Inequality Explained: Everything you need to know about the TPP’s arbitration provision

This explainer was written by a group of UBC graduate students as part of our Lind Initiative series on inequality. It was an assignment from a course on public policy. 

Details of the Trans-Pacific Partnership (TPP), the multilateral trade agreement set to create the world’s largest trade zone and comprising nearly half of the world economy, were released recently. The release of the text cemented previous concerns. Some of the critique centred not around the scope or volume of trade, but on a more controversial provision: investor-state dispute settlement (ISDS).

What is ISDS?

ISDS is an arbitration mechanism commonly found in bilateral and international trade agreements. Arbitration is a way of settling dispute outside court. ISDS gives investors the right to take foreign governments to dispute settlement proceedings. Since proceedings are extrajudicial, the process occurs outside of the regular court system. Verdicts are reached in private tribunals adjudicated by appointed arbitrators.

ISDS provisions in trade agreements determine the balance of power between investors and governments. Some agreements, such as NAFTA (North American Free Trade Agreement), favour investors over governments. Others, such as CETA (Comprehensive Economic and Trade Agreement), prioritize the sovereignty of states over investors. ISDS provisions in the TPP are somewhere in the middle of NAFTA and CETA.

Article 9B of the TPP gives investors (called ‘claimants’) the right to submit a claim against a foreign government (called a ‘respondent’) if the government has violated any of their obligations. The obligations are established by Articles 9.4 through 9.15. These Articles guarantee non-discrimination and “fair and equitable treatment” to investors, provisions for conditions under armed conflict and civil war, for expropriation and compensation, and even for corporate social responsibility and regulatory objectives. The provisions are comprehensive, but their language is vague. Foreign governments are liable for knowingly or arguably violating any of the provisions or impinging on the actual or expected profits of investors. The ambiguity of the text suggests that ISDS boils down to skillful lawyering.

Still, ISDS is not as black and white as it is made out to be. There is speculation that not many people are willing to actually read the 6,000-page document. Even those willing to peruse the entire text would get little out of the experience. In the words of The Globe and Mail, “to read the TPP and understand it would require legal training and the experience in international trade to place the proposed deal in the context of current agreements. You’d need to be a student of Canada’s economy, with a specialty in its marketing boards, its exports and its tariff structure. You’d have to bone up on our laws on intellectual property, banks, labour and telecommunications. A familiarity with Vietnam’s tariffs on ‘meat of horses, asses, mules or hinnies, fresh, chilled or frozen’ wouldn’t hurt either, not to mention knowing what a hinny is in the first place.” 

Among those who have read the text, strong arguments have been made in favour of and against its ISDS provisions. With this in mind, we endeavoured to evaluate the controversies surrounding ISDS. 

Where does the idea come from?

International commercial arbitration dates back to the medieval ages. Medieval merchant law, lex mercatoria, established the private settlement of dispute among merchants in merchant courts (which were separate from local courts of law). Medieval arbitration was limited to private actors and institutions, whereas the contemporary system involves public and private actors, institutions and processes.

Contemporary ISDS provisions are far from unique to the TPP. They can be found in a number of regional treaties, and in over 3,000 bilateral investment treaties. These agreements form the backbone of an emerging transnational investment regime that privatizes, denationalizes and decentralizes investment decision-making. According to legal expert Claire Cutler, “despite the absence of explicit links between ISDS provisions,” their shared language, principles, and decision-making and interpretive structures nurture a network metaphor and lead to the conclusion that there has been a significant “treatification of international investment law.”

The development of the investor–state regime and the steady global expansion of international investment agreements is attributed to a number of geopolitical, economic, institutional and ideological developments. Early foreign investment disputes were ‘arbitrated’ through “gunboat diplomacy,” and later by Friendship, Commerce and Navigation (FCN) treaties. FCN treaties were not designed for foreign investment, but they began to incorporate investment protections. At that time, states were the primary subjects of international law— individuals or corporations had limited options for taking legal action against states: either by initiating a claim in the national court of the host state, or by exerting political influence to persuade their home state to advance a legal claim on their behalf.

