Explaining The Popularity of Bilateral Investment Treaties: Why ldcs Sign Treaties That Hurt Them



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Explaining The Popularity of Bilateral Investment Treaties:Why LDCs Sign Treaties That Hurt Them
Andrew T. Guzmán *

26 August, 1997



Abstract
Bilateral Investment Treaties (BITs) have become the dominant mechanism for the international regulation of foreign direct investment. The tremendous popularity of these treaties is puzzling because they provide investment protections that exceed those offered by the former rule of customary international law, the Hull Rule, to which developing countries have long objected on sovereignty grounds. Furthermore, as the paper demonstrates, BITs may be welfare reducing for developing countries. By forcing LDCs to compete for inward foreign investment, and by providing a mechanism through which developing countries are able to make binding commitments to investors, BITs may reduce the benefit developing countries obtain from foreign investment.

Because the treaties are bilateral in nature, however, they offer an LDC an advantage over other countries in the competition to attract investment. For this reason, individual countries are willing to sign such agreements, despite the fact that LDCs as a group are harmed.

After developing the above analysis, the paper discusses the implications of its results on the role of BITs in the formation of customary international law, concluding that the treaties should not be taken as evidence of the existence of customary law.
Explaining The Popularity of Bilateral Investment Treaties:

Why LDCs Sign Treaties That Hurt Them

Andrew T. Guzmán




I. The Basic Problem 33

1. BITs 48

II. The Welfare Implications of BITs 64

Introduction

In recent years, foreign direct investment (“FDI”) has grown at an unprecedented rate. Between 1986 and 1990, total world FDI flows increased from US$88 billion dollars to US$234 billion, representing an average rate of increase of twenty-six percent in nominal terms and eighteen percent in real terms.1 From 1980 to 1993, the stock of foreign investment increased at an average annual rate of eleven percent in real terms, reaching a total of $2.1 trillion in 1993.2 A significant proportion of FDI flows is directed at developing countries. FDI flows to these countries grew from $13 billion in 1987 to $22.5 billion in 1989 to $90.3 billion in 1995.3

This paper considers how the treatment of foreign investment is regulated at the international level. Specifically, it considers bilateral investment treaties (“BITs”) and why they have become the preferred way to govern the relationship between host governments and investors. Because BITs impose obligations that are similar – and, indeed, that exceed – the obligations imposed by the traditional rule of customary law (the “Hull Rule), and because the legal position advocated by developing states has always been for fewer such legal requirements, the simultaneous opposition to the Hull Rule and embracing of BITs is a paradox.4 The paper offers a novel explanation of why developing states fought aggressively against the former rule of “prompt, adequate, and effective” compensation for expropriation and in favor of a more lenient standard, and why they contemporaneously flocked to sign BITs that offer investors much greater protection than the old rules of customary law. It is demonstrated that although an individual country has a strong incentive to negotiate with potential investors -- thereby making itself a more attractive location than other potential hosts -- developing countries as a group are likely to benefit from forcing investors to commit to a country through their investment before the final terms are established -- thereby giving the host a much greater ability to gain value from the investment. Put another way, developing countries as a group may have sufficient market power in the “sale” of their resources as host countries that if they act collectively they stand to gain more than if they compete against one another and bid down they receive. The analysis in this paper offers a better explanation for the behavior of developing countries than what is currently in the literature and allows an assessment of the desirability of BITs.

In addition, the paper discusses the welfare implications of BITs, as compared to the “appropriate compensation” standard that developing countries have advocated at the United Nations -- concluding that while they almost certainly increase global efficiency, they may be welfare reducing for developing states. Developing countries continue to sign these treaties, however, because although the treaties are welfare reducing for LDCs as a group, an individual developing country is better off agreeing to BITs. Finally, the paper discusses the impact of BITs on customary international law -- pointing out that if BITs represent a successful drive to undermine the efforts of developing countries to increase their gains from foreign investment, then the treaties should not be considered to support a customary law that includes the Hull Rule. Instead, they should be recognized as a mechanism through which capital importing countries are forced to compete for investment dollars -- thereby offering the greatest return to the foreign investor. BITs effectively elevate the relationship between a private foreign investor and a host state to the level of international law -- including a mandatory dispute settlement procedure. Although international law does not formally recognize private firms as international actors, it does, through BITs, allow states to bind themselves to agreements with such firms.

