Illicit Money Flows as Motives for FDI

M. Fabricio Perez, Josef C. Brada & Zdenek Drabek, “Illicit Money Flows as Motives for FDI”, 40 Journal of Comparative Economics 108-126 (2012)

The use of arbitration for the purposes of international money laundering has received a significant degree of discussion recently.  Perez, Brada and Drabek do not focus on (or even address) this specific question, but their discussion of the use of foreign direct investment as a means of laundering money from illicit enterprises is clearly of interest to any practicing arbitrator.

To anyone unfamiliar with the topic, illicit money flows will turn out to be a surprisingly significant element of international money transfers.  Indeed according to the authors, “[i]llicit money flows, meaning flows of money that is either earned through, or used for, illegal activity or moved across borders illegally, may be as large as one trillion US dollars per year from developing countries alone” (109).

It may seem that foreign direct investment would be an implausible method of laundering money, given the requirement of significant spending in the Host State in order to establish the entity through which money is to be laundered.  However, the authors to a good job of explaining both the process involved and why it is attractive to those wishing to launder money.  “First, the establishment of foreign firms constitutes a movement of money from the home country to the host country that in itself may constitute the transfer of illicit funds abroad.  The second, and more important in terms of the amount of money moved offshore, way in which FDI facilitates illicit international money flows lies in the ability of the foreign affiliate to internalize, and thus lower, the transaction costs of moving illicit funds between the home country and the host country in which the affiliate is domiciled through channels such as under- or over-invoicing, false payments for services, phony capital injections and loans, etc.  Third, FDI may ‘legitimize’ investors’ assets of dubious origin in the home country by establishing a bona fide corporate presence in the host country.  The establishment of a physical presence abroad through FDI will fundamentally strengthen the investor’s ownership of the assets by putting them under the protection of a foreign legal system or bilateral investment treaty.” (110)

The major problem faced by any study of illicit money flows is, of course, precisely the illicit nature of those flows, as the secrecy such flows requires makes it almost impossible to identify how much of any given portion of FDI has resulted from the illicit movement of funds.  Acknowledging this problem, the authors have nonetheless adopted a method reasonably suited to provide at least a plausible estimate of the impact of illicit money flows on FDI.

The authors analyse FDI outflows for six East European transition economies (Bulgaria, the Czech Republic, Estonia, Hungary, Macedonia and Slovenia), and conclude that the ultimate destinations of significant amounts of this FDI can only be explained through an assumption that the funds in question were being transferred for illicit purposes.  That is, certain countries known to be used for money laundering attract significantly more FDI (from the countries being studied) than would be predicted by the conventional measures of the attractiveness of a State for FDI.

In quantitative terms, the authors conclude that “in average 29% percent [sic] of total FDI [from the countries being studied] is directed toward countries that are money laundering centers and that, of the FDI going to these countries, about 20% is motivated by the desire to facilitate illicit money flows.” (125)  The article is very thorough, and investigates and rejects a variety of potential alternative explanations for the observable patterns of FDI flows.

Admittedly, the detailed statistical analyses that compose most of the article are unlikely to be interesting to most arbitration specialists, but the results of the study clearly are.  After all, the possibility that foreign direct investment might be used as a means of laundering the proceeds of criminal operations poses notable issues for arbitration as it is currently conceived.  Arbitrators almost universally see their role as one based entirely on a contractual agreement between the arbitrator and the parties, that gives them the right to decide the dispute that has been submitted to them, but certainly does not allow them to exercise the broader public responsibilities of a judge.

To some degree this understanding of the role of arbitrator has to be right.  However, the possibility of a “fake” arbitration, created by the parties as a means of legitimising illicit money flows, creates a clear problem for this contract-centered conception of arbitration.  The terms of an arbitrator’s contract, after all, are hardly likely to specifically give him/her the right to resign if he/she decides there is something questionable about the transaction.  Moreover, the contractual conception of arbitration is arguably inconsistent with the very notion of arbitrators unilaterally determining the legitimacy of the dispute they are being paid to decide.  If clear evidence arises that delivering an award would facilitate a criminal transaction then clearly the arbitrator can legitimately refuse to do so.  However, there is little question that parties hiring an arbitrator do not implicitly give the arbitrator an unchecked power to derail the arbitral process merely because he/she is suspicious that something illicit might be going on.

This put arbitrators in a very difficult position, though, as no legitimate practitioner is going to be comfortable with the notion that he/she is facilitating a criminal enterprise, no matter how formally legitimate his/her own activities may be.

That discomfort on the part of the arbitrator is the only issue arbitration-based money laundering raises for the contractual conception of arbitration is, though, surely problematic in itself.  After all, it is simply no longer true that arbitration is a process chosen by private parties and merely accepted by acquiescing governments.  Instead, in many jurisdictions arbitration has been actively embraced by both legislatures and judiciaries as part of the civil justice process.  Courts in these jurisdictions no longer merely allow parties to arbitrate, but have instead adopted “pro-arbitration” stances that require parties to arbitrate where only a purely formal consent to arbitration exists.

This is not a case, that is, of courts respecting the free choice of parties to take their disputes to a private dispute resolution mechanism.  It reflects instead a policy decision to use arbitration as a means of settling disputes that would otherwise be pursued in the courts.  Increasingly, that is, in many jurisdictions, arbitration is no longer accurately characterised as a purely private process, but has instead become an amalgam of private and public dispute resolution.

