What is ISDS?

Investor-state dispute settlement, or ISDS, is a way of settling disputes between investors and states.

It most often happens in the form of an arbitration, so some people call it investor-state arbitration, or ISA. ISDS provisions have traditionally been inserted in bilateral investment treaties, which are negotiated between two states and provide for certain benefits and protections when an investor located in one of the states invests in the other state.

One of the problems investment treaties try to solve is that the host state could seize the investment outright, or might introduce limits on currency convertibility that make it difficult to patriate profits, or introduce regulations that discriminate against foreign investors. These concerns loom particularly large in countries with an ineffective legal system or weak rule of law, but even countries that we might think would know better will sometimes discriminate against foreign companies.

When the foreign investor can’t get justice in domestic courts, the traditional remedy has been to get the investor’s home state to try to convince the host state to pay some compensation through diplomacy, or perhaps by threatening retaliation in some other area. In the 19th century, the home state might have sent along some gunboats or even started a full scale war. Today the use of military force to settle commercial disputes is frowned upon.

The first bilateral investment treaty allowing an investor to take a state to arbitration was signed by France and Tunisia in 1969. Since then, hundreds of treaties have included arbitration clauses, and a few multilateral ones have too, notably NAFTA and the Energy Charter Treaty.

ISDS provisions give investors some confidence that if their investment is confiscated or otherwise impaired, they can take their case to an impartial tribunal and receive compensation. While an investor would probably not invest in a state that has a terrible legal system and is certain to ignore property rights, the option of using ISDS can provide a little more assurance and could tip the scales in favor of a particular country, or investing versus not investing.

ISDS provides a way to circumvent weaknesses in the host state’s rule of law and respect for property rights; it might be better to just fix that, but major institutional changes can be challenging to realize.

Even in places where courts work well, arbitration is often seen as a more efficient, faster and cheaper process than a traditional lawsuit that can take years, especially when the state is the defendant.

Most ISDS cases have been brought by European investors against poorer countries. Unsurprisingly, Argentina and Venezuela dominate the league tables of respondent states as a result of their large scale nationalizations of foreign businesses.

ISDS clauses usually say that arbitration has to follow one of two sets of rules, those set out by ICSID, part of the World Bank, or UNCITRAL, a UN institution. UNCITRAL arbitral awards against a state can be enforced in courts around the world like traditional arbitral awards. ICSID awards are easier to enforce because they are supposed to be treated like a domestic court judgment. In most cases, a state that loses will simply pay up.

Why are we talking about ISDS now?

There have been a few high-profile ISDS cases that were widely seen as abuses of the process, which has created anxiety that ISDS, which is ultimately a limitation on a state’s sovereignty, could have a chilling effect on legislation in areas like environmental protection, health and patents, and perhaps undermine democracy itself.

After the Fukushima nuclear incident in 2011, Germany decided to phase out nuclear power by 2022. As part of the phaseout, some older nuclear reactors were shut down. The Swedish state-owned energy company Vattenfall, which owned two of those reactors, decided to sue request arbitration for billions of euros—we don’t know exactly how much because arbitration proceedings are secret—under the ISDS provision of the Energy Charter Treaty.

Even if Vattenfall wins, the reactors will stay closed and Germany will still be nuclear free by 2022. Arbitrators cannot issue an injunction that orders German regulators reopen the reactors and their awards have no direct influence on public policy. Many regulations will end up costing someone money, and if that someone is a foreign investor from a country with an ISDS clause, regulating them in a way that benefits the public—for example by reducing the risk of a nuclear disaster—could end up costing a lot of money.

In most countries, the government has to pay compensation if it confiscates a piece of property and takes it into its own ownership, but usually not when there is a good public policy rationale for the regulation. If the kind of legislation that legislators routinely enact could end up being ruinously expensive because a foreign investor happens to lose out, legislators could be reluctant enact it in the first place. That is alleged to have happened in Canada in 2014 when legislation mandating plain packaging for cigarettes was withdrawn. Australia is currently engaged in an ISDS case on the same issue because Philip Morris Asia, which is nominally a Hong Kong investor, argues that the Australian plain tobacco packaging law expropriates its investment.

ISDS cases can also be brought when courts reinterpret existing legislation to limit investors’ property rights. The Supreme Court of the United States has sharply limited what can be patented in the US through a series of decisions over the past decade, with the effect of limiting or eliminating those patent owners’ “property” rights. We think of those decisions as simply clarifying what the law always was, but arbitrators may not see it that way. No investor has yet sued requested arbitration over CLS v. Alice or other American patent decisions, but Eli Lilly is doing so over an aspect of Canadian patent law known as the “promise doctrine.” The same could also happen as a result of the new Unified Patent in Europe.

