A New Cost-Benefit Analysis

Foreign direct investment (FDI) is key to economic growth for developing and developed countries.[1]  In the last few decades, FDI has expanded tremendously and states have entered into a number of legal agreements to protect and facilitate it.  These bilateral investment treaties (BITs) are designed to increase investment flows by creating “favorable conditions for greater investment by nationals and companies of one state in the territory of the other state.”[2]   If an investor feels that he has been treated in a way that violates the conditions of the BIT, he can initiate arbitration against the host government.  One of the most significant aspects of the BIT regimes is that they require the state party signatories to submit in advance to binding international arbitration in case of investment disputes.  The BIT agreement specifies the method of international dispute resolution to which the government and the investor will submit. The mechanism of dispute resolution most frequently chosen is the International Convention on the Settlement of Investment Disputes (ICSID), which has been ratified by 140 states.[3]  The number of arbitrations under ICSID has grown exponentially, matching the increase in the number of BITs signed.[4]  

While BITs have been around for decades, a real ICSID “jurisprudence” has only developed since the mid-1990s.  With almost a hundred arbitral decisions now available to review, academic commentators and policymakers have recently begun to study international investment law to determine if, in fact, BITs are having the desired result of encouraging FDI and promoting economic growth and development.  Their findings are, at best, inconclusive.  BITs may or may not be increasing foreign direct investment,[5] but they are definitely infringing upon sovereign regulatory decisions in areas ranging from environmental policy to monetary policy.[6]  Our short experience with BITs has already produced many critics, who argue that the price paid by BIT signatories is simply too high when measured against their unclear benefits. 

In this paper, I will explore a new critique of the ICSID system. Under a BIT, foreign investors are able to bypass the courts of the country in which they operate.  This aspect of the BIT regime clearly benefits investors, who are permitted to avoid national courts that may be corrupt, biased, slow, or ineffective.  However, little attention has been paid to the impact that removing these cases has on the development of national court systems.  In this paper, I review the limited existing empirical evidence, which suggests that removing these cases is negatively correlated with the development of a strong, transparent judicial system.   I propose possible hypotheses as to why the removal of these cases would stunt the development of the legal system and I discuss the developmental consequences of choosing to accelerate FDI at the expense of the country’s legal infrastructure.  

Over the last few decades, FDI flows have increased dramatically.  From 1982 to 2003, FDI inflows increased from $59 billion to $560 billion,[7] peaking in 2000 at $1,393 billion[8] then falling somewhat as the global economy experienced a recession.  The acceleration in flows was brought about in part as a result of the deep economic reforms passed by many developing countries as part of the “structural adjustment” programs required by international financial institutions.  These flows were encouraged and welcomed by developing countries, as the steady influx of FDI was expected to cure a wealth of evils.[9]  Despite much optimism, however, developmental progress has been slow in coming for all but a handful of countries. In the words of development economist William Easterly, the “$1,000bn spent on aid since the 1960s, with the efforts of advisers, foreign aid givers, the International Monetary Fund and the World Bank, have all failed to obtain the desired results.  Sub-Saharan Africa has not emerged from a decades-long economic crisis; Asia remains the home of the majority of the world’s poor; Latin America has known only erratic and low growth; the Middle East has not converted oil riches into sustained development.”[10]

In recent years, the development community has begun to look beyond basic economic reforms to emphasize the role of strong national institutions in promoting development objectives.[11]  In the last decade, a well-known group of economists has been advancing the theory that disparities in economic development can be attributed not just to the sophistication of a country’s legal system, but to its legal tradition.[12]  Several commentators have argued that the establishment of a reliable and accessible legal system is a prerequisite to growth and investment.[13]  Indeed, “the capacity of national institutions to protect property rights, reduce transaction costs, and prevent coercion may be decisive in determining whether economic development takes place.”[14]  One study by economist Dani Rodrik even suggests that the quality of institutions “trumps” both geography and integration into the world economy as a determinant of income levels around the world.[15]

