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Peter Drysdale’s weekly editorial for the East Asia Forum, along with related postings to that blog and enormous media attention in Australia and elsewhere, focuses ‘on the continuing detention of Rio Tinto executive, Stern Hu, in Shanghai on allegations of espionage’. Drysdale signposts some future analysis of ‘the legal framework under which Hu’s detention has taken place’. He also emphasises that we need ‘a cooperative framework—bilaterally, regionally and globally‘ for ‘China’s authorities to avoid damage to the reliability of markets and for Australia to avoid the perception of investment protectionism’. The most pressing legal (and diplomatic) issues concern China’s criminal justice system, especially when ‘national security’ is allegedly involved. But we need already to consider some broader ramifications, including how we think about FDI legislation and (increasingly intertwined) investment treaty protections.

In short, most agree that the Chinese government got annoyed when Australia itself invoked national security interests to restrict Minmetals bid for OZ Minerals back in March 2009. Then it got really annoyed when Chinalco’s bid for Rio Tinto fell through, even though the Australian government wasn’t directly involved. And so, one story goes, Stern Hu has been arrested to send a message – in the hope that Australia (and other potential host states) will be think twice before invoking national security exceptions to restrict future FDI from China. The China-watchers are better placed to decide whether this is really the motivation behind his arrest. My point here is rather that we should not be surprised that host states may be increasingly tempted to invoke exceptions to limit FDI at the outset, which in turn generates risks of (over-)reactions by home states, as we may be witnessing in Hu’s case. And the initial temptation may arise due to proliferating investor-state arbitration provisions in investment treaties, because those later restrict their room to invoke national security or other limits once the FDI has been approved.

The starting point is that even today states retain considerable sovereignty when it comes to deciding what foreign investments are and are not permitted into their territories. Investment treaties – bilateral and now sometimes regional, either stand-alone or folded into broader Free Trade Agreements) – now often entrench substantive liberalisation. But these treaties still generally do not apply extensively to the pre-establishment phase, leaving that instead basically to national FDI legislation, and/or they maintain exceptions for national security or national interest. So even if Australia and China conclude their current FTA negotiations to make it broadly easier for firms from either country to invest in the other, that sort of exception is likely to be remain. We could therefore quite easily get another Minmetals – OZ Minerals situation.

Such overt up-front substantive restrictions on investments became less noticeable over the 1990s, especially in developed countries like Australia, as competition for FDI burgeoned world-wide. But now they may be on the rise again, with UNCTAD monitoring trends carefully. Concerns have grown about sovereign wealth funds, for example, as well as China’s push to secure resources directly (rather than through long-term contracts with smaller equity stakes, the longer-standing approach by Japanese companies active in Australia). And after an initial period where countries were desperate to attract funds after the GFC, those market collapses are perhaps forcing a rethink of (explicit or mostly implicit) models based on the merits of lightly regulated markets.

However, part of the recent shift may be due to the growing importance of investor-state arbitration provisions in investment treaties. Under these procedural rights, the investor can claim directly against the host state for breaching substantive protections (such as expropriations, ‘national treatment’ or transparent ‘fair and equitable treatment’) for investments that have been made. Thus, for example, the NZ-China FTA contains full investor-state arbitration provisions. It also has a narrow exception for certain ‘essential security interests’ (Art 201). However, more importantly, that FTA anyway does not extend full protections to the pre-establishment phase. For example, Art 138 on ‘national treatment’ - treating the foreign investors like national investors - does not extend to the initial ‘establishment’ of the investment (cf eg ASEAN-Australia-NZ FTA chapter 11 Art 4; or China-ASEAN FTA regarding services: Cai Congyan, ‘China-US BIT Negotiations and the Future of Investment Treaty Regime’, 12(2) JIEL 457 (2009) at 470). So NZ, for example, can maintain quite a broad national interest test for FDI, especially regarding ‘sensitive land’, under the Overseas Investment Act 2005. (That FDI legislation was recently subject to review, and some regulations were changed in July.)

