knowhow, the optimal way to organise the interdependency might be through an MNE. In the case of reputation, an alternative way for a company from one country to exploit its reputation in another country would be through franchise contracts. However, as Hennart (2001) emphasises, free-riding poses a huge problem to franchising. A single franchisee has the incentive to lower his quality. The reputational costs will be borne by the whole franchise chain and only to a very small degree by the single franchisee – especially when customers are mainly non-repeat customers. When it is very costly or impossible to contractually define quality, ownership (via an MNE) may be a more efficient way to exploit reputation across borders than franchising contracts. The motivation for vertical integration across borders in the case of raw materials and components is different. Here, the problem with market transactions is often the absence of a large number of buyers and sellers. According to Hennart (2001), a small number of market participants in raw materials markets is often the result of economies of scale, high transportation costs, government barriers, and asset specificity.35 Asset specificity means that the value of an asset is (mainly) specific to a certain transaction and thus loses value if used otherwise. As described prominently by Williamson (1985), the party undertaking investment in specific assets may be subject to the hold-up problem, which is opportunistic renegotiation by the other party to the point where the investment would not have been profitable in the first place. Consequently, a value-creating cooperation might not be pursued when the hold-up risk is high. Long-term contracts are a potential solution for this dilemma. However, when long-term contracts are not feasible and transaction-specific investments are considerable, ownership might be a sensible strategy to overcome the hold-up problem. Comparable to the example of raw materials, markets for distribution can be inefficient and subject to hold-up problems as well. Distributors may be reluctant to invest in manufacturer-specific distribution systems. As Hennart (2001) states: "When the physical or intellectual investments necessary to effectively sell a product are large and manufacturer-specific, and the environment is hard to predict, the integration of manufacturing and distribution within an MNE will often be the best solution."36 The last example illustrating the purpose of MNEs concerns financial capital. As mentioned before, classical trade theorists considered FDI as a result of differences in the real interest rate. The preceding paragraphs demonstrated that a number of reasons for the existence of MNEs do not require the existence of interest rate differences.

35 36

Hennart (2001), p.139. Hennart (2001), p.140f.

Foreign Direct Investment

11

Nevertheless, financial capital from country A might often be invested more profitably in country B. The question here is why this should not always simply be done through lending. The problem is that lending money creates problems of moral hazard on the side of the borrower who may take too much risk or not exert enough effort. The cross-national nature of the transaction may make the lender’s control of the funds even more problematic. One solution to this problem could be the use of collaterals. However, when collaterals are not available and the project is nevertheless profitable, a sensible strategy could be the integration of lenders and borrowers into an MNE. As these examples illustrate, the key question for the existence of MNEs and thus FDI is why the organisational form of an MNE for the cross-national transaction is more efficient as compared to the use of the market or contracts. The prerequisite is, of course, that the cross-national transaction is profitable. This prerequisite is evidently not sufficient for the occurrence of FDI. Indeed, in many cases, the cross-national transaction will simply be executed through markets or certain types of contracts. However, if the existence of hold-up risks or information asymmetries means that the transaction is more efficiently structured along the hierarchical lines of a multinational enterprise, FDI will occur. Therefore, the motives for FDI naturally bear a lot of resemblance to the classical reasons for vertical integration as identified by the transaction cost economics literature, adding the cross-national nature of the economic transaction at hand. A different theory of FDI that is often considered the predominant paradigm for direct investment is called the OLI or eclectic paradigm.37 The OLI theory is for the most part not incompatible with the transaction cost/internalisation theory of FDI. As a matter of fact, internalisation is an integral part of the OLI framework. The main difference is that the OLI framework emphasises, apart from internalisation (I), the importance of ownership-specific advantages (O) and location-specific advantages (L). Ownership-specific advantages are the advantages the potential MNE has that it wishes to exploit across borders, while location-specific advantages are the advantages of a potential host country of FDI compared to its competitors.38 As a practical matter, FDI is often classified into three categories: market seeking FDI, resource/asset-seeking FDI and efficiency-seeking FDI. This classification is used by the United Nations Conference on Trade and Development (UNCTAD).39 As the transaction cost theory of FDI has illustrated, the existence of attractive markets or the demand for natural resources is not sufficient for FDI to emerge. In addition,

37 38 39

Ethier and Markusen (1996), p.2. See Dunning and Lundan (2008) for the description of the OLI paradigm. See e.g. UNCTAD (2003), p.85.

12

Foreign Direct Investment

ownership must be a more efficient organisational structure than, for example, market transactions. Nevertheless, the classification used by UNCTAD (2003) can be useful in some respects. 2.3

FDI and Development

Before proceeding, it appears worthwhile to take a closer look at the impact of FDI on the host country's economy. The term host country (HC) is used to denote the country that receives the investment (as opposed to the home country of the investor). With special regard to developing countries, Jain and Vachani (2006) provide an overview on the potential effects of multinational enterprises (MNEs).40 These effects include technology spillover, export spillover and productivity spillover, as well as effects on wages, competition and consumer preferences. The empirical evidence on some of these effects appears to be mixed. One reason is that spillover is hard to measure. As Saggi (2002) notes, spillovers "do not leave a paper trail."41 The question of the effect of FDI on the host country can be approached on two different levels. First, one could look at the effect of FDI on micro-level data like wages, productivity, exports etc. Alternatively, one could look at the growth rate of countries and directly analyse its connection to direct investment. Lipsey (2002) takes the first approach and summarises the main empirical findings of the impact of FDI on wages, productivity, exports, and the introduction of new industries. He observes that the impact of FDI on local wages is positive. Virtually all studies on this matter show that foreign-owned companies pay higher wages than local firms.42 The question is whether these findings reflect that MNEs might mainly operate in high-wage sectors and/or that MNEs might have a higher propensity to hire more highly qualified personnel than domestic firms for reasons unrelated to their foreignness. The numerous studies on this question are very diverse in the sense that they focus on many different countries and regions (including developing as well as developed countries) and employ a diverse set of control variables (firm size, education level, industry sector, etc.). As the overview in Lipsey (2002) illustrates, foreign firms clearly tend to pay higher wages, independent of the region in which they operate (and independent of a wide set of other controlled variables). Another important question concerns the wage effect of MNEs on the labour market (that is, on the wages paid by local firms) in general. Here, the evidence is more ambiguous. Some studies find positive, while others find no or negative spillover of MNEs on

40 41 42

Jain and Vachani (2006), p.8ff. Saggi (2002), p.208. Lipsey (2002), p.20.

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13

wages in domestic owned firms.43 In sum, the effect of the presence of MNEs on the average wage appears to be mainly positive, which indicates that even if there are negative spillovers, these are offset by the higher wages paid by the MNEs themselves.44 Concerning productivity spillover, a logical prerequisite is that foreign-owned firms are on average more productive than domestic firms. Virtually all empirical studies on this matter confirm that foreign firms indeed are more productive, in developing as well as in developed countries.45 The spillover of productivity (or knowledge and technology) to domestic firms is obviously much harder to measure. The main transmission channel for the spillover of productivity to domestic firms is likely backward linkages. These backward linkages describe the connection of MNEs to suppliers. MNEs usually have an interest in establishing or sharing production technology and quality-control techniques in a vertical direction in order to build reliable production networks.46 On the other hand, MNEs have an interest to avoid knowledge spillover in a horizontal direction. These spillovers may nevertheless take place due to imitation, competitive pressures or the movement of employees.47 The empirical evidence on the effect of FDI on productivity is mixed. Some studies even seem to indicate negative spillover effects.48 As Lipsey (2002) points out, the measuring of productivity spillover poses a number of econometric problems, including the validity and availability of productivity indicators as well as problems with model specifications.49 As a logical matter, it is hard to hypothesise that MNE activity should not have any (positive) effect on domestic firms at all. As Moran (2006) provocatively phrases, it "is possible to imagine in the abstract that foreign investors enter a host economy and train local managers and workers who never leave the foreign-owned firms, set up operations without any local firms copying their use of machinery or their management techniques, and create supply chains with indigenous companies that learn nothing new from the relationship, enjoy no scale effects, or, if they do, use the novel skills to sell exclusively to the foreign subsidiaries who capture all the benefits that result."50 Obviously, this scenario appears to be rather unlikely. Nevertheless, given the mixed empirical findings on this issue, it is hard to make any firm assertions. Lipsey (2002) concludes that "the mixed story for spillover, combined

43 44 45 46 47 48 49 50

Lipsey (2002), p.32. Lipsey (2002), p.34. Lipsey (2002), p.40. Moran (2006), p.21. Moran (2006), p.24. Lipsey (2002), p.46. Lipsey (2002), p.49ff. Moran (2006), p.23.

14

Foreign Direct Investment

with the strong evidence for superior productivity of foreign-owned firms, suggests that overall productivity is improved by the presence of foreign-owned operations, although that question is rarely, if ever, examined."51 The evidence of the effect of FDI on exports and the introduction of new industries is, however, well-established and positive.52 The affiliates of MNEs are usually not only more export-oriented than their domestic counterparts; there is also evidence that the presence of an MNE also raises the export propensity of the domestic firms in that industry.53 Consequently, the host country establishes a tighter linkage in the world trading system through FDI. This assertion also partly holds true for imports. The question here is whether trade and FDI are substitutes or complements. At first glance, the answer given by the internalisation theory appears simple: FDI is described as an alternative to trade and consequently, FDI and trade should be viewed as substitutes. However, this simplistic view ignores a number of more complicated processes related to MNE activity. Most importantly, the MNE may import intermediate goods necessary for the production of the final good. Also, the presence of a firm's production facilities for one product in a country may increase the demand of other products of the same company in that country, even when the other products are produced somewhere else. Potential channels might be, among others, increases in demand due to the publicity related to the presence of the firm54 or more efficient deliveries and distribution.55 While there are theoretical arguments both for substitutability and complementarity, the majority of empirical studies finds strong evidence for net complementarity.56 However, depending on the data aggregation level (product specific data as compared to firm or industry specific data), substitution effects can also be shown.57 In sum, while FDI substitutes for imports to some extent, on the aggregate level, FDI leads to even more imports. Examining the possible spillover effects of FDI on certain economic variables leads to the more general question regarding the impact of FDI on economic growth. The importance of the dissemination of ideas for economic development, also through FDI, has been noted by Romer (1993)58, one of the co-founders of the endogenous growth theory. However, the empirical studies on this issue show mixed results. While some studies find no systematic effect of FDI on growth, other studies find that, for certain

51 52 53 54 55 56 57 58

Lipsey (2002), p.59. Lipsey (2002), p.54. Lipsey (2002), p.53. Lipsey and Weiss (1984), p.305. Blonigen (2001), p.84. Blonigen (2001). See Swenson (2004) and Blonigen (2001). Romer (1993).

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15

subsets of countries, there is a robust positive relationship.59 Two recent studies should be mentioned here as illustrative examples. Li and Liu (2005) investigate the relationship between FDI and growth in a panel data study for 84 countries for the period between 1970 and 1999. From the mid-1980s onwards, the authors identify a significant relationship between FDI and economic growth. On the other hand, Carkovic and Levine (2005), using a panel data study for 72 countries from 1960 to 1995, do not find a robust, positive influence of FDI and economic growth. A number of authors have tried to detect the reasons for the inconclusive results of the impact of FDI on growth. Borensztein, De Gregorio et al. (1998) show that FDI can have an important positive impact on growth, but only when the host country already has a certain stock of human capital. In other words, a lack of human capital limits the absorptive capability of the host country. Busse and Groizard (2008) explore the importance of regulatory quality for the impact of FDI on growth. The authors find that excessive business and labour regulations frustrate a positive growth effect of FDI. Alfaro, Areendam et al. (2003) stress the importance of the stage of development of the local financial markets for a positive impact of FDI. Balasubramanyam, Salisu et al. (1996) emphasise the importance of trade policy, or, more specifically, trade openness, for FDI to exert a positive effect on growth. A similar point is made by Moran (2006), who uses a number of examples to illustrate that FDI has detrimental effects where it is understood as part of an import substitution policy, while positive effects accrue in the absence of trade protection. This discussion illustrates that it would be inaccurate to simply imply that more FDI will lead to higher economic growth rates. However, FDI can indeed work as a vehicle for higher growth when certain host country characteristics and policies are met. Nevertheless, as a number of authors emphasise, FDI and MNE activity can also have a negative effect on certain host country variables. Some of these effects have already been mentioned, like the possible negative effect on host countries’ productivity. Also, as Moran (2006) has pointed out, where MNEs operate in protected markets as part of an import substitution strategy, they may use inefficient technology and may also not be able to exploit economies of scale, thus doing more harm than good to the host country's economy.60 Other authors have raised concerns of the impact of MNE activity on environmental and social standards61, on the competition in domestic markets and the loss of market share of domestic firms62, the crowding out of domestic

59 60 61 62

Lipsey (2002), p.55. Moran (2006), p.7ff. For a short overview, see Meyer (2004), p.269ff. See, e.g., Aitken and Harrison (1999).

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Foreign Direct Investment

investment63 and the possible negative balance of payments effects.64 Evidently, the economic literature on these issues can be characterised as controversial. Nevertheless, the majority of economists seem to emphasise the positive effects of FDI on the respective host country. It also seems clear that some of the potential negative effects of FDI can be addressed through adequate domestic policies and thus might, if at all, only pose minor or temporary problems. While the academic debate on the effects of FDI on host countries is far from being over, as a practical matter, the issue seems to have been decided. Governments all over the world seemingly consider the contribution of FDI to domestic welfare as positive and adapt their regulatory systems to attract FDI. From the 184 regulatory changes in 2006 with regard to FDI as monitored by UNCTAD, 147, representing a share of almost 80%, were favourable to FDI.65 For the time span of 1992 to 2001, Kobrin (2005) finds that even 95% of the changes were liberalizing rather than restrictive. Using cross-sectional regressions, Kobrin (2005) shows that external factors do not play a significant role in the liberalisation decision – indicating that favourable FDI policies were not imposed through external pressures. In addition, international development organisations such as UNCTAD emphasise the importance of FDI for development.66 Not surprisingly, developed countries represented by the OECD also see MNE activity as mainly beneficial.67 Lastly, the predominant perception of the beneficial nature of FDI with policy-makers is also reflected by the lasting trend to protect international investment by means of international law, namely through bilateral investment treaties (BITs).

63 64 65 66

67

See, e.g., De Backer and Sleuwaegen (2003). UNCTAD (1997), p.88. UNCTAD (2007a), p.14. See, for example, the foreword by Ban Ki-moon to the World Investment Report 2007, UNCTAD (2007c), p.iii. See e.g. OECD (2002).

3

Economic and Legal Protection of FDI

The preceding section has shown that most countries perceive FDI as predominantly beneficial. Obviously, the companies that engage in FDI prefer this form of transaction to other forms like trade or licensing. If FDI is beneficial to both parties of the transaction, why would FDI need any protection at all? The following section will explain the inherent risk to FDI as the consequence of a time inconsistency problem (section 3.1). MNEs, international organisations and policymakers have implemented economic and legal measures to protect FDI. The former will be introduced in section 3.2. and the latter in section 3.3. 3.1

Time Inconsistency and Expropriation Risk

Investors operating in a risky international environment are naturally concerned with the protection of their assets. Apart from the regular economic risks associated with the operation of a business, a major concern for MNEs is political risk.68 A useful definition of political risk goes back to Weston and Sorge (1972), taken up by Kobrin (1979): political risks "arise from the actions of national governments which interfere with or prevent business transactions, or change the terms of agreements, or cause the confiscation of wholly or partially foreign owned business property."69 The main problem here is the problem of the taking of property owned by foreigners through expropriation or through regulatory measures (indirect expropriation). At the core of this issue is usually the redistribution of assets from foreign businesses to the government or third parties. 3.1.1

Time Inconsistency

The economic problem related to expropriation, be it direct or indirect, is a problem of time inconsistency70 or hold-up.71 Once the investment is sunk, the host state has an incentive to expropriate (or exploit, redistribute etc.) the assets in one way or another. This could be considered a form of opportunism that is present in many if not most sequential transactions. A useful definition of time inconsistency can be found in

68 69 70

71

See, e.g., Busse and Hefeker (2007). Kobrin (1979), p.67. See Guzman (1998). The idea of time inconsistency in government action goes back to Kydland and Prescott (1977). Guzman (1998) uses the expression dynamic inconsistency instead of time inconsistency. See, e.g., Williamson (1983).

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_3, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

18

Economic and Legal Protection of FDI

Drazen (2002).72 In his example, a government has to choose a tax rate for a certain time period in the future. It can either decide on this tax rate immediately or it can wait until the relevant period arrives. "Time inconsistency is said to arise if, though nothing has changed (at least ostensibly), these choices are not equal (…)".73 From a gametheoretic point of view, the interaction with respect to international investment resembles a trust game.74 The problem of time inconsistency can in this way be presented as a game-theoretic problem of subgame-(im)perfection.75 The underlying logic can be illustrated in a simple sequential two-player game of complete information involving a representative multi-national enterprise (MNE) and a host country (HC). First, the MNE decides whether to invest or not. If no investment takes place, the payoff for both players is zero. If the investment takes place, the host country has two options: it can either accommodate or expropriate the investment.76 If the host country accommodates, both player receive their share of the cooperation gain: the MNE receives CM and the host state gains CH, where CH is a measure indicating how much a country can gain through FDI, be it through taxes or spillover effects, with CH ! 0 . Further, it is assumed that WH (with WH t 0 ) describes how much the investment is worth to the host state if expropriated.77 In that case, the remaining value of the investment to the investor (which is often negative and therefore rather a loss or damage) is defined as LM. Consequently, the extensive form of the game looks as follows:

72

73 74 75

76

77

See Drazen (2002), p.101f. The focus of Drazen (2002) is, however, on time inconsistency problems where governments use that phenomenon to increase social welfare by misleading their constituents. The focus of this book is, on the other hand, how time inconsistency can be avoided when it is anticipated by the economic agents. Drazen (2002), p.102. For an illustration of the trust game, see, e.g., Kirstein (1999), p.20 ff or Schmidtchen (1994). Time Consistency and Subgame Perfection are not identical concepts. First of all, the notion of time consistency is usually related to macro-economic issues, while subgame perfectness (or perfection) is a game theoretic expression. More importantly, subgame perfectness is a useful solution concept in numerous dynamic games that have no reference to time consistency. Nevertheless, for the exposition of time consistency in a game theoretic context, subgameperfectness seems to be the most practical way. The similarity between time consistency and subgame perfectness is also illuminated in McTaggart and Salant (1989) and explained in Rasmusen (2001), p.105. For a more game-theoretic reflection on Kydland and Prescott (1977), see Fudenberg and Tirole (1991), p.74ff. Please note that by expropriate, the judicial term implying the payment of compensation is not meant, but simply the appropriation of the assets of the investor/MNE. Yet, the use of the word appropriate or, alternatively, confiscate, could be equally misleading. Or how much the host country can win (thus WH) by taking the opportunistic action. The notation used here is in line with Dixit (2004), p.15.

Economic and Legal Protection of FDI

19

(0,0) Don't Invest

(CM,CH)

M Accommodate Invest H

Expropriate

(LM,WH)

Figure 3.1: Time Inconsistency

Notation CM

=

Cooperation gain for the MNE (profit)

CH

=

Cooperation gain for the host country (taxes, spillover, etc.)

LM

=

Loss for the MNE in case of expropriation (Loser's payoff)

WH

=

Value of the assets to the host country if expropriated (Winner's payoff)

Player There are two players: the host country (HC) and a representative investor or multinational enterprise (MNE) Strategies The game has two stages. In the first stage, the MNE decides whether to invest. When there is no investment, the game is over. In the case of investment, there is a second stage. The host country now must decide whether to accommodate or expropriate the investment. Payoffs In the case where no investment takes place, the payoff to both players is normalised to zero (second best opportunity). When the MNE invests and the host country accommodates, the MNE generates a profit of CM and the HC gains spillover and taxes of CH. In the case where the MNE invests and the HC expropriates, the MNE will incur damages LM and the HC an expropriation gain WH. In the baseline (no cooperation) case, we assume CM >0, LM <0 and WH > CH.

20

Economic and Legal Protection of FDI

This kind of game is also known as the trust game, which is a one-sided version of a prisoner’s dilemma.78 Assuming rationality, the solution of this game can be derived straightforwardly using backwards induction. This solution concept requires starting the analysis at the final decision node or final stage of the game. At the second (and final) stage of the game, the host country must decide whether to accommodate or to expropriate. If WH < CH, that is, if the investment yields more payoff to the host state when it is in the hands of the MNE, the outcome is the cooperative outcome (Invest/Accommodate). However, in many cases, the assumption WH > CH appears to be more realistic. If that is the case, the host state will expropriate in the second stage. As rationality and complete information are assumed, the MNE will anticipate this and, if LM <0, decide not to invest. The subgame-perfect Nash-Equilibrium is thus (Don't Invest/Expropriate) with payoffs of zero for both players. Clearly, the equilibrium is Pareto-suboptimal. Both players could achieve a higher payoff through the combination (Invest/Accommodate). However, this does not constitute a subgameperfect equilibrium. Obviously, the subgame-perfect equilibrium depends on the respective payoffs. The following summary illustrates this (with LM < CM, the gray-shaded area is the case of time inconsistency):

Payoffs

Equilibrium

CH > WH and CM >0

Invest, Accommodate

CH > WH and CM <0

Don't Invest, Accommodate

CH < WH and LM <0

Don't Invest, Expropriate

CH < WH and LM >0

Invest, Expropriate

The definition of time inconsistency included the notion that choices differ even though "nothing has changed". Figure 3.1 shows that this statement is not entirely true.79 Between stage 1 and stage 2 of the game, the investor has made his investment decision, albeit in a predictable way. The statement that "nothing has changed" must

78

79

See Kreps (1990) for a discussion of the trust game. An application to legal aspects can also be found in Kirstein (1999). See also Drazen (2002), p.108.

Economic and Legal Protection of FDI

21

consequently be understood in a way that there are no changes that could not have been predicted in the first place. Two clarifications with regard to the game structure as presented above must be made. The first concerns the notion of expropriation. In this model, the term expropriation is not used as a legal term. Here, any government measure that deprives the investor of the benefit of his investment is subsumed under expropriation. This includes not only outright seizure of the asset, but also partial expropriation, revenue expropriation or other governmental provisions and measures that reduce the value of the investment, but do not fit into the legal definition of expropriation. In the case of revenue expropriation, governments do not expropriate the asset as such, but leave the asset in the hands of the investor and expropriate only the surplus or revenue of the investor. Consequently, expropriation as defined for the game described above includes situations where states set operating conditions in a way to leave just enough revenue to cover the operating costs, thereby providing sufficient ex-post incentive to operate, but certainly not enough to invest in the first place. Therefore, the simple model above captures, depending on the values and interpretation of the variables, all forms of expropriation and asset deprivation. As long as LM <0 (the value of the investment to the investor is negative after state intervention) and CH < WH (the value of the asset to the state is higher if it is actually possessed by the state), we are dealing with the underlying economic problem of time inconsistency. A second preliminary note should be made regarding social welfare and the differentiation between nationals and non-nationals. The model as specified above does not make any statements about the objective function of the government. As a matter of fact, time inconsistency can arise even when the government is considered to be a benevolent social planner.80 In other words, if the government maximises social welfare and redistributes the expropriated assets to its citizens (while ignoring the welfare of the investor), the time inconsistency problem also applies to welfaremaximizing governments. Drazen (2002) emphasises that, contrary to the standard view, a conflict of interests is a necessary condition for time inconsistency to arise.81 In our model, the conflict of interests between the government /state and the investor, once the investment is sunk, is obvious (as long as CH < WH). But this conflict of interests also exists when dealing with a benevolent (with regards to its own citizens) government. Nevertheless, the legal characteristics of the Bilateral Investment Treaties show that many clauses foremost address governments that maximise their own welfare and that this behaviour aggravates the time inconsistency problem. This point

80 81

Drazen (2002), p.101. See also Fischer (1980). Drazen (2002), p.110 ff.

22

Economic and Legal Protection of FDI

will be discussed in chapter 5. However, the disposition of the appropriated assets is not relevant for this chapter. Here, the focus is on the time inconsistency problem as such, how governments and investors structure their transactions to alleviate this problem and how international law, and, more specifically BITs, can contribute to reducing this problem. 3.1.2

On the Relevance of Expropriation Risk

Before proceeding, it appears be conducive to highlight that expropriation or the risk of expropriation (and other forms of appropriation of international investment) is not only a theoretical problem. Three points illustrate this assertion. First, a historical examination of the issue reveals that expropriation has occurred frequently in the 20th century, especially since 1917. The nationalisation in the context of the Russian and the Mexican Revolutions in that year placed the issue of the protection of foreign property on the international law agenda.82 Following World War II, almost all countries in Eastern Europe and a number of countries in Latin America as well as China and later Cuba expropriated foreign (as well as national) investments due to a shift towards communism.83 Another wave of expropriations occurred in the 1970s, when most Arab countries nationalised their oil industries.84 Recent events in South America, particularly in Bolivia and Venezuela, highlight the importance of the issue even today.85 Also, in highly industrialised countries like Germany, expropriation had been part of the political discussion in the wake of the financial crisis.86 Second, there is empirical evidence that political risk (which subsumes the risk of expropriation) can influence FDI decisions.87 Third, the existing legal remedies in international law are widely used. The rise of Bilateral Investment Treaties and the increasing number of arbitrations, as illustrated in section 3.3, show that there is a certain "demand" for these instruments – which would not be the case if investors and governments considered the risk of a loss of FDI through government measures to be negligible. 3.2

The Economics of FDI Protection

If the logic of the one-sided prisoner's dilemma holds true, why does foreign direct investment nevertheless flow to countries that do not offer any legal protection? Put more generally, why would a party fulfil its contractual obligations in the absence of

82 83 84 85 86

87

Lowenfeld (2008), p.470ff and Dolzer (1985). Lowenfeld (2008), p.483f. Lowenfeld (2008), p.484. See for example, The Economist, August 7th, 2008, "The Autocrat of Caracas". See for example, Frankfurter Allgemeine Zeitung, January 31st, 2009, "Steinbrück erwägt Verstaatlichung der HRE". Busse and Hefeker (2007).

Economic and Legal Protection of FDI

23

coercive power? There are a number of devices that can foster cooperation. For one, if we add the factor of time to the game presented in section 3.1.1, cooperation might emerge automatically without the need for the parties to take specific actions that make cooperation more likely. Due to the time dimension, we refer to these devices as dynamic devices. Before turning to these dynamic devices, the static prisoner's dilemma situation as presented in section 3.1.1 will be discussed first. 3.2.1

Static Devices

Obviously, expropriation will not occur when CH > WH, that is when the state can receive a higher payoff through taxes, spillover, etc. compared to expropriation. This is typically the case when the value of the asset to the state is low. The investor might bring skills, like technological knowledge, organisational capabilities, or access to markets that would be lost in the case of expropriation and thus make expropriation pointless.88 In other words, the government cannot manage the asset as efficiently as the investor and is thus better off leaving the investment in the hands of the investor (thereby profiting from taxes and spillover). This is especially true when the taxes and spillover effects are large. However, in these cases, governments do not face a time inconsistency problem in the first place. Put differently, there is no prisoner's dilemma (“PD”) situation that is hostile to a cooperative outcome. If, however, governments and investors do find themselves in a PD situation, the parties might be able to take actions that transform the trust game into a game with an expected cooperative outcome. As mentioned before, the central problem is the lack of coercive power in international relations and law. Otherwise, the parties could simply contract on playing (Invest/Accommodate). In a seminal paper, Kronman (1985) identifies four mechanisms that enhance transactional security and the exchange of promises in a state of nature, a state that in some respects also characterises international relations. With reference to the classic writings of Thomas Hobbes, yet with some modifications, Kronman (1985) defines the state of nature as a situation where "those who make covenants are not subject to any 'common power' with the 'right and force sufficient to compel performance'."89 The author emphasises that the state of nature is relational, meaning it describes a relationship between two parties. This view of the state of nature is certainly comparable to the relationship of a foreign investor vis-à-vis the host state. The four mechanisms Kronman (1985) identifies are hostages, collaterals, hands-tying and union. Acknowledging that the lines between these measures may be blurred,

88 89

Eaton and Gersovitz (1984). Kronman (1985), p.7. Quotation marks in original.

24

Economic and Legal Protection of FDI

Kronman (1985) treats these four devices distinctively.90 This approach will be followed here. In addition to the mechanisms identified by Kronman (1985), this paper adds three additional ones: insurance as a mechanism to enhance transactional security, the devaluation of assets as a strategy to avoid expropriation and lobbying. At the core of each of these mechanisms is the modification of the payoffs of the original PD game, namely CH, CM, WH and LM, to achieve a cooperative and thus a mutually more beneficial outcome. 3.2.1.1

Hostages

Parties to a transaction that is not simultaneous might exchange hostages.91 More specifically, the party that performs first (party A) might ask the party that performs second (party B) for a hostage, that is, anything that is of value for party B. The hostage is ideally of no or little value to party A or anybody else, but at any rate of less value to party A than to party B.92 This feature makes the hostage attractive to party B: it can be sure that the hostage will be returned after performance. The ultimate aim of hostages-giving is to achieve "artificial simultaneity".93 However, the exchange of hostages has certain problems, mainly the problem for party A to assess whether the hostage is indeed (or to what extent) of value to party B. Also, and probably more important, for party A it is virtually never optimal to carry out the inherent threat in hostage-giving to destroy the hostage. This may allow party B to bargain for the added value of the transaction. How could hostages be used to increase transactional security in international investment? Monaldi (2002) describes hostage-giving in the context of the Venezuelan oil industry. In Venezuela, investment in the oil industry was significant in the first half of the 20th century. At that time, external enforcement through the western States, especially the U.S., and through powerful international oil cartels was strong and the sovereignty of the Venezuelan government thus low. However, when external enforcement mechanisms ceased to be effective and the government gained more sovereign control in the late 1950s and the 1960s, revenue expropriation increased, leading to less investment by multi-national companies, capacity shortages in the early 1970s and eventually to the nationalisation of the oil industry in 1976.94 Yet, when the Venezuelan government decided to open the industry again to FDI in the early 1990s, the country received substantial investment. As Monaldi (2002) asks, how "could this

90 91 92 93 94

Kronman (1985), p.11. On hostages, see also Eger (1995), p.176 ff. This is the main difference to collateral, see section 3.2.1.2. Kronman (1985), p.13. Monaldi (2002), p.3.

Economic and Legal Protection of FDI

25

happen in a country with a clear pattern of expropriation of oil revenues in times of fiscal need, with a weak judicial branch, and more generally with an apparent lack of domestic restraints to governmental opportunism?"95 Monaldi’s answer is that hostage mechanisms played a crucial part in this development.96 He identifies at least two distinct hostage mechanisms: first, the use of offshore assets and revenues as a guarantee against expropriation and second, the use of future offshore receivables as a hostage. The former will be described in a little more detail. As Monaldi (2002) points out, the Venezuelan government used offshore assets and revenues by its state-owned oil company PDVSA as a hostage. As a first step, the government made agreements with the governments with regards to the conditions of the investment. In a second step, PDSVA contractually agreed to compensate the foreign investors if these agreements (between the investor and the government) were not respected by the government. PDSVA held substantial assets in the U.S and Europe. These assets and the revenues generated by the assets were the actual hostage. To avoid the potentially biased Venezuelan court system, it was agreed that the contracts between the investors and PDSVA should be covered by international arbitration. The logic of hostages can be easily fitted in the time inconsistency model from above. It is assumed that the HC offers a hostage that will be handed to the investor upon investment. Now, imagine the extreme case where the hostage has no value to the hostage-taker (the investor (MNE)), only to the hostage giver (the host country (HC)). Loss of the hostage (in the following denoted by X where XH denotes the value of the hostage to the host country and XM the value of the hostage to the MNE) reduces the gain from expropriation from WH to WH - XH. If, as a consequence, CH > WH - XH, the hostage will induce cooperation between the players. Nevertheless, the main problem with hostages can also be demonstrated with a small modification of the game above. Remember that often, the hostage taker has no incentive to destroy the hostage because that may incur an additional cost or there may even be costs associated with keeping the hostage (these costs will be denoted as T as they can be understood as a form of transaction costs). In addition, the hostage has no or little value to the hostage taker. We can easily extend the game tree to include a third stage with the choice of the MNE between destroying or keeping the hostage and returning it:

95 96

Monaldi (2002), p.4. See also Monaldi (2001). The importance of hostages for economic transactions in general in the absence of legal remedies has especially been emphasised by Williamson (1983).

26

Economic and Legal Protection of FDI

(LM+ XM - T, WH-XH) Don't Invest

Keep

(0,0) M

M

Return

Accommodate

(CM, CH)

Invest H

(LM+ XM - T, WH-XH) Keep

Expropriate M

Return

(LM, WH)

Figure 3.2: Hostage-Mechanism

The game presented in figure 3.2 has an implicit assumption, namely that the hostage will be transferred at the time of investment. Further, we assume that the host country will expropriate retroactively if the MNE keeps or destroys the hostage despite prior accommodation of the HC.97 If keeping or destroying the hostage is indeed costly to the MNE while the value of the hostage itself is low, that is if XM - T <0, returning the hostage is a dominant strategy for the MNE even if the HC expropriates. The HC will know this and therefore identify the threat of the MNE to destroy the hostage as noncredible. Therefore, the HC will expropriate if CH<WH and accommodate otherwise – the bottom line is that we are dealing with the same game structure as if there had not been an exchange of the hostage in the first place. This insight can also be discussed in the context of the above described example of the Venezuelan oil industry as presented by Monaldi (2002). In contrast to other commitment mechanisms such as hands-tying, hostages require the action of the hostage taker in the case of defection by the hostage giver.98 If enforcing the contracts using international arbitration to actually collect the foreign assets of PDVSA would 97

98

Which is not relevant for the point being, but will be relevant in the following section with regard to collaterals. Hands-tying will be discussed in section 3.2.1.3.

Economic and Legal Protection of FDI

27

have been extremely costly or if the assets would have been more or less useless to the investor (because, for example, a lack of a liquid market for these assets), the hostage mechanism could not have been used to overcome the time inconsistency problem. In other words, the fact that the foreign assets are valuable to the respective host country, in this case Venezuela, cannot guarantee cooperation. If the assets are also very valuable to the investor/MNE, they are rather referred to as collaterals. As the following section will illustrate, collaterals solve the specific problem of non-credible threats inherent with the hostage mechanism, but pose a different set of problems. 3.2.1.2

Collateral

The major difference between a hostage and collateral is that the collateral is equally valuable to both parties to the transaction. Often, collaterals are assets with welldefined market value. In this case, the asset (that is, the collateral) is a "direct substitute"99 for the promised performance. The distinction between a hostage and collateral can be blurry. Consider again the example of the Venezuelan oil industry as described above. Whether the offshore assets are considered as hostages or as collaterals depends on the valuation of the assets by the MNE (including the costs to obtain them). If the MNE values possession of the offshore assets as much as the original assets, the assets would be seen as collaterals rather than hostages. While hostages may create ex-post bargaining power on the side of the hostage-giver (as the hostage-giver knows that the hostage-taker values performance more than the hostage), the reverse can be true with respect to collaterals. As Kronman (1985) puts it: "By giving me collateral that is equal in value to the performance I have been promised, you create an opportunity for bargaining that I can exploit, if I am skilful enough, to appropriate the gain you expected to realize from our transaction."100 In addition and equal to hostages, the use of collateral presupposes under normal circumstances the existence of substantial offshore assets, which might be true for some but certainly not all countries that are trying to attract foreign investment. Consider the use of collateral in our baseline example. As in the hostages example, we assume that the HC offers a collateral that is handed over if the MNE invests. It is also assumed that, in contrast to the hostage, the collateral has equal value to the MNE and to the HC, again denoted by X with X=XH=XM. Loss of the collateral makes expropriation more costly to the HC relative to accommodation. Consequently, collaterals can support a cooperative outcome of the game. The problem with

99

100

Kronman (1985), p.16. For a description on the functioning of collaterals, see also Eger (1995), p.182ff. Kronman (1985), p.17.

28

Economic and Legal Protection of FDI

collaterals is, as mentioned before, that the collateral taker might prefer keeping the collateral over completing the original bargain. (LM+ X - T, CH-X) Don't Invest

Keep

(0,0) M

M

Return

Accommodate

(CM, CH)

Invest H

(LM+ X - T, WH-X) Keep Expropriate M Return

(LM, WH)

Figure 3.3: Collateral

The game structure is similar to the game presented in figure 3.2. Equivalent to the hostage game, the collateral game models the decision of the MNE to keep or return the collateral as an additional, third stage. We assume as before that, if the MNE chooses to keep the collateral although the HC played accommodate, the HC will expropriate immediately. Therefore, the game sequence (Invest, Accommodate, Keep) generates the same payoffs as (Invest, Expropriate, Keep) to the parties. Important to understanding the problem with collateral is the payoff to the MNE. This payoff is relevant for the decision whether the MNE in the third stage decides to keep the collateral although the HC accommodated or if the MNE returns the collateral. The MNE will do the former if LM+X-T>CM. As X, the value of the collateral, represents a direct substitute for the promised performance, the inequality will often be true. The HC anticipates this and might not offer the collateral in the first place. Cooperation cannot be achieved, although the high value of the collateral will prevent the HC from expropriating the assets. In the example of the Venezuelan oil industry, this would be the case if the investor could seize the assets of PDSVA too easily, for example if international arbitration had a strong bias in favour of the investor.

Economic and Legal Protection of FDI

3.2.1.3

29

Hands-Tying

The expression "hands-tying" is attributed, as Kronman (1985) notes, to Williamson and Schelling and describes "actions that make a promise more credible by putting it out of the promisor's power to breach without incurring costs he could otherwise have avoided."101 The major difference between hands-tying and hostages is that handstying is self-executive – it requires no additional actions by the parties to the transaction. For FDI, probably the most widely used form of hands-tying is domestic investment law enforced by an independent judiciary. In the absence of an independent judiciary, hands-tying can and will take more complicated forms. To give an example, imagine that the state or a state-owned bank lends some or all of the money required for the investment project to the foreign investor. If the government expropriates, the investor will obviously have to stop the repayments and also any interest payments. Put differently, as the investor is no longer in possession of the assets that are supposed to create the income stream flowing to the bank, this income stream will run dry more or less automatically. If the government cares about the revenues, these are extra costs triggered automatically by an event of expropriation, making this option less attractive to governments. (0,0) Don't Invest

(CM,CH)

M Accommodate Invest H

Expropriate

(LM,WH-D)

Figure 3.4: Hands-Tying

The loss resulting from hands-tying is here denoted by D. As in the examples before, the HC offers to "tie its hands" and will do so when the MNE invests. The main advantage of hands-tying, as compared to hostages and collateral, is that the costs 101

Kronman (1985), p.18.

30

Economic and Legal Protection of FDI

result automatically in the case of non-cooperative behaviour – there is no need to include a third stage into the game. HC will accommodate if D>WH-CH. One of the problems with hands-tying is that it is often not an available option. Besides, while the automaticity of the sanction is desirable as it enhances the credibility of the commitment, it may be problematic in certain cases, especially when circumstances have changed. 3.2.1.4

Union

The method of union is another method to align divergent interests. This method is more comprehensive than the mechanisms described before in the sense that it aims to eliminate rather than mitigate the divergence of interests.102 Obviously, the term union describes the situation where two parties merge or integrate to become a single party. In general, the method of union has its own limitations.103 First, union can often not be completely achieved, meaning that it can usually not eliminate all conflicts of interest between the parties. Second, the method of union might, under some circumstances, increase the risk of exploitation in the short run, for instance through, as Kronman (1985) puts it, "the relaxation of defenses"104 vis-à-vis the partner in the union, which might entail sharing of information, etc. In the context of FDI, transnational integration plays an important role. A huge proportion of FDI is based on cross-border mergers and acquisitions (“M&A activity”). In 2007, the amount of FDI resulting from M&A activity was 1,637 billion USD.105 However, for the purposes of this paper, mergers and acquisitions must be differentiated: while mergers might be able to mitigate political risks, this is not the case for acquisitions where the acquired asset is wholly owned by the foreign investors. In the case of a merger, at least part of the asset is owned by a domestic party, which might, as described before, reduce the political risk. Obviously, the two relevant parties to the original transaction, the government and the investor, cannot merge. Nevertheless, a merger might take place, for example, between a state-owned enterprise and a foreign company. In that case, the state has a direct incentive to protect the interests of the new company (the same is obviously true for other governance structures, like joint ventures). If the domestic company is, however, not state-owned, the method of union only works if the government places value on the welfare of the domestic partner to the union. It is important to note that the underlying reasons for companies to merge are manifold and not primarily rooted in the protection

102 103 104 105

Kronman (1985), p.22. See Kronman (1985), p.23. Kronman (1985), p.23. UNCTAD (2008a), p.xv.

Economic and Legal Protection of FDI

31

of FDI. Nevertheless, the effect of the ownership structure on political risk is potentially a strong argument in favour of a cross-country merger. 3.2.1.5

Insurance

Another way to countervail potential under-investment as a result of time inconsistency is insurance. Many countries have agencies that provide insurance against political risks like expropriation or similar government measures. The most prominent might be the U.S. government agency OPIC, the Overseas Private Investment Corporation. Like many state operated political investment agencies, the OPIC has, inter alia, the purpose of promoting economic development. According to the OPIC statute, the purpose of the agency is to "mobilize and facilitate the participation of United States private capital and skills in the economic and social development of less developed countries and areas, and countries in transition from nonmarket to market economies, thereby complementing the development objectives of the United States […]".106 In addition, there is also a private market for political risk insurance. According to the World Bank's Political Risk Insurance Centre, the biggest market place for political risk insurance is organised through Lloyd's, where individuals and corporations can syndicate to provide political risk insurance.107 The Multilateral Investment Guarantee Agency (MIGA) plays a very important role in the insurance of political risk. MIGA is part of the World Bank Group and had, as of September 2010, 175 member countries, 150 of which are developing countries.108 The preamble of the MIGA Convention emphasises, comparable to OPIC, the development purpose of MIGA as a measure to promote FDI. As stated in the MIGA Convention, Article 11, MIGA covers the following risks: x Currency Transfer x Expropriation and Similar Measures x Breach of Contract (by a host government) x War and Civil Disturbance Please note that while insurance can induce investment in reality, it cannot overcome the time inconsistency problem as such in a framework of complete information and risk-neutral agents. Obviously, insurance does not really alter the incentives of governments. If expropriation yields a higher payoff than accommodation, the HC will

106 107

108

See OPIC Statute, sec. 231. See http://www.pri-center.com/directories/partner_specific.cfm?pgid=5&orgnum=34313 tember 1st, 2010). See http://www.miga.org/quickref/index_sv.cfm?stid=1577 (September 1st, 2010).

(Sep-

32

Economic and Legal Protection of FDI

expropriate to the detriment of the insurance company. Under complete information, no insurance company would offer such an insurance contract. Only if there is asymmetric information and the law of large numbers applies will a company offer insurance under such conditions (unless its operation is motivated by development goals). The demand for insurance naturally requires risk-aversion on the side of MNEs. 3.2.1.6

Devaluation of Assets

Additionally, investors might adopt strategies to avoid expropriation. One of these strategies is to make the assets deliberately less profitable to other owners.109 These strategies often imply additional costs on the investor itself or even entail the devaluation of the assets. One approach might consist of upgrading the investment before it is actually worthwhile to do so in order to stay ahead in expertise. Put differently, the investor will use (costly) new technology that is impossible for the host country to operate even if using this technology would actually not be efficient. An alternative approach is to locate different parts of the production chain in different countries.110 Owning only one part of the production chain may make the asset useless to the host country. Translated to our stage game, the MNE will try to take measures to reduce the value of the asset to the host country, namely WH. The problem with this strategy is that this can be costly, therefore also reducing CM and thus diminishing the incentive to invest in the first place. 3.2.1.7

Lobbying

It has been argued that the time inconsistency problem applies to welfare and nonwelfare maximizing governments. Consequently, the measures that MNEs and governments may take to mitigate time inconsistency are mostly independent of the motivations of the government. A notable exception in this respect is lobbying (and possibly corruption): the lobbying of MNEs for protection of their investment directly uses the fact that there are principal-agent conflicts between the government (the agent) and the citizens (the principal). As in the case of union (see section 3.2.1.4), lobbying will change the welfare function of the government (and thus reduce the value of WH in our example) – however, the difference is that lobbying should not be possible if the state is welfare maximizing. The problem with lobbying is that it is costly and does not necessarily lead to the desired outcome.111

109 110 111

See for example Eaton and Gersovitz (1983). Eaton and Gersovitz (1983), p.90ff. Of course, this type of action equally distorts efficiency. Notwithstanding the problem that lobbying is a form of rent-seeking and can be detrimental to social welfare.

Economic and Legal Protection of FDI

3.2.2

33

Dynamic Devices

Dynamic devices refer to mechanisms where time plays a crucial role. For one example, the payoffs of the games may change over time. This is exemplified in section 3.2.2.1. Also, reputation, which plays a crucial role in the area of investment, can only develop over time. The role of repetition and reputation is discussed in section 3.2.2.2. 3.2.2.1

Expertise and Time

A rational investor might be aware of the time inconsistency problem of the host state and still find it worthwhile to invest, knowing that he will lose control over the assets. Eaton and Gersovitz (1983) provide the following example: an investor may realise that the only protection against expropriation is his monopoly over special knowledge. Further, he knows that this knowledge will subsequently be passed over to the host state over time so that finally, expropriation will occur. However, the profits up to the point of expropriation might be high enough to make the investment profitable anyway. 3.2.2.2

Repetition and Reputation

A crucial question is whether the time inconsistency problem as described above can be reduced or even completely overcome through repeated interaction. It is conventional wisdom in game theory that repeated "interactions give rise to incentives that differ fundamentally from those of isolated interactions".112 The simplest way to understand how repetition can induce MNEs to invest would be to consider an infinite repetition of the stage game. Reputation, however, is more complex than mere repetition and requires the existence of asymmetric information. Both approaches will be discussed in the following sections. 3.2.2.2.1

Repetition

One explanation of the occurrence of FDI in the absence of legal protection may be rooted in the repetitive nature of the game. In such a model, potential gains from continuous cooperation and the threat of termination of that cooperation may be able to exert a strong influence on the host country. Consider again the stage game as presented in section 3.3.1. As in the baseline case, it is assumed WH>CH which implies that cooperation would fail in a single-shot setting. According to the Folk Theorem, the Nash equilibrium of the stage game, namely (Don't Invest/ Expropriate), need not

112

Mailath and Samuelson (2006), p.2.

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Economic and Legal Protection of FDI

be the outcome of the infinitely repeated game.113 If the stage game is infinitely repeated, any feasible average payoff combination that is Pareto-superior to the stage game Nash equilibrium can emerge as a subgame perfect equilibrium when the discounting of future payoffs is sufficiently small.114 We need to find a pair of strategies that yield a cooperative result from which none of the parties has an incentive to deviate. One possible and widely used strategy here is the grim trigger strategy. We assume that the host country plays a different MNE each round, but MNEs in later rounds observe the outcomes of prior rounds. The grim trigger strategy for a given investor is then:

(1) Play invest in the first round. (2) Continue to choose invest in the following rounds, unless the HC expropriated in the prior round, in which case play the strategy of the stage game Nash Equilibrium (Don't Invest/Expropriate) forever.

It is straightforward to show that the host country will always play accommodate and therefore the equilibrium (invest/accommodate) will prevail when:

G t 1

CH WH

(3.1)

where  is the discount rate of the host country with 0<<1.115

This very simple model is already able to map some interesting features concerning the incentives to expropriate in a dynamic setting. Cooperation can be sustained through repeated interaction, even when there is a different investor in each round. It is crucial to note that this conclusion depends on the assumption that MNEs that play the HC in later rounds can observe the outcome of earlier games. One might refer to this as an effect of reputation. However, most game theoretic accounts, including the authoritative Fudenberg and Tirole (1991), refer to reputation mainly in the case of incomplete information: "modelling reputations as complete-information strategies

113

114 115

Please note that the Folk Theorem does not work when the number of repetitions is finite, which is the conclusion of Selten's famous chain-store paradox. Holler and Illing (2006), p.140. See Appendix A for the derivation of this result.

Economic and Legal Protection of FDI

35

cannot capture the idea that a player's reputation corresponds to something that his opponents have learned about him."116 Equation (3.1) shows the condition for cooperation. If the ability of the host state to use the investment efficiently, that is WH, is high, then expropriation becomes more likely, while the ability to extract more of the rents of cooperation in the cooperative outcome (CH) reduces the incentives to expropriate. Furthermore, and a standard result of models of this sort, is the fact that cooperation is more likely when the host state values future payments highly, namely when  is big. A shortcoming of these kinds of models that are based on the Folk Theorem is the strong dependence on the type of trigger strategy. In fact, an indefinite number of other equilibria are possible and accurate predictions based on the attained equilibrium are therefore impossible to sustain. 3.2.2.2.2

Reputation

In the repetition model, the assumption of an infinite time horizon is unrealistic, especially given the rather short time horizons of political decision-makers.117 Also, investors might not be perfectly informed about the payoffs of decision-makers. Some of these issues can be addressed through a model of a finitely repeated game of asymmetric information or, put differently, a reputation model. The functioning of reputation in FDI settings has also been described by Veugelers (1993) and Thomas and Worrall (1994). The model by Veugelers is an application of the seminal gametheoretic description of reputation by Kreps and Wilson (1982).118 The application of game-theoretic models to the issue of reputation is not unproblematic and requires the use of mixed-strategy equilibria in games of incomplete information. The logical structure of the game in our context, which is also followed by Veugelers (1993), is as such: the basic assumption is that there are two types of states, a "good" (or reliable) and a "bad" (or unreliable) host country. While the host country knows if it is "good" or "bad", the MNE does not have this information. However, as the game proceeds, each MNE observes the prior moves. The MNE updates its beliefs concerning the type of the host country according to Bayes' Rule. Similar to the grim trigger strategy used in section 3.2.2.2.1, it can be assumed that MNEs stop investing once they have observed the expropriation outcome (or use a similar punishment strategy). For certain

116

117

118

Fudenberg and Tirole (1991), 367. See also Gibbons (1992), p.225. The following section will address the topic of reputation directly. Introducing limited time-horizons of political decision-makers might be considered as a deviation from the assumption of a social welfare maximizing government. However, another interpretation could be that this reflects merely limited time-horizons of the constituents. For a useful description of the Kreps and Wilson reputation game, see Holler and Illing (2006), p.168ff.