Following World War II, the United States introduced the Hull Rule, a requirement of “prompt, adequate, and effective” compensation for expropriation under customary international law. The Hull Rule was received positively by the ‘developed world’ (capital-exporting states), but challenged by developing countries (capital-importing states) who were asserting their independence amid decolonization.

The 1960s witnessed the emergence of international investment agreements in response to this impasse. The International Centre for the Settlement of Investment Disputes (ICSID) was created in 1966 to facilitate direct legal action against host states under bilateral investment treaties. Developing countries were hesitant to use the ICSID — evidenced by the lack of cases in the first five years — but bilateral investment treaties (BITs) grew considerably from the 70s onwards. The growth of BITs corresponded to an increasing use of the ICSID and similar institutions, such as the United Nations Commission on International Trade Law (UNCITRAL), the Stockholm Chamber of Commerce (SCC), and the International Chamber of Commerce (ICC). Traditionally, BITs were entered into between developed, capital-exporting states and developing, capital-importing states, but increasingly between developing dyads.

How has ISDS changed over time?

The North Atlantic Free Trade Agreement (NAFTA) was the first trade deal among developed countries to include an investor-state provision, called Chapter 11. Experts agree that international trade law has been significantly affected by globalization and transnationalism, but they are divided on the historical significance of Chapter 11. Chapter 11, designed to protect Canadians and Americans from the corruption of Mexican courts, resulted in “claims [being made] against the United States by Canadian investors and against Canada by U.S. investors.” Some scholars maintain that “Chapter 11 grew out of a long tradition” whereas others describe the developments as “radical” and paradigm-changing.

Investor-state dispute settlement is a growth industry. Nearly a hundred claims have been filed by foreign investors against governments in the past two years alone, comparable to 500 in the quarter century before that. In addition to an expansion in the number of claims, experts have also observed “an expansion in the types of claims.” The “sharp rise in contentious arbitrations” is attributed to “companies [having] learnt how to exploit ISDS clauses.” This new arbitration industry consists of “entrepreneurial lawyers advising potential clients about options for resolving investment disputes through international arbitration that would not have been considered only a few years ago.”

Why are some countries more affected by ISDS?

ISDS claims are filed in growing numbers against all countries, but the “distribution of arbitral claims varies among states.” In other words, not all countries have the same proportion of claims filed against them. Canada has been the target of 45 percent, or 35 of 77, known NAFTA claims, compared to the 22 claims brought against Mexico or the 20 against the United States. This proportion is growing. Since 2005, Canada has been the target of over 70 percent of NAFTA claims. Canada has paid over $CAD172 million in NAFTA damages, not including the millions of dollars in legal costs. Some estimate these legal costs around $CAD65 million. Even though the United States has never lost a case, it has racked up millions in legal fees as well. It’s unclear whether the economic benefits of being part of NAFTA offset the incurred legal fees and damages.

Some researchers have tried to find out why Canada has been sued more than Mexico and the U.S. under NAFTA. It is arguably the result of the “[Canadian] federal government’s ideological commitment to [Chapter 11] and its demonstrated willingness to settle and pay compensation,” which encourages even more cases. Another analysis discovered “countries with greater institutional capacity experience fewer disputes than those with lower capacity.” The suggestion that Canada has less ‘institutional capacity’ than Mexico seems counterintuitive. If anything, these analyses emphasize the limits of our knowledge as to why some countries receive more claims than others.

What are some examples of controversial ISDS cases?

There are many examples of controversial ISDS cases over the last few decades. The following five recent and ongoing cases highlight some of the important issues in the dispute over ISDS.

 1. On Environmental and Health Regulations: Gabriel Resources v Romania (ongoing since 2015): ISDS provisions are increasingly used to challenge environmental and health regulations. Gabriel Resources, a Canadian company, has been petitioning to open a gold and silver mine in Romania for over a decade. A civil movement around health, environmental and cultural concerns rose in response to the proposed mine, which is expected to use cyanide and endanger nearby archeological sites.  Large protests and public pressure convinced the Romanian government to deny Gabriel Resources’ environmental permits. Gabriel Resources sued Romania, under the ISDS provision in the UK-Romania free trade agreement, for over $2.5 billion in compensation –  the equivalent of two percent of Romania’s GDP. The Canadian company sued Romania under a treaty with the UK by using a shell company incorporated in Jersey, a UK-affiliated tax haven.