A serious analysis of the origin of BITs and their implications on both investment levels as the distribution of the gains from investment is timely. BITs have become the dominant vehicle through which investment is regulated under international law. As of the summer of 1996, there were 1010 BITs in existence around the globe,5 more than half of which have been signed or brought into force since the start of 1990.6 The number of countries who have signed at least one BIT has reached 149 (including some countries which have ceased to exist, such as the USSR), leaving very few countries without any such treaties.7 Surprisingly little attention has been given to these treaties which have established a web of regulations for the protection of foreign investment that reaches virtually every corner of the globe. This paper seeks to contribute to a deeper and more coherent understanding of BITs, their role in the regulation of foreign investment, and their impact of the welfare of nations.

The paper proceeds as follows. Section II offers some background material. Section III describes the Hull Rule and its role in the regulation of foreign investment. Section IV outlines the position of developing states both with respect to the Hull Rule and BITs. Section V presents and applies a theoretical framework that will be used to analyze foreign investment regulation. Section VI examines the behavior of developing countries and offers an explanation of their behavior with respect to the Hull Rule and BITs. Section VII considers some of the implications of the analysis in the paper and Section VIII concludes.

Background

In the last forty years, the international community has witnessed a fundamental change in the regulation of foreign investment.8 Not long ago, the rights of foreign investors vis a vis the state in which they invested (the “host”) were protected by two forces. First, foreign investors had the protection of customary international law. Public international law, though lacking an effective enforcement mechanism, offered investors at least some assurance that their investment would not be seized by host governments. Although the existence of expropriations demonstrates that this protection was not perfect, there is no serious doubt that international law offered investors some security. In the context of investments, like in many other contexts, it is recognized that nations consider themselves bound by international law and will often modify their behavior in order to avoid being seen to be as violators of that law.9 Beyond the general sense of moral or legal obligation, violations of international law often carry a tangible price. States recognize that a failure to abide by the dictates of international law can have adverse consequences on their relations with foreign states and, in serious cases, may lead to the imposition of sanctions against them.10 The second source of protection for investors was the international political, and sometimes military, power of their “home” state. To the extent that host nations feared reprisals of some form from the home state of investors, the investment was not at serious risk.11

The customary international law that has traditionally applied to takings by the host state is referred to as the “Hull Rule,” in reference to Secretary of State Cordell Hull who authored the most famous articulation of the rule in 1932.12 The key words, penned by Hull, that have come to represent the traditional “full compensation” position is that the expropriation of property owned by foreigners requires “prompt, adequate and effective” compensation.

The world is very different today. The customary international law that once governed foreign investment was successfully called into question by developing states who advocated an alternative international norm and who ultimately left the international community without any legal standard having the status of customary law. The Hull rule was challenged by developing countries who claimed, on sovereignty grounds, the right to determine how they would treat investors and the standard of compensation that should apply if that treatment was sufficiently harmful. Although many countries continue to advocate the Hull Rule, a sufficient number of developing states oppose it to ensure that it can no longer be considered a rule of customary law.

The bilateral investment treaty has risen to fill the void created by the demise of the old customary rules.13 These treaties are typically signed between developed and developing nations,14 and are binding international treaties governing the treatment of foreign investment. Curiously, despite the fact that developing countries as a group have objected vociferously to the Hull Rule for many years (and continue to do so), these same developing countries have signed hundreds of BITs that incorporate obligations equivalent to the Hull Rule. Indeed, looking at the entire text of most BITs, it is clear that they offer investors much greater protection, at the expense of the host countries, than the Hull Rule ever did. For example, and most importantly, BITs include terms that protect the foreign investor against a “contractual breach” by the host. In other words, when a BIT is in place between the host and the home state, an agreement made between the investor and the host is binding on both. A breach of the agreement by the host is a violation of the BIT and, therefore, a violation of international law. The BIT also provides the aggrieved investor with binding dispute resolution mechanisms; thereby creating an enforcement mechanism that is much more effective, and thus better able to ensure compliance by the host than what existed under the Hull Rule. Because BITs allow investors and hosts to establish binding contracts whose terms are subject to arbitration in a neutral forum, potential investors can negotiate for much greater protection than they ever enjoyed under the Hull Rule.