Assuming this characterisation is true, however, it then follows that the contractual conception of arbitration is simply no longer accurate, as it is no longer the case that arbitrators are merely serving private parties, and so need only worry about their obligations to those parties.  Instead, while an arbitrator’s obligations to the parties clearly still exist, the incorporation of arbitration into the judicial structure of a jurisdiction means that arbitrators are also performing the role of civil justice administration traditionally allocated to the courts.  Arbitrators, that is, however unwillingly, are being used as agents of the public judicial process, rather than only being agents of the parties to the dispute.

Rejection of the contractual conception of arbitration, however, means that arbitrators can no longer legitimately ignore the possibility that the procedure they administer is being used for money laundering.  While the obligations of an arbitrator remain importantly different to those of a judge, the role of any individual engaged in the administration of civil justice must surely involve preventing the process being used for criminal purposes.

Of course, this arguably puts arbitrators in an even more difficult position.  Fidelity to the arbitral process requires that arbitrators not undermine the confidence of the parties by undertaking unilateral investigations into the legitimacy of the dispute underlying the arbitration.  Yet open discussions with the parties of an arbitrator’s concerns might result in allegations of impartiality that could undermine the enforceability of the award, or could even result in threats if the arbitrator’s suspicions are true.

Ultimately, however, it may be that openness and honesty on the arbitrator’s part is the best approach.  If the contractual conception of the role of an arbitrator is indeed no longer accurate, then the arbitrator cannot simply shrug off his/her obligation to protect the integrity of the civil judicial process merely by pointing to the “private” nature of the arbitration he/she is administering.  A tactfully-phrased request to the parties for further information on the underlying details of the transaction, emphasising the arbitrator’s obligations rather than his/her suspicions, should, however, avoid raising any significant risk of a challenge for impartiality, while still fulfilling the arbitrator’s obligation to administer a legitimate proceeding.

A New Generation of International Adjudication

Gary Born, “A New Generation of International Adjudication”, 61 Duke Law Journal 775-879 (2010)

Gary Born is, of course, widely recognised as not only one of the leading experts on international commercial arbitration, but also both a prominent arbitrator and a top practitioner.  Consequently, a 100 page article published in a leading U.S. law review is unavoidably of interest to anyone who works in or on arbitration.  Indeed this article is clearly intended by Born to be a major statement on contemporary international adjudication.  It should be emphasised, though, that this article is importantly different to the works for which Born is famous, as it is squarely aimed at scholars of public international law (PIL) rather than specialists in arbitration, and is intended to contribute to academic debate rather than legal practice.

With this in mind, it has to be acknowledged that the article is only a partial success.  Born has identified an important point, and with his characteristic thoroughness makes a convincing case for his position.  However, the article is ultimately undermined by both a one-sidedness that befits a legal brief more than an academic article, and a failure to address what Born himself identifies as the most difficult and interesting aspects of his topic.

Born’s goal in writing this article is to alter the approach that PIL scholars overwhelmingly adopt in discussing the nature of international adjudication.  As Born notes, most PIL scholars discuss international adjudication as though it consisted solely of hearings before tribunals such as the International Court of Justice or the International Tribunal for the Law of the Sea, which Born labels “first generation” tribunals.  Tribunals of this type hear only State-State disputes, cannot compel an unwilling State to participate in proceedings, are rarely (sometimes almost never) used, and lack any real power to enforce the judgements they deliver.  Because of these characteristics, PIL scholars broadly concur that international adjudication is fundamentally different in nature to domestic court adjudication.  At best it is merely a means of providing information to States that can be fed into a subsequent settlement between the parties, and at worst it is a useless charade adopted solely for political purposes.

Born spends a long time discussing the structure and operation of a number of first generation tribunals, and reiterates the conventional criticism that they are ultimately ill-designed to resolve the disputes brought before them.  In this respect, then, there is little innovative in Born’s argument, as he is merely repeating criticisms regularly made by PIL scholars themselves.

The important second step that Born takes, however, is to turn from first generation tribunals to what he calls “second generation” tribunals, including international investment arbitration tribunals and WTO tribunals.  These tribunals, Born argues, are of a fundamentally different nature to first generation tribunals.  They can compel unwilling States to participate in proceedings (or else conduct the proceedings without the State’s participation), are regularly used as fora for the resolution of disputes, and issue judgments that are far more enforceable than those issued by first generation tribunals.

These fundamental differences between first and second generation tribunals, Born argues, mean that any discussion of international adjudication that concentrates only on first generation tribunals will simply be inaccurate.  Contemporary international adjudication simply cannot be understood without attending properly to the important role of second generation tribunals in the resolution of international disputes.

Born’s insight is important, and he makes his case convincingly.  However, he makes no attempt to proceed beyond the simple identification of the need to attend to second generation tribunals.  Instead, he simply notes that it is “striking and necessary” to consider the appropriateness of second generation tribunals for “future forms of international adjudication”, but that such issues will be addressed in “a forthcoming companion piece” (876).

This is, though, simply to sidestep the truly interesting and important aspects of the topic he is addressing.  After all, first generation tribunals do not adjudicate the same disputes as second generation tribunals, so can hardly be taken to have replaced them.  Moreover, Born has spent the entire article comparing the structures of first and second generation tribunals, and criticising first generation tribunals as inadequately designed for the resolution of international disputes.  Yet he does not even consider whether these differences in structure indicate that the two types of tribunal are intended to serve different functions – and that the resolution of international disputes is not actually the primary function of a first generation tribunal.

