Balkinization: The Case Against ISDS

The Case Against ISDS

Guest Blogger

David Singh Grewal and Marco Simons

If the Obama administration’s ambitious new trade agreements—the Trans-Pacific Partnership (TPP) and the Trans-Atlantic Trade and Investment Partnership—are ultimately ratified, what kinds of stories are we likely to hear from the world of international trade?

In Washington State, a mining company wants to expand a quarry. The local communities participate in the environmental impact statement (EIS) process, and many residents object to the project. Citing these concerns, the state government rejects the quarry expansion. Is this participatory democracy in action? No, it’s the violation of a foreign trade agreement. Because the mining company is registered abroad, a panel of arbitrators rules that the U.S. government needs to pay the company for the loss of profits it might have made had the expansion been approved.

In Philadelphia, the city twice denies a permit to build a hazardous waste dump; residents are concerned about threats of contaminated water. A new private company buys the site and obtains federal and state licenses to build the dump. Rather than wait for a city construction permit, it begins construction. The city again denies the permit, citing the fact that construction had started illegally without a permit, as well as environmental impact and public opposition. Unfortunately, the company is a subsidiary of a foreign corporation, and an international tribunal decides that the government needs to pay back the company for its investment in the project, including the costs it expended in the unlicensed construction.

Horror stories? Fear-mongering from the likes of Senator Elizabeth Warren—or what President Obama has dismissed as “law professor hypotheticals”? We wish that were the case. But substitute Nova Scotia for Washington State, and Gaudalcazar, Mexico, for Philadelphia, and these cases have already happened. In March of this year, a NAFTA arbitration panel awarded Bilcon, a Delaware-based mining company, damages because the Canadian authorities rejected its EIS for a quarry expansion. This was not a particularly novel ruling; the case against Mexico, which denied a construction permit for a hazardous waste facility in Guadalcazar, was decided by a tribunal back in 2000.

These results are the consequence of a procedure known as “investor-state dispute settlement,” or ISDS. Thanks to the Obama-Warren debate over fast track, this acronym has made an unlikely journey from the obscure world of international arbitration to the headlines of major newspapers. But what is ISDS – and why does it have us worried?

ISDS is an arbitration mechanism unfamiliar to many legal academics and businesspeople, let alone the politicians and activists who are now rapidly getting up to speed on its arcane details. In essence, it allows multinational corporations that believe they’ve been harmed by government regulation to sidestep the national court system and turn, instead, to a panel of private arbitrators. Trade and investment treaties, such as NAFTA and the proposed TPP and TTIP, grant multinationals the right to special investment protections, including compensation when government regulation affects their expected profits. Arbitration panels are empowered to decide on the extent of the harm and the appropriate level of compensation.

Giving foreign corporations the right to sue governments, including our government, has many people worried. Senator Warren has pointed to a litany of ISDS cases, including challenges to a minimum wage increase in Egypt and to financial regulation in the Czech Republic, to argue against the current trade deals. The White House has responded that these concerns are unfounded – and that the investor protections in the TPP and TTIP merely provide the “same protections” provided by U.S. law, and that arbitrators cannot force changes in U.S. regulations.

Neither side is completely correct. But Warren is right to believe that Americans should be very concerned about incorporating this procedure in the trade deals that will encompass most of the world’s economy.

Let’s take a look at NAFTA, rather than the examples that Senator Warren has chosen, since the Egyptian and Czech cases have arisen under different agreements, and have not yet been decided. Anyone who suggests that NAFTA provides the “same protections” as U.S. law is either unfamiliar with the law, or simply not telling the truth. Consider, for example, NAFTA’s provision protecting companies from loss due to “indirect expropriation.” Direct expropriation is expropriation as normally understood – as the White House puts it, when the government “takes its citizens’ property from them.” But indirect expropriation is a different concept altogether: it allegedly occurs when government regulation hurts a foreign corporation’s expected profits or increases its costs of doing business. Under U.S. law, such “indirect expropriation” would be considered under the standards developed to assess “regulatory takings.” These standards are, rightly, strict—since an expansive view would make government nearly impossible—and they include looking at a range of factors.

In NAFTA decisions, indirect expropriation occurs when a corporation suffers a loss of a “significant part” of its “reasonably-to-be-expected economic benefit.” And it is compensable if a panel of arbitrators decides that the government’s action is not “proportional” to the public interest rationales for its regulation, in relation to the corporation’s economic harm.

The White House is thus correct to claim that arbitrators cannot make a government change its regulation. But they can force it to pay money to keep those regulations in place. That’s what actually happened in the Guadalcazar case, Metalclad v. Mexico, which was decided under NAFTA. The arbitrators decided that even though the company had gone forward with construction of a hazardous waste dump without a municipal permit, they reasonably expected that permit to be issued anyway, despite the fact that it had been denied twice before.

And this is only one of several interpretations of “indirect expropriation.” Because there is no system of precedent in ISDS, different arbitrators may come to different conclusions without regard for previous rulings. The Metalclad decision is one approach, but another – which also arose in a case against Mexico – is even more worrying. Tecmed v. Mexico was another case involving a hazardous waste dump, in which the government had refused to renew a license to operate the facility. The arbitrators decided that expropriation was present so long as the company suffered a substantial economic loss due to the regulation, and that the government’s action was not “proportional to the public interest presumably protected” in relation to the company’s financial loss. (Bizarrely, this proportionality test was borrowed from decisions of the European Court of Human Rights.) While Tecmed was decided under a different treaty, its proportionality test has since been adopted by at least one NAFTA tribunal.

