September 20, 2015

EU commission ISDS proposal a threat to democracy and civil rights

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The commission has tabled its investor-to-state dispute settlement (ISDS) reform proposal for discussion with the United States and published it on 12 November 2015.

Summary

This analysis concludes that the commission’s proposal would undermine democracy, civil rights, and the rule of law.

The proposal contains neither exhaustion of local remedies, nor a wide margin of appreciation for states, lacks various institutional safeguards for judicial independence – leading to perverse incentives – , gives greater procedural rights to foreign investors, includes substantive rights open to broad interpretation, and contains a “right to regulate” that does not protect against unlimited backward looking damages including expected profits and interests. Unlimited damages and the threat of such damages have a chilling effect on policy makers, compromise the independence of officials, and could force a state to revise a regulation or decision as part of a settlement.

The commission’s proposal would place investment tribunals above states, above democracies. The transfer of power would be as good as definitive: we can not expect the EU to withdraw from TTIP or other deep integration trade agreements.

The adjudicators would be paid per day worked. This creates perverse incentives to accept frivolous cases, let cases drag on, and to let the only party that can initiate cases (foreign investors) win to stimulate more cases. The proposal doesn’t provide certainty that this will
ever change.

At a national level, parliaments can change laws that do not work out well. This is not possible at the supranational level. The development of law would take place beyond democratic scrutiny.

The commission’s proposal gives foreign investors – and only foreign investors – the right to bypass domestic legal systems and use ISDS to challenge government decisions. It gives greater rights to these foreign investors, without correspondingly actionable responsibilities.

The proposal would not remove all unfair procedural advantages for the United States.

Furthermore, the commission undermines any possible positive element in its reform proposal as it intends to add “old ISDS” to the trade agreements with Canada and Singapore, giving foreign investors the possibility to route their investments into the EU through these countries.

The right approach is to improve weak aspects of domestic legal systems. Domestic legal systems can combine equal access to the law with democratic scrutiny of the development of law. Investors are not obliged to invest in countries with weak legal systems. This may create an incentive for states to improve their legal system. Investors can take out political risk insurance for additional certainty.

1 The system

1.1 Not independent

According to Germany’s largest association of judges and public prosecutors (original in German), and the European association of judges, the arbitrators would not be independent. Both associations note that the ISDS proposal is not compatible with the Council of Europe’s Magna Charta of Judges.

1.2 Perverse incentives

The adjudicators would receive a retainer fee of around 2000 euro a month (Section 3 article 9(12), page 17).

In addition they would receive 3000 US dollars for each day worked (Section 3 article 9(14), page 18, refers to ICSID rules). This creates perverse incentives to accept frivolous cases, let cases drag on, and to let the only party that can initiate cases (foreign investors) win to stimulate more cases.

1.3 Perverse incentives at appeal level

The proposal would create an appeal tribunal. The adjudicators would receive a retainer fee of around 7000 euro a month and a fee for each day worked of about 720 euro (Section 3, article 10(12), page 20). This would create perverse incentives as well.

The appeal tribunal could give more consistency, but would not protect against expansive interpretations of investors’ rights which interfere with states’ policy space.

1.4 Unfair procedural advantages for the United States

The ICSID platform gives the US unfair procedural advantages. The commission’s proposal removes some roles for ICSID (especially appointing arbitrators), but not all. Furthermore, the adjudicators could also work on the side as arbitrators under ICSID, a system with perverse incentives and unfair procedural advantages for the US. The US never lost an ISDS case.

1.5 An optional second phase

The fees and expenses may be permanently transformed into a regular salary (Section 3 article 9(15), page 18). This would remove the perverse incentives. However, there is no certainty this will ever happen. Such a change takes the consent of all the other states involved. States may have reasons not to want this.

First, a party may opt to continue to be an investment routing hub by not agreeing with this change. Investors who route their investments through this country would continue to benefit from the perverse incentives.

Second, the U.S. negotiated unfair procedural advantages in NAFTA, their investment treaties and the draft TPP. They never lost an ISDS case. The commission negotiated unfair procedural advantages for the U.S. in CETA and EUSFTA. The commission’s proposal for TTIP still contains some procedural advantages for the U.S., as we saw above. The U.S. secured them in TPP (if ratified) and may get some of them in TTIP. They will have no reason to give them up.

It is uncertain what the tribunals’ decisions would look like – what our societies would look like – by the time the perverse incentives are removed, if that ever happens.