This is a particularly important omission because the dismissive approach that Born takes to first generation tribunals (stating at one point, for example, that “it is impossible to conclude that the ICJ has played a significant role in international affairs over the course of its sixty-five year history” (807)) suggests that even in this article’s companion piece this issue is unlikely to get the attention it deserves.

This is because Born’s standard for the effectiveness of an international tribunal ultimately focuses overwhelmingly on the ability of that tribunal to resolve specific disputes.  That is, to resolve the cases brought before it.  Yet it is hardly surprising that second generation tribunals, which address narrow disputes and have the power to award financial damages (of one form or another), are more successful than first generation tribunals, which focus on the development of broad points of international law and deliver verdicts that impact directly on issues of national sovereignty (such as the awarding of territory between disputing States).  A more modest goal is always easier to reach.

It is not clear, though, why the resolution of specific disputes should be the standard by which international tribunals are judged.  It may be appropriate for a second generation tribunal, which is indeed designed specifically for this purpose, but it is unclear that first generation tribunals really serve this role any longer.  That is, while a decision by the International Court of Justice is still technically the resolution of a dispute between two States, and is not formally binding on any other State, it is actually approached both by the Court and by those reading the judgment as a statement of the content of international law.  First generation tribunals, that is, are perhaps better understood as fora for the development of principles of law, rather than as fora for the resolution of specific disputes.

Yet if it is true that first and second generation tribunals serve different purposes, as their different structures would suggest, it is inappropriate to judge both of them by their ability to achieve a goal that only one of them is attempting to achieve.

A real evaluation of international adjudication, then, certainly requires attention to second generation tribunals as well as first generation tribunals, as Born convincingly argues.  However, it also requires careful attention to the nature of each tribunal, in order to understand its function within the broader scheme of international adjudication, and this is something that in this article Born fails to achieve.

Supersanctions and Sovereign Debt Repayment

Kris James Mitchener & Marc. D. Weidenmier, “Supersanctions and Sovereign Debt Repayment”, 29 Journal of International Money and Finance 19-36 (2010)

A standard feature of almost every discussion of the history of international investment law is a negative use of the term “gunboat diplomacy” to describe the methods used by developed States in the 19^th Century to protect the interests of their investors abroad.  The image invoked by this term is one of powerful European and North American States dispatching military units as a sort of global “enforcer”, threatening death and destruction to any State whose actions appear likely to cause losses to the sending State’s citizens.  In short, it creates an image of a richer State bullying a developing State into actions likely inconsistent with that developing State’s best interests.  It’s a politically useful image, but unsurprisingly the reality is more complicated.

The primary concern raised by gunboat diplomacy relates, of course, to national sovereignty, as the allegation is not that developed States in this period used military force to extract payments to investors that were not actually owed.  It is sometimes claimed that developed States made insufficient efforts to determine the legitimacy of the claims of their foreign investors, and instead merely took them at their word.  However, this is merely to claim blameworthy negligence, rather than intentional extraction of undeserved payments, and so doesn’t change the nature of what was being done.

The issue, then, is that developed States were using their superior military force to require developing States to make payments that the governments of those States had decided were not in the national interest to make.  States, of course, had long possessed the power simply to disown debt when it was convenient to do so, generally suffering no greater consequence than less accessible credit in the future.  The use of military force to require payment was fundamentally inconsistent with this power, and subjected developing States to the desires of other governments with little or no interest in the impact of debt repayment on domestic policies.

It is important to remember, though, that applying pressure to a State in order to influence its policies is not in itself unacceptable under international law.  Indeed, the skillful application of pressure is precisely what diplomacy is all about.  Moreover, these actions were taken in the 19^th Century, the time of Clausewitz’s notion of war as the “continuation of politics by other means”.

As disturbing as the possibility of the use of military force was, then, to those against whom it was threatened, it is far from clear that it was actually against international law as it existed at the time.  Which, of course, leads to the interesting follow-up question: If it was legal, was it nonetheless right?

Mitchener and Weidenmier’s article attempts to provide one type of answer to this question, by focusing on the impact of gunboat diplomacy and similar actions on the long-term credit-worthiness of developing States.  They focus, that is, on whether what they term “supersanctions” ultimately provided a benefit to those States against which they were used, or whether they only served to protect the interests of the investors on whose behalf they were imposed.

As used by Mitchell and Weidenmier, the term “supersanction” includes not only gunboat diplomacy but also actions taken by developed States in the 19^th Century that deprived developing States of important aspects of their fiscal sovereignty – resulting in what Mitchener and Weidenmier memorably term “fiscal house arrest”.  However, while in this respect the article is broader than a discussion merely of gunboat diplomacy, in another important respect it is actually narrower.  That is, it only addresses the use of supersanctions in the context of sovereign default, not as a means of protecting the interests of foreign investors more generally.  Consequently, actions taken to protect the interests of foreign investors from threats other than sovereign default are simply not considered.

