The need to reform ISDS and BITs

This post will question the wisdom of the provision of international arbitration granted to foreign investors from countries with which India has Bilateral Investment Treaties (BITs) or more generally the process of Inter-state Dispute Settlement (ISDS). I blogged on this here in the context of an essay by Columbia Professor Katharina Pistor that traced the legal origins of capital claims. 

It assumes significance in the backdrop of the ongoing India-UK trade deal negotiations where BIT is also on the table. Following a spate of high-profile arbitration reversals, India suspended BIT with 68 countries with a request to renegotiate based on the 2016 model BIT. The old BITs allowed for recourse to international arbitration. The argument is that local remedies are either weak or take too long, and therefore investors need international arbitration access to get them to invest in India. 

However, the newspaper report also mentioned that the Government of India may concede to the retention of international arbitration in its BIT with the UK. That would be a very bad idea. It's important that India stand its ground on the principle of BIT. Its quid-pro-quo concessions should not be on fundamental principles like BIT and instead focus on tariff lines.  

Rana Faroohar has an op-ed on the issue of ISDS and how it has become a feature of a global trade system that elevates the interests of multinational corporations over those of sovereign nations. She urges the US to take the lead and organise a multilateral exit from all ISDS arrangements. 

ISDS is a very common part of free trade agreements and bilateral investment treaties, in essence allowing foreign companies investing in particular nation states to sue governments for anything that stops them making profits — including climate regulations, financial stability measures, public health policy, and any number of other areas that are typically the purview of the state. The idea originated in the early 1990s, the era of nonstop globalisation, as a way to draw foreign investment into developing countries while also protecting rich country investors from the weak legal and governance systems in those nations. As of 2022, 1,257 ISDS cases had been launched, according to Unctad... 

The asymmetries of the system have always been stark. Only foreign investors have rights and only foreign investors can initiate claims. And claims can include not just actual losses but future ones, too. As a new white paper co-authored by academics from Georgetown and Columbia universities, as well as trade experts from the American Economic Liberties Project, points out, “corporations rarely invoke ISDS to protect against blatant expropriation or gross denial of justice”. Instead, they have been “consistently successful in exploiting the vaguely worded provisions within ISDS-enforced trade and investment agreements” to “initiate or threaten claims against democratic measures taken in the public interest that they believe have harmed their business interests.” 

Multinational airport operators have used ISDS to challenge Chile’s pandemic shutdown measures; a Canadian company has argued that mining rights should trump environmental protection measures in Colombia. Huawei has launched a case against Sweden over measures limiting its participation in 5G because of security concerns. In the US, the Keystone pipeline is the classic example. TransCanada sued the US during the Obama presidency because they weren’t allowed a permit to build, then revoked it under Trump (who allowed it) then sued again under Biden. So ISDS is also a pain for rich countries, but their companies usually benefit. For poorer countries, it can be devastating. Actions deemed to be in the public interest (such as raising health or labour standards) can lead to billions of dollars in claims that they can’t afford to pay. 

The big worry now is that such agreements could be used to prevent the clean energy transition. Fossil fuel companies and investors have filed numerous ISDS cases, totalling billions. Academics have estimated that global climate change efforts could result in $340bn of claims (the Keystone XL suit alone is for $15bn) Given all this, it’s little wonder that a lot of countries, including the US, Canada, Mexico, some EU member states, South Africa, India, Indonesia, and Ecuador are limiting or ending future ISDS agreements and even attempting to pull out of existing ones... According to Nobel laureate Joseph Stiglitz, there is little evidence that countries signing ISDS treaties saw more or better foreign direct investment than those that didn’t: “These deals just haven’t lived up to their promise.”

As an illustration of the egregiously bad nature of ISDS in BIT, consider this example. A foreign investor makes a commercial investment decision to take a stake in a project in India. The investor could be a private entity or a sovereign wealth fund. It subsequently transpires that the project is vitiated (by corruption or violation of local laws). The new development leads to a revision of the terms of the project, which is obviously less favourable to the investors. The investors respond by approaching the local courts. After exhausting the appellate process, the Supreme Court of India has upheld the revision. The domestic investors accept the verdict and move on. 

But the foreign investor now invokes the provisions of the BIT and takes the matter to international arbitration. The arbitration jury at London or Hague questions the revision and rules in favour of the investor and against the Government of India. It compensates the foreign investors for their commercial losses arising from the revision. 

Or consider the example of a taxation provision that's introduced afresh. Without getting into the merits of such an introduction, the fact remains that this is non-discriminatory and applies to all businesses operating in the country and it's a sovereign prerogative to tax. One can understand the Supreme Court of a country weighing in on the issue, but allowing an international arbitration jury to adjudicate on what's essentially a sovereign prerogative is deeply troubling. 

In the circumstances, we need to consider the following: 

1. International arbitration effectively becomes an appeal on the Indian judicial process. This is a direct and omnibus subordination of national law to international law. 