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Economic and Legal Protection of FDI

values of the parameters and the prior beliefs, it is possible to define a subgame perfect equilibrium where the bad host country mimics the behaviour of the good type. More specifically, the bad host country will randomise between its strategies. As soon as the randomised outcome is expropriate, the MNEs will stop investing in the future. As long as the randomised outcome is accommodate, the MNEs update, as before, their beliefs using Bayes' Rule and increase their belief that the MNE is actually of the good type. As the host country takes the beliefs of the MNEs into account, it will in turn increase its probability of playing accommodation. The reputational capital rises until the last round, where the bad type expropriates with certainty. Veugelers (1993) builds a rich model based on this logic and finds that the reputation outcome will prevail for intermediate values of the discount factor. In addition, much depends on the initial probability that the MNE places on the possibility that the HC is reliant. The more pessimistic these priors are with regard to the realibilty of the HC, the weaker are the incentives of the bad HC to accommodate – with the result that the (likely) expropriation will happen earlier. The fact that the players should play mixed strategies might be confusing at first glance. If mimicking the behaviour of the good host country is worthwhile for the bad type, why not play the good type's strategy all the time? This cannot be an equilibrium for the following reason: the incentive for a bad host country to play accommodation is based on the idea that his behaviour induces the MNE to invest in the following period. However, if the bad host country always plays accommodate, the MNEs will not receive new information through this behaviour. Thus, playing accommodate does not influence the action of the MNE in the following period. Consequently, the bad host country has no incentive to play accommodate in the first place. On the other hand, if the host country never plays accommodate, he cannot build any reputation at all.119 This can also be highlighted in a two-period setting using the basic trust game with only a few modifications. Most importantly, there must be the possibility that the HC is not of the (bad) type as described in section 3.1.1, but of the good type as exemplified in figure 3.5.

119

A similar argument can be made for the MNEs playing mixed strategies. See Appendix B.

Economic and Legal Protection of FDI

37

(0,0) Don't Invest

(CM,CH)

M Accommodate Invest H

Expropriate

(-LM , WHLOW )

Figure 3.5: Time Inconsistency and the Good Host Country (HCgood)

with WHLOW  WH and WHLOW  CH The "good" host country always prefers the cooperative over the uncooperative outcome. A second deviation from the trust game as introduced in section 3.1.1 is that the expropriation payoff for the MNE has been set specifically to -LM with LM>0.120 The game proceeds as described above, yet limited to two periods. The MNE is uncertain about the host country’s payoffs. It assigns a certain probability to the possibility that payoffs are either those specified in figure 3.1 (with -LM) or those in figure 3.5. The investment decision in the second period depends on the observation made in the first period. In this simple two period setting, a subgame perfect Bayesian equilibrium where the bad type builds a reputation can be described as follows:121

Notation : a-priori probability that the host country is of the good type (prior) q2: probability that the host country is of the good type as assessed by the MNE in period two (after observing the history of the game based on Bayes' Rule) z: probability that the bad type will play accommodation in the first period

120

121

This assumption does not alter the game but only the notation. This change simplifies the derivation of the equilibrium. See Appendix B. For a derivation of this result, see Appendix B.

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Economic and Legal Protection of FDI

v: probability that the MNE plays invest

q2 is computed the following way: (a) if there is no investment in the first stage, then q2 =  (b) if there is investment in the first stage and this investment is accommodated, and  >0, then the MNE updates his belief according to Bayes' Rule, (c) if there is investment in the first stage and this investment is expropriated, then q2 =0

The proceeding of the game can be described as follows: for T 

L2M , the MNE ( LM  CM ) 2

will not invest in the first round. The HC consequently cannot build a reputation. Thus, the MNE will also not invest in the second round (as in that case, T 

LM has to LM  CM

hold; please note that the “required prior” for investment in the second round needs to be larger, because in the second round, the bad type would definitely expropriate and never mimic the strategy of the good type). However, for T !

L2M , there is a ( LM  CM ) 2

perfect Bayesian equilibrium (“PBE”) where the MNE will invest in the first round. In the reputation equilibrium (that we are interested in), the bad HC will randomise and play accommodate with probability z

T ª CM  LM º  1» . If the outcome of this « (1  T ) ¬ LM ¼

randomisation process was accommodate, the MNE will update his belief according to Bayes' Rule and invest with probability v

WH  CH . G WH

What is of interest here is the behaviour of the bad HC in the first round. Indeed, under certain parameter specifications, a pooling (or mimicking) equilibrium occurs. Pooling equilibrium means that the bad HC plays accommodate, which is the same strategy the good type would play as well. Whether he mimics in the first period depends crucially on the priors ( T or prior beliefs) of the MNE. If the priors are sufficiently high, the bad HC randomises. If, as a result of the randomizing, the bad

Economic and Legal Protection of FDI

39

HC nevertheless plays expropriate, there will be no more investment by the MNE in the second round. So, can reputation really solve the time inconsistency problem? Some qualifications must be made with respect to reputation models (as presented here), but also with regard to reputation in general. It has been highlighted that the reputation equilibrium depends on the fact that players are using mixed-strategies, which not only considerably complicates the analysis, but may also cause interpretation problems. Nevertheless, it appears to be common sense in economic theory that the mixed strategies need not be interpreted as strategies in the strict sense but rather as a probability distribution over identical players.122 A second criticism concerns the fact that the prior beliefs are exogenous and not determined within the model. Therefore, if one only assumes high enough priors, cooperation will occur with certainty. However, as Drazen (2002) asserts in a similar context, this is rather "a description of reality".123 Of course, countries will rather cooperate when the disposition of investors, as embodied in their priors, to invest is high – there will be more to gain in the future. Lastly, a common problem (and comparable to the repetition case) in these models is the multiplicity of equilibria.124 This might also simply be a description of reality rather than a problem as such. Naturally, it must be acknowledged that the existence of multiple equilibria limits the predictive power of these sorts of models. Please note that the main purpose of the model in this context is to show that bad types may cooperate – even when there is the endgame problem. Another crucial point is the importance of the priors. In this context, this is also a shortcoming since the HC can only build a reputation if the MNE invested in the first place; if the priors are low, the HC does not even have the chance to build a reputation. In sum, reputation may support cooperation, but is no panacea: the behaviour of the HC depends on the time horizon and reputation can only play a role when MNEs cannot differentiate between host countries (put differently, the existence of asymmetric information is a prerequisite – which is an assumption that could be challenged in the case of international investment law). Also, as in the repetition model, MNEs must use a punishment strategy to induce cooperation. This, in turn, demands that MNEs are able to observe the host country's behaviour.

122 123 124

Rasmusen (2001), p.69. Drazen (2002), p.182. See also Drazen (2002), p.187. This problem is not as evident in the two-period example used here, but is prevalent for example in the model presented by Veugelers (1993).

40

Economic and Legal Protection of FDI

3.2.3

Discussion

It has been argued that there is a time inconsistency problem in the area of foreign direct investment and that this problem is relevant to investors and policy-makers. From an economic point of view, several options are conceivable to mitigate this problem and have been discussed. While all of these options might have the potential to make FDI more secure, each has its own limitations.125 Hostages, collateral and hands-tying might not always be available. In addition, hostages suffer from the inherence of non-credible threats and collateral from the potential of opportunistic behaviour. Unions are also prone to opportunistic behaviour and a suitable partner with whom to build a union is not necessarily always at hand. Other forms of protection, like insurance, the devaluation of assets and lobbying, are affected by high costs and uncertain impact. Repetition and reputation can be undermined by limited time-horizons and high discount rates. In sum, none of these mechanisms can completely remedy the time inconsistency problem. In the next section, the legal protection of FDI, especially through international law and, more specifically, Bilateral Investment Treaties, will be described. These treaties will then, in chapter 4, be integrated into the context of the economics of FDI protection. 3.3

Legal FDI Protection

Foreign direct investment is legally protected on the national (domestic) level and on the international level. The protection of FDI in international law includes customary international law, multilateral treaties and bilateral treaties. Bilateral treaties can be directly concluded between an investor and a state (investor-state contracts) and between two states (for instance through Bilateral Investment Treaties, BITs). The multitude of instruments and treaties that relate to FDI protection is remarkable. Sauvé and Zampetti (2007) rightly note that providing "a concise but reasonably comprehensive summary account of the international legal framework for foreign investment is thus a difficult task, because there are so many international rules that have a clear impact on foreign investment, spanning such fields as taxation, intellectual property, trade in services, antitrust, labour-relations and corporate social responsibility."126 Therefore, this chapter will describe only the most important of the legal mechanisms with a focus on Bilateral Investment Treaties.

125

126

A discussion on the major ex-ante mechanisms with regard to their specific problems can also be found in Eger (1995), p.187. Efficient incentives cannot be achieved under all circumstances. Beviglia Zampetti and Sauvé (2007), p.211.

Economic and Legal Protection of FDI

3.3.1

41

Domestic Regulation

States that are recipients of foreign direct investment are obviously free to adopt domestic regulations intended to protect foreign investment and have done so with varying strictness. In 2006, according to the UNCTAD database on national laws and regulations, 93 countries made a total of 184 changes in their national regulations with regard to FDI.127 Of these changes, 147 were favourable to FDI – which constitutes almost 80%. The importance of adequate national regulations as a tool to attract foreign investment has obviously not escaped policy-makers. To give an example, in the newly released Investor’s Guide to São Tomé and Príncipe, the positive national regulatory framework with regard to FDI has been strongly emphasised.128 It should be noted that home countries might also have national regulations aimed at influencing the activities of their constituents abroad. These measures can have either promoting or rather restricting effects depending on the motivation of the home state. For example, states may promote foreign investment as part of their development policy, such as through insurance schemes. Alternatively, states may also restrict capital outflows on grounds of balance-of-payments concerns.129 3.3.2

Customary International Law

Customary International Law (CIL) can be defined as a "general and consistent practice of states followed by them from a sense of legal obligation".130 With regard to the treatment of foreign investment, disagreement prevails as to whether CIL indeed exists and, if so, what standard of treatment it demands.131 This disagreement has a long history, reflected by the disagreement between developing and developed countries regarding the amount of compensation in the case of expropriation throughout the past century.132 Regardless of the standards set by CIL, it offers foreign investors little effective protection on its own, as it lacks a binding mechanism to settle investment disputes.133

127 128

129 130

131

132 133

UNCTAD (2007a), p.14. Guide available under http://vcc.columbia.edu/pubs/documents/SaoTome-sept11eng.pdf (October 11, 2009). UNCTAD (2004), p.7. Restatement (Third) of the Foreign Relations Law of the United States §102(2), quote taken from Goldsmith and Posner (1999), p.1113. See Sornarajah (2004), p.205, rejecting the notion that there is CIL in investment matters. Herdegen (2005), p.203, alternatively claims that certain minimum standards as to the treatment of foreign investment can be identified. A short illustration of the relationship of BITs to CIL can be found in section 3.3.3.9. See, e.g., Lowenfeld (2002), p.391 ff. for an historical account of this disagreement. Salacuse (1990), p.659f.

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Economic and Legal Protection of FDI

Prior to World War I, there was a general acceptance between nations that takings of private property would trigger an obligation to pay prompt and adequate compensation and that aliens were entitled to equal treatment compared to nationals of the host state. The revolutionary movements in Russia and especially Mexico, which involved the expropriation of foreign held assets, introduced the approach that the protection of private property was to be subordinated to the common welfare. The Western nations protested these uncompensated takings. Subsequently, Mexico and other countries of Latin America advocated the so-called Calvo doctrine. This doctrine traces its roots to the writings of 19th century Argentine jurist Carlos Calvo. In its narrowest interpretation, the Calvo doctrine postulated simply that aliens should have no greater rights than the citizens of the host country. However, some countries adopted a broader interpretation, stipulating that foreign investors could obtain no diplomatic protection from their home states at all. The classical Western view, especially promoted by the United States, called for an international minimum standard for the protection of foreign investment. In this context, the so-called Hull formula gained importance, dating back to a diplomatic exchange between US Secretary of State Cordell Hull and the Mexican Ambassador to the United States in the 1930s as a consequence of unresolved expropriations of property owned by American citizens. This formula claimed that compensation should be prompt, adequate and effective. The quarter century following World War II saw a wave of expropriations and nationalisations in all parts of the world, for example in Eastern Europe and Latin America. These expropriations were typically followed by negotiations between the relevant states and usually resulted in some type of compensation. However, while the Hull formula (also called Hull rule) and the Calvo doctrine played a role in the judicial discourse, no approach gained general acceptance.134 Attempts to create an international investment law through multinational agreements, such as through the United Nations and its organs, remained without effect. The 1962 UN Resolution on Permanent Sovereignty reflected only a short-lived compromise that did not align the opposing views on the appropriate protection of foreign investment.135 Another important event that reflects the controversy over the protection of FDI was the call for the New International Economic Order in the United Nations General Assembly in 1974. One of its cornerstones was the focus on national remedies in cases of nationalisation, expropriation or transfer of ownership of foreign property.136 This focus, which reflected the view expressed in the Calvo doctrine, was however undermined by the growing spread of Bilateral Investment Treaties. These treaties,

134 135 136

Neither could the Soviet position that no compensation should be paid at all. Lowenfeld (2002), p.415. Dolzer and Schreuer (2008), p.15.

Economic and Legal Protection of FDI

43

which will be described in section 3.3.5, generally contained a compensation standard in accordance with the Hull rule. The trend towards increased economic liberalism, starting in the late 1980s and reflected in the Washington Consensus, supported the protection standards as expressed in BITs.137 In summary, the question on the existence and extent of protection of foreign investment in customary international law remains unsettled. There has been new research that deals with the question of how far the aforementioned large amount of BITs contributes to the emergence of CIL.138 Nevertheless, in the absence of other international agreements that cover FDI, the protection of these assets through CIL can safely be described as weak. 3.3.3

Multilateral Treaties

Until now, all attempts to establish a comprehensive multilateral agreement have failed. Consequently, no truly international multilateral treaty on the regulation of foreign direct investment exists. Promising attempts in recent history were launched through the Organisation for Economic Co-operation and Development (OECD) and the World Trade Organization (WTO). The draft of the OECD was referred to as the Multilateral Agreement on Investment (MAI).139 The project was launched in 1994 and mirrored the protection standards that were at that time long established in Bilateral Investment Agreements. Intensive negotiations were held between 1995 and 1998, when the process finally came to a halt. Dolzer and Schreuer (2008) state a number of reasons for this, including the lack of support from the United States and France and intense criticism by NGOs over the lack of public involvement in the negotiations. The focus then shifted to the efforts within the WTO. However, discussions on a multilateral investment treaty, which were put on the agenda during a meeting in Singapore in 1996, were abandoned in 2004. According to Dolzer and Schreuer, the negotiations failed mainly due to the resistance of a number of developing countries, especially India and Brazil. Despite having concluded a big number of BITs with comparable content, these countries feared that a multilateral agreement under the auspices of the WTO would limit their regulatory sovereignty to an undue extent. Although a comprehensive multilateral treaty on foreign investment has never come into existence, a number of important regional investment agreements have been concluded. Also, various regional trade agreements and a number of sectoral

137 138 139

Dolzer and Schreuer (2008), p.15f. This question will be covered in greater detail in section 3.3.3.9. On the failure of the MAI and the discussion within the WTO, see e.g., Dolzer and Schreuer (2008), p.26.

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Economic and Legal Protection of FDI

agreements cover investment issues. The Energy Charter Treaty and the North American Free Trade Agreement (“NAFTA”) are probably the most important two examples in this respect. Before turning to these treaties, the investment regulations that form a part of international trade law will first be discussed. 3.3.3.1

WTO

In spite of the failure of the WTO negotiations with regard to a multilateral treaty, certain aspects of foreign investment interfere with trade matters and are thus covered on the margin of WTO regulations. As the most prominent codification in this respect, the Agreement on Trade Related Investment Measures (TRIMs Agreement) should be mentioned. The TRIMs Agreement was enacted during the Uruguay round of trade negotiations and applies to investment measures related to trade in goods only.140 Prieß and Berrisch (2003) emphasise that the TRIMs Agreement has not yet played an important role in the WTO dispute settlement procedures.141 The TRIMs Agreement bans performance requirements, such as local content or trade balancing requirements, when they are considered to distort trade.142 Also the General Agreement on Trade in Services (“GATS”) and the Agreement on Trade-Related Aspects of Intellectual Property Rights (“TRIPS”) have certain links to matters of foreign direct investment.143 3.3.3.2

Energy Charter Treaty

The Energy Charter Treaty (ECT), along with the Protocol on Energy Efficiency and Related Environmental Aspects, was signed in Lisbon in December 1994. With the ratification by the first thirty members in April 1998, the ECT entered into force. The Energy Charter Treaty has now been ratified by 52 countries, but is limited to investments in the energy sector only.144 More specifically, part III of the treaty covers the promotion and protection of investment and contains standards of treatment like national and most-favoured-nation treatment. Disputes between an investor and a contracting state can be settled through international arbitration. A recent case that has drawn some attention to the ECT in Germany is Vattenfall v. Germany 145 concerning environmental restrictions on the construction of a power plant imposed by the city of Hamburg.

140 141 142 143 144 145

See Article 1 of the Agreement on Trade-Related Investment Measures. Prieß and Berrisch (2003), p.334. Sornarajah (2004), p.73. Sornarajah (2004), p.297ff. Herdegen (2005), p.224. ICSID Case No. ARB/09/6.

Economic and Legal Protection of FDI

3.3.3.3

45

NAFTA

The North American Free Trade Agreement (“NAFTA”) is an agreement between the United States, Canada and Mexico that was formed on January 1st, 1994. As the name implies, it is mainly a free trade agreement between the three states. Nevertheless, chapter 11 of NAFTA covers investment issues. In short, chapter 11 includes roughly the same provisions with regard to investment that can be found in BITs.146 These enclose, among other aspects, national treatment, most-favoured-nation treatment, the prohibition of performance requirements and compensation for expropriation. NAFTA is an important treaty in international investment law as a number of arbitrations under NAFTA have garnered significant public attention and the arbitration awards have significantly influenced the interpretation of clauses also within the context of BITs. 3.3.4

Investor-State Contracts

Bilateral agreements on investment matters can be made either between the investor and the host state or between two states. The first are referred to as Investor-State Contracts.147 These contracts are not limited to questions of investment protection, but usually encompass clauses on these issues. Obviously, not every contract between investors and states is considered to be part of international law. However, through the use of choice-of-law and stabilisation clauses it has been attempted to “internationalise” investor-state contracts. Whether an internationalisation of investorstate contracts is actually possible under international law remains an unresolved question.148 3.3.5

Bilateral Investment Treaties

The modern legal landscape in international investment law is mainly shaped by the impressive amount of bilateral agreements between states on investment matters. These Bilateral Investment Treaties (“BITs”) are the main source of international investment law and constitute the main focus of this work. Generally, the main function of a BIT is reflected by its name. For example, the Bilateral Investment Treaty between the US and Argentina is called: “Treaty between the United States of America and the Argentine Republic concerning the encouragement and reciprocal protection of investment.”149 Though obligations in BITs are reciprocal, they are in practice generally concluded between industrialised, capital-exporting states and

146 147 148 149

See section 3.3.5. See Comeaux and Kinsella (1997), p.133, for the nature and content of these kinds of contracts. Herdegen (2005), p.214. This treaty was concluded in 1991 and is available under http://www.unctad.org/ sections/dite/iia/docs/ bits/argentina_us.pdf (October 12, 2009).

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developing, capital-importing states.150 Clearly, for the first group of countries, it is the aspect of the protection of the investments by their nationals that is the main objective for concluding a BIT, while the latter countries focus on the encouragement of investors to invest in their country. 3.3.5.1

Overview and History

Bilateral Investment Treaties are the cornerstone of the protection of foreign direct investment in international law. By the end of 2009, 2750 BITs had been concluded (with 82 new treaties concluded in 2009).151 UNCTAD counts 179 countries that have signed at least one BIT.152 The significance of BITs can best be understood through a short review of the historical development of international investment law.153 The emergence of bilateral investment agreements took place within the controversial setting outlined in section 3.3.2. Customary international law offered no consensual standards on the extent of protection of FDI and the different positions on this matter showed no sign of convergence. The legal landscape changed when, in 1959, the first BIT was concluded between Germany and Pakistan.154 This event was followed by a slow but steady growth of the number of BITs during the 60s, 70s and 80s. In early 1991, about 440 of these treaties had been concluded. The 15 years that were to follow saw the strongest increase in BITs, leading to the substantial number of BITs in effect currently. During the expansion of BITs, treaties were also signed by countries that were traditionally sceptical of strong investment protection, e.g., many Latin American countries. While the number of BITs continues to rise, the speed of growth seems to be declining recently.155 In the recent past, the spread of BITs has differed between regions. While many Asian countries are actively expanding their BIT network, Latin American countries concluded only 4 BITs in 2007 and some countries in that region took steps towards withdrawal from the modern system of FDI protection.156 Most prominently, Bolivia withdrew from the International Centre for the Settlement of

150

151

152 153 154

155 156

This pattern seems to be changing recently. But even in a South-South relationship, one country might still be the “capital-importer”, while the other is the “capital-exporter”. UNCTAD (2010), p.81. However, it must be noted that not all of these treaties are actually in force. See Sauvé and Zampetti (2007), p.215. UNCTAD (2008c), p.2. The following paragraph is based on Lowenfeld (2002), p.391 ff. and Sornarajah (2004), 37 ff. It must be noted that the modern BITs had predecessors in the form of Treaties of Friendship, Commerce and Navigation (FCN) which were concluded from the 18th century onwards. See Sornarajah (2004), p.209. However, these treaties covered a wide range of issues apart from investment matters and offered only little effective protection to investors. FCNs were thus no longer considered an appropriate instrument for the protection of foreign investment. Dolzer and Stevens (1995), p.11. See UNCTAD (2006), p.26 and UNCTAD (2008c), p.2. UNCTAD (2008c), p.6.

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47

Investment Disputes (ICSID) in 2008. Ecuador denounced 9 of its 25 BITs and has initiated renegotiations with regard to its remaining BITs.157 Equally noteworthy is the trend towards the conclusion of BITs between developing countries themselves (often called South-South BITs), as formerly BITs were mainly concluded between a developed and a developing country. More specifically, in 2007, 26% of all new BITs were concluded between developing countries.158 3.3.5.2

Treaty Practice and Treaty Interpretation

BITs vary in the degree of protection they grant to foreign investors, but resemble each other in their underlying structure. The following section describes some of the main contractual clauses of a typical BIT.159 As Karl (2008) notes, recent treaties have become more complex in their contents and start to reflect public concerns, such as the environment and labour rights.160 However, before examining these treaty clauses in greater detail, it is worthwhile to take a brief look at the methods usually employed by tribunals to interpret these clauses. Starting point for most tribunals is Article 31 of the Vienna Convention on the Law of Treaties (VCLT).161 Article 31 of the VCLT determines the general rules of treaty interpretation. These rules include, among other things, that the treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.162 Preambles and Annexes naturally have to be taken into account,163 as well as any subsequent agreements between the parties regarding the interpretation of the treaty164, subsequent practice in the application of the treaty that establishes the agreement of the parties regarding its interpretation165 and any relevant rules of international law applicable in the relations between the parties.166 In some cases, and in accordance with Article 31 of the VCLT, the preparatory work (Travaux Préparatoires) of the ICSID Convention have been consulted as a supplementary means of interpretation.167

157 158 159

160 161 162 163 164 165 166 167

UNCTAD (2008c), p.6. UNCTAD (2008c), p.4. For a comprehensive survey about treaty practice including a large number of representative clauses, see Dolzer and Stevens (1995). A more recent overview is Dolzer and Schreuer (2008). Karl (2008), p.229. See Dolzer and Schreuer (2008), p.31 and the examples given therein. Article 31 (1) VCLT. Article 31 (2) VCLT. Article 31 (2(a)) VCLT. Article 31 (2(b)) VCLT. Article 31 (2(c)) VCLT. As Dolzer and Schreuer (2008) note, the travaux préparatoires of BITs are usually not available. See Dolzer and Schreuer (2008), p.33.

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With regard to BITs, and unlike in arbitration cases under NAFTA, interpretative statements by one of the parties usually do not play a crucial role in treaty arbitrations.168 Concerning precedent, it must be noted that tribunals are not bound at all by previous cases, which prevents the development of a coherent body of case law. Nevertheless, tribunals have frequently taken earlier arbitration awards into account. A citation analysis considering 207 publicly available decisions and awards from 1972 onwards reveals that ICSID tribunals cite earlier decisions "in much the same manner than common law courts do".169 Especially since 2001, tribunals have increasingly based their decisions on prior arbitration awards.170 An increase of the number of citations of earlier tribunals can also be found in cases that were arbitrated under the ICSID Additional Facility and other ad hoc arbitrations, such as those governed by the UNCITRAL rules.171 Tribunals have also taken into account the numerous decisions rendered by the Iran-US Claims Tribunal. However, the precedential value of these decisions and arbitral awards in general must be considered carefully as the circumstances and the underlying treaty of the respective investment disputes may differ strongly and these differences naturally must be taken into consideration.172 3.3.5.3

Preamble and Definitions

Bilateral Investment Treaties usually start with a statement of intention, articulating the aim to protect and foster reciprocal investment, followed by a definition of certain important expressions used in the treaty.173 Most importantly, this part of BITs defines what kind of investor and what kind of investment is protected. 3.3.5.3.1

Investor

Investors can either be natural or judicial persons.174 The right of an investor to invoke protection under a BIT naturally depends on his nationality. For natural persons, nationality is determined by the regulations of the home state. For judicial persons like corporations, the determination of nationality is often more complex.175 The German 168

169 170 171 172 173

174 175

Dolzer and Schreuer (2008), p.34f. In the case of NAFTA, the Free Trade Commission (FTC) can and has issued binding interpretations of the treaty. It must be noted that this body consists of representatives of all three member countries. Commission (2007), p.5. Commission (2007), p.6. Commission (2007), p.6. On the different fora of arbitration, see section 3.3.3.8. Sornarajah (2004), p.96. See the 2004 US Model BIT, available under http://www.state.gov/documents/ organization/117601.pdf (September 1st, 2010) or the German Model BIT, available under http://www.unctad.org/sections/dite/iia/docs/Compendium//en/201%20volume%207.pdf (September 1st, 2010). See German Model BIT, Article I(3) (a). Dolzer and Schreuer (2008), p.49.

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Model BIT covers the investment of "any judicial person as well as any commercial or other company or association with or without legal personality having its seat in the territory of the Federal Republic of Germany, irrespective of whether or not its activities are directed at profit".176 In other treaties, the place of incorporation, rather than the seat, is relevant.177 Some treaties go beyond these formal definitions and employ criteria like the effective control over the corporation by nationals of the state or, alternatively, of genuine economic activity of the company in the state.178 Obviously, interpretation of these rather ambiguous criteria may give rise to conflicting interpretations. 3.3.5.3.2

Investment

The scope of the application of the treaty is not only limited by the definition of the term investor, but also by the definition of what exactly constitutes an investment. According to the US Model BIT, an investment "means every asset that an investor owns or controls, directly or indirectly, that has the characteristics of an investment, including such characteristics as the commitment of capital or other resources, the expectation of gain or profit, or the assumption of risk."179 The Model BIT presents a non-exhaustive list of examples, including enterprises, shares, loans, intellectual property rights, licenses and permits. Two questions have occupied arbitral tribunals with respect to shareholding: first, whether a shareholder can pursue claims under a BIT on the basis of its own nationality (if the nationality of the company as such does not qualify for BIT protection) and second whether minority shareholding is sufficient to invoke protection through a BIT.180 As Dolzer and Schreuer (2008) note, arbitral practice has answered both of these questions positively. Even when the company itself does not meet the nationality qualifications, the foreign investor is entitled to pursue the claim in its own name. This also holds true for minority shareholders. In the case CMS v Argentina, the claimant CMS held only 29.42% of TGN, a company incorporated in Argentina that was negatively affected by a government regulation.181 The high extent of BIT protection may, according to Dolzer and Schreuer (2008), cause future problems as multiple claimants have a right to sue and therefore, different tribunals will be concerned with the same case at the same time.182

176 177 178 179 180 181

182

German Model BIT, Article I (3) a ii. Dolzer and Schreuer (2008), p.49. Dolzer and Schreuer (2008), p.51. US Model BIT, Section A, p.3. See Dolzer and Schreuer (2008), p.56ff. Dolzer and Schreuer (2008), p.58. Please note that 29.42% is still well above the threshold of the way portfolio investment is defined. So far there appears to be no case law on whether portfolio investment is covered or not. Dolzer and Schreuer (2008), p.59.

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3.3.5.4

Admission

Admission relates to the right of investors to buy or start a business in a foreign country. It is normally acknowledged that entry depends on the relevant host state’s legislation (that is, there is no absolute right of entry for foreign investors). The German Model BIT reflects this perception and states: "Each Contracting State shall in its territory promote as far as possible investments by investors of the other Contracting State and admit such investments in accordance with its legislation."183 Governments may be opposed to FDI for social and environmental but also protectionist reasons. The US treaty practice substantially differs in this respect from the approach of other countries, as US BITs specifically demand national treatment on the question of admission. Article 3 (1) of the US Model BIT reads: "Each Party shall accord to investors of the other Party treatment no less favourable than that it accords, in like circumstances, to its own investors with respect to the establishment, acquisition, expansion, management, conduct, operation, and sale or other disposition of investments in its territory." This strategy has also been adopted by Japan and Canada.184 Nonetheless, it must be noted that exceptions may be applied to certain sectors and subsectors.185 Consequently, completely unrestricted access is rarely found in practice. In addition to the right of admission, recent US treaties also included the prohibition of certain performance requirements, such as contents requirements, as a prerequisite for admission.186 3.3.5.5

Standards of Treatment

With regard to treatment, once investment has been admitted, there are a number of standards that can be found in different formats in almost all investment agreements. The most important ones are fair and equitable treatment, most-favoured-nation and national treatment as well as full protection and security. 3.3.5.5.1

Fair and Equitable Treatment

Article 2 (2) of the German Model BIT demands that each "Contracting State shall in its territory in any case accord investments by investors of the other Contracting State fair and equitable treatment as well as full protection under the treaty". Currently, this standard, referred to as the Fair and Equitable Treatment (FET) standard, appears to

183 184 185 186

German Model BIT, Article 2 (1). Dolzer and Schreuer (2008), p.81. Dolzer and Schreuer (2008), p.81. Lowenfeld (2002), p.474.

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be the most important standard in investment disputes.187 Dolzer and Schreuer (2008) remark that successful claims in international investment arbitration are in most cases grounded on the FET standard. Although clauses with regard to fair and equitable treatment have been part of the vast majority of treaties since the 1970s,188 the importance of the FET standard only manifested itself rather recently, namely in the year 2000 with the cases Metalclad v. Mexico and Maffezini v. Spain. The exact meaning of the fair and equitable treatment standard is controversial. This also holds true for most of the standards in BITs, apparently as a result of the vagueness of these standards. An ongoing discussion continues over whether the fair and equitable treatment standard merely reflects the protection offered through CIL or whether it constitutes an autonomous standard on its own that goes beyond the minimum standard in international law.189 Arbitral decisions on disputes relating to Bilateral Investment Treaties have shown a tendency to treat the fair and equitable standard as an autonomous standard whose interpretation depends on the treaty context.190 Schreuer (2005), reviewing the case law, developed a non-exhaustive list of criteria that are of relevance to the application of the fair and equitable standard. These principles include transparency and the protection of the investor’s legitimate expectations, freedom from coercion and harassment, procedural propriety and due process as well as good faith.191 Particularly the notion of legitimate expectations has been taken up in a number of important arbitration awards, including Saluka Investment v. Czech Republic, Azurix Corp. v. Argentina and CMS v. Argentina. The tribunal in Saluka Investment v. Czech Republic describes the notion of legitimate expectations as the dominant element of that standard.192 The tribunal, in line with Schreuer (2005), asserts that the "expectations of foreign investors certainly include the observation by the host State of such well-established fundamental standards as good faith, due process, and nondiscrimination."193 In that respect, the standard of due process contains, among other things, the obligation to grant a hearing before an independent tribunal and the timely transmission of relevant information.194 Based on the recent case law, Westcott (2007) developed a working definition of fair and equitable treatment. This definition reflects the main elements also emphasised by Schreuer (2005). The working definition by Westcott (2007) contains the regard for 187 188 189 190

191 192 193 194

See Schreuer (2005), p. 357. For a recent overview see also Westcott (2007). UNCTAD (1999), p.9. Westcott (2007), p.409. Schreuer (2005), p.364. In the context of NAFTA, however, the official interpretation is that the fair and equitable standard simply reflects the international minimum standard. Schreuer (2005)p.373-374. Saluka v. Czech Republic, para 302. Ibid., para 303. Choudhury (2005), p.305.

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due process rights and demands treatment that does not affect an investor's legitimate expectations. States are also prohibited from acting in an arbitrary or discriminatory manner. In addition, the state must respect the good faith principle. The FET standard has now been applied to a diverse set of circumstances. This wide scope of application and lack of precision may cause some criticism, but can also be considered a virtue.195 Dolzer and Schreuer (2008) argue that, as possible infringements of the investment are impossible to anticipate, the FET standard "allows for independent and objective third party determination of this type of behaviour on the basis of a flexible standard".196 3.3.5.5.2

Most-Favoured-Nation Treatment

A standard that bears similarity to fair and equitable treatment is the most-favourednation (MFN) treatment. The MFN standard demands of the host state treatment of investors that is not less favourable than the treatment it grants to nationals and companies of any other country. Most BITs combine this standard with a national treatment standard.197 National treatment calls for treatment that is not less favourable than the treatment of nationals of the host state. The fundamental difference between the MFN standard and the fair and equitable treatment standard is that the former is a relative standard, depending on the treatment accorded to other investors, while the latter is an absolute standard that “provides a fixed reference point.”198 Just like in the case of the fair and equitable treatment standard, the scope of the MFN clause is subject to debate and has been interpreted by arbitral tribunals in different ways.199 The MFN standard has been applied to both substantive and procedural aspects of investment treaties.200 It appears that the application of the MFN standard to substantive aspects is less controversial compared to its application to procedural aspects.201 With regard to substantial rights, the MFN clause was, inter alia, successfully combined with the fair and equitable treatment standard (e.g., MTD v. Chile) and with the question of compensation for expropriation (Bayindir v. Pakistan). As Dolzer and Schreuer (2008) hold, the "weight of authority clearly supports the view that an MFN rule grants a claimant the right to benefit from substantive guarantees contained in third treaties."202

195 196 197 198 199 200 201 202

See especially chapter 5 on this issue. Dolzer and Schreuer (2008), p.148. Dolzer and Stevens (1995), p.65. Schreuer (2005), p.367. Teitelbaum (2005) and Hsu (2006) provide overviews. Chukwumerije (2007), p.598. Chukwumerije (2007), p.599. Dolzer and Schreuer (2008), p.191.

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With regard to procedural aspects, the main question relates to the access to dispute resolution procedures that may be more favourable in some treaties than in others. An arbitration ruling from the year 2000, Maffezini v. Spain, especially attracted a lot of attention and caused some criticism.203 In the given case, the investor, originally protected under the Argentina-Spain BIT, invoked the MFN clause to avoid the duty to resort to the host state's domestic courts for 18 months before he could initiate arbitration. This duty was part of the Argentina-Spain BIT, but another Spanish BIT, the Chile-Spain BIT, contained no equivalent obligation. Relying on this Chile-Spain BIT, the investor successfully argued that the duty to wait did not apply to him. A number of tribunals, including Siemens v. Argentina and S.A. v. Argentina, followed this line of reasoning. However, other tribunals have interpreted the MFN clause more narrowly and have stressed its limited applicability to procedural rights.204 At this point, the case law has not converged towards a reliable and generally accepted interpretation of the MFN standard for procedural rights. What is clear is that contracting parties can explicitly exclude certain areas from the application of the MFN clause in the treaty. As Dolzer and Schreuer (2008) emphasise, the straightforward application of the MFN standard, though common in trade law, is more problematic in international investment law. More precisely, investment treaties contain clauses specifically negotiated by two parties. Consequently, the question arises whether the MFN clauses are supposed to alter the results of these specific negotiations. Kurtz (2004) has also expressed scepticism on this matter. The author's concern is mainly based on the wider scope of operation of an MFN clause in investment law as compared to trade law, as in the latter, a potentially large number of regulatory areas are concerned. In addition, economic theory provides a rather uncontroversial welfare-enhancing case for tariff reduction in international trade law. Yet, according to Kurtz (2004), in international investment law, no similar unequivocal economic case can be made. 3.3.5.5.3

Additional Standards

BITs usually include a diverse number of additional standards. Among these are "full protection and security", the "umbrella clause" and the "transfer of funds".205 The “full protection and security” clause is a frequent standard that relates to the amount of protection a host state must provide for the investment vis-à-vis third parties. As a

203

204 205

ICSID Case No. ARB/97/7, award available under http://icsid.worldbank.org/ICSID/Index.jsp (September 1st, 2010). For instance, Plama v. Bulgaria or Telenor v. Hungary. Please note that this overview on standards in bilateral investment is not exhaustive. Treaties may also address the access to justice, armed conflicts or arbitrary measures. For a recent and complete overview, see Dolzer and Schreuer (2008).

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practical matter, this clause requires the host state to exercise due diligence in the protection of foreign investment.206 The so-called "umbrella clause" defines the relationship between investor-state contracts and Bilateral Investment Treaties. Article 8 (2) of the German Model BIT requires that each "Contracting State shall observe any other obligation it has assumed with regard to investments in its territory by investors of the other Contracting State." On the other ahdn, the 2004 US Model BIT does not contain an umbrella clause. In sum, about 1000 BITs are estimated to incorporate an umbrella clause.207 The exact wording of umbrella clauses differs to a certain extent among treaties concluded by different countries.208 The umbrella clause did not receive much attention until the interpretation of the clause by the tribunal of SGS v. Pakistan in 2003. Since then, two different lines of jurisprudence regarding the interpretation of the clause have emerged: a narrow and a wide interpretation. The narrow interpretation rests on the classical distinction between violations of international and contractual breaches.209 Yet, as Kunoy (2006) remarks, "bearing in mind that this conceptual distinction is not a peremptory norm, and in the event that the clause is clear and unambiguous, ICSID tribunals are under the obligation to confer an effet utile to the umbrella clause."210 In practice, the matter is unresolved and some but not all tribunals have been reluctant to internationalise contractual obligations of host states vis-à-vis investors. The "transfer of funds" relates to the import of funds to initiate the business and to the repatriation of profits. Small countries may especially be concerned about their current account balance and therefore impose restrictions on the in- and outflow of capital. Although virtually all treaties deal with this matter and there is an inherent conflict of interest between investors and states, the transfer of funds is rarely the subject of arbitral proceedings. Dolzer and Schreuer (2008) attribute this to the high specificity of regulation in most treaties.211 3.3.5.6

Expropriation and Compensation

Virtually all Bilateral Investment Treaties contain provisions concerning the expropriation and nationalisation of property held by foreign investors. The treaties formulate the conditions under which a taking is considered lawful. An expropriation is accordingly considered legitimate if it serves a public purpose, is conducted in a

206 207 208 209 210 211

Dolzer and Stevens (1995), p.61. See Dolzer and Schreuer (2008), p.153. See OECD (2006) for an overview on treaty language. Kunoy (2006), p.299. Kunoy (2006), p.299. Dolzer and Schreuer (2008), p.192.

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non-discriminatory manner, is followed by prompt, adequate and effective compensation and is in accordance with due process of the law.212 It is evident that as to the question of compensation, when drafting treaty provisions, the contracting parties have adhered to the Hull-Formula, although the specific determination of compensation remains opaque.213 Even though outright nationalisations and expropriations, as in the case of Bolivia, have received a lot of public attention, it is mainly the problem of indirect expropriation with which arbitral tribunals must deal. 3.3.5.6.1

Indirect Expropriation

Indirect expropriation, also referred to as regulatory expropriation, describes a situation where the host state deprives the owner of his property rights through regulatory measures. The differentiation between a regulatory taking (implying compensation for the asset-owner) and a regulation (implying no such compensation) is a problem persistent also in the domestic sphere. The economic discussion focuses primarily on the question whether takings justify the payment of compensation at all214 - with regard to the differentiation in practice, the standards applied obviously differ from country to country.215 In international investment law, BITs take account of the danger of indirect expropriation by extending the cover to measures “equivalent” or “tantamount” to expropriation.216 Finding criteria that distinguish compensable expropriation from justified, non-compensable regulation poses a great challenge to arbitrators and international legal scholars. Evidently, the concept of indirect expropriation is problematic as it affects the regulatory space of a country. Various arbitral tribunals have approached the topic from different angles, some focusing solely on the effects of the regulation, others placing emphasis on the purpose of the measure and some taking the middle ground between these two approaches.217 Undoubtedly, the variance in the interpretation of BITs and other treaties regarding the question of indirect expropriation has created some legal uncertainty. Kriebaum (2007b) distinguishes between the Sole Effects doctrine, the Radical Police Powers doctrine and the Moderate Police Powers doctrine. As the name implies, the Sole Effects doctrine only considers one factor decisive as to whether a regulatory measure constitutes expropriation: the effect of the measure on the investment. The motivation and purpose of the measure is irrelevant. If the effect of the measure exceeds a threshold, it is expropriation. The case of Metalclad v. Mexico is often cited as an

212 213 214 215 216 217

See Dolzer and Stevens (1995), p.99-101, for different variations of this clause. On the dispute with regard to the Hull formula, see section 3.3.3.1. Miceli and Segerson (1999) See also section 5.4.3 on this issue. Dolzer and Stevens (1995), p.98 ff. See Fortier and Drymer (2004).

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example for this reasoning. Alternatively, the Radical Police Powers doctrine does not look at the effects on the investment but at the purpose of the measure. Put differently, no expropriation will have occurred when the government measure was in the public interest and non-discriminatory.218 The problem with this approach, as Kriebaum (2007b) notes, is that it leads to a fragmentation of international investment law. Compensation will be required in case of a direct expropriation (even when in the public interest), but a regulatory measure with the same effect will not lead to a compensation payment. An intermediate position is adopted by the Moderate Police Powers doctrine. This doctrine is mainly based on the effect of the measure, but takes considerations like the purpose of the measure and the existence of legitimate expectations into account.219 New treaty practice appears to abandon the Sole Effects doctrine. The 2004 US Model BIT emphasises three criteria that should be considered in identifying indirect expropriation:220 "the economic impact of the government action, although the fact that an action or series of actions by a Party has an adverse effect on the economic value of an investment, standing alone, does not establish that an indirect expropriation has occurred; the extent to which the government action interferes with distinct, reasonable investment-backed expectations; and the character of the government action." Further, the Model BIT clarifies: "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."221 As mentioned, this wording seems to be closer to the Police Power doctrine than to the Sole Effects doctrine. However, as Kriebaum (2008) notes, the legitimacy of measures will strongly depend on the interpretation of the term "rare circumstances".222 3.3.5.6.2

Compensation

Once a tribunal has decided that a state measure has been of an expropriatory nature, the investor is entitled to compensation. It has been mentioned before that this

218 219 220 221 222

Kriebaum (2007b), p.726. Kriebaum (2007b), p.727. 2004 US Model BIT, Annex B, Article 4. (a) (i-iii). 2004 US Model BIT, Annex B, Article 4. (b). Kriebaum (2008), p.267. There are no arbitral awards based on this formulation yet.

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compensation must usually be prompt, adequate and effective. With regard to the amount of compensation, some treaties stipulate the "fair market value".223 Sornarajah (2004) lists three common methods of valuation: the book value, the market value and the discounted cash flow (DCF) method. The difference between the last two remains unclear as the DCF should equal the market value. Consequently, Marboe (2006) lists the DCF method as one possible method to determine the fair market value. Alternative methods are the comparative method, multiples and the liquidation value. The comparative method simply looks at the market value of comparable objects. The method of multiples combines the DCF method and the comparative method by multiplying key figures of the enterprise (e.g., EBIT) with certain factors (which are derived from sales prices of a comparable enterprise). The liquidation value is selfexplanatory. Obviously, the appropriate method depends on the specific characteristic of the case and the availability of the relevant data. It is also clear that tribunals cannot, as has happened in the past, add the expenses incurred and the lost profits as this would be double counting.224 3.3.5.7

Public Concerns

Public concerns regarding to the host country's right to regulate have played an increasing role in recent BIT negotiations.225 Norway, for example, published a new draft Model BIT that includes an article on the "Right to Regulate" (Article 12).226 The relevant article reads: "Nothing in this Agreement shall be construed to prevent a Party from adopting, maintaining or enforcing any measure otherwise consistent with this Agreement that it considers appropriate to ensure that investment activity is undertaken in a manner sensitive to health, safety or environmental concerns." More specifically, international arbitration as the most important instrument to settle disputes in investment matters has in the past been described as "ill-equipped" in protecting the public interest.227 How public concerns can be incorporated in Bilateral Investment Treaties will certainly be of importance in future BIT negotiations. For example, environmental considerations have come up in the BIT negotiations between China and Canada.228 It is yet unclear if this trend will continue to expand as public concerns have been recognised already by arbitral tribunals based on the existing standards of treatment.

223 224 225 226

227 228

Kriebaum (2008), p.528. Wells (2003). UNCTAD (2008c), p.5. See also Karl (2008), p.229. Available under www.regjeringen.no/upload/NHD/Vedlegg/hoeringer/Utkast%20til%20modellav tale2.doc (September 1st, 2010). See, e.g., Gruner (2003), p.924. On dispute settlement, see the following section. UNCTAD (2008c), p.5.

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3.3.5.8

The Settlement of Disputes

Disputes may arise between the contracting parties (inter-governmental disputes) and between the investor and the host state (investor-state disputes or investment disputes). Bilateral Investment Treaties usually address both issues.229 In both cases, treaties generally provide for arbitration. While this is standard for disputes between governments, it is remarkable in the context of international law that private parties can initiate arbitration under an inter-governmental treaty. As the investors are actually not contracting partners to the treaty, this type of arbitration has been termed “arbitration without privity”.230 The main advantage for the investor here is that he does not have to rely on the diplomatic protection of his home state to take legal action. In the case of diplomatic protection, the home state of the investor pursues the claim of its national against the host state in its own name. Although diplomatic protection was the major remedy in traditional international investment law, its usefulness is limited.231 The main problem is that the investor depends on the willingness of his own government to pursue the claim. Obviously, the use of domestic courts is the natural first step if a conflict cannot be resolved through negotiations. As a matter of fact, states may make the exhaustion of local remedies a condition for the consent to arbitration. As Dolzer and Schreuer (2008) point out, this possibility is not used very frequently.232 In addition, BITs sometimes require the investor to decide between the use of local remedies and international arbitration. This requirement has been termed a "fork in the road provision". As with diplomatic protection, the use of domestic courts is often not very promising. A lack of impartiality and competence may be the two most important problems in many jurisdictions. These shortcomings of domestic courts and diplomatic protection have made international arbitration a valuable tool to foreign investors. There are different types of arbitration rules that contracting states employ in their BITs. Most common are references to arbitration under the institutional framework of the International Centre for the Settlement of Investment Disputes (ICSID). However, reference to UNCITRAL Rules or other forms of arbitration, as well as a combination thereof, is also possible. Consequently, the wording of the relevant BIT determines which type of arbitration an investor can access. The number of investor-state arbitrations has seen a sharp increase in recent years. By the end of 2009, the total number of known treaty arbitrations reached 357 cases.233 In 2009 alone, at least 32

229 230 231 232 233

Dolzer and Stevens (1995), p.119 ff. Paulsson (1995). Dolzer and Schreuer (2008), p.211. Dolzer and Schreuer (2008), p.215. UNCTAD (2010), p.83.

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new cases were filed.234 No universal public registry of claims exists; consequently, the actual number is likely higher. As mentioned before, the drafters of a BIT have a number of choices concerning the forum of arbitration. Most common is the reference to ICSID. According to UNCTAD (2009b), out of the 317 known treaty-based arbitrations by the end of 2008, 201 were handled under the institutional framework of ICSID, while 83 were initiated under the UNCITRAL Rules, 17 under the rules of the Stockholm Chamber of Commerce (SCC), 5 under the International Chamber of Commerce (ICC), 5 using ad-hoc arbitration and the remaining cases under the Cairo Regional Centre for International Commercial Arbitration. The Permanent Court of Arbitration (PCA) in The Hague also administered one case.235 Evidently, ICSID is and can be expected to remain the most frequently used arbitration facility in the context of investment disputes. The following section will therefore describe the arbitration process under ICSID in greater detail.236 3.3.5.8.1

ICSID

The International Centre for the Settlement of Investment Disputes was established in 1965 under the auspices of the World Bank through the so-called ICSID or Washington Convention.237 So far, 143 states have signed and ratified the convention. ICSID is one of the five international organisations that make up the World Bank Group. ICSID is not an arbitral tribunal itself but instead a secretariat that assists in the arbitral process and provides a set of rules for arbitration.238 These rules include, for example, provisions about the appointment of the arbitrators, the procedure itself and the costs of proceeding. The jurisdiction of the Centre is outlined in article 25 of the ICSID Convention: "The jurisdiction of the Centre shall extend to any legal dispute arising directly out of an investment, between a Contracting State (or any constituent subdivision or agency of a Contracting State designated to the Centre by that State) and a national of another Contracting State, which the parties to the dispute consent in writing to submit to the Centre. When the parties have given their consent, no party may withdraw its consent unilaterally."239

234 235

236

237 238

239

UNCTAD (2010), p.83. The rules applied by the PCA are, in turn, the UNCITRAL Arbitration Rules. See Dolzer and Schreuer (2008), p.229. For the remaining four cases, UNCTAD (2009b) provided no information on the venue. For a description of the ICC and UNCITRAL Rules, see Collier and Lowe (1999), p.45ff. The different arbitration rules tend to have very similar procedural rules. Blackaby, Paulsson et al. (2004), p.1ff. Arbitration is not the only form of dispute settlement that is supported by ICSID. The ICSID convention also provides guidelines for conciliation. ICSID Convention, Article 25, available under http://www.worldbank.org/icsid/highlights/04-1006.htm. Even if the investor is not from a contracting state or the host state has not signed the

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In the context of Bilateral Investment Treaties, it is important to note that ICSID accepts arbitrations that arise from indirect consent, such as in a BIT or a multilateral investment treaty.240 In other words, when an investor files a claim against a state, the ratification of the ICSID Convention is taken as a written consent. Consequently, the state cannot frustrate the arbitration process unilaterally. Once a valid request for arbitration has been filed, an arbitration tribunal is constituted. The choice of arbitrators and size of the panel is supposed to be made cooperatively. However, ICSID provides default rules in cases where the parties cannot find a consensus on these issues. Usually, an arbitral tribunal consists of three members. The actual proceedings of the arbitration are regulated in Articles 41 to 47 of the convention and in the Arbitration Rules 13 to 38. The arbitration process consists of written and oral procedures. According to Article 45, failure of a party to appear before the tribunal will not frustrate the proceedings.241 As to which legal grounds the arbitral tribunal must use to decide the case, article 42 (1) of the ICSID Convention states: "The Tribunal shall decide a dispute in accordance with such rules of law as may be agreed by the parties. In the absence of such agreement, the Tribunal shall apply the law of the Contracting State party to the dispute (including its rules on the conflict of laws) and such rules of the international law as may be applicable." Obviously, the underlying investment agreement is the starting point of the legal analysis of the investment dispute at hand. BITs usually refer to the provisions in the treaty itself, the laws of the contracting party involved in the conflict, specific agreements concluded in relation to the relevant investment and applicable principles of international law.242 Regarding interpretation, the general rules of the Vienna Convention on the Law of Treaties, especially article 31, apply.243 While BITs often do not specifically prescribe how the different sources of law are to be combined, arbitral tribunals have given priority to the application of international law as compared to the domestic law of the contracting state.244 Within 120 days of the closure of proceedings, the tribunal must render an award. As to the costs of proceedings, if the parties do not agree otherwise, the tribunal decides in its final award on the allocation of costs.