These questions of scope noted, Mitchener and Weidenmier’s analysis is important for any analysis of the appropriateness of the use of gunboat diplomacy in the 19^th Century, as they present compelling evidence that the imposition of supersanctions did indeed significantly improve the credit worthiness of sanctioned States:  “The use of gunboats or financial ‘house arrest’ had a significant impact on the reputation of sovereign debtors in the London capital market and appears to have deterred future default.  According to data on new debt issues, the ex ante probability on a principal default decreased by more than 60 percent after a country had been supersanctioned.  We also find a country’s risk premium, measured as the yield spread over consols, declined by approximately 200 basis points because of improved fiscal discipline.  An improved trade balance also seems to have been a factor in reducing sovereign risk following the implementation of debt sanctions.” (34)

Sovereign default was certainly a major problem in this period, particularly in Latin America, where almost every State defaulted at least once in the period 1867-1912, and some States defaulted two, three or even four times.  Consequently, evidence that the imposition of supersanctions reduced the risk of subsequent defaults, and lowered the cost of future borrowing by the sanctioned State, suggests that bullying a weaker State into maintaining sovereign debt repayment was unlikely to have been the primary motivation of sanctioning States.  This was, after all, a period in which international trade was seen as enormously important, and even the United Kingdom, the State most likely to employ such measures, routinely asserted that it felt no obligation to use supersanctions to protect those who had decided to invest abroad.

Mitchener and Weidenmier’s analysis, then, supports a richer understanding of the use of gunboat diplomacy in this period, in which it can only be understood in the context of broader political and policy goals of the sending State, and not merely as the use of military force in support of foreign investors.

That said, the article is nonetheless significantly handicapped by the ignoring of normative issues that characterises much writing by economists.  After all, it is surely unsurprising that the threat of military attack, or of the loss to a foreign State of control over important aspects of national finances, was both positively received by the financial markets, and effective at restoring fiscal discipline to defaulting States.  After all, when State is run in a manner that prioritises the payment of foreign debt over other governmental concerns, the risk of default will unavoidably be lower, and foreign lenders will therefore be much more willing to lend.

This ignores, though, that repayment of foreign debt is not the only obligation a government has, and that prioritising such repayment will unavoidably result in other needs not being met – most likely the needs of those most vulnerable within the State.  Whatever the effectiveness of supersanctions as a means of restoring a State’s fiscal respectability, then, it simply does not follow from this effectiveness that supersanctions are desirable – a point that is worth noting in light of Mitchener and Weidenmier’s concluding suggestion that contemporary defaulting States might benefit from “third-party financial control by foreign central bankers” (35).

What would be interesting as follow-up research to Mitchener and Weidenmier’s useful article is an analysis of the domestic impact of supersanctions in those countries in which they were imposed.  Only with this information would it be possible really to evaluate the acceptability of the use of supersanctions, including gunboat diplomacy, in a period enormously important for the development of contemporary international investment law.

National Oil Companies and International Oil Companies in the Middle East

Paul Stevens, “National Oil Companies and International Oil Companies in the Middle East: Under the Shadow of Government and the Resource Nationalism Cycle”, 1 Journal of World Energy Law & Business 5-30 (2008)

Although the title of Stevens’ article suggests it is a specialised discussion of the oil industry in the Middle East, this underestimates the broad applicability of Stevens’ often-insightful analysis.  From the perspective of anyone interested in investment law more generally, then, the article can certainly be approached as a discussion of the changes in attitude of developing State governments to foreign investment through the course of the twentieth century.

Stevens divides the twentieth century into four broad periods, and in this respect his analysis is little different from that provided in most commentaries.  What is distinctive and valuable about Stevens’ approach, however, is the emphasis he places on identifying and explaining the influential economic theories for each period.  In this way he does an excellent job of demonstrating that economists were not always opposed to State control of major national industries, and indeed at the time that developing State governments undertook their major wave of nationalisations, much economic theory supported precisely such actions.  His article provides a useful corrective, then, to many discussions of that period, which often treat developing State governments as almost unthinking pawns of nationalist and anti-Western ideology.

The four periods Stevens identifies are as follows:

(1) “Pre-World War II: Seeding the conflicts”:  As is well known, much of the developing world remained dominated by colonial powers in this period.  As a result, there simply was no room for any discussion of “resource nationalism” or the desirability of foreign investment as an aid to development.  Instead, developed States often simply controlled foreign investment in whatever way would be most beneficial to themselves, either economically or politically, leaving local populations little to no real input.  As put by Stevens with respect to the Middle Eastern oil industry: “[B]y the end of the 1930s, the spheres of influence had been agreed and the oil concessions allocated accordingly between the various companies.  In this period, the Middle East governments were not allowed by their colonial masters to harbour any thoughts of ‘resource nationalism’ or indeed any form of nationalism, although at times Ibn Saud tended to side step such niceties.” (9)

(2) “The 1950s and the 1960s: Golden Years”:  This situation changed radically after World War II, with the end of colonialism and the independence of a significant number of States.  Local populations now had the power to put into practice their own views on the desirability of foreign investment, and many were not very positive about it.  Of course, this is again well-known history.  As noted above, however, Stevens spends considerable time discussing the contemporary economic theories on State control of important national industries, on which many governments relied when justifying expropriations and nationalisations.  Political motivations were, of course, just as important as legitimate economic analysis, although Stevens’ own discussion fails to give adequate recognition to this point.  Nonetheless, by clarifying the level of support among contemporary economists for State control of important national industries, Stevens decisively undermines the view that developing State governments of this period simply rejected economic expertise in favour of political ideology.  Economic opinion soon changed, of course, and ultimately the retention of State-owned industries came to be motivated less by solid economic theory than by a combination of political ideology and personal corruption.  However, at this time even many economists supported the actions that developing State governments were taking.