A strong legal system is hypothesized to promote growth in several ways.  Secure property rights and a strong enforcement regime encourage innovation and entrepreneurship by protecting their rewards.[16]  A transparent regulatory system permits efficient resource allocation and business operation.  An effective legal system can help to counteract the corroding effects of corruption and can thereby make the business environment more attractive to aid and foreign investment.  The new importance assigned to the role of the legal system in development has resulted in the investment[17] of hundreds of millions of dollars of public and private donor funds into rule of law reform programs in Latin America, Sub-Saharan Africa, Asia, and Central and Eastern Europe.[18]  Despite these broad-based efforts by governmental agencies and non-governmental organizations, reform has been slow in coming and has been complicated by difficulties in defining what constitutes progress towards creating the “rule of law.”[19]  Generally, the problem of developing successful legal institutions has proven intractable.[20]  Underlying the failed institutions is a deeply rooted culture, which is difficult to change through the kind of targeted reform programs that are funded by development agencies. 

Investment treaties have been viewed as a “quick fix” to the problem of failing institutions.  BITs substitute for domestic law and domestic legal institutions by stipulating international standards for the treatment of foreign investors and providing arbitral tribunals in which claims of violation can be adjudicated.  In most BITs, “governments make a commitment to provide foreign investors with national treatment (treatment as favorable as that provided to the host country’s citizens), most favored nation treatment (treatment as favorable as that given to other countries’ citizens), fair and equitable treatment, full protection and security for the investment, and treatment at least as favorable as that provided by international law.”[21]   Additionally, governments often agree not “to engage in arbitrary, unreasonable or discriminatory conduct that restricts the operation, management, maintenance, or expansion of the investment.”[22]  Standards by which the host state may lawfully expropriate foreign investor property are also established in the terms of the BIT.[23]  Therefore, by signing a bilateral investment treaty a developing country can compensate for its weak domestic legal institutions with respect to its foreign investors.  The BIT establishes “an effective normative framework: impartial courts, an efficient and legally restrained bureaucracy, and the measure of transparency in decision that has increasingly been recognized as a control mechanism over governments and as a vital component of the international standard of governance.”[24] The problem is that this normative framework only protects and benefits foreign investors.

This discriminatory treatment in favor of foreign investors would not be problematic if the international dispute resolution mechanism acted as complement to the developing country’s legal system.  There are certainly plausible pathways by which foreign investment could improve domestic institutions, improving conditions for foreign and domestic investors alike. FDI brings new and sophisticated foreign players into national markets, creating “competition that [could] break domestic monopolies and oligopolies, resulting in greater levels of judicial and regulatory independence.”[25]  Foreign investors can help to promote a culture of rule of law, beginning within their own business initiatives, by  “transfer[ing] to employees not only valuable business know-how and technical expertise, but expose them to a certain work ethic, business practices, ethical standards, and codes of conduct.”[26]  Finally, the availability of ICSID might “spur domestic courts to compete for the business of resolving commercial disputes,”[27] providing the incentive for reforms to improve the national legal system.  By creating greater competition and improving the quality of the market participants and increasing their expectations, FDI attracted by BIT commitments could result in improvements to the overall business environment in the host country.  Internationalization of dispute resolution would be a temporary measure, compensating for the weakness in domestic country institutions, which would eventually become obsolete as developing country courts systems developed the capacity to manage large international commercial cases fairly and competently.

Unfortunately, the limited empirical evidence in this area suggests that ICSID does not complement domestic legal systems, but rather is replacing them, with devastating consequences for domestic investors and long-term economic growth.  Because regular reliance on ICSID tribunals has only really taken off since 2000, the data in this area is very limited. Professor Tom Ginsburg’s preliminary study suggests, however, that the presence of a BIT regime is negatively correlated with the development of strong legal institutions. Ginsburg examined data on government effectiveness, regulatory quality, rule of law, and corruption control in two-year intervals from 1998 to 2002.[28]  Controlling for other variables including wealth, level of democracy, and political stability, he found that new BITs adopted in 1995 or 1996 were associated with a decline in perceptions of the quality of host state institutions.[29]  Ginsburg points out that finding any negative correlation between BIT adoption and institutional quality is unexpected, given the way the data was collected.  The data was composed of an “index [of] a variety of indicators that rely on surveys of international businessmen and other external observers of the economy.”  He notes that “[o]ne would think that adoption of a BIT, to the extent it is a signal to such actors, [would] be associated with increases in perceived government performance, so that any observed negative result may in fact understate the real decline.”[30]  The decline in institutional performance is somewhat surprising for the additional reason that a government bound by a BIT regime has every incentive to protect against regulatory failure, corruption, or any other official activity that might subject it to liability to the foreign investor under its legal commitment.  