240 241 242 243 244

Washington Convention, arbitration may still be undertaken under the auspices of ICSID by using the ICSID Additional Facility. See Blackaby, Paulsson et al. (2004), chapter 3. Collier and Lowe (1999), p.70, call this “perhaps the most important provision”. Redfern, Hunter et al. (2004), paragraph 11-19. Dolzer and Stevens (1995), p.15. See also section 3.3.3.2. Comeaux and Kinsella (1997), p.206 and Redfern, Hunter et al. (2004), paragraph 11-19.

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3.3.5.8.2

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Remedies

ICSID awards are binding and are not subject to any appeal or remedy other than those provided for in the convention itself.245 In other words, awards under ICSID cannot be reviewed by national courts. The ICSID convention offers only three post-award remedies: interpretation, revision and annulment. The first two appear to be of limited practical importance: as of February 2010, ICSID has, according to the cases listed on its homepage, only received five requests for interpretation (Marvin Roy Feldman Karpa v. United Mexican States in 2003, Wena Hotels Limited v. Arab Republic of Egypt in 2004, Archer Daniels Midland Company and Tate & Lyle Ingredients Americas, Inc. v. United Mexican States in 2008, Tanzania Electric Supply Company Limited v. Independent Power Tanzania Limited in 2008 and Corn Products International, Inc. v. United Mexican States in 2009) and only three requests of revision (American Manufacturing & Trading, Inc. v. Democratic Republic of the Congo in 1999, Víctor Pey Casado and President Allende Foundation v. Republic of Chile and Siemens A.G. v. Argentine Republic, both in 2008).246 One of the requests of revision was settled before the tribunal made a decision; the other two cases are still pending. The third available remedy, annulment of the award, is only possible on very limited grounds, for instance if the tribunal was not properly constituted or manifestly exceeded its powers.247 However, there have been a number of annulment cases in the past.248 It is important to note that ICSID awards are not subject to annulment (or review) by domestic courts. Upon request of a party, the chairman of ICSID's Administrative Council will appoint an ad hoc committee consisting of three persons. The enforcement of the award may be deferred until the annulment procedure is completed. The main point is that the ad hoc committee may evaluate only the legitimacy of the process of the original arbitration and does not review the substance of the award. If the legitimacy of the original arbitration process was frustrated, the case should be submitted to a new tribunal. Article 52 (1) of the ICSID Convention lists the five exhaustive criteria for annulment: (a) that the Tribunal was not properly constituted; (b) that the Tribunal manifestly exceeded its powers; (c) that there was corruption on the part of a member of the Tribunal; (d) that there was a serious departure from a fundamental rule of procedure; or (e) that the award failed to state the reasons on which it was based.

245 246 247 248

ICSID Convention, article 53. See http://icsid.worldbank.org/ICSID/Index.jsp (September 1st, 2010). ICSID Convention, article 52. Out of the 205 concluded cases (through settlement or award) listed on the ICSID website (November 2nd, 2010), 25 cases triggered an annulment procedure.

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In non-ICSID arbitrations, an award may be challenged through national courts. The procedure depends on whether the defendant is a party to the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, the socalled New York Convention. The New York Convention was adopted in 1958 and deals, as the name implies, with the recognition and enforcement of international arbitral awards. A total of 138 states have signed the convention. The New York Convention allows domestic courts to review an arbitral award on certain limited grounds and is less severe than the ICSID Convention as it allows, for instance, the review of an award if the "recognition or enforcement of the award would be contrary to the public policy of that country".249 If the country is not party to the New York Convention, domestic arbitration laws apply. Many of these laws are modelled on the UNCITRAL Model Law.250 The UNCITRAL Model Law is, in turn, based on Article V of the New York Convention. 3.3.5.8.3

Enforcement and Execution of Arbitral Awards

The ICSID Convention contains an automatic recognition and enforcement mechanism. An award must be enforced by each contracting state “as if it were a final judgment of a court in that state.”251 Consequently, investors can enforce awards not only in the host state, but in any state that is a signatory to the ICSID Convention. Nevertheless, enforcement of the award and execution are distinct procedures. Domestic courts have refused to execute arbitral awards if the assets in question were considered as being protected by sovereign immunity.252 Sovereign immunity is generally the only argument that can prevent the execution of international arbitral awards. A waiver of sovereign immunity included in the investment agreement could solve this problem, but states will be reluctant to agree to such a waiver.253 As relative recent research shows, attempts to enforce ICSID awards in domestic courts have been rare so far. As of 2006, there are only four known cases.254 This implies a high compliance rate. However, the number of cases may obviously increase due to the rising number of arbitrations under ICSID. As with remedies, the execution and enforcement of non-ICSID awards depend on the regulations of the New York Convention (if applicable) and on national laws.

249

250 251 252

253 254

United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, also called the New York Convention, Article V 2. (b). Dolzer and Schreuer (2008), p.278. ICSID Convention, article 54 (1). Blackaby, Paulsson et al. (2004), p.107ff. Which assets actually fall under the category of sovereign immunity depends on national legislation and varies between countries. Comeaux and Kinsella (1997), p.209. Baldwin, Kantor et al. (2006), p.5.

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As mentioned earlier, the New York Convention leaves more room for appeal than the ICSID convention. Nevertheless, in principle, the New York Convention also requires the contracting state to recognise arbitral awards as binding and enforce them.255 3.3.5.8.4

Costs

The costs associated with arbitration proceedings can be substantial. This does not concern so much the fees charged by arbitration institutions like ICSID.256 Instead, the cost of legal representation is by far the largest cost for the parties and may amount to millions of USD.257 The cost sharing rule depends on the applicable arbitration rules. Article 61 (2) of the ICSID Convention places the decision on the distribution of costs in the hands of the tribunal. The UNCITRAL Arbitration Rules, however, specifically place the burden of the costs on the losing party by default.258 Arbitral practice in this respect is not uniform.259 Tribunals have in some cases required the parties to carry their own expenses, in other cases the losing party must cover the expenses of the winning party as well. 3.3.5.8.5

Empirical Aspects of Arbitration

Scholars have recently begun to collect data on the different aspects of international investment treaty arbitration. In addition, the importance of empiricism in international law and international investment law has been emphasised.260 Franck (2007) has compiled a number of figures on investment treaty arbitration to evaluate the merits of frequent claims on investment dispute resolution. A total of 102 awards from 82 separate cases formed part of the examination. Of these awards, 52 finally resolved the case's treaty claims. The analysis showed that investors who filed claims were predominantly from developed countries, in most cases from the United States. The situation looks different with regard to government respondents. Based on World Bank classifications, in 18% of the cases the respondent government was a high-income country, in 45% an upper middle income country, in 28% a lower middle income country and in 8.5% a low income country. This qualifies earlier assertions that only very few cases are brought against non-developing countries. As Franck (2007) states, this "suggests that 'middle income' countries, particularly those with a higher income,

255

256

257 258 259 260

United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, Article III. The schedule of fees for ICSID (as of January 1, 2008) stipulates administrative charges of 20.000,00 USD per case and 3.000,00 USD payments to arbitrators per day. Dolzer and Schreuer (2008), p.276. Article 40, UNCITRAL Arbitration Rules. Dolzer and Schreuer (2008), p.276. See Franck (2008).

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were at the greatest risk of arbitration."261 Only three cases concern countries usually classified as Least Developed Countries (“LDCs”). Karl (2008) uses slightly different figures and asserts that only about 20% of all known investment disputes were filed against a developed country.262 It is obvious that much depends on how the line between developed and developing countries is drawn. An interesting point concerns whether investors win more often than governments. The data collected by Franck (2007) are rather surprising in this respect. Out of the 52 cases that finally resolved a treaty claim, 30 cases were decided in favour of the government. Put differently, in 57.7%, the government had to pay nothing. In 38.5%, the investor was awarded damages, and two awards embodied settlement agreements. The claim that tribunals are biased towards investors accordingly could not be verified by Franck. But if investors do win, do they recover large amounts? The average amount in the 21 cases where investors actually were awarded damages was 10.4 million USD. In most cases, investors received less than 5 million USD. To quote Franck: "When investors did win, they did not win big."263 Franck also finds a striking difference between the amounts claimed and the amounts awarded. The high claims often put forward by investors may have fostered the perception that governments are facing high financial risks through investment treaties (in one case, Generation Ukraine v. Ukraine, the investor claimed 9.4 billion USD264). Concerning the total number of investment arbitrations, Karl (2008) emphasises that given the number of BITs (approximately 2.700) and the number of potential claimants (78.000 transnational companies could in theory invoke arbitration procedures), the number of arbitrations is still very small.265 3.3.5.9

BITs and Customary International Law

With almost 2700 BITs signed by more than 170 countries, the question arises whether BITs are evidence of customary international law, that is, if they are “applicable even when a given situation or controversy is not explicitly governed by a treaty”.266 There is no unified answer to this question. Some writers reject the notion that BITs represent CIL by stating that BITs merely constitute a lex specialis between the

261

262 263 264 265 266

Franck (2007), p.32. This does, of course, not control for the magnitude of investment flows and the number of investment treaties. Also, there were two huge outliers: Argentina faced fifteen cases alone and Mexico faced nine. Karl (2008), p.233. Franck (2007), p.61. Franck (2007), p.57. Karl (2008), p.230. Lowenfeld (2002), p.486.

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contracting states.267 To quote Sornarajah (2004): “It would be wrong to subscribe to the thesis that the treaties stabilised customary international law. If there was a definite conviction as to the existence of customary law in the area, there would have been little need for such frenetic treaty-making activity on investment protection.”268 Other writers argue that common principles have nevertheless passed into customary international law.269 These principles include, for instance, that the host state is under the obligation to treat foreign investors fairly or that disputes between foreign investors and host states should be subject to impartial adjudication or arbitration.270 However, it must be noted that “there are particular provisions of BITs that, although widely used, are applicable only between the parties.”271 3.3.5.10

Summary

Studying the realm of international investment law reveals that this is a dynamic area. Many specific questions are the subject of controversy. The historical debate on the appropriate amount of compensation for expropriations has calmed with a changing attitude of most developing countries towards FDI. Meanwhile, the growing number of BITs has brought up a whole set of more specific questions and controversial issues related to the rightful application and interpretation of certain treaty clauses. This includes for instance the fair and equitable treatment standard, the most-favourednation clause and the question of when a regulation is of an expropriating nature. This vagueness in some areas of international investment law does not imply that international investment law is useless and ineffective. From the investor’s point of view, Bilateral Investment Treaties offer a number of advantages: the investor does not have to rely on the diplomatic protection of his government; the level of protection in BITs is usually higher and better specified than the rules in customary international law; the investor can expect that his case will be handled by an unbiased panel of international experts; Bilateral Investment Treaties are backed up by multilateral treaties on the recognition of arbitral awards, etc. It must be noted that BITs have received considerable attention in the past years. Some concerns by commentators relating to the (possibly negative) impact of dispute resolution on developing countries have not (yet) been verified empirically. The large amount of attention is also surprising in another respect: BITs are obviously international law and international law is often rather perceived as (too) weak. The logical next question is therefore to

267

See, e.g., Kishoiyian (1994) or Guzman (1998), p.686f. Sornarajah (2004), p.213. Hindelang (2004), Lowenfeld (2002), p.486ff. 270 Hindelang (2004), p.799. 271 Hindelang (2004), p.809. 268 269

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ask if BITs actually make a difference and if so, why. The next section will deal with this question.

4

The Economics of BITs

Bilateral Investment Treaties are the cornerstone of international investment law. While empirical research indicates that BITs can increase foreign investment to the signatory state, the economic analysis of law has so far only barely been applied to BITs. The decisive question in this context is why BITs function given that international law is weak and lacks a supranational authority with coercive power. Further, how do litigation costs, damages, reputational concerns etc. impact the economic functioning of BITs? Which countries can actually utilise BITs to attract investment? This chapter will attempt to answer these and similar questions and proceeds as follows: after discussing the perceived weakness of international law (section 4.1), the empirical literature on the impact of BITs on FDI will be reviewed (section 4.2). The burgeoning research approach of international law and economics will be introduced (section 4.3) and the main findings of this method will be applied to international investment law (section 4.4). Special focus will be given to the commitment and signalling properties of BITs. These properties will be checked against the existing empirical research on the topic (section 4.5). Section 4.6 discusses the main results and concludes. 4.1

The (Perceived) Weakness of International Law

Because international law lacks the coercive enforcement that is present on the domestic level, international law may be perceived as weak and ineffective. One might conclude that states only comply with international law when it coincides with their general policy goals. Put differently, international law as such does not affect state behaviour. This idea can be exemplified using a simple game-theoretic example:272 two countries have agreed on a treaty (in the example of Guzman (2002), the treaty concerns a ban on satellite-based weapons) and must make a compliance decision. We are considering a one-shot game with the following payoffs: Country 2 Comply

Violate

Comply

5,5

2,6

Violate

6,2

3,3

Country 1

272

This example is taken from Guzman (2002), p.1841 ff.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_4, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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Using the satellite-based weapon example, both countries have a preference for obtaining the weapon while the other country does not have it. In addition, both countries not having the weapon is preferred to both having the weapon. In other words, both countries prefer a situation where the other country complies while violating itself. The well-known equilibrium of this prisoner's dilemma is (violate/violate). While this situation might be called the "bad state of nature", payoffs can alternatively be modelled as follows (the good state of nature): Country 2 Comply

Violate

Comply

10,10

6,8

Violate

8,6

4,4

Country 1

The satellite system might be unreliable and a waste of resources. Still, each country prefers that the other does not even have an unreliable weapon system. In this case, for both countries, compliance is the dominant strategy. If the payoffs are frequently as depicted in the second case, states will usually comply with their international legal commitments. This behaviour satisfies the famous observation that "almost all nations observe almost all principles of international law and almost all of their obligations almost all of the time".273 At the same time, international law itself did not make a difference. The decisions of the states were guided by the underlying fundamental payoffs. However, the example shows immediately that the theory that international law does not make a difference is based on the assumption that the law does not affect the payoffs of states in any meaningful way.274 In this spirit, it could reasonably be argued that BITs - as being part of international law - do not affect state behaviour and can, consequently, also not help attract additional FDI. Put differently, the (potential) costs that are generated by a BIT may not influence the decision of states or governments.275 The following sections will 273 274

275

This is a quote from Louis Henkin cited by Guzman (2002), FN 79. If, however, the existence of a treaty between the parties reduces the payoff of game 1 in the case of violation by 2, compliance would also be the dominant strategy. A second argument against the efficacy of BITs could be that MNEs do not consider the additional legal protection to be important. As Sornarajah (2004) notes on whether investment treaties facilitate investment flows: "This is an untested hypothesis. […] Stability and other factors have a greater influence on investment flows than do investment treaties." Sornarajah (2004), p.215, FN 32. This might be true, but does not refute the hypotheses that BITs influence FDI flows at the margin. See section 4.2.

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analyse the economic case for (or against) the efficacy of BITs using a commitment and a signalling framework. However, before evaluating the functioning of BITs from a theoretical point of view, it is worthwhile to review the empirical literature in this respect and thereby to shed some light on the impact of BITs on FDI. 4.2

The Effect of BITs on FDI

Several empirical studies have tried to evaluate whether BITs fulfil their aim of attracting FDI.276 These studies differ in their methodology, complexity, sample selection and, most notably and rather unfortunately, in their results. While some studies affirm a robust link between the conclusion of investment agreements and FDI, other studies find only weak or no correlation at all. Put differently, a number of studies could not confirm a positive effect of BITs. 4.2.1

Empirical Studies on the Effect of BITs on FDI

The first empirical analysis concerning the impact of BITs on foreign direct investment was carried out by UNCTAD in 1998.277 The authors analyse time-series data for 200 BITs (of the approximately 1.300 BITs in existence at that time) from the period 1971 to 1994. More specifically, they test the bilateral investment flows between two countries that have signed a BIT with each other for different time frames using T-statistics. The study finds a weak effect of BITs on FDI. A consistent time lag between the signature of the BIT and the effect on FDI cannot clearly be defined, but is most likely two years. The authors also conduct a cross-sectional regression for 133 countries for the year 1995. Dependent variables are FDI flows and stocks, independent variables include the number of BITs, GDP, GDP growth, population, etc. The overall result is that BITs play - compared to market size (GDP and population) only a weak, secondary role in attracting FDI. Quite similar are the results by Hallward-Driemeier (2003): the author analyses dyadic (bilateral pairs) investment flows from OECD to developing countries in the years 1980 to 2000 using panel data in a fixed-effects model. The independent variable of interest is the existence of a BIT between the country pair (using a dummy variable), while other independent variables control for the size of the relevant states, macroeconomic stability, trade openness, education, etc. She detects only slight evidence that BITs have induced additional investment. At first, the coefficients on the BIT variable are negative and insignificant, only after five years appears to be an extremely weak positive correlation. Furthermore, BITs are found to be more of a complement

276 277

Sauvant and Sachs (2009) provide a recent overview of the relevant literature. UNCTAD (1998).

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than a substitute for domestic institutions. In other words, countries that actually profit from investment agreements already possess reasonably strong domestic institutions. This rather pessimistic view on the efficacy of BITs is further supported by Aisbett (2007). The author tests whether BITs have stimulated the flows of FDI from OECD countries to 28 low- and middle-income countries between 1980 and 2005 using panel data with fixed-effects (including year effects and country-pair fixed effects). While the BIT indicator in the study is positive and significant, Aisbett (2007) attributes this not to a positive impact of BITs on FDI, but to a problem of endogeneity mainly based on reverse causality and omitted variable bias. Put differently, according to a simple model developed by Aisbett (2007), the benefit of signing a BIT depends on the magnitude of the existing stock of FDI. The underlying reason is that in the proposed model, the signature of BITs reduces the maximum tax rate the host state can impose on new and existing investment.278 Controlling for this relationship in the econometric model reveals that the positive correlation between BITs and FDI might be driven by endogeneity. Rose-Ackerman and Tobin (2003) use panel data from 1980 to 2000 in a fixed effects as well as random effects specification. The dependent variable are FDI inflows as a percentage of World-FDI. In testing the impact of cumulative BITs on FDI, the authors control for GDP, political risk, population, growth, natural resources and the interaction of BITs with risk. BITs turn out to have a positive impact on FDI, though not a statistically significant one. Statistical significance (in the expected directions) can be shown for GDP, political risk and population. The authors further find that – surprisingly - for high risk countries, a higher number of BITs lowers FDI inflows. Only for low risk countries does the flow of FDI increase. Specifically, studying the effects of US-BITs, the authors find no significant effects on FDI. These rather pessimistic findings on the impact of BITs on FDI are counterbalanced by a number of studies that confirm a robust and positive relationship between the two variables. Salacuse and Sullivan (2005) run cross-country regression of US-BITs, OECD-BITs and other BITs on aggregate FDI inflows to more than 100 countries controlling for GDP, GDP per capita, inflation, real effective exchange rate, population and rule of law. In addition, the authors analyse US FDI inflows to 31 countries over a ten year period using panel data in a fixed-effects model. With both techniques, the authors find that US-BITs are correlated with higher FDI inflows. The same strong result cannot be established for other BITs. Thus, the authors conclude that "1. A U.S. BIT is more likely than not to exert a strong and positive role in promoting U.S. investment. 2. A U.S. BIT is more likely than not to exert a strong and

278

Which is a rather arbitrary and therefore in our view not a convincing assumption.

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positive role in promoting overall investment. 3. A U.S. BIT is likely to exert more of an impact than other OECD BITs in promoting overall investment."279 Two studies limit their attention to the analysis of BITs and FDI in specific regions. Grosse and Trevino (2005) investigate the impact of institutional factors on FDI flows in Central and Eastern Europe (CEE countries). The authors use a data set for 13 CEE countries from 1990 to 1999 and employ a random effects model. They find that the presence of Bilateral Investment Treaties was positively and significantly related to inward FDI. Similar results are obtained by Gallagher and Birch (2006) who use fixed effects regressions with panel data on 24 countries in Latin America for the time period 1980 to 2003. According to this study, the total number of BITs has a positive and independent effect on FDI flows. No independent effect could be found for USBITs on FDI inflows from the United States. Remarkably, the authors discover regional differences. While BITs could be shown to augment FDI in South America, this was not true for BITs in Mesoamerica. Swenson (2005) runs separate negative binomial regressions for the time frames 1990 to 1994 and 1995 to 1999 to account for the hypothesis that investments may be characterised by lags or leads. The author controls in her regression for previous investment flows, country risk and regional differences (through region dummies). In addition, she differentiates between US-BITs and non US-BITs. The data set includes 80 countries for the first time frame (1990-1994) and 84 countries for the second time frame (1995-1999). The author finds that signing a BIT with the US was correlated with a much larger stimulus to investment flows than were BITs with other countries. Further, BITs fostered investment in the second half of the 1990s, but not in the first half. Robust results indicating a positive of impact of BITs on FDI have been published by Egger and Pfaffermayr (2004). The authors use a panel of OECD data on outward FDI and include fixed country-pair effects as well as fixed time effects. The study covers the time period from 1982 to 1997 and includes 19 home and 54 host countries. Control variables include market size (in GDP), ratio of skilled to unskilled labour, distance as well as EU and NAFTA membership. The authors differentiate between the signing and the implementation (ratification) of BITs. Signing a BIT exerts only a low, in most cases statistically insignificant, positive influence on FDI. However, the ratification (and thus implementation) of a BIT provokes a significant rise of investment. The study estimates a relative increase of FDI of up to 30%, with 15% as a lower bound.

279

Salacuse and Sullivan (2005), p.111.

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The Economics of BITs

The affirmative results by Egger and Pfaffermayr (2004) are supported by Neumayer and Spess (2005). The latter use both random effects and fixed effects estimations on panel data for 91 countries (120 in some specifications) covering the years 1984 to 2001 (1970 to 2001 in some specifications). To account for the difference in importance among BITs, the main explanatory variable is not simply the number of cumulative BITs with OECD countries, but each BIT is weighted by the share of outward FDI flows the OECD country accounts for relative to total world outward FDI flow. Control variables include GDP, population, growth, trade agreements, different measures of institutional quality (country risk) etc. Robust to sample size and model specification, the authors find very strong evidence for a significant rise in FDI caused by the conclusion of Bilateral Investment Treaties. In a recent working paper, Busse, Königer et al. (2008) provide similar evidence. The authors use a gravity type model and find that BITs indeed increase investment flows to developing countries. It is important to note that they choose a dyadic approach, that is, the authors look at bilateral flows and thus show that BITs promote FDI even absent signalling effects. In addition, the (preferred) dependent variable “is the share of FDI attracted by a specific host country in total FDI flows from the source country under consideration to all developing host countries included in our sample.”280 Consequently, the authors measure the attractiveness of a particular developing country relatively to other developing countries and not absolute investment flows. Finally, the authors find some evidence that BITs may serve as a substitute for weak domestic institutions, but not for unilateral liberalisation regarding FDI. 4.2.2

Discussion

The myriad of different results on the empirical relevance of BITs with regard to FDI is rather unsettling. Can any conclusion on the efficacy of BITs be drawn at all? Some of the studies have significant shortcomings that should be taken in account before forming an opinion. UNCTAD (1998) is certainly not up-to-date with regard to its methodology.281 The study by Hallward-Driemeier (2003) may well be criticised by its restricted sample size (31 countries). In addition, the study has been criticised for its focus on dyadic relationships only, thus ignoring possible signalling effects of BITs.282

280 281

282

Busse, Königer et al. (2008), p.11. Neumayer and Spess (2005), going as far as calling the UNCTAD study “garbage can” modeling (FN5). However, the authors cannot explain the differing results as compared to the study of Tobin and Rose-Ackerman, as both studies use high sample sizes and sophisticated methodology. Neumayer and Spess (2005), p. 1572. If BITs have a signalling effect, this would imply that signing a BIT with country A would also increase FDI inflows from country B, C, etc. A dyadic estimation can obviously not account for this. The question on the signalling properties of BITs is explored in greater detail in section 4.4.4.

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Egger and Pfaffermayr (2004), Busse, Königer et al. (2008) as well as Neumayer and Spess (2005) all have larger sample sizes and are up-to-date in their methodology. All three studies find a positive effect of BITs on FDI, and Busse, Königer et al. (2008) find one even with a dyadic approach. With regard to sample size and methodology, the same can be said about Rose-Ackerman and Tobin (2003) - finding, on the other hand, no robust link between the two variables. Possibly, the affirmative studies may suffer from endogeneity problems as Aisbett (2007) suggests. Omitted variable bias could be problematic in the sense that BIT conclusion and higher FDI flows may both be caused by changes in domestic policy. In addition, endogeneity problems may be caused by reverse causality. This would imply that higher FDI flows lead to more BITs in later periods. However, Aisbett (2007) fails to provide a convincing theory on this possibility. It could be theorised that MNEs lobby for stronger protection once they have made their investment. However, if the influence of MNEs on governments was strong enough to lobby them into concluding a BIT – why would MNEs need a BIT in the first place? In addition, Busse, Königer et al. (2008) control for this potential endogeneity problem. Clearly, the matter on the impact of BITs on FDI flows is not closed yet. At this point, the more sophisticated studies confirm a positive link between BITs and FDI. Given the vast number of potential factors that influence investment decisions by MNEs, this result is indeed remarkable. In addition, no positive impact of BITs on the "investment climate" would imply that governments all over the world have wasted and still waste time and resources to negotiate and conclude Bilateral Investment Treaties. This massive irrationality is possible, yet unlikely. In sum, the hypothesis of a positive impact of BITs on FDI on the margin appears to be reasonable. 4.3

Law and Economics of International Law

In section 4.1, it was noted that BITs, as part of international law, could be perceived as ineffective. The notion that international law is irrelevant has mainly been put forward by the neorealist school of international relations.283 Obviously, most scholars of international law and international relations (IR) do not share the view that international law is irrelevant. At the same time, disunity persists as to why states create and follow rules and norms of international law. The approach used in this book is based on the economic analysis of law and could be termed the law and economics of international law. This approach, based on rational choice theory, has recently especially been put forward by Guzman (2008a). The following section briefly discusses the key assumptions of this approach and the main differences to other

283

See the discussion of this approach in Guzman (2002).

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The Economics of BITs

prominent theories of compliance with international law. Only by understanding compliance with (and breach of) BITs, can one understand why states conclude BITs in the first place. 4.3.1

Theories of International Law

Why do states obey international law? Legal scholars have given multiple answers to this question.284 Traditional legal theories include the managerial model, consent-based theories, legitimacy theory and the transnational legal process. The managerial school was developed by Chayes and Chayes (1995) and includes the idea that states find it costly to violate international law because it has the status of law. In other words, states have a propensity to comply with international law. Non-compliance is mainly rooted in informational ambiguity and limited capacity and can thus be 'managed' through increased transparency, fewer ambiguities in rules and greater capacity. The consent-based theory is, as the name implies, based on the notion of consent. A state’s consent to a treaty creates a legal obligation that leads to compliance. This logic obviously lacks explanatory power. Another theory advanced by Thomas Franck has been termed legitimacy theory. States obey rules that were created in "accordance with the right process"285 which, in turn, depends on four factors: determinacy, symbolic validation, coherence, and adherence. If these factors are present, states perceive the respective rule as legitimate and are inclined to comply with it. A theory called transnational legal process has been advanced by Koh (1996). Through the multilayered interaction of state and non-state actors in different fora "patterns of behaviour and norms emerge and are internalised, leading to their incorporation within the domestic legal institutions of states and, in turn, compliance".286 4.3.2

Rational Choice Approach

This book is based methodologically on the economic analysis of law or, put differently, law and economics. Consequently, the underlying assumptions of the book are based on rational choice theory and in accordance with Guzman (2008a): "States are assumed to be rational, self-interested, and able to identify and pursue their interests. Those interests are a function of state preferences, which are assumed to be exogenous and fixed. States do not concern themselves with the welfare of other states but instead seek to maximise their own gains or payoffs. States, therefore, have no innate preference for complying with international law, they are unaffected by the 'legitimacy' of a rule of law (Franck 1995), past consent to a rule is insufficient to

284 285 286

The following overview is based on Guzman (2002) See Franck (1988), p.706. See Guzman (2002), p.1835.

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ensure compliance, and there is no assumption that decision-makers have internalised a norm of compliance with international law (Koh 1997)."287 4.3.3

Methodological Individualism

Guzman (2002) deviates from the standard assumptions of economic theory in one important respect: he treats states as unitary actors and thus departs in a certain respect from the assumption of methodological individualism. Put differently, the domestic political process is treated as a “black box”. This mainly concerns the principal-agent problem between governments and citizens, the interaction among policy-makers as well as the influence of certain interest groups on government behaviour. Law and economics of international law as such is not incompatible with methodological individualism. For example, in the realm of international trade law, Sykes (1991) successfully explains the GATT escape clause as the result of domestic interest group politics. Also, when an international treaty, for example a human rights treaty, is used by governments to signal properties to its own citizens, certain elements of the treaty cannot be analysed without recourse to the domestic political landscape. Nevertheless, it can often be useful to leave the "black box" state closed, namely where incorporating the domestic principal-agent problem and interest group dynamics does not yield additional explanatory power. To give an example: when analyzing the way governments structure dispute settlement mechanisms in treaties, it can be very useful to assume government preferences as fixed since it is not the focus of analysis whether these preferences were formed as a process of maximizing social welfare or as the result of successful lobbying. When analyzing the specific rules within the same treaty, however, incorporating the interest and incentives of governments can deliver fruitful additional insights. The same logic applies to BITs. Of course, the distinction between mechanisms and contents is to some extent artificial. Governments may choose different content when they know that only weak mechanisms will be employed in the treaty. Keeping that in mind, this book will nevertheless assume government preferences as exogenous when the formation of these preferences is unlikely to yield additional insights (especially in chapter 4). Yet, this assumption will be abandoned where certain phenomena related to BITs need further elaboration based on the principal-agent problem between governments and domestic constituents (especially in chapter 5).

287

Guzman (2008a), p.17. Parentheses and quotation marks in original. Please note that this book will deviate from the assumption of state having exogenous preferences in chapter 5.

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4.3.4

The Three R's: Reputation, Reciprocity and Retaliation

Based on the preceding assumptions, why do states create international law and comply with it? At first glance, the assumptions – and here especially the emphasis on the self-interest of states – appear to be hostile to cooperation. According to Guzman (2008a), compliance with international law can be sustained through the three R's: reputation, reciprocity and retaliation.288 Reputation refers to the ability and willingness of a state to honour its international commitments. Consequently, reputation can only be valuable when there is asymmetric information regarding these characteristics of a state. The value of reputation is rooted in a state's ability to conclude agreements. Put differently, the greater a state's reputation, the more credibly it can commit itself to a certain course of action, which makes cooperation in the future more feasible. Thus, reputation can only be valuable in a situation of repeated interactions. Consider the following simple example: imagine two states have already concluded a treaty. Now, they must decide whether to comply with it. Three situations are possible: states comply with the treaty because they would have chosen the respective action even in absence of the treaty. Second, states may find the action associated with non-compliance most attractive and decide not to comply. Third, states may decide to comply because of the existence of the treaty. As this paper attempts to understand why international law matters, the third case is of most interest here. When would a state choose to comply when the actual payoffs of non-compliance are higher? This will only be the case when there are additional costs associated with the breach of international law. These costs accrue when the treaty partner and/or third parties observe the breach and adjust their assessment on the state's (government's) internal discount rate or its payoffs, that is, its willingness and/or ability to forgo short-term profits for future gains of cooperation. States that are perceived, for example, to have a low discount rate will find it harder to establish cooperation in the future. The advantage of this form of punishment is that it occurs rather automatically as the punishment is not costly to the punisher. Why, then, do we need the presence of asymmetric information? As the theory of repeated games implies, cooperation is possible even in PD situations with complete information when games are repeated infinitely and discount rates are low. In that case, international law would indeed be useless. Every party would already know what the other party will do. Treaties and other instruments of international law would only serve to define a focal point and would not affect compliance decisions. It seems clear that this might be the case sometimes, but is not in line with reality on a more general

288

Guzman (2008a), p.33ff. The following section is a short summary of Guzman (2008a), especially p. 33-49.

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basis. The assumption of the existence of asymmetric information is therefore reasonable. As mentioned, international law can only affect compliance when it changes the payoffs of parties. The mechanism of reputation is one way to affect these costs. Another mechanism is the concept of reciprocity. Put simply, if a partner to a treaty decides to breach, he may face the costs that the other partner also breaches. This mechanism is related to reputation, but yet a distinct concept. First, reputation applies to all third parties that form expectations on the characteristics of a breaching party, whereas reciprocity refers only to the relevant treaty. The termination of reciprocity may therefore very well be a stronger compliance factor than reputation, especially in bilateral treaties. On the other hand, the termination of reciprocity might be a weak factor compared to reputation in other circumstances. Consider the example of a human rights treaty between country A and country B that commits both states to refrain from torture with regard to their citizens. If country A violates this treaty, country B is not likely to react by torturing its own citizens. Reciprocity in this setting will not help to induce compliance, while reputation might play a crucial rule. More generally, reciprocity does not enhance compliance if the threat of termination of reciprocity is not credible or if the termination of reciprocity does not impose costs on the original violator. The last of the enforcement mechanisms of the three R's is retaliation. Retaliation or retaliatory sanctions describe actions by an aggrieved party to punish the violator of international law. These actions are usually costly, which differentiates them from reputational sanctions and the withdrawal of reciprocity (which are, in an immediate sense, beneficial to the aggrieved party). These costs, however, constitute the main problem with retaliation. States may refrain from retaliatory sanctions to avoid these costs, making the threat of retaliation non-credible in the first place. In that case, why would a state retaliate at all? Again, reputational concerns play a role, yet this time not with regard to the violating party but with regard to the retaliating party. In line with the theory advanced here, the aggrieved party will only retaliate when the benefits outweigh the costs. This might very well be the case when the retaliating state wants to build or maintain a reputation of dealing harshly with states that violate their treaties. As a result, other states will come to expect that violating a treaty with the retaliating state is costly – and thus make cooperation for the retaliating state cheaper in the future. Of course, the efficacy of retaliation depends not only on the payoffs of the (potential) retaliator (which determines the credibility of the threat), but also on the question of whether retaliatory sanctions are available. For instance, if imports from country A to country B are virtually non-existent, country B will not have the option to impose retaliatory tariffs on imports from country A.

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In summary, according to the rational choice approach, states will honour their international legal commitments only when benefits outweigh costs. They do not feel any form of internal compliance pull. Consequently, international law can only make a difference when it creates costs that would otherwise be absent. These costs may consist of reputational losses, the withdrawal of reciprocity or retaliatory sanctions by the treaty partners. The costs and their consequences with regard to BITs will be discussed in the following chapter. 4.4

The Functioning of BITs

Where do BITs fit in the outlined theory of international law? Clearly, if BITs are supposed to promote FDI and protect investor's rights, a breach must impose costs on the violating party. The framework of the analysis is again set by the trust game as introduced in section 3.1. The Pareto-optimal solution would be that the host country credibly commits to play accommodate whenever the MNE invests. In domestic law, this could easily be done through a contract. However, the inherent problem with international law is the lack of a supranational enforcement agency. Simply speaking, making expropriate more costly compared to accommodate will, at the margin, increase the attractiveness of investment. The starting point of the analysis of BITs is the assumption that BITs must affect the payoffs of the involved parties in some way. The second important feature of BITs is that due to the lack of supranational enforcement, their impact can ex-post only be mainly informational. Yet, the possible enforcement of arbitration awards in third countries may impose costs that go beyond the costs usually suffered by violators of international law according to the three R's. In addition, not only the ex-post costs of breach play role with regard to the functioning of BITs, but also the costs of concluding BITs. Also, the merits of BITs might not be found in making certain actions more costly, but in the benefits of additional information. Yet, we have seen from the discussion on reputation (section 3.2.2.2.) that in the case of FDI, asymmetric information may be at the core of the problem. The BIT may then rather be understood as signal. The following sections will discuss each of these possibilities in turn, starting with a more general description of the costs of BITs. 4.4.1

The Costs of BITs

Many different costs are associated with BITs which slightly complicates the analysis. Directly and evidently, the negotiation and conclusion of a BIT creates costs. A second class of costs results from the breach of BITs. To define these costs, it is first necessary to lay out what constitutes breach. These costs are mainly reputational, but also include non-reputational factors. The costs related to BITs have also been referred to as sovereignty costs. Elkins, Guzman et al. (2006) describe these sovereignty costs

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as the "costs any government pays when it negotiates, ratifies, and complies with an investment treaty. We would include here the political costs of assembling a coalition in support of foreign investors' rights, as well as the costs associated with giving up a broad range of policy instruments relevant to domestic social or developmental purposes (taxation, regulation, performance requirements, property seizure, and currency and capital restrictions). Most striking are the sovereignty costs associated with the delegation of adjudicative authority: virtually any legal change or rule that affects foreign investors is potentially subject to review by a foreign tribunal."289 The following sections will focus on the costs of concluding and breaching the BIT, but not on the compliance costs. The reason is that this book is primarily interested in the question of when a BIT can deter breach and the compliance costs are implicitly already part of the cooperation payoff (CH) of the host country.290 4.4.1.1

Concluding BITs

As with any international agreement, concluding BITs generates a number of direct costs to a country. First, states must invest resources into negotiations. However, given the existence of Model BITs used by many capital-exporting states and the brevity of BITs, these negotiations are probably less complex than the negotiations of other international agreements. In addition, UNCTAD provides developing countries with technical and advisory assistance and has also hosted BIT negotiations in the past. Second, the BIT must be ratified according to the procedures of the respective state. Obviously, this process strongly differs from country to country. Yet, the overall direct costs appear to be manageable even for countries with limited resources. 4.4.1.2

Breaching BITs: The Three R's Revisited

Section 4.3 outlined a general theory of international law based on the rational choice approach. Reputation, reciprocity and retaliation were identified as the main enforcement mechanisms. These mechanisms increase the costs of a violation of international law. The following sections will evaluate the three R's in relation to BITs. 4.4.1.2.1

Reciprocity and Retaliation

Reciprocity implies that a party to a treaty will terminate behaviour that is in accordance with the treaty as a reaction to the breach by the other party. It has been pointed out that reciprocity does not enhance compliance if the threat of termination of reciprocity is not credible or if the termination of reciprocity does not impose costs on 289 290

Elkins, Guzman et al. (2006), p.825. Therefore, in the model that will be introduced below, adding these costs would only complicate the analysis without yielding additional insights.

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the original violator. Unfortunately, this is exactly the case with BITs. It appears improbable that, for example, Germany would decide to refrain from the protection of investment from a particular country when that country is in breach of a BIT with Germany. In addition, investment flows are very often asymmetric, so that the revocation of reciprocal investment protection would not affect a substantial amount of investment flows and stocks. Retaliation, or punishment, of a violator of a BIT might in theory indeed have a strong impact on the violator. Potential retaliatory actions can take numerous forms, including economic sanctions or even, in the extreme case, military actions. All retaliatory measures have in common that they are costly to the party that retaliates. It appears that retaliation only plays a minor role in investment law. It may be that the stakes of individual investment are not high enough to induce governments to act in a retaliatory manner. In addition, the costs of retaliation seem to be rather high. For example, economic sanctions like tariffs as a reaction to expropriation would trigger proceedings under the WTO and are thus not an attractive option. Military actions to solve economic conflicts are certainly not extinct, yet it seems that the stakes in the case of FDI are not high enough to prompt military sanctions. In addition, please also note that retaliation (as well as reciprocity) requires an action from the home government of the investor. The home government is unlikely to be a perfect agent of the investor and may thus not consider it important to acquire a reputation of acting tough on BIT violators. It is exactly the independence from the home government that makes BITs a valuable tool for investors. In sum, reciprocity and retaliation are unlikely to play a major role in the realm of international investment law. Consequently, it is reputation that seems to matter the most in disputes regarding international investment. In this respect, it is important to differentiate between reputation vis-à-vis other states and reputation vis-à-vis investors. 4.4.1.2.2

Reputation vis-à-vis Other States

A breach of an international agreement will induce other states to update their beliefs with regard to the breaching state. This is also true for BITs. As pointed out earlier, reputational sanctions require the existence of asymmetric information. Consequently, the costs of a breach when a BIT is in force are limited to the reputational loss the country faces in the eyes of other countries concerning its ability and willingness to keep (other) international commitments. These commitments may consist of other BITs, but also of commitments unrelated to the investment sector. The reputational losses therefore differ among governments. Governments that already have a very low reputation or that are not interested in international cooperation in the future will face only small reputational sanctions and vice versa. The reputational losses vis-à-vis other states are limited in an important respect relating to the disposition of third countries to

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make inferences concerning the willingness and ability of the country to honour international commitments based on the breach of a BIT. With regard to other BITs, it seems reasonable to assume a certain connection. If a state repeatedly fails to comply with the treaty clauses, other states may very well infer that the respective government is inclined to forgo long-term for short-term profits or that domestic checks and balances against unjustified interferences with the property rights of investors are weak. Combined with the fact that BIT arbitrations are lengthy and costly, other governments might therefore rightfully conclude that investment agreements with that country are not a sensible investment protection strategy. Yet, third countries might not make any inferences at all from the breach of BITs relating to host countries’ reliability in other important realms of international law, like environmental treaties or non-proliferation treaties.291 To summarise, costs in the form of reputational sanctions with regard to third countries certainly must be taken into account; nonetheless, these costs are limited to the extent a breach of a BIT actually impacts the beliefs of other states. 4.1.1.2.3

Reputation vis-à-vis Investors

To see how a BIT can be costly in terms of reputation vis-à-vis investors, it seems reasonable to recapitulate the repeated trust game from section 3.2.2.2.1. It has been demonstrated that repetition can play a role in fostering cooperation and preventing expropriation (section 3.2). Yet, such an equilibrium depends on a trigger mechanism. As Kreps (1990) points out: "The point is that when one player cannot observe directly that the agreement is carried out, and when this player can only rely on noisy, indirect observations, the problem of finding self-enforcing arrangements is vastly more complicated".292 Remember that the payoff for the host country when accommodating was CH, while it was WH when expropriating (with CH < WH). Given that the host country discounts future profits with G , the condition for cooperation was: CH t WH 1 G œ G t 1

291

292

CH WH

(4.1)

(4.2)

Guzman (2008a) refers to this as the "compartmentalizing of reputation", p.100ff. This compartmentalizing may not only relate to issue areas, but also to regimes and dyadic relationships. Kreps (1990), p.105.

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The left-hand side of equation 4.1 was the discounted payoff in the case of infinite cooperation; the right-hand side was the one-shot payoff for the uncooperative behaviour. This calculation was based on a grim trigger strategy where the MNEs stop investing once they observe an expropriation. Now imagine that the investor can observe a deviation of the HC only with a certain likelihood, say s. With probability (1-s), the deviation goes unpunished, that is, the MNEs keep playing the cooperative strategy: CH C t sWH  (1  s ) H 1 G 1 G œ G t 1

CH sWH  (1  s)CH

(4.3)

(4.4)

The right-hand side of this equation is increasing in s. This indicates that increasing the probability of observation relaxes the requirement on the minimal discount factor that ensures cooperation (remember: a higher discount factor means that the HC discounts future profits less strongly). Consequently, if the BIT increases observability of defective behaviour, breach of the BIT will induce a reputational sanction in the sense of losing future profits. It is obvious that in reality governments care about their reputation vis-à-vis investors. Section 3.2.2.2.2 described a situation where governments adapt their behaviour to build up or protect a reputation for being investor-friendly. Irrespective of the existence of a BIT, investor will reduce, discontinue or hold back their investment when the government acts in a manner that derogates the investment. The question is whether there is an additional reputational cost vis-à-vis the investors that is generated through investment agreements. Two mechanisms seem possible: investors may learn about an arbitration proceeding through the media or through postings on relevant websites, such as the ICSID website itself, and draw inferences from that. Secondly, investors may consider the award as a reliable and neutral source of information and will adjust their behaviour accordingly. Is it reasonable to assume that the breach of a BIT usually does not convey any information to the investment community additional to the act of expropriation (or any other derogation of the assets) itself? To put it another way: is the reputational harm that may induce potential investors not to invest mainly caused by the expropriation itself or does the breach of international law add to it? One should think that investors expend money and resources to inform themselves about past behaviour of potential host governments before making investment decisions. In addition, the ability of international investment arbitration to do so is questionable, as arbitration is often kept private and as such is not a reliable source of information. Claims might be rejected on

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formal grounds although the act of the government would actually be considered as undue by investors. On the other hand, investors will use all publicly available information including information generated through an investment dispute. Consequently, BITs may indeed trigger an additional reputational loss vis-à-vis MNEs, albeit with limited impact. At this point, it is worth noting that BIT arbitrations are certainly not specifically designed to enhance the information flow on host state behaviour to (potential) investors. 4.4.1.3

Breaching BITs: Non-Reputational Costs

Section 3.4 pointed out that the enforcement mechanisms in international law are reputation, reciprocity and retaliation. Although part of international law, Bilateral Investment Treaties appear to possess an additional form of enforcement. More specifically, in the case of BITs, enforcement is sometimes also possible through domestic courts. The ICSID Convention, for example, contains an automatic recognition and enforcement mechanism. An award must be enforced by each contracting state “as if it were a final judgment of a court in that state.”293 Consequently, investors can enforce awards not only in the host state, but also try to seize assets in any state that is a signatory to the ICSID Convention. It was already pointed out that the enforcement of awards in third countries is a very tedious and costly strategy for the investor and often not very promising.294 Obviously, nonreputational sanctions can only play a role when the legal prerequisites for an application of the ICSID or, respectively, the New York convention apply. This, in turn, can only be the case when the relevant country is a member of one of these conventions. Also, trying to enforce an arbitral award only makes sense when the country holds certain assets in a member state which can be seized (and sold) to satisfy the claim. Especially poor countries will not possess substantial assets in third countries that could readily be seized. In any case, a government that is being sued will have to expend substantial resources to protect its foreign assets. Consequently, even if the incentive of the MNE to initiate arbitration is moderate, the high costs induced by arbitration might affect the behaviour of states (especially if deterrence is understood as the product of the likelyhood of being sued and the potential costs). To sum up, although the possibility of enforcing arbitral awards through the ICSID or the New York Convention might not always exist, in cases where it does, this possibility might have a certain deterrence effect. Potentially, it is also the threat of domestic

293 294

ICSID Convention, article 54 (1). See section 3.3.3.8.3. For a recent and longsome case from Germany, see Sedelmayer against the Russian Federation, Az. OLG Köln 22 U 98/07.

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enforcement that induces governments to comply with arbitration awards, thus keeping the number of known enforcement procedures so low.295 The possibility of enforcing arbitral awards through domestic courts might contradict the theory that reputation, reciprocity and retaliation are the only enforcement mechanisms in international law. However, it should be noted that this possibility is in itself based on an international agreement which can be denounced by the member state. Article 71 of the ICSID convention reads: "Any Contracting State may denounce this Convention by written notice to the depositary of this Convention. The denunciation shall take effect six months after receipt of such notice." As article 72 further points out, the denunciation does not affect cases initiated before such notice was received by the depositary. Consequently, in the short run, the investor has under certain conditions a legal tool at his disposal that goes beyond the usual enforcement mechanism in international law. Yet, in the middle and long run, reciprocity, retaliation and reputation are indeed the only available enforcement mechanisms in international law. 4.4.1.4

Summary

Bilateral Investment Treaties are associated with numerous costs. It seems reasonable to assume that the actual direct costs from negotiating and concluding a BIT are rather low. When it comes to breach, (termination of) reciprocity and retaliatory sanctions do not appear to be forceful factors. Non-reputational costs like the seizure of assets through domestic courts might under certain circumstances play a certain role. Yet, the most important factors seem to be reputational. Here, one must differentiate between reputation vis-à-vis investors and reputation vis-à-vis other states. While arbitration proceedings are not explicitly designed to help third parties to update their beliefs, it is still plausible to assume that investors as well as governments will use all available information, including that generated through arbitration proceedings. However, the potential reputational losses are not uniform among countries but may vary greatly. To understand the functioning of BITs, the following sections will illuminate the influence of this diversity of costs on the strategic interaction between host governments and investors. 4.4.2

Commitment and Signalling

The main question regarding the functioning of BITs is whether investment agreements rather solve a commitment problem or a problem of adverse selection

295

Unfortunately, there is no way to evaluate this claim.

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through signalling. Both possibilities have been suggested in the literature,296 albeit without providing a systematic analysis of this question yet. This is an important distinction as it relates not only to the question of which countries may find a BIT to be useful, but also to what potential investors can learn from BITs. With regard to signalling, there can be different theories relating to what is actually being signalled. Also, understanding the functioning of BITs might give some guidance to the effects of arbitration awards on the incentives of states. However, one might suggest that BITs go beyond signalling and commitment and are rather related to the question of allowing for flexibility in long-term contracts or the question of development aid. Yet, as will be argued, these two points can be subsumed under the theory that BITs are a commitment device or a signal. The analysis regarding commitment on one side and signalling on the other side rests on slightly different methodological grounds. The time inconsistency problem that causes what has been termed "hold-up" is rather related to transaction cost theory as pioneered by Williamson (1990). More specifically, the focus is "the comparative efficacy with which alternative governance structures manage transactions during contract execution."297 The foundation of this theory is the idea that contracts (here: treaties) that are unsupported by credible commitments will suffer from opportunism. The signalling theory, on the other hand, goes more into the direction of agency theory. Only one type of state is prone to opportunistic behaviour – the problem then is that the MNE lacks the information to differentiate between states. Taking this approach does not contradict transaction cost theory – in the end, the lack of information might be interpreted as the result of transaction costs in terms of information gathering. 4.4.3

Commitment

The starting point of the commitment model developed here is the assumption that both parties have symmetric information. As the game structure introduced earlier exemplifies, once the MNE has sunk its resources, it is prone to opportunistic behaviour by the host state. Knowing that under these circumstances the MNE will not invest, both parties have ex-ante an incentive to write a contract, or, in our case, a treaty.298 As the host state has the incentive to violate the contract as soon the investment is made anyway, an enforcement mechanism must be put in place that 296

297 298

See, e.g., on commitment Elkins, Guzman et al. (2006), p.823, on signalling see also Grosse and Trevino (2005), p.129, or Neumayer and Spess (2005), p.1571. Williamson (1990), p.67. For the analysis at this moment, it does not matter that the contract (treaty) is not really concluded between the state and the MNE, but between two states. The important point is that the MNE is protected under the treaty.