Even without investor-state arbitration provisions in treaties, there may be somewhat more likelihood nowadays of the foreign investor being able to get their home state to bring a claim in public international law (say before the International Court of Justice) against the host state. This indirect means of protecting investors (‘diplomatic protection’) has been unpopular among investor and indeed prompted the development of investor-state arbitration, cemented particularly through investment treaties. The aversion to diplomatic protection was partly due to legal complications, such as the need first to exhaust remedies in the host state. But two major practical problems were that there was usually no obligation for the home state to pass on any compensation obtained from the host state to its investor, and the home state often hesitated to claim anyway in order to maintain a good broader relationship with the host state.

However, the experience of WTO dispute resolution shows how states often now sue each other over other economic issues, with interested industries or firms egging them on (think of Microsoft and the US enforcing TRIPS obligations) despite ‘compensation’ not flowing through directly to them. And investment disputes, thanks to burgeoning arbitrations that are brought directly by investors against hosts, are likewise increasingly seen as economic rather than political or diplomatic disputes. They too are seen to be appropriately capable of resolution through a much more ‘judicialised’ procedure, compared to even a decade ago. Thus, at least over the medium- to long-term, we may see some revival of diplomatic protection claims on behalf of foreign investors even where investment treaties lack investor-state arbitration provisions.

Either way, the indirect or increasingly direct threat of a claim about an investment that has been made provides an incentive for a host state to rely more on residual exceptions to allowing investments in the first place, such as the national security exception in national legislation or treaties. If so, we are likely to see more cases like that involving Stern Hu. That is, the (more broadly frustrated) home state of a frustrated investor reacts – even in a later context – against what it may have perceived as over-eager invocation of the national security exception. The irony in this case, perhaps intentional, is that China is now using its own national security law against a citizen of Australia. But it would be particularly unfair to make an example of an individual for the actions of his country, particularly when employed by a firm (Rio Tinto) not involved in Australia’s original invocation of the national security exception currently retained in its FDI legislation.

These sorts of issues are likely to become even more acute in light of some very recent developments in investment treaty arbitration practice (Investment Arbitration Reporter 2(11), 29 June 2009). In cases involving treaties with Russia and now China, tribunals have ruled that provisions that seemed to restrict arbitrations to quantification of compensation amounts should be read to extend arbitrability to the question of whether expropriation took place. Thus, even first- or second-generation investment treaties with China (including Australia’s dating back to 1988) may already apply far more extensively than almost everyone had thought (cf eg Gallagher and Shan, Chinese Investment Treaties, OUP 2009). In any event, China is renegotiating such treaties or concluding ones with new partners (like NZ) that clearly allow arbitrability of all issues. The backdrop is that China is now a major FDI-exporter, with Chinese investors already beginning to bring claims abroad – although so far no investor (or law firm wanting to do other business in China!) has risked claiming against China.

If these trends continue, namely direct investor-state arbitration provisions are concluded or reinterpreted to restrict the ability of home states to have second thoughts about foreign investments once they have been accepted, it seems to me that they will become more cautious when allowing in FDI in the first place. But if host states do impose restrictions, somewhere down the line they may experience a ‘Hu’ reaction from the frustrated home state. If so, then how Australia in turn reacts to China’s detention of Hu will be very important for the evolving field of investment treaty law and practice more broadly – the subject of a major conference at Sydney Law School over 19-20 February 2010.

Comments

P.S. One well-known China watcher adds this in today's Sydney Morning Herald (Hamish McDonald 'China thought we wouldn't care for Hu', 25-6 July 2009, News Review p10, http://www.smh.com.au/opinion/china-thought-we-wont-care-for-hu-20090724-dw32.html):

"There has been speculation the arrests were a payback for the failure of Chinalco's bid to double its stake in Rio Tinto, and/or anger at the concerns about Chinese military power raised in Canberra's Defence White Paper.

The more that comes out in China, however, the more clearly the arrest is related to the iron ore negotiations, and a battle between State and Big Capital inside China itself.