2. On the Costliness of ISDS Proceedings: Philip Morris v Uruguay (ongoing since 2014): While wealthy countries can feel the pinch of the costs of ISDS proceedings, developing countries may find the costs insurmountable. Philip Morris sued Uruguay for $25 million over the passage of a law demanding an increase in the required size of health warnings on cigarette packaging. Uruguay could ill-afford the costs of defending the suit, let alone paying the subsequent damages. In response, Bloomberg Philanthropies and the Bill and Melinda Gates Foundation launched an Anti-Tobacco Trade Litigation Fund to help developing countries create and protect anti-smoking regulations in the face of threats from the tobacco industry.

3. On Secrecy: Vattenfall v Germany II (ongoing since 2012): In light of the Fukushima disaster, the German government decided to phase out their use of nuclear energy. The Swedish Company energy Vattenfall had invested heavily in nuclear power in Germany and demanded compensation for expected loss of property and profits. Vattenfall made a claim under the ISDS provisions of the Energy Charter Treaty. Because both parties have agreed to secrecy, it is not known what arguments Vattenfall cited or how much compensation it claimed or received, though it is estimated at 4 billion euros.

4.  On Treaty Shopping: Philip Morris v Australia (ongoing since 2011): As investment treaties become more common, investors are able to “shop” for the treaty that best suits their interests. When in 2011 Australia implemented stricter laws on cigarette packaging, American company Philip Morris was unsuccessful in challenging the law in the domestic courts. Also, the investment treaty between Australia and the United States did not contain an ISDS provision. However, Philip Morris was able to use a small subsidiary in Hong Kong to bring a claim against Australia under the ISDS provisions in the Hong Kong-Australia trade agreement. It claims compensation from Australia for the loss of its ability to take full advantage of its trademarks on tobacco packaging.

5.  On Respect for State Sovereignty: Chemtura v Canada (decided in 2010): In the early 2000s, Canada introduced a ban on lindane, a known carcinogen. At the time, Chemtura manufactured a pesticide containing lindane, and sued Canada under NAFTA’s ISDS provisions for nearly $80 million in compensation. The tribunal ruled in favour of Canada, finding the ban consistent with public health standards worldwide, such as in Japan and the U.S., despite the fact that the ban also “indirectly expropriated” Chemtura’s investment.

The pros and cons

The debates over ISDS are multifarious and extensive, with a myriad of reports, analyses and articles on the topic. Nevertheless, the necessity or efficacy of ISDS remains inconclusive. In the following section, we aim to provide a succinct and holistic analysis of some of the main questions surrounding ISDS. Following an evaluation of each argument, we include insights from Nobel Laureate Joseph Stiglitz based upon commentary we received following a presentation of our research. We also include responses from professors Keith Head and Ljiljana Biuković from the University of British Columbia, obtained through email correspondence. 

Pro: ISDS is a necessary protectionary provision that promotes Foreign Direct Investment (FDI) into developing economies.

There is a general consensus amongst scholars and economists that Foreign Direct Investment (FDI) promotes economic development and growth. A United Nations Conference on Trade and Development (UNCTAD) report states that “foreign direct investment can play a key role in the economic growth and development process.” Considering the importance of FDI, developing countries with weak or corrupt judicial systems and volatile governments must be able to ensure that there is a secondary framework upon which potential investors can rely, which is where ISDS comes in. By ensuring both “fair and equitable treatment”, while also combating “expropriation without compensation,” ISDS provides an external form of protection for investors and corporations.

Recently, however, this argument has come into question as companies begin to find ways to exploit the ISDS provisions under the guise of compensation. Furthermore, many ISDS claims are made towards already developed economies such as Canada, with relatively reputable judicial systems and stable government and thus little need for an ISDS provision in the first place. In addition, countries such as Brazil – which is currently fifth in the world for FDI inflows – have refused to sign agreements containing ISDS clauses, while South Africa and India have indicated their intent to withdraw from treaties involving ISDS clauses.

