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[This is based on research for the project, 'Fostering a Common Culture in Cross-Border Dispute Resolution: Australia, Japan and the Asia-Pacific', supported by the Commonwealth through the Australia-Japan Foundation which is part of the Department of Foreign Affairs and Trade.]

The Australian Government’s Productivity Commission (PC) released on 13 December its Research Report on Bilateral and Regional Trade Agreements (BRTAs). Recommendation 5 of the Draft Report in July had suggested that BRTAs (including International Investment Agreements or IAAs) should include Investor-State Dispute Resolution (ISDS) only if Australia’s counterpart country has a relatively underdeveloped legal system, and more generally only if foreign investors did not obtain more expansive protections than domestic investors. Following criticism of some factual errors and various arguments included in the Draft Report, the PC convened a policy workshop for officials, academics (including myself) and other stakeholders. Some views expressed there are partly reflected in the longer and somewhat better-argued section on ISDS now found in the final Report (at Part 14.2, pp265-77). Unfortunately, however, there remain serious problems with the analysis, which includes the following Findings by the PC:

'1. There does not appear to be an underlying economic problem that necessitates the inclusion of ISDS provisions within agreements. Available evidence does not suggest that ISDS provisions have a significant impact on investment flows.

2. Experience in other countries demonstrates that there are considerable policy and financial risks arising from ISDS provisions.'

Below I focus on the implications of this approach. They are particularly acute for Australia’s present negotiations for a Free Trade Agreement (FTA) with Japan, for accession to the Trans-Pacific Partnership Agreement (TPP, which Japan is also interested in joining), and for developments more generally within APEC and at the multilateral level

The PC's Findings underpin its Recommendation 4(c), namely: the Australian government should

'seek to avoid the inclusion of investor-state dispute settlement provisions in BRTAs that grant foreign investors in Australia substantive or procedural rights greater than those enjoyed by Australian investors' (p285).

This recommendation, also found in the draft Report, is further elaborated towards the end of the final Report’s analysis of ISDS (pp276-7):

'Nor, in the Commission’s assessment, is it advisable in trade negotiations for Australia to expend bargaining coin to seek such rights over foreign governments, as a means of managing investment risks inherent in investing in foreign countries. Other options are available to investors.'

However, in contrast to the draft Report, the PC no longer suggests that the Australia should seek ISDS in treaties with countries with underdeveloped legal systems:

'a bilateral arrangement with Australia to provide a ‘preferential legal system’ for Australian investors is unlikely to generate the same benefits for that country than if its legal system was developed on a domestic non-preferential basis. To the extent that secure legal systems facilitate investment in a similar way that customs and port procedures facilitate goods trade, there may be a role for developed nations to assist through legal capacity building to develop stable and transparent legal and judicial frameworks.'

In other words, the PC’s final Report adopts a position even more antithetical to ISDS than in its draft Report (Strategy No 6 in my Table downloadable here). This does meet concerns about the legitimacy of Australia insisting on ISDS only when dealing with developing countries, and the practical difficulties raised when negotiating regional treaties like the TPP that do or may include countries with a variety of legal systems and levels of economic development. But it leaves Australia promoting the most extreme strategies conceivable regarding ISDS (Nos 7 and 9 of my Table downloadable here). If its treaties omit provisions for Investor-State Arbitration (ISA), in particular, then investors wishing to protect their investments will be left with only four options.

One would be to try to get their home states to invoke inter-state dispute resolution procedures. These would presumably remain in Australia’s future IAAs, or else be available under customary international law (albeit subject first to exhaustion of local remedies). The well-known difficulty with inter-state procedures, and a major reason for the historical development of ISDS, is that home states have their own (eg security) agendas that may conflict with the investor’s desire to protect its economic interests. Problems of equity arise too, in that large investors are more likely to be able to mobilise their home states than smaller investors.

A compromise solution (strategy No 8 in my Table downloadable here) might be to allow investors the rights to force their home states to bring an inter-state arbitration claim against the host state, perhaps after a period where the states attempt a negotiated or even mediated settlement. The inspiration comes from provisions added from 2007 into the OECD Model Tax Treaty, although so far Australia has only included such provisions in its revised Tax Treaty with New Zealand (not the recently amended one with Japan, for example), and the OECD experience highlights difficulties in ensuring that the firm (not technically party to the inter-state dispute resolution process) at least remains fully informed about progress after it has triggered the process.

A second option is therefore for foreign investors to conclude individual contracts with host states, including provisions for arbitration. But, as the PC itself notes, ‘it would be expected that this particular alternative is more feasible for large businesses rather than small and medium [sized] businesses’ (p270, adding examples from large mining investments in Australia and abroad). Even if only large investors negotiate contracts, in the absence of ISA protections contained in IAAs, the transaction costs are likely to be enormous. Many law firms are already keenly interested in potential fee income from helping to resolve ISA claims, but they will delight (and taxpayers should shudder) at the prospect of having to negotiate detailed substantive and procedural law provisions in contracts with host states – in addition to their clients’ contracts with commercial partners in those states.