Before proceeding, a note of caution is in order. The bulk of the literature on BITs and foreign investment protection has focused on expropriation, devoting much less attention to other types of disputes between investors and hosts. It is important to recognize, however, that the analysis here encompasses all disputes between investors and hosts. Indeed, disputes that do not involve a direct taking are the more interesting ones today because takings are quite rare. The importance of the contracting provisions and the dispute resolution mechanisms present in BITs is magnified by the rarity of expropriation. The most common source of tension between an investor and a host state is not expropriation but rather conflicts that fall short of a taking. Customary international law -- even under the Hull rule -- provides virtually no protection for the investor against these less extreme actions by the host. BITs, on the other hand, allow potential investors to negotiate for whatever protections and safeguards they feel are needed. In other words, over the bulk of investor-host conflicts, BITs provide the investor with protections that are far superior to those of customary law.

The Hull Rule

Before BITs were conceived of, foreign investment was protected by customary international law. Because BITs arose, in part, due to of the demise of the old customary law, a discussion of the role of BITs must begin with a review of the regime that preceded these treaties.

Early in this century, there was a broad consensus among the world’s principal nations regarding the appropriate level of protection for foreign investment. These countries believed that investors were entitled to have their property protected by international law and that the taking of an alien’s property by a host nation required compensation that was “prompt and adequate.”15 This view should not surprise us. The nations forming this rule were, by and large, wealthy, European countries, whose nationals were engaged in investment abroad but which faced relatively little inward foreign direct investment. Nevertheless, customary international law does not consider the intentions behind countries’ behavior, merely the practice and sense of legal obligation. Regardless of the motivation of these countries, therefore, it is fair to say that the prompt and adequate standard was customary international law at the time.

One version of this standard is presented in The Chorzow Factory Case,16 decided by the Permanent Count of International Justice (P.C.I.J.). The case has its roots in the Treaty of Versailles, signed in 1919. The treaty contained a requirement that certain territories be transferred from German to Polish control and that the status of certain other lands be determined by plebiscite. The Geneva Convention -- adopted to implement the Treaty of Versailles -- and the plebiscites that followed ceded the region of Chorzow, located in Upper Silesia, to Poland. Under the Geneva Convention, countries that took over German territory had the right to seize land owned by the government of Germany and credit the value of that land to Germany’s reparation obligations. Any disputes that arose under the Convention were to be referred to the P.C.I.J.

Shortly after Poland took over Chorzow, a Polish court decreed that land belonging to the German company, Oberschlesische Stickstoffwerrke A.G., be turned over to Poland. Litigation ensued on the question of whether the land was “property” of Germany or if it was privately owned by Oberschlesische Stickstoffwerrke A.G. The dispute eventually reached the P.C.I.J.. The Permanent Court concluded that the land was privately owned, and that Poland had seized private property. The Court stated that “there can be no doubt that the expropriation . . . is a derogation from the rules generally applied in regard to the treatment of foreigners and the principle of respect for vested rights.”17 The Court also spoke to the question of appropriate compensation, stating that “reparation must, as far as possible, wipe out all the consequences of the illegal act and reestablish the situation which would, in all probability, have existed if that act had not been committed.”18 Thus, the Permanent Court enunciated the then existing international law -- expropriations were not permitted and if they occurred, full compensation must be paid.

The requirement of full compensation for expropriation was most clearly articulated in the 1930s when it was challenged by the government of Mexico. Mexico confiscated various properties between 1915 and 1940.19 The United States, whose nationals suffered from these acts of expropriation, sought compensation for its affected citizens. In response to the takings by Mexico, the American Secretary of State, Cordell Hull, put forth what has become the leading formulation of the full compensation standard:

The Government of the United States merely adverts to a self-evident fact when it notes that the applicable precedents and recognized authorities on international law support its declaration that, under every rule of law and equity, no government is entitled to expropriate private property, for whatever purpose, without provision for prompt, adequate, and effective payment therefor.20

The requirement of “prompt, adequate, and effective” compensation has become known as the “Hull Rule,” in reference to this statement by Secretary of State Hull.