The Nova Scotia case, Bilcon v. Canada, was decided under a different NAFTA investor protection – the “minimum standard of treatment” – but the analysis was similar to Metalclad. In both cases, a panel of arbitrators decided that the corporation’s expectations were an important factor in determining whether their rights had been violated. And, in both cases, the arbitrators decided that the government needed to pay a foreign company as the price of domestic environmental protection decisions. We are confident that this would never have happened under U.S. law.

It isn't at all clear that these cases would have come out this way under US law. Further, these cases are being decided by a class of private adjudicators acting without precedent or public accountability. ISDS puts private arbitration panels in the position of deciding whether governments have chosen policies to protect labor rights, public health, and the environment in a way that changes the expected profits of multinational corporations—and whether those changes should be compensated. What this means is that these agreements create a bias against new regulations, including those in the public interest. Without these treaties, the U.S. government would be free to regulate in any way consistent with the Constitution – even if it were to diminish the expected profits of domestic or foreign companies in doing so.

While these would be worrying results for the United States, ISDS poses perhaps a greater risk to our foreign allies. We already have a robust system of environmental, public health, and labor protections, but many of our trading partners – especially the several developing countries in the 12-nation TPP negotiating bloc – do not. They are still working to write new laws as their economies develop. President Obama has suggested that the TPP will help these countries bring their laws up to global standards, but ISDS may, in fact, lead to the opposite result. Each new law will be subject to challenge if it costs multinationals or reduces their profits—and thus the very “catch-up” that proponents hope to stimulate may be undermined.

Some commentators have referred to this problem as regulatory “chill”—that governments will be afraid to enact new regulations owing to the threat of ISDS arbitration. Last year the New York Times reported that Namibia has delayed implementing tobacco regulations due to such threats. But regulatory “freeze” might be a more accurate description. Regulations are effectively frozen at the time ISDS is enacted: everything that happens after that might diminish an investor’s value becomes the basis for a potential lawsuit.

While this concern about ISDS has been raised by academic commentators—including celebrated economists Joseph Stiglitz and Paul Krugman, and over a hundred law professors and jurists—there are other serious issues, which have not gotten enough attention in this debate.

First, the usual rationale for ISDS is that it increases investment where it is most needed—in the developing world—by protecting foreign investors from undue government interference. But by shielding the most powerful corporations from the normal judicial system and putting them into a privatized, parallel track, ISDS may take pressure off these countries to achieve judicial reforms that would benefit everyone—foreign corporations and ordinary citizens alike.

With ISDS, multinational corporations have no need to support the rule of law, because they don’t need local courts. Likewise, governments that want to attract investment don’t need to root out corruption and unfairness in their judicial systems as a whole.

Second, ISDS rather obviously threatens to undermine sovereignty by substituting ad hoc private arbitral panels for the decision-making of the legitimate public authorities. But a recently proposed solution to this problem—the creation of permanent courts of arbitration—would only compound the legitimacy gap. An ad hoc panel deciding cases that come before it may prove compatible with national legal systems, particularly if future ISDS mechanisms specify that panel rulings may be subject to appellate review by national bodies. But a “closed list” of arbitrators constituting a permanent “Investment Court,” as recently proposed by European trade negotiators, presents not a viable reform to ISDS but a far-reaching transfer of sovereign power from national governments to a new supranational body. Such a move may be consistent with recent European Union experience, but not with American norms of self-government.

So why is ISDS in Obama’s proposed trade agreements? To be clear, we don’t know what role it will play in these agreements, as the drafts remain classified under a national security provision—and it is only from leaks and the release of the European negotiating draft that we know about the proposed ISDS. But there is no doubt that U.S. negotiators are pushing to include ISDS provisions.

Some of the enthusiasm for investor-state arbitration can be attributed to the success of a different, earlier arbitration regime. Under a 1958 treaty, commercial arbitration for cross-border disputes between companies has become extremely widespread and highly effective. Such international commercial arbitration (ICA) differs crucially from ISDS in that the parties under ICA are only corporations, not entire governments and their attendant public policies. Nonetheless, the success of ICA has boosted arbitration in the view of international lawyers, who have sought to extend this success to the very different terrain of foreign investment disputes.

But it would be naïve to place too much weight on the success of ICA in explaining the current push for ISDS. The real force behind this push comes from the interests of powerful corporations and the politicians they influence. The current U.S. Trade Representative in charge of shepherding these agreements through Congress, Mike Froman, is a former managing director of Citigroup. The U.S. negotiating positions were drafted with abundant input from over 500 “advisors” – 85% of whom represent corporate interests – and it is unsurprising that they offer a corporate perspective on ISDS.

It is now up to the House of Representatives to decide whether it wants to keep special rights for foreign corporations in these agreements. If the House rejects fast track authority, Congress can exercise its discretion in choosing what it wants to pass of any proposed trade deals. But even in granting fast track, it would still be possible to keep ISDS out, via an amendment to specify the terms of any future agreement.

In the recent Senate vote for fast track authority, Senator Warren’s proposed amendment to prohibit ISDS was defeated. But a new chance to stop ISDS will come up in the House debates. Legislation sponsored by Representative Mark Pocan (D-WI) and co-sponsored by a dozen lawmakers would ban investor-state provisions in future trade agreements.

It remains to be seen whether the strange alliance of President Obama and the House Republicans will succeed in pushing through these trade agreements—and, with them, a new legal regime for cross-border corporate investment. President Obama has argued that the TPP is necessary because “if we don’t write the rules, China will.” But with these special investor protections included, the only rules that will get written are those that pass muster with multinational corporations.

David Singh Grewal is Associate Professor, Yale Law School. You can reach him by e-mail at david.grewal at yale.edu

Marco Simons is Legal Director, EarthRights International. You can reach him by e-mail at marco at earthrights.org.

Posted 7:21 PM by Guest Blogger [link]