What the experts say: 

Head: The argument for ISDS is very much like the Ulysses and the Sirens myth. Ulysses needs to be bound to the mast so he cannot heed the Sirens’ song. Similarly, Less Economically Developed Countries (LDCs) sometimes agree to bind themselves with ISDS so that corporations will feel more safe about investing there. This is potentially a winner for the LDCs if the additional investment helps to transfer valued technologies and market access.

Stiglitz: There is no evidence that poor countries who have signed trade agreements with ISDS have received more foreign investment than those who have not. Furthermore, ISDS proponents often argue that you cannot “trust” governments and legal systems to treat foreign firms fairly, which is insulting to governments and states generally, while there is also no evidence of this for wealthy democratic countries in any case.

Con: ISDS provisions increase investor power and corporate influence on domestic politics.

A main argument opposing ISDS relates to the idea that once corporations gain the ability to sue governments, this may lead to corporations wielding too much power in the political sphere, undermining government authority and national sovereignty. Essentially, fears are that a government will “start taking its cues from companies and not its citizenry.” Addressing the issue of ISDS from the perspective of inequality, one can extend the argument of corporate power influencing politics to make the claim that such influences may obstruct policies aimed towards reducing various forms of inequity and inequality. However, a report from the Jacques Delors Institute has shown that very large multinationals –  which would wield the most influence – were responsible for only eight percent of complaints. The same report also states that despite claims for compensation averaging about $USD 343.5 million, the actual average amount awarded was about $USD 10.4 million, equivalent to only three percent of original claims for compensation.

Nevertheless, with regards to the TPP, there are worries about the state’s “right to regulate,” where right to regulate refers to “the state’s ability to legislate and adopt administrative acts without running the risk of having to pay damages as the result of a dispute based on an International Investment Agreement (IIA).” Indeed, it remains difficult to say to what extent the mere threat of a billion dollar lawsuit may affect how governments address the imposition of new regulations.

What the experts say:

Stiglitz: Lawyers and firms have only just begun to learn how to use the ISDS provisions to their advantage. The TPP allows investors to sue regarding any change in regulation, even if the change applies equally to foreign and domestic firms. In addition, the TPP has no language on climate change or exempting legal measures to address climate change from challenge, and although it has language exempting legal measures to address “health and safety,” they were drafted ambiguously and such exemptions do not override other provisions of the TPP.

Biuković: Armand de Mestral has recently said that NAFTA is pro-investor, while CETA pays more attention to the preservation of regulatory sovereignty of states. The TPP is probably somewhere in the middle when it comes to ISDS. But it is worth looking at Article 9.15 to see some admittedly limited exceptions (similar to WTO exceptions) safeguarding rights of states to adopt, maintain or enforce restrictive measures states consider appropriate to protect environmental, health or other regulatory objectives. 

Pro: ISDS provides necessary protections for companies who have been treated unfairly by foreign governments.

One of the main reasons for the existence of ISDS provisions is to protect corporations against expropriation, where a state nationalizes or takes over private investor property. In general, ISDS serves as a means to protect foreign investors from having their property taken over by host governments, yet many cases seem to go beyond this under the guise of “indirect expropriation,” with corporations claiming compensation for any legislation that may lead to lost profits. This sets a dangerous precedent.

A key example is the Philip Morris v. Uruguay case, as previously described, where prosecutors argued that Uruguay’s anti-smoking legislation led to a loss of profits for tobacco company Philip Morris and Uruguay should therefore pay compensation. It is worth noting that under the TPP, “tobacco companies won’t be able to use the TPP to block public health-minded tobacco regulations.” Nevertheless, it remains uncertain whether TPP provisions and clarifications are enough to mitigate issues of corporate greed with regards to ISDS.

What the experts say:

Stiglitz: The TPP in effect freezes the current laws and allows firms to sue for any loss of expected profits resulting from a legal change. This goes well beyond compensation for expropriation of property or loss of previous investment value, which again would be more justifiable.