The protection of foreign investment is typically considered a matter of international law, but domestic law makers have from time to time sought to influence the treatment of investors abroad through domestic legislation. In the early 1960s, for example, the United States Congress passed what would become known as the “First Hickenlooper Amendment.”21 This law requires that the President terminate aid to any country that has seized American-controlled property,22 has repudiated or nullified contracts with Americans,23 or has “imposed or enforced discriminatory taxes or other exactions, or restrictive maintenance or operational conditions,”24 and that has failed to “discharge its obligation under international law . . . including speedy compensation for such property in convertible foreign exchange, equivalent to the full value thereof . . . .”25 The statute represents an attempt on the part of the United States to provide an enforcement mechanism, through domestic law, that could carry out the American interpretation of international law. Since its adoption, however, the First Hickenlooper Amendment has been applied only twice, once against Ceylon in 1963 and once against Ethiopia in 1979.26

A few years later, Congress passed the “Second Hickenlooper Amendment,”27 which was a reaction to the United States Supreme Court decision in Banco National de Cuba v. Sabbatino.28 In the early 1960s, the United States reduced the import quota for Cuban sugar. In response, Cuba nationalized various companies in which American citizens held interests, including C.A.V.. A commodities broker named Farr, Whitlock that had contracted to purchase Cuban sugar from C.A.V. found that its seller had been nationalized. Farr, Whitlock entered into a new agreement to purchase the sugar from the Cuban government, agreeing to make payment to Banco National de Cuba. Instead of making payment to Banco National, however, Farr, Whitlock made payment to C.A.V.. Banco National then sued for recovery of the proceeds. The Supreme Court, after reviewing the case, held that:

[T]he Judicial branch will not examine the validity of a taking of property within its own territory by a foreign sovereign government . . . in the absence of a treaty or other unambiguous agreement regarding controlling legal principles, even if the complaint alleges that the taking violates customary international law.29

The Permanent Court relied on the act of state doctrine in ruling that it would not examine the legality, under international law, of the actions of Cuba’s government in expropriating property.

This Supreme Court ruling provoked a strong reaction from the business community and from the legislative branch. Congress very quickly passed the Second Hickenlooper Amendment which effectively overruled the holding in Sabbatino.

[N]o court in the United States shall decline on the ground of federal act of state doctrine to make a determination on the merits giving effect to the principles of international law in a case in which a claim of title or other right to property is asserted be any party . . . based upon . . . a confiscation or other taking.30

Although the Hull Rule could, at one time, lay claim to the status of customary international law, it can no longer be said to represent a binding international legal norm. This change in status is the result of disagreement between developed and developing countries as to the validity of the Hull Rule. The set of countries that are, and that have been, net importers of investment capital in this century includes a majority of the developing countries (LDCs) of the world. This is true both at the individual country level -- most developing countries import capital -- and at the collective level -- LDCs, taken as a group, are very clearly net importers of investment. On the other hand, most of the outward foreign investment is made from developed countries.

The Paradoxical Behavior of Developing States

The conflicting views of developed and developing nations on the question of compensation for expropriation is evidence of the predictable fact that one’s view regarding the appropriate standard of compensation is determined by whether one is a net importer or exporter of investment capital. It is the direction of the flow of investment capital and wealth and power disparities31 between developed and developing countries that gives them different perspectives on questions of investment regulation.32

Consider the behavior of developed states on the topic of expropriation and dispute settlement. The publicly stated view and the behavior of these countries have remained quite consistent over the years.33 These countries have, over all relevant periods, insisted that expropriation of property owned by foreigners should be permitted only if it is for a public purpose and only if accompanied by prompt, adequate, and effective compensation. In other words, they have advocated international rules to protect the investment made by their nationals.

LDCs, in contrast to developed states, have exhibited behavior that is, at first glance, contradictory. In public statements, LDCs as a group have condemned the Hull Rule as an infringement on the sovereignty of the expropriating nation and have called for a less exacting expropriation standard. In fact, as is discussed below, LDCs have objected so strenuously to the Hull Rule that they have succeeded in calling into question its validity as customary international law. In their private behavior, however, many LDCs, have agreed to treaties that not only implement the Hull Rule, but that go much further in providing protections for foreign investors.34

The Sovereignty Approach

Consensus surrounding the Hull Rule was possible during the first half of this century at least in part because many countries that currently oppose the rule were colonies rather than sovereign states. While under the control of colonial powers, the views of these states were, of course, controlled by their colonial masters, who supported a regime of full compensation. Furthermore, colonies were not recognized as independent states, implying that even if they had an independent view of how international law should protect investors, that view would have no impact on the establishment of international customary law. As decolonization took place, LDCs were able to voice their own views and those views became relevant to the determination of international law. As the number of independent former colonies grew, their opinions carried greater weight in the international arena, and as they questioned international norms that had previously been considered unobjectionable, the status of those norms changed.35

