Strategies of Investors in Conflict with Host Governments: Why do some Investors Avoid International Protections when their Investments are in Trouble?

Date July 24, 2008
Speaker Louis T. WELLS(Herbert F. Johnson Professor of International Management, Harvard Business School)
Commentator SHIMIZU Takashi(Assistant Professor, Graduate School of Arts and Sciences, the University of Tokyo)
Moderator MATSUMOTO Kayo(Fellow, RIETI)


Louis T. WellsLouis T. Wells
The overwhelming majority of foreign investment disputes arise in developing nations. Due to political influence and erratic judgments in local courts, foreign investors do not trust the judicial systems of host countries. Rather than turning to the courts of the investors' home countries, which are politically unacceptable to the governments of developing nations, investors look for protection from several principal sources.

Efforts to negotiate a multilateral agreement on foreign investment that would parallel the World Trade Organization have failed. What is left is a network of bilateral treaties (BITs) and regional trade agreements (RTAs) that include investment provisions that call for arbitration as a method of settling disputes. They have been made possible by The International Center for the Settlement of Investment Disputes (ICSID), a World Bank-sponsored organization, the United Nations Commission on International Trade Law (UNCITRAL), and the New York Convention. ICSID and UNCITRAL provide frameworks for arbitrations, while the New York Convention provides, in theory, a means of enforcement for decisions from arbitrations.

Investors from several leading economies also offer official political risk insurance, which is sponsored by their home governments, and the World Bank offers insurance through its Multilateral Investment Guarantee Agency (MIGA). Home government intervention is form of investor protection, although military intervention has fallen out of use.

The U.S., however, retains the ability under its domestic laws to cut off official assistance and privileges under the Generalized System of Preferences to a government that confiscates U.S. property without prompt and adequate compensation. Also, U.S. representatives in multilateral finance organizations can be instructed to vote against loans to countries that take U.S. property. Prior to 1990, however, State Department concerns that actions would push offending nations toward the communist camp, such actions were carried out only twice. Nevertheless, home government intervention has remained a threat and offers some protection to investors just by its existence.

The best form of protection for investors is the provision of needed technology and control over export markets. If a host government sees an investor's continued presence as necessary, there is very little chance that that investor's assets will be expropriated.

ICSID was established in 1972 and in its first 24 years saw only 36 cases of disputes between investors and host governments. From 1996 to 2004, however, the number of cases jumped to 71, and it continues to climb today. There are three possible reasons for this rise in disputes.

There are currently more than 2,500 BITs and RTAs that call for arbitration as a means of settling disputes between investors and their host governments. As a result, the option of arbitration has become available to more investors. Also, increases in raw material prices are leading host governments to believe that they do not receive a fair share of profits from their resources. This has led host governments to call for renegotiations of contracts. In turn, investors turn to arbitration to dispute the host government's demands.

The third reason is the growth of foreign investment in infrastructure projects. Private investment in infrastructure has made up more than half of the investment disputes that have gone to arbitration. Between the 1920s and 1990s there was growth and then decrease and eventual disappearance of private investment in infrastructure. By the late 1980s, infrastructure in the developing world was overwhelmingly state-owned. Its reappearance in the 1990s brought in some very inexperienced investors who were largely unaware of the kinds of risks they would be undertaking and inept at managing those risks.

Infrastructure contracts generally involved government concessions, such as granting monopoly or quasi-monopoly rights to foreign investors. Most of the contracts called for price of, say, electricity that were denominated in dollars and they imposed fixed payments obligations on the governments, in terms of "take-or-pay" commitments or they involved output such as water that faced inelastic demand.  As far as the host government was concerned, such contracts were economically equivalent to debt, in that the amount (set in dollars) that they were obliged to pay the investors increased many fold if the value of the local currency fell, as happened in the Asian Financial Crisis. Also, financial crises brought declines in demand for the output of infrastructure projects, especially in the case of electric power. Even though the use of such commodities as electricity plummeted, the host government was still obliged to pay the contracted amount. Even worse, the volumes for which countries had contracted were based on assumptions that demand would continue to grow, not fall.

Politics also has also played a role in the problems with infrastructure investment. For opposition politicians, infrastructure investment is easy to attack, because local populations are particularly sensitive to foreign ownership of infrastructure. While telecommunications is perhaps the least sensitive kind of infrastructure investment, due to the possibility of competition in domestic markets, foreign ownership of water is the most sensitive, with the issue with which controversy can be created when a foreigner "owns" such a critical resource. Additionally, the lack of bargaining power on the part of the investor adds to the ease of expropriation. A foreign infrastructure investor who is reluctant to renegotiate a water supply contract cannot very well say, "Well, we will leave with our water pipes."

In the wake of the Asian Financial Crisis, Indonesia's power projects provided examples of how such problems can occur. Out of 26 private power projects in the country, 19 were foreign-owned. The vast majority of the partnerships were with politically connected individuals, relatives of Suharto, or military officials, who put up no money and held a 10%-15% share of the project. The shares were paid for by loans from foreign equity holders, which were repaid out of a percentage of dividends. As the power was generally overpriced, the projects offered good returns with low commercial risks for domestic partners.