A third option is for investors to conclude ‘political risks insurance’ contracts with third-party insurers. The PC gives as examples the World Bank’s Multilateral Investment Guarantee Agency (MIGA), established by a treaty to which Australia is a party, as well as the government’s Export Finance and Insurance Corporation. However, the latter typically only offers indemnity for companies (not their shareholders) up to 90 percent (not fully) for investments of up to 10 years (only). MIGA’s coverage has also been criticised as too narrow, although its treaty has recently been amended to extend for example to brown-field investments. Perhaps most importantly, the contracts offered by such insurers are typically limited to more specified adverse events (presumably easier for actuaries to calculate premiums for), such as expropriation, war and civil disturbance, and currency transfer restrictions. Contemporary IAAs include many other protections, including basic norms of transparency and due process (‘fair and equitable treatment’ or FET on the part of the host state) which are often invoked in ISA cases, as Professor Shotaro Hamamoto and I show in our ‘reverse engineering’ of Japan’s IAAs concluded since 1977 – almost all of which also include ISDS provisions. Of course, foreign investors may be able to persuade an insurer to extend cover for FET or the like; but that seems more likely to ensue from a government-supported insurer than a purely commercial insurer. Anyway, if the government supports an (international or national) insurer, why not support its investors by negotiating IAA protections – saving the additional transaction costs involved in investors negotiating individual contracts with insurers?

If none of these three options is available for an investor, the only remaining option is to seek a remedy in the host state’s courts. But even if those courts are not corrupt or biased in favour of their government, and have highly-trained judges (as in Japan), treaty protections may not be directly applicable and the local (constitutional and statute) law may not offer the sorts of protections (such as FET) now widely found in IAAs. Procedurally, too, the investor may have to litigate in a foreign language through multiple levels of appeals, before judges much less familiar with investment dispute resolution than international arbitrators. ‘Capacity-building’ in all these respects for the host state’s legal system may indeed help investors – both foreign and local – but it is certainly ‘not an immediate solution’ (as the PC notes at p277). It also brings its own costs upon the Australian government, and allows non-Australian governments and investors outside the host state to ‘free ride’ on Australia’s ODA and other efforts. Meanwhile, until the host state’s legal regime improves sufficiently, either foreign investors will give up (suffering financially and also not contributing to improvements in the host state’s judicial system) or law firms will generate large fees from prosecuting such claims through local courts rather than ISA proceedings.

In sum, therefore, hopefully the rest of the Australian government (particularly its Department of Foreign Affairs and Trade) will not adopt the extreme approach suggested by the PC. Nothing is perfect, including the ISA regime, but there exist many feasible alternative strategies (Nos 2-5 in my Table downloadable here) which can better balance its risks versus benefits. DFAT is already developing some of these, and they also promise a better fit with the approach taken by its major trade and investment partners such as Japan. A more measured approach towards ISDS would also probably mesh better with Australia’s contribution to work by APEC’s Committee on Trade and Investment examining convergence on investment treaty regimes across the region, as well as with talk within the OECD recently about developing a (non-binding) ‘Model Investment Treaty’.

Interestingly, buried within the PC's final Report is Appendix A containing a dissent (unusual in PC Reports) from part-time Associate Commissioner Andrew Stoler, a former US trade negotiator and WTO Deputy Director-General who had been seconded from the University of Adelaide to assist with the Review. He adds these sensible points about ISDS provisions:

'[at pp 320-2] The Associate also disagrees with the Commission’s recommendation regarding the inclusion of investor-state dispute settlement (ISDS) in future Australian BRTAs. He notes that foreign direct investment is very important in the modern economy and that Australians have significant investments in other economies. He considers that where the Australian Government deems it appropriate to negotiate a BRTA with a partner, that agreement should promote and protect investment and where the legal system of a partner is judged as not sufficiently developed to effectively handle investment disputes, Australian negotiators should preserve the option of including ISDS in the agreement.

The report argues that Australia’s investors do not require this added protection and that, by including ISDS, the Australian Government is taking on a risk (of being sued by foreign investors). The Associate notes that the report suggests that the investors are able to protect their overseas interests by accessing a variety of insurance schemes. In the view of the Associate , this is analogous to arguing against the need for a fire department because homeowners can buy property insurance.

The Associate notes that those who oppose ISDS in BRTAs also tend to cite the risk of ‘regulatory chill’ for Australia — in other words, the Australian Government might elect not to proceed with certain policies or regulations because it may be afraid of being sued in the ICSID. Opponents of ISDS cite cases such as where governments may back off regulating cigarette packaging due to the threat of a suit by a foreign investor. In the Associate’s view, the appropriate response to these concerns is to ensure that the ISDS-related provisions of a BRTA are drafted carefully enough that they preclude challenges to those regulatory areas that Australia wants to ensure are protected (for example, health-related policies). In addition, in the Associate’s view, there is reason to believe that a little bit of ‘regulatory chill’ might be a good thing, even in Australia.

Finally, the Associate considers that it is not realistic to suggest, as in his view part (c) of the recommendation suggests and the report implies, that it might be possible to agree an ISDS provision in a BRTA that does not give foreigners rights not available to nationals, or that a BRTA partner might seek to offer ISDS to Australia without seeking a reciprocal grant of ISDS rights.

... [p 326 re] Findings 14.1 and 14.2, ie:

The Associate objects to both of these findings and notes that the reasoning behind them underlies the Commission report’s recommendation that ISDS provisions should not be included in Australia’s BRTAs. The Associate’s reasons for arguing in favour of maintaining the option of including ISDS in BRTAs are detailed earlier. In the context of Australian BRTAs with certain developing countries, the Associate believes that the potential benefits to our investors of ISDS clearly exceed the downside risk to the Australian Government.

In the view of the Associate, the possible invocation of fair and equitable treatment provisions in an ISDS case involving alleged indirect expropriation is analogous to the WTO concept of nullification and impairment where a WTO Member’s ‘reasonable expectations’ have been undermined by the policy actions of another Member. An investor might not be able to count on securing his or her government’s support for a dispute and, in the Associate’s view, should have the right to pursue relief through ISDS. In relation to the finding concerning other countries’ experiences with ISDS, as noted earlier, the Associate considers that the appropriate response is to ensure that BRTA provisions are drafted carefully enough to preclude challenges to what might be considered to be ‘off limits’ regulatory areas.'

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