Investor State Dispute Settlement (ISDS) and International Trade Agreements

When Donald Trump won the 2016 U.S. Presidential Elections, one of his first executive orders was to end the U.S.  partnership in the Trans-Pacific Partnership. The Trans Pacific Partnership is a trade agreement between 12 Pacific Rim countries, except China. This was his election campaign promise that was seen as an appeal to the American working classes, who have lost out on jobs and have become disenchanted with free trade policies. With the rise of nationalist politics around the world that threaten globalization and free trade deals, the future of free trade seems dismal.

An important part of trade deals that is often not in the limelight is the Investor State Dispute Settlement clause that is the major cause of concern in the US and the European Union.

Investment agreements are often signed between developed countries and developing countries, or countries with legal systems that do not offer the same guarantees of independence, effectiveness and transparency as those of their investment partners. In 1959, Germany and Pakistan reached a trade agreement to encourage and protect investments between the two countries. The agreement included the first ever investor–state dispute settlement (ISDS) mechanism. Since then, thousands of agreements containing a similar provision have been reached around the world. An ISDS mechanism is a legal provision in bilateral or multilateral investment agreements or in the chapters on investment protection in free trade agreements. It gives investors the right to international arbitration if they believe a foreign government that is party to the agreement has breached one of its provisions.

ISDS provisions are included primarily to send a signal to investors in developed countries that their money will be protected from misuse by local governments, through such actions as expropriation without proper compensation, for example. By offering this protection, developing countries hope to increase investment flows into their economies.

If there is no ISDS mechanism, foreign investors can turn to the domestic courts of the countries in which they have invested. However, that means of recourse presents a problem on two levels:

First, domestic courts differ from one country to the next. Investors could be concerned that the court system lacks the guarantees of transparency and effectiveness to which they are accustomed in their home countries. Second, some claim that domestic courts may not be fully independent and may be biased against foreign investors, particularly since the respondent party is the government of the country where the courts are based.

ISDS in International Trade Agreements

Several Free Trade Agreements like TPP, TTIP (Transatlantic Trade and Investment Partnership: An agreement between the US and European Union), NAFTA (North Atlantic Free Trade Agreement :An agreement between the US, Mexico and Canada January 1994)  and CETA (Comprehensive Economic and Trade Agreement :A agreement between Canada and the European Union signed in October 2016) have ISDS as a clause under the Dispute Settlement mechanism. But there is major disagreement as to the effectiveness and transparency of such a legal mechanism.

Joseph Stiglitz, the renowned Economist, warns of the dangers of ISDS under the TPP: he says that defenders of ISDS claim that it prevents discrimination against foreign firms, foreign firms have in fact sued and won, even when they are treated the same as domestic firms in the host country. The provisions in fact help the foreign firms discriminate in their favour. A foreign firm can sue the US government in private arbitration for cash rewards if the firm believes that the government policies violate the new rights and privileges granted under TPP, but domestic firms have no such privileges in US courts. Under the TPP, foreign investors could sue any law, policy or government decision that hinders their growth and profits.

Another common criticism is that ISDS panels, including those of the TPP, do not allow governments to sue corporations. This ignores the fact that governments can, and do, charge corporations with civil or criminal violations in the domestic court system: ISDS panels exist precisely because governments can use the courts, and other means, to discriminate against foreign investors in ways that often are insidious. Indeed, it is a lack of trust in the fairness and transparency of foreign governments, shared among investors of many nationalities, which led to the creation of the ISDS panels.

However, the Canadian parliament’s background paper on the ISDS mechanism claims that it is an unbiased system that is conducted in sync with the regulations laid down by the ICSID (International Centre for Settlement of Investment Disputes: An International Arbitration Institute established in 1965 for legal dispute resolution and conciliation between international investors, part of the World Bank) and that it does not have the power to influence sovereign legislation and regulation:

The Office of the United States Trade Representative has made available a fact sheet on their website that provides details on ISDS, its implementation, structure and address criticism against ISDS:

“ISDS is a neutral, international arbitration procedure. Like other forms of commercial, labour, or judicial arbitration, ISDS seeks to provide an impartial, law-based approach to resolve conflicts. Various forms of ISDS are now a part of over 3,000 agreements worldwide, of which the United States is party to 50. Though ISDS is invoked as a catch all term, there are a wide variety of differences in scope and process. ISDS in U.S. trade agreements is significantly better defined and restricted than in other countries’ agreements.