It’s important to note that the chilling effect only exists if legislators, regulators and courts are chilled by it. As long as they are not ruinous, the host state could choose to pay out any arbitral awards and just continue governing as if they never happened. The US Congress and state legislatures would probably not feel very chilled.

ISDS is part of the drafts for both the new Trans-Pacific Partnership deal being negotiated by the US and various Pacific rim countries, and the TTIP deal between the US and the European Union, which makes it very relevant. People who are debating TPP and TTIP spend a lot of time discussing whether ISDS should be part of those deals. It also looks bad that ISDS provisions grant special privileges to foreign companies, because only foreign investors can request arbitration against a state.

[For my 🇺🇸 readers: United States has yet to lose an ISDS case. That might be because American courts are awesomesauce, because the system is rigged, or it might just be luck. Also, check out this hilarious pro-ISDS-argument that invokes the Federal Circuit.]

[For my 🇪🇺 readers: There are some intra-EU ISDS treaties. The European Commission requested their termination a few months ago because they’re not really compatible with EU law.]

How can ISDS be fixed?

The intentions behind ISDS are good: ISDS can help attract investment by protecting property rights, and by circumventing ineffectual legal systems. With some fixes—some small, some radical—I think ISDS can be cut down to size and be made palatable, while still achieving the goals it was created for.

Countries with good legal systems

When Vattenfall felt expropriated by the German government, did they really need access to an alternative judicial system to receive the compensation they deserved? Germany has very well-functioning and widely respected courts. I poo-pooed Vattenfall’s claims over its two nuclear reactors, but if they truly have merit, couldn’t German courts have decided that?

In fact, RWE and E.ON, two other energy companies with large investments in Germany, sued in German courts over a nuclear fuel tax, a different provision of the phaseout, and won. Well, the European Court of Justice in Luxembourg later ruled that the tax was legal. In any case, that lawsuit is close to being resolved, while Vattenfall’s case appears to be never-ending. So much for arbitration being faster.

Swedish investors don’t need ISDS to be reassured that it is safe to invest in Germany. Hong Kong investors don’t need ISDS to invest in Australia. American investors don’t need it to invest in Canada.

Vattenfall used the Energy Charter Treaty, which includes countries that at the time did not have great legal systems, and it would probably look bad to only apply ISDS to cases involving those countries. But there is no pressing need for TTIP, which is between the United States and the European Union, to include an ISDS provision. (There is an argument making the rounds that ISDS in TTIP is necessary to get China to agree to ISDS, and it doesn’t quite make sense.)

Stronger public policy exceptions

Most recent ISDS clauses include some recognition that not all losses caused by government action constitute a taking, and many arbitrators accept that. The leaked TPP investment chapter explains in an annex that

Non-discriminatory regulatory actions by a Party that are designed and applied to protect legitimate public welfare objectives, such as public health, safety, and the environment, do not constitute indirect expropriations, except in rare circumstances.

These guarantees can be made stronger, so something like the Australian plain tobacco packaging law is understood by everyone to not be expropriation.

Multilateral investment treaties often allow a commission of government representatives to issue interpretations of the treaty that are binding on arbitration panels. NAFTA has one and the TPP draft has one too. These commissions should be used more frequently and aggressively to curb abuses of the arbitration process.

Appeals

Arbitration panels consist of three often not very well selected arbitrators, and they can make mistakes. When a judge in a conventional court makes a system, there is usually an appeals court that can correct the mistake. ISDS awards can amount to billions of dollars and the consequences of an error can be serious to the losing state.

While there are a few narrow ways in which an arbitral award can be set aside, a permanent appeals body, like the WTO has, could do much to curb bad arbitral awards and abuses of the system. Arbitration awards can normally not be appealed because that would increase the potential cost of a system that is supposed to save money. One way to preserve that is to limit appeals to awards over a certain size.

Transparency

Arbitration is secret. The arbitration panel has the option of issuing wide-ranging confidentiality orders over the documents in the case, and in-person sessions are usually not open to the public. Opening up the proceedings whenever possible would reduce anxiety about the process.

Alternatives to ISDS

Arbitration is not the only way that investors can be protected against expropriation. MIGA, an agency of the World Bank, sells insurance against breach of contract and political risks such as expropriation. Many countries’ export-import banks offer similar coverage.

An investor with such an insurance policy may be even better protected than with an ISDS clause, because the insurer is less likely than a state to resist paying out a valid claim. MIGA’s capital can be expanded so the $720 million per-country limit can be raised and more investors can take advantage of this kind of insurance.

MIGA has only paid out eight claims so far, and only one of those was for a project in Argentina. According to the agency itself, the number is so low because they are awesome at negotiating an informal solution before a full claim is necessary.