by: Shannon Moloney, Articles Editor

Investor-state dispute settlement (“ISDS”) provisions provide investors and nations with a framework to arbitrate issues that arise under both bilateral investment treaties (“BIT”) and free trade agreements (“FTA”). Investors often pursue damages against host countries that are parties to international treaties with ISDS provisions if host nations do not abide by the treaty’s terms. ISDS provisions usually provide an unbiased mechanism for nations and foreign investors to resolve disputes. However, ISDS provisions have become increasingly controversial because they invite third-party litigation funding and frustrate social policy advancements.

ISDS in BITs and FTAs attract third-party litigation funding (“TPLF”), resulting in an unbalanced approach. Third-party funder litigation financing occurs when investors seek ISDS arbitration cases and pay litigation fees in exchange for a settlement percentage. Concerns about TPLF include lack of transparency, enhancing the power of malignant foreign parties, and skewed incentives. These concerns create an unbalanced approach because governments oftentimes implement regulations to uphold social policy interests while these regulations can negatively impact investors.

Financiers of third-party funder litigation are incentivized to accept settlement agreements to maximize return on investment. Financiers’ willingness to settle before receiving an adequate offer may result in poor representation for investors attempting to recoup losses on foreign investments because of state regulatory action that violates an international treaty. Additionally, TPLF funders are not required to disclose their identity, which creates a lack of transparency in ISDS proceedings. This lack of transparency increases national security risks because anonymous financiers are given sensitive information belonging to foreign countries. Lastly, TPLF empowers foreign adversaries’ business endeavors by entangling prominent international companies in expensive, time-consuming litigation. These risks may influence governments to avoid entering international agreements with ISDS provisions.

Despite the challenges TPLF presents to foreign governments, TPLF can be advantageous to companies investing in developing countries. Arbitration and litigation are notoriously expensive in these countries. Thus, third-party funding increases claimants’ ability to bring claims and seek justice against foreign governments. Ultimately, increasing funding for smaller claimants helps voice the concerns of individuals negatively impacted by sweeping government regulations.

ISDS can also impede governments’ pursuit of social policy as investors can sue for damages resulting from the adverse effects of social policy on their investments. The Paris Climate Accord ushered in rounds of litigation as new policies supporting green transition objectives adversely affected nonrenewable energy investments. Article 2.1.C. of the Paris Agreement stipulates that the agreement’s primary objective is to “[make] finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” Thus, state governments’ environmental regulations resulting from ratification of the Paris Climate Accord often curtail nonrenewable energy sector operations, resulting in a diminution of their foreign investments.

Further, because parties in international treaties with ISDS provisions often have conflicting social policy interests, there can be indirect expropriation of investments. Indirect expropriation occurs when a government controls or disrupts the use or benefit of an investment by depreciating its economic value without taking the property. As a result, investors are forced to change their activities and investments in the host countries to adhere to local government regulations. This increases costs and delays investors’ projects in developing countries. Addressing this, ISDS provisions enable investors to sue foreign governments for actions that adversely affect their investments.

For example, it has become more common for government entities to implement environmental sustainability regulations and reduce their reliance on nonrenewable energy sources. Consequently, the fossil fuel industry has become the most litigious in the ISDS system, with the oil and gas industry accounting for ninety-two percent of these arbitration cases. These industries’ investments have often been indirectly expropriated for contradicting host state regulations combating climate change. In response, large carbon-emitting corporations such as ExxonMobil Corp. have initiated legal action, resulting in $19 billion in awards from arbitral tribunals.

Similarly, in the arbitration case of Metaclad v. Mexico, a U.S. waste management firm initiated an investor-state dispute against Mexico under the North American Free Trade Agreement (“NAFTA”) for expropriating the company’s investments. In this case, Mexico denied the U.S. company’s construction permits after it began constructing a toxic waste facility with the support of the state government. Subsequently, the tribunal ordered Mexico to compensate the U.S. company for devaluing its investments in Mexico because Mexico violated the parties’ NAFTA agreement by not providing “transparent and predictable” regulations.

“Further, governments often implement regulations to advance social policy interests, including environmental protection, economic development, and social welfare aimed at benefitting the state and its citizens. Thus, the decision to enter FTAs and BITs with ISDS provisions has become more controversial because such agreements can impede the adoption of social policy regulations.”

Shannon Moloney

These cases involving NAFTA members and ExxonMobil Corp. showcase governments’ struggle to uphold social policy objectives when ISDS provisions empower foreign companies to claim reparations for their negatively impacted investments. Further, governments often implement regulations to advance social policy interests, including environmental protection, economic development, and social welfare aimed at benefitting the state and its citizens. Thus, the decision to enter FTAs and BITs with ISDS provisions has become more controversial because such agreements can impede the adoption of social policy regulations.

In recent years, practitioners have discussed reforming ISDS provisions to combat challenges to social policy advancement and transparency. ISDS reform discussions have commonly featured two approaches: (1) renegotiation or (2) termination of international investment agreements to renounce obligations. Termination of treaties is rare, yet nearly three hundred intra-EU BITs have been terminated due to internal EU concerns. Renegotiation is a way to reduce the reach of ISDS obligations. However, renegotiating treaties with ISDS provisions can potentially cause uncertain ripple effects across thousands of BITs and FTAs, demanding significant time and resources.  

In conclusion, ISDS provisions allow foreign governments and investors to settle disputes through arbitration. However, challenges such as third-party funder litigation and conflicting policy interests undermine the intended collaborative nature of ISDS provisions.