1.6 Expert bias

Even if all perverse incentives are removed, the proposal would still create a risk on expert bias.

As an example of expert bias, in the US the concentration of appeals of patent cases in one court led to expansive interpretations regarding for instance software and business methods. In the US the Supreme Court now steps in to correct experts’ bias and Congress works on reform.

The supranational level does not have a supreme court to balance various law systems and cancel out experts’ bias.

1.7 Beyond democratic scrutiny

At a national level, parliaments can change laws that do not work out well. This is not possible at the supranational level. Supranational adjudication does not have a legislative feedback loop for democratic scrutiny of the development of law. If things go wrong, our societies would be unprotected.

1.8 Lock in

EU member states can withdraw for their stand-alone investment treaties; this also gives leverage to renegotiate them. Governments, harmed by their investment treaties, can act. In contrast, EU member states can’t withdraw from agreements concluded by the EU. In addition, we cannot expect the EU to withdraw from TTIP or other deep integration trade agreements. Regarding lock in, the commission’s proposal is worse than the EU member states’ stand alone investment treaties.

It is possible to renegotiate trade agreements, but it takes the consent of all the other parties.

Binding interpretations (Section 3 article 13(5), page 21) require the consent of all the other parties involved. Moreover, arbitration tribunals did not always follow such binding interpretations. They are the final instance. Compare the NAFTA interpretative declaration with Lise Johnson and Lisa Sachs, page 5, on the Bilcon award.

1.9 Lack of institutional safeguards for judicial independence

All international courts have institutional safeguards for judicial independence. The commission’s proposal would not create a real court as it would lack fixed salary and prohibition of outside remuneration.

Section 3 article 11, page 20, reads:

“The Judges of the Tribunal and the Members of the Appeal Tribunal shall be chosen from persons whose independence is beyond doubt.”

This is a wrong approach. The right approach would be to first create a system with institutional safeguards of judicial independence, and then choose persons whose independence is beyond doubt. That would exclude current arbitrators.

1.10 ISDS versus European human rights system

Under the European Convention on Human Rights (ECHR) the right to property is enshrined in article 1 of Protocol 1:

“Protection of property

(1) Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one shall be deprived of his possessions except in the public interest and subject to the conditions provided for by law and by the general principles of international law.

(2) The preceding provisions shall not, however, in any way impair the right of a State to enforce such laws as it deems necessary to control the use of property in accordance with the general interest or to secure the payment of taxes or other contributions or penalties.” (emphasis added)

The formulation “as it deems necessary” gives the member states a wide margin of appreciation. As a human rights court, the European Court of Human Rights will also be aware of the effects its decisions may have on other human rights.

In contrast to the European human rights system, the commission’s ISDS proposal (a) lacks institutional safeguards for judicial independence, (b) does not require exhaustion of local remedies, (c) does not provide access to the mechanism for all, but only to foreign investors, (d) does not provide standing for all, (e) provides wide discretion to for-profit adjudicators, (f) does not provide a wide margin of appreciation to states, and (g) provides unlimited backward looking damages including expected profits and interests.

As a safeguard, the text mentions a right to regulate – which is ineffective, see below.

See also Gus Van Harten, Matthew C. Porterfield, Kevin P. Gallagher, Investment Provisions in Trade and Investment Treaties: The Need for Reform, page 2, Granting Greater Rights to Foreign Investors.

1.11 Vastly expanding exposure

Presently one percent of US investments in the EU are covered by ISDS; this led to nine cases. Adding the commission’s proposal to a trade agreement with the US would extend coverage to 100 percent of US investments, which can reasonably be expected to lead to a corresponding increase in the number of cases. The highest award to date is 50 billion dollars.

The commission would vastly expand the EU’s exposure.

1.12 ISDS is not necessary

Local courts, contracts, state-state arbitration and insurance are alternatives.

The Multilateral Investment Guarantee Agency (MIGA), a member of the World Bank Group, offers insurance for political risks. If problems arise, they are very effective in settling them. This approach does not have any of the problems ISDS has. Companies can also take out commercial political risk insurance.

2 The investment protection rules

As we will see, the investment protection rules do not leave states a wide margin of appreciation. For-profit supranational adjudicators could second guess states’ decisions.

2.1 Ineffective right to regulate

The proposal’s “right to regulate” clause does not protect against unlimited backward looking damages including expected profits and interests. The commission is aware of this.