Head: Policies that allow for compensation for “de facto expropriation” are in principle very subject to abuse. Why? Almost any legitimate regulation that imposes costs or restrictions on the Multinational Enterprise (MNE) will reduce its profits and therefore be arguable as an expropriation. So it really matters a great deal how the ISDS panels handle such cases.

Con: ISDS clauses lack transparency.

Another controversy surrounding ISDS and particularly ISDS within the TPP is the lack of transparency surrounding the process through which such agreements have been negotiated, as well as many of the arbitration cases themselves. Negotiations around the TPP have been conducted in complete secrecy, and newly elected Canadian Prime Minister Justin Trudeau spoke out against the Harper administration, which was involved in the creation of the text, stating that it “failed to be transparent through the entirety of the negotiations.” In the U.S., Senator Elizabeth Warren has also criticized the “locked doors” behind which TPP negotiations have taken place.

A counterclaim to the issue of transparency, particularly regarding case settlements, is that “even in some advanced democracies, national courts can be just as opaque as arbitral tribunals.” Furthermore, there have been ongoing efforts to increase transparency in trade deals, an example being TTIP and the European Commission introducing a “full transparency clause” with public access to hearings and court documents, as well as the possibility of third-party submissions, amongst others. However, it just came to light that the European Union has seemingly provided U.S. oil corporation ExxonMobil access to confidential documents and negotiation strategies surrounding TTIP.

What the experts say:

Stiglitz: European countries are starting to resist ISDS. ISDS flouts the rule, as under the current system, it operates under a private and secret dispute resolution system. There are no checks on conflicts of interest, where the same small group of lawyers act as counsel and as arbitrators. The current arbitration system further increases legal uncertainty as decisions have no precedential value.

Biuković: [On CETA] On the EU side, the European Commission negotiated for the most part with the federal government and all Canadian provinces on the other side. It was a long and complicated negotiation and we saw that even after the provisional signing of the treaty it took a while for the text to be completed. While both sides were consulting regularly with industry stakeholders, the European Commission was releasing all sorts of feasibility studies to the general public and my sense was that [Canada’s] government was not as transparent as the EU in that regard. TPP negotiations seemed even less transparent so there was more opposition to the deal.

How to fix ISDS: Possible solutions

A consensus may be emerging that ISDS provisions in their current state are in need of reform or replacement. Alfred de Zayas, the United Nations Independent Expert on the Promotion of a Democratic and Equitable International Order, claims that ISDS “threatens the existing system of justice, the concept of checks and balances, the very core of the rule of law. Its implications for the respect of human rights around the world are devastating. If it is allowed to continue to exist, it will hijack the dreams of a just international order born out of the second world war” and that “the international investment regime and ISDS have resulted in growing inequality among states and within them.”  Even some normally pro-investment sources are starting to agree that the ISDS mechanism needs to be rebalanced. But what alternatives are there, and are they any better? A number of approaches have been proposed and/or taken to rectify the concerns associated with ISDS.

Here are five ways to fix ISDS:

1. Establish a Public and Professional International Trade Court: In response to concerns in European countries over ISDS, the European Commission has proposed an International Investment Court to be included in all future trade agreements (such as TTIP and CETA) and to replace all ISDS provisions.

The proposal includes: A public international court similar to the current International Court of Justice; public appointments to the Court of highly qualified and internationally respected jurists; public proceedings, an appeal court and a precedent system, with opportunity for online public comments and for third-parties to obtain intervenor status; narrow and precise definitions of the types of cases that can be brought, focusing on discrimination and expropriation; and language strongly reinforcing state government’s right to regulate all forms of trade in the public interest.

However, it looks to us that the political feasibility of this suggestion is in doubt. Earlier this year, the U.S. rejected a similar proposal from the EU. The ISDS system is entrenched in a large number of investment treaties. As noted by Andrew McDougall, an arbitration partner at law firm White & Case, “the treaties we’re dealing with date back a long time and now it’s difficult to get international agreement on a new treaty.”