This data is limited and preliminary, as is most of the statistical work done to-date on rule of law issues.[31]  More comprehensive studies are necessary to understand the ongoing impact of the BIT regimes on local institutional development. More focused data on the effectiveness of the judicial system is necessary to distinguish the impact of the BIT on the general political culture from its influence on the legal environment.  This preliminary data is disturbing, however, given the demonstrated importance of the legal system on general development objectives.  If the ICSID system is indeed impeding the development of good domestic regulatory and judicial structures, this would substantially change the cost-benefit calculus for countries considering whether to sign new BITs.

There are at least two possible reasons why the adoption of BITs might have a negative impact on the legal systems of developing countries.  First, by permitting sophisticated international investors to bypass developing country legal systems, BITs have removed these parties from the coalition advocating for more accessible, transparent, and effective legal institutions.  Countries that would otherwise have been required to invest in developing their judicial system to attract foreign investors can, under the BIT regime, continue to receive foreign investment without pursuing legal reform.  This is an unfortunate development, as foreign investors could play a significant role in helping the host nation develop a business-friendly legal environment.  In developing countries “legislative reform is [often] hijacked by an elite group that determines the contents of the new law, obtains limited comments from a narrow circle of cronies, and then pushes the new legislation through a parliament that tends to rubber-stamp executive initiatives.”[32]   Involving a broad range of foreign interests in the legislative process can help simulate more open and public debate among those affected by the policy change, work to counter the anti-competitive interests of domestic monopolists who resist the transition to a more transparent, competitive system, and generally promote adherence and respect for rule of law.[33]  In some cases, “[t]he foreign business community and its legal and accounting advisors represent the most efficient and accurate mechanism for identifying inadequacies and problems in existing commercial legislation and regulations.”[34]  Additionally, once some foreign investors have taken on the cause of reform, other investors “piggyback” on those efforts and build upon the improved regulatory framework.[35]  The actions of a critical mass of investors thus create momentum for further action and reform.

Once a country becomes part of the BIT regime, the situation changes.  The applicability of the host state’s domestic laws and regulations are weakened vis-à-vis the foreign investor.  The foreign investor knows that serious infringements on its investment are likely to create a cause for action under the BIT, at which point, the investor can pull the government into international arbitration.  The investor’s interest in promoting or participating in rule of law reforms, and particularly in improvements to the judicial system, is substantially and immediately diminished.

In addition to losing the political advocacy of foreign direct investors, when BIT cases are moved to the international arbitral arena, developing country courts lose out on the opportunity to develop expertise through adjudicating large commercial cases involving foreign investors.  In other words, domestic courts lose this kind of business.   This is a substantial loss-–large foreign investors bring with them representatives from some of the largest and most prestigious international law firms and law schools.  Working through complicated questions of regulatory, constitutional, and international commercial law with a group of talented and experienced legal minds presents a unique learning opportunity for all participants.   Under the BITs, these cases are heard outside of domestic courts-–and usually outside of the host country in a “neutral” location.  Each case removed to international arbitration therefore represents a real loss in terms of human capital development in the host country.

There are thus plausible reasons why adopting a BIT might be negatively correlated with improvements to the judiciary of the host state. If additional empirical research proves this to be the case, the consequences of BIT regimes could far outweigh their developmental benefits.

As a consequence of the BIT regime, foreign and domestic investors currently receive differential treatment in the same country.  If a domestic investor has its property expropriated, its only recourse is under domestic law, in domestic courts.  Even if the domestic court resolves the claim in a timely and fair manner, the protections for the domestic investor may be lower under domestic than under international BIT law.  In the United States, for example, certain expropriations that are legitimate under the Takings Clause of the Constitution may be illegal under NAFTA or BIT commitments.[36]  This differential treatment, therefore, creates an additional barrier as domestically-owned, developing country businesses struggle to compete in international markets.   If the BIT regime is negatively impacting the development of the local judiciary, this differential effect will extend into the future, with local investors trapped in a slow, corrupt, or inexperienced legal system.  Ironically, the incentive created is for local investors to remove their money from their home country, so as to receive the preferential treatment as foreign investors.   In theory, therefore, the BIT regime which was designed to increase the overall volume of investment in developing countries and to improve local business competitiveness through exposure to foreign expertise, may in fact be having the opposite effect.