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places costs on the non-cooperative behaviour. We refer to the commitment case when these costs are big enough to change the incentives for the host state. 4.4.3.1

Repetition Revisited

A very simple first step to analyse the problem could be to refer to the repeated baseline model from section 3.2.2.2.1. The condition for the HC to choose a strategy of accommodating the investment was established as: G t 1

CH WH

(4.5)

Cooperation emerges if the MNE values future payoffs highly (high ) and/or has high payoffs from accommodation as compared to expropriation. Modelling BITs simply as an addition of costs in the case of playing the defective strategy (here denoted, as in the case of hands-tying, as D), the condition for cooperation changes to: G t 1

CH WH  D

(4.6)

Obviously, increasing the costs of defection at the margin makes investment c.p. more likely. Unfortunately, this approach cannot shed light on the incentives of MNEs to actually initiate arbitration. In addition, it ignores the peculiarities of international law, including the fact that states always have an exit option. The following section will therefore describe the commitment game as a one-shot game played between the (representative) investor (MNE) and the host country. 4.4.3.2

The Commitment Game

Section 4.4.1 has identified a number of costs related to BITs. Some costs were exante in the sense that they were directly related to the conclusion of the BIT. For the moment, we consider these costs as sunk. Put differently, we are looking at a situation where the government has already concluded a BIT, thus not taking the costs of conclusion into account anymore. This approach can be justified by the fact that we are trying to understand under what conditions the investment decision of the MNE will be influenced by the BIT. Only when this is the case, the host country has an incentive to conclude a BIT in the first place and carry the costs of negotiation and ratification associated with BITs. The analysis is based on the trust game as introduced in section 3.1.1. Consequently, the game starts as before: the MNE has to decide between Invest and Don't Invest. If the MNE decides not to invest, the game ends –

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payoffs in this case are normalised to zero. If the MNE invests, the host country can accommodate or expropriate. In the case of accommodation, the MNE will receive its return on investment CM, the HC will receive taxes, spillover benefits etc., denoted as CH. Until this point, the game is identical to the baseline game of time inconsistency. However, if a BIT is in place, the investor can bring a claim before an arbitral tribunal (Arbitration) or not (Keep Still). Theoretically, he can do that even if there was no expropriation in the first place. Keeping still will yield the prior expropriation payoff (LM and WH with LM <0) or, respectively, the cooperation payoff (CH and WH with CH < WH). If the MNE starts arbitration, a tribunal will decide on the case. The decision of the tribunal is not explicitly modelled, but can be understood as a move of nature (we are not interested in strategic tribunals); the tribunal finds with probability y a violation of the law in the case of the defective behaviour and with probability (1-y) no violation (even if there was defective behaviour).299 If the tribunal finds a violation, then the host country must pay damages to the MNE amounting to D. In addition, there will be reputational sanctions based on the fact that the HC has breached its obligations under international law, denoted as R. Please note that reputational costs include especially the loss of future cooperation. Therefore, the repeated game as presented in the preceding section is implicitly reflected in these costs. Arbitration is assumed to be costly to both the MNE and the host country. These transaction costs include legal fees, costs of using arbitration facilities and paying the arbitrators etc., and are denoted by T. For simplicity, it is assumed that the costs are equally high for both parties, consequently TM=TH=T. The game can be presented in extensive form as such:

299

y can therefore be understood as the ability of the tribunal to make the "right" decision or as the probability of error. In that sense, the probability of being convicted although being not guilty amounts to (1-y). A more sophisticated approach at this stage would be to differentiate between type 1 and type 2 errors of courts. This would then imply an inherent trade-off between the error types. However, for our purposes, this approach would only complicate the analysis without yielding further insights.

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(CM +(1-y)D-T, CH –(1-y)(R+D)-T) Don't Invest

(0,0)

Arbitrate

M M

Accommodate

Keep Still

(CM, CH)

Invest H

(LM +yD-T, WH -y(R+D)-T) Expropriate

Arbitrate

M

Keep Still

(LM, WH)

Figure 4.1: The Commitment Game

Notation CM

=

Cooperation gain for the MNE (profit)

CH

=

Cooperation gain for the host country (taxes, spillover etc.)

LM

=

Loss for the MNE in the case of expropriation (Loser's payoff)

WH

=

Value of the assets to the host country if expropriated (Winner's payoff)

y

=

Probability of error (ability of the tribunal to detect violation)

D

=

Damages/Compensation

T

=

Litigation costs

R

=

Reputational loss

This is a game of complete information; the possible equilibria can therefore be derived straightforwardly using backwards induction, starting at the last decision node of the game.

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The Tribunal's Decision

The decision of the tribunal is assumed to be non-strategic and can be understood as a move of nature (although not explicitly modelled). Put differently, the tribunals are not assumed to follow an agenda of their own. It could be argued that this assumption deviates too strongly from reality. Yet, arbitrators are chosen jointly by the parties. An arbitrator that consistently fails to act neutrally and makes biased decision will soon be lacking mandates. The tribunal here, in line with Guzman (2008b), is defined "as a disinterested institution to which the parties have delegated some authority and that produces a statement about the facts of a case and opines on how those facts relate to relevant legal rules".300 The assumption is that the tribunal rules in favour of the MNE only with a probability y if there was uncooperative behaviour in the first place. The idea is that in some cases the uncooperative behaviour of the host country cannot be verified with regard to third parties. In addition, the value y depends on the clarity of the underlying legal rule, which is limited in our case as the standards in BITs are often subject to wide interpretation. Lastly, y is also determined by the competence of the relevant tribunal. Despite these qualifications, it should be expected that y>1-y, which is true for any value of y that is above 0.5, indicating that the tribunal has some ability to differentiate between the defective and the cooperative behaviour. The ruling of the tribunal will not only define the amount of compensation D, but also impose the reputational sanction R on the host country, as it is then verified by a third, expert party that the country has violated the terms of the BIT.301 This reputational sanction relates not only to investors, but also to other states who might refrain from cooperation (also in other areas of international law) in the future. 4.4.3.2.2

The Arbitration Decision

At the final stage of the game, the MNE will have to decide between initiating arbitration or keeping still. This stage of the game will only be reached if the MNE has invested in the first round. The decision of the MNE to file for arbitration depends on the behaviour of the host state in the preceding round. Therefore, we have to differentiate between two cases:

300 301

Guzman (2008b), p.185. Unless the proceedings were not held in private. See chapter 7 on this issue.

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Case 1: HC accommodated in Case 2: HC expropriated in the prior round the prior round The MNE will C + (1-y)D-T > C M M initiate rearranges to arbitration if: T < (1-y)D

LM + yD-T > LM rearranges to T < yD

The MNE will initiate arbitration if the cost of arbitration is smaller than the expected compensation payment of the arbitration award. The two conditions are straightforward. The decision to initiate arbitration depends on the possibility to prove the wrongdoing to the tribunal and the expected damage payments. The MNE does not care about the reputational losses of the HC. Equally, the payoff from the investment (LM or CM)is sunk at that point. It is simple to see that a low value of y may give room for opportunistic behaviour on the part of the MNE who might be tempted to initiate arbitration even if there was no defective HC-behaviour in the first place. If, however, the ability of the tribunal to differentiate between defective and cooperative behaviour is reasonably high, this case is rather unlikely. Depending on the payoffs of the MNE, we can identify three cases: (1) the MNE will always initiate arbitration: (1-y)D > T, (2) the MNE will only initiate arbitration if the HC expropriates (but not otherwise): yD > T > (1-y)D (3) the MNE will never initiate arbitration: T > yD. A theoretical fourth case is that the MNE would only initiate arbitration when the HC accommodates but not otherwise. This can be ruled out as y > (1-y) which implies that T < (1-y)D and T > yD cannot both be true. 4.4.3.2.3

The Expropriation Decision

Again, reaching this stage of the game presupposes that the MNE has invested in the first round. The decision of the host country then depends on the subsequent choice of the MNE. The HC will anticipate the behaviour of the MNE in the subsequent stage and adapt his strategy accordingly. The three possible cases are summarised in the following table (the assumption y>(1-y) holds):

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Case 2: MNE will Case 1: MNE will Case 3: MNE will only initiate always initiate never initiate arbitration if the HC arbitration arbitration expropriates CH -(1-y)(R+D)-T < CH < WH -y(R+D)-T HC will WH -y(R+D)-T expropriate rearranges to rearranges to if WH - CH > (2y- WH - CH > y(R+D)+T 1)(R+D)

CH < WH

Starting with case 3: obviously, if the MNE will never initiate arbitrations, the game is practically similar to the basic trust game and the HC will, in a one-shot setting, expropriate as long as CH < WH. With regard to case 1, we can see that the HC will expropriate if the expropriation value is high compared to the cooperation payoff. The assumption y > (1-y) ensures that the higher the sanction (R+D), the smaller the incentive to expropriate. Equally, with growing ability of the tribunal to detect the uncooperative behaviour, the incentive to expropriate naturally declines. However, it has been mentioned in the previous section that the prerequisite for this case, namely (1-y)D > T, is unlikely to be true. Clearly, the interesting case for our purpose is case 2 where T takes an intermediate value. Only if the cost of the BIT can counterbalance the difference in payoffs between defection and cooperation (WH - CH ) will the BIT be able to serve as a commitment device. This will be true for high values of y, high reputational costs (R) or damages (D) and also high litigation costs (T). Noteworthy, at the same time, high litigation costs will diminish the incentive of the MNE to seek arbitration in the first place. 4.4.3.2.4

The Investment Decision

The investment decision marks the first stage of the discussed model and relates to the crucial question: when can the BIT induce the MNE to invest? As before, the subsequent choices of the players shape the strategy of the MNE in the first round (including the choices of the MNE itself). Remember that the payoff in the case where no investment takes place is normalised to zero. The choice to invest may be followed by the HC to expropriate or to accommodate, which may, in turn, be followed by the binary choice to seek arbitration or not. This leaves four cases to look at:

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MNE keeps still and

MNE seeks arbitration and

Case 1: HC Case 2: HC Case 3: HC Case 4: HC accommodates expropriates accommodates expropriates MNE invests if

CM>0

LM>0

CM+(1-y)D-T>0

LM+yD-T>0

By assumption, we have LM < 0, which rules out case 2. Consequently, the MNE will either invest if the host country does not expropriate or if the remedy D compensates for the losses despite litigation costs. 4.4.3.3

Equilibria

First, one point must be remembered that has been neglected in the preceding sections: the fact that concluding the BIT itself is associated with costs. These costs consist mainly of negotiations and the ratification process. Only if the existence of the BIT has a positive impact on the investment decision of the MNE will a host country ever bother to incur these costs. Therefore, we are interested in the equilibria where the MNE actually invests. Four of these investment equilibria (also exemplified by the final nods in figure 4.1) exist and without making any assumptions on the values of the variables, each of these final nodes is a possible equilibrium of the game. Yet, if the assumptions of the baseline game are used, the equilibrium relating to the strategy set (invest, expropriate, keep still) can be eliminated. If the remedies of the BIT are not used, the HC will not have to adapt its behaviour. Therefore, the situation is identical to the baseline game – consequently, this cannot be an equilibrium of the game as long as LM < 0. Put differently, if the MNE would prefer keeping still despite expropriation, the HC would anticipate this and expropriate. This, in turn, would be anticipated by the MNE leading to no investment in the first place. If this is the case and the conclusion of a BIT is associated with costs, the HC never has an incentive to conclude a BIT. The remaining three equilibria cannot be ruled out in a similar fashion. However, two of these equilibria include the use of arbitration and require strong assumptions. First, the equilibrium relating to (invest, accommodate, arbitrate) presupposes that the MNE has a high chance of success even if there was no uncooperative behaviour by the HC in the first place (T< (1-y)D). This is certainly possible and may sometimes be the case in reality, but certainly does not reflect the intentions when concluding a BIT. Second, the equilibrium based on (invest, expropriate, arbitrate) presumes that the MNE would invest knowing that there will be expropriation, which will be the case if LM+yD-T>0. Especially as LM<0, this

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equilibrium appears removed from reality and has no explanatory power with regard to the functioning of BITs. For the functioning of BITs, the interesting equilibrium is therefore the equilibrium where the MNE invests and the HC accommodates because of the BIT (invest, accommodate, keep still). Yet, for the BIT to make a difference, the MNE must have the incentive to initiate arbitration when the investment was expropriated, that is T < yD. This will only be the case when arbitration costs are low and/or the compensation and the probability of winning the case are high. It is important to note that the reputational losses to the HC do not play a role in the decision-making of the MNE. However, these costs play a role with regard to the decision of the host country to expropriate or not. The BIT will only induce cooperation if the arbitration threat is credible and the expected costs of arbitration offset the gain of non-cooperation compared to cooperation (which can be understood as the opportunity costs of noncooperation), namely WH - CH < y(R+D)+T. Consequently, if the payoffs in the cases of accommodation CH and expropriation WH differ too strongly relative to the costs of BITs, the BIT will not be able to induce investment. A BIT can consequently not be a commitment device for countries that have a very strong incentive to play expropriate. An interesting point also relates to the litigation costs T. As long as parties must carry their own legal costs, high arbitration costs, such as those arising through lengthy proceedings, will deter MNEs from seeking remedies under the BIT. At the same time, the very same high arbitration costs may deter HCs from expropriating in the first place. Any call to make tribunals more “efficient” in the sense of reducing litigation costs must take these opposing deterrence effects into account. 4.4.3.4

Hostages and Collateral

Section 3 discussed how MNEs protect their investment in the absence of legal protection. Based on the analysis in section 4.4.3.3, we can now subsume BITs in the economics of FDI protection. First, the functioning of BITs requires an action of the affected investor – therefore, a BIT does not imply hands-tying in the economic sense of the term. In fact, a BIT institutionalises the exchange of hostages and/or collateral. The difference between hostages and collateral is the value the asset has to the hostage or collateral taker, in our case the MNE. While a collateral is valuable to both parties, a hostage is usually primarily only valuable to the hostage giver. How does this relate to a BIT? In essence, through the enforceability of arbitration awards, BITs collateralise the foreign assets of the host country (or convert them into hostages). At the same time, through the ascertainment of wrongdoing by a neutral body and the publication of awards, the HC places its reputation as a hostage or, depending on the ease with which this reputation can be converted into a compensation for the MNE, a collateral. As a consequence, with regard to BITs, the same incentive problems are

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encountered as before: if destruction of the hostage is too costly (high litigation costs, small expected awards), the investor may have no incentive to do so. On the other hand, high expected awards (such as through the lack of tribunals to differentiate between cooperative and uncooperative behaviour) and small litigation costs may raise the incentive to "collect the collateral" even if no uncooperative behaviour took place. As Eger (1995) notes, the perfect incentive structure in all cases using ex-ante guarantees cannot be achieved.302 The functioning of BITs as a commitment device suffers inevitable from the same shortcomings. 4.4.3.5

Extensions

The commitment game is obviously a stylised game and, in reality, the host country and the MNE have many choices that could not be incorporated here. The basic intention was to underline the similarity to the hostage/collateral case and to discuss the interplay of the main variables. In this section, three directions into which the game can be extended are analysed. For example, the above model assumes that the HC would comply with a ruling and pay the damages D to the MNE. If the host country fails to comply, the MNE may seek to enforce the arbitration award using domestic courts. This aspect is discussed in section 4.4.3.5.1. Also, at virtually every stage of the game and certainly prior to arbitration, parties can decide to settle. This will be discussed in section 4.4.3.5.2. Lastly and inherent to international law, states always have an exit option in the sense that they may leave the system altogether if it is no longer beneficial to them. This will be discussed in section 4.4.3.5.3. 4.4.3.5.1

Compliance and Enforcement in Third Countries

An interesting observation can be made that relates to the potential strength of international adjudication and especially BITs: the host country always has the option to ignore the award. Note that the costs of ignoring the award are only marginally influenced by the tribunal, but rather depend on the reputational costs of ignoring and the possibilities of enforcement of the award in a third country – two factors lying outside the scope of the tribunal. A consequence is that higher compensation payments determined by tribunals will not necessarily induce the HC to accommodate, but may simply lead the HC to ignore the award. This will be exactly the case when the reputational sanction of non-compliance is low or the likelihood of a loss of assets that may be enforced through domestic courts, e.g., under the ICSID convention, is negligible (either because such assets do not exist or the enforcement in third countries is too costly for the MNE). At this point, the country already faced a reputational loss

302

Eger (1995), p.187.

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when the tribunal declared the country had breached its obligations.303 So, if the additional reputational loss for not complying is small, ignoring the award can be a rational strategy. Argentina is an interesting case in this respect, facing more than 25 pending cases under ICSID304, mainly due to measures taken during its financial crisis. It remains to be seen how the payment behaviour of Argentina develops if many of those awards find the defendant guilty. A noteworthy aspect is that the smaller the damages the tribunals awards, the more the HC will, ceteris paribus, be inclined to pay the damages specified in the award and thus avoid further reputational losses and lawsuits in third countries. Whether the HCs comply with their obligations as expressed in BIT arbitration awards is not monitored. Yet, it appears that the enforcement of awards in third countries does not occur very often.305 In addition, and supported by the empirical research by Franck (2007), the amount of the damages awarded might - after all - on average be negligible for states.306 4.4.3.5.2

Settlement vs. Trial

Settlement relates to the possibility of the party finding a consensual solution to any conflict before or after arbitration has been initiated.307 Settlement is, at first glance, preferable to arbitration in the sense that it is consensual and saves litigation costs. It is straightforward to see that settlement is facilitated through the shadow of arbitration. As a first step, this section will sum up the discussion on settlement vs. litigation in the domestic context, as there are many similarities to the context of international investment law. Nevertheless, the analysis of international investment law must consider the potentially high importance of reputational concerns. Frequently, cases where a settlement was reached after the arbitration proceeding was initiated can be observed. Unfortunately, no information exists on the frequency of claims settled even before arbitration is initiated, but as arbitration imposes costs on the parties, this number should considerably exceed the number of known arbitrations.

303

304 305 306

307

This is, of course, only true when the award was public. On the transparency of international investment law, see chapter 7. According to the ICSID website as of September 1st, 2010. See section 3.3.3.8.3. Remember that at this point, the arbitration process has already been initiated. The question of compliance therefore relates to the award, not the treaty. The point that the amount of damages is often not extremely high is therefore consistent with the discussion in section 4.4.1.3 where the non-reputational costs of treaty breach are discussed (which include, in addition to the awarded damages, considerable legal costs). Please note that this is not part of the commitment game as such. In the commitment game, there will usually be no trial. Nevertheless, a conflict is already persistent at this point. The reason for the conflict is not relevant here; possibilities include asymmetric information and/or different estimations on the interpretation of the relevant legal rule.

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In the domestic context, the question of trial vs. settlement has been analysed extensively.308 The standard results from the domestic context are summarised by Posner (2007), Shavell (2004) and Cooter and Rubinfeld (1989). If parties to a trial do not differ in their subjective estimation on the outcome of the trial or the settlement costs and the stakes are zero-sum in the sense that the penalty for the defendant equals the compensation for the plaintiff, settlement will only occur when the transaction costs for settlement are smaller than the litigation costs.309 In addition, the space for settlement is affected by the relative difference of the parties' beliefs on the outcome of the trial (e.g., due to private information). Specifically, settlement is feasible when the plaintiff's estimate of his probability of winning is lower than the defendant's estimate (of the plaintiff winning). Such is the case, for example, when the parties are pessimistic regarding their subjective chances of winning. Settlement may also occur when both parties are optimistic – "as long as the plaintiff's estimate of the expected judgement does not exceed the defendant's estimate by more than the sum of their costs of trial".310 As a consequence, when the stakes of the lawsuit are high (and symmetric), the more likely it is that the case will be litigated.311 A similar logic applies to a divergence of the stakes of the case. If the defendant’s stakes are high compared to the plaintiff’s, litigation is less likely compared to when stakes are equally high.312 In addition, if the parties are risk-averse, the likelihood of litigation will ceteris paribus be lower.313 These points are well-established in the economics of the legal process and equally true for international investment law. There is consequently no need to scrutinise them in more detail here. However, specific to international investment is that especially the difference in stakes can be of high relevance and this aspect shall thus be analysed in more detail. The approach used here is similar to that introduced by Cooter and Rubinfeld (1989). The assumptions of the commitment model, most importantly risk neutrality, still hold. In addition, it is assumed that settlement imposes costs (e.g., for negotiations) S, which do not differ between parties. Further, both parties have the same estimation on the outcome of the trial, denoted by the probability y that the tribunal finds the defendant guilty. Finally, we assume that the HC will comply with the ruling of the tribunal. A natural prerequisite for settlement is the existence of a

308

309 310 311

312 313

See Cooter/Rubinfeld (1989), p.1075 or the overviews in Posner (2007), p.597ff or Shavell (2004), p.401ff. Cooter and Rubinfeld (1989), p.1075. Shavell (2004), p.403. Shavell (2004), p.405. Notably, a countervailing effect is that higher stakes may also induce more effort by the parties. See Posner (2007), p.599f. Posner (2007), p.599. Posner (2007), p.599.

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range of payoffs that is acceptable to both parties. The range is defined by the threat values of each party. The threat value is here defined as the value the party receives in the case of non-cooperation (proceeding with the trial and paying damages instead of settlement). The notation is similar to the commitment game, where y denotes the likelihood the defendant (HC) is found guilty, T the litigation costs, D the compensation payment and R the reputational damages. Threat value of the HC (payoff in the case of non-cooperation)314 y(- R - D) - T

(4.5)

Threat value of the MNE yD - T

(4.6)

The non-cooperative value is the sum of the subjective threat values y(- D - R) - T+ yD - T = -yR -2T

(4.7)

The cooperative value is (the net transfer between the parties amounts to zero) -2S

(4.8)

The surplus of cooperation is therefore the difference between cooperation and noncooperation. If this surplus is positive, the parties will prefer settlement over trial. -2S -(-yR -2T)> 0 Ù

(4.9)

yR - 2 (S-T)>0 Ù

(4.10)

yR > 2 (S-T)

(4.11)

This result is in principle equivalent to the situation in the domestic context as summarised above. Imagine that there were no reputational sanctions (R =0) in excess to the zero-sum damages. In that case, the choice between settlement and trial would simply depend on which procedure created fewer costs. However, the point emphasised here relates to the impact of asymmetrical stakes as a result of reputational sanctions. Please note that the threat to seek arbitration must be credible notwithstanding the reputational sanctions. There will neither be arbitrations nor settlement if yD - T <0, as otherwise the threat of the MNE to bring a suit will not be credible. The important aspect highlighted by equation 4.11 is that high reputational sanctions will weaken the threat point of the HC and thereby make settlement more

314

Please note that the payoffs for expropriation (WH) and the losses of the MNE (LM) are at that point sunk and do not influence the decision of the parties. The payoffs are taken directly from figure 4.1.

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likely. In that case, settlement is preferable for both parties. It is noteworthy that the settlement decision may have distributional implications. Lacking further information, it is reasonable to assume that the surplus to the parties will be equally divided. Put differently, a reasonable settlement agreement will yield a payoff for each party that matches the respective threat value plus an equal share of the surplus.315 The surplus has been derived in equation (4.10) as yR - 2 (S-T). The expected payoffs for settlement vs. trial are summarised in the following table: Settlement vs. Trial Settlement Trial

Payoff MNE

Payoff HC

yD - T + 0.5 (y R - 2 (S-T))

y(-D - R) - T+ 0.5 (yR - 2 (S-T))

= y(D + 0.5 R)

= y(-D - 0.5 R)

yD - T

y(- D - R) - T

The important point is that the MNE profits from high reputational sanctions for the HC only in the settlement case. In that case, the MNE can obtain a share of the reputational capital (in this example one half). The reputation is lost in the case of trial. This is exactly the negative-sum feature inherent in reputation as an enforcement mechanism. The analysis differs with regard to the settlement surplus when settlement after the case has been officially filed and made public is considered. While the structure is essentially equal to settlement before registration, two points must be considered here: (1) any reputational sanctions from the registration of the case (assuming it is an ICSID case) will already be sunk. (2) Settlement itself may create reputational sanctions in the sense that the willingness to settle may be interpreted by third parties as a negative signal. If T is rather understood as the cost for a continuation of the arbitration, and R' < R (as part of the reputational loss is sunk) and S’ denotes the reputational losses for settlement, equation 5, the settlement surplus, can be modified to: -2S – S’ -(-y R'-2 T)> 0

(4.12)

Two effects affect the settlement surplus compared to the analysis prior to registration of the case (initiating arbitration). Higher reputational sanctions for settlement, R', will reduce the settlement surplus and make trial more likely. In addition, part of the

315

Cooter and Ulen (2004), p.415, use the same assumption.

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reputational losses to the HC are already sunk (R' < R), thereby also tipping the calculation in favour of trial. Consequently, it can be expected that the registration of the application reduces the settlement surplus. This observation raises an important point, namely the question of whether there will always be a settlement solution as long as the value of cooperation (settlement) exceeds the value of non-cooperation (trial). One of the possible reasons for the failure of (early) settlement may be asymmetric information. In the given example, the HC may not be sure whether the condition for going to trial (yD - T >0) holds for the MNE and the MNE may not be able to signal this information. Filing for arbitration may provide exactly such a signal and consequently a settlement solution can be reached (which is, however, more costly to the parties). Moreover, settlements may fail as a result of the potential inability of parties to divide the surplus316 and/or principal-agent problems between lawyer and client.317 The importance of reputation for the settlement process may raise concerns on the existence of nuisance suits. A nuisance suit has been defined as "a lawsuit with low probability of success at trial, brought even though the plaintiff knows that his probability of prevailing would not justify his costs if the judicial process were to be completed instantly."318 It might be argued that the high potential reputational sanctions and the fact that the MNE will obtain some of the reputational capital in the case of settlement will lead to a high frequency of nuisance suits. However, if yD - T <0, the MNE’s threat of going to trial is not credible. Knowing this, the (risk-neutral) HC will never agree to a settlement – irrelevant of the magnitude of the reputational sanctions. Exceptions may apply, inter alia, in cases of sunk costs (e.g., the plaintiff pays his lawyers up front to increase the credibility of his claim), different timing of costs (e.g., the defendant incurs costs before the plaintiff does) and asymmetric information (the defendant cannot evaluate the merits of the claim ex-ante).319 None of these points appears to be particularly important with regard to BITs. For example, while there may be cases of asymmetric information, it is not reasonable to assume that states frequently lack a reasonable estimation on the merits of a claim. In addition, it is noteworthy that the ICSID Convention provides a safeguard against frivolous suits. Article 41 (5) of the ICSID Arbitrations Rules states: "Unless the parties have agreed to another expedited procedure for making preliminary objections, a party may, no later than 30 days after the constitution of the Tribunal, and in any event before the first session of the Tribunal, file an objection that a claim is manifestly without legal

316 317 318 319

See Cooter, Marks et al. (1982). See Miller (1987). Rasmusen (1998), p.690. See Rasmusen (1998), p.691 for a short description of the different approaches.

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merit." If the tribunal decides that a claim is without legal merit, it can render an award in favour of the defendant and the arbitration proceeding will be discontinued. To the knowledge of the author and based on the list of cases as presented by ICSID, this clause has only been invoked once, namely in the case Trans-Global Petroleum Inc. v. Hashemite Kingdom of Jordan. The request of the defendant in this case was only partially successful.320 In sum, it appears that nuisance suits do not pose a major problem in international investment law. What can be inferred from the analysis? First, it is straightforward to identify the factors that facilitate settlement, as these are in principle similar to the domestic context: high litigation costs and pessimistic parties will encourage a settlement solution. Naturally, high settlement costs will tip the outcome in favour of trial. High stakes will favour settlement solutions if the plaintiff is more optimistic than the defendant. An important point is that higher reputational sanctions will increase the likelihood for settlement. In addition, the reputational costs have a distributional dimension in the settlement case as MNEs can capture some of the benefits that accrue if the HC can avoid trial. These points are equally true for settlement after registration of the trial. The difference in this case, however, is that the surplus of settlement will be lower. Nuisance suits do not appear to play an important role, neither in theory nor in practice. While reputational sanctions and compensation payments influence the question of settlement vs. trial, another important point should not be neglected: when reputation and compensation costs become excessive, HCs will be tempted to "leave" the BIT system altogether, e.g. in the short term by ignoring awards, and in the long term by not concluding any BITs in the future. This problem will be discussed in the following section. 4.4.3.5.3

The Perils of Success

Section 4.4.3.5.1 highlighted an important point: states always have the option of not paying the award. In addition, states always have a more fundamental exit-option of leaving the BIT system altogether. If tribunals consistently interpret the terms of the BIT too broadly, the BIT might become too costly for countries trying to commit themselves. The result is that these countries might exit their existing obligations and abstain from entering new ones and thus weaken the system as such. This tendency has been observed by Van Aaken (2008a), who gives a number of examples of what she refers to as "perils of success". One aspect concerns the problematic balancing by

320

See Trans-Global Petroleum Inc. v. Hashemite Kingdom of Jordan, ICSID Case No. ARB/07/25, Decision on the Respondent’s Objection under Rule 41(5) of the ICSID Arbitration Rules (May 12, 2008).

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tribunals between ex-ante commitment and ex-post flexibility. Often, the problem is therefore not rooted in verifiability, but in the fact that BITs bear similarity to incomplete long-term contracts and that the standards in BITs require interpretation. The risk exists, for example, that tribunals will interpret the standards of the BIT too narrowly. This point will be discussed in more detail in section 4.4.5.1. In any case, the danger persists that even reliable countries might refrain from signing BITs in the future or quit their existing obligations if these become too expensive. To provide a recent example, Ecuador decided to denounce the ICSID Convention effective January 2010.321 4.4.3.6

Summary

Based on the analysis above, it is possible to summarise the main findings and hypotheses of the commitment model as such: x Crucial for the functioning of the commitment mechanism is that the threat of the MNE to initiate arbitration is credible. However, using the enforcement mechanism places costs on the MNE. Consequently, the enforcement costs must be small enough to induce the MNE to seek enforcement. High expected compensation can achieve the same effect. x For the host country, commitment is only valuable if the potential additional costs of breach exceed the opportunity costs of non-cooperation. It is, prima facie, irrelevant whether these additional costs are the result of high damages or high reputational sanctions. x Structurally, the BIT features elements of hostages and collateral. Only if these elements are valuable to the HC can the BIT induce cooperation. Put differently: only when the HC has a reputation to lose or foreign assets to be confiscated can a BIT credibly commit the country. x Higher (in terms of compensation) awards are not necessarily helpful for the MNE as the host country can always choose to ignore the ruling and also make commitment too costly altogether (as MNEs seek arbitration although no expropriation occurred in the first place). x Further, excessive awards will not only shift the incentive of the HC towards ignoring the award, but, if tribunals expand the scope of application of BITs, may lead countries to leave the BIT game altogether. However, if the expected costs of breach are too low, the BIT may not induce commitment and, if

321

See ICSID NEWS RELEASE: Ecuador Submits a Notice under Article 71 of the ICSID Convention, July 9, 2009.

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expropriation already occurred, incentives for settlement solutions in the "shadow" of arbitration might vanish. This is the same structural problem in the hostages/collateral case in general. x Using the BIT as a commitment device is therefore only interesting for countries that have sufficient benefits through spillover and have foreign assets that can be placed as collateral or a reputation vis-à-vis investors or third parties that can be placed as a hostage. However, the reputational loss of the HC is not a gain for the MNE. Therefore, even potentially high reputational losses will not induce investment if the MNE has no incentive to "destroy the hostage". 4.4.4

Signalling

The preceding section analysed Bilateral Investment Treaties in their function as a commitment device. The analysis rested on the, arguably problematic, assumption of complete and symmetric information. However, the problem addressed by BITs might not be so much the hold-up caused by time inconsistency as such, but a problem of asymmetric information in the sense that investors cannot differentiate between states (or governments) that have the willingness and ability to protect the (sunk) investment or not. The following section quickly reviews the reputation model that is equally characterised by the existence of asymmetric information. It will be argued that the framework of the reputation model is not suitable for the analysis of BITs in a situation of asymmetric information. The more fruitful approach is to understand the BIT as a signal (section 4.4.4.2 following). 4.4.4.1

Reputation Revisited

The discussion in section 3.2.2.2.2 on reputation in international investment law was based on the premise of asymmetric information between the MNE and the host country. More specifically, there were two types of states, a good (reliable) and a bad (unreliable) type. The MNE was assumed to be unable to differentiate between these two types. How can we analyse BITs in the environment of this kind of asymmetric information? A natural starting point for this analysis would be to insert the costs of BITs (or rather of breach) into the existing reputation framework that has been outlined before. However, as this section will argue, an analysis of this kind is not instrumental for two reasons: first, it has been shown that BITs cannot induce investment of the MNE in the first period of the game. Investment will occur when

The Economics of BITs

T!

103

L2M , which is independent of WH. In other words: investment will occur ( LM  CM ) 2

when the payoffs to the MNE itself are high (high CM as compared to LM). Consequently, a country facing low prior beliefs concerning its reliability cannot, in this framework, use BITs to induce the investment in the first place. Put differently, modelling BITs as additional costs in the case of breach cannot overcome the inherent weakness of the reputation model in the trust game that the countries cannot start building up a reputation for good behaviour when prior beliefs do not lead to investment in the first place. Second, and even more problematic, when T 

L2M , the effect of BITs ( LM  CM ) 2

represented as additional costs in the case of breach has an adverse impact on the likelihood of investment. The MNE is playing invest with probability

WH  CH . We G WH

are interested in the change of the probability when we change WH. Therefore we calculate: d § WH  CH · ¨ ¸ dWH © G WH ¹

CH

G WH2

! 0 (because CH ! 0 ).

The probability that the MNE will invest is increasing in WH. Consequently, reducing WH by subtracting a (reputational) sanction reduces the probability that the MNE will invest in the market. This result is counterintuitive and not realistic. The reasons for this result lie in the mixed strategy properties of the equilibrium. Reducing WH makes, all other things being equal, accommodation for the HCbad in the present round more attractive (note that the HCbad will expropriate in the last round for sure). To keep the HC indifferent between expropriation and accommodation again (which is necessary for a reputation equilibrium), the MNE must reduce his probability of investing. The result that reducing the benefits from expropriation in a reputation game based on Kreps and Wilson (1982) leads to lower probability of investment is troublesome. In the original game itself, where a weak monopolist tries to deter market entrance, a similar observation arises: increasing the payoff for the monopolist when there is no market entry makes entry even more likely (while one should assume that the monopolist fights even harder when he has more to gain). As before, this is the consequence of the mixed strategy equilibrium where one player calculates his

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strategy using the payoffs of the other player in a way to keep the other party indifferent between his options. However, if there were only pure-strategy equilibria, for example a pooling equilibrium where both (the bad and the good type) play accommodation, no reputation building could occur. The same is true for a separating equilibrium in pure strategies. The bad type reveals his type right away and the MNE reacts accordingly. A conclusion could be that it is unreasonable to assume that players play their perfect Bayesian mixed strategies and that our focus should be shifted to different, more reasonable strategies.322 In any case, the bottom line is that dealing with the effect of BITs on asymmetric information cannot fruitfully be analysed within the framework of the reputation model outlined above. Therefore, for the analytical purpose of this book, it appears reasonable to address the question of asymmetric information in international investment law from a signalling perspective. This approach will be taken in the following sections. Put differently, the BIT will be interpreted as a signal and thus as an attempt to induce investment. The main points will be highlighted using a simple signalling model (section 4.4.4.4). Before that, the basic functioning of signals will be described (section 4.4.4.2) and also the idea of rights as signals will be presented (section 4.4.4.3). 4.4.4.2

Signalling Theory

Signalling theory goes mainly back to Spence (1973).323 Signalling games are concerned with the strategic submission of information. The starting point is the assumption that producers have private information on the quality of the good they are selling that consumers cannot observe. The consumer's willingness to pay increases with the quality of the product. Since consumers are not able to assess the quality of the good before purchase, they will only be willing to pay a price based on the (perceived) average quality of all goods. This, in turn, incites producers of high quality goods to invest into signals that convey to the consumers the true (high) quality of the good. However, low quality producers might be able to imitate these signals. The original signalling model as developed by Spence (1973) dealt with the question of how applicants (or employees) can signal their productivity to employers through education. A necessary condition for a signalling model to function relates to the costs of the signal. The activity that is supposed to serve as a signal must generate different (marginal) costs for different economic agents (single crossing condition). In the education example, acquiring education must be less costly for the more productive

322 323

See Holler (1993) for an example. The following introduction to signalling follows Holler and Illing (2006), p.177ff.

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105

employees as compared to the unproductive employees. There can be two types of pure strategy equilibria: a separating equilibrium and a pooling equilibrium. In the separating equilibrium, the different types send different signals, while in the pooling equilibrium, both types invest into the same signal (or send no signal at all). If a separating equilibrium can be established, the good type (e.g., the type with better quality or higher productivity) can reveal his true nature and, as in the context of symmetric information, obtain a higher price on the market. In a pooling equilibrium, however, the consumer (e.g., employer) still cannot differentiate between the types. Thus, the price will be formed based on the average quality on the market and the good type would get a smaller price as compared to the symmetric information context while the bad type would get a higher price. A separating equilibrium can only emerge when it is, apart from different marginal costs, not profitable for the bad type to imitate the signal of the good type. 4.4.4.3

Rights and Treaties as Signals

The idea of rights and treaties as signals is based on the signalling theory described in the preceding section. The basic concept is simple: states or governments have characteristics that cannot be observed by third parties. A treaty might be more costly to one group of states as compared to another group in relation to that hidden characteristic – therefore, states might use treaties as a signal. Farber (2002) uses a signalling framework to analyse the connection between human rights, the rule of law and international investment. At the core of his argument lies the assumption "that legal reform is a good signal of being truly committed to economic reform."324 In addition, investors can also infer important conclusions from the observation of the enforcement of human rights generally. Farber (2002) considers the adoption of constitutionalism as a signal that the ruling coalition has a low discount rate. The idea is that constitutionalism benefits the economy in the long run, but has short term costs to the ruling coalition, embodied especially in a loss of power. In addition, an independent judiciary that enforces human rights issues signals that the investor can also rely on this judiciary with regard to expropriation issues. This enforces the investor's belief that the ruling coalition does not discount long-term profits too heavily. Hathaway (2002) also looks at human rights and ascribes them a dual role: a functional and an expressive one. The functional role relates to the commitment function of the treaty, while the expressive role may relate to signalling; as Hathaway (2002) asserts: "Yet treaties also have an expressive function that arises

324

Farber (2002), p.84.

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from what membership in a treaty regime says about the parties to the treaties."325 If the treaty provides for strong monitoring or enforcement mechanisms, the two functions of the treaty usually are indivisible. Yet, if there are no monitoring or compliance mechanisms in place, the two functions may divorce. This disjuncture might even have the adverse effect that the treaty will "serve to relieve pressure for real change in performance in countries that ratify the treaty".326 As a result of nonexisting compliance mechanisms (or imperfect information) and potential reputational benefits of simply expressing commitment to a (human rights) treaty, signing such a treaty might, paradoxically, be especially interesting for countries that are ex-ante in non-compliance with the treaty terms.327 These countries then have no incentive to make the costly domestic policy changes necessary to come into compliance. Clearly, this interpretation of human rights treaties is at odds with the aforementioned interpretation by Farber (2002).328 With regard to international law in general, Simmons (2000) describes international legal commitments, especially those relating to the International Monetary Fund, as a "signaling device to convince private market actors as well as other governments of a serious intent to eschew the proscribed behavior."329 In addition, the author empirically analyses the compliance decisions with regard to IMF obligations and finds that international commitments have a distinctive effect on the behaviour of governments, probably because of reputational concerns. Martin (2005) links the idea of treaties as signalling devices to the domestic decision of the US President between different forms of international commitment. In the United States, the government can construct an international commitment either as an executive agreement or as a treaty. The idea is that treaties are more costly (because they require a two-thirds majority in the Senate to be ratified) than executive agreements. Therefore, the choice between these devices is a strategic one: the President can be of two types, either reliable or unreliable. The agreement he offers may signal something to the potential treaty partner with regard to the President's type. In addition, the action depends on other parameters, as for example the potential benefits of the agreement. An empirical analysis underpins the author's assertion that the probability that the agreement is a treaty is negatively correlated with the reliability of the president. The idea that BITs are a signal is mentioned in virtually every publication on BITs, yet is never developed and tested on functionality. With regard to BITs, Sauvé and Zampetti (2007) assert that the “trend accelerated anew in the 1990s, albeit in a 325 326 327 328 329

Hathaway (2002), p.2005. Italics in original. Hathaway (2002), p.2007. In addition, these countries might have less reputational capital to lose. Hathaway (2002), p.2013. Hathaway (2002), p.2012. Simmons (2000), p. 324.

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markedly changed policy and ideological environment, as host country (i.e. capitalimporting) governments in both developing and transitions countries sought to exploit the putative signalling properties of BITs".330 The question therefore is: are the signalling properties of BITs only putative or realistic? 4.4.4.4

The Signalling Game

The signalling function of Bilateral Investment Treaties can be exemplified and discussed using a simple model. As in the reputation model, there are two types of host governments: a good (or reliable) type and a bad (unreliable) type. The type is determined by nature: with probability , the host government (or host county, HC) is reliable. The two types differ in the following way: the unreliable type will always expropriate the investment once it is made, while the reliable type will always accommodate. The HC knows its type and has the first choice of action: the HC can sign a BIT or not. The investor (MNE) does not know the government's type, but can observe the action of the HC, namely its decision to conclude a BIT or not. The interesting question with regard to the signalling game is what an investor can infer from the action of the HC. Therefore, it is assumed that it is irrelevant whether the country with which the HC concludes the BIT is the home country of the MNE or not. After observing whether the host country concluded a BIT, the MNE decides whether to invest or not. Because of the asymmetric information, the MNE at this point does not know whether it is facing the reliable or the unreliable type. After the investment decision, the game ends. The payoffs are as such: concluding the BIT comes with two different costs - the direct costs of concluding a BIT and the expected costs or compliance costs of the BIT once it is in force. The costs of concluding the BIT include negotiation and ratification costs and should not differ substantially between reliable and unreliable types. These costs are denoted as A. The compliance costs of the BIT once it is in force should, on the other hand and crucially for a signalling model, differ between the two types and are denoted by B. The reliable type will always accommodate the investment and should therefore not face costs of arbitrations (unless there are no systematic errors of tribunals or nuisance suits). Put diffently, the standards of the BIT reflect the general behaviour of the reliable type, only minor changes to the institutional order might be necessary331 and/or a small arbitration risk exists (therefore BR>0). On the other hand,

330 331

Sauvé and Zampetti (2007), p.215. One might think of the sovereignty costs as discussed in section 4.4.1. Nevertheless, the MNE does not care about the costs to the host country, but about the arbitration (expropriation risk). This will of course be lower when the sovereignty costs are low – in that sense, the two aspects are closely related.

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the unreliable type will expropriate and thereby expose itself to high arbitration risk. It will have to face reputational costs, pay legal fees and may be forced to pay compensation. The assumption is therefore BR < BU.332 Obviously, the arbitration risk will also depend on the amount of investment covered by the BIT in question, meaning that, for example, a BIT with a major capital-exporting country like Germany may have a bigger effect on BU than a BIT with a small, non capital-exporting country. If there is no investment and no BIT is in force, payoffs for all parties are zero. If there is no investment and a BIT is in force, the MNE has a payoff of zero, while both the reliable and the unreliable type must carry the cost of concluding the BIT. If there is investment and no BIT in force, payoffs correspond to the baseline game (see section 3.1.1) with CH for the reliable type and WH for the unreliable type. In that case, the MNE receives CM if he is facing a reliable type and LM if he is facing the unreliable type (as before LM <0 holds). Finally, if there is a BIT in force and the MNE invests, the HCs receive the respective gains (CH or WH) minus the costs of conclusion and the compliance costs of the BIT. The extensive form of the game can be illustrated as follows:

332

The subscript R identifies the reliable host country, the subscript U the unreliable host country.

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109

Nature

Reliable ()

Unreliable (1-)

HC

HC

No BIT

BIT MNE

Invest

CH- A - BR CM

BIT

MNE

Don’t Invest

Invest

-A 0

CH CM

No BIT

MNE

Don’t Invest

0 0

Invest

WH -A- BU LM

MNE

Don’t Invest

Invest

-A 0

WH LM

Don’t Invest

0 0

Figure 4.2: The Signalling Game

Notation CM

=

investment return for the MNE

CH

=

benefit of investment for the HC: taxes and spillover for the reliable type

WH

=

expropriation value of the asset for the unreliable type

LM

=

expropriation value of the asset for the MNE



=

probability that the HC is of the reliable type

A

=

costs of concluding the BIT

BR

=

compliance costs of the BIT for the reliable type (arbitration risk)

BU

=

compliance costs of the BIT for the unreliable type (arbitration risk)

with BU > BR

110

4.4.4.5

The Economics of BITs

Equilibria

As the MNE cannot observe the type of the host country, but can observe the action the host country takes, the reliable type might use BITs as a signal. Three types of equilibria are possible: separating, semi-separating and pooling equilibria. In the separating equilibria, the optimal strategies of the reliable and the unreliable type differ. Typically, the reliable type will sign a BIT and the unreliable type will not sign a BIT. In a semi-separating equilibrium, at least one type uses mixed strategies. In pooling equilibria, both types will take the same action, that is, both will either sign a BIT or refrain from doing so. Depending on the parameter specifications, all of these equilibria are possible. Therefore, it appears reasonable to make further assumptions on the feasible and realistic parameter space. First, the existence of many BITs can be observed in reality. If the signalling model has any explanatory power, a pooling equilibrium where nobody signs BITs can be ruled out. Such an equilibrium exists, inter alia, when the expected payoff of the MNE is positive despite the absence of a BIT – the MNE would invest in any case. Consequently, and considering that a BIT creates costs for both types of HC, no HC would ever bother to sign a BIT. This is exactly the case when T CM  (1  T ) LM ! 0 . This equation will be especially true when the probability of facing an unreliable type is very low. In the following, it is assumed therefore that T CM  (1  T ) LM  0 . Put differently, in the absence of a BIT, the MNE will not invest. Yet, as CM>0 and LM<0, the MNE would invest if certain that it faces the reliable and not invest if certain that it faces the unreliable type. The costs of concluding a BIT (A) do not differ between reliable and unreliable types. The MNE will choose its strategy taking the incentives of the respective HC into account. The prevailing equilibria therefore depend on the payoffs for the HC and can be summarised as follows:333

333

See Appendix C for a derivation of these results.

The Economics of BITs

Payoff

111

Equilibria

host country Pooling on No BIT (1) CH  A  BR  0

Signing a BIT is not worthwhile for any type of HC. The MNE will not invest.

and WH  A  BU  0

Strategy HC: (No BIT/ No BIT) Payoff HC: 0

Strategy MNE: invest/Don't Invest)

(Don't

Payoff MNE: 0 Separating Equilibrium

and

Signing a BIT is worthwhile for the reliable type but not the unreliable type. The MNE will invest if it observes a BIT and not invest otherwise.

WH  A  BU  0

Strategy HC: (BIT/No BIT)

CH  A  BR ! 0

Payoff HC: T (CH  A  BR )

Strategy MNE: (Invest/ Don't Invest) Payoff MNE: CM

Pooling on No BIT (2)

and

Signing a BIT is not profitable for the reliable type and consequently also not for the unreliable type. The MNE will not invest.

WH  A  BU ! 0

Strategy HC: (No BIT/No BIT)

CH  A  BR  0

Payoff HC: 0

Strategy MNE: (Don't Invest /Don't invest) Payoff MNE: 0

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The Economics of BITs

Pooling on No BIT (3) The unreliable type has the incentive to mimic the behaviour of the reliable type. Sending the signal is therefore not profitable for the reliable type. The MNE will not invest. Strategy HC: (No BIT/No BIT) Payoff HC: 0

Strategy MNE: (Don't Invest /Don't invest) Payoff MNE: 0

If CH  A  BR ! 0

CH  A  BR ! WH  A  BU

and

in addition:

WH  A  BU ! 0

Semi-Separating Equilibrium The reliable type signs a BIT, the unreliable type signs a BIT with probability q and the MNE invests with probability s. Strategy HC:

Strategy MNE:

(BIT/BIT with prob. CM T ) q  LM (1  T )

(Invest/Invest with prob.

Payoff HC:

Payoff MNE: 0

s

A ) CH  BU

T > s (CH  A  BR )  (1  s )( A) @

Before discussing the equilibria as such, a few words seem to be in order concerning the prior belief of the MNE with regard to the reliability of the HC, in the signalling game denoted as . The prior belief can be interpreted twofold: either, there is a population of host countries and the MNE cannot differentiate between these countries at all but knows the respective fraction of reliable () and the fraction of unreliable (1) HCs in the basic population. The MNE uses this knowledge to form a belief about the HC he is playing, simply taking the known values for  and (1-) as the probabilities of facing a reliable or, respectively, an unreliable HC. A different – and more realistic – interpretation of the prior belief would be that the MNE has a certain amount of information with regard to a specific HC and has, based on this information, formed a certain belief with regard to the reliability of the HC, namely . If following this interpretation, the value of  does not denote the fraction of reliable HCs in the

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basic population of HCs, but is an individual value formed for each HC separately. As a basic prerequisite for the ability of BITs to function as a signal, the condition T CM  (1  T ) LM  0 was introduced. If the prior belief of the MNE that the relevant HC is reliable is high, the host country has no incentive to sign a BIT. Using this insight, we can make a point that has so far been neglected when applying signalling theory to international law: a signal must be seen in perspective with the prior estimation of the signal-taker on the characteristic that is being signalled. More specifically and concerning the problem at hand: a signal will not necessarily be sent by the most reliable HCs. If the prior estimation that a relevant HC is reliable is already high, these countries especially will not bother to send a signal. A linear positive relationship between institutional quality and the existence and/or number of BITs cannot be inferred based on signalling theory. A second important point is that the condition that the signal is more expensive to the unreliable than to the reliable type is certainly not enough to ensure a separating equilibrium. Especially in the investment context, the benefits of the investment (be it through spillover and taxes on the one hand or expropriation on the other) need to be taken into account. If the benefits to the reliable type are low, it may not bother to send the signal at all and a pooling equilibrium without BITs and investment will result. The same is true if the signal is very expensive to the reliable type. In addition, if the benefit of the investment to the unreliable type is very high, a pooling situation without a BIT and without investment would result again as the unreliable type would try to mimic the behaviour of the reliable type. The reliable type will anticipate this and not bother to send the signal in the first place. Looking at the separating equilibrium more closely reveals the following interrelations: an equilibrium where BITs fulfil a signalling function is more likely when the benefits to the reliable host country are high (high CH) or the costs of the signal to the reliable type are modest (low BR). Consequently, if BR rises above a certain threshold, which might be the case when tribunals inflict unexpected costs on actually reliable states, the reliable type will refrain from sending the signal. This concern is not unfounded.334 MNEs pursuing illegitimate claims and errors by tribunals could be reasons for an increase in BR. On the other hand, if the benefits to the unreliable state are also substantial (high WH) or the costs of the signal negligible (low BU), a separating signalling equilibrium is ceteris paribus less likely. Under the reasonable assumption that conclusion costs do not differ between types, it is evident that these costs are unable to help MNEs differentiate between types; ergo only ratified BITs can be a signal. However, if conclusion costs rise above a certain threshold, a separating equilibrium might shift into a pooling

334

See also section 4.4.3.4.4.