Commission proposal Section 2 article 2(1), page 3, mentions a right to regulate:

“The provisions of this section shall not affect the right of the Parties to regulate within their territories through measures necessary to achieve legitimate policy objectives, such as the protection of public health, safety, environment or public morals, social or consumer protection or promotion and protection of cultural diversity.” (emphasis added)

The formulation is very weak; it is full of holes.

First, the “right of the Parties to regulate” is not defined. The adjudicators could argue that the right to regulate is embodied in Section 3 article 28.1, page 29, which states that the “Tribunal may not order the repeal, cessation or modification of the treatment concerned” (likewise Section 3 article 19, page 25).

As long as the tribunal would not order the repeal, cessation or modification of the treatment concerned the tribunal would not “affect” the right to regulate.

Compare US government statement: “The reality is that ISDS does not and cannot require countries to change any law or regulation”.

However, ISDS tribunals can award unlimited backward looking damages including expected profits and interests. The highest damages award to date is 50 billion US dollars. Unlimited damages and the threat of such damages have a chilling effect on policy makers, compromise the independence of officials, and could force a state to revise a regulation or decision as part of a settlement. Settlements do not have to be published; the public could stay unaware of the details.

Second, the clause applies only to measures which are “necessary”. The necessity test is a very strict test. Years after the decision tribunals can decide: you chose option A, you could have chosen option B. Or vice versa. Arbitrators could second guess decisions.

Van Harten (page 7): “Many existing exceptions in ISDS treaties are unreliable because they use qualified language. For example, many existing ISDS exceptions apply only to state conduct that is shown to be ‘necessary’ to achieve a regulatory aim or only where an ISDS award is shown to ‘prevent’ the state conduct.11 This language creates significant uncertainty by leaving open the risk of unavoidable liability for the state, at the time of an ISDS award, if ISDS arbitrators decide that the state could have adopted some other measure instead of the impugned one or that the state is not prevented from adopting a measure merely because it must pay compensation for the measure.”

Third, the clause only applies to “legitimate policy objectives”; legitimate is not defined.

2.1.1 Commission knows how to do better

In the proposal the commission shows it knows how to design good safeguards. Regarding certain decisions on subsidies, paragraph 3 uses the formulation “shall not constitute a breach of the provisions of this Section”. This is much stronger than the article 2(1) language.

For greater certainty, paragraph 4 adds:

“For greater certainty, nothing in this Section shall be construed as preventing a Party from discontinuing the granting of a subsidy and/or requesting its reimbursement, or as requiring that Party to compensate the investor therefor , where such action has been ordered by one of its competent authorities listed in Annex III.” (emphasis added, footnote removed)

Regarding discontinuing subsidies, the proposal rules out “compensate the investor therefor”. By explicitly mentioning this in paragraph 4, but not in paragraph 1, lawyers can argue that the commission did not want to rule out compensation for regulation in general, beyond subsidies.

The commission knows how to formulate strong safeguards, but opted for a weak right to regulate. See also Van Harten, Key Flaws in the European Commission’s Proposals for Foreign Investor Protection in TTIP, point 4, and Van Harten An ISDS Carve-out to Support Action on Climate Change.

2.1.2 Stabilisation?

Do states have to compensate regulation? Article 2(2) reads:

“For greater certainty, the provisions of this section shall not be interpreted as a commitment from a Party that it will not change the legal and regulatory framework, including in a manner that may negatively affect the operation of covered investments or the investor’s expectations of profits.”

The formulation does not rule out damages awards. The provisions of the section, like fair and equitable treatment (FET), do not commit states to not change laws. However, if the change is deemed manifestly arbitrary, or a breach of an other condition, the for-profit supranational arbitrators can award damages.

2.2 Fair and equitable treatment open to abuse

The commission’s proposal includes the problematic fair and equitable standard (Section 2 article 3, page 4), which tribunals have interpreted expansively, restricting democratic policy space.

The commission aims to limit application of the FET standard with a list. The commission presented a very similar list in the ISDS consultation (table 3). Over 110 scholars commented in their joint submission that this approach may have very little effect on expansive interpretations (answer to question 3). The elements in the list are open to broad interpretation.