Additionally, if BITs are damaging the long-term development of the judiciary, other users of the domestic legal system are being left to resolve their claims in underdeveloped institutions.  It is at least plausible that a judiciary that is made more independent, experienced, and effective through interventions on behalf of large commercial users would provide small commercial and non-commercial users with fairer hearings.  This means a stronger legal system for thousands of users dealing with property disputes, contractual breach, marriage and divorce, and trusts and estates.  It also means a stronger legal system for those seeking to enforce the social and political rights established in national constitutions and in international human rights.  Respect for rule of law is a cultural norm that is established through practice and custom.   Strengthening the judicial system for foreign investors would benefit all participants in the legal system.  Likewise, weakening the judicial system by removing those with voice and clout from its user-base diminishes the quality of these institutions for all whom they govern.

By signing BITs, developing countries may have traded long-term economic and social development for short-term investment opportunities.  If this is true, the fundamental premise of the ICSID regime should be reconsidered, and possibly reconceived.  Additionally, these findings would have implications for the internationalization of other areas of law.

The considerations presented here have implications beyond the BIT system.  International investment law is not the only area in which there is a movement toward removing cases from weak developing country systems to international tribunals or courts. Business-to-business arbitration is also increasingly managed through international arbitration, rather than in the domestic courts of either party.  The World Trade Organization has an international dispute resolution mechanism, created to provide an international forum for the adjudication of trade disputes.  As world markets become more integrated, commercial law is becoming increasingly international and increasingly removed from national courts.  In the non-commercial arena, human rights advocates have made some strides in convincing developed countries to permit international human rights violations to be adjudicated outside of the countries in which they occurred.[37]  For a time, the state of Belgium provided the most extensive exercise of universal jurisdiction over violations of human rights.[38]  In July 2002, an International Criminal Court was established to prosecute certain particularly heinous crimes.[39]

While increasing the rule of law internationally is certainly a worthy objective, the emerging evidence about the effects of the ICSID regime suggests that the development community should be cautious about the move to compensate for weak judicial systems in developing countries by internationalizing the adjudication of the most significant commercial and non-commercial cases.  While internationalizing these cases helps to ensure that they are properly adjudicated (or indeed that they are heard at all), if it diminishes the pressure on developing country judiciaries to reform, and the resources available to them to do so, the trade-off may not be worth it.  For each of the large cases that is properly resolved, there are thousands of small cases that are not.  Ultimately, the successful resolution of the small cases is what creates the legal infrastructure that is essential to social and economic development.

This is not to say there is no role for internationalization in resolving commercial and non-commercial cases.  However, I suggest above that their total removal from the geographic and legal context of the country in which they occur is immensely problematic.  Returning to the BIT cases, an arbitration that occurs before an ICSID tribunal is completely removed from its national context.  All opportunities for domestic institutional capacity building are lost.  Perhaps a system modeled on international criminal law would offer a more appealing possibility.  One model is that of a “hybrid court” such as been implemented in East Timor, Sierra Leone, and Cambodia.[40]  Hybrid courts bring international attention and expertise into the country, but trials take place within the country in which the events giving rise to the cause of action occurred, allowing that national community to act as an audience.[41]  International judges sit along side domestic judges, improving the perceived legitimacy of the process and creating opportunities for capacity-building and norm generation.[42]  While a direct analogy to ICSID is probably impossible, it might make sense to have the arbitration occur in the host country where it is more likely to attract the attention of the public. Because ICSID decisions can have dramatic and far-reaching domestic consequences, they deserve to be argued in the view of the population which will bear the brunt of the decision.  The newly-established International Criminal Court (ICC) provides another model, with the court accepting jurisdiction only when national courts are unwilling or incapable of prosecuting criminals themselves.  The ICSID system could be reintroduced as an appellate system, available only after the unsatisfactory or discriminatory resolution of an investment dispute in domestic courts. 

Concerns about promoting transparency, reconciliation, capacity-building and justice animated the decision to replace international criminal tribunals with hybrid tribunals and to limit the jurisdiction of the ICC. These same concerns should inform the development of international investment law, particularly if further empirical research supports the hypothesis proposed here.

Endnotes

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