An early demonstration of the view that would eventually find its way to the floor of the United Nations General Assembly is provided by the government of Mexico during discussions with the Untied States regarding Mexican expropriations of property in the first half of this century.36 In a note dated August 3, 1938, the Mexican Minister of Foreign Affairs stated:

My Government maintains . . . that there is in international law no rule universally accepted in theory nor carried out in practice, which makes obligatory the payment of immediate compensation nor even of deferred compensation, for expropriations of a general and impersonal character . . . .37

It was not until after the Second World War, however, that expropriation and conflict over expropriation became common.38 Nationalizations and expropriations in the form of direct takings became much more common as newly communist countries in Eastern Europe and, later, the People’s Republic of China, seized property, and as former colonies became newly independent states and sought to flex their newfound sovereignty. Such expropriations continued into the 1970s.39 The home countries of the investors who suffered losses due to expropriations reacted by attempting to discourage and punish such behavior. Whether for this or other reasons, the period of simple takings turned out to be relatively short lived. By the early 1980s, acts of direct and explicit taking of property had become very rare.40 In fact, from 1984 to 1992, one observer counts only 3 expropriations.41

Throughout this period, the majority of the developing world supported a less stringent compensation requirement for expropriations than the Hull Rule’s “prompt, adequate, and effective” standard. The inevitable disputes that arose following expropriations proved difficult to resolve. Without an existing procedure to deal with such disputes, and without a mechanism to resolve the conflicting views of LDCs and developed countries, the international community appeared to be at an impasse. The lines of disagreement were clear; capital importers supported a less stringent rule and capital exporters supported the Hull Rule. There seemed to be no room for negotiation. In the battle for international legitimacy, both sides of the debate claimed that customary international law was on their side. The developed world pointed to the history of the Hull Rule and to the support it had received both in practice and in writings by commentators. In response, LDCs pointed out that practice had not always accorded with the Hull Rule and that, in any event, the rule simply lacked the broad international support that customary international law requires. Although the developed world denied the point, it seemed that the debate itself was undermining the claim that the rule retained its status as customary international law. Although one can always ask how much practice is necessary and how many countries must feel legally bound in order for a norm to become customary law, as the number of countries against the Hull Rule increased, the claim that it was customary law would prove unpersuasive.

While the debate over the status of customary international law was ongoing, LDCs used the strength of their numbers to undermine the developed states’ position. From the early 1960s through the mid 1970s, the General Assembly of the United Nations -- dominated by LDCs -- passed a series of resolutions intended to emphasize the sovereignty of nations with respect to foreign investment. First, in 1962, the Resolution on Permanent Sovereignty over Natural Resources (Resolution 1803) was passed.42 This resolution provided that in cases of expropriation, “appropriate compensation, in accordance with the rules in force in the State taking such measures in the exercise of its sovereignty” must be paid.43 Resolution 1803 used the term “appropriate” compensation, which has since come to mean a standard that is lower than the traditional Hull Rule of “prompt, adequate and effective” compensation. In the 1960s, however, advocates of the Hull Rule were not prepared to concede that the Hull Rule had lost its status as customary law. The United States, for example, chose to interpret “appropriate” to mean “prompt, adequate and effective.”44 Though perhaps not the fairest reading of the resolution, such an interpretation allowed the United States to persist in its claim that the Hull Rule remained international law.

In 1973, the General Assembly adopted another Resolution on Permanent Sovereignty over Natural Resources (“Resolution 3171”),45 which removed any doubt that may have existed about whether or not the Hull Rule was included in the term “appropriate.” The resolution stated, among other things, that:

the application of the principle of nationalization carried out by States, as an expression of their sovereignty in order to safeguard their natural resources, implies that each State is entitled to determine the amount of possible compensation and the mode of payment, and that any dispute which might arise should be settled in accordance with the national legislation of each State carrying out such measures . . . .46