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equilibrium without BITs. Nevertheless, in reality, these costs appear to be rather moderate. Yet, the existence of BITs is observed in the real world and, if the signalling function plays a role in reality, the answer probably lies in the semi-separating equilibrium. A BIT is not too costly for either type of HC, yet the unreliable HC will sign a BIT only with a certain probability. This could explain the strategy of some countries to sign BITs, while others, seemingly very similar countries, almost completely abstain from doing so. In the example presented here, the mixed-strategy equilibrium rests on a number of conditions. For both types, the investment must be profitable despite the costs of the BIT, namely CH  A  BR ! 0 and WH  A  BU ! 0 . For the bad type, this might be the case if the chances of being punished for uncooperative behaviour are low. Nevertheless, the payoff for the reliable type must be higher than for the unreliable type, denoted by the equation CH  A  BR ! WH  A  BU . Obviously, if this wasn't the case, a pooling equilibrium would emerge. High conclusion costs A may destroy the semi-separating equilibrium (just as the separating equilibrium) altogether. 4.4.4.6

Hidden Characteristics and Hidden Intentions

The analysis of the signalling properties of BITs is further complicated by the fact that the asymmetric information may take different forms. So far, the set-up of the signalling model was simply based on the separation between two types: a reliable type that always accommodates the investment and an unreliable type that prefers expropriation. The question arises as to how the two types specifically differ from each other and why it should be impossible for MNEs to differentiate between types. At this point, the connection to the commitment game as presented in section 4.4.3.2 can be seen. In essence, the reliable type is the type that would accommodate the investment anyway or that would do so induced by the BIT335 - this, inter alia, implies a low discount or strong political constraints. Consequently, the asymmetric information can consist of many different elements – some more reasonable than others. Broadly, these may be divided into hidden characteristics and hidden intentions. At first glance, the basic problem addressed by BITs appears to be a factual or perceived lack of institutional quality. The question of whether BITs are a signal or a commitment device is therefore often translated into the question of whether BITs complement the given institutional quality or substitute for the lacking institutional quality, serving thus as a signal in the former and a commitment device in the latter case.336 Yet, the information on the institutional quality of countries is abundant. For

335 336

Therefore, the commitment and the signalling function can never completely separated. See e.g. Ginsburg (2005).

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example, one of the most widely used set of indicators of institutional quality, the Worldwide Governance Indicators, published by the World Bank, even divides institutional quality into six parameters: Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption. This indicator is only one among various, easily accessible sources of information. A signalling model, however, requires the existence of asymmetric information. The idea that a bilateral investment treaty can convey yet unknown information in this regard is therefore, at best, questionable.337 However, concerning the discount factor and the payoffs of a specific country, asymmetric information might indeed persist. Namely, the value of CH and WH may depend on political characteristics not easily observable. In addition, the discount factor represents the willingness of a country to forgo current for future profits. This might depend on objective factors like the political system as such, but certainly also on the plans and objectives (or better, preferences) of the constituents (represented by the government) and might therefore better be understood as hidden intentions than hidden characteristics. The problem is that hidden intentions cannot be revealed through the publication of information, e.g., by an investment promotion agency. A signal in the form of an international treaty might therefore indeed be suitable to reduce information asymmetries. Nevertheless, institutional quality is not unimportant: if the quality is high, the short-run intentions of the constituents become less important as the government (representing the constituents) is more strongly limited in its actions by domestic safeguards – also with regard to foreign investment.338 The conclusions from this discussion are twofold: first, if BITs function as signals, their occurrence is not necessarily correlated with high institutional quality, at least not in a linear way. If the prior  is understood not as distribution over types, but as a specific prior belief on the reliability of the host country, the effect might even be the reverse: the signal is sent by countries that are perceived as having high political risk or low institutional quality, especially with regard to their judicial system. Countries that are perceived as "safe" will not bother to incur the costs of the signal. Second, if the signal relates to the current preferences of the constituents, "old" BITs cannot have a signalling function. The logic here is immediately obvious: a BIT that has been

337

338

Please note that the point here is not to refute the existence of asymmetric information. Rather the ability of BITs to address the type of asymmetric information that actually exists is questioned. Notably, if there was no asymmetric information from the start, the commitment model would also not be backed up by reputational concerns and therefore be useless. This does not presuppose that governments are non-benevolent. It has been explained before that time inconsistency problems are also relevant for benevolent governments.

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The Economics of BITs

concluded in the early 1980s will not provide much information on the preferences and planned policies of the current government. 4.4.4.7

Summary

International law and international treaties have been described as signals in a number of issue areas including the area of human rights and the provisions established by the IMF. Many authors have alluded to a potential signalling function of BITs without analyzing this function in detail. As with any economic signal, the signalling function of BITs presupposes the existence of asymmetric information. In addition, different types of players need to have different costs associated with the signal. The analysis of BITs as a signal in the preceding sections highlighted the following points: x Signed but not ratified BITs cannot be a signal as long as negotiation and conclusion costs do not differ between types. x The investment decisions of MNEs depend on their prior belief regarding the reliability of a country: if this prior does not reflect the distribution in the general population of host countries, but is formed specifically for each country, a BIT can be talked about as a signal only in "perspective": the signal will therefore not necessarily be sent by "low risk"-countries (as a result, positive correlations between institutional quality and BITs cannot necessarily be expected based on signalling theory) x If the unreliable type can obtain significant benefits from investment, it might try to mimic the signal despite higher signalling costs. This will undermine the ability of the reliable type to separate himself. The result may then be a semiseparating equilibrium or pooling without BITs. In addition, if the potential gains of the investment to the reliable host country are low, the signal will equally not be sent. x Increasing the costs of the signal to the reliable type will make the reliable type exit the game. This concern is not unfounded. Alternatively, increasing the costs for the unreliable type can support a separating equilibrium. Consequently, BITs with "big" states should have a stronger signalling function (if at all). x A mixed-strategy equilibrium can exist where the unreliable type signs a BIT with a specified probability. This equilibrium aligns signalling theory best with the uneven spread of BITs in reality. x The nature of the asymmetric information is problematic: the asymmetric information is more likely found in the intentions (current preferences) of the host countries and less in their institutional quality (as the latter is public

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information). Consequently, the signalling function of older BITs is certainly rather limited. Before turning to the question of how far BITs are really capable of serving as a signal or a commitment device, conceivable additional functions of BITs will be discussed as well as the relevant empirical literature. 4.4.5

Beyond Commitment and Signalling

It can be argued that a BIT is neither primarily a device to commit host countries nor a signal, but instead serves a different function. To start with, BITs might be best understood as tools to ensure an optimal trade-off between flexibility and commitment. A different theory categorises BITs rather as a form of development aid. In addition, BITs may be designed to deal with the risk-aversion of investors. Each of these ideas will be discussed in turn. 4.4.5.1

Flexibility vs. Commitment

Any form of effective commitment comes naturally at the cost of less flexibility at a later stage. This is not only true for BITs, but for any issue area where states optimally pre-commit to a certain course of action, e.g., in the area of monetary policy.339 The potential for international investment protection law to balance these diverging interests has recently been analysed by Van Aaken (2009). As the author notes, "states trade credibility for sovereignty, as international investment law not only restricts regulatory conduct of states to an unusual extent but also subjects it to control through compulsory international adjudication mechanisms."340 The question of how BITs and especially tribunals are coping with uncertainty and unforeseen contingencies from an economic point of view is certainly an important one. Indeed, tribunals have dealt with cases where investors were not subject to opportunistic measures, but where the respective host country reacted to unforeseen contingencies in good faith.341 In this sense, BITs and arbitration might be less of a commitment device but rather an attempt to efficiently deal with necessary adaptions of a long-term contract, thereby saving transaction costs when drafting the contract.342 In that case, the problem is not the hold-up situation as such. The idea is not, in deviation to the other two approaches (signalling and commitment), the observation that international law lacks supranational enforcement and that, at the same time, the host country faces a time

339 340 341 342

See for example Drazen (2002), p.126ff. Van Aaken (2009), p.3. Van Aaken (2009), p.15. Chapter 5 discusses this point in more detail.

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The Economics of BITs

inconsistency problem. The idea is rather that the BIT as a contract is incomplete and needs neutral interpretation and specification along the way. The functioning and importance of mechanisms that support the adaption of long-term contracts to unforeseen contingencies is described by Eger (1995).343 Arbitral tribunals can then be a less expensive and better suited solution as compared to national courts. It is clear that BITs and the system of international investment law in general need to deal with the problem of unforeseen contingencies. Obviously, if the ex-post costs of inflexibility rise above a certain threshold, states will no longer use BITs to commit to an investor-friendly course of action. However, in the case of BITs, arbitration is not mainly an alternative instrument for the adaption of contracts. First, international arbitration is unlikely to be less expensive than national courts. Second, if the main issue were simply contract adaption, BITs would also exist between developed countries and thus cover a more substantial amount of FDI. Put differently, even though the BIT and the tribunals need to address the problem of ex-post flexibility, the main issue is nevertheless a perceived (signal) or factual (commitment) lack of reliability and/or a functioning domestic adjudication. The decisive point is that the relationship between investors and states is hierarchical in the sense of Kreps (1990). There are unforeseen contingencies that one cannot contract on but, in theory, the host country could solve this problem through its own courts (or other mechanisms, e.g., by building up a reputation for dealing with unforeseen contingencies in a fair and consistent manner). Therefore, while balancing the interests of host countries and investors is certainly important, the existence of a BIT must nevertheless either be based on commitment or signalling properties of the BIT. 4.4.5.2

BITs as Development Aid

Domestic investors profit from the BITs concluded by their governments. The incentives and motives of capital-exporting countries to conclude BITs therefore appear to be obvious. Neumayer (2006) explores the question of with whom capitalexporting countries conclude BITs in more detail using econometric tools. The selfinterest of capital-exporting countries as presumed in this book could be confirmed by Neumayer (2006). If a developing country is economically attractive (by having a larger market and by being more open to trade), it will indeed have more BITs. Nevertheless, in addition, the author finds that "poorer countries have more, not fewer, BITs, which suggests that developing countries needs also play a role in developed countries' BIT programs. Good governance in the form of either democracy or human rights protection does not matter."344 The author concludes that BIT programs fulfil -

343 344

Eger (1995), p.146. Neumayer (2006), p.261.

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similar to aid programs - the dual functions of self-interest and foreign need.345 While this research sheds some light on the patterns of BIT conclusion, it should be noted that self-interest is substantially more important than using BITs as an indirect aid to development. In addition, the aid aspect does not contradict the analysis of the functioning of BITs as presented in the preceding sections. Quite to the contrary: the results underline that countries seem to consider BITs as a suitable means to overcome commitment problems. 4.4.5.3

Risk Aversion

The main motive for the existence of BITs may neither be commitment nor signalling, but the existence of risk aversion. The idea works similarly to the function of warranties. Consumers may perceive the warranty either as a quality signal or consumers may be interested in the general protection of the warranty in the sense of insurance.346 In sales contracts, such insurance is a Pareto-improvement if the buyer is risk-averse while the seller is risk-neutral – the buyer is willing to pay a premium if the seller takes on the risk that the product is defective. The seller will accept this if the risk premium is higher than the expected value of replacing defective products. Can this theory be applied to BITs? In the preceding sections, MNEs were assumed to be risk-neutral. This assumption must be abandoned if insurance comes into play. While abandoning this assumption is unproblematic, the application of the insurance rationale to BITs is problematic for another reason: the price system. The host country can certainly not charge a premium to investors that are protected by a BIT. The remuneration for assuming the risk would therefore be indirect: a higher amount of FDI. With regard to product warranties, the buyer may choose between a cheaper product without the warranty and a more expensive product that has a warranty. The quality of the product and specifically its default rate is known to the buyer. If this default rate is rising, the seller can only charge a lower price and will have to charge more for a warranty (as the revenue from the warranty must at least cover the expected replacement costs). This mechanism can certainly not be applied to BITs. A higher default rate would correspond to higher political risk in the respective host country. While more political risk may well lead to less investment ("lower the price"), we do not see that high-risk countries offer stronger protection in their BITs (and receiving thereby additional investment that covers the cost of the "warranty" BIT). Put differently, the price mechanism that adequately reflects the prices for higher risks does not work in international investment law. Consequently, while investors and

345 346

Neumayer (2006), p.262. See, e.g., Schäfer and Ott (2005), p.478ff.

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MNEs may very well be risk-averse, the insurance rationale is unlikely to be the foundation for the existence of BITs. 4.5

Empirical Studies and the Functioning of BITs

Section 4.2.1 summarised the relevant empirical studies on the effects of BITs on FDI. Some of these studies also touch (indirectly) on the functioning of BITs. Other empirical research addresses the question of which country characteristics are related to the conclusion of BITs. Four interesting points can be analysed using the existing empirical research. The first relates directly to correlations between institutional quality or political risk and the number of signed BITs. Two papers address this question directly. Ginsburg (2005) finds that countries that have adopted a BIT have higher levels of governance (as measured by the World Bank governance indicators) than those that have not adopted a BIT.347 Swenson (2005), on the contrary, asserts that those countries that were viewed as risky exhibited a propensity for entering into a larger number of BITs.348 The inconsistency of these results is not surprising as the analysis of this chapter suggests that a linear correlation between BITs and institutional quality can neither be expected with regard to signaling theory, nor with regard to commitment. The second interesting question is how BITs and institutional quality interact with regard to FDI. Note that this does not concern how FDI reacts to political risk or institutional quality. Empirical research rather clearly indicates that there is a positive relationship between FDI and good institutions349. The question is rather: how does political risk in reference to a BIT influence FDI. Econometrically, the tool to answer this question is the use of an interaction term. This implies inserting the product of BITs and institutional quality or risk into the regression as an independent variable (e.g., BIT*institutional quality). Finding a positive and significant relationship between the interaction term BIT*institutional quality and FDI would indicate that BITs have a higher impact when institutional quality is high, while a negative relationship would obviously indicate the opposite. Two papers employ such a variable: Neumayer and Spess (2005) find that "there is some limited evidence that BITs function as substitutes for institutional quality, as in a few estimations the interaction term between the accumulated number of BIT variable and institutional quality is negative and statistically significant."350 In a similar direction, Busse,

347 348 349 350

Ginsburg (2005), p.120. Swenson (2005), p.141f. Grosse and Trevino (2005). Neumayer and Spess (2005), p.1582.

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Königer et al. (2008) state: "BITs may even substitute for weak local institutions"351 as the interaction term between BITs and institutional development, proxied by the political constraints on the executive branch, is negative and significant. The third question relates to the research design and can be divided into two parts: first, whether the research design is dyadic and second, whether a distinction is made between signed and non-ratified BITs on the one hand and signed and ratified BITs on the other hand. Hallward-Driemeier (2003) uses a dyadic research design, which means that she is only looking at the effects of BITs on the specific investment inflows from the respective treaty partner and not on the investment flows from all other countries. As her study finds no or only marginal effect of BITs on FDI, it has been criticised as ignoring the signalling effect.352 Aisbett (2007) addresses the question of the existence of a signalling effect by comparing a dyadic with a cumulative research design and finds no signalling effect. However, studies that use a cumulative approach, like Neumayer and Spess (2005), did find a positive relationship between BITs and FDI, which indicates the existence of a signalling effect. However, this effect could alternatively be explained by the fact that investment from one source (that is protected by the BIT) attracts additional investment from third countries (that may not be protected), for example through suppliers, but also through the existence of knowledge-spillover and agglomeration rents. With regard to the distinction between signed and non-ratified as compared to signed and ratified BITs, Egger and Pfaffermayr (2004) find that a positive effect of just signing, which they call the anticipation effect, is not significant in most specifications, leading them "to conclude that the advantages to simply signing a BIT are inconsequential."353 Considering the discussion on the commitment game and the signalling game, this result is not surprising. 4.6

Discussion and Conclusions

Despite the perceived weakness of international law, Bilateral Investment Treaties appear to attract FDI at the margin. This chapter analysed the economic foundations of this effect by using the recent insights of the literature on international law and economics. Prerequisite for international law (including BITs) to influence the behaviour of the relevant actors is an impact on the payoffs. Three factors have been identified to do so, namely reciprocity, retaliation and reputation. While the former two certainly play an important role in many fields of international law, for example in

351 352 353

Busse, Königer et al. (2008), p.17. Neumayer and Spess (2005), p.1582. Egger and Pfaffermayr (2004), p.79.

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trade law, it was argued that, in the case of international investment law, reputation plays the most important role. However, and particular to international law, in the case of BITs, the reputation mechanism is “backed up” in the short run by non-reputational costs, more specifically the possibility of enforcing arbitration awards against assets in third countries. Two explanations have been put forward in the literature to describe the function of BITs, namely commitment and signalling. Each of these approaches has been discussed on the basis of a simple game-theoretic model. Structurally, the two approaches differ in the existence of complete vs. asymmetric information. Unfortunately, the empirical research did not shed much light on the question of whether we are rather dealing with a signal or a commitment device. The problem is that institutional quality will not necessarily be related to the commitment or the signalling function. An exception could be an independent judiciary or political constraints in the following sense: if either of the two exist (and MNEs know that or attach a high probability to this), expropriating is not an option to start with – consequently, a BIT will neither be used as a commitment device nor as a signal (as MNEs will also invest absent the signal). This hypothesis readily explains why highlydeveloped countries, despite extensive FDI flows, do not conclude BITs with each other and also with the empirical observations by Neumayer and Spess (2005) and Busse, Königer et al. (2008) that countries with lower institutional quality can profit more strongly from a BIT. Yet, below a certain threshold, the connection between institutional quality and BIT-signing remains empirically dubious. This is not surprising as in neither of the two models (signalling or commitment) do countries with high institutional quality have the incentive to sign BITs. How do the commitment and the signalling theory relate to each other? A signal can only work when (apart from other factors like observability, low prior beliefs etc.) there are different costs associated with BITs for the reliable and the unreliable type. The costs will only differ when arbitration creates costs which will, inter alia, only be the case when the MNE has an incentive to initiate arbitration in the case of expropriation. This is exactly the place where the two approaches overlap. Put differently, it is the countries which can use the BIT as a commitment device or happen to be reliable from the start (but are not perceived as such by third parties) that could use BITs as a signal. Consequently, it is important to note that the approaches do not exclude each other, but in a way condition each other (and can never be completely separated). The commitment model is therefore a useful tool to analyse the interaction between MNEs and host countries, as the mechanism is also a prerequisite for the signalling model. The hypotheses developed in section 4.4.3.6 summarised the main points under which HCs must anticipate sanctions in the case of expropriation and are hence in principle valid even with regard to the signalling function of BITs. The

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question then is which of the two groups use the mechanism more –the countries that can commit themselves or the countries that already are committed - assuming the existence of asymmetric information. However, it is precisely the existence of asymmetric information that raises concerns on the validity of the signalling model: clearly, if the relevant asymmetric information could be easily measured, it would not be asymmetric information in the first place. This makes the signalling of political risk and institutional quality unlikely as information on these two aspects is readily available. Further, the overall pattern of BIT conclusion makes the BIT a very noisy signal. Most countries in the world have concluded at least one BIT, while the actual number of BITs varies vastly between countries. In addition, the signalling strength of a BIT should vary depending on the treaty partner. If BITs are mainly a signal, why not conclude a BIT with only the three or four major capital-exporting countries in the world? It nevertheless seems likely that a certain signalling function of BITs exists, especially with regard to the hidden intentions of host countries. Obviously, MNEs will use all information they can obtain to make informed investment decision. Yet, BITs as signals must be interpreted with care and particularly BITs signed and ratified a long time ago might not convey much information. To sum up, while BITs may have a certain signalling function, a separating equilibrium that clearly reveals the type is not a good approximation of reality. Finally, the signalling function may only have a temporary effect, while the commitment function will last. In that sense, a BIT will be a very costly signal in the long run.

5

BITs and Institutional Competition

Countries are competing for capital. Bilateral Investment Treaties are a tool in this competition. The use of laws and regulations to attract foreign investment has been termed institutional competition. Bilateral Investment Treaties have so far not been directly discussed in light of the different theories of institutional competition. However, the famous prisoner’s dilemma thesis as put forward by Guzman (1998) and the literature based on this article can be subsumed under the theory of institutional competition. The literature on institutional competition suggests that this competition can be either beneficial or harmful for the involved countries. The important question asked here is therefore: are BITs better understood as part of a ruinous competition for capital or, to the contrary, can BITs help overcome domestic inefficiencies and foster the positive effects of institutional competition? This question will be addressed with a focus on developing countries. The chapter proceeds as follows: section 5.1 describes the notion of efficiency in the context of international investment law to provide a useful frame of reference. Section 5.2 describes the prisoner’s dilemma hypothesis and subsumes this hypothesis under the theory of institutional competition. The examples of tax competition and environmental competition will be discussed to highlight the potential benefits and costs of institutional competition. Section 5.3 illustrates to what extent international investment law may interact with the concept of institutional competition. This implies the consideration of political economy elements. As international investment law has thus far rarely been analysed from a political economy point of view, this paper takes recourse to the well-established political economy of international trade law. This approach entails a deviation from the unitary actor assumptions as employed in the previous chapters. It will be argued that BITs can help overcome domestic inefficiencies, but may at the same time pose a threat of an underprovision of domestic regulation. Taking this into consideration, section 5.4 analyses the relevant provision of BITs and reviews the case law focusing on the specific example of environmental regulation. Section 5.5 discusses the main results and provides a conclusion. 5.1

Efficiency and BITs

The economic analysis of law employs the notion of efficiency as a normative criterion. Two concepts of efficiency are usually applied: Pareto efficiency and Kaldor-Hicks efficiency.354 A situation can be called Pareto-efficient when no one can

354

See Posner (2007), p.10ff.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_5, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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be made better off without making somebody else worse off. Similarly, the notion of a Pareto-improvement is employed if the relevant transaction or reform is beneficial to the parties involved. The Kaldor-Hicks criterion, on the other hand, does not require that there are only winners to a reform: it suffices that the winners could compensate the losers (which does not necessitate that the winners actually do).355 Even without compensation, the use of the Kaldor-Hicks criterion can be justified on the grounds that in the long run, everyone in society will be better off as compared to a society that only employs the Pareto criterion. This section argues that the Kaldor-Hicks criterium is not well-suited to analyse international investment law. Further, the application of the Pareto principle also raises a number of concerns that forces us to limit our attention to Pareto improvements within a subgroup of countries, namely the developing countries. When applying the concept of efficiency to the area of international investment law, one crucial question relates to the level of consideration, namely: what parties will be included in the efficiency considerations? To start with, Bilateral Investment Treaties are treaties between two states. Assuming that states act in the best interests of their citizens and that no party threatens to use (military) force, the treaty, similar to a contract, should be Pareto-efficient for the two states concerned. If a capital-importing and a capital-exporting state are assumed, the former must weigh the benefits and costs of higher investment protection. Idealy, the BIT will help overcome the commitment problem and therefore attract additional FDI. The additional investment will increase taxes, create spillover-effects and therefore contribute to the development of the country. The capital-importing state should consequently offer a level of investment protection where the marginal benefits equal the marginal costs. The capital-exporting state should accept the offer when the treaty implies higher investment protection to its MNEs as compared to a situation without the treaty. In sum, both parties are better off. The issue is then to find the right balance between commitment and flexibility (in the presence of contracting imperfections). This approach is taken by Van Aaken (2009) who argues, with regard to BITs, that "(t)he point of optimality between commitment and flexibility still needs to be found."356 Possible reasons are that the treaties lack adequate mechanisms that ensure flexibility or that tribunals interpret the terms of the treaty too strictly.357 Therefore, it appears that a BIT is virtually by definition Pareto-optimal as long as only the welfare of the two contracting parties is concerned. However, this argument

355 356 357

Schäfer and Ott (2005), p.32. Van Aaken (2009), p.31. See Van Aaken (2009), p.16.

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would neglect the fact that a BIT may have consequences for third parties.358 Consequently, this approach is unsatisfying as the whole strategic interaction between developing countries is based on this external effect. In this respect, it is also important to remember that Pareto efficiency is actually a measure of social welfare. The question must therefore be whether BITs are efficient when looking at the global welfare or a larger subgroup of states and parties. Yet, defining boundaries on the unit of analysis is difficult.359 An alternative approach would therefore be to look at global welfare and apply the Kaldor-Hicks instead of the Pareto criterion. In the case of investment protection, the BIT regime strengthens property rights and is in this sense very likely efficient. However, the efficiency concept applied here cannot be the Kaldor-Hicks criterion for the following reasons: investment flows are rather stable over time and generally flow from MNEs in developed countries to developing countries. The basic justification of the Kaldor-Hicks criterion, a compensation of the loser in the long run, will therefore never occur. Given these myriad of problems with the efficiency concept in international investment law, the following approach is chosen: first, the specific problem is indeed that the BIT has an external effect; the additional investment will fully or partly be a diversion of investment from another developing country. Compensation in the long run as implicit in the Kaldor-Hicks criterion is unlikely. Therefore, this section is concerned with whether the BIT regime is beneficial for developing countries as a group. Second, governments may not always act in the best interest of their citizens. Hence, where possible, the utility of subgroups of society will be taken into account. Finally, the Pareto criterion will not be applied in the sense of Pareto optimality (as this would also imply a global perspective) but rather in the sense of a Pareto improvement or Pareto superiority. The modest question to be asked is consequently: is the BIT regime as such a Pareto-improvement for developing states?360

358

359

360

The following sections are basically a discussion as to whether this external effect is negative or positive. However, the discussion here rather relates to the question whether to consider this effect at all. A different aspect could be emphasized here: first, think about FDI as flows: the decision where to invest is taken every period new and the fact that a country has received this investment in one period entails no entitlement to receive investment in the following period. From this point of view, there is actually no effect on the third party of the investment decision. Alternatively, one might focus on FDI as stocks: increasing the stock in one country usually goes together with a decreasing stock in another country. In that sense, any investment decision (and indirectly also the BIT) has an external effect on third parties that needs to be considered. Which is probably the reason that most approaches in international law and economics have so far been positive and not normative in nature. A global perspective is for example chosen by Posner (2006). Obviously, a different approach would be to disregard the notion of efficiency given its lack of definition for the international level and simply ask whether the BIT regime is “beneficial” to all or a subgroup of countries. Nevertheless, this would only solve a semantic problem and the definition

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Institutional Competition

5.2.1

BITs and the Prisoner’s Dilemma

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Probably one of the most widely cited articles in the area of international investment law is entitled 'Why LDCs Sign Treaties That Hurt Them: Explaining the Popularity of Bilateral Investment Treaties' by published Andrew Guzman in 1998.361 The article focuses on why least developed countries (“LDCs”) sign Bilateral Investment Treaties even though these treaties may have a detrimental effect on their welfare. The starting point of the analysis by Guzman is the observation that developing countries have frequently rejected committing themselves to multilateral rules with high protection standards (as embodied by the Hull Rule), but have, at the same time, concluded bilateral agreements (BITs) that reflect exactly these high standards (or even higher ones). The reason lies, according to Guzman, in the prisoner's dilemma situation in which developing countries find themselves. The author claims that "although an individual country has a strong incentive to negotiate with and offer concessions to potential investors – thereby making itself a more attractive location relative to other potential hosts – developing countries as a group are likely to benefit from forcing investors to enter contracts with host countries that cannot be enforced in an international forum, thereby giving the host a much greater ability to extract value from the investment."362 Notably, Guzman’s argument does not imply a loss of efficiency through BITs. Guzman writes: "In global terms, the most efficient outcome is achieved if investment takes place where it will earn the greatest total return."363 Therefore, if BITs help to mitigate the time inconsistency problem (see section 3.3.1) and the related issue of underinvestment, BITs do not pose a problem of efficiency and may even enhance efficiency. The PD situation is consequently foremost a distributional problem. The point Guzman emphasises is that the increase in investment through BITs comes at the expense of other developing countries.364 In addition, the concessions the BIT makes will shift the surplus of the additional FDI to the investors (leaving the respective country with low or zero economic profit). In sum, developing countries would be better off without any international legal investment protection - yet, as in the cases of cartels, countries have the incentive to defect from this strategy by signing BITs. This result rests on a number of assumptions. One assumption, as Guzman acknowledges, concerns the elasticity of

361 362 363 364

of the parties included in the considerations would require a discussion similar to the one in this section. Guzman (1998). Guzman (1998), p.643. Guzman (1998), p.666. Guzman (1998), p.670.

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investment with regard to legal protection: "Specifically, the above theoretical claims are true only if the flow of investment into LDCs as a group is relatively insensitive to the terms on which that investment is made as compared to the flow of investment into a single developing country".365 In addition, the BIT must indeed be able to constrain the ability of the host country to extract surplus from the investment. The thesis that BITs are a tool in the competition for capital was later backed up empirically by Elkins, Guzman et al. (2006). Evidence for alternative theories of BIT conclusion, like coercion, learning or cultural explanations based on emulation, was less significant. More specifically, the authors find that countries sign more BITs when their competitors have also signed BITs. Three alternative measures are used to define competitors: countries with the same export trade relationships, countries that export the same basket of goods and countries that have similar educational and infrastructural resources. All three measures turn out to be significant. Coercion is proxied through the use of IMF credits and can be shown to have some influence on the decision of host states. Cultural factors (such as language or religion) seem to play only a minor role with regard to BIT conclusion. Learning from success is modelled by Elkins, Guzman et al. through the inclusion of a variable that captures the relationship of the number of BITs of a specific country in the preceding five years and its FDI inflows. This variable had some explanatory power, yet does not seem to play an equally crucial role as the competitive pressures to catch a share of FDI in light of the behaviour of potential competitors. While the results by Elkins, Guzman et al. clearly indicate that BITs are a tool in a competitive market, the distributional effects are not elucidated. The argument of Guzman has been addressed, formalised and critiqued by Bubb and Rose-Ackerman (2007). The authors argue that a prisoner’s dilemma situation is not necessary to understand the behaviour of LDCs. The authors present a model that "makes clear that poor countries may be caught in a prisoner's dilemma where they have incentives to sign BITs but are made worse off with a BITs regime. However it also illustrates that such a result is by no means necessary. It depends on the trade-off between FDI creation and sharing of gains between investors and host countries."366 Consequently, as compared to Guzman (1998), the authors are much more critical with regard to the hypothesis that investment to LDCs as a group is inelastic. On one point, Bubb and Rose-Ackerman (2007) and Guzman (1998) clearly agree: "The net effect of FDI on developing countries under a BIT regime compared with traditional customary law is an empirical question."367 The prisoner's dilemma hypothesis is also analysed

365 366 367

Guzman (1998), p.674. Bubb and Rose-Ackerman (2007), p.302. Guzman (1998), p.305.

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further by Engel (2008) in a comment to Elkins, Guzman et al. (2006). The author hypothesises a situation where policy makers maximise internal political support, not wealth. Benefits to the country stem from being ahead of similar countries (while the sovereignty cost of the BIT is expressed as an absolute value). Based on these assumptions, it is possible to lay out different structures of the game that are different from the prisoner's dilemma game (e.g., the chicken game, asymmetric games where states have different preferences, two period games) that result in equilibria where only a fraction of countries sign BITs– without having to give up the hypothesis that investment flows to LDCs as a group are inelastic. Yet, if the relative position of the country enters the welfare function, it is difficult to make a prediction on the actual outcome of the game. To sum up, the validity of the argument by Guzman (1998) strongly depends on the elasticity of investment flows. Put differently, the prisoner's dilemma hypothesis is certainly not the only possible explanation for the behaviour of LDCs and may not necessarily be the best description of the strategic situation that LDCs face vis-à-vis each other. As Sykes (2007) notes: "An alternative hypothesis, of course, is that developing countries came to realise that their strategy in the United Nations was a mistake, and that retaining an opportunity to expropriate raised their cost of capital by more than the gains from any expected expropriation (perhaps because of the risk aversion of investors). Although Guzman’s thesis is surely an intriguing one, it likely does not represent the final word on the matter."368 5.2.2

The Economics of Institutional Competition

The discussion on the strategic situation between host countries fits into the broader framework of the discussion on the merits of institutional competition. Institutional competition is a widely discussed phenomenon in (institutional) economics and legal studies.369 Different terms have been attributed to this phenomenon, emphasizing slightly different aspects, for example regulatory competition370 and (new) systems competition.371 There exists neither consensus among scholars with regard to the efficiency and welfare effects of institutional competition nor a well-established definition of the term. A short but very useful definition was put forward by Siebert and Koop (1990): "Institutional Competition is the competition of the immobile for the mobile factor."372 The history on the economic discussion of institutional competition, 368 369

370 371 372

Sykes (2007), p.811f. A lucid and balanced recent overview on the topic with special attention to the question of regulatory harmonisation vs. centralisation is provided by Behrens (2009). Romano (2005). Sinn (2003). Siebert and Koop (1990), p.4.

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which started mainly with the famous Tiebout model in 1956, shall not be reiterated here.373 It suffices to note that there are different forms of institutional competition and, as already mentioned, different assessments on the impact of institutional competition. At least four manifestations of institutional competition can be distinguished: (1) yardstick competition, (2) indirect institutional competition through trade, (3) locational competition and (4) institutional competition through the choice of law. Yardstick competition relates to the ability of constituents to compare the performance of their domestic governments with that of foreign governments and pressure for changes.374 Indirect institutional competition through trade describes the fact that the consumer's decision for or against a specific good is always also an implicit decision for or against the regulatory framework under which the good was produced.375 Locational competition evidently describes the choice of location of mobile factors where institutions may play an important role. Lastly, institutional competition through the choice of law does not require factor mobility and describes a situation where users can choose between different legal arrangements without changing their location. The form of institutional competition with regard to BITs can be subsumed under the label of locational competition. Countries use the "institution" BIT to compete for capital. Economists that have analysed the functioning of institutional competition diverge in their estimation on the usefulness of the concept. A rather negative assessment on institutional competition has been developed by Sinn (2003). The author develops a concept which he terms the Selection Principle: “The Selection Principle says that governments have taken over all those activities which the private market has proved to be unable to carry out. Because the state is a stopgap which fills the empty market niches and corrects the failures of existing markets, it cannot be expected that the reintroduction of the market by the back door of systems competition will lead to a reasonable allocation result. Instead, it must be feared that the failures that originally caused the government to take action will show up again at the higher level of government competition.”376 Other authors have emphasised the positive effect of market forces of institutional competition that may lead to overall better results and reduce inefficiencies of the domestic political process. Representative of this view is the evolutionary approach advanced by Kerber and Vanberg (1994). This view emphasises the knowledge-

373 374 375

376

Tiebout (1956). For an explanation of the term and application to the EU, see Salmon (2003). This type of competition is especially relevant in the European Union in relation to the country of origin principle. Sinn (2003), p.6. See also Eger and Wagener (2009), p.361f.

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creating process of competition in the sense of Schumpeter and Hayek.377 A key difference to the more sceptical approaches as exemplified by Sinn (2003) is, apart from the importance of knowledge-creation, the assumption on the nature and incentives of governments. The public choice literature highlights the prevalence of deficiencies in the domestic political process. Based on the influential writings of James Buchanan and Gordon Tullock378 is the argument that governments do not necessarily maximise the social welfare, but rather concede to the rent-seeking activities of subgroups of society. A major advantage of institutional competition is consequently a control function: as the mobile factors prefer efficient regimes over inefficient ones, their location decision will induce governments to offer an efficient set of regulations. This logic is clearly analogous to markets where the competition forces companies to act efficiently. In the legal literature, the market analogy has especially found its way into the discussion on the regulatory competition in corporate law and securities regulation. For example, with regard to the latter, Romano (2001) lists as the benefits of regulatory competition that it "reduces the possibility that a regulator will be able to transfer wealth across different regulated entities or redistribute wealth from the regulated sector to preferred individuals or organizations"379, that it "more quickly corrects for policy mistakes than a single regulator can"380 and that it "can be expected to foster innovation, since the feedback mechanism of interjurisdictional flows that reduces the possibility of regulatory error also provides an incentive for regulators to improve their regimes".381 This view is also influential among the forerunners of law and economics. As Gary Becker states: "Competition among nations tends to produce a race to the top rather than a race to the bottom by limiting the ability of powerful and voracious groups and politicians in each nation to impose their will at the expense of the interests of the vast majority of their populations."382 5.2.2.1

Tax Competition

Institutional competition may affect a wide array of issue areas. Put differently, governments may use different institutional parameters to compete for FDI. Most evident and probably most widely discussed is the use of tax rates (or subsidies) to attract FDI. Another example may be the lowering of environmental standards. Both discussions reflect the general discussion on institutional competition. With regard to

377 378 379 380 381 382

Kerber and Vanberg (1994), p.198. See, e.g., Buchanan and Tullock (1962). Romano (2001), p.5. Romano (2001), p.5. Romano (2001), p.6. Becker (1998), p.22.

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tax competition, a number of authors have raised the concern that it might be detrimental for the involved countries. Oates summarised this concern as early as 1972: “The result of tax competition may well be a tendency toward less than efficient levels of output of local services. In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs, particularly for those programs that do not offer direct benefits to local business.”383 This concern has been formalised, most notably by Zodrow and Mieszkowski (1986). The authors conclude that tax competition will lead to an underprovision of public goods. The claim is logically based on a Bertrand-like competition. As Wilson (1999) emphasises: "A central message of the tax competition literature is that independent governments engage in wasteful competition for scarce capital through reductions in tax rates and public expenditure levels."384 At the core of the argument lies the fiscal externality that arises because countries do not consider the effect of their tax rate on the tax base of other countries. A different view has recently been expressed by Baldwin and Krugman (2004). The authors depart from the traditional models of tax competition by introducing a model where the investment in certain regions produces agglomeration rents as a result of good infrastructure, accumulated experience etc. These agglomeration rents are valuable to investors and as a result, tax competition may not lead to an inefficient race to the bottom but "may lead same-sized nations to have different equilibrium tax rates".385 Also, more optimistic views on tax competition may prevail when states face internal inefficiencies which may be overcome through institutional competition. In general, this may be the case when governments have interests other than the maximisation of social welfare. The economic foundation of this argument is usually attributed to Brennan and Buchanan (1980). The basic idea is that Leviathan governments act to maximise tax revenues and that it is beneficial to constrain the government to do so. If the government does not face any domestic fiscal constraints on the taxing power, intergovernmental competition may be a substitute for these restraints.386 This argument is also applied by McLure (1986) who argues that the “likely benefits of reducing tax competition are relatively slight”, while “the benefits of tax competition are potentially quite important”.387 The benefits he identifies in favour of tax competition are the same as the benefits of mitigating the problems posed through Leviathan governments. Different specifications of the Leviathan model have subsequently been used to analyse tax competition. In general, the introduction of non383 384 385 386 387

Oates (1972), p.143 as cited in Wilson (1999), p.269. Wilson (1999), p.269. Baldwin and Krugman (2004), p.19. Brennan and Buchanan (1980), p.184. McLure (1986), p.346.

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benevolent interests of policy-makers leaves a welfare-enhancing role for tax competition. Some contributions predict an ambiguous net effect on welfare. Edwards and Keen (1996) argued that decision-makers that are not welfare maximizing face a trade-off between social welfare (interests of voters) and creating rents for themselves. The introduction of tax competition will in this setting have two different effects on welfare: while the rent-seeking behaviour of the politicians is mitigated (implying positive welfare effects), providing the public good will equally become more costly (implying negative welfare effects). A recent contribution by Eggert and Sørensen (2008) goes into a similar direction: absent tax competition, politicians have the incentive to create efficiency-distorting rents for the public sector employees. Introduction of tax competition will mitigate this problem, but may at the same time cause an underprovision of public goods (similar to the fiscal externality argument). The authors note that tax competition is "a double edged sword" that may reduce rentseeking, but "that also tends to distort the supply of public goods."388 The conclusion is that "to a certain point tax competition may play a useful efficiency-enhancing role, but if it becomes too intense it is likely to be welfare-reducing."389 The analysis underlines that the literature cannot be clearly divided into two strands with the assumption of benevolent governments leading necessarily to inefficient outcomes of tax competition on the one hand and the assumption of self-interested or Leviathan governments leading inevitably to efficient results of tax competition on the other hand. Janeba (1998) is an example of where inefficiencies (in the form of subsidies to domestic firms) are persistent as a result of imperfect competition, but these inefficiencies can be overcome through tax competition when governments cannot discriminate between domestic and foreign firms. In this case, the government is benevolent in nature and yet, there is a welfare-enhancing role for tax competition. Nevertheless, the control function is at the core of optimistic accounts of institutional competition and it is clear that the control function loses its impact when ignoring the control problem through the assumption of benevolent governments. 5.2.2.2

Environmental Competition

With regard to environmental competition, the theoretical research is likewise inconclusive. In general, the focus of the literature is less on taming Leviathan governments but more on the internal inefficiencies or inefficiencies of the competitive process. Nevertheless, the basic functioning is similar to the case of tax competition. A number of scholars have expressed the concern that institutional

388 389

Eggert and Sørensen (2008), p.1157. Eggert and Sørensen (2008), p.1157.

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competition may lead to a race to the bottom on environmental standards. The logic of the race to the bottom hypothesis is simple: as strict environmental policies raise costs for companies, governments will opt for lax standards to attract capital, resulting in, in the extreme case, a race to the bottom.390 According to Revesz (1992), this idea became commonplace following two articles by Richard B. Stewart that were used by the US Congress to justify federal environmental statutes.391 In one of these articles, Stewart (1977) argues: “Given the mobility of industry and commerce, any individual state or community may rationally decline unilaterally to adopt high environmental standards that entail substantial costs for industry and obstacles to economic development for fear that the resulting environmental gains will be more than offset by movement of capital to other areas with lower standards.”392 An influential model by Oates and Schwab (1988) asserts that the competition among jurisdictions will lead governments to set environmental standards where the trade-off between additional investment and environmental protection is optimal. However, Kunce and Shogren (2005) posit that the efficiency result of Oates and Schwab (1988) is driven by the assumption that the pollution rents (the economic rents for using the environment as a production factor) are completely captured by the domestic wage earners. It is also noteworthy that the efficiency result does not hold when capital taxes are (inefficiently) high or when the government does not maximise social welfare, but instead maximises its budget. The model introduced by Wellisch (1995) accounts for the fact that pollution rents are not fully captured by domestic constituents but partly captured by the polluting industry, usually owned by non-residents (as MNEs locate where pollution rents are the highest). Using certain policy instruments (namely direct controls) the result may actually be overprotection of the environment. The following quote by Wellisch (1995) explains the intuition behind the model: "If direct controls are used, then the implicit factor reward on pollution is left with the firms which are not (entirely) in the hands of local residents. Residents do not share the rents from environmental pollution but have to bear the entire burden. Therefore, the environmental agency has too strong an incentive to protect the environment. If emission taxes are used and the tax revenues are distributed among local residents, the implicit rent from local pollution is also internalised and the environmental agency has incentives to choose a socially efficient pollution level."393 The approach of Markusen, Morey et al. (1995) yields a similar result. The authors find that under some circumstances, namely only a small

390 391 392 393

See Wilson (1996) for a discussion of this issue. Revesz (1992), p.1210f. Stewart (1977), p.1211f. Wellisch (1995), p.292.

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disutility from pollution, two competing jurisdictions will try to attract FDI by lowering environmental standards. Quite to the contrary, if disutility of pollution is substantial, the jurisdictions may even increase their environmental standards in an attempt to drive production of the good into the other jurisdiction (while still being able to consume the good through exports). The authors refer to what is known as the NIMBY-strategy: not in my backyard. 5.2.3

Discussion

The articles and models discussed constitute by no means an exhaustive account of the literature, but rather are a representative cross-section. The theoretical discussion on institutional competition is voluminous and diffuse. General conclusions with regard to institutional competition are therefore difficult to draw. Most commentators share this view. Kunce and Shogren (2005) state in this respect that "the setting of tax policy and environmental standards remains a central but unresolved public policy question"394 while Oates (2001) diagnoses with regard to the issue of environmental protection that the “theoretical literature is, in my view, inconclusive on this issue"395 and Wilson (1996) declares that "neither the theoretical nor empirical work points clearly in one direction."396 The indecisiveness of the matter may call for more empirical research, but the empirical literature on the topic is equally inconclusive.397 The problem here is that the arguments of each side with regard to social welfare are hardly verifiable. Empirical evidence may find that tax competition leads to a reduction of tax rates. However, these findings cannot shed light on the welfare question as it is questionable whether tax rates were at the efficient level in the first place. With regard to standards, like environmental standards, this evaluation is likely even more complicated. One point that can nevertheless be derived from the diverse literature on institutional competition is that a positive view on institutional competition usually requires some form of domestic inefficiency: this inefficiency is mostly the result of a non-benevolent government. However, even the assumption of a self-interested government does not necessarily lead to an efficiency-enhancing effect of institutional competition. The distortions of institutional competition identified by many scholars may nevertheless arise and outweigh the positive control effects of institutional competition. It is also important to understand that the assumption of a self-interested (or Leviathan) government is not a necessary assumption to reject the race to the bottom hypothesis.

394 395 396 397

Kunce and Shogren (2005), p.212. Oates (2001), p.8. Wilson (1996), p.408. See Oates (2001), p.13ff.

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Other factors, like agglomeration rents, may enable countries to set tax rates that are not subject to a downward pressure by institutional competition. It should also be noted that the term race to the bottom relates to an extreme case and therefore any model that suggests such a condition requires very strong assumptions, mainly regarding the sensitivity of investment to policy choices. Therefore, in the following sections, the potential underprovision of public goods will be discussed instead of the extreme case of a race to the bottom. Finally, it seems that none of the approaches is clearly true while ruling out the others. Rather, institutional competition has countervailing effects that need to be balanced. This idea becomes especially apparent in the models of Edwards and Keen (1996) and Wellisch (2000). The latter points out regarding tax competition: “The gains derived so far of an increased supply of local public goods must be contrasted with the disadvantage of less competition among self-interested policy makers wasting tax revenues.”398 5.3

BITs in the Context of Institutional Competition

How do BITs relate to the different theories of institutional competition? To begin, it is evident that neither the discussion on tax competition nor ecological competition can fully capture the use of BITs in the competition for capital, as BITs cover potentially almost every area of domestic policy-making. The purpose of the preceding sections was rather to illustrate that the theoretical literature on institutional competition is divided. This is even true without giving up the assumption of benevolent governments (and ignoring the importance of learning effects). The equilibria where states choose inefficiently low taxes or lax regulation as a result of institutional competition for capital are in essence prisoner’s dilemma situations for the involved states.399 In that sense, Guzman (1998) basically subsumes the existence of a detrimental institutional competition under a prisoner's dilemma scheme. Guzman’s argument certainly holds as long as investment to developing countries is indeed quite inelastic. Obviously, if investment is inelastic, any measure that limits the behaviour of host states must lead to a prisoner’s dilemma. In that case, it is even irrelevant if governments do not intend to maximise social welfare. What is important is simply if the measure (in our case, the BIT) limits in any way the ability of

398 399

Wellisch (2000), p.74. For the tax case, see Wellisch (2000), p.64.

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developing countries to redistribute rents at all to domestic constituents (that are part of the welfare function).400 The following will deviate from these assumptions and assume that additional investment and/or agglomeration rents may theoretically leave a surplus of the transaction that may be captured by the host country. The implication of this assumption is not necessarily that there will be no prisoner’s dilemma. The consequences of the competition for capital may still lead (developing) countries to end up in a prisoner’s dilemma. Yet, the opposite may also be true and institutional competition in the form of BITs may help overcome domestic inefficiencies and countries will, after all, profit from the competition for capital. The question is consequently: can BITs be understood as a manifestation of an institutional competition that is harmful to developing countries? Or do BITs, on the other hand, help overcome internal deficiencies, for example, by aligning the interests of governments and constituents? A plausible hypothesis is therefore that the competition for capital reduces the ability to redistribute rents from the MNE to preferred groups, but at the same time reduces the ability of governments to take measures that are welfare-enhancing. A number of aspects can be examined in this respect. First, it will be discussed whether domestic inefficiencies regarding investment protection can be expected in the first place. A useful frame of reference here is the (well-established) political economy of international trade. Second, the underprovision hypothesis regarding investment protection will be illuminated. Finally, the content of BITs and the existing case law (using the example of environmental regulation) will be discussed in light of these theories. 5.3.1

BITs and Self-Interested Governments

5.3.1.1

Political Economy and International (Trade) Law

The simplifying assumption that states act as unitary actors was a useful approximation while analyzing the economic functioning of BITs. It may, however, be problematic for explaining the outcomes of international investment policy making. With regard to regulation in general, a deviation of the interests of governments from

400

Think about the extreme case where investment protection does not exist at all and developing countries would always expropriate 100% of the investment inflows, but these inflows remain stable despite the lack of protection. Any commitment that limits the discretion of developing countries would then be a prisoner’s dilemma.

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the social welfare has been observed by the theory of regulation for a long time.401 For example, when investment is sunk, governmental opportunism may result from a shorter time horizon or the need to redistribute rents in favour of powerful interest groups to ensure re-election.402 An interesting empirical underpinning of a similar idea, namely that governments use regulation as a rent-extracting device, has been provided by Djankov, La Porta et al. (2002). The authors analyse the behaviour of 85 governments concerning (domestic) regulation of firm entry (start-ups) and find that "heavier regulation of entry is generally associated with greater corruption and a larger unofficial economy, but not with better quality of private or public goods".403 The authors conclude that these findings are hard to reconcile with the public interest theories of regulation: "The principal beneficiaries appear to be the politicians and bureaucrats themselves."404 Theories based on the political economy approach have especially been applied to international trade law. The starting point of the analysis is the observation that the economic case for trade barriers is weak.405 Many economists have long argued that a unilateral abolishment of trade barriers is welfare-enhancing. Nevertheless, many if not most countries engage in protectionist policies. The reason is that while free trade may be welfare-enhancing, it also has distributional implications.406 Some interest groups may consequently lose under a free trade regime. If politicians do not maximise welfare, but rather their chances to be re-elected, the economic rents for some interest groups may play a more important role in the domestic political process than the rents for other groups. In the case of international trade, it appears that free trade may especially hurt the interests of well-organised groups, for example producers, while the winners of free trade, for example consumers, are less-well organised and face a collective action problem that is exacerbated by the fact that the individual gains of free trade may be low. As a result, there may be protectionist policies in favour of certain producers despite their detrimental consequences for the overall social welfare. Interest cleavages among interest groups regarding the trade regime have also been identified between capital and labour and between different firms or different industry sectors.407 A problem with that line of reasoning is that it can explain the existence of trade barriers, but not why countries seek to simultaneously abolish the trade barriers 401

402 403 404 405 406 407

According to Ekelund and Tollison (2001), p.357, the approach can already be found in the writings of Adam Smith and James Madison. Walter and Sen (2009) provide an overview of this approach with regard to international economics. See, for example, Spiller and Tommasi (2008). Djankov, La Porta et al. (2002), p.35. Djankov, La Porta et al. (2002), p.35. See Walter and Sen (2009), chapter 3. See, for example, WTO (2008), p.123. Walter and Sen (2009), p.70ff.