...

[reportedly] "the Rio Tinto affair is really a struggle between the market power of China's steel companies and the political power of China's government planners".

Stern Hu can look forward to up to 19 months' detention, by recent precedent in State Security cases, before he is brought to court. He is entitled under a bilateral treaty to monthly consular visits by Australian officials, but not to a lawyer. Nor can a lawyer engaged for him carry out any investigation to prepare a defence.

When the trial is held, family and media cannot attend, diplomats may or may not be allowed to observe, witnesses are not always called and the judges are subject to direction by a Party supervisor in the backrooms. Once charges are laid, an acquittal is unheard of: the best the convict can hope for is a lenient sentence for co-operation and an early deportation on "medical grounds".

What can be done? Not much use pointing out the failings of the Chinese legal system - best to convince leaders that their officials are inflicting massive self-damage."

If China's judicial process is that grim, however, I am reminded by my colleague Chester Brown and UMelbourne's Jurgen Kurtz that Australia might well have a "diplomatic protection" claim anyway against China, for "denial of justice" towards its citizen. But this leaves other major questions: whether jurisdiction could be secured, and especially whether Australia would be willing to escalate the dispute in this way given its interest in a FTA and other relationships with China.

Interesting post, Luke - rightly pointing out that investment treaty arbitration is placing increased pressure on domestic national security exceptions. I have briefly addressed this in the August edition of my firm's trade/investment newsletter: http://www.chapmantripp.com/Pages/Publication.aspx?ItemID=619

Another view on Hu:

(Peter Hartcher, http://www.smh.com.au/opinion/in-this-chinese-fable-the-chicken-upsets-the-fox-in-his-lair-20090821-etpk.html)

Kevin Rudd studied China's most famous political prisoner, Wei Jingsheng, for his university thesis. Today Wei Jingsheng studies Kevin Rudd.

"The Chinese Government is putting the Australian Government through a trial with the arrest of Stern Hu," Wei said this week ...

It's obvious now the Chinese Government is attempting to put down the Australian Government, not Stern Hu. And it's quite evident that it is putting down the Australian Government as a precedent for other governments around the world."

...

Senior officials in the Australian Government believe that Beijing has four principal grievances against Australia at the moment. First was Rudd's speech on Tibet [April 2008]

Second was the collapse of the bid by China's state-owned Chinalco to buy a bigger stake in Rio Tinto. It was a rebuff to China's ambitions, and it stung.

Stern Hu was duly arrested. Since then, Beijing has downgraded the charge against him from stealing state secrets to stealing trade secrets. That reduces the potential punishment from the death penalty to a seven-year jail term. But the vengeful anger smoulders still.

Third was Australia's defence white paper, which nominated China as potentially the biggest source of instability in the Asia-Pacific.

Fourth was the visa for Rebiya Kadeer [exiled Uighur activist]. Taken together, it's enough for Chinese state-controlled media to denounce the "sinophobic government" of Kevin Rudd, as it did this week.

Yet despite the rage in Beijing, the economic relationship is thriving, utterly untouched by the diplomatic storm. This week's gas deal was stunning. China invited the Resources Minister, Martin Ferguson, for the ceremonial signing of the biggest business deal in Australian history, the $50 billion, 20-year deal to buy liquefied natural gas from the Gorgon field. Ferguson also met a senior Chinese minister, Zhang Ping, chairman of the National Development and Reform Commission.

At the same time, China's Commerce Minister, Chen Deming, has agreed to a new round of negotiations for a free trade agreement with Australia.
...

And more again on Hu
(http://business.smh.com.au/business/shock-and-ore-20090821-etrb.html):

Secret agents are shadowing Australian executives as the Communist Party's hardliners gain the upper hand. Now Rio Tinto must play by China's rules, writes John Garnaut in Beijing.

...