Because of the safeguards in U.S. agreements and because of the high standards of our legal system, foreign investors rarely pursue arbitration against the United States and have never been successful when they have done so.”

A corporation may choose to invoke the ISDS in the following situation: An Argentine subsidiary of a U.S. company wants to challenge an Argentine government regulation. The firm could pursue its case in a simple way: use the protection afforded to the parent company under the U.S. Argentina bilateral investment treaties (BIT), have its case heard in the perennially operating ICSID facilities, and later seek enforcement in U.S. courts.

Alternatively, the U.S. company can manipulate its multinational holding company structure so that its Dutch subsidiary is the legal owner of its Argentine operations. It can then bring the case under the Dutch-Argentina treaty, get that treaty’s protections, and seek enforcement in Dutch courts.

Between these options lie many others, such as taking advantage of the treatment standards under third country treaties (e.g., the Argentina-Chile BIT), enforcement opportunities of third country courts (e.g. Switzerland or Britain), or private non-ICSID arbitral centres. Through the ISDS mechanism, corporations can get the governments of both developed and developing countries to do their bidding.

Vattenfall AB and others v. Federal Republic of Germany

To show how corporations can manipulate entire countries, a prominent case that shows the working of ISDS: After the 2011 nuclear disaster in Fukushima, and as the culmination of a decades-long public debate, the German parliament decided to amend the Atomic Energy Act to speed up the phase-out of nuclear energy, so that it would be completed by 2022. The amendment entailed the immediate shutdown of some of Germany’s oldest reactors. Vattenfall, an energy company wholly owned by the Swedish State, operates and owns two of those oldest reactors.

According to Vattenfall’s CEO at the time, the shutdown of the two reactors resulted in a loss of expected revenues of 10.5 billion Swedish Kronor (US$1.5 billion) in 2011 alone .Seeking to “obtain fair compensation for the financial losses,” Vattenfall and the two power plant companies initiated arbitration proceedings against Germany before the ICSID and also filed a lawsuit before the Federal Constitutional Court of Germany.

The precise agreement between both parties is, however, unknown, although it is recognised that Germany nevertheless provided the licence to Vattenfall. On 31 March 2015, it was reported that the EU Commission was about to lodge a complaint against Germany before the European Court of Justice for having decreased its environmental requests vis-à-vis Vattenfall, which consequently breached EU requirements.

Vattenfall v. Germany has brought Germany’s international investment policies to the attention of local decision-makers and the public. Unfortunately, international investment arbitration is now conducted behind closed doors in Germany, leaving citizens to speculate what is at issue in the dispute and how much taxpayer money Germany might have to pay.

Investors have a choice of whether to launch the case at ICSID (a World Bank arbitration centre with relatively better transparency), or at a private arbitral centre with lower transparency requirements.

Once a tribunal has rendered a ruling, the investor can seek enforcement in any country it estimates likeliest help secure payment (which might be driven by investor friendly national arbitration laws or courts, or the presence of sizeable assets).

The system is unusual in international law. Most international courts only allow disputes between states. ISDS, in contrast, creates one way rights: Corporations can sue governments, but not vice versa.

It’s also ad hoc: The legal challenges are decided by arbitrators hired for that case only. The typical set up is that the foreign investor appoints an arbitrator, the host state appoints a second, and the two parties or arbitrators appoint a third to chair the case. After their decision, they are paid by the parties, and the tribunal is dissolved. The burden of exorbitant legal fees that has to be borne by public money, dissuades governments and they eventually give in, either by settling claims or by redesigning legislation to suit investors.

The parties that benefit the most from such a legal setup are private legal advisors/experts who act as arbitrators. They charge exorbitant legal fees to the States and the investors involved in the dispute.

Now with the roll-out of Nationalist/ Far Right parties with the US presidential elections, Brexit and rise of Marine Le-Pen in France, the TTIP has lost political traction, in part due to its anti-protectionist policies and with the roll back in globalization tendencies. ISDS has proven to be a mechanism used by non-state actors to directly challenge policy of sovereign states, but it remains to be seen if trans-national legislation like the ISDS will survive this new emerging global trend. With the end of the TTP, it remains to be seen what the future of globalization and trade would look like. Does the growing distrust in free market trade, especially in the US and Western Europe, spell the end of corporations dominance in the world market? Or will this protectionist trend force countries to rethink trade laws and policies?

Vedika Inamdar