2. Any commercial investment decision is a contract. Such an omnibus international arbitration clause elevates contractual obligations above even sovereign law. 

3. The foreign investors enjoy a judicial recourse that domestic investors do not have. This forum shopping goes against fairness and equality. Foreign investors cannot have superior protections to what domestic investors enjoy. 

4. The BIT becomes an insurance against bad investment decisions and vitiated contracting. This generates moral hazard. It encourages businesses to invest without proper due diligence, and at worst nudges them to pursue dodgy deals to make quick and large profits. 

It’s time to seek revision of the boilerplate templates of BITs. There was a time when foreign investors needed the assurance of a BIT to invest in India. There are several reasons to argue that this insurance is no longer a requirement. 

Then there are the problems with the arbitration process itself. 

1. There’s an implicit bias among arbitration juries that developing countries tend to expropriate investors, and the default norm is to protect foreign investors. When the margins are thin, such cognitive biases invariably end up distorting jury decisions. 

2. International arbitration in places like London is dominated by a few global law firms that also compete for business from multinational corporations. This creates unavoidable conflicts of interests which all too often are apparent underneath the surface Developing country governments are constrained by having to rely on the same pool of law firms who also provide services to these private companies. 

3. Hamstrung by bureaucratic factors, governments cannot pursue these cases with the same intensity and focus as private investors can. Unlike private investors with the flexibility to undertake bilateral negotiations and settlements with various stakeholders, governments cannot cut corners in pursuing such informal pathways. 

4. Then there are the usual problems of nepotism, cronyism, and corruption within the worlds of law and finance, which further tilts the playing field against government interests. 

In light of all this, it's time to ease out the provision of BIT that allows foreign investors to do forum shopping and enjoy preferential treatment by way of access to international arbitration in their preferred locations that foreign (western) businesses enjoy while doing business in India. The BITs should be amended to this effect. India does not have a track record of expropriation of foreign assets to merit this undesirable layer of contract insurance against the Indian political, bureaucratic, and judicial system.

Update 1 (10.02.2024)

Times has a very good article illustrating the problems with international arbitration. In this case, two small-time Irish businessmen won $6.6 billion in damages from a London arbitration panel for the revocation of a corrupt contract won by them with the Nigerian Ministry of Petroleum Resources. Consider the contract.

The original contract said that Nigeria had to give P.&I.D. wet gas not for a year or two, but for 20 years. Nigeria had failed to do this. Even though P.&I.D. hadn’t yet spent a penny on construction, Nigerian law — like British law — held that the party who breached a contract had to make the other party whole by paying them the amount they would have made had the contract been fulfilled. What this meant: When Nigeria paused on the wet gas, a legal wire was tripped. Nigeria owed P.&I.D. for two decades of hypothetical future profits from the sale of gas byproducts they had never processed, in a facility they had never built. But how much was that?

P.&I.D. had commissioned a report by a consulting firm, Berkeley Research Group, which laid out estimates of revenue and cash flow if the project had come to fruition. Financiers use something called a “discount rate” to calculate the value of future profits, taking into account all the risks that might be involved. The greater the risk of an investment, the higher the discount rate, and the lower the present-day value. Investments in Nigeria were considered risky because of political instability and corruption, so the standard discount rate at the time was more than 10 percent; the Berkeley report used 2.6 percent. On another page of the report, Berkeley predicted that oil — whose price historically correlates with that of natural-gas byproducts — would rise steadily, year after year, to $115 a barrel in 2024; but commodity prices fluctuate for all sorts of reasons, and today oil trades for $75 a barrel...

They weren’t paying bribes to lubricate an otherwise-solid project; they seemed to be paying bribes because they barely had a project at all. An early drawing of the wet-gas unit was a ripped-out piece of lined paper with hand-drawn pipelines on it, squiggles of blue marker representing water. A later drawing — the one they showed the Ministry — was a screenshot they took from designs for a different facility. By the end, the 34 bundles of evidence told a story that one lawyer for Nigeria categorized as “industrial scale” fraud. The former band managers, they argued, had shaken down a sovereign state for $6.6 billion, for failing to fulfill an illegally procured contract that relied on copied plans for a different project... The company was essentially a financial abstraction, a piece of paper that might or might not be worth a fortune (the award was now $11 billion with interest). It all depended on the outcome of the trial.

The case exposed the problems with secret arbitration proceedings. 

Born estimates that about 1,600 arbitration cases are filed every year in which one party is an investor and the other party is a state or state-owned enterprise, but the opacity of the system makes exact figures impossible to get. In some arbitrations, we know the parties, but the specific details of the proceedings remain private. In a majority, however, the existence of the arbitration itself is never disclosed... “If it was in court, it would be public,” Stephan Schill, a professor of international law at the University of Amsterdam, says of the P.&I.D. affair. “The press would monitor it, and would immediately pick out problems. The confidentiality is a big problem. It makes it easier to hide corruption.”

In one of the rarest examples, a Civil Court in London over-turned the arbitration judgement.