Stern Hu and his three Chinese colleagues have now been charged with receiving bribes and commercial secrets. People close to the case note the opportunities for bribery that can present themselves in a climate of iron ore shortage and large price differences between contract and spot market purchases. Many say the Chinese Government is unlikely to have gone as far as it has without what it considers to be sound evidence that is prepared to publicly present. A trial is likely to proceed by early next year.

But the Chinese Government's initial framing of the case as one of "national security" suggests Rio and Australia may also have been caught up in a larger struggle for influence over China's 540 private and state-owned companies, which together produce more steel than the rest of the world put together. Steel, with its central, visceral place in China's modernisation and national mythology, can provide a proxy battleground for the path of Chinese development.

"This is about: do you let the market determine prices domestically and internationally or do you insist on political intervention? " David Goodman, a professor of Chinese studies at the University of Sydney, says. "How do you allocate resources, politically or economically? Within the leadership you can imagine the arguments going on between those calling for a more open political and economic system and others saying, 'You must not rock the boat.' "

UNCTAD has released a new report on the Protection of National Security in IIAs.
http://www.unctad.org/en/docs/diaeia20085_en.pdf

Many countries have started to re-evaluate investment liberalization policies, and some have introduced adjustments, thereby exercising their right to regulate foreign investment to pursue domestic policy objectives. One of the main areas where a more restrictive approach towards foreign investment has become manifest relates to national security, and to the protection of strategic industries and critical infrastructure. Cases have become more frequent in recent years where foreign investors have been rejected for national security reasons or subjected to other restrictive measures after establishment. National security interests have in recent years also been invoked in connection with economic crisis. This was the case, for example, during the Argentinean financial crisis in 2001, when the Argentinean Government adopted a number of emergency measures to stabilize the economy, including some measures that restricted the operations of foreign investors, such as transfer restrictions. Argentina argued that these measures were required to protect its internal security interests in the face of domestic upheavals and extended social tensions.

This leads to the issue of the role of international investment agreements (IIAs) in connection with investment restrictions based on national security considerations. By establishing obligations on Contracting Parties concerning the treatment of foreign investors, IIAs impose certain limits on the sovereign right of each country to regulate foreign investment in its territory, including its regulations in the area of national security. There is, therefore, a potential conflict between the objective of investment protection on the one hand, and addressing the Contracting Parties’ security concerns on the other. However, numerous IIAs expressly dispense Contracting Parties from all or parts of their treaty obligations in cases where an investment poses a threat to national security.

This paper explores what role IIAs play in this context, and what approaches these treaties have taken with regard to national security exceptions. Such exceptions are included in the majority of recent free trade agreements (FTAs) with investment provisions, and in 12 per cent of the bilateral investment agreements (BITs) reviewed. Security-related exceptions appear consistently in the BITs concluded by Germany, India, Belgium-Luxembourg, Canada, the United States, and to a lesser degree, Mexico.

The issue of national security may become more important in future IIA negotiations, since the number of States either introducing or considering introducing national laws aimed at restricting foreign ownership for national security reasons and at securing greater government control over strategic sectors, such as natural resources and the extractive industries, is increasing.

Determining the right balance between ensuring a sufficient level of protection for national security interests, while at the same time ensuring that investment protection is still strong enough to keep the country attractive for foreign investors, might become even more important in light of the global economic crisis, and the emergency response measures countries are implementing in this context. (see Investment policy developments in G20 countries at
http://www.unctad.org/en/docs/webdiaeia20099_en.pdf).

In light of these developments, IIA negotiators may wish to pay more attention to the possible coverage of strategic industries and economic crisis in national security exceptions and related concepts. They have to ask themselves whether they see a need for a broad and undefined security exception that gives them maximum discretion, or whether they prefer a more limited clause in the interests of better legal security and predictability.

The paper offers a number of options in this regard. These aim at helping to prevent that the subject of national security exceptions in IIAs becomes a “black and white” matter, thus allowing for more differentiated solutions to be adopted and permitting a fair balance between the interests of the Contracting Parties and the foreign investors.

With best regards,

James Zhan
Director
Investment and Enterprise Division
UNCTAD

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