Resolution 3171 made absolutely clear that the General Assembly, dominated by developing countries, supported a rule under which expropriation was permitted with less than full compensation. At this point, it would have been difficult to make a persuasive argument that the Hull Rule retained its status as customary international law. With 109 countries47 voting in favor of a resolution contradicting the Hull Rule, it is simply not plausible to claim that it remained a general practice and that it was considered legally binding.48

In May of 1974, the General Assembly went a step further, declaring a New International Economic Order in Resolution 3201.49 This resolution stated that every state enjoys:

[f]ull permanent sovereignty over its natural resources and all economic activities. . . . [E]ach State is entitled to exercise effective control over them and their exploitation with means suitable to its own situation, including the right to nationalization or transfer of ownership to its nationals . . . . No State may be subjected to economic, political or any other type of coercion to prevent the free and full exercise of this inalienable right.50

Note that Resolution 3201 considers unacceptable any form of sanction on a country that has expropriated the assets of an investor. This resolution, therefore, seeks to undermine one of the few mechanisms that might enforce a rule against expropriation, whether it be the Hull Rule or the standard of “appropriate” compensation favored by many LDCs. In addition, this resolution, like the earlier United Nations General Assembly resolutions, does not even recognize the existence of an international obligation of repayment. Although the resolutions are not inconsistent with such an obligation, they do not explicitly recognize one, except in suggesting that the resolution of the dispute should be consistent with domestic legislation.

Finally, in December of 1974, the General Assembly adopted Resolution 3281, the Charter of Economic Rights and Duties.51 The Charter states that each state has the right:

(a) To regulate and exercise authority over foreign investment within its national jurisdiction in accordance with its laws and regulations and in conformity with its national objectives and priorities. . . .

(b) To nationalize, expropriate or transfer ownership of foreign property, in which case appropriate compensation should be paid by the State adopting such measures, taking into account its relevant laws and regulations and all circumstances that the State considers pertinent. In any cases where the question of compensation gives rise to a controversy, it shall be settled under the domestic law of the nationalizing State and by its tribunals, unless it is freely and mutually agreed by all States concerned that other peaceful means be sought on the basis of the sovereign equality of States and in accordance with the principle of free choice of means.52

The Charter served to further emphasize the sovereignty of LDCs with respect to their treatment of foreign investors, including over the dispute resolution process. Essentially, the Charter puts the host country government in full control and places the investor at the mercy of that government.53

Taken together, the above resolutions offer powerful evidence that developing countries, when acting as a group, prefer a regime under which they are able to expropriate property when they feel it is justified and to pay what they determine to be appropriate compensation. These repeated efforts to establish the “appropriate compensation” standard represent a frontal assault on the traditional norm of full compensation. The developing states undertook an active campaign to change international customary law. This point is important because it demonstrates a vigorous opposition to the Hull Rule. The resolutions also demonstrate a preference among developing states for a dispute resolution system that relies on local courts rather than international fora. They seek control over the entire relationship between investor and host; essentially rendering it a matter of domestic law rather than international law.54

All of the actions described in this section and taken by developing states rely on the notion of state sovereignty in order to support their view that international law provides only minimal protections against expropriation. The actions discussed succeeded, by demonstrating a lack international consensus, in undermining the Hull Rule’s status as customary international law. Once it became clear that the Hull Rule was no longer customary law, which certainly occurred in the wake of Resolution 3171, and may have occurred much sooner, there was no other source of international law to govern international investment. There was nothing to prevent individual states from determining what constitutes appropriate compensation.55

The Bilateral Treaty Approach

The behavior of developing countries, as manifested through the United Nations Resolutions and calls for rejection of the Hull Rule, stands in stark contrast to their behavior as manifested through the signature of bilateral investment treaties. In this section, we will briefly review the history of these treaties and consider their most important terms. In a very short period of time, BITs have become an important part of the foreign investment landscape. By 1991, well over 400 BITs had been signed56 with more than ninety developing states and “virtually every developed state” being party to at least one such treaty.57 By mid 1996, over one thousand such treaties had been signed, and almost every country on the globe has signed at least one such treaty.58 Regardless of the impact that these treaties have on customary international law,59 they represent an important part of the international investment landscape in their own right.

Description & History of BITs60

The United States BIT program has existed for almost twenty years,61 and it has been fifteen years since the first American BIT treaty was signed with Egypt.62 Bilateral Investment Treaties, however, have been part of the international landscape for a considerably longer period; as have American treaties that include investment protections. This section will review the origins of the BIT, both in the United States and elsewhere.

