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Free trade agreements

Investor-state dispute settlement: What accounts for the “special” process?

Published 01 March 2018

Trade rules typically cover a category of goods or services that affect all firms engaged in trade. Investment disputes, on the other hand, are usually about a state's treatment of an individual enterprise.

Note to Readers: This post is the first of three on the subject of investor-state dispute settlement in trade policy. Part two will review who uses these procedures, and part three will consider the debate over investor protections in the NAFTA.

A Different Set of Procedures for Investments

Modern trade agreements incorporate provisions to settle disputes between the parties. Chapter 20 of the North American Free Trade Agreement (NAFTA), for instance, outlines the procedures for resolving a dispute for everything but the commitments on how the governments treat investment. These are the State-to-State Dispute Settlement procedures. But for NAFTA’s Investment rules, found in Chapter 11, a different mechanism, called Investor-State Dispute Settlement (ISDS), is used. Why?

Investment Disputes Often Affects a Party of One

Trade rules typically cover a category of goods or services and affect all firms engaged in trade. For instance, the rules covering preferential tariffs on automobiles apply to any company or individual engaging in international trade in autos. The rules are administered by the governments who joined the agreement, and if there is a dispute, it logically is handled between the governments-known as state to state dispute settlement. The WTO’s Dispute Settlement Understanding is a well-known facility: WTO disputes are brought by members (states) when other members (states) are acting in a manner at odds with their obligations.

Investment disputes, on the other hand, are usually about a state’s treatment of an individual enterprise. The substantive obligations in the investment agreement cover matters like non-discrimination, the ability to transfer assets in and out of the jurisdiction, and protection against expropriation without compensation. Imagine Country X, where there are 100 U.S. firms with investments in the economy. One of these firms has its plant nationalized. The other 99 firms may be unaffected, but the affected firm has a claim that Country X breached its obligations.

Asking the State Department for Help Got Old

Investment disputes have not always relied on ISDS-in fact, the precursor to ISDS was a state-to-state mechanism known as “espousal.” If a U.S. firm believed it had been mistreated by a foreign government, it could make its case to the State Department and request assistance. This practice had, and still has, a number of drawbacks: diplomats tend to view such claims as a distraction from other policy priorities; practically, the process was often ineffective; and, espousal tended to politicize the dispute, increasing the difficulty of resolution.

Around 60 years ago, diplomats worked to address the deficiencies of investor protection by drawing from the principles of commercial arbitration. Existing treaties of Friendship, Commerce, and Navigation were modified to incorporate specific obligations on the treatment of investment. The new instruments were known as Bilateral Investment Treaties (BITs), the first of which was adopted in 1959 between Germany and Pakistan. Core elements of commercial arbitration, including a facility where investors could make claims on equal footing to states, were incorporated by the parties. Frequently, these cases are heard by the World Bank’s International Center for the Settlement of Investment Disputes (ICSID), or they may be commonly brought under special United Nations rules known as UNCITRAL.

3,000 Investment Agreements and Counting

The BIT has been a remarkably successful policy innovation: today, there are over 3,000 international investment agreements in force worldwide. That includes around 2,700 BITs or similar stand-alone investment agreements, as well as free trade agreements that include investment chapters with similar types of commitments.

Most of these agreements offer foreign investors specific guarantees regarding the treatment of their investments, and most also rely on a neutral set of international arbitration procedures accessible through the treaty’s Investor-State Dispute Settlement mechanism or ISDS.

Any policy must be evaluated versus alternatives, and in many respects, ISDS represents an advance in the peaceful resolution of disputes. Other TradeVistas posts will examine the experience with ISDS and why it has become a salient topic for policymakers.

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Scott Miller is a senior adviser with the Abshire-Inamori Leadership Academy, focusing on leadership development programs for public- and private-sector executives.

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