The Virtues of Investor-State Arbitration

In my last post I discussed the different options for reforming investor-state dispute settlement put forward in a recent UNCTAD policy paper and argued that enacting institutional reforms without addressing substantive law is unlikely to fully address investment law’s legitimacy problems. Instead, I suggested that the current regime could be reformed from within, that is, by arbitrators bringing their conduct in line with public law values, in particular the idea of the rule of law. Today, I want to discuss the virtues of investor-State arbitration in order to show why reforming this institution from within, rather than restricting access to it, or completely overhauling it, makes sense.

The Importance of Individual Recourse to Investor-State Dispute Settlement

Investor-State arbitration is important because, above all, it offers foreign investors a mechanism to hold States accountable for breaches of the promises they make in investment treaties. This transforms investment treaties from political declarations into readily enforceable rules to stabilize investor-State relations. Conversely, from the host State’s perspective, the investor’s access to arbitration enables States to make the commitments vis-à-vis foreign investors under investment treaties credible. This, in turn, reduces the political risk of foreign investment, lowers the risk premium connected to it, and makes foreign investment projects more cost-efficient. This benefits investors and host States, as the products and services offered become cheaper.

Certainly, the credibility of commitments of the host State is not only a matter of the availability of dispute settlement. Reputation, community pressure, the moral obligation to keep promises, or host States’ self-interest may also contribute to its living up to promises made in investment treaties. A host State will also be restrained in its treatment of foreign investors as mistreatment of one investor may keep others from investing. Yet, such mechanisms only work imperfectly because host States can benefit by unilaterally breaching their original obligation after an investor has made its investment, for example the construction of a power plant or factory, by imposing additional obligations or even expropriating the investment. For host States to make credible commitments and to offer ways to be held accountable, independent third-party dispute settlement mechanisms are necessary.

Domestic and International Fora and Their Limits

Such mechanisms can be set up at the domestic and/or the international level. However, host State courts are often not well-positioned to enforce governments’ promises vis-à-vis foreign investors. Often these courts are not, or are not perceived to be, sufficiently neutral in resolving disputes with their own governments. Sometimes, independent courts that administer justice efficiently are even missing altogether, in particular in developing and transitioning countries. Furthermore, corruption and lengthy court proceedings in many domestic courts may frustrate efforts to hold host States accountable.

The situation in classical international courts and tribunals is not any better. Here, investors are regularly denied standing. Only their home States are able to espouse their claims through diplomatic protection. This has a number of significant drawbacks. Home States remain free to exercise diplomatic protection; they exercise exclusive control over the rights of their nationals on the international level and can settle, waive or modify them; the entitlement to receive compensation for the violation of international law is not vested in the alien, but in their home States; and diplomatic protection is subject to the exhaustion of local remedies. While exhaustion of local remedies affords host States an opportunity to review their conduct, it brings the insufficiencies of domestic courts back into the picture.

Both domestic and international courts therefore face significant limits to serving as effective accountability and control mechanisms for host government conduct.

The Limits of Contract-Based Arbitration

Contractual solutions for dispute resolution, including alternative means for settling disputes, that some suggest as an alternative, also have significant drawbacks. Above all, they are only available to investors with sufficient negotiating power. While large-scale investment contracts have always contained arbitration, choice of law, stabilization, or internationalization clauses, small- or medium-sized investors, who play a considerable role in foreign investment relations, often lack the necessary bargaining power to negotiate for such protections. Moreover, contractual solutions are unavailable to investors that make their investments based on a country’s general investment legislation. For them, reaching agreement with the host State on non-domestic dispute settlement will be difficult once a dispute has arisen. To hold host States efficiently accountable, it is important that pre-agreed dispute settlement mechanisms are available to administer justice fairly and independently. Treaty-based arbitration clauses as fall-back options may be the only alternative to achieve that purpose.

Controlling Arbitral Law-Making through Fragmentation

Notwithstanding the benefits of treaty-based arbitration, it is problematic if such a review and accountability mechanism produces inconsistent outcomes. More centralized dispute resolution institutions, for example an appeals facility or a permanent international investment court, could remedy this problem. Yet, there is an undeniable danger with the creation of such institutions. While they lead to more consistency, they raise considerable legitimacy concerns themselves. Apart from the question of who sits as a decision-maker, and who appoints or elects them, permanent institutions may display stronger dynamics in enlarging their jurisprudential powers than a system of one-off arbitral tribunals. After all, a permanent institution would be able to develop international investment law much more consistently in ways that governments do not agree with.

Santiago Montt designates the underlying logic of the current system as a “BIT lottery.” He argues that States had no interest in creating a permanent investment court because that would have increased the risk of such a court going in the wrong direction in interpreting the vague standards of investment protection. Arguably for reasons of legitimacy, namely to avoid the permanent wrong-headedness of outcomes in investor-State dispute settlement, States deliberately risked incoherence in order to reduce systemic effects of individual decisions.

In a sense, the one-off nature of arbitration therefore served to control the interpretive powers of the investment dispute settlement. Arbitration could therefore be understood as a way to disperse the law-making powers of dispute resolvers across one-off tribunals to limit their authority. Creating a permanent investment court or a centralized appeals facility, by contrast, would necessarily raise the question of how to further concretize the substantive standards and how to set up a political organ that controls the decision-making of such institutions without a truly multilateral system. In a setting where the governing law is mostly enshrined in bilateral treaties, the very idea of creating a permanent institution is daunting.

Investment Treaty Arbitration as an Accountability Mechanism

Certainly, the situation of investors behaving opportunistically and attempting to renege on their original promises also exists. However, the host State as a sovereign actor can typically react to such conduct by unilaterally imposing sanctions on the investor and enforcing them. Host States do not depend on international dispute settlement to make investors comply with their contracts or domestic law. The States’ ability to unilaterally impose and to enforce decisions on foreign investors is also the deeper structural justification for having a unilateral procedural right for investors. This is but a modest limitation on host States’ sovereignty and fulfils the function of an accountability mechanism that has the potential to bind host States to the rule of law. Accordingly, the fact that investor-State arbitration makes host States comply with their substantive obligations vis-à-vis foreign investors should not be considered as discounting its legitimacy but as furthering the rule of international law.

In sum, when considering its alternatives –domestic or more centralized international courts – investor-State arbitration is an institution worth preserving because it can serve as an accountability mechanism for host government conduct that embodies and implements the rule of law without requiring strong and mutlilateral political institutions as a counterweight. For this reason, proposals to limit access to this institution by foreign investors should be analyzed critically and assessed in light of the question whether alternatives are able to serve not only the interests of host States in preserving sufficient policy space, but also the interest in holding these States accountable under the concept of the rule of law.

Enculturating the Rule of Law within Investment Arbitration

Nonetheless, investor-State arbitration is not immune from criticism. On the contrary, viewing it as an instrument furthering the rule of law requires that investor-State arbitration itself, and those serving as arbitrators, have to be faithful to the requirements of the rule of law. Unlike some critics, I have faith that arbitrators are able to live up to high rule of law standards and are able to fulfil the expectations that are commonly vested in adjudicatory institutions that administer justice and control the exercise of public authority without turning into despotic institutions themselves. Short of fundamental change to the institution of investor-State dispute settlement, this requires that arbitrators reorient their decision-making towards administering justice in accordance with the idea of the rule of law. What this reconceptualization can look like and what it means is what my next post will focus on.