(3) “The 1970s: Nationalization and Closure”: The 1970s represented an important turning point in the views of developing States regarding foreign investment.  Foreign investors were initially still regarded with suspicion, and the high profits of certain industries meant that government control of important industries could easily be portrayed as a success.  However, by the end of the decade it had become clear that the wave of nationalisations and expropriations had not led to the rapid development that had been expected.  Nationalised companies often had goals incompatible with those of the government, meaning that either the company was forced by the government to sacrifice profit for political gain, or the company yielded profits but became largely indistinguishable from the foreign-owned corporations they had been created to replace.  In addition, the importance of many nationalised companies to their national economy gave those in charge of the companies enormous political power, and created significant opportunities for corruption.  Consequently, by the end of the decade, developing State governments were open to an alternative approach.

(4) “The 1980s: The Washington Consensus and Opening”: Stevens’ discussion of the intellectual context of the turn by developing States towards foreign investment is as valuable as his discussion of the rejection of foreign investment in the 1950s and 1960s.  Again, he convincingly shows that this change was not exclusively driven by the failure of most developing States to achieve the development they had expected from the pro-national-control policies of the past.  Instead, while the obvious failure of past policies had made a change in economic ideology politically workable, economic theory had itself changed since the 1960s, and now was almost uniformly opposed to State control of industries and in favour of foreign investment and the unfettered rule of the free market.  Again, then, Stevens’ discussion allows proper credit to be given to those involved in decision-making in developing State governments, rather than simply portraying them as blindly wandering from one ideology to the next in the hope that eventually something will work.

All in all this is an excellent article, and highly recommended for anyone not already conversant with the economic theories that justified and then opposed State control of important national industries.  It would be significantly stronger if it also paid proper attention to the influence of political beliefs on governmental decision-making, but it remains nonetheless a fascinating article that is a valuable addition to the literature on this period.

Arbitration Without Privity

Jan Paulsson, “Arbitration Without Privity”, 10 ICSID Review – Foreign Investment Law Journal 232-257 (1995)

“Arbitration without Privity” was one of the earliest publications to give voice to the idea that something importantly new had occurred with the recognition by investor-State arbitration tribunals that a consent to arbitration found in a bilateral investment treaty (BIT) could be binding on a State even absent a second consent by the State to arbitrate specifically with a particular investor.  It also gave this new development a memorable title, which is routinely invoked today as capturing an important reality about contemporary investor-State arbitration.  Paulsson’s article is, then, unquestionably of major historical importance.  Unfortunately, it lacks real importance beyond the historical, as Paulsson’s discussion of the new development that he wishes to identify is analytically quite weak, and fails to tackle seriously the specific way in which privity might or might not be lacking in contemporary international investment arbitration.

The concept of “privity” is at heart a fairly basic one, and reflects the common law’s commitment to the idea that a contract is ultimately a private matter between the parties that have agreed to it.  Consequently, no non-party to a contract can enforce a contract’s obligations, even if that non-party stood to benefit from the contract’s performance, as the obligation to perform the contract is owed only to the other parties to the contract, not to the third party.

At this point the potential discordance between the doctrine of privity and contemporary BIT-based arbitration becomes clear, as an arbitration in which the State’s consent to arbitrate is found in a BIT involves an attempt by a non-party to the BIT (the investor) to enforce the BIT’s obligations.  There is a clear sense, then, in which BIT-based arbitration constitutes “arbitration without privity”, and it is this notion of investors enforcing obligations contained in an agreement to which they are not a party on which Paulsson focuses (232).  For Paulsson, this makes BIT-based arbitration “dramatically different from anything previously known in the international sphere.” (256)

Unfortunately, Paulsson’s analysis never extends beyond this basic observation, and the rest of the article merely consists of a catalogue of recent agreements in which “arbitration without privity” can be found.  This is a pity, as consideration of the ways in which privity is and isn’t present in investor-State arbitration can have substantive impacts on how such arbitrations should operate.

It is, for example, unclear that “arbitration without privity” as Paulsson conceives it is quite as revolutionary as he presents it as being.  Privity is an important doctrine in the context of litigation precisely because there is no agreement of any form between the plaintiff and the defendant.  Contemporary investor-State arbitration, however, unquestionably involves an agreement, namely the agreement to arbitrate.  Yet there was never anything that would have prevented a Host State entering into an agreement to arbitrate with an investor about whether the Host State had respected its obligations under a treaty with the investor’s Home State.  Host States had little incentive to agree to such arbitrations, but this was nonetheless a procedural option that was available.

“Arbitration without privity”, that is, doesn’t actually exist, as the arbitration agreement itself constitutes the agreement that the doctrine of privity requires.  What is notable about contemporary BITs, then, is not that they involve an assault on the “citadel of privity”, as Paulsson argues (255), but that they take up a procedural mechanism that was always available that but had rarely, if ever, been used.  Privity remains in such a context, but in an importantly different way.

However, merely because the procedural mechanism in question was always available does not mean its adoption was not a significant new development, as its impacts can potentially be considerable.  There are, after all, now two agreements operative with respect to the substantive obligations contained in the BIT: the BIT itself and the arbitration agreement between the Host State and the investor.  There is, however, no reason why these two agreements must say precisely the same thing.