Article 3(4) mentions a specific representation which does not have to be in writing. This opens the possibility to start cases based on oral promises and leaves the door open for future application of the Bilcoin approach. Lise Johnson and Lisa Sachs: “Under that approach, a tribunal identifies what it considers to be reasonable or legitimate expectations – which may have been generated by a wide range of even non-binding government conduct and need not rise to the level of actual ‘rights’ – and then strictly scrutinizes government actions or inactions to determine whether the investors’ expectations were wrongly frustrated.” In comparison, the Dutch Raad van State’s Administrative Jurisdiction Division (Netherlands’s highest general administrative court) is very restrictive regarding legitimate expectations; see for instance decision 201113437/1/R2, 20 juni 2012.

No margin of appreciation.

2.3 Indirect expropriation

Indirect expropriation is regulatory expropriation, laws or measures which lessen the value of investments including expected profits.

Gus Van Harten, Matthew C. Porterfield, Kevin P. Gallagher: “Most countries, however, do not require compensation based on the adverse impacts of regulations. Virtually all regulations have a negative economic impact on someone and, if compensation was required for all such impacts, many regulations would simply be too costly to implement.”

The commission’s proposal places strict conditions on the states for both direct and indirect expropriation: (a) for a public purpose; (b) under due process of law; (c) in a non-discriminatory manner; and (d) against payment of prompt, adequate and effective compensation (Section 2 article 5, page 5). States would always have to pay, not just for direct expropriation, but also for regulatory expropriation.

The exception follows in Annex I: Expropriation, page 9. States can take non-discriminatory measures to protect legitimate public welfare objectives, unless the impact of a measure is so severe in light of its purpose that it appears manifestly excessive. The commission’s proposal gives discretion to for-profit adjudicators to decide on three cumulative conditions: “non-discriminatory measures”, “designed and applied to protect legitimate policy objectives”, “except in the rare circumstance when the impact of a measure or series of measures is so severe in light of its purpose that it appears manifestly excessive”.

Nationality-based discrimination falls under national and most favoured nation (MFN) treatment. Related to indirect expropriation, the “non-discriminatory measures” condition could incorporate any disparate government treatment. Lise Johnson and Lisa Sachs: “The risk of claims is particularly high in the context of administrative enforcement actions that often and, in some cases, necessarily result in disparate treatment of different actors.”

No margin of appreciation, second guessing of states’ decisions.

2.4 Umbrella clause

Commission proposal, Section 2 article 7, page 7, “Observance of written commitments” is a so-called umbrella clause. It gives the tribunal competence to rule over contracts. In the past tribunals have decided that even if the contract contains its own dispute settlement mechanism, for instance local courts, they can declare themselves competent to rule over contracts. Tribunals can expand their competence this way. The commission’s proposal does not rule this out.

On this point the commission’s proposal for TTIP is worse than the EU-Canada trade agreement (CETA) text, as CETA does not have an umbrella clause.

Section 3, article 13(3), page 22, reads:

“For greater certainty, pursuant to paragraph 1, the domestic law of the Parties shall not be part of the applicable law. Where the Tribunal is required to ascertain the meaning of a provision of the domestic law of one of the Parties as a matter of fact, it shall follow the prevailing interpretation of that provision made by the courts or authorities of that Party.”

A contract will normally be under domestic law. There may or may not be prevailing interpretations of domestic laws. Various articles of domestic law may have to be weighted. An umbrella clause seems incompatible with Section 3, article 13(3), and thus with the EU treaties.

2.5 MFN loophole

The European Union published its proposal for services, investment and e-commerce (beyond investment protection) in July 2015. It contains a most favoured nation clause which repeats a loophole found in CETA.

MFN allows ISDS arbitrators to import clauses from other, including older, treaties. This way improvements in newer treaties are lost. In the EU-Canada trade agreement (CETA) text the commission solved this for procedural rules, but not for substantive rules.

The post legal scrub CETA text, article 8.7, page 46, excludes ISDS procedures provided for in other international investment treaties and other trade agreements. However, the exclusion of substantive obligations contains the condition “absent measures adopted or maintained by a Party pursuant to those obligations.”. This creates a risk that the (for-profit) adjudicators would interpret local laws as implementations of treaty obligations, and interpret such laws in the light of old, very investor friendly, investment treaties. This way substantive improvements would be lost.

The TTIP proposal on MFN contains the similar formulation “absent measures adopted pursuant to such provisions” in Chapter II, article 2-4 (4), page 6.

See commission’s proposal Section 3 article 1, page 11, and ANNEX II: Public debt, page 9, point 2 for the references to an MFN chapter.