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on the international level. Shouldn't the very same special interest groups prevent governments from advancing international cooperation? The standard answer to this question is the emphasis of the importance of international negotiation and the reciprocity these negotiations entail.408 The idea is that governments know that a unilateral tariff reduction is not feasible exactly because of the opposition of the aforementioned interest groups, but at the same time, all governments are in a similar position. By concluding a trade agreement, the governments can rally political support from other groups of society, thereby making the tariff reduction possible in the first place. As the WTO puts it: “Reciprocity is the key because it will convert each nation’s exporters from bystanders in the tariff debate to opponents of protection within their own nation.”409 A different political economy argument can be put forward concerning trade agreements. This argument relates to time inconsistency problems between governments and the electorate.410 The idea is that governments use trade agreements to commit themselves to domestic interest groups in cases where optimal government plans may be time inconsistent. Different specifications of this argument have been developed.411 The core of the argument is that governments seek to avoid distortions that may arise in the future. An illustrative example has been provided by Matsuyama (1990).412 In his example, the government intends to liberalise a protected industry, but the (representative) domestic firm in the protected industry is at the present time inefficient. The threat to liberalise the industry in the future is supposed to induce the domestic firm to invest. However, this threat may not be credible as, if the domestic firm does not invest, the government may find it not optimal to liberalise at the preannounced, future date.413 One possible solution is that the "government might be able to sign a contract with a third party (perhaps, the GATT) to make the cost of postponement of liberalisation (or renewal of temporary protection) prohibitively high."414 5.3.1.2

Political Economy and International Investment Law

The questions to be answered are whether these problems may also emerge in the context of the regulation of FDI and whether institutional competition (in the form of

408

409 410 411 412 413 414

Krugman and Obstfeld (2009), p.228ff. A very good overview on the issue can also be found in WTO (2007), p.55ff. WTO (2007), p.57. For a description of the approach see Bagwell and Staiger (2002), p.32ff. WTO (2007), p.59f. See also WTO (2007), p.59. Obviously, the structure here is similar to the time inconsistency game laid out in chapter 3.1.1. Matsuyama (1990), p.490.

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Bilateral Investment Treaties) can provide a remedy for these inefficiencies. The literature on international trade and the theory of regulation have underlined that governments may favour the interests of certain interest groups over others, that governments may use regulation mainly to extract rents and that governments may have problems committing themselves to domestic interest groups. In the absence of a (domestic) time inconsistency problem, the interpretation of BITs as solely the outcome of a complex interplay of different interest groups is problematic. Certainly, it is reasonable to argue that different interest groups have different interests concerning the regulation of FDI. A point in case is market-seeking FDI. Domestic producers of the same or similar products will be strongly opposed to the admission of MNEs. Even if the MNE is admitted, domestic producers might nevertheless lobby for regulation that will ensure a competitive advantage. On the other hand, consumers and potential employees that might profit from the presence of the MNE are not a strong interest group. However, domestic suppliers can also gain through the production facility of an MNE. In sum, the situation is as complicated as the one of trade law and indeed, the interactions of interest groups may sometimes result in strong protection of domestic industries and in other cases not. But why should governments limit their discretion through a BIT? In the case of trade, the key answer to this question was reciprocity. Of course, BITs are also reciprocal in nature, but due to the asymmetric nature of investment flows in most cases, governments can hardly use this reciprocity to convert the indifference of some interest groups into support for FDI protection. Lacking reciprocity, the interest-group case for BITs in the absence of a time inconsistency problem is weak. If the government is able to extract rents from the political process, it is probably better off in maintaining its political discretion than relinquishing it under a BIT. Consequently, the time inconsistency problem cannot be ignored when analyzing the political economy of BITs. This problem was examined in detail in chapter 3. Yet, analogous to international trade law, the commitment problem might apply to the private sector more than to foreign investors. Similar to the case in trade, a company or sector may require protection at the present date, but will not enhance its efficiency if the threat to withdraw the protection is not credible. A logical legal equivalent to tariffs in the case of FDI regulation would be entry requirements. However, the preestablishment stage is usually not addressed by most BITs (with the notable exception of US BITs) and has, as a practical matter, not been relevant to international investment arbitrations. Indeed, BITs are mainly concerned with post-establishment issues. Therefore, a BIT is not well suited to influence the present behaviour of the private sector through making its threats credible. To be clear, governments may of course be concerned with future rent-seeking of the private sector. Yet, it is precisely the government that will profit from these rents – again, there will technically be no

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time inconsistency problem and the situation is similar as described above. The government will probably be better off not to limit its discretion. Nevertheless, the time inconsistency problem vis-à-vis investors (as mentioned in section 3.1.1) can indeed be exacerbated through the influence of interest groups and short time horizons of political decision-makers. Of course, the time inconsistency problem as such is the result of sunk investments and thus affects any host country. Yet, we observe that that developed countries do not use international agreements to protect their (substantial) investment flows among themselves. This is a strong indicator that the time inconsistency problem has an important political economy dimension (assuming that the patience of citizens and the value of spillover effects do not differ systematically and substantially between populations). The simple repetition model introduced in section 3.2.2 can highlight this point. The condition for a cooperative equilibrium in a repeated game was derived as: G t 1

CH WH

If the interests of the government deviate from social welfare goals in the sense that governments are less patient (lower ), value the expropriated asset higher (higher WH, e.g. because the asset can be given to cronies or special interest groups) or profit less from the investment (lower CH, e.g. because the positive spillover are widely diffused and can therefore not easily be converted into political support), the BIT can be a suitable tool to tie the government behaviour more closely to social welfare objectives by inducing cooperative behaviour.415 Indeed, especially the non-discrimination clauses in BITs seem to be suited to prevent governments from taking distributional actions that would forgo future investments. These provisions will be considered in more detail in section 5.4. Apart from the substantial ability of BITs to prevent selfinterested governments from acting opportunistically (disregarding social welfare), it should nevertheless not be forgotten that the BIT will only work if the sanctioning mechanism works. In addition, the expected sanction to the government must be high relative to the benefits of the opportunistic behaviour. To sum up: in contrast to the political economy of international trade law, BITs are neither well-suited to reap gains of reciprocal commitment nor to mitigate domestic commitment problems. Nevertheless, interest group politics and self-interested

415

Obviously, the same mechanisms depicted in the preceding chapter determine the incentives of governments to actually sign a BIT. Specifically, the BIT will only be useful if it is a credible commitment.

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politicians potentially play an important role for BITs. The institutional competition through BITs may therefore indeed cure a domestic inefficiency and be welfareenhancing, especially if it can prevent governments from taking distributional actions that forgo future spill-over effects for the immediate gain to well-organised interest groups to the detriment of social welfare. 5.3.2

BITs and the Prisoner's Dilemma Revisited

Section 5.2.1 described the prisoner's dilemma hypothesis that was developed in the context of BITs. In light of the discussion on institutional competition, two aspects can be identified that may foster the occurrence of a PD situation. The first relates to the underprovision hypothesis, which is the concern by some commentators that institutional competition will lead to an underprovision of public goods. The second aspect relates to the distributional implications of BITs and analyses to what extent BITs are able to influence the distribution of surplus between countries and investors. 5.3.2.1

BITs and the Underprovision Hypothesis

The underprovision hypothesis embodies the potential detrimental effects of institutional competition. With regard to BITs, the public good that is potentially underprovided is regulation. Governments may refrain from welfare enhancing regulation for fear of being sanctioned by international law - the structural similarity to environmental competition is immediately apparent. Indeed, environmental issues have been of concern in a number of arbitration proceedings. Yet, a BIT covers in principle any kind of regulatory measure. An underprovision of regulation consequently means over-deterrence with regard to enacting regulation.416 Is overdeterrence a real concern in international law? After all, is it not the perceived weakness of international law that arouses the most criticism? The answer is yes and no. Obviously, in areas like disarmament, it would be far-fetched to worry about overdeterrence. However, a different picture might be drawn in international investment law. Indeed, a number of critics have pointed out the dangers of what has been termed regulatory chill, especially in the area of environmental regulation.417 This concern has also been mentioned by a number of international organisations, such as the OECD, the World Bank and UNCTAD.418

416

417 418

The extreme case of this theory could be, as before, a race to the bottom. However, the author is not aware of any commentator expressing this extreme view and will thus focus on the potential regulatory chill. See, e.g., IISD (2001). OECD (2001), p.8, World Bank (2001), p.16 and UNCTAD (2007b), p.85.

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The discussions on this issue in the area of international investment law seem to have begun with a number of investment cases under NAFTA Chapter 11, namely Ethyl Corporation v. Canada, Methanex v. U.S., Metalclad Corp. v. Mexico, S.D. Myers v. Canada and Pope & Talbot Inc. v. Canada.419 For example, the Methanex v. U.S. case concerned the ban of a certain additive, called MTBE, in gasoline by the state of California. Methanex, a Canadian company that produced an important component of MTBE, filed for arbitration and claimed 900 million USD in damages. This case sparked a controversial discussion on the influence of international investment law on the state’s regulatory powers. Environmental and social interest groups as well as scholars raised strong concerns about the incentives of states to pass environmental and social reforms in the presence of investment treaties.420 Would states abstain from sensible and important (environmental) regulation to avoid being sued by an international arbitration tribunal? The alleged reluctance to raise legal standards for fear of losing capital would then be aggravated by an additional international legal sanction. With regard to the NAFTA cases mentioned above, Wälde and Kolo (2001) as well as Neumayer (2001) have argued that the concerns for a regulatory chill are unfounded. As Neumayer (2001) concludes "(h)ardly any concrete evidence is available on whether states might be scared away from enacting stringent environmental standards due to the threat of a potential dispute challenge."421 However, the (recent) impact of BITs might differ substantially compared to the NAFTA cases at the beginning of the century. Indeed, legal commentators have observed an expansion of the scope of some BIT provisions by tribunals.422 The concern that BITs may aggravate the problem of regulatory chill rests on a number of assumptions. To start with (and similar to the case of controlling selfinterested governments), the sanctioning mechanism must "function" in the sense that the benefits of regulation must be low compared to the expected sanctions. Most importantly, BITs must theoretically be able to challenge welfare-enhancing regulation and there should be cases where this has actually happened. The existing evidence with regard to these points will be discussed in section 5.4.

419 420 421

422

Wälde and Kolo (2001), p.812. See, e.g., Mann and Moltke (1999), Banks (1999) or Ganguly (1999). Neumayer (2001), p.87. Nevertheless, legal scholars criticizing international investment law for posing dangers to environmental regulation still seem to base their claims mainly on these cases. As an example, see Miles (2008), p.3, fn 6. Picherack (2008).

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Distribution of the Benefits of FDI

Even if the strengthened investment protection can generate additional investment flows to developing countries as a group, countries will find themselves in PD situations when the benefits of these investment flows are mainly or fully captured by the MNEs. This point has a direct and an indirect aspect: the former is the specific distribution of profits that may be agreed upon in an investor-state contract and that may be "stabilised" through the BIT. The latter aspect relates to the ability of governments to regulate FDI in a way that helps maximise the indirect profits of the investment. The specific contents of investor-state contracts may vary substantially and can obviously not be analysed here. If the competition between states for capital would be perfect competition (and countries would therefore be price-takers), the country could only "charge" marginal costs and the surplus would end up completely with the MNEs. However, it seems unlikely that the bargaining position of the host country is always weak compared to the MNE. If, for example, the market access is valuable to the MNE, because the MNE can profit through agglomeration rents, etc., a host country may very well have a certain amount of bargaining power vis-à-vis the MNE. In addition, many indirect (and immeasurable) benefits to the host state cannot be captured by the MNE. Nevertheless, even if it is assumed that investor-state contracts have a strong distributional bias in favour of MNEs, do Bilateral Investment Treaties strengthen these contracts via stabilisation provisions? This question relates to the umbrella clause and has already been addressed in section 3.3.3.5.3. As the OECD notes, the umbrella clause was not evaluated by an arbitral tribunal until the 2003 case SGS Société Générale de Surveillance, S.A. v. Pakistan.423 In that case, the tribunal concluded that breaches of investor-state contract clauses are not automatically breaches of international treaty law. A number of subsequent decisions employed a wider approach to the interpretation of the umbrella clause. For example, the tribunal in LG&E v. Argentina found that the umbrella clause "creates a requirement by the host State to meet its obligations towards foreign investors, including those that derive from a contract; hence such obligations receive extra protection by virtues of their consideration under the bilateral treaty."424 The case law at this point is not conclusive.425 Yet, tribunals have frequently granted BIT protection to investor-state contracts. Consequently, there is indeed a certain risk that contracts that have an inherent distributional bias in favour of investors are covered by international law.

423 424

425

OECD (2006), p.15. ICSID ARB/02/1, Decision on Liability (10/03/2006), paras. 169-175. Similar interpretations seem to have been applied in Noble Ventures v. Romania and SGS v. Philippines. See Dolzer and Schreuer (2008), p.156. Dolzer and Schreuer (2008) refer to “disturbingly divergent lines of jurisprudence.” Dolzer and Schreuer (2008), p.155.

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However, it has also been remarked that it is unclear whether this bias exists in the first place. Further, it has been estimated that fewer than half of all BITs actually contain an umbrella clause.426 5.4

Provisions and Evidence

A number of treaty provisions appear to be relevant in the context of institutional competition. Obviously, especially the non-discrimination clause may address preferential treatment of (domestic) interest groups and will be discussed in section 5.4.1. On the other hand, the scope of the fair and equitable treatment clause and the topic of indirect expropriation may have repercussions on the propensity of governments to enact regulation and are addressed in sections 5.4.2 and 5.4.3. Notwithstanding the actual treaty clauses, a threat of a regulatory chill requires that relevant regulatory policies have been challenged through BIT arbitrations. The problem of the regulatory chill may concern any issue area, but has so far been mainly discussed in the context of environmental regulation. Therefore – and also to keep the problem traceable – the discussion on the relevant case law will be limited to the cases that have so far been put forward in the environmental realm. This will be done in section 5.4.4. 5.4.1

Non-Discrimination

Evidently, especially the provisions in BITs that include standards of nondiscriminatory behaviour may impede the redistribution of rents from MNEs to domestic interest groups. The non-discrimination principle can be considered as an integral part of BITs. In many BITs, non-discrimination represents a standard of its own and is often combined with the fair and equitable treatment standard.427 The nondiscrimination principle is also implicit in a number of other typical BIT clauses. For example, the fair and equitable treatment certainly has a strong non-discriminatory connotation.428 In addition, non-discrimination is insured through a most-favourednation clause, which can be found in virtually all BITs. Most BITs combine the MFN clause with the national treatment standard.429 Also, the expropriation clause itself usually defines an act of expropriation as lawful if it was conducted in a nondiscriminatory manner. It has been mentioned before that the non-discrimination standard is a relative standard in the sense that it compares the treatment of the foreign

426 427 428 429

See section 3.3.3.5.3. Dolzer and Stevens (1995), p.62. This will be discussed in the following section. See for example Article 3 of the German Model BIT.

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investor to the treatment of domestic (or other foreign) investors.430 The verification of discriminatory behaviour in reality is certainly not a trivial task. For example, questions may arise as to the correct group of reference. Put differently, can a comparison only be drawn within an industry or also across industries and even sectors? In addition, Van Harten (2007) emphasises with regard to national treatment that to some extent, regulators must differentiate between the subjects of regulation.431 Furthermore, different interpretations exist concerning the relevance of discriminatory intent.432 Nevertheless, a number of cases with regard to NAFTA and also BITs have found the defendant in breach of some form of the non-discrimination principle. Examples include Feldman v. Mexico433, Lauder v. Czech Republic434 and Occidental v. Ecuador.435 5.4.2

Fair and Equitable Treatment (FET)

The fair and equitable treatment provision is among those most likely to be relied upon in an investment dispute with an investor.436 At the same time, the content and interpretation of the standard is still disputed.437 Section 3.3.3.5.1 has summarised the main criteria that have been employed in the context of the FET standard, including transparency and the protection of the investor’s legitimate expectations, freedom from coercion and harassment, procedural propriety and due process as well as good faith. Certainly, the FET standard also contains a non-discrimination element, such as that inherent in the good faith requirement. As the tribunal in Saluka v. Czech Republic underlined: “A foreign investor protected by the treaty may in any case properly expect that the Czech Republic implements its policies bona fide by conduct that is, as far as it affects the investor’s investment, reasonably justifiable by public policies and that such conduct does not manifestly violate the requirements of consistency, transparency, even-handedness and non-discrimination.”438 The language of the FET standards is broad enough to apply to virtually any adverse circumstance involving an investment. As Picherack (2008) emphasises, recent, more stringent requirements that

430 431 432 433 434

435

436 437 438

See Schreuer (2005), p.367. Van Harten (2007), p.86. Dolzer and Schreuer (2008), p.183. ICISD Case No. ARB(AF)/99/1, Award (December 16, 2002). Lauder v. Czech Republic, UNCITRAL, Final Award (3 September 2001), available under http://ita.law.uvic.ca/documents/LauderAward.pdf (September 5, 2010). Occidental Exploration and Production Company v. The Republic of Ecuador, LCIA Case No. UN3467, Award available under http://ita.law.uvic.ca/documents/Oxy-EcuadorFinal Award_001.pdf (September 5, 2010). Schreuer (2005), p.375. Picherack (2008), p.255. Saluka Investments v. The Czech Republic, Partial Award (17 March 2006), available under http://ita.law.uvic.ca/documents/Saluka-PartialawardFinal.pdf (September 5, 2010), para 307.

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tribunals have applied with regard to the FET standard create "greater risks that traditionally legitimate, good faith governmental regulatory, legislative, judicial, or administrative actions will be impugned simply because they have a negative impact on a foreign investment."439 The requirements the author criticises are the consideration of the legitimate expectations of the investor, a stable and predictable business and regulatory environment and total transparency of governmental regulations. Arguably, regulatory measures can nevertheless be structured so as not to be in breach with these requirements. According to Fauchald (2008) “(i)t is hard to argue that public authorities may need to take “unfair” or “inequitable” measures in order to achieve environmental protection."440 Nevertheless, a strict interpretation of the fair and equitable treatment clause may very well lead to a breach of the standard by measures taken in good faith, but lacking other criteria as defined by arbitral tribunals, such as due process. 5.4.3

Indirect Expropriation

The problem of indirect or regulatory expropriation has been introduced in section 3.3.3.6.1. Obviously, capital-exporting states are aware of the dangers of regulatory expropriation and include provisions in their BITs that demand compensation in these cases. For example, article 6 of the 2004 US Model BIT on expropriation and compensation explicitly covers indirect expropriations as well. These statutes are evidently not very precise and arbitral tribunals have struggled to find the right distinction between indirect expropriation and non-compensable regulation.441 The problem at hand is not unique to the international domain. Domestic courts have a long history of trying to define the appropriate border between regulation and regulatory taking.442 As summarised before, the different approaches used by tribunals are the Sole Effects doctrine, the Radical Police Powers doctrine and the Moderate Police Powers doctrine. The Sole Effects doctrine constitutes the most stringent interpretation on the occurrence of indirect expropriation, focusing exclusively on the effect of the measure on the investment. According to Fortier and Drymer (2004), enrichment of the host state and the deliberate targeting of the investor have in the past been taken as

439 440 441 442

Picherack (2008), p.272. Fauchald (2008), p.18. See Behrens (2006) for a recent overview. In German law, the so called “Naßauskiesungsbeschluss” of the Bundesverfassungsgericht (BVerfGE 58, 300) based on Art. 14 GG serves as the reference case. See Maurer (1999), p.678. Important US case law is discussed in Miceli and Segerson (1999). The problem is that the discussion cannot be simply transferred to the international domain. As has been emphasised in the case of land by Blume, Rubinfeld et al. (1984), compensation for expropriation in the domestic context is economically not necessarily justified. However, non-compensation of expropriation would fail to reflect the trade-offs countries face on the international level.

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signs of a regulatory taking by arbitral tribunals, while the promotion of the general welfare, as also contained in the US Model BIT, has been an indicator of a noncompensable regulation. Evidently, with regard to a regulatory chill, the Sole Effects doctrine can be problematic as it does not consider the intentions and purpose of the regulatory measure but only the effect on the investment. Tribunals have applied this doctrine, for example, in Biloune v. Ghana, Southern Pacific Properties v. Egypt and Metalclad v. Mexico.443 However, according to the OECD, the balanced (that is, Police Powers) approach is the predominant approach in practice.444 5.4.4

Evidence

5.4.4.1

Case Law

The discussions on non-discrimination, the FET standard and regulatory expropriation have underlined that BIT clauses have at least the potential to chill the regulatory efforts of developing countries. Much depends on the interpretation by tribunals. Nevertheless, considering the initial example of environmental regulation, the actual number of cases involving BITs is rather limited. As Fauchald (2008) notes: "It can be argued that BITs have existed for approximately fifty years and that few cases have come up in which there have been serious conflicts with environmental interests."445 Cases regularly cited by scholars expressing fears about a regulatory chill include especially the NAFTA cases mentioned in section 5.3.2.1. (Ethyl Corporation v. Canada, Methanex v. U.S., Metalclad Corp. v. Mexico, S.D. Myers v. Canada and Pope & Talbot Inc. v. Canada) and, with regard to BITs, the cases Azurix Corp. v. Argentine Republic (Azurix)446, Técnicas Medioambientales Tecmed, S.A. v. United Mexican States (Tecmed)447 and Compañía del Desarrollo de Santa Elena, S.A. v. Costa Rica (Santa Elena)448. It has been argued by Neumayer (2001) as well as Wälde and Kolo (2001) that the NAFTA cases do not frustrate efforts of governments to implement reasonable environmental regulations. For example, with regard to the Ethyl Case (which was actually settled before the tribunal reached a ruling), Neumayer (2001) points out that the case does not prove that governments cannot enact (environmental) regulation, but rather that "discriminatory measures can be successfully challenged under the investor-to-state dispute settlement provisions if

443 444 445 446 447 448

See Kriebaum (2007b), p.724. OECD (2004), p.15. Fauchald (2008), p.35. Miles (2008), p.13 and Fauchald (2008), p.18. See Tienhaara (2008a), p.140, fn 4. See Miles (2008), p.18 and Tienhaara (2008a), p.140, FN 4.

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they are justified with dubious reasons, environmental or not."449 Wälde and Kolo (2001) conclude with regard to the NAFTA cases mentioned: "It is only when the environment becomes a pretext for domestic protectionism and when elements of discrimination, of breach of governmental commitments or of use of regulation to extract benefits unrelated to the legitimate purpose of the regulation can be detected that a regulatory taking would, and should, be found."450 Can a similar claim be made regarding the relevant BIT cases mentioned above? The case Tecmed was filed with ICSID on July 28, 2000.451 In 1996, Tecmed, a Spanish company, acquired a landfill for hazardous industrial waste in the municipality of Hermosillo (which it operated under the name Cytrar). This landfill had, prior to the purchase, an unlimited licence to operate the landfill issued by the relevant regulatory agency, which was, after the purchase, replaced with a limited licence. The limited licence had a duration of only one year, but could be extended every year for an additional year. In 1998, the extension was not granted. Tecmed invoked arbitration under the BIT between Spain and Mexico based on numerous BIT provisions including expropriation, fair and equitable treatment and national treatment. As Mexico is not a signatory state of the ICSID convention, the case was handled under the ICSID Additional Facility. The refusal to grant the extension was seemingly based on the community opposition to the landfill.452 On May 29, 2003, the tribunal found the Mexican government's behaviour expropriatory and in breach of the fair and equitable standard and awarded 5,533,017.12 USD to Tecmed. Regarding fair and equitable treatment, the tribunal underlined that bad faith is not a prerequisite for a violation of this standard.453 In addition, the tribunal emphasised that the regulatory act was not directly driven by environmental considerations, but rather by strong community opposition to the landfill. In this regard, the tribunal states that "it is irrefutable that there were factors other than compliance or non-compliance by Cytrar with the Permit's conditions or the Mexican environmental protection laws and that such factors had a decisive effect in the decision to deny the Permit's renewal. These factors included 'political circumstances'."454

449 450

451 452 453 454

Neumayer (2001), p.89. Wälde and Kolo (2001), p.846. The Methanex case was at that time not decided, but the tribunal dismissed the claim in August 2005. See Methanex Corporation v. United States of America, Final Award (3 August 2005), available under http://ita.law.uvic.ca/documents/MethanexFinal Award.pdf (October 13, 2009). ICSID Case No. ARB (AF)/00/2, Award (May 29, 2003). ICSID Case No. ARB (AF)/00/2, Award (May 29, 2003), para 127ff. ICSID Case No. ARB (AF)/00/2, Award (May 29, 2003), para 153. ICSID Case No. ARB (AF)/00/2, Award (May 29, 2003), para 127. Original emphasis.

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In Azurix, the dispute related to a long-term contract as part of the privatisation process of water utilities between the province of Buenos Aires and the US company Azurix in 1999.455 Apparently, the contractual relationship was problematic from the start, but escalated in April 2000. Due to an algae bloom in the water reservoir, the water quality was greatly reduced. The authorities issued warnings to the population, prohibited Azurix from invoicing residents for the water and imposed a fine on Azurix. Subsequently, the company terminated its concession agreement and filed for bankruptcy. Azurix claims that the algae bloom was caused by a failure of the local authorities to provide the necessary infrastructure prior to Azurix taking over the responsibility for the algae removal works. The company filed for arbitration under the US-Argentina BIT, claiming, among other things, that Argentina's behaviour constituted indirect expropriation and violated the FET standard. The tribunal did not find indirect expropriation, but a breach of the FET standard. The interesting point is that the tribunal confirmed the view that failure of fair and equitable treatment does not require bad faith on the part of the defendant.456 Azurix was consequently awarded 165,240,753.00 USD. In September 2009, a tribunal repudiated the defendant’s attempt to have the award annulled. The Santa Elena case is remarkable as it concerns a direct expropriation that was not even denied by the defendant.457 The case was based on the US-Costa Rica BIT and concerned the expropriation of land that was located next to a National Park and had been acquired by the claimant to build a tourist resort. Aiming to preserve biodiversity, the government of Costa Rica expropriated the land in 1978. The claimant did not object to this act as such, but rather considered the amount of compensation to be insufficient. After long negotiations and legal proceedings in the domestic realm, the claimant filed for ICSID arbitration on June 2, 1995. As the lawfulness of the expropriation (and its nature of being for a public purpose) was not disputed, the sole function of the tribunal was to determine the amount of compensation. The tribunal argued that "(w)hile an expropriation or taking for environmental reasons may be classified as a taking for a public purpose, and thus may be legitimate, the fact that the Property was taken for this reason does not affect either the nature or the measure of the compensation paid for the taking."458 The award was finally set at 16,000,000.00 USD.

455 456 457 458

ICSID Case No. ARB/01/12, Award (July 14, 2006). ICSID Case No. ARB/01/12, Award (July 14, 2006), para 372. ICSID Case No. ARB/96/1, Final Award (February 17, 2000). ICSID Case No. ARB/96/1, Final Award (February 17, 2000), para 71.

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151

Analysis

It has been mentioned that serious conflicts based on BITs with regard to environmental issues are rare. In addition, the cases discussed in the previous section appear to have only limited potential to actually impact the regulatory behaviour of governments in the area of environmental regulation. For example, the Santa Elena case did not directly affect a regulatory measure but an outright expropriation. The approach of the tribunal is in principle in line with the eminent domain principles of most countries. It is therefore unclear how this case could induce policy-makers to abstain from environmental regulation in the future. In the Tecmed case, the behaviour of the government was strongly driven by political pressures, while a solid proof of actual environmental damages through the MNE activity was not provided. In addition, the award was, from a financial point of view, rather small (yet, reputational damages may be substantial in these cases)459. The Azurix case, although not strictly dealing with an environmental issue but rather an issue of public health, may indeed be problematic due to the high sanction and the explicit negligence of the good faith principle by the tribunal. In sum, the concern that Bilateral Investment Treaties may cause a regulatory chill cannot be completely rejected. However, the existing evidence in the realm of environmental regulation does not provide strong support for this thesis. If governments act in good faith and in a non-discriminatory manner, the risk of facing arbitrations against environmental regulation under BITs is low (but certainly not zero). The problem, however, may be more persistent in other issue areas.460 It is noteworthy that some developed countries have already taken specific steps towards strengthening the importance public purpose considerations, which underlines that the concern is taken seriously by policy-makers. The most prominent example in this regard is the 2004 US Model BIT.461 The amendments of the US Model BIT have been

459

460

461

High reputational sanctions may cause strong deterrence even if the probability of arbitration is low. A possible solution would be to increase confidentiality. This will be discussed in chapter 7. Argentina and the measures taken during the financial crisis are still a strongly-disputed example. However, as the caseload resulting from the financial crisis is inconclusive and not representative of "regular" BIT cases, Argentina's financial crisis was not discussed here. For an overview, see Burke-White (2008). The 2004 US Model Bit, Annex B, specifies: “(a) The determination of whether an action or series of actions by a Party, in a specific fact situation, constitutes an indirect expropriation, requires a case-by-case, fact-based inquiry that considers, among other factors: (i) the economic impact of the government action, although the fact that an action or series of actions by a Party has an adverse effect on the economic value of an investment, standing alone, does not establish that an indirect expropriation has occurred; (ii) the extent to which the government action interferes with distinct, reasonable investment-backed expectations; and (iii) the character of the government action. (b) 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.”

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preceded by similar developments in NAFTA, probably as a result of the United States and Canada finding themselves unexpectedly in the position of the defendant in a number of treaty claims.462 5.5

Discussion and Conclusions

Bilateral Investment Treaties are used by countries that compete for capital. However, while a BIT would not be concluded if it were not a Pareto-improvement for the two signatory states, the BIT regime as such may very well be Pareto-inferior for developing countries. If the elasticity of FDI flowing to developing countries is low, these countries find themselves inevitably in a prisoner's dilemma situation. This prisoner's dilemma situation can be interpreted as a result of a detrimental form of institutional competition. This competition may lead to sub-optimal results even if the assumption of inelastic investment is abandoned. The literature on institutional competition is vast, but contains two recurring concepts. One is the potential for institutional competition to act as a control mechanism when domestic inefficiencies prevent welfare-optimal policies; the other is the threat of an underprovision of public goods. In addition, the competitive situation may lead to a distributional bias of the surplus of the investment in favour of MNEs. If the latter two effects dominate and are reinforced by BITs, the BIT regime will leave developing countries worse off despite additional investment to developing countries as a group. On the other hand, a Paretoimprovement can be expected if BITs successfully exert a control function. That the incentives of governments may indeed deviate from the goal of welfare-maximisation is an assumption that is well accepted in the political economy of international trade law. However, BITs cannot be understood as reaping the benefits of the political support due to the reciprocal nature of the treaty. Yet, governments are likely to have higher discount rates and a propensity to redistribute rents to interest groups to the detriment of social welfare. Therefore, the time inconsistency problem, which theoretically concerns all countries that receive FDI, will be exacerbated if governments are unconstrained by domestic safeguards. In this case, a BIT will help align the incentives of governments and citizens. The content and also the interpretation of BITs certainly display elements of both manifestations of institutional competition.463 This is not surprising as richer models of institutional competition equally contain elements with countervailing welfare effects. While the (theoretical) ability of BITs to prevent governments from redistributing rents to domestic interest groups is obvious (yet difficult to apply in reality), the content and interpretation of BITs also have the ability to raise concerns regarding the 462 463

Van Aaken (2009), p.32. The answer to the question raised in the introduction of the chapter is therefore: both.

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ability of countries to enact welfare-enhancing regulation. Finally, the distributional dimension, which is mainly part of investor-state contracts and not BITs, is difficult to evaluate. The assumption that MNEs always have more market power is nevertheless unreasonable. In addition, the extent to which these agreements are actually covered by BITs is still disputed and additionally restricted by the limited spread of the umbrella clause. With regard to the specific example of environmental issues, the risk of an underprovision of the "public good regulation" was argued as being low. Nevertheless, some states have taken steps towards a specific emphasis of the public policy goals of regulatory measures. This implies that policy-makers take the threat seriously. This chapter argues therefore that, as far as the welfare of developing countries is concerned, BITs should foster the positive elements of institutional competition while mitigating the harmful effects. The question is therefore not if BITs should limit state sovereignty or national regulatory discretion as such - the question is rather how.464 More specifically, the BIT regime should rather focus on the abolition of internal inefficiencies without inducing a regulatory chill. Put differently, discriminatory behaviour requires sanctioning, while the public purpose and good faith of any measure should certainly be taken into account. The concept of legitimate expectations might be a good approach that captures this idea. This conclusion is perfectly in line with the judgement of Van Aaken (2009), yet the argument presented here emphasises a different aspect. In Van Aaken (2009), the optimal trade-off between commitment and flexibility was compromised by the lack of adequate measures in BITs or the far-reaching interpretations by tribunals. The argument presented here is rather that this trade-off is not necessarily distorted as under certain circumstances, even the Sole Effects doctrine may be Pareto-efficient for the treaty partners.465 The problem stems from the competitive interactions of the involved countries and is therefore a systematic problem rather than a problem of treaty design. At the same time, this competition may have beneficial effects as long as FDI flows to developing countries are not completely inelastic. That developing countries find themselves in a prisoner's dilemma is therefore questionable. In any case, improvements of the BIT regime along the lines outlined above would certainly

464 465

If BITs did not limit regulatory discretion at all, they would be useless in the first place. Namely, if the Sole Effects doctrine induced a lot of additional FDI and the benefits of this FDI offset the opportunity costs of regulation. In addition, the argument here does not rest on a trade-off in the sense of a relationship along a single variable. The problem of investment protection has several dimensions and the point is rather, as explained below, that it is beneficial to strengthen certain aspects of commitment, while loosening others. This would not be possible if investment protection only had one dimension. Nevertheless, the notion of a trade-off is not completely misplaced.

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be beneficial under the development aspect. Nevertheless, as Van Aaken (2009) rightly emphasises, it is mainly the few countries where reciprocity (e.g., in the context of NAFTA) has played a role that have adapted their treaty design to ensure the lawfulness of measures taken in support of the public purpose. Whether this step will be followed by capital-exporting countries that face a low risk of being subjected to investment arbitrations remains to be seen.

6

BITs and Institutional Quality

Bilateral Investment Treaties are designed to increase investment flows to the signatory states. Section 4.2.1, reviewing the empirical evidence regarding BITs, revealed that some studies have found robust evidence that BITs indeed have a positive impact on investment flows. In addition, BITs might not only fulfil their stated purpose of attracting FDI but may also have external effects on domestic institutional quality. These external effects have been suggested to be either of a positive or negative nature. As the importance of institutional quality on economic growth has been emphasised by a number of authors,466 the question of an interaction between BITs and domestic institutional quality is of high relevance. This chapter addresses the question of the interplay between BITs and institutional quality using panel data in a fixed effects model. Specifically, we run regressions using the World Governance Indicators as the dependent variable over the time period 1996 to 2007 for non-OECD countries. The number of BITs and changes in domestic regulation in the field of investment are utilised as independent variables. The analysis further controls for GDP per capita, FDI inflows, trade openness, development aid and membership of the ICSID convention. The chapter will proceed as follows: Section 6.1 introduces the competing theories, explaining why one might expect BITs to have a negative or positive impact on domestic institutions. Section 6.2 describes the model and the data that are used to test this impact and displays the results. Section 6.3 presents potential problems with regard to the results of the regressions. Section 6.4 discusses the results and presents a conclusion. 6.1

The Effect of BITs on Institutional Quality

6.1.1

Some Theory

What are the benefits of Bilateral Investment Treaties? The stated purpose of BITs is the "encouragement and reciprocal protection of investment."467 A number of empirical studies suggest that BITs accomplish this purpose.468 While FDI is, by now, generally associated with positive effects on economic development, it has been suggested that BITs might be detrimental to the welfare of developing countries who

466 467 468

See, e.g., Rodrik, Subramanian et al. (2004). See, e.g., the US Model BIT or the German Model BIT. See section 4.2.1.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_6, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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find themselves in a prisoner's dilemma situation.469 This point was discussed in the previous chapter. The argument was that individually, developing countries can attract additional investment through the conclusion of a BIT. However, this investment constitutes merely a diversion from one developing country to another. As a group, developing countries would be better off without any BITs. This argument falls into the discussion of the problems and merits of institutional competition. Chapter 5 also pointed out that it has been suggested that FDI as such may have a negative or positive impact on certain government policies in the sense of a race to the bottom or a race to the top, e.g., in the area of tax policy.470 The preceding chapter tried to answer whether BITs support the negative or the positive aspects of institutional competition. This chapter deals with a different, yet closely related issue, namely the specific impact of BITs on institutional quality. The analysis goes beyond the question of whether BITs can have immediate effects like a regulatory chill or the prevention of discriminatory government behaviour, but rather asks what effects BITs may have on institutional quality in general. Certainly, in the discussion presented below on the interplay between BITs and domestic institutions, arguments related to the theory of institutional competition will also play a role. However, the primary thrust of this chapter is a general and fundamental discussion on the causes of the quality of institutions. The BITs are in this context not analysed as being a direct manifestation of institutional competition, but rather as exerting a (mainly unintended) external effect on institutional quality. The idea that the effect of BITs on institutional quality may be negative was first put forward by Daniels (2004).471 The author argues that the BIT "has systematically diverted the interests of potentially influential foreign investors from demanding the creation of good generalised laws and legal institutions, and has further encouraged them to enter into long term arrangements that impair the state's capacity to regulate effectively in the public interest and which further increase the risk of corruption and abuse."472 The argument rests on two pillars. The first relates to the well known importance of exit and voice in the political process as put forward by Hirschman (1970). Daniels asserts that in "Hirschmann's terms, the BIT enclave enables foreign investors to exit from domestic legal regimes and this, in turn, implies a withdrawal of their voice from the domestic debate over the need for, and character of, good laws

469 470

471

472

Guzman (1998). See Basinger and Hallerberg (2004) and the literature mentioned therein. The authors themselves develop a model that implies that a race to the bottom will in many specifications not occur. See also Sinn (2003). While the article of Daniels (2004) is only a working paper, it has been noticed and cited by other authors in the field. See, e.g., Franck (2007) and Dammann and Hansmann (2008). Daniels (2004), p.37.

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and legal institutions."473 This logic can obviously be taken one step further: if the institutional quality does not matter to investors that are protected by a BIT, the relevant state has no incentive to improve the quality to attract investment in the first place. The second pillar relates to the influence of domestic political elites. In this respect, Daniels argues that "the BIT allows domestic political elites to access foreign capital but without having to abide any restrictions on the exercise of their political power by independent courts that would be required were a more general set of rule of law reforms enacted."474 In other words, the author suggests that domestic elites profit from BITs and, as a consequence of the existence of BITs, have an incentive to frustrate legal reform. Ginsburg (2005) follows a line of reasoning similar to Daniels (2004). He argues that, under some circumstances, BITs can lead to reductions in governance quality. The reason is that BITs allow foreign investors to bypass domestic courts. This may reduce the courts' incentives to improve performance. In addition, the existence of BITs allows "the government to segment its reputation among domestic and foreign actors."475 A third point that might lead to a reduction of institutional quality is that, under certain circumstances, foreign investors may "exacerbate corruption and poor governance".476 A problem with this line of reasoning is that it implicitly assumes that foreign investors have a significant influence on domestic processes, either through their mere participation in the market or their own lobbying efforts. This assumption might be challenged on the grounds that the very reason BITs exist is that investors are not very powerful when operating in foreign counties. As Ginsburg (2005) acknowledges, an argument can also be made that the adoption of BITs leads to higher (perceived) institutional quality.477 First, BITs contain specific provisions to prevent behaviour that might be considered as bad governance (e.g., fair and equitable treatment standards) and also provisions that may cause a reduction of rent-seeking efforts (e.g., national treatment clauses). As Dolzer (2005) notes: "[…], reformers in developing countries nevertheless see these treaties as powerful tools for the modernisation of the domestic administrative legal system, providing effective external checks and discipline on deficiencies and shortcomings which may be difficult to agree upon and to implement at the domestic level."478 Second, BITs may induce domestic courts to engage in some kind of regulatory competition with international arbitration.479 A plausible argument

473 474 475 476 477 478 479

Daniels (2004), p.25. Daniels (2004), p.25. Ginsburg (2005), p.119. Ginsburg (2005), p.119, referring to Hellman, Jones et al. (2003). Ginsburg (2005), p.119. Dolzer (2005), p.972. Ginsburg (2005), p.119.

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might also be that domestic investors lobby against the discrimination that they might face vis-à-vis foreign investors and thus pressure for an improvement of domestic institutional quality. The view that BITs can help promote the rule of law in developing countries seems to enjoy - hardly surprising - some sympathy in the arbitration community. In a speech at the University of Richmond, prominent arbitration lawyer Jan Paulsson asserts in relation to investment protection treaties: "Others write that such treaties are false promises because it is not demonstrable that they actually lead to more foreign investment. But what if they 'merely' lead to better justice – say in Mexico, where in the wake of NAFTA we are told that officials have developed the salutary instinct of avoiding conduct which might be criticised in an international forum: a direct case of compliance pull to the benefit of local citizens. And I confess impatience with some writers – apparently chained to their desks – who criticise arbitration because, they posit, the availability of decent justice in international arbitration stunts the development of good practices in national courts!"480 6.1.2 Empirical Literature The empirical question that results from this discussion is: can we identify an influence of investment treaties on institutional quality? Ginsburg (2005) runs empirical tests to verify this hypothesis. He finds that for the rule of law, as reported in the Worldwide Governance Indicators, BIT adoption leads to a subsequent decline of quality. More specifically, Ginsburg uses the changes in government effectiveness, regulatory quality, rule of law and corruption control for the years 1998, 2000 and 2002 as the dependent variable. The independent variable is a dummy variable for each country that adopted a BIT in 1995 or 1996. The author controls for GDP per capita, democracy and political stability. However, the empirical results are rather weak. Apart from Ginsburg, this question has not been addressed empirically. Also, while studies of the effects of institutional quality on economic development are legion481, less effort has been spent to evaluate the (empirical) determinants of institutional quality. Nevertheless, a number of factors have been identified that shape domestic institutions. Especially in the field of corruption, scholars have tried to discover the causes of this phenomenon. One study addresses the effect of FDI on corruption directly: Kwok and Tadesse (2006) find that, controlling for a number of factors and checking for reverse causality, corruption is lower in countries that experienced high FDI inflows in the

480 481

Paulsson (2007), p.12. See, e.g., Knack and Keefer (1995), Rodrik, Subramanian et al. (2004) or Barro (2003).

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past. In addition, the authors "find strong evidence that the harmful effects of culture on corruption are lower and the beneficial effects of education on corruption are higher in countries with higher FDI in the past."482 In a well-known cross-national study, Treisman (2000) analyses several indexes of perceived corruption. He identifies six factors that influence the level of corruption, finding that federalism leads to more corruption. In addition, countries with Protestant traditions, histories of British rule, more developed economies, and higher imports were perceived to be less corrupt. Surprisingly, perceived corruption is not positively related to the current level of democracy. Only a long tradition of democracy could be shown to have a positive (that is, reducing) impact on corruption. Serra (2006) provides a sensitivity analysis on the empirical determinants of corruption as identified by the literature. He confirms the robustness of five variables: political instability leads to more corruption, while a long democratic tradition, economic development and a high fraction of Protestants among the population as well as British colonial history are associated with lower corruption. Persson, Tabellini et al. (2003) examine the influence of electoral rules on corruption. Analyzing the variation across countries, they find that certain aspects of the electoral system have an impact on corruption. Even more interesting, the authors also look at the time variation of the data using a panel analysis with country fixed effects. It appears that increasing the legislators individually accountable under plurality rule as well as increasing district magnitude reduces corruption. Other studies have not limited their focus on corruption, but include other measures of institutional quality like indexes of the rule of law or expropriation risk. Berkowitz, Moenius et al. (2005) find that signing the New York Convention, especially without reservations, has a positive and statistically significant influence on the rule of law.483 Further, signing the convention reduces expropriation risk as well as corruption. An influential paper on the quality of institutions is La Porta, Lopez-de-Silanes et al. (1999). In a cross-country study, the authors examine a wide array of performance indicators for governments, including corruption and property rights indexes.484 The authors find that ethnolinguistic heterogeneity, legal origins and religion have a significant influence on government performance. In sum, countries that are poor, closer to the equator, ethnolinguistically heterogeneous, use French socialist law and

482 483

484

Kwok and Tadesse (2006), p.781. As mentioned before, the New York Convention, officially known as the Convention on the Recognition and Enforcement of Foreign Arbitral Awards, is an international treaty that requires all Member States to enforce arbitration awards issued outside their own jurisdiction without reviewing these awards through their own courts. The treaty was signed in 1958 and currently has 142 signatory states. But also more objective indicators of government performance like the size of the public sector, the infant mortality rate or the illiteracy rate.

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BITs and Institutional Quality

have large proportions of Catholics or Muslims tend to have worse governments. Comparable results have been obtained by Hall and Jones (1999). Looking primarily at the question of why some countries are more productive than others, the authors find that differences are mainly driven by government policies and institutions, which they call social infrastructure. This social infrastructure is, in turn, positively associated with distance from the equator, trade share, the fraction of the population speaking English and, alternatively, the fraction of the population speaking a European language other than English. Another variable that has been identified as influencing the quality of institutions is development aid. Knack (2001) shows that aid has a negative impact on governance quality (measured as a combined index of corruption in government, bureaucratic quality, and the rule of law). In a similar vein, Djankov, Montalvo et al. (2005) test the influence of aid on democracy and find a negative impact of aid. 6.2

Model and Data

6.2.1

Fixed-Effects Model

To assess the relationship between institutional quality and BITs, a panel-data model with fixed effects is used. Specifically, the following regression is estimated:

Institutional Qualityit=0 + 1BITsit + 2Controlsit + countryi + yeart+it

where i denotes country i, and t denotes year t. The variables countryi and yeart are dummy variables for each country and each year respectively. Expressed verbally, annual frequency data is used to examine the within-country effects of BITs on institutional quality. In most specifications of the model, the independent variables are lagged by one period (t-1).

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161

Fixed-effects panel models are now widely used in economics.485 A fixed-effects model allows for different intercepts for different groups of observation (in this case, different countries) and thus controls for unobserved (time-invariant) country effects. The fixed-effects model is especially suited to analyse dynamic adjustment. One advantage for our purpose is that non-time varying omitted variables that jointly influence the amount of BITs and the quality of governments do not pose any problems in this set-up. The reason is that the very nature of the fixed-effects models eliminates any non-time varying variables from the regression. The logic is quite simple: in a fixed-effects model, a dummy variable for each individual country is included. This dummy does not vary over time and must therefore be perfectly collinear with any non-time varying characteristic of the country, e.g., a dummy for civil law tradition or British colonial past. Nevertheless, the country dummy is needed to allow for different intercepts for each country. In essence, fixed-effects models do not explain differences or deviations between groups (here, countries) but deviations of variables from their mean within groups. Put differently, a fixed-effects model cannot so much tell us why the level of corruption is high in India and low in Finland, but it can shed light on the question if a change in corruption in India was associated with a change of some other variable (here, Bilateral Investment Treaties) in India. Put differently: did the fact, that India had 5 ratified BITs in 1996, but 47 in 2006 have any impact on or relation to institutional quality?486 In most specifications, a time-fixed effect is also included to control for events that affected all recorded values of institutional quality in a given year. All regressions use robust standard errors (clustered by country), allowing for serially correlated disturbances.487

485

486 487

An alternative approach would be to use a random-effects model. The random-effects model also allows for different intercepts, yet interprets them as being randomly drawn from a normal distribution. The advantage compared to the fixed-effects model is that the random-effects model uses fewer degrees of freedom and produces a more efficient estimator. However, the random effects estimator is biased when its composite error term is correlated with the explanatory variables. In the current case, there is a strong theoretical case for the fixed effects: as we are dealing with countries, it is very likely that there are unobserved country-specific effects that can be controlled for using the fixed-effects model. In addition, the fixed-effects approach is usually appropriate when the data exhausts the whole population or there is selection bias as opposed to drawing a sample from a large population (see Kennedy (2003), p.312). Especially, the fixedeffects approach primarily uses the variation within groups (countries), which is exactly the information of interest here. Finally, virtually all new panel data studies analyzing panel data in relation to different countries employ the fixed-effects model. See, e.g., Tobin and Rose-Ackerman (2006), Rodrik and Wacziarg (2005) or Büthe and Milner (2008). See Kennedy (2003), p.301ff, for a good comparison of fixed- and random-effects models. Figures are based on own counting using the country lists of BITs as provided by UNCTAD. This appears to now be the conventional approach in fixed-effects panel studies. See also Bertrand, Duflo et al. (2004). For the exact method employed here, see Cameron and Trivedi (2009), p.233

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BITs and Institutional Quality

The short literature review on the empirical determinants of institutional quality showed that many if not most empirical determinants as identified by the literature are time-invariant. Geography (e.g., distance to the equator), culture (e.g., language or religion), history (e.g., colonial past) and legal tradition (e.g., common law) do not or only marginally change over time. Consequently, these determinants cannot be included in the fixed-effects model.488 The focus is therefore on the explanatory variables that have at least some variation over time. These variables are discussed in the following section. Before that, however, some words with regard to sample selection are in order. The following regressions only consider countries that are not rich.489 Similar to the World Bank classification, a rich country is defined as having more than $ 11,115 of GDP per capita.490 The reason is that BITs remain to be a tool for developing countries. Although they are no longer only concluded between developed states on the one side and developing states on the other side, BITs are never concluded between two developed states. Bilateral Investment Treaties are obviously also binding for rich countries as they are reciprocal in nature. Nevertheless, in practice the focus is on the encouragement and protection of investment in developing countries. This is also reflected in the research design of the main studies analyzing the effects of BITs on FDI.491 Therefore, it does not seem unreasonable to assume that the effect of BITs on institutional quality, if existent, mainly affects low and middle income countries. 6.2.2

Variables

6.2.2.1

Dependent Variables

For the quality of institutions, a set of perception-based indicators called the Worldwide Governance Indicators (WGI) is used. The WGI are collected by World Bank economists Daniel Kaufmann, Aart Kray and Massimo Mastruzzi. The notion of "perception-based" refers to the fact that a score is given to countries depending on one or more surveys that ask for the subjective estimation by investors, experts, development agencies etc., on the situation in a given country. The indicators are divided into six subcategories: Voice and Accountability, Political Stability and

488

489 490

491

and p.251ff. Indeed, running test statistics as described in Drukker (2003) revealed serial correlation in the error terms. And could reveal nothing about the source of changes in institutional quality anyway. For a good overview on panel data, see Kennedy (2003), chapter 17 or Verbeek (2000), chapter 10. A similar approach is taken by Büthe and Milner (2008) albeit excluding OECD countries. Actually, the World Bank uses GNI per capita. However, these data were not available and the difference in sample selection should be negligible. See, e.g., Neumayer and Spess (2005) or Hallward-Driemeier (2003), both focussing on the FDI flow to developing countries only.