2. Increase the number of exemptions in trade deals: The proposed TPP exempts the tobacco industry from the benefits of ISDS. Known as a “carve out,” it prohibits tobacco companies from bringing ISDS claims against countries to challenge regulations on tobacco. Similar “carve outs” in trade agreements could be included for other important measures that require government regulation, such as climate change and environmental protection.

However, it has been argued that the very need for a “carve out” at all shows that the states negotiating trade agreements understand that their rights to regulate public health and the environment in the public interest are infringed by trade agreements. We suspect that an exemption for every topic of importance to the public may not be a realistic option.

3. Stronger language to protect state sovereignty and the ability to regulate in the public interest: Trade agreements usually contain language that purports to preserve state power to regulate in the public interest. For example, in the TPP, two provisions are highlighted. First, Annex 9-B states that: “non-discriminatory regulatory actions […] 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.” 

This language does refer to “rare circumstances,” a phrase liable to a variety of interpretations, and only applies to “indirect expropriations” which may or may not include items such as loss of expected profits. However, some experts, such as international trade lawyer Nikos Lavranos, claim that this language is very clear and that “measures adopted for the protection of the environment, such as for example the reduction of CO2 emissions, cannot – in principle – be considered to constitute “indirect” expropriation, which makes an ISDS claim under TPP practically useless.” It is possible that this clause will be used effectively by governments to protect public health, safety and the environment. 

Second, Article 9.15 of the TPP states: “Nothing in this chapter shall be construed to prevent a party from adopting, maintaining or enforcing any measure otherwise consistent with this chapter that it considers appropriate to ensure that investment activity in its territory is undertaken in a manner sensitive to environmental, health or other regulatory objectives.”  

While this may appear to protect governments, some experts disagree. George Kahale III, chairman of the arbitration firm Curtis, Mallet-Prevost, Colt & Mosle LLP, notes that the entire provision is negated by five words in the middle – “otherwise consistent with this chapter” – and so “at the end of the day, this provision, which really held out a lot of promise of being very protective, is actually much ado about nothing.” Drafting language in trade agreements that clearly and unambiguously protects the rights of governments to regulate in the public interest could be an important step forward.

4. Protect against “forum-shopping”: Cases such as Philip Morris v Australia and Gabriel Resources v Romania show that, as more investment treaties are concluded, firms may try to “forum shop” and create shell companies to take advantage of favourable treaties in countries where the firm has no real business presence.  In the CETA negotiations, Canada and the EU have implemented specific measures to avoid “treaty shopping”. Similar measures could be adopted in other trade agreements such as TTIP and the TPP.  We think this solution is politically feasible and worth pursuing in future trade agreements.

5. Revert to State-to-State dispute resolution: Brazil has refused to enter into any trade agreement with an ISDS clause. Instead, it has opted for a State-to-State resolution model under the name of Cooperation and Facilitation Investment Agreements (CFIAs). Under these agreements, investors with complaints must first attempt to negotiate through a joint governmental committee comprised of members from both states. If negotiations fail, the government of the investor can choose to pursue a claim against the other country, but the investor cannot make a direct claim on its own. 

This solution retains the traditional model of international law, where only governments can bring claims to enforce international treaties. This ensures that issues of state sovereignty and global politics are considered directly by the state whenever a treaty is sought to be enforced.  However, given the large push internationally by investors to be able to challenge state laws directly, we think it is unlikely that most countries would follow Brazil’s example.

The TPP: An opportunity for reform

The TPP has drawn renewed criticism of ISDS. ISDS could pose a real threat to the future of democracy and the ability of states to govern in the public interest. With one of the largest free trade agreements on the table, it is critical that the parties affected by the provisions understand what they are signing up for.

 The TPP does provide benefits by reducing tariffs, opening markets, and providing protection for investors, but the ISDS system needs to be considered carefully. While the TPP could be an opportunity to ensure that ISDS is reformed by setting higher standards, stronger safeguards and better transparency provisions, as it stands, it still leaves a large door open for misuse.

This explainer was written by a group of UBC graduate students as part of our Lind Initiative series on inequality. This article can be reprinted under a Creative Commons license.