For example, as Paulsson notes, many BITs are silent on the question of a State’s ability to bring counterclaims against the investor (232).  However, as was argued in the recent Roussalis v. Romania case, a situation may arise in which the investor and the Host State have separately agreed that counterclaims can be brought.  As the arbitration agreement constitutes a separate agreement from the BIT, there is not clearly any reason why the State should not be allowed to bring counterclaims in such a situation.  It is, after all, the Home State that lacks privity in this situation (i.e. to the arbitration agreement), not the investor, and so the Home State has no power to determine the content of the arbitration agreement.

It is certainly possible, though, that the BIT will not be silent on the question of counterclaims, but might instead expressly forbid them.  Given independence of the BIT and the arbitration agreement, and the lack of privity of the Home State to the arbitration agreement, this constaint included in the BIT would seem unable to constrain the content of the arbitration agreement.  As a result, counterclaims would seem to be acceptable if allowed by the arbitration agreement, even though by bringing a counterclaim the Host State has unquestionably violated the BIT.

The interesting question becomes how this violation can be addressed.  Traditional investor-State arbitration doctrine would hold that the arbitration agreement included in the BIT entitles the investor to enforce the provisions of the BIT.  Arguably this includes the prohibition on the bringing of counterclaims.  Consequently, the investor can indeed preclude counterclaims, despite having agreed to them.

However, such an analysis ignores the independence of the arbitration agreement and the BIT, and the power of the two parties to the arbitration agreement to create their own permissions and obligations.  Under the terms of the agreement to arbitrate, that is, the investor has an obligation to allow the Host State to bring counterclaims.  Consequently, any attempt by the investor to block counterclaims, through invocation of the relevant provision of the BIT, would arguably constitute a violation of the arbitration agreement.  As a result, the State might be held to have a right to bring a counterclaim under the arbitration agreement for the value of the counterclaim under the BIT, based on the investor’s violation of the arbitration agreement.

The independence of the arbitration agreement and the BIT, then, and a close analysis of the ways in which privity is and isn’t present with respect to the two agreements (and the three parties) significantly complicates what might initially have seemed a fairly basic problem.

The analysis provided here, of course, is merely one possible analysis of the situation described, and perhaps not the correct one.  The point being made is merely that recognition of the independence of the arbitration agreement from the BIT, and the impact this independence has on a “privity” analysis, potentially has important consequences for the functioning of investment arbitration.  That Paulsson did not fully appreciate these consequences in so early an article is understandable, but the simplicity of his analysis of the existence of “privity” in the investment arbitration context does significantly undermine the ongoing value of what was without question a ground-breaking article at the time it was written.

Expropriation of Foreign Direct Investments

Christopher Hajzler, “Expropriation of Foreign Direct Investments: Sectoral Patterns from 1993 to 2006”, 148 Review of World Economics 119-149 (2012)

Hajzler’s article isn’t based on any new research and merely collects and analyses data generated by other authors and already published elsewhere.  Nonetheless, his analysis is very well done, and as a result this article provides some very useful insights into the factors that are most likely to result in expropriations.

As with any empirical study it’s important to take close note of precisely how the central terms are defined, and Hajzler’s definition of expropriation is a notably narrow one, covering only direct expropriation, in which part or all of the title to an investment passes to the government.  This is a major limitation, as it is widely acknowledged that indirect expropriation is now far more common than direct expropriation.  As a result, Hajzler’s comments on the observable trends in expropriation have to be questioned, as they are based on far too limited a data set.  That noted, though, this problem shouldn’t be taken to undermine the value of Hajzler’s substantive analyses of the causes of expropriation, which are easily generalised to indirect expropriation as well.

Importantly, Hajzler does not attempt to identify a single factor that explains historical trends of expropriation, but instead argues that several factors are simultaneously operative, and that the rate of expropriation at any given time over the last four decades can be explained by the interaction of these factors.  Rather than attempting to explain expropriation through a pre-decided theoretical model, that is, Hajzler is willing to be guided by the evidence, and accepts the complexity of expropriation, rather than trying to explain it away.

Hazjler identifies four primary factors that appear to affect the rate at which governments expropriate foreign investments:  (i) the economic theory dominant within the government of the expropriating State, (ii) the ability of an act of expropriation to serve as a political statement, (iii) the ownership by foreign investors of certain categories of investments that are more likely to be subjected to expropriations, and (iv) the ability of the expropriating State to profit financially from the expropriation.

The first thing to be noted about this list is that financial profit is only one of the potential motivating factors for an expropriation.  Moreover, while this factor is perhaps understandably one that appears to foreign investors themselves to be the most influential (the State attempting to take for free what the investor has created), it turns out to play the smallest role of the four factors Hajzler identifies.  That is, there will indeed be cases in which a State expropriates an investment in order to take advantage of its profitability, but this will usually only be the case when the profits of that business are abnormally high (e.g. resulting from an enormous surge in natural resource prices).  Moreover, even when this factor is operational it will usually be tied to a more political consideration, such as the opportunity a State has to make a strong political statement by expropriating an investment that is popularly seen as generating unjustifiably high profits.

In short, money is rarely all that expropriation is about.  Instead, Hajzler argues, rates of expropriation can best be understood by concentrating on political and ideological factors.  Expropriation, that is, is usually a political act, not an economic one.