The United States began to sign treaties of “Friendship, Commerce and Navigation” (FCNs), the precursor to the BIT, soon after the birth of the country.63 FCNs were a common part of United States policy toward outward foreign investment until after the Second World War.64 As the name of these treaties suggests, and contrary to the BIT, Treaties of Friendship, Commerce and Navigation were not exclusively, or even primarily, vehicles to protect investments abroad. Nevertheless, the treaties included some protections for American investors in foreign countries, including a prohibition on expropriation without compensation. The primary purpose of these agreements, however, was the promotion of international trade. With the rise of the General Agreement of Tariffs and Trade (“GATT”) after World War II, the international law of trade came to be governed by this multilateral agreement, reducing the need for FCNs. Because many of the objectives of the FCNs were met by the GATT, the treaties were supplanted by it and, by the mid 1960s, the American FCN program had wound down.

At about the same time, other countries were discovering and implementing a new instrument for the protection of foreign investment -- the BIT. By the time the American FCN program had completely shut down, several European countries were busy negotiating and signing bilateral investment treaties with developing countries. Unlike the FCNs, these treaties focused exclusively on the protection of investment -- a topic not covered by GATT. The first such treaty was between West Germany and Pakistan, and was signed in 1959.65 Switzerland was also an early participant in BITs66 and other European countries began to establish BITs in the late 60s.67 Eventually, Japan and the United States would join the growing number of developed states with BIT programs aimed at developing states.68

The United States, a latecomer to the BIT, established its BIT program in 1977.69 The program was put in place with a number of specific objectives regarding the protection of foreign investment overseas. These goals were (1) to bolster the claim that the Hull Rule remained customary international law by establishing a network of treaties that included this principle;70 (2) to protect current and future foreign investment from host government behavior; and (3) to provide a mechanism for resolving investment disputes that did not rely on either local courts or direct involvement by the United States Government.71

As was true of most BITs, the developed partner to these agreements -- the United States -- initiated the process. Indeed, the United States made considerable preparations prior to the start of negotiations with potential BIT partners. With the objectives of the BIT program in mind, the United States prepared a prototype BIT which was to form the foundation for negotiations with potential BIT partners.72 The original model text was completed in 198173 and has since been modified several times.74 Although the U.S. treaty is, in principle, open to negotiation, the final BIT is usually very similar to the model treaty, demonstrating the strong negotiating position of the United States. While some negotiation is possible on some issues, the United States is committed to the basic structure of the model treaty and will only accept relatively small changes.75 In fact, looking beyond BITs signed by the United States to those of other developed countries reveals that BITs around the world are bear a strong resemblance to one another.76 Typical provisions include terms governing compensation for expropriation, the repatriation of profits, dispute settlement procedures (usually through some neutral forum), national treatment requirements, and “most favored nation” requirements. In order to provide greater context, we will briefly review the main elements of the U.S. model treaty.

The Contents of a BIT

The model United States Bilateral Investment Treaty consists of a preamble and sixteen articles. Article I defines certain key terms. Of greatest interest for present purposes is the definition of “investment,” which is defined to include:

every kind of investment owned or controlled directly or indirectly by that national or company, and includes investment consisting or taking the form of:

(i) a company;

(ii) shares, stock, and other forms of equity participation, and bonds, debentures, and other forms of debt interests, in a company;

(iii) contractual rights, such as under turnkey, construction or management contracts, production or revenue-sharing contracts, concessions, or other similar contracts;

(iv) tangible property, including real property; and intangible property, including rights, such as leases, mortgages, liens and pledges;

(v) intellectual property . . .

(vi) rights conferred pursuant to law, such as licenses and permits.

Notice the broad reach of this definition. It covers not only hard investments such as real estate and equipment, but also financial assets (stocks, bonds, etc.) and, critically, contractual rights and rights conferred by law. This definition is important because, as mentioned above,77 “hard-core” expropriation that involves the outright seizure of assets has become quite rare. The definition of investment, however, protects not only against these seizures, it also protects against the “breach” of agreements signed between the host and the investor and the withdrawal of licenses and other such rights. By defining investment in this way, the United States is essentially making any agreement between the host and the investor part of the “investment.” The relationship between the host and the investor is made to look very much like the relationship between two private contracting parties within a single country. It is important to keep this definition in mind as one examines the other terms of the BIT. As will be discussed below, the protection of contractual rights is one of the most interesting and potentially influential aspects of the BIT. Indeed, it is the definition of investment that makes virtually any dispute between host and investor -- at least any dispute based on negotiated agreement between the two -- a matter of international law. Combined with the dispute settlement provisions, the definition of investment effectively removes these disputes from the legal control of the host -- something customary international law never did.