Note the Dutch government is in favour of the loophole (Dutch) and the TPP text also contains the loophole.

2.6 Pandora’s box?

Section 3 article 13(2), page 21, mentions

“and other rules of international law applicable between the Parties”

This may open the door to investment adjudicators interpreting all kinds of treaties and possibly adding enforcement to treaties without (strong) enforcement themselves – but only for the benefit of foreign investors.

3 Various issues

3.1 Intellectual property

Copyright and patent law need reform. International agreements, like the TRIPS agreement, limit policy space. Expansive interpretation of international treaties would further limit our policy space.

The commission’s proposal contains a broad definition of investment which includes intellectual property rights (patents, copyright, etc; page 1 and 2 (x2, g)).

Exceptions only relate to expropriation and fair and equitable treatment, not to national and most favoured nation treatment standards.

Regarding indirect expropriation, Section 2 article 5(6), page 5, reads:

“This Article does not apply to the issuance of compulsory licenses granted in relation to intellectual property rights, to the extent that such issuance is consistent with the Agreement on Trade-Related Aspects of Intellectual Property Rights in Annex 1C to the WTO Agreements (‘TRIPS Agreement’).” (emphasis added)

This would give supranational (for-profit) investment adjudicators discretion to interpret and decide on compliance with the TRIPS agreement (even though the WTO has its own (state-state) dispute settlement mechanism). This changes the dynamic, as private parties have less restraint than states regarding policy space. And there is a difference between seeing intellectual property rights as innovation stimulants and seeing them as assets.

Article 5(7) reads:

“For greater certainty, the revocation, limitation or creation of intellectual property rights to the extent that these measures are consistent with TRIPS and Chapter X (Intellectual Property) of this Agreement, do not constitute expropriation. Moreover, a determination that these actions are inconsistent with the TRIPS Agreement or Chapter X (Intellectual Property) of this Agreement does not establish that there has been an expropriation.” (emphasis added)

This would give supranational investment adjudicators discretion to interpret and decide on compliance with TRIPS and Chapter X (Intellectual Property). Inconsistency would, in itself, not establish expropriation, but could establish expropriation if one of the conditions in ANNEX I: Expropriation (page 9) point 3 is not met.

Regarding fair and equitable treatment, article 3.6 reads:

“For greater certainty, a breach of another provision of this Agreement, or of any other international agreement, does not constitute a breach of this Article.”

This only applies to fair and equitable treatment, not to other protection clauses, and the way the decision is taken can still be a breach of the fair and equitable treatment standard. Lise Johnson and Lisa Sachs report strict (and uneven) scrutiny in the Bilcon case (page 5).

See also Sean Flynn, “TTIP Stakeholder Statement: Protect IP from ISDS” and generally “How the Leaked TPP ISDS Chapter Threatens Intellectual Property Limitations and Exceptions” .

3.2 Privacy

The EU Court Of Justice has invalidated the Safe Harbour agreement that allowed data transfers to the US. If competent authorities would suspend data transfers to the US, US investors would be able to start ISDS cases. The threat of high damages awards would put pressure on the authorities competent to suspend data transfers and compromise their independence. This would undermine our privacy.

The formulation of data transfer clauses and their exceptions are important. However, a system with perverse incentives (and possibly unfair procedural advantages for the US) can make any safeguard unsafe, and, through high damages awards, compromise the independence of our authorities.

See also FFII, Broken data protection in EU trade agreements, section 5.

3.3 Public debt

Commission proposal Annex II on public debt, page 9, limits states’ ability to default and gives creditors leverage as the exception is conditional. This may prejudice the eurozone’s ability to solve financial crises.

3.4 Automatic consent

Section 3 article 7(1), page 16: automatic consent to arbitration.

4 Overview

Overview commission’s proposal:

Definitions specific to investment protection, page 1
Section 2 Investment Protection, page 3
ANNEX I: Expropriation, page 9
ANNEX II: Public debt, page 9
ANNEX III: Competent authorities mentioned in article 2 paragraph 4, page 10
Section 3 Resolution of Investment Disputes and Investment Court System, page 11
ANNEX I Mediation Mechanism for investor-to-state disputes, page 32
ANNEX II Code of Conduct for Members of the Tribunal, the Appeal Tribunal and Mediators, page 36

Not part of the published draft: national treatment, most favoured nation treatment, and final chapter.

Older version: reform proposal 16 September 2015]]; changes document 16 September – 12 November 2015