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163

Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption.492 Regressions are run for four of these categories that seem most relevant, namely the Government Effectiveness index, the Regulatory Quality index, the Rule of Law index and the Control of Corruption index. The data are available for up to 212 countries for the years 1996 to 2008 (depending on the country).493 Data are coded from –2.5 (worst) to +2.5 (best).494 6.2.2.2

Independent Variables

The independent variables of interest are Bilateral Investment Treaties and domestic regulations in investment law. The BIT variable is simply the number of BITs of a given country in a given year.495 We use the BITs that are ratified and not only signed because a non-signed BIT is comparable to "cheap talk" in game theory: it is communication (a signal) between players that does not affect payoffs.496 The number of BITs is logged. A similar approach is taken by Tobin and Rose-Ackerman (2005). Logs have the advantage that the results are not driven by a few influential data points.497 In another specification of the variable, the sum of ratified BITs in three preceding years (respectively) is calculated. This variable is supposed to account for the possibility that BITs only exert short term or signalling effects (as the dependent variable is perceived institutional quality) of statistical significance. The BIT variables were constructed for the years 1992 to 2006. The domestic regulation variable is the sum of changes in investment law with an expected favourable impact on FDI minus the changes with an expected unfavourable impact on FDI. These data are collected by UNCTAD and submitted to the relevant state for verification. They are regularly used as an indicator for trends in FDI policies in UNCTAD's World Investment Report.498 Eight areas of national FDI policies are incorporated in this statistic: foreign ownership, sectoral restrictions, approval procedures, operational conditions, foreign exchange, promotions (including incentives), protection (including guarantees) and corporate regulation (stock

492 493 494 495

496 497

498

These subsets are also used in Ginsburg (2005). No values are available for 1997, 1999 and 2001. With a few outliers scoring less than –2.5. The numbers for each country were compiled using the country lists of BITs available on www.unctad.org See the discussion in chapter 4. This also accounts for the idea that the marginal effect of an additional BIT/regulation is decreasing. A general disadvantage is losing data points with the value of zero. However, in the given data set, this is not a concern as virtually all countries have a positive number of BITs in the first year included. The transformation employed here is that one BIT was added to the cumulative number of BITs before taking the natural log. See, e.g., UNCTAD (2007a), p.14.

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BITs and Institutional Quality

exchange/ financial market laws). The major drawback for analytical purposes of these figures as well as for the BIT variable is that the numbers are unweighted: one major change in domestic regulation might have the same impact as a number of minor changes. Equally, a BIT with a large, rich country might have a much bigger impact on institutional quality than a BIT with a small developing country. This makes the interpretation of coefficients difficult if not impossible. Nevertheless, it can still be observed if these variables have an impact at all and if this impact is of a negative or positive nature. In any case, the use of this variable is not so much to identify the impact of these regulatory changes on institutional quality, but to have a control for the domestic reform activities of the relevant country. The UNCTAD figures appear to be a good proxy for that. The number is logged or summed over three years, depending on specification, for the same reason and using the same technique as the BIT variable. Data were available from UNCTAD (upon request) for the time period of 1992 to 2006. The control variables are essentially the time-varying variables that have been shown to influence the quality of institutions. GDP per capita is used as a measure of a country's economic performance, aid as a percentage of GNI as a country's dependency on foreign aid and the value of imports of goods and services as a share of GDP as a measure of a country's trade openness. Further, it has been argued that the amount of FDI may have an impact on the quality of government.499 Clearly, a reversed effect can be expected: countries with higher institutional quality attract more FDI. Following the convention in empirical studies using these data, the values for GDP per capita and FDI are used as natural logs. All the figures are taken from the World Bank's World Development Indicators. Finally, a dummy for the ratification of the ICSID Convention is included to control for the possibility that not the BITs themselves but the legal enforcement through ICSID is important for the (perceived) institutional quality. In most specifications, the independent variables are lagged by one period (year) to account for a lagged adjustment of the perception-based indicator (or, in the case of BITs, that the treaty is ratified at the end of the year).

499

See Jensen (2006), chapter 4 and Kwok and Tadesse (2006).

BITs and Institutional Quality

6.2.2.3

165

Overview Variable Name

Description

Source

Regulatory Quality

the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development

Worldwide Governance Indicators

Government Effectiveness

the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies

Worldwide Governance Indicators

Rule of Law

the extent to which agents have confidence in and abide by the rules of society, in particular the quality of contract enforcement, the police, and the courts, as well as the likelihood of crime and violence

Worldwide Governance Indicators

Corruption Control

the extent to which public power is exercised for private gain, including petty and grand forms of corruption, as well as “capture” of the state by elites and private interests

Worldwide Governance Indicators

BITs

Number of ratified Bilateral Investment Treaties (logs and averages)

Own Composition based on UNCTAD

Domestic Regulation

Differential of positive (FDI friendly) and negative (FDI hostile) changes in domestic investment regulation (logs and averages)

Own Composition based on UNCTAD

GDP per capita

Gross Domestic Product divided by population World Development (logs) Indicators

FDI

Inflows of Foreign Direct Investment (logs)

World Development Indicators

Aid

Development Aid (% of Gross National Income)

World Development Indicators

Trade

ICSID Convention

Measure of Trade Openness: value of imports World Development of goods and services as a share of GDP Indicators Dummy Variable for the ratification of the ICSID Convention

ICSID

166

6.2.3

6.2.4

BITs and Institutional Quality

Summary Statistics Variable Name

Mean

SD

Min

Max

Regulatory Quality

-0,282

0,762

-3,175

1,505

Government Effectiveness

-0,356

0,665

-2,109

1,491

Rule of Law

-0,403

0,704

-2,274

1,545

Corruption Control

-0,392

0,639

-2,084

1,616

BITs (log)

1,815

1,204

0

4,489

Domestic Regulation (log)

1,302

1,047

0

4,934

GDP per capita (log)

7,036

1,230

4,034

9,315

FDI Inflow (log)

18,823

10,667

0

25,654

Development Aid

7,233

40,631

0

124,349

Trade Openness

83,818

2,553

10,831

316,740

ICSID Convention

0,696

0,460

0

1

Regulatory Quality and the Rule of Law

The following table displays the regression results for regulatory quality from the World Development Indicators as the dependent variable:500

500

All regressions are calculated using STATA, version 10.

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167

Dependent Variable: Regulatory Quality -IBITs (log)

-II-

-III-

-IV-

BITs in t-1 (log)

-0.0737*

-0.0681

-0.0620

(0.0424)

(0.0428)

(0.0431)

BITs (sum 3 years) Domestic Regulation (log)

0.0992***

0.133***

(0.0374)

(0.0392)

0.847***

0.803***

0.738***

0.845***

0.552***

(0.179)

(0.168)

(0.180)

(0.179)

(0.155)

0.00632** (0.00260)

0.00743*** (0.00223)

0.00596** (0.00271)

0.00766*** (0.00239)

0.00592** (0.00232)

-0.000620 (0.00135)

-0.000678 (0.00129)

-5.94e-05 (0.00139)

-0.000290 (0.00136)

-0.00127 (0.00137)

0.0336*** (0.0118)

0.0320** (0.0126)

0.0302** (0.0122)

0.0337*** (0.0121)

-0.000885 (0.00116)

0.0471*** (0.0124)

FDI Inflow in t-1 (log) -0.0233 (0.0826)

ICSID Convention in t-1 -8.409*** -1.431 Observations 932 Number of Countries 133 Time Effects Yes R-squared (within) 0.212 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

(0.0299)

0.00862*** (0.00288)

Trade Openness in t-1

ICSID Convention

-0.00658

0.991*** (0.193)

Development Aid in t-1 (%GNI)

FDI Inflow (log)

(0.0430)

0.00559 (0.00773)

GDP per Capita in t-1 (log)

Trade Openness

-0.149***

0.108*** (0.0408)

Domestic Regulation (sum 3 years)

Development Aid (%GNI)

-VI-

0.00369 (0.00371)

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-V-

-0.0538 (0.0463)

0.00420

0.0103

0.0453

-0.0138

-0.0115

(0.0844) -6.626*** -1.242 1045 133 Yes 0.171

(0.0870) -6.202*** -1.201 1124 140 Yes 0.132

(0.0808) -5.794*** -1.306 1105 133 Yes 0.152

(0.0837) -6.609*** -1.259 1063 133 Yes 0.148

(0.0857) -4.364*** -1.026 1045 133 No 0.091

The number of countries and the number of observations is not constant as a result of missing data. In general, data were used for the time frame of 1996 to 2007.501 Here

501

No data for the dependent variable are available for 1997, 1999 and 2001, so these years are excluded from the regression. The control variable domestic regulation was only available until 2006. Therefore, the first, non-lagged specification covers the years 1996 to 2006, the lagged specifications cover the years 1996 to 2007.

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BITs and Institutional Quality

and in the following tables, robust standard errors (clustered by country) are reported in parentheses below the coefficients. The first column reports the values for the nonlagged variables, while one-year lags are used in all other columns. Columns 2 to 5 vary with regard to the selection of control variables. Column 6 differs from the rest of the estimations as it does not include time effects, which are by now standard in empirical panel studies.502 The first observation that can be made is that the control variables are often significant and mostly point in the expected directions. Domestic legislation and GDP per capita are robustly and positively related to institutional quality. The same is true for FDI inflows (if lagged) and development aid. The latter might be surprising as some commentators have emphasised the negative impact of aid on institutional quality.503 Trade Openness is significant only in some of the specifications. The negative sign is not surprising as trade and FDI may often substitute each other.504 Signing the ICSID convention has a positive coefficient but lacks statistical significance. The second important observation is that the variable of interest, the BIT variable, indeed has negative coefficients. However, the variable is not significant in most specifications of the model. Statistical significance can only be observed in two of the regressions. First, significance at the (low) 10% level can be observed with the full set of controls in the lagged model.505 Yet, this result proves to be very dependent on the structure of the controls: omitting either Domestic Regulation or FDI Inflows from the regression leads to a disappearance of significance. Second, the BIT variable is statistically relevant at the 1% level when the time effects (time dummies) from the regression (column VI) are excluded. However, year dummies are standard in modern panel data studies as they have an important function: they eliminate common effects that affect all data points in a given year. Especially in the example of perception based indicators, year dummies appear to be important: the compilation of the indices may differ between years for technical reasons. For example, compilation weights of the used surveys might have been adapted; certain surveys may have been taken into account while others were removed etc. In addition, political factors that affect all or most countries in a given year which cannot be controlled for may have influenced the overall perceptions of institutional quality. Finally, it can be acknowledged that the average number of ratified BITs in the preceding three years (column V) has a positive sign but is not significant at all. It

502 503 504 505

Examples include Neumayer and Spess (2005) and Dreher and Voigt (2008). See, e.g., Djankov, Montalvo et al. (2005). See section 2.2. Sometimes, significance at the 10% level is not even reported as the 5% threshold is usually considered to indicate statistical significance.

BITs and Institutional Quality

169

appears therefore that the ratification of many BITs has no immediate signalling effect in the sense that it positively affects the perception about the institutional quality of a country.506 The estimation results for government effectiveness are very similar to the results for regulatory quality and are reported in Appendix D. The following table displays the results for the rule of law index:

506

This also holds also true when using a two year average.

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BITs and Institutional Quality

Dependent Variable: Rule of Law -IBITs (log)

-II-

-III-

-IV-

-0.0575*

-0.0554*

-0.0528

(0.0325)

(0.0321)

(0.0326)

BITs in t-1 (log) BITs (sum 3 years) Domestic Regulation (log)

0.0339

0.0580**

0.00539

(0.0249)

(0.0254)

(0.0255)

0.458*** (0.144) 0.290**

0.334**

0.274**

(0.143)

(0.121)

(0.141)

(0.108)

0.00435** (0.00188)

0.00462** (0.00211)

0.00400** (0.00162)

0.00597*** (0.00225)

0.00455*** (0.00172)

-0.00206** (0.000971)

-0.00158 (0.00101)

-0.00151 (0.00103)

-0.00172* (0.00100)

-0.00224** (0.000970)

0.0264*** (0.00892)

0.0291*** (0.00845)

0.0232*** (0.00849)

0.0252*** (0.00826)

(0.000828)

0.0166 (0.0106)

FDI Inflow in t-1 (log) 0.0684 (0.0653)

ICSID Convention in t-1 -3.679*** -1.045 Observations 926 Number of Countries 133 Time Effects Yes R-squared (within) 0.090 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

0.231

(0.141)

-0.00239***

Trade Openness in t-1

ICSID Convention

0.353** 0.00352** (0.00146)

Development Aid in t-1 (%GNI)

FDI Inflow (log)

(0.0284)

0.00125 (0.00242)

GDP per Capita in t-1 (log)

Trade Openness

-0.0848***

0.0423 (0.0265)

Domestic Regulation (sum 3 years)

Development Aid (%GNI)

-VI-

0.00202 (0.00220)

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-V-

-0.0405 (0.0317)

0.0363

0.0383

0.0653

0.0226

0.0340

(0.0550) -3.249*** -1.091 1039 133 Yes 0.088

(0.0559) -2.324** -1.027 1115 140 Yes 0.065

(0.0544) -2.416*** (0.893) 1099 133 Yes 0.061

(0.0576) -2.994*** -1.032 1057 133 Yes 0.078

(0.0547) -2.485*** (0.750) 1039 133 No 0.072

BITs and Institutional Quality

171

As before, the BIT variable has a negative sign, but shows only a very weak significance that is not robust to changes in the specification. Again, truly significant results (at the 1% level) can only be obtained without year dummies. The other control variables mostly display the same patterns as in the other regressions (government effectiveness, regulatory quality).

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BITs and Institutional Quality

6.2.5

Corruption

Dependent Variable: Corruption Control -IBITs (log)

-II-

-III-

-IV-

-0.0279

-0.0125

-0.0220

(0.0349)

(0.0350)

(0.0345)

BITs (sum 3 years)

(0.00208) (0.0285) 0.0478 (0.0304)

0.0659** (0.0290) 0.00119

0.375** (0.150) 0.167

0.347**

0.263**

(0.138)

(0.145)

(0.149)

(0.118)

0.00395** (0.00185)

0.00491** (0.00201)

0.00324* (0.00181)

0.00566*** (0.00212)

0.00370** (0.00162)

-0.00198**

-0.00151

-0.00175*

-0.00150

-0.00211**

(0.000946)

(0.000944)

(0.00100)

(0.000975)

(0.000925)

-0.00223*** (0.000710)

0.0204** (0.00978)

FDI Inflow in t-1 (log)

0.00592

0.00693

0.00417

0.00540

(0.0110)

(0.0103)

(0.0108)

(0.0112)

0.197** (0.0784)

ICSID Convention in t-1 -3.334*** -1.064 Observations 912 Number of Countries 133 Time Effects Yes R-squared (within) 0.102 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

0.289**

(0.152) (0.00176)

Trade Openness in t-1

ICSID Convention

0.342** 0.00478***

Development Aid in t-1 (%GNI)

FDI Inflow (log)

0.0169 (0.0230) (0.00337)

GDP per Capita in t-1 (log)

Trade Openness

(0.0332)

0.0748***

Domestic Regulation (sum 3 years)

Development Aid (%GNI)

-0.0595* 0.00357*

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-VI-

(0.0338)

BITs in t-1 (log)

Domestic Regulation (log)

-V-

-0.0295

0.159**

0.163**

0.168**

0.155**

0.151**

(0.0750)

(0.0768)

(0.0704)

(0.0764)

(0.0736)

-2.795** -1.079 1026 133 Yes 0.063

-2.573** -1.044 1101 140 Yes 0.051

-1.647 -1.072 1085 133 Yes 0.047

-2.850*** -1.063 1044 133 Yes 0.059

-2.188*** (0.802) 1026 133 No 0.048

BITs and Institutional Quality

173

Also in the case of corruption, no robust impact of Bilateral Investment Treaties can be detected. In this regression, we see a positive impact of the average number of BITs concluded in the preceding three years, however significant only at the 10% level. As before, changes in domestic regulation show a relatively robust relation to changes in the corruption score. Remarkably and in opposition to the other regressions, the corruption variable displays a significant and robust relation to the ratification of the ICSID convention. 6.2.6

Outliers, Economic Freedom and OECD BITs

Different specifications of the model were tested to examine the validity of the results.507 First, outliers with regard to excessive BIT conclusion did not affect the results. This problem was addressed from the start by using logged values for the BIT variable. Three countries have nevertheless been excluded: China (88 ratified BITs in 2006), Egypt (71 ratified BITs in 2006) and Romania (77 ratified BITs in 2006). Leaving these countries out of the regression did not alter the results. Second, an alternative measure of government quality, the Index of Economic Freedom, has been used as the dependent variable. The index is compiled by the Heritage Foundation and is a composite index accounting for the following aspects: business freedom, trade freedom, fiscal freedom, government size, monetary freedom, investment freedom, financial freedom, property rights, freedom from corruption and labour freedom. BITs did not manifest a positive impact on this index (and neither did the control variables except for GDP per capita). A third specification relates to the choice of BITs: it may be argued that some BITs have a stronger impact than others. Especially BITs with developing countries that do not cover large amounts of FDI flows may be less influential than others. To account for this possibility, regressions have been run using only BITs with OECD countries. Again, the results are mainly similar to the results presented above. The full results of these regressions are displayed in Appendix D. 6.3

Caveats

The regressions presented above can contribute to place the discussion on the effects of BITs on domestic institutions on a more objective foundation. Quite novel for studies of this kind is the inclusion of a control variable for the domestic reform propensity. Yet, before discussing the results, a few problems with these empirical results must be addressed.

507

The tables for the tests mentioned in this section as well as the correlation matrix are presented in Appendix D.

174

6.3.1

BITs and Institutional Quality

Selection and Composition of Variables

The lack of significance for the number of BITs might be a consequence of the fact that the BITs (as well as the domestic regulatory changes) are unweighted. One possible approach would be to weigh the BIT of a specific country with the investment flows from that country.508 The problem was indirectly addressed through the use of BITs from OECD countries only. Yet, for future research, more sophisticated weights might be in order. These weights might go beyond the amount of FDI, but also consider the legal differences within BITs regarding the level of protection. 6.3.2

Perception Based Indicators

Strong criticism could be expressed regarding the use of perception based indicators as the dependent variable. Among others, Kurtz and Schrank (2007) have criticised the use of perception based indicators as good indicators for the quality of institutions. The authors suggest that the perception based indexes suffer, among other things, from perceptual biases and adverse selection in sampling. Recently, the criticism on the measuring of institutions has been analysed by Voigt (2009). The author discusses, inter alia, the thesis as presented by Glaeser, La Porta et al. (2004) that the Worldwide Governance Indicators and other, comparable indicators (e.g., the International Country Risk Guide), measure policy outcomes rather than institutions. A better approach might therefore be to focus on more objective criteria that indicate the quality of governance.509 However, it is not clear which variables could constitute a good proxy for the impact BITs have on the quality of institutions. A related criticism might be that the changes over time are too small to allow for statistical inferences or that they reflect technical rather than factual changes of institutional quality. The latter point is addressed by the composers of the data themselves who claim that changes in the behaviour of governments are mainly factual.510 Also, technical changes that affect all countries should be accounted for through the year dummies. As to the former point, it can indeed be observed that the statistical power is low. Certainly, institutions as such suffer from inertia and path dependency. Yet, at the same time, the control variables move in the expected directions and often with statistical significance. Consequently, the data can certainly contribute to point in the right direction. Obviously, more research in this direction and especially the identification of more useful indicators is needed. In sum, the criticism on perception based indicators is manifold and in many cases justified. Nevertheless,

508 509 510

Neumayer and Spess (2005) use that approach when testing the effect of BITs on FDI. Voigt (2009), p.3. Kaufmann, Kraay et al. (2008), p.20f.

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given the research question at hand and the prior research in the field, the Worldwide Governance Indicators constituted the natural choice.511 6.4

Discussion and Conclusions

It has been argued in the literature that BITs influence the quality of institutions in a positive as well as in a negative manner. In addition, empirical evidence has been presented in the literature that supports the latter thesis. In this chapter, a simple set of regressions in a fixed-effects framework have been presented to approach the problem. Using this standard approach, the data showed no signs at all of a potential positive impact of BITs on institutional quality. On the other hand, a negative impact of BITs was only detected in few regressions and was virtually never robust to the inclusion of time fixed effects and/or model specification. Therefore, the prior empirical findings that BITs do have a negative influence on institutional quality might be exactly driven by the lack of control for time effects and the set of chosen controls. Nevertheless, the consistent negative sign of the BIT variable and the (yet small) significance in some specifications is troubling and calls for further research. A strength compared to earlier studies has been that the efforts of domestic reform could be controlled for. On the other hand, the use of perception-based indicators is not unproblematic. Remarkably, despite the problems with these indicators, the relevant control variables are usually significant and point in the expected directions. Namely, changes of GDP per capita are strongly and significantly associated with changes in institutional quality in most of the regressions. A possible explanation might be that more GDP results in higher tax revenue – money that could be invested in improving institutions. Also, richer or growing countries might simply be perceived as having better institutions. The causality here most likely goes both ways and improved institutions lead to higher GDP per capita. A relatively stable connection between most institutional quality indicators and changes in domestic investment regulation can be shown. The unweighted nature of this variable makes quantitative predictions impossible. Also, regulation in investment law is usually part of a larger reform program that influences the institutional quality more directly. The domestic regulation variable should therefore rather be understood as a proxy for the propensity of domestic reform and not as an accurate predictor of institutional change. Nevertheless, it can be relatively safely said that domestic reform can influence the (perceived) institutional quality. This is a remarkable result as most other empirical determinants of institutional quality, like history, religion and geography, cannot be influenced by governments. 511

See Ginsburg (2005) or Berkowitz, Moenius et al. (2005), who use comparable data from the ICRG (International Country Risk Guide) as the dependent variable.

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In summary, while optimistic expectations on the effect of BITs on institutional quality are evidently unfounded, neither could a robust negative impact be established. The negative sign of the BIT covariates is nevertheless striking and calls for further research on the issue. This is especially true as the perception-based indicators employed here suffer from a number of shortcomings. However, plausible proxies based on objective indicators will be difficult to identify.

7

BITs and Transparency

The current system of international investment law has been criticised for a lack of transparency.512 The main concern is that topics of public interest should not be decided without the knowledge and influence of citizens who are potentially affected. In domestic law, it seems obvious that, for example, constitutional courts hear all cases in public and publish the verdicts. In contrast, international investment arbitrations are characterised by a high amount of confidentiality, despite the fact that these arbitrations are usually concerned with issues similar to those heard in constitutional courts. Often, cases that are not administered by ICSID are not registered anywhere. Consequently, the exact number of investment arbitration cases is not even known.513 While the proponents of increased transparency have very strong arguments, this chapter argues that transparency comes at a cost. At the core of the argument lies the functioning of international law and the fact that reputational losses are not zero but negative-sum to the parties. It will become clear why parties, apart from the desire to protect business secrets, often prefer confidentiality and under which circumstances it might be reasonable to allow for confidentiality. The aim of this chapter is in no way to disavow the merits of transparency and indeed, in many cases if not most, a balancing of arguments will result in favour of transparency. Yet, also in these cases, it will be seen that transparency comes with costs that should not be neglected. This chapter is organised as follows: the starting point is the legal background of transparency in the different investment arbitration fora (section 7.1). The arguments for more transparency with regard to international law and international investment law will be summarised in section 7.2. Section 7.3 presents the case for confidentiality emphasizing the incentive to comply with arbitration awards, the issue of efficient breach and the incentive to conclude agreements. Section 7.4 discusses the results and concludes. 7.1

Legal Background

The rules regarding transparency differ depending on the arbitration rules and fora. Arbitration proceedings based on BITs are usually ICSID arbitrations, UNCITRAL arbitrations or ad hoc-arbitrations.514 Obviously, in ad hoc-arbitrations, parties can

512

513 514

See, e.g., Knahr (2007) and Van Harten (2007), p.159. See also the Model International Agreement on Investment developed by the International Institute for Sustainable Development (IISD), available under http://www.iisd.org/pdf/2005/investment_model_int_agreement.pdf (October 13, 2009). Karl (2008), p.226. See section 3.3.3.8.

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_7, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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agree on many different modalities regarding confidentiality. This includes the possibility of not disclosing the existence of the conflict at all. With regard to the UNCITRAL arbitration, the publication of awards is governed by article 32 (5). The article states: "The award may be made public only with the consent of both parties." With regard to public or third party access to hearings, article 25(4) stipulates that “(h)earings shall be held in camera unless the parties agree otherwise”. The UNCITRAL arbitration rules do not require parties to publicise the existence of an arbitration proceeding. Yet, as article 32(7) establishes, the tribunal must register or file the award if this is required by the national laws of the country where the award is made. Quite similar to the UNCITRAL rules, the Convention on the Settlement of Investment Disputes between States and Nationals of Other States, namely article 48 (5), prohibits the publication of awards by the centre without the consent of the parties. Often, the awards of concluded cases are published on the ICSID website. However, parties have also frequently chosen not to do so. Recent examples for non-disclosure of the award include Europe Cement Investment and Trade S.A. v. Republic of Turkey and Bernardus Henricus Funnekotter and others v. Republic of Zimbabwe. The existence of a dispute as such (including the names of the plaintiff and the defendant) is usually not confidential and consequently published on the ICSID website.515 It must be remarked that many ICSID cases are settled before an award is issued. The terms of settlement are normally not made public. The same rules apply in principle for NAFTA Chapter 11 Proceedings as these proceedings are also based on the ICSID (Additional Facility) or UNCITRAL arbitration rules. Nevertheless, the NAFTA Free Trade Commission (FTC) has recently established that “nothing in the NAFTA imposes a general duty of confidentiality on the disputing parties to a Chapter Eleven arbitration, and, subject to the application of Article 1137(4), nothing in the NAFTA precludes the Parties from providing public access to documents submitted to, or issued by, a Chapter Eleven Tribunal."516 Evidently, confidentiality constitutes a prominent feature in the realm of international investment law. Regularly, not even the existence of a proceeding is made public. At the same time, observers and scholars have called for more transparency in international investment law. With regard to amicus curiae, ICSID and also NAFTA (as well as the WTO in international trade law) have taken steps towards more transparency.517

515 516

517

OECD (2005), p.3. Notes of Interpretation of Certain Chapter 11 Provisions (NAFTA Free Trade Commission, July 31, 2001), Article 1a, available under http://www.international.gc.ca/ (November 2nd, 2010). See Knahr (2007).

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The publication of documents during the proceedings and of the award has been discussed in a few cases. With regard to NAFTA Chapter 11 proceedings, Loewen Group, Inc. v. U.S. is often cited in the context of transparency.518 The tribunal had to consider a request by the United States to release documents related to the arbitration proceedings. The tribunal decided that there is no general duty of confidentiality in NAFTA arbitrations or imposed through the rules of the ICSID Additional Facility. The tribunal argued that especially arbitrations involving a state party should not be confidential as this would deprive the public of knowledge and information concerning government and public affairs.519 Another NAFTA case touching on this issue is Methanex Corporation v. United States of America. This case is especially of relevance with regard to amicus curiae.520 Nevertheless, the tribunal also stresses the importance of the public interest in investment arbitrations in general, which goes beyond regular commercial arbitrations. Noteworthy, the tribunal emphasised that the public interest is not based on the fact that one party of the arbitration is a state. The tribunal notes: "There is an undoubtedly public interest in this arbitration. […] This is not merely because one of the Disputing Parties is a State: there are of course disputes involving States which are of no greater general public importance than a dispute between private persons. The public interest in this arbitration arises from its subjectmatter […]."521 NAFTA cases have gone as far as allowing hearings to be public and broadcasted live. Examples are United Parcel Services of America v. Canada and Canfor v. United States of America. In both cases, the disputing parties agreed to this procedure.522 The case Biwater Gauff v. Tanzania is the most prominent case regarding confidentiality based on a BIT and is discussed in detail by Knahr and Reinisch (2007). Two points made by the tribunal appear to be of particular importance. First, the tribunal asserted that the coverage of the case in the media or the publication of documents "may aggravate or exacerbate the dispute and may impact upon the integrity of the procedure."523 Second, the tribunal "argued that the tensions between increasing transparency and safeguarding procedural integrity were only pertinent as long as proceedings were pending."524 Evidently, the concern of the tribunal was that

518 519 520 521

522 523

524

See e.g. Buys (2003), p.132 and OECD (2005), p.6. Fracassi (2001), p.218. OECD (2005), p.7. Methanex Corporation v. United States of America, Decision of the Tribunal on Petitions from third persons to intervene as "Amici Curiae" (January 15, 2001), para. 49, available under http://ita.law.uvic.ca/documents/Methanex-AmiciCuriae.pdf. OECD (2005), p.7ff. ICSID Case No. ARB/05/22, procedural note 3, para 136, available under http://ita.law.uvic.ca/documents/Biwater-PONo.3.pdf (October 13, 2009). Knahr and Reinisch (2007), p.108.

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extensive discussions of the case in public has a negative impact on the proceeding itself especially through the aggravation of the conflict between the parties. The tribunal referred to comparable statements made by other tribunals, namely Loewen Group, Inc. v. U.S. and Metalclad Corporation v. Mexico.525 A key term in this line of reasoning is therefore the procedural integrity. According to Knahr and Reinisch (2007), the term appears “to comprise the entire set of circumstances necessary for the efficient conduct of proceedings of which confidentiality seems to be just one, albeit a crucial aspect.”526 In a recent decision, the tribunal in Giovanna a Beccara and others v. Argentine Republic had to decide on a number of issues with regard to confidentiality, including the right of the parties to engage in public discussions of the case and the publication of the award as well as of minutes and records of hearings.527 As a general rule, the tribunal stated: “In conclusion, the Tribunal deems that the ICSID Convention and Arbitration Rules do not comprehensively cover the question of the confidentiality/transparency of the proceedings. Thus, in accordance with Article 44 of the ICSID Convention and Rule 19 of the ICSID Arbitration Rules, unless there exist an agreement of the Parties on the issue of confidentiality/transparency, the Tribunal shall decide on the matter on a case by case basis and, instead of tending towards imposing a general rule in favour or against confidentiality, try to achieve a solution that balances the general interest for transparency with specific interests for confidentiality of certain information and/or documents.”528 For the specific case, the tribunal decided, inter alia, that public discussion of the case “is restricted to what is necessary”, that the award shall be published (as that had been agreed by the parties in the first place) and that minutes and records of hearings “shall be restricted unless the Parties otherwise agree, or the Tribunal otherwise directs”.529 The case law revealed that tribunals have recognised the tensions between transparency and confidentiality. The arguments for transparency will be discussed in the following section. It will become obvious that these arguments are certainly well founded. Indeed, openness and transparency have a natural and understandable appeal. A wide range of virtues are promoted by transparency, including honesty, predictability, accountability, and legitimacy. Nothing in the argument presented below contradicts or resists these advantages of transparency. The modest point that will be developed in section 7.4 is that under certain circumstances, confidentiality has 525 526 527 528

529

Knahr and Reinisch (2007), p.106. Knahr and Reinisch (2007), p.106. ICSID Case No. ARB/07/5, Procedural Order on Confidentiality (January 27, 2010). ICSID Case No. ARB/07/5, Procedural Order on Confidentiality (January 27, 2010), para 73. Bold in original. ICSID Case No. ARB/07/5, Procedural Order on Confidentiality (January 27, 2010), para 153.

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its own advantages which should be weighed against the benefits of openness when deciding upon the rules of a dispute settlement system. In the next section the conventional case for transparency in international law in general and in international investment law specifically will be laid out. Then, in section 7.4, the circumstances in which confidentiality might be beneficial will be considered. 7.2

The Case for Transparency

7.2.1

International Law

Transparency has become a key concept in international law. Scholars with different backgrounds have identified transparency as a means to induce compliance with international legal norms. As Chayes and Chayes (1995) note: "Transparency influences strategic interaction among parties to the treaty in the direction of compliance: x It facilitates coordination converging on the treaty norms among actors making independent decisions. x It provides reassurance to actors, whose compliance with the norms is contingent on similar action by other participants that they are not being taken advantage of. x It exercises deterrence against actors contemplating non-compliance."530 Scholars using the rational choice approach have emphasised the importance of transparency in international law from a game-theoretic point of view. Abbott (1993) has described international treaties as prisoner's dilemmas, repeated prisoner's dilemmas or stag hunt games. In these games, information is crucial for a cooperative outcome to emerge. Therefore, the costs of the acquisition of information should be kept low. As Mock (2000) implies, games of perfect information lead more easily to cooperation than games with imperfect information, where means such as signalling need to be applied to achieve a cooperative outcome. Other scholars have taken the assertion that transparency is crucial to the effectiveness of international regimes as given and focus on how to reach more transparency.531 In addition, arguments for transparency include the positive external effects of awards in the sense that every award clarifies the contents and meaning of international law.532 Also, transparency might reduce corruption and gives third parties that are affected by

530 531 532

Chayes and Chayes (1995), p.22. Mitchell (1998). For the example of bilateral investment treaties, see, e.g., Franck (2005).

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the issue at hand, for instance NGOs or other public institutions, the possibility to express their views and participate in the decision process. The calls for more transparency have not been limited to international law in general, but have also been specifically applied and extended to the area of dispute settlement and arbitration.533 However, most commentators acknowledge that confidentiality has its place in private commercial arbitration. Nevertheless, there is a strong request for more transparency when at least one party to the arbitration is a state. The main argument here is that when a state is party to an arbitration proceeding, the public interest is concerned.534 NGOs like CIEL (The Center for International Environmental Law) and IISD (International Institute for Sustainable Development) therefore call for a revision of the UNCITRAL Arbitration rules.535 The public interest obviously results from the fact that residents are naturally interested in how their governments behave in international arbitration, awards of compensation might affect the budget of the country, arbitrations often concern the misconduct of governments (and residents should be informed about that misconduct) and arbitrations penetrate deeply into domestic decision making processes. More generally, transparency is seen as a central aspect of good governance as such.536 Also, most authors emphasise the importance of transparency for a consistent body of case law to emerge.537 This, in turn, will increase predictability (and avoid unnecessary disputes) and thus increase the confidence in the whole arbitration system. Another side effect that Mistelis (2005) mentions is that the publication of awards assists scholars and practitioners in studying the topic.538 As Buys (2003) notices, these arguments have also been used by the US and the EU to call for increased transparency of the WTO dispute resolution, as the "(1) WTO disputes deal with sensitive issues that affect large segments of civil society; (2) Transparency would assist other Members in understanding the issues involved and would permit more widespread and effective participation in the system; and (3) Transparency would increase public confidence in the WTO dispute settlement system, which in turn could facilitate compliance with DSB recommendations."539

533 534 535

536 537 538 539

See, e.g., Gruner (2003). See Mistelis (2005), Buys (2003) and Knahr and Reinisch (2007). See http://www.iisd.org/pdf/2007/investment_revising_uncitral_arbitration.pdf (November 2nd, 2010). Knahr and Reinisch (2007), p.110. Knahr and Reinisch (2007), p.111, Mistelis (2005), p.172. Mistelis (2005), p.172. Buys (2003), p.134.

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International Investment Law

The advantages of transparency in international law and dispute settlement naturally also apply to international investment law and investment arbitration. Arbitral tribunals frequently base their decision on earlier awards.540 Consequently, more transparency could very well contribute to the growing body of (informal) precedent in international investment law. As predictability increases, unnecessary disputes may be avoided. In addition, confidence in the system of international investment arbitration may be strengthened.541 It appears, prima facie, reasonable to assume that transparency has the potential to make the system more effective. Nevertheless, the most important issue of transparency with regard to international investment arbitration is the involvement of state parties as defendants and thus the presence of a general public interest. As Mistelis (2005) points out: "Increased public visibility and the emerging 'transparency' evident in investment disputes are not only justified by the participation of states, but is also an underlying public expectation held by citizens in many countries. The subject matter of many investment disputes affects the daily life of citizens, and some could even have an impact upon on the provision and cost of 'public' services such as water, waste management, electricity, gas etc." Put differently, transparency is not only a value in itself, but also enables citizens to make informed decisions such as voting or the consumption of public goods. As Knahr and Reinisch (2007) find regarding transparency: "Against the background of this host of strong policy reasons in favour of transparency, i.e., publication of awards, it is difficult to see any reason why the outcomes of investment arbitration should remain confidential."542 The argument presented in the following does not seek to invalidate these strong arguments for transparency in international law, international investment law and international dispute settlement. It will be shown that confidentiality in a certain respect, namely with regard to the proceeding of international tribunals, can be beneficial – mainly as an incentive to comply with awards. In addition, it will be pointed out that increased transparency will strengthen the negatives-sum nature of sanctions - with potentially problematic effects for the parties. The idea that the parties to a dispute have a strong interest in confidentiality, while the benefits of increased transparency accrue to third parties might reduce the incentive of using the dispute settlement mechanism in the future. The net effect of increased transparency is therefore not unambiguously positive.

540 541 542

See Commission (2007). See Knahr and Reinisch (2007), p.110. Knahr and Reinisch (2007), p.115.

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The Case for Confidentiality

To understand the benefits of confidentiality in international dispute resolution, it is worthwhile to recall how dispute settlement in international law works and, more importantly, what it seeks to achieve.543 The main mechanisms of dispute settlement in international investment law are, apart from direct negotiations, international tribunals. It has been emphasised that, although international tribunals generate rulings, there is a contrast to the domestic context as there is no centralised system of enforcement in place. In this sense, the tribunal cannot prevent a losing defendant from ignoring the ruling. The functioning of international tribunals despite the lack of coercive enforcement powers was already described in chapter 4. However, it is worthwhile to repeat that the key (and only) action performed by an international arbitration tribunal is the rendering of a judgement. Whatever the tribunal can achieve must be achieved by the ruling itself (or the threat of a ruling). In other words, the function of a tribunal is mainly informational.544 In addition and specific to international investment law, there frequently exists (depending on the case) the option of enforcement of the award in third countries. Given that this is a very tedious path not used very often in practice, the focus of the remainder of this chapter is on the informational impact of the tribunal’s ruling. As mentioned, the information provided by the tribunal has the potential to provide its own form of enforcement. This enforcement is, to be sure, weaker than the coercive enforcement of domestic courts, but if international tribunals are effective in any way it is because their rulings have the potential to impose costs on losing defendants. Out of the Three R’s of Compliance introduced in section 4.3 namely retaliation, reciprocity and reputation – the latter has been identified as the main enforcement mechanism in international investment law. The tribunal clarifies the facts of the case (if there are ambiguities) and states whether the defendant has breached international law or not. Consequently, the conflicting party as well as observing states and parties can update their beliefs concerning the willingness (and ability) of the defendant to comply with norms of international law. Since observing parties have no inside information on the facts of the conflict, they therefore need a neutral body like a tribunal to state the facts and render a ruling to allow them to understand the situation. As observing states adjust their beliefs based on the information provided by the tribunal, the tribunal’s ruling directly affects the 543

544

The functioning of international law and dispute settlement from the rational choice perspective were previously discussed in section 4.3 and will only be briefly repeated here. The standard assumptions of rational choice theory equally apply in this section. See, e.g., Guzman (2008a), p. 17. These assumptions include that states are rational, self-interested and have exogenous and fixed preferences. The following description is based on Guzman (2008b) and Guzman (2008a).

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defendant's ability to conclude beneficial agreements in the future. This applies to other states but also to potential investors. In other words, the existence of an arbitration tribunal increases the reputational costs of a violation of international law. One important point to emphasise in this context is that the sanctions in international law are usually not zero-sum. That means, for example, that the reputation loss of the defendant does not accrue to the country that wins the case or to anyone else (except maybe through some kind of belief updating). As will be seen shortly, the negativesum nature of the sanctions can be problematic. Before turning to the structural arguments in favour of confidentiality based on the enforcement mechanism described here, the conventional arguments for confidentiality in international arbitration will be restated. 7.3.1

Conventional Arguments for Confidentiality

The conventional arguments for confidentiality have become partly evident in the discussion of the case law in section 7.2 and are well summarised by Buys (2003). First, it may be necessary to protect sensitive business information and trade secrets from disclosure. This is an argument usually put forward for confidentiality in private commercial arbitration, but might in some cases also be important when one party is a state. In addition, in private proceedings parties may take positions that they would not take publicly. This concerns the bargaining space. Parties to the arbitration “may not wish to expose certain allegations to the public, e.g., allegations of bad faith, misrepresentation, incompetence, lack of adequate financial resources, etc.”545 In a similar vein, parties “may not want a “loss” publicised, especially if a party is involved in other cases with similar claims and defenses”.546 The arguments presented below are also concerned with the reputational losses of defendants, but link these losses to the enforcement structure of international investment law. A different point in favour of confidentiality does not only concern the publication of awards but the publication of documents during the trial. The point here is that publication of documents during the hearings might frustrate or politicise the arbitration process. Confidentiality can in that case facilitate settlement.547 Lastly, often confidentiality will be cheaper in terms of litigation costs. In other words, more transparency might come with prolonged and more complicated proceedings. Knahr (2007) makes this point with regard to the admittance of amicus curiae.548

545 546 547 548

Buys (2003), p.123. Buys (2003), p.123. Knahr and Reinisch (2007), p.110. Knahr (2007), p.352.

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Structural Arguments for Confidentiality

As mentioned, the argument presented here goes beyond these arguments for confidentiality and focuses more on the systematic way international tribunals function. In that sense, these arguments might be termed structural arguments. International arbitration may come about for a number of different reasons. First, there may be ambiguities about the interpretation of the legal rule. The defendant may come off as a winner or a loser in this trial. Second, the legal rule may be clear and the state deliberately chooses to breach as it deems the benefits of the breach higher than the costs. In some circumstances, this situation may constitute what is known as efficient breach in contract law and economics.549 In any case, arbitration in relation to transparency might lead to reputational costs that are zero-sum by nature and may therefore negatively affect the incentive of states to conclude treaties in the future. Each of these cases will be discussed in the following sections. Before discussing the benefits of confidentiality in more detail, a simple confidentiality mechanism will be introduced as a frame of reference to the case of transparency. In discussing the merits of confidentiality, the mechanism shall be such that the existence and the result of a dispute resolution proceeding should be kept secret from others, including other states.550 Furthermore, and critically, this confidentiality is conditional on compliance by the losing party with the ruling of the tribunal. If the losing defendant fails to comply with the ruling, the existence of the dispute should be publicised along with the tribunal ruling and the defendant’s failure to comply. The way the term is used here, confidentiality does not mean that the parties hide information from each other or the tribunal. Nor does it imply that the tribunal’s ruling is kept secret from one of the parties. Confidentiality is limited to keeping the proceeding and its results confidential among the parties as long as a losing defendant complies with the tribunal’s ruling. 7.3.2.1

Informational Ambiguities and the Incentive to Comply

As a first step, it is assumed that there is uncertainty about the content of the underlying legal rule or a clause in the respective BIT. For example, the exact extent of the fair and equitable treaty standard is still not undisputed.551 A country may then be sued under international law for actions that it may perceive as lawful. If the proceedings are not secret, there are reputational sanctions by the time a country is

549

550

551

Obviously, a combination of these two reasons is also possible and probably closer to reality. Nevertheless, for analytical purposes, it makes sense to consider these two points separately. It has already been mentioned that this is a common feature in international investment arbitration, especially with regard to ad hoc tribunals. See section 3.3.3.5.1.

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being sued. Third countries will consider the defendant as a less reliable partner concerning its compliance with international treaties. Consequently, the defendant will find it harder to conclude mutually beneficial agreements with his international partners in the future. Even if the final ruling clearly asserts that the defendant was not in breach of international law, his initial reputation may not be completely recovered. At a minimum, the defendant will face negative reputational sanctions during the time the case is pending. These costs can be avoided through confidentiality. Now it is assumed, in contrast to before, that the tribunal finds the behaviour of the defendant unlawful and the defendant thus guilty. The defendant now has to decide whether to comply with the ruling.552 Compliance will impose direct costs on the defendant as he has to pay damages. These costs will be the same, no matter whether the proceedings have been held secretly or not. Nevertheless, confidentiality as described above changes the compliance decision in an important way: it makes noncompliance relatively more expensive and therefore increases the incentive for compliance. To understand the impact on the compliance incentive, it is useful to first take a look at public proceedings: as before, the defendant faces a loss of reputation simply for being sued. In addition, the defendant faces a reputational loss for breaking his commitments (as he is found guilty). Put differently, in the case of transparency, the public at that point already knows that the losing state is a violator or international investment law. All of these costs are sunk at the moment of the compliance decision. Consequently, the defendant will weigh the direct costs of the damages against the costs or the reputational loss of being perceived as a country that does not comply with the rulings of the arbitral tribunal. Under confidentiality, there will be a different payoff structure: when the case is filed, the defendant does not face a reputational sanction. If there is a conviction and the state complies, there is also no reputational sanction either. The state faces, however, as before, direct compliance costs, such as expectation damages. The state will weigh these costs against the reputational loss of non-compliance which, in this scenario, includes being sued, breaking the law in the first place and also ignoring the subsequent award. Consequently, while the costs of compliance remain the same, at the very moment the compliance decision must be made, non-compliance is relatively more expensive when the proceedings have been kept secret. In other words, in the case of confidentiality, compliance with the tribunal’s ruling is more likely. Second, there are no reputational losses where the tribunal finds the defendant guilty, but the defendant complies with the ruling. The argument is in essence simply that confidentiality changes the cost-benefit analysis of the compliance decision of a violator of international law in favour of compliance. The reason is that if the arbitration was confidential before and non-compliance will trigger 552

On the compliance decision, see also section 4.4.3.2.1.

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the publication of the award, the reputational losses for the violation of international law are not sunk yet and will enter the cost-benefit analysis of the state when it comes to compliance with the ruling. In this sense, transparency will, contrary to popular opinion, not increase the effectiveness of international law, at least not with regard to compliance with arbitral awards. International investment arbitration, it may seem, does not suffer from severe compliance problems. Indeed, cases where investors have tried to enforce an award in national courts, which would be a reasonable reaction to non-compliance, appear to be rare.553 The problem is, however, that this strategy is costly and the chances of success are low. Therefore, it is not possible to be certain that the seemingly low frequency indicates high compliance. In addition, it can be observed that many arbitration awards were recently followed by annulment proceedings. The latter part is especially remarkable as the drafters of the ICSID convention deliberately chose only narrow grounds on which annulment proceedings could be based.554 Argentina is a case in point here: it appears that the country is attempting to annul all unfavourable awards relating to the proceedings initiated as a result of the measures taken during the financial crisis.555 Annulment is clearly an attempt to avoid compliance without incurring the risk of the award being enforced in national courts. An important point has not been addressed yet: if there was only uncertainty about the rule, why do the parties not simply enter into negotiations? Why start (costly and lengthy) arbitration proceedings at all? Despite the lack of reliable data on this issue, it is reasonable to assume that these pre-arbitration negotiations indeed take place between investors and governments. The problem is that negotiations can easily fail for various, well-known reasons, often related to asymmetric information or the inability of parties to find a distribution scheme for the surplus.556 The area of human rights shows that the mechanism as described above is also being used in practice, yet in a different context. The so-called Inter-American System of Human Rights provides a good example. This system consists of the Inter-American Commission on Human Rights and the Inter-American Court of Human Rights. Both bodies are organs of the Organization of American States (OAS).557 The former resumed its work in 1960 and bases its legitimacy on a resolution of the General

553

554 555

556 557

However, there appears to be no database collecting information on this issue, consequently, accurate statements on the frequency and significance of this problem cannot be made. See section 3.3.3.8.2. Examples are Siemens A.G. v. Argentine Republic (ICSID Case No. ARB/02/8), LG&E Energy Corp., LG&E Capital Corp. and LG&E International Inc. v. Argentine Republic (ICSID Case No. ARB/02/1) and Sempra Energy International v. Argentine Republic (ICSID Case No. ARB/02/16). See, e.g., Cooter and Rubinfeld (1989), 1078f. See Harris (1998) for an overview.

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Assembly of the OAS. The rules of its organisation and functions are laid down in the American Convention on Human Rights. The tribunal consists of seven members, is headquartered in Washington, D.C., and has two main functions: the preparation of country reports on the human rights situation in specific member states and the examination of individual petitions. These petitions follow a procedure as laid down in the "Rules of Procedure of the Inter-American Commission on Human Rights". Petitions can be submitted by "any person or group of persons or nongovernmental entity legally recognised in one or more of the Member States of the OAS" (Article 23). The assessment of the petition includes an initial review by the secretariat of the commission (Article 26), a decision of admissibility by the commission (Article 37), on-site investigations (Article 40) and the encouragement of a friendly settlement (Article 41). If no friendly settlement is reached, the Commission will compose an intermediary report with a decision on the merits. The process is – in short – as such (Article 42 to 45). If the Commission finds no violation, the report will be published with the annual report of the OAS Assembly. If the Commission finds one or more violations, it will include proposals and recommendations into the intermediary report that aim to ensure compliance with the relevant human rights regulations. This intermediary report is transmitted to the state in question. In that case, the intermediary report also contains a deadline by which the state in question must adopt the measures proposed. If the state fails to do so, the case will, under certain conditions, be referred to the Inter-American Court of Human Rights. If the case is not referred to the court, Article 45 of the Rules of Procedure of the Inter-American Commission on Human Rights describes the next steps:558

558

See also Article 50 and Article 51 of the American Convention on Human Rights: Article 50 1. If a settlement is not reached, the Commission shall, within the time limit established by its Statute, draw up a report setting forth the facts and stating its conclusions. If the report, in whole or in part, does not represent the unanimous agreement of the members of the Commission, any member may attach to it a separate opinion. The written and oral statements made by the parties in accordance with paragraph 1.e of Article 48 shall also be attached to the report. 2. The report shall be transmitted to the states concerned, which shall not be at liberty to publish it. 3. In transmitting the report, the Commission may make such proposals and recommendations as it sees fit. Article 51 1. If, within a period of three months from the date of the transmittal of the report of the Commission to the states concerned, the matter has not either been settled or submitted by the Commission or by the state concerned to the Court and its jurisdiction accepted, the Commission may, by the vote of an absolute majority of its members, set forth its opinion and conclusions concerning the question submitted for its consideration.