As an illustration of how Hajzler’s factors can be seen as operating, it can be useful to consider the 1970s, when rates of expropriation were far higher than had been seen before, or than have been seen since.  An explanation for these unusually high rates of expropriation might run as follows:  (i) Developing countries at the time had embraced an economic theory that emphasised the benefits to be gained by direct State ownership of important industries and criticised foreign investment as merely channelling profits abroad; (ii) Many of the States that engaged in expropriations in this period were newly emerged from colonialism, which meant that the act of taking an investment from a foreign owner could constitute a political statement of the new independence of the country; (iii) Those investments with the most political sensitivity (notably those in the natural resources sector) began the decade in the hands of foreign investors; (iv) Expropriation in the natural resources sector became particularly attractive to developing States because of the significant rise in prices for those materials, which both made an expropriation potentially more profitable and made the long-term contracts then in effect seem like an undeserved windfall for the foreign investor.

The particularly high rates of expropriation observed in the 1970s, then, resulted from an alignment of all four influences in a pro-expropriation direction.  In turn, the extraordinarily low rate of expropriation in the 1980s might be attributed to the rise of a pro-FDI economic theory and the fact that those assets most likely to be expropriated had already been expropriated in the 1970s.

The above are, of course, very casual analyses, and don’t give a proper feel for the sensitivity of Hajzler’s own analysis.  However, hopefully they give a sense of the usefulness of the observations that Hajzler makes.

This usefulness, though, shouldn’t be understood as being solely in the analysis of historical trends.  After all, if Hazjler is correct in his identification of the factors that influence rates of expropriation, then it is also possible to use these factors to analyse potential future trends in expropriation.  Doing so suggests that the recent rise in expropriation rates is not likely to end soon, as we are arguably again in a stage of aligned pro-exproriation influences, although by no means as extreme as the one encountered in the 1970s.  (i) The pro-business economic theory that has dominated since the 1980s has taken a battering in recent years.  It is certainly unlikely that any economic theories will take broad hold that encourage a return to widespread government ownership, but nonetheless it is clear that even the most business-friendly developed States are now endorsing an approach to capitalism that involves significantly more governmental control, intervention and even ownership than has recently been popular.  (ii)  The widespread perception in developing countries that the pro-business agenda urged upon them since the 1980s has failed to generate the promised rewards has already seen a rising backlash.  As a result, expropriation has become a useful way of making a political statement against both pro-business capitalism generally and developed States specifically.  (iii) The extensive wave of privatisations in the 1990s throughout developing countries has created a situation in which once again many of the most politically-sensitive industries in developing countries are now in private hands, often foreign ones.  (iv)  Profits in natural resources industries in particular are sky-rocketing, making expropriation potentially more profitable, and making previously-negotiated contracts seem too favourable to foreign investors.

These are, of course, very broad general trends, and Hajzler presents them as large-scale forces, rather than things operative on the level of an individual State.  Nonetheless, it’s worth emphasising that although the way that these factors operate may vary between States, they are nonetheless still potentially useful on a country-specific basis.  Investors considering investing in a given country, that is, could consider the degree to which these factors appear to be operative within that country, and adjust their investment plans in whatever way is necessary to provide security against expropriation.

On this last point, though, of investors protecting themselves against expropriation, one further aspect of Hajzler’s discussion is worth noting, even though it is not related to the large-scale trends with which the article is predominantly concerned.  One of the more interesting observations Hajzler makes is that in their efforts to minimise the damage that will result from an expropriation, foreign investors can often take actions that actually make an expropriation more likely.  Hajzler’s own discussion focuses specifically on the natural resources sector, but it can certainly be applied more generally.

Hajzler notes that the standard model of foreign investment  in natural resources involves the investor paying a significant up-front cost for the right to undertake the investment, and receiving in exchange the long-term right to retain the profits the investment generates.  States are attracted to this model because it gives them immediate access to significant new funding, while shielding them from the possible failure of the investment.  In turn, investors favour this model because it maximises their potential profits.

The difficulty, however, is that while both sides find this model attractive, it actually serves to encourage expropriation, particularly in any field in which future profits are difficult to predict with any certainty.  Investors will be well aware that significant future success will increase the likelihood that the State will expropriate the investment, on the rationale that the investor is receiving far more benefit than justified by the price paid for the investment.  In response, they will attempt to maximise short-term profitability.  However, by maximising short-term profitability, investors themselves increase the risk of an expropriation happening, as they generate precisely the super-normal profits that make an expropriation both economically and politically attractive.

Importantly, though, this isn’t a necessary situation, but is instead one created by the investment model that States and investors have chosen to use.  As a result, this problem could be avoided by intelligent structuring of the investment, such as by incorporating profit-sharing between the investor and the State.  Neither side would get precisely what they wanted from the investment (the State would not get an immediate injection of income, and the investor could not count on enormous future profits), however both sides would avoid the problems associated with expropriation.

The above is just one example of the ways that an understanding of the large-scale influences on rates of expropriation can be of more than academic or historical interest, and can instead be used by both investors and States to avoid expropriations.  Hajzler does an excellent job in this article of presenting the available evidence on why expropriations happen, and anyone interested in the topic is strongly encouraged to read it.

Investment Treaty Arbitration as a Species of Global Administrative Law

Gus Van Harten and Martin Loughlin, “Investment Treaty Arbitration as a Species of Global Administrative Law”, 17 European Journal of International Law 121-50 (2006)

Van Harten and Loughlin’s article, published in 2006, was one of the earliest coherent expressions of the idea that international investment arbitration has evolved into a type of global administrative review mechanism.  That is, that investment arbitration has moved beyond its origins as a simple dispute resolution forum, in which one party brings a claim against another for violation of an obligation, and now serves as a means by which governmental action is reviewed and kept within acceptable bounds.