Article II attempts to provide investors with a certain minimal level of protections that are intended to cover all investments, regardless of the agreement that the host and the investor reach. In other words, taken as a whole, Article II serves to establish the minimum standards of treatment required from the host country. It ensures that investors will not suffer discriminatory treatment relative to either nationals of the host country or other foreign investors, and it emphasizes that the host’s conduct must conform to international law

Article II(1) of the treaty requires that foreign investment be accorded national treatment or most favored nation treatment, whichever is more favorable to the investment.78 Exceptions to this requirement are permitted for certain sectors that are subject to negotiation and inclusion in the Annex to the treaty.79

Article II(3) is intended to ensure that investment from a BIT partner receives the basic protections of international law. Specifically, Article II(3)(a) provides that the host must provide “fair and equitable treatment and full protection and security and shall in no case accord treatment less favorable than that required by international law.”80 Although Article II does not, in principle, change any substantive rights, it at least brings those protections that exist under international law within the reach of the treaty and, therefore, within the reach of the dispute resolution mechanism. Also in subpart three is a prohibition on unreasonable or discriminatory measures that impair the management, conduct, operation, and sale or other disposition of investments.81 Article II(4) requires the host country to “provide effective means of asserting and enforcing rights.”

Article III deals with the expropriation of investments. Because “investment” is defined so broadly in Article I, however, the section on expropriation applies to any number of actions that a host may take in violation of an agreement with an investor. Section 1 prohibits expropriation or nationalization “directly or indirectly,” “except for a public purpose; in a non-discriminatory manner; upon payment of prompt adequate and effective compensation; and in accordance with due process of law . . . .”82 This clause is, of course, a restatement of the Hull Rule. Because of the context in which the rule applies, however, this clause imposes obligations on host governments that far exceed the traditional Hull Rule. Because it applies not only to the expropriation of assets, but also to “breach” of an agreement, a host may be required to make “prompt, adequate, and effective” compensation for actions that, under the customary law version of the Hull Rule, would not have been considered expropriations. Also, notice that dispute resolution mechanisms discussed below imply that neutral parties can be called upon to establish the amount of compensation that is required. Given the expansive definition of investment, this section provides tremendous security for investors, both in terms of their hard assets and in the rights they have acquired through contract with the host government.

Article V governs the transfer of assets to and from the host country. It requires that the host allow free transfer both into and out of the country as long as they relate to covered investments.83 For example, the host is not permitted to restrict the repatriation of profits.84

Article VI prohibits performance requirements such as local content requirements, technology transfer requirements, and so on. Notice that rather than being an alternative to the national treatment requirement, the prohibition against performance requirements is an additional obligation. Therefore, even if domestic firms must meet, for example, a local content regulation, Article VI makes it a violation of the BIT to demand the same from a foreign investor.

Articles IX and X provide a dispute settlement mechanism to govern relations between the host and the investor. Under these provision, arbitration is available to settle disputes and is binding on both parties. This mechanism effectively solves the dynamic inconsistency problem discussed in Section IV of this paper because it allows disputes to be settled in binding fashion in a neutral forum. It thus becomes possible for a country to commit itself by contract in a manner that can be enforced through arbitration.

The above discussion demonstrates that BITs offer foreign investors much greater protection that the Hull Rule ever did. They do so primarily by providing a mechanism through which a potential investor and a potential host can establish a contract that is binding under international law. In addition, the provision of dispute settlement procedures offers investors a disinterested forum in which they can be heard and whose decisions bind the host. The other provisions of BITs offer substantive protections such as national treatment, most favored nation treatment, free transfer of assets, and a prohibition on performance requirements. Finally, not to be forgotten is the fact that BITs reproduce the Hull Rule’s requirement of prompt, adequate, and effective compensation for expropriation, including “expropriations” that fall short of a direct taking.

The Dynamic Inconsistency Problem




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