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"1. If within three months from the transmittal of the preliminary report to the State in question the matter has not been solved or, for those States that have accepted the jurisdiction of the Inter-American Court, has not been referred by the Commission or by the State to the Court for a decision, the Commission, by an absolute majority of votes, may issue a final report that contains its opinion and final conclusions and recommendations. 2. The final report shall be transmitted to the parties, who, within the time period set by the Commission, shall present information on compliance with the recommendations. 3. The Commission shall evaluate compliance with its recommendations based on the information available, and shall decide on the publication of the final report by the vote of an absolute majority of its members. The Commission shall also make a determination as to whether to include it in the Annual Report to the OAS General Assembly, and/or to publish it in any other manner deemed appropriate." It is important to understand that cases before the Inter-American Court of Human Rights are usually heard in public559 and judgements are publicised.560 Put differently (and keeping in mind that reputation is one of the main enforcement mechanisms in international law), non-compliance with the preliminary report will either trigger publication of the case as it is referred to the Inter-American Court of Human Rights, or if it is not referred, a final report will be drafted. Non-compliance with that final report will usually trigger a publication of the report. The main point here is that the state can avoid being publicly denounced as a violator of human rights and international law by complying with the measures proposed by the Inter-American Commission on Human Rights. This mechanism is structurally comparable to the confidentiality mechanism described with regard to international investment law as it uses the potential costs of reputational sanctions to induce compliance. 7.3.2.2

Efficient Breach and Settlement Problems

The preceding section focussed on compliance with the arbitration award. This does not necessarily imply that confidentiality always improves compliance with the

559 560

2. Where appropriate, the Commission shall make pertinent recommendations and shall prescribe a period within which the state is to take the measures that are incumbent upon it to remedy the situation examined. 3. When the prescribed period has expired, the Commission shall decide by the vote of an absolute majority of its members whether the state has taken adequate measures and whether to publish its report. See Article 14 of the court's rules of procedure (http://www.corteidh.or.cr/reglamento.cfm). See Article 30 of the court's rules of procedure (http://www.corteidh.or.cr/reglamento.cfm).

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underlying legal rule. Quite to the contrary, confidentiality of the proceedings under certain circumstances may make breach with the underlying rule easier – to the benefit of both parties. It should be noted that in many instances in international law, legal rules are akin to clauses in domestic contracts between private parties. These clauses have a simple function: to maximise the joint surplus for the contracting parties. In some cases, a contractual breach may be beneficial to both parties. In other words, the benefit of the breach is sufficiently high that the breaching party can fully compensate the other party and still be better off. Situations of this kind have been termed efficient breach.561 Efficient breach in international law is problematic, mainly because sanctions are not zero-sum. In addition, the breaching parties will face reputational sanctions that are impossible to assess and most likely exceed the benefits of the breach. The concept of efficient breach in relation to international arbitrations has been addressed by Wells (2003) who reviews the award in Kahara Bodas Company (KBC) v. Pertamina and PLN with reference to the methods the tribunal used to calculate the award. Please note that this arbitration was actually not based on a BIT and also not administered by ICSID. The claim was based on an investor-state contract and governed by the UNCITRAL arbitration rules (Pertamina is a state-owned company). Nevertheless, the issues the author raises when discussing the award are equally relevant for arbitrations based on BITs. The main point that Wells emphasises is that the tribunal in the case issued an excessive award due to an economically unjustified double counting. More specifically, the tribunal awarded KBC with 111.1 million USD for "lost expenditures" and 150 million USD for "loss of profits".562 The author asserts that the aggregation of the two types of losses is economically not justified as the expenditures are a prerequisite for the profits.563 Put differently, if "the project was expected to generate 'normal' rates of return for the business, then the amount of investment itself provides a reasonable starting point for determining FMV."564 The conclusion is that the award was excessive and that this may have problematic implications: "[…] excessive awards discourage government takings, or breach of contract, when such actions are in fact efficient and thus desirable."565 The author quotes in this context Richard Posner, who asserts: "Notice how careful the law must be not to exceed compensatory damages if it doesn't want to deter efficient breaches."566

561 562 563 564 565 566

On efficient breach, see Schäfer and Ott (2005), p. 461f. Wells (2003), p.472. Wells (2003), p.474. Wells (2003), p.475. FMV represents the fair market value of the project. Wells (2003), p.478. See Wells (2003), p. 478, fn 23 referring to Posner (1986), p.108.

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Marrela and Marboe (2007) apply these arguments to international investment law. The problem with international investment law is that in addition to the damages awarded, the state in question will also face reputational sanctions. As the authors point out: "The 'cost' of a treaty breach then will turn out to be much higher than the amount of payable damages or compensation. The State might face a decline in foreign investment, higher political risk rating and thus insurance premiums and a higher threshold hurdle rate of return to compensate for such risk."567 The authors conclude that, as these costs of a breach are not only virtually impossible to forecast, but may also be excessively high, efficient breach does not seem to be an available option in international investment law. The authors discuss some potential remedies for this problem. This includes the fact that efficient breach is, in a certain way, built into BITs, namely through the fact that the requirements of an expropriation are included in the treaty.568 The authors point out: "If the payment of compensation for a lawful expropriation (usually the fair market value of the expropriated property rights) in the eyes of the host State seems to be more sensible than to perform the contract (or to pay contract damages) it may well opt for a lawful (preferably direct) expropriation."569 Another option would simply be negotiations. While the latter would suffer from the same problems as identified in the preceding section (particularly asymmetric information and high transaction costs), a lawful expropriation is in many cases not an available option for at least two reasons: first, a regulation that may be at odds with a BIT cannot always be structured as a lawful (and compensated) expropriation. Second, there may be valuation problems with regard to the lost profits of the MNE that need to be solved through a neutral forum.570 More specifically, as interests are strongly opposed once the expropriation has taken place, an arbitral tribunal might be necessary as a neutral forum to clarify the facts of the case and evaluate if, for example, the expropriation was lawful in the first place. To sum up, there may be over-deterrence because host countries may abstain from efficient breach for fear of high reputational damages if the fragile process of negotiations fails.571 Marrela and Marboe rightfully conclude that the concept of efficient breach is difficult to adapt to the specific investor-state relationship and that, given the high and hard to estimate costs, "can therefore, also from an economic point of view, hardly be recommended."572

567 568 569 570 571

572

Marrela and Marboe (2007), p.13. Therefore, it is actually technically incorrect to talk about breach here. Marrela and Marboe (2007), p.16. The case Santa Elena, which was discussed in chapter 5, is a good example. If the BIT puts strong limits on regulations (as, for example, the sole effects doctrine does), this might even lead to over-deterrence in regulatory matters. This problem has been discussed in more detail and with regard to institutional competition in chapter 5. Marrela and Marboe (2007), p.19.

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The problem with regard to settlement and efficient breach is exacerbated by the fact that settlement has a distributional dimension. The decision of settlement vs. trial has been analysed in section 4.4.3.5.2. It was pointed out that a settlement agreement divides the surplus of the settlement. The assumption made in section 4.4.3.5.2 was an equal division of the surplus between the parties. The surplus itself was defined as the difference in payoffs between cooperation (settlement) and non-cooperation (trial). The payoff to the host country (“HC”) in the case of settlement therefore reflected the potential avoidance of reputational sanctions. However, this saving for the HC is partly captured by the investor as part of the settlement payment. In the example presented in section 4.4.3.5.2, the payoff to the HC was defined as y(- D - 0.5R). Assuming the behaviour of the HC was unquestionably a breach, that is y=1, the HC will have to pay 0.5R in addition to the damages potentially awarded by a tribunal (presumably expectation damages). Put differently, even when the host state can negotiate a settlement agreement, it will face costs higher than expectation damages as a result of the potential of reputational sanctions. In a similar vein, Cooter and Rubinfeld (1989) emphasise with regard to the domestic context that “[...], a defendant who wants to avoid the publicity of a trial will settle cases that he has a high probability of winning”.573 As explained, this is especially also true for the international investment context where reputation is a, if not the most, valuable asset. Please note that the payment from the HC to the MNE is obviously not a net loss to the parties. Nevertheless, it must be noted that efficient breach becomes ceteris paribus less likely if the potential for reputational losses exists (because the gain to the HC must be larger to cover the higher settlement sum). In other words, while the system of investment arbitration is justified to threaten to abstain from unlawful behaviour, the existence of high reputational sanctions may render this threat too strong. This also holds true, as has been argued, if a settlement can be reached. Even if efficient breach is nevertheless worthwhile, there will be a possibly unintended transfer of welfare from the HC to the MNE (which may be especially problematic if the HC is a developing state). Confidentiality could play an important role here as the reputational sanctions may be avoided. This would make efficient breach, which is by definition value-enhancing, a more available option. The logic is simple: if neither the existence of the case nor the final award (as long as the HC complies) is made public, there will be no reputational sanctions in the case of efficient breach. This will also have an impact on any settlement agreement as the MNE can no longer capitalise on the reputational losses of the HC. The advantages for the HC are immediately evident. The important question is

573

Cooter and Rubinfeld (1989), p.1075.

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therefore: will the MNE have a unilateral incentive to ignore the confidentiality agreement (or threaten to do so to obtain the reputational capital)? Would this be a credible threat? In other words, is confidentiality stable to unilateral deviation? Before answering these questions from a theoretical point of view, it should be noted that in practice, many ad hoc arbitrations are indeed often settled confidentially. Apparently, in these cases, the plaintiff has neither before, during or after trial the incentive to disclose the existence of his claim. The main reason is possibly that the threat of disclosure is not credible due to the classic hostage problem. The reputation as a hostage is not as such valuable to the MNE while destruction of the hostage is not only costly but deprives the MNE of any benefit the hostage might have. Second, the compliance effect as discussed in the preceding section could also exercise a pull towards confidentiality. Specifically, the MNE has no interest in taking actions that might frustrate or reduce the likelihood of compliance with the final award. Finally, as long as third countries cannot verify the existence of the conflict, the reputational damage (and consequently also the threat potential) appears to be weak.574 7.3.2.3

The Incentive to Conclude an Agreement

The risk of facing high reputational sanctions in case of informational ambiguities and the difficulties related to efficient breach have repercussions on the incentives to conclude agreements. In particular, the costs associated with transparency may undermine the incentives of countries to conclude new treaties or encourage them to search for alternatives that are less costly like, for example, ad hoc arbitrations. This point is related to Van Aaken (2008a) who demonstrated the tendency of states to “exit” their commitments in international investment law when they become too costly. Ecuador, to give a recent example, denounced the ICSID convention on July 6, 2009.575 In accordance with Article 71 of the ICSID Convention, the denunciation will take effect six months after notification. With regard to the choice between ICSID and ad hoc-arbitrations, it is impossible to find out if the number of (confidential) ad hoc arbitrations is rising. The crucial point concerning the issue of transparency is the negative-sum character of reputational sanctions. The problems that arise from the non zero-sum (negative) character of sanctions in international agreements have been discussed by Guzman (2005). The underlying logic is simple (and closely related to the preceding sections): reputational sanctions are a loss to the state that has violated the law that is not offset by a gain to the treaty partner (in the present case, the investor). Although high

574 575

I thank Andrew Guzman for pointing that out to me. See the ICSID News Release from July 9, 2009, available under www.worldbank.org/icsid.

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(reputational) sanctions are positive in the sense that they increase compliance with the underlying legal rule, states are aware that they will sometimes have to face these sanctions (even if they do not intend to act unlawfully). In that sense, the sanctions are a net loss to the parties. As Guzman (2005) asserts, the “desire to increase the credibility commitment, then, is tempered by a desire to avoid this loss.”576 This is exactly the reason why countries do not always choose the strongest type of commitment available to them. With regard to international investment law, it can be argued that a higher potential for reputational losses through increased transparency might incentivise parties to avoid BITs or use different, more confidential, means of conflict settlement like ad hoc arbitrations. When the dispute is public, this gain flows to all states rather than being limited to the parties of the dispute. From the perspective of the parties, then, the harm to the defendant is not matched by a gain to the complainant – the sanction imposes net costs on the parties. This “negative sum” feature might not only be a problem in the instant the conflict is prevalent, but it could also be a more systematic problem because it reduces the potential joint surplus from the agreement. This may make the signing of the particular treaties in question less attractive. As mentioned, states may refrain to employ arbitration as a means of dispute resolution in their international agreements, while a regime where proceedings are kept secret could avoid these costs. International cooperation or the use of international arbitration would in the end be more likely. This problem might be exacerbated by the fact that the conventional benefits of transparency as cited in section 7.4.1 do not mainly flow to the parties of the agreement but rather to third parties (for example the value of precedence). As a result, arbitration might not be chosen in the future if it loses its valuable feature of confidentiality. The question is, however, whether this logic holds for both partners to a treaty. The provisions of the treaty itself obviously apply to both partners and developed countries have already had costly experiences with the reciprocal nature of investment rules.577 Nevertheless, an asymmetry in investment flows between treaty partners still persists in many cases. If one country is capital-importing while the other country is capitalexporting, the latter, acting as an agent of the domestic MNEs, may have a certain interest in increased transparency in the sense that in settlements, transparency influences the distribution of the surplus in favour of MNEs. Further, benefits of

576 577

Guzman (2005), p.582. See also section 4.1.1. A recent case concerns the German government and the energy company Vattenfall, albeit with regard to the investment provisions under the Energy Charter Treaty. See ICSID Case No. ARB/09/6. A tribunal was constituted on August 06, 2009. At the moment, the case is suspended (September 5, 2010).

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precedent and information are also captured by the domestic MNEs of capitalexporting states. However, these benefits can only be captured partially and, in addition, a countervailing effect exists, namely the risk of the domestic governments themselves being the defendants in arbitration proceedings. 7.3.3

More Transparency?

Section 7.4.2 introduced a simple benchmark mechanism to highlight the problems and costs associated with transparency. Another mechanism to avoid unjustified reputational (negative-sum) sanctions could go in the opposite direction and may imply even more transparency.578 For example, it has been argued that many cases are based on different interpretation of the rules of the treaty. Upon registration of the case the state may face reputational sanctions even though its behaviour may later be deemed lawful. More transparency, e.g., through open hearings, might be valuable in the sense that third parties will be better able to draw informed conclusions. This may mitigate the potential loss that arises when an arbitration proceeding is registered especially when the host country can credibly ascertain that its behaviour was not opportunistic and that it intends to comply with the ruling of the tribunal. However, this credibility may exactly be the problem in the absence of neutral ruling. In addition, the problems associated with efficient breach and over-deterrence will probably not be solved through increased transparency. 7.4

Discussion and Conclusions

The striking argument against a confidentiality mechanism as presented above is certainly the public policy argument. Indeed, in many cases, the underlying issues and conflicts are of paramount public interest and should therefore not receive confidential treatment. On the other hand, some cases involving a state party are actually more akin to commercial arbitrations. A good example in this respect is the case Malaysian Historical Salvors, SDN, BHD v. Malaysia. The subject matter of this case is a contract between a marine salvage company (the claimant) and Malaysia (the respondent) to salvage a British vessel that sank off the coast of Malacca in 1817.579 The recovered items were at a later stage auctioned for a total value of approximately 2.98 million USD. Subsequently, a conflict arose on the division of the proceeds and whether the respondent withheld valuable items from the auction. Clearly, this case does not concern vital issues of public regulation such as social or environmental policy. In addition, the financial stakes are low while reputational sanctions are

578 579

I thank Thomas Eger for pointing that out to me. Malaysian Historical Salvors, SDN, BHD v. Malaysia, ICSID Case No. ARB/05/10, Award (May 17, 2007).

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potentially huge. Consequently, in cases that do not concern major public policy issues and high stakes, greater confidentiality might indeed be a feasible mechanism. That, however, would require tribunals to decide at the beginning of the arbitration if transparency is warranted by public policy concerns on a case-by-case basis. Taking this kind of decision would not be a novel one for tribunals: they employ the same case-by-case evaluation when they decide on the admission of amicus curiae580 and recently the tribunal in Giovanna a Beccara and others v. Argentine Republic has also emphasized in principle the legitimacy of a case-by-case approach with regard to issues of confidentiality.581 The confidentiality mechanism as presented here was mainly used as a benchmark to highlight the costs that are induced through (increased) transparency. However, it is noteworthy that this mechanism exhibits strong similarities to confidential ad hoc arbitrations. Ad hoc arbitrations are by definition not registered and often operate under confidentiality. If the losing party fails to comply, the winning party may try to enforce the award in domestic courts – thereby making the case, the verdict and the non-compliance decision of the losing party public. Consequently, this form of mechanism is in principle available to the parties. Drawing inferences about efficiency and social welfare is problematic in international investment law. As host countries and investors choose confidentiality in practice with regard to their arbitration proceedings, this arrangement must therefore in fact under certain circumstances be Pareto-superior compared to other arrangements (considering only the two treaty partners).582 For the treaty partners, the net benefits for the capitalexporting state are unclear. However, capital-importing states should profit from confidentiality as compared to transparency as they are primarily affected by the potential loss of reputation. This is also true when settlement solutions are frequently feasible. Consequently, if only the welfare of capital-importing (mainly developing) countries was of concern, the avoidance of reputational losses through confidentiality would probably be welfare enhancing. If, however, social welfare on a global scale is concerned, the welfare effects of more confidentiality are impossible to calculate or forecast. Calls for more transparency in international investment law are legion. Definitely, issues of great public concern cannot be kept secret from the public. In addition,

580 581

582

Knahr (2007), p.336. However, as pointed out in section 7.1, the tribunal did not decide on the question whether the dispute as such should be made public, but rather on minor issues concerning confidentiality as for example the right of the parties to discuss the case in public. Keeping in mind the problems with using the Pareto criterion in this context. See also section 5.1 on this issue.

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increased transparency, as has been argued in the literature, might strengthen the legitimacy of the system of international investment arbitration. Therefore, it has been emphasised that the merits of transparency should not be neglected. However, it was also pointed out that increased transparency will not inevitably lead to increased effectiveness. If effectiveness is understood as compliance with final awards, transparency may actually weaken effectiveness. Transparency, as some authors have claimed, has a deterrence effect against breach.583 This may be true, but if failure to comply with the ruling does induce publication, deterrence would not be undermined. At the same time, over-deterrence will be reduced and efficient breach enabled. Put differently: through confidentiality, it is possible to avoid the reputational losses without reducing compliance. This may, in turn, lead to more use of arbitration in the first place. Nevertheless, it might be argued that the reputational loss of the defendant is zero-sum to the treaty partners, but still valuable to third parties, as it helps them update their beliefs about the defendant. In other words, there is a positive external effect of precedence. This argument, as well as the public interest argument, is undoubtedly true, yet both must be weighed against the potential benefits of confidentiality. The existence of a public interest is not per se sufficient to disregard the potential benefits of confidentiality. After all, issues in international law by definition touch the public interest, and yet international law contains areas where confidentiality is crucial. In summary, a comprehensive discussion on the matter of transparency vs. confidentiality should not neglect that transparency also creates costs. These costs are mainly rooted in the negative-sum of reputational sanctions that may lead to overdeterrence when it comes to efficient breach as well as to disincentives to conclude new treaties (or incentives to exit existing ones). Furthermore, confidentiality can make compliance with a ruling more likely once the violation has occurred. A remarkable point is that developing or capital-importing countries might profit from confidentiality more than developed countries. Yet, the overall welfare effects of the trade-off between transparency and confidentiality remain unclear. Consequently, this chapter does not argue in favour of increased confidentiality. Obviously, some benefits of transparency are undeniable and in some cases of paramount importance. The modest aim of this chapter is simply to introduce a new perspective based on rational choice arguments on the issue of transparency vs. confidentiality that has not yet been part of the discussion on this matter and that may highlight the incentives of the relevant parties. This allows an understanding of why parties may choose confidential arbitrations and raises some pessimism with regard to the likelihood and feasibility of moves towards increased transparency in the future. 583

Chayes and Chayes (1995), p. 151.

8

Summary and Outlook

8.1

Summary

Foreign direct investment is of considerable importance in bringing goods and services across national borders to consumers and also constitutes the most important source of external finance for developing countries. However, FDI is vulnerable to opportunistic behaviour once the MNE has sunk the investment. This phenomenon can be understood as a time inconsistency problem countries face or can, in game-theoretic terms, be translated into a trust game. The international realm is mainly characterised by its lack of supranational enforcement mechanisms. Consequently, economic actors that care about the time inconsistency problem cannot simply “contract around” the problem. Nevertheless, economic and legal scholars have discussed a number of mechanisms that can support the transaction even in the absence of contract enforcement. These mechanisms include the exchange of hostages or collateral, handstying and union. Additionally, in the context of FDI, investors may buy insurance, actively devaluate the assets to avoid expropriation and engage in lobbying. Forceful mechanisms to achieve cooperation in a trust game are, under certain circumstances, also what have been called here dynamic devices, most importantly repetition and reputation. All of these mechanisms were discussed with regard to FDI and none turned out to be a perfect substitute for domestically enforceable contract law. Depending on the respective mechanism, problems exist concerning availability, high transaction costs or an imperfect incentive structure. Dynamic devices may face the endgame-problem, insufficient observability of past behaviour or high discount rates. Following the analysis of the economic mechanisms to protect FDI, an overview on the legal landscape in the realm of international investment was provided. It was pointed out that Bilateral Investment Treaties are the cornerstone of modern international investment law. By now, there are more than 2700 BITs in force and the number of (known) treaty arbitrations has been steadily rising. More important than the actual number of BITs is probably the fact that a couple of empirical studies provide robust evidence that BITs can indeed attract FDI. To critics of international law, the spread and success of BITs may be surprising – how can BITs work despite a lack of supranational enforcement? International law and economics has identified mainly retaliation, reciprocity and reputation as the relevant mechanisms that ensure compliance in international law. In the case of BITs, it appears that reciprocity and retaliation do not play significant roles. It is therefore mainly the potential loss of reputation (also vis-à-vis treaty partners) that will make uncooperative behaviour more costly when a BIT is in place. In addition, arbitration is backed up by

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3_8, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

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multilateral treaties that in many cases allow the enforcement of awards against assets in third countries if the (losing) defendant fails to comply with the award. Although the actual enforcement in third countries appears to be costly and tedious, this option will certainly raise the expected cost of breach. The (expected) costs of the BIT can be “used” in two ways: countries may credibly commit themselves by ratifying a BIT or countries may ratify BITs with the intention to signal hidden, positive characteristics. Both approaches were discussed using simple, game-theoretic examples. Noteworthy, the two approaches do not strictly exclude each other. In a sense, the commitment model that was introduced is also at the heart of the signalling function. Exactly the countries that can use the BIT as a commitment device or happen to be reliable from the start might use BITs as a signal. As the models are interrelated, similar conclusions can be drawn about the importance of credible threats (e.g., low litigation costs, sufficiently high damages) and the availability of hostages or collateral. With regard to signalling, it is worth mentioning that, contrary to common perception, the prior belief on the reliability of the country needs to be low – consequently, the signal will not necessarily be sent by low-risk countries. It must be noted that the signalling approach suffers from a convincing explanation on the nature of asymmetric information. Institutional quality, as may be argued, cannot be at the core of the information asymmetry as information in this area is readily accessible. Asymmetric information may exist if the current preferences of a country (represented by its government) are not known to MNEs. If this is the case, it should be noted that the signal function of BITs is rather short-lived. On the other hand, the commitment function suffers from the incentive problems that are well-known in the context of hostages and collateral. While the strategic interaction between (potential) MNEs and host countries is certainly at the core of BITs, the strategic interaction between countries to attract the MNE is also of high importance. Put differently, countries are using BITs to compete for capital, a claim that can be empirically validated. Yet, the consequences of this competition on welfare are dubious. Given the complicated nature of efficiency and welfare considerations in public international law, the focus was set on developing countries. When the treaty policy of these countries has an external effect, a treaty will still be a Pareto-improvement for the two treaty partners, but may result in a Paretoinferior situation for the developing countries as group. In the case of investment protection, it has therefore been argued in the literature that developing countries will end up in a prisoner’s dilemma situation – a claim that is certainly true if stronger investment protection will not lead to higher investment flows to developing countries as a group. If this assumption is relaxed, countries may still bring themselves in a PD situation with BITs. However, the opposite (in the sense of a Pareto-improvement) may also be true. This discussion reflects the more general discussion on the merits and dangers of institutional competition, a discussion which touches on a number of

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different issue areas. The main contributions in tax as well as ecological competition have been reviewed, concluding that the benefits of increased government control (and commitment) and the threat of underproviding public goods need to be balanced. Certainly, BITs are commitment devices to start with, but additional positive welfare effects can be expected when government incentives do not align with social welfare goals, e.g., as a result of the influence of private interest groups. A deviation from the social welfare goal has been part of the discussion on international trade for a long time. Although it was argued here that the insights of the political economy of international trade cannot be transferred one-to-one to international investment law, redistributive pressures to the detriment of social welfare are probably nevertheless existent. On the other hand, the underprovision hypothesis has unquestionably been part of the discussions on international investment law under the catchword of regulatory chill. Therefore, BITs were analyzed in light of this discussion and, to keep the problem traceable, the case law was reviewed in a specific issue area, namely environmental regulation. The relevant provisions in BITs certainly show extensive elements of the non-discrimination principle. On the other hand, the importance of good faith and the public purpose of a regulatory measure may be and has been neglected by tribunals applying a strict interpretation of the standards of treatment and the provisions regarding indirect expropriation. The case law regarding the specific issue of environmental regulation indicated that the threat of a widespread regulatory chill may be unfounded. Nevertheless, strict interpretations by tribunals that do not take account of the good faith of the government and/or the public purpose of a measure give rise to concern. Consequently, if the development aim of BITs is to be taken seriously, policy-makers and tribunals should underline the lawfulness of measures taken in the public interest. This argument does not imply a relaxation of the commitments as such: governmental measures in favour of interest groups to the detriment of the investor and indirectly also to the detriment of social welfare need to be strictly sanctioned. Closely related to the discussion on institutional competition is the question whether BITs may have an external effect on institutional quality. This effect may either be positive (e.g., domestic investors demand equal protection or BITs serve as a “good example”) or negative (e.g., investors bypass domestic courts or governments “segment” their reputation). This question was approached empirically using panel data from 1996 to 2007 in a fixed-effects model. As the dependent variable, different dimensions of the World Governance Indicators were used, namely regulatory quality, government effectiveness, rule of law and corruption control. As the relevant independent variable, the cumulative number of BITs was utilised. Control variables included domestic investment regulation, GDP per capita and trade openness. Clearly, the regression results show that a positive impact of BITs on institutional quality

202

Summary and Outlook

cannot be expected. With regard to the opposite, the regressions produced negative coefficients for the BIT variable, albeit in most cases not significant and not at all robust to model specifications. A negative effect of BITs on institutional quality cannot therefore be entirely excluded, but also cannot be confirmed. In any case, this result calls for further research, especially as the subjective measures of institutional quality have aroused a lot of criticism in the literature. It might therefore be attempted to find a better, more objective dependent variable. Interesting is the strong and positive relation between (lagged) domestic reform (proxied by the number of regulatory changes favourable to FDI) and institutional quality. This is an indicator that countries can shape the quality of domestic institutional quality (or at least the perception thereof) through regulatory measures. Given the somewhat static explanatory variables like religion, colonial and legal heritage, language etc. that have been identified in empirical research to shape the quality of institutions, this result provides some optimism on the potential impact of domestic reform in this regard. Calls for increased transparency are not only standard in international law and international governance, but also in international investment law. The traditional confidentiality that is actually a key feature of commercial arbitration has also shaped investment arbitration to a certain degree. As arbitration based on BITs (or other treaties that incorporate investment provisions like NAFTA or the Energy Charter Treaty) frequently touches upon issues of great public interest, the calls for more transparency have therefore a solid ground. Nevertheless, increased transparency will also come with costs that have so far been neglected in the literature, namely the opportunity costs of the non-availability of efficient breach and a potentially reduced incentive to comply with an award. That the latter idea can play a role in the realm of international law has been underlined with the example of the OAS. In addition, the high reputational threat may have a distributional implication in the sense that in settlement negotiations, the host country is disadvantaged by the threat of reputational sanctions. Nevertheless, this book did not make a univocal argument in favour of more confidentiality. The public interest argument probably outweighs the potential benefits of confidentiality. An exception may be arbitration proceedings that primarily concern the commercial activity of countries. Another point has also been highlighted: the costs of more transparency are primarily carried by the parties to a dispute (who may have the option to choose confidentiality). On the other hand, the benefits of increased transparency, like a higher legitimacy of the system or the value of precedence, accrue to all players in the system. This observation raises concerns as to whether moves towards more transparency are actually feasible.

Summary and Outlook

8.2

203

Outlook

The law and economics approach has only recently started to systematically analyse issues of international law. International investment law is no exception. This thesis attempted to shed light on the economic functioning of BITs and other economic and legal aspects of Bilateral Investment Treaties. Nevertheless, much work remains to be done to better understand the structure, content and impact of international investment law. Two potential areas for further research will shortly be sketched. The first relates to empirical issues and the second to theoretical aspects regarding the overall landscape of international investment law. With regard to empirical research, it has already been mentioned that the results derived in chapter 6 call for more research. In addition, the growing number of investment arbitrations may open the opportunity for interesting empirical studies, for example with regard to the relationship between characteristics of the defendant and the number of investment arbitrations. At this point, the number of cases is too low to obtain any meaningful results using regression techniques. However, it would certainly enhance the understanding of international investment law if it were known what kind of countries are prone to higher arbitration risk. A different area for empirical research would be to use event studies to measure the impact of the arbitration mechanism on share prices of the involved companies. This might give a hint as to how market participants estimate the value and efficacy of the arbitration mechanism. Certainly, the area of international investment law and economics offers opportunities for empirical research going beyond the question of whether or not BITs attract FDI. A different potential area for future research rather touches the general structure of international investment law. In the mid-1990s, discussions on the necessity of a multilateral investment treaty peaked with the attempt of the OECD to establish a Multilateral Agreement on Investment (MAI). With the failure of this initiative, the discussion on this topic has calmed. However, the legal landscape of international investment law may change with the ratification of the Lisbon Treaty by the member states of the European Union. The treaty will subsume the area of investment protection under the Common Commercial Policy (article 188 C of the Lisbon Treaty). It is doubtful to what extend this might influence the BIT regime of the member states. Nevertheless, this step may trigger a new discussion on the question of a multilateral treaty on investment. Whether a multilateral regime is indeed superior to bilateral solutions is a topic where economic analysis can definitely make a useful contribution.

Appendices

Appendix A The grim trigger strategy is defined as: (1) Cooperate (here: invest (MNE) or accommodate (HC)) in the first round (2) Continue to choose invest or accommodate in the following rounds, unless the other player deviates, in which case play the stage game Nash Equilibrium (Don't Invest/Expropriate) forever.

This strategy constitutes a subgame-perfect Nash-Equilibrium when both players have no incentive to deviate from the strategy, assuming the other player plays the strategy. So, if the investor plays the grim trigger strategy and the host state always accommodates, payoff for the host state is: CH ª¬1  G  G 2  ...º¼

CH ¦ t 0 G t f

CH 1G

(A1)

with G 1/(1  i )

where G is the discount rate of the host state.

What is the payoff when the host state deviates? Because of the stationary character of the game and the fact that future payoffs are discounted, deviation will be most attractive in the first round of the repeated game. If the host state plays expropriation in the first round, it will receive the opportunistic profit in the first round and, as the investor plays the grim trigger strategy, a payoff of 0 in all following rounds. In mathematical terms: WH  0G  0G 2  ... WH

(A2)

Unilateral deviation from the grim trigger strategy does therefore NOT pay off when: CH C t WH œ G t 1  H WH 1G

J. P. Sasse, An Economic Analysis of Bilateral Investment Treaties, DOI 10.1007/ 978-3-8349-6185-3, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

(A3)

206

Appendix A

The case for the investor is trivial. He cannot gain an opportunistic profit through unilateral deviation. His profit will be CM in every round the host state accommodates (which is the highest payoff he can achieve).

Appendix B We want to show that the strategies and beliefs presented in section 3.2.2.2.2 are indeed a perfect Bayesian equilibrium.584 The following notation holds:

: a-priori probability that the host country is of the good type q2: (a-posteriori) probability that the host country is of the good type as assessed by the MNE in period two (after observing the history of the game) z: probability that the bad type will play accommodation in the first period v: probability that the MNE plays invest r: probability that the HC plays accommodate in the first round

The expected profit of the MNE in the second round amounts to: –2

q2CM  (1  q2 )( LM )

(B1)

If – 2 ! 0 , the MNE will invest in the second round. q2CM  (1  q2 )( LM ) ! 0

(B2)

solving for q2: q2 !

LM CM  LM

Consequently, if T !

(B3) LM , there will be investment for sure in the first stage. CM  LM

Let z denote the probability with which the bad host country accommodates in the first period. The MNE in round two updates his beliefs according to Bayes' Rule. If he observed accommodating behaviour, his belief will be:

q2

584

T T  (1  T ) z

(B4)

This description draws on Holler and Illing (2006), p.168ff. and Feess (2004), p.624ff.

208

Appendix B

From equation (B3) we know that the MNE will invest if q2 !

LM . Combining CM  LM

equation (B3) with (B4) yields: LM T ! CM  LM T  (1  T ) z

(B5)

It has been explained in section 3.2.2.2.2 that the only way to build a reputation is to play mixed strategies. Therefore, the HC in round 1 will set z to make the MNE indifferent between investment and non-investment in the following round. The MNE will be indifferent if his expected profit is zero: q2CM  (1  q2 )( LM ) 0

(B6)

Rearranging

q2

LM CM  LM

(B7)

Combining (B4) and (B7) T T  (1  T ) z

LM CM  LM

(B8)

This is the indifference condition for the MNE in round two. Solving for z:

z

ª CM  LM º  1» « (1  T ) ¬ LM ¼

T

(B9)

z is the probability that the bad HC must choose in round one to make the MNE indifferent between investment and no investment in round 2. Also the MNE must play mixed strategies to make the bad HC indifferent in the preceding round (otherwise, the HC wouldn't play mixed strategies). Let v denote the probability with which the MNE invests in the second period. The bad HC will be indifferent if the following equation holds: CH  vG WH  1  v G 0 WH

(B10)

Appendix B

209

Note that the HC could expropriate in period 1 and thus reveal his type. It would receive its expropriation payoff, but the MNE would not invest in the second period (right-hand side of the equation). Alternatively, the HC could accommodate and receive CH in period 1 and expropriate in the second round. Its expected payoff then depends on the probability with which the MNE invests in the second round. Solving for v:

v

WH  CH G WH

(B11)

This is the probability the MNE needs to play that makes the bad HC indifferent. The HC will react with playing z as specified in equation (B9).

Until now, it was assumed that the MNE has invested in the first period so that there could be Bayesian Updating. When will the MNE indeed invest? We denote this probability by r. The MNE cares about the probability that the HC will play accommodation. Because not only the good type plays accommodation, but also the bad type with probability z, the probability r is bigger than the a-priori probability ; specifically: r T  (1  T ) z

(B12)

Probability z in equation (B9) has already been calculated. Consequently: r T  (1  T )

T ª CM  LM º  1» « (1  T ) ¬ LM ¼

(B13)

simplifying to r T

CM  LM LM

(B14)

The profit for the MNE in round 1 is S1

rCM  (1  r )( LM )

The MNE will only invest if

(B15)

210

Appendix B

rCM  (1  r )( LM ) ! 0

(B16)

This simplifies to: r!

LM LM  CM

(B17)

Inserting (B14) T

CM  LM LM ! LM LM  CM

(B18)

rearranging T!

L2M ( LM  CM ) 2

(B19)

Consequently, it can be shown that the equilibrium described in section 3.2.2.2.2 is indeed a PBE of this game. If T  round. If T !

L2M , the MNE will not invest in the first ( LM  CM ) 2

L2M , the MNE will invest in the first round as its expected profit ( LM  CM ) 2

is positive. The bad HC will randomise and play accommodate with probability z

T ª CM  LM º  1» . This is exactly the probability that makes the MNE indifferent « (1  T ) ¬ LM ¼

between investment and no investment in the following round. If the outcome of this randomisation process was accommodate, the MNE will update its belief according to Bayes' Rule and invest with probability v

WH  CH . This probability makes sure that G WH

the bad type is indifferent between expropriation and accommodation in the preceding round – consequently, none of the players has an incentive to deviate from this equilibrium.

Appendix C We are looking for perfect Bayesian equilibria (PBE). The MNE has a prior belief () on the reliability of the HC and updates this belief using Bayes' Rule, depending on the action (BIT or No BIT) of the HC. We can differentiate between pooling, separating and semi-separating equilibria. The following assumptions hold:

(a) The (expected) ex-post costs of a BIT are lower for the reliable type: BR0 and WH>0. (c) The MNE would invest in the case of the reliable HC, CM>0, but not invest in the case of the unreliable type, LM<0. (d) The MNE will not invest absent a BIT: T CM  (1  T ) LM  0 (e) MNEs update their beliefs using Bayes' Rule. (f) Equilibria not fulfilling the intuitive criterion as introduced by Cho and Kreps (1987) shall be eliminated.

1) Pooling on No BIT (1) Imagine that CH  A  BR  0 and WH  A  BU  0 . These conditions imply that for both types, signing a BIT is not rational even if it would induce investment. If no type signs a BIT, no information will be transmitted to the MNE. The MNE will calculate its payoff using the prior probability  that the HC is reliable. The payoff if the MNE invests is T CM  (1  T ) LM , not investing will generate a payoff of zero. Assumption (d) postulates that T CM  (1  T ) LM  0 . Consequently, the MNE will not invest. Therefore, we have a pooling equilibrium where no party signs a BIT, the MNE will not invest, and the payoff to both parties is zero. As playing BIT is not rational for any HC with any positive probability, equilibria in mixed strategies can also be ruled out.

2) Separating Equilibrium Imagine that CH  A  BR ! 0 and CH  A  BU  0 and assume that the MNE will invest when it observes a BIT, but not invest otherwise. The reliable type will sign a BIT and the unreliable type will not. Given the MNE strategy, does any type of HC have the incentive to deviate? No, as CH  A  BR ! 0 assures that the reliable type is better off with a BIT and investment, while CH  A  BU  0 assures that the unreliable type prefers no investment compared to a BIT with investment. The MNE has no incentive

212

Appendix C

to deviate from the strategy as its expected payoff T CM  (1  T )0 T CM is the highest payoff it can obtain. As a matter of fact, any HC strategy where the unreliable type plays BIT with a positive probability can be ruled out.

However, there could be a PBE where the strategy for both types of HC is No BIT. If no BIT is signed, the MNE has no incentive to deviate from its earlier strategy of never investing because it cannot differentiate between types and assumption (d) holds. This constitutes a PBE with pooling on No BIT. Please note that this equilibrium can be eliminated using the intuitive criterion. The problem with PBE is that there are no restrictions on the beliefs parties have after moves that are out-ofequilibrium. The intuitive criterion postulates that unexpected moves will not be chosen by parties that can only lose as compared to the relevant equilibrium.585 In our case, if the MNE observed a BIT, this would obviously be the reliable HC signing it – therefore, the reliable type can "destroy" this pooling equilibrium – consequently, this equilibrium can be eliminated using the intuitive criterion.

3) Pooling on No BIT (2) Imagine CH  A  BR  0 and WH  A  BU ! 0 . In this situation the unreliable type actually prefers a situation with the investment and a BIT, while the BIT is too costly for the reliable type. As BRCH, that is, the benefits of the expropriated asset to the unreliable type must be high. Nevertheless, a situation where only the unreliable type signs a BIT and consequently induces the MNE to invest cannot be an equilibrium as the MNE would have an incentive to deviate (as (1)LM<0). In turn, the unreliable HC will have no incentive to sign the BIT in the first place (as –A <0). The only pure-strategy equilibrium is where both parties refrain from signing a BIT and no investment takes place. The MNE cannot update its belief, assumption (d) assures that it will not invest and thus not deviate from this strategy. The reliable type has no incentive to sign a BIT and "destroy" the pooling equilibrium as CH  A  BR  0 , the unreliable type has no incentive to sign a BIT and reveal itself as the unreliable type as concluding a BIT is costly (–A <0) and the MNE would optimally react by not investing.

4) Pooling on No BIT (3) Given the following two conditions

585

Holler and Illing (2006), p.185.

Appendix C

CH  A  BR ! 0

213

(C1)

and WH  A  BU ! 0

(C2)

even the unreliable type would sign a BIT if it can induce investment. However, the only pure strategies equilibrium is a pooling equilibrium on No BIT. As a first step, the two other potential pure-strategies can be eliminated. First, imagine a separating equilibrium where only the reliable types sign BITs and the MNE invests if it observes a BIT, but does not observe otherwise. The unreliable type has an incentive to deviate from its strategy as it has the incentive to "bluff" as long as WH  A  BU ! 0 . For the same reason there cannot be a separating equilibrium where only the unreliable type signs a BIT. Now, imagine a pooling equilibrium where both types sign a BIT. If both types sign a BIT, there cannot be Bayesian Updating. The MNE will calculate its payoff using the prior probability  that the HC is reliable. Yet, according to assumption (d), the MNE will not invest. Consequently, no HC will bother to send the costly signal. The only pure strategies equilibrium given conditions (C1) and (C2) can be the equilibrium where the HCs both do not sign a BIT and the MNE does not invest. The strategy of the MNE is never to invest, while the strategy of the HCs is never to sign a BIT. No party has an incentive to deviate from this equilibrium – equally, this equilibrium cannot be eliminated using the intuitive criterion.

5) Semi-Separating Equilibrium Please note that under the assumptions (C1) and (C2), there can be a PBE in mixed strategies under the following additional condition: CH  A  BR ! WH  A  BU

(C3)

In a semi-separating equilibrium, a reliable type will sign a BIT while an unreliable type randomises between signing and non-signing. The MNE will not be able to differentiate between the types and randomise itself unless the unreliable clearly identifies itself by not signing a BIT. Let q with 0
214

Appendix C

s (WH  A  BU )  (1  s)( A) 0 œ

s

A WH  BU

(C4)

Equally, the unreliable HC will choose q to make the MNE indifferent. The MNE updates its belief using Bayes' Rule. If the MNE observes a BIT, its updated belief given the prior probability  is: T

(C5)

(T  q(1  T ))

In words: the probability that the HC is reliable - after observing a BIT - is the prior probability that the HC is reliable () multiplied with the probability that a reliable HC signs a BIT (1), divided by the prior probability of a BIT being signed (T  q(1  T )) . The converse probability, that is the probability that the HC is unreliable despite having signed a BIT, is therefore q(1  T ) (T  q(1  T ))

(C6)

The expected investment payoff of the MNE after observing a BIT can be written as T (T  q(1  T ))

(CM ) 

q(1  T ) ( LM ) (T  q(1  T ))

(C7)

If no investment takes place, the MNE will receive a payoff of zero. It is consequently indifferent between investing and not investing if T (T  q(1  T ))

(CM ) 

q(1  T ) ( LM ) 0 (T  q(1  T ))

(C8)

solving for q yields (given 0<<1)

q

CM T  LM (1  T )

(C9)

Appendix C

215

The unreliable type will sign a BIT with probability q

CM T . If the unreliable  LM (1  T )

type signs a BIT, the MNE will invest with probability s

A . If no BIT is being CH  BU

signed, the MNE will not invest. For this equilibrium to be stable, the reliable type must also not have an incentive from deviating from its strategy of always signing a BIT. Theoretically, he may be tempted to refrain from always doing so and saving the costs of signing a BIT. Will this increase his expected payoff? When the reliable type doesn't sign a BIT, the MNE will not invest. The payoff to the reliable HC would be zero. Imagine that the reliable HC would also randomise and sign a BIT with probability u, where 0 d u d 1 . Given the equilibrium strategy of the MNE, the expected payoff would be u ( s (CH  A  BR )  (1  s )( A))  (1  u )0 .

(C10)

It is known from (C3) that CH  A  BR ! WH  A  BU and also s (WH  A  BU )  (1  s)( A) 0 .

(C11)

and therefore s (CH  A  BR )  (1  s)(  A) ! 0

(C12)

It follows that u=1 is the optimal strategy for the reliable HC as the payoff of the reliable type is increasing in u. The reliable type has no incentive to refrain from signing a BIT in the presented equilibrium. Please note that without condition (C3), the reliable type could have an incentive to destroy this mixed equilibrium by playing No BIT. But can a "reverse" mixed strategies equilibrium exist in the sense that the unreliable type signs a BIT with probability 1, while the reliable type randomises with 0
Appendix D Correlation Matrix

Appendix D

217

Dependent Variable: Government Effectiveness -IBITs (log)

-II-

-III-

-IV-

-0.0570* (0.0324)

-0.0415 (0.0344)

-0.0437 (0.0324)

BITs (averaged 3 years) 0.0825*** (0.0292) 0.0564** (0.0267)

0.0744*** (0.0269)

Domestic Regulation (averaged 3 years) 0.747*** (0.128)

0.542***

0.438***

(0.134)

(0.115)

(0.105)

0.00448*** (0.00149)

0.00586*** (0.00177)

0.00390** (0.00153)

0.00577*** (0.00173)

0.00432*** (0.00147)

-0.00161** (0.000778)

-0.00162* (0.000827)

-0.000801 (0.000762)

-0.00129 (0.000817)

-0.00198** (0.000769)

0.0241** (0.00951)

0.0205** (0.00941)

0.0235** (0.00984)

0.0217** (0.00955)

0.132 (0.0906) -4.858*** (0.774) 1044 133 Yes 0.127

0.143 (0.0911) -4.606*** (0.765) 1123 140 Yes 0.102

0.119 (0.0922) -4.700*** (0.786) 1062 133 Yes 0.111

0.128 (0.0887) -3.661*** (0.640) 1044 133 No 0.105

0.112 (0.0848)

ICSID Convention in t-1 -5.990*** (0.886) Observations 931 Number of Countries 133 Time Effects Yes R-squared (within) 0.148 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

0.441***

(0.109)

0.0140 (0.0108)

FDI Inflow in t-1 (log) ICSID Convention

0.553***

(0.114)

-0.00176** (0.000701)

Trade Openness in t-1 FDI Inflow (log)

0.569*** 0.00492*** (0.00151)

Development Aid in t-1 (%GNI) Trade Openness

0.0225 (0.0222) 0.00245 (0.00344)

GDP per Capita in t-1 (log) Development Aid (%GNI)

-0.0730*** (0.0270) 0.00150 (0.00267)

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-VI-

(0.0341)

BITs in t-1 (log)

Domestic Regulation (log)

-V-

-0.0482

0.163* (0.0887) -3.632*** (0.935) 1104 133 Yes 0.093

218

Appendix D

Dependent Variable: Economic Freedom -IBITs (log)

-II-

-III-

-IV-

-0.0333 (0.642)

-0.0848 (0.618)

-0.0897 (0.641)

BITs in t-1 (log) BITs (averaged 3 years) Domestic Regulation (log)

0.552 (0.526)

0.561 (0.547)

15.38*** -3.002 15.44*** -2.531

16.67*** -2.779

12.19*** -2.236

-0.0265 (0.0468)

-0.0407 (0.0426)

-0.0420 (0.0485)

-0.0225 (0.0463)

-0.0314 (0.0396)

0.0118 (0.0171)

0.0197 (0.0165)

0.0122 (0.0164)

0.0165 (0.0169)

0.00447 (0.0177)

0.331** (0.163)

0.374** (0.169)

0.318* (0.163)

0.283* (0.145)

0.841 -1.186

0.762 -1.204

1.060 -1.174

0.810 -1.254

0.664 -1.213

-62.41*** (19.50) 1322 123 Yes 0.235

-54.97*** (20.29) 1380 127 Yes 0.226

-54.53*** (17.40) 1393 124 Yes 0.228

-68.26*** (19.12) 1339 123 Yes 0.243

-35.12** (14.59) 1322 123 No 0.202

0.186 (0.217)

FDI Inflow in t-1 (log) 1.467 -1.223

ICSID Convention in t-1 -57.57*** (20.43) Observations 1222 Number of Countries 123 Time Effects Yes R-squared (within) 0.216 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

14.41*** -2.836

0.00561 (0.0162)

Trade Openness in t-1

ICSID Convention

15.78*** -2.854 -0.0451 (0.0552)

Development Aid in t-1 (%GNI)

FDI Inflow (log)

0.0461 (0.453) -0,0244 -0,0409

GDP per Capita in t-1 (log)

Trade Openness

-0.170 (0.571)

0.440 (0.568)

Domestic Regulation (averaged 3 years)

Development Aid (%GNI)

-VI-

0.0697 (0.0523)

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-V-

-0.0921 (0.697)

Appendix D

219

Dependent Variable: Regulatory Quality (OECD BITs) -IOECD BITs (log)

-II-

-III-

-IV-

OECD BITs in t-1 (log)

-0.0804*

-0.0762

-0.0752

(0.0459)

(0.0479)

(0.0466)

BITs (sum 3 years) Domestic Regulation (log)

0.0988***

0.133***

-0.0192

(0.0372)

(0.0392)

(0.0293) 0.00352 (0.00532)

0.990*** (0.193) 0.740***

0.835***

0.539***

(0.168)

(0.180)

(0.182)

(0.156)

0.00624**

0.00733***

0.00586**

0.00765***

0.00581**

(0.00263)

(0.00225)

(0.00274)

(0.00239)

(0.00233)

-0.000668 (0.00133)

-0.000704 (0.00127)

-9.86e-05 (0.00137)

-0.000341 (0.00136)

-0.00138 (0.00136)

0.0318***

0.0306**

0.0315**

0.0305**

(0.0118)

(0.0125)

(0.0125)

(0.0122)

-0.000916 (0.00115)

FDI Inflow (log) 0.0461*** (0.0124) -0.0226 (0.0834)

ICSID Convention in t-1 -8.411*** -1436 Observations 932 Number of Countries 133 Time Effects Yes R-squared (within) 0.211 *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses Constant

0.805***

(0.180) (0.00291)

Trade Openness in t-1

ICSID Convention

0.851*** 0.00862***

Development Aid in t-1 (%GNI)

FDI Inflow in t-1 (log)

(0.0490) (0.00732)

GDP per Capita in t-1 (log)

Trade Openness

-0.153***

0.107*** (0.0404)

Domestic Regulation (sum 3 years)

Development Aid (%GNI)

-VI-

0.00472

Domestic Regulation in t-1 (log)

GDP per Capita (log)

-V-

-0.0513 (0.0472)

0.00725

0.0131

0.0490

-0.0126

-0.0135

(0.0847) -6.631*** -1249 1045 133 Yes 0.171

(0.0874) -6.195*** -1205 1124 140 Yes 0.132

(0.0811) -5.811*** -1306 1105 133 Yes 0.154

(0.0838) -6.554*** -1274 1063 133 Yes 0.147

(0.0863) -4.241*** -1035 1045 133 No 0.083

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