This is an important argument from both theoretical and practical perspectives.  Firstly, of course, it attempts to identify the fundamental character of investment arbitration, so is worth addressing simply as a means of understanding what investment arbitration really is.  Potentially more importantly, though, it also has significant consequences for investment arbitration jurisprudence if it is correct.  That is, while a dispute resolution tribunal is fundamentally neutral between the two parties in the dispute, an administrative review tribunal’s entire purpose is to constrain governmental action.  It is not biased against the State, but it is also not neutral.  Because its role is to ensure that State action remains within acceptable bounds, its focus necessarily is on the actions taken by the State, and whether they were permissible.  An investment arbitration tribunal that sees itself as performing an administrative review role, then, will likely adopt a different approach to its job than one that sees itself merely as a resolver of disputes.

Van Harten and Louglin’s article is certainly not a neutral theoretical analysis.  Rather, it is a decidedly partisan piece, intended to demonstrate not only that contemporary investment arbitration performs an administrative review role, but also that it is unacceptable that it does so.  Unfortunately this gives many of the arguments in the article a rather tendentious character, as the authors are clearly driven to reach what they have already decided is the correct conclusion.   As a result, much of the article, while presenting interesting parallels between investment arbitration and domestic administrative review tribunals, is ultimately under-argued.  The authors simply identify a way in which investment arbitration tribunals might be seen to be performing administrative review, draw a fairly broad parallel between investment treaty arbitration and domestic administrative law, and then just assert that investment treaty arbitration is therefore a form of administrative review.  Their conclusion may be right, but this sort of argument-by-resemblance can’t suffice to make their case.

In short, the article’s argument is that “[l]ike the members of any administrative tribunal or court, in reviewing [governmental] measures, arbitrators rule on the legality of state conduct, evaluate the fairness of governmental decision-making, determine the appropriate scope and content of property rights, and allocate risks and costs between business and society.  This is the stuff of administrative law.” (147)

Van Harten and Louglin’s claim, then, ultimately relies on this central contention, that what investment arbitration tribunals and domestic administrative review tribunals are doing is fundamentally the same thing.  An investment arbitration tribunal “is an administrative review agency because, but for its establishment in the international sphere, it would be performing a role similar to that of a semi-autonomous domestic tribunal, charged with resolving regulatory disputes.” (149)

The main difficulty with this claim is that it is not really true.  It is certainly the case, as the authors note, that both types of tribunal review governmental conduct, and so in this respect a parallel unquestionably exists.  However, this parallel can’t itself suffice to justify attributing an administrative review role to investment arbitration.  After all, the authors also acknowledge that States are perfectly capable of entering into private arbitration agreements, and that tribunals in international commercial arbitration involving a State, while also reviewing governmental action, are not performing an administrative review role.

Something more must be added, then, to the mere review of governmental action, to make a tribunal an administrative review tribunal.  One possibility is the substantive standards that the tribunal will apply, but nothing would preclude an investor and a State from entering into a contract that included the standard BIT promises of fair and equitable treatment, MFN, and so on.  However, by the terms of their own argument the authors must acknowledge that a tribunal addressing such a contract would be addressing a private dispute, and not acting as an administrative tribunal.  It cannot be, then, that either the subject matter being addressed by the tribunal, nor the potential impact of the tribunal’s decision on governmental regulatory action, determines whether a tribunal is undertaking administrative review, rather than just resolving a dispute.

Instead, what is essential, but goes unaddressed by the authors, is that administrative review tribunals operate in a fundamentally different way than commercial arbitral tribunals.  An administrative review tribunal, that is, enforces what can be called “constitutive” standards, that are derived from the nature of the entity whose action is being reviewed, rather than contractual standards that arise from an agreement between the two parties.  A dispute resolution tribunal, that is, when it holds against a State, is merely saying “you broke your promise”, while an administrative review tribunal that holds against a governmental body is saying “you did something you were simply not permitted to do”.  Dispute resolution, then, involves evaluating the conformity of an entity’s action with the promises it has voluntarily undertaken, while administrative review evaluates whether the entity’s actions were acceptable, whether or not they were in conformity with a promise made to the other party.

Once this distinction is recognised, though, it is clear that investment arbitration tribunals fall into the dispute resolution category.  They are reviewing the conformity of State action to commitments into which the State has voluntarily entered, whether through a treaty or a contract.  The standards the tribunal applies may, and indeed often do, mirror the standards that would be applied in administrative review, but they are nonetheless being applied because the State voluntarily chose to submit itself to them, not because they are constitutive of the nature of the State.

There are, then, unquestionably parallels between international investment arbitration tribunals and administrative review tribunals, in that they both review government action and will often do so using similar standards.  Moreover, the authors clearly feel that investment arbitration tribunals are poorly designed for applying these standards.  However, even if this criticism is correct, the combination of these two points does not make investment arbitration a form of administrative review.  It just makes investment arbitration tribunals powerful, and potentially problematic.  This itself is certainly a point worth making, it’s just not the point the authors wish to make.

Nonetheless, while the authors may not succeed in demonstrating the truth of their central claim, they do an excellent job of laying out clearly the reasons why so many people are wary of the power that investment treaty tribunals have to affect State regulatory activities.  For this reason the article is well worth reading.