After the Asian Financial Crisis hit, the Indonesian government demanded that all of these foreign investors renegotiate their contracts. The companies responded in different ways to this demand. Those projects where the principal owner was in the power business to stay were, for the most part, renegotiated. Those projects that were owned by oil and gas companies were all renegotiated.

One of the companies that refused to renegotiate and, instead, went to international arbitration was CalEnergy, which held insurance provided by the U.S. government affiliate, OPIC. When the arbitration panel ruled that the company's projects had been expropriated and the government had not yet paid, the company was eligible to collect its political risk insurance. The U.S. government then approached Indonesia and demanded compensation for the sum paid to CalEnergy.

An Enron subsidiary had insurance with MIGA and filed the first claim that MIGA had ever received for expropriation. It collected, and MIGA in turn collected from Indonesia.

Karaha Bodas, which was mainly a project of U.S. energy companies Caithness and Florida Power & Light (FPL), went to conventional arbitration and won a substantial award. Karaha Bodas's domestic partner was a group of wealthy and well-connected individuals, allegedly including relatives of Suharto's wife and the son of the vice president. The arbitrators awarded Karaha Bodas $268 million on a claimed investment of $90 million for an unfinished project. In addition, the company collected $75 million from private insurance, which was not reported in the arbitration. The award has been criticized as double counting, in awarding the amount of investment plus the net present value of their future earnings, which should include return of investment.

The pattern that is apparent among power projects in Indonesia is clear. If an investor has no other business in the country and is exiting the business line anyway, it has no hesitancy to go to arbitration. On the other hand, if the company has other significant business in the country (or if it is Japanese) it seems to renegotiate.

The reluctance of some companies to take disputes to arbitration comes from the fact that arbitration is a bitter process. Taking a dispute to arbitration generally ensures that a company's business in that country will be dead. Even companies with similar projects in other countries hesitated to go to arbitration, as doing so could cause them to gain a bad reputation with other host governments.

Although the U.S. government backed its foreign investors abroad more strongly after the end of the Cold War, it seems to be moving back toward reluctance to enforce contracts between U.S. investors and host governments. Prior to the end of the Cold War, its reluctance to provide strong support was due to the fear that doing so would push host governments toward the socialist camp. In very recent years, reluctance has increased because of concerns that such actions might discourage countries to cooperate in the war on terror.

The Japanese government behaved quite different from the U.S. government in the Indonesian disputes. Rather than defending a rigid view of contract, the Japanese government stepped into one of the disputes in Indonesia and offered a low-cost loan to the Indonesia government to help it out of the situation that it faced. When this was turned down by the Indonesians for fear of setting a precedent of guaranteeing debt related to the power projects, the Japanese again approached the Indonesians with an offer of a lease-back arrangement. This avoided the precedent that the Indonesians feared and ended the dispute in a harmonious way.

Takashi ShimizuComments:
Takashi Shimizu
Two dilemmas exist in foreign investment: one for investors and one for host countries. Host countries want to promote investment, but want to control investments so they may stay in line with national policies. Investors, on the other hand, are looking to exploit the market and also want to adapt to their new environment to create a good relationship with the host government. Disputes arise when these goals clash.

According to Professor Wells, three types of external protections are available when a dispute arises; arbitration, official political risk insurance, and home government intervention. While the use of arbitration and other protection measures is increasing, its usefulness to investors is dubious.

In the case of the Indonesian contracts, many companies renegotiated, but some refused and utilized the aforementioned protections. Those looking to exit the market were more likely to arbitrate and also had U.S. government insurance. Those that wished to remain in Indonesia did not want to appear hostile to the Indonesian government and chose the more conciliatory solution.

Japanese companies are generally unwilling to resort to international protections for different reasons. Problems with arbitration include being rigid and inflexible, lacking consistent results, lacking considerations for national goals, having asymmetric access to arbitration and a focus on damages rather than settlement.

In my opinion, there are some more problems regarding arbitration. In particular, the neutrality and predictability of legal procedures in arbitration is questioned by host governments. The results of arbitration are seen as unstable and biased. On the other hand, investors see domestic legal proceedings in much the same light.

As for asymmetric access to arbitration, the right of starting arbitration is only given to investors. While a foreign investor can initiate arbitration against a host government, neither a host government nor a domestic investor may initiate arbitration. Many BITs contain clauses allowing investors to choose from bring a case to a domestic court or arbitration. This creates a bad situation for the host government, as investors may choose the legal setting they feel is more advantageous. My question to Professor Wells is, should these clauses be eliminated to alleviate the problem of asymmetry?

According to Professor Wells, improvement of arbitration is the best way to solve the problem. It seems difficult to secure neutral and predictable arbitration, however. Encouraging a settlement is also difficult because common law lawyers may believe that arbitration and mediation should be separated and refuse to introduce the process of mediation into arbitration.

Another possible way to solve the problem is to improve the judicial systems of host countries and abandon the system of arbitration. Arbitration is useful only for investors, but can be harmful when domestic courts are neutral and predictable. As such, several BITs that exist do not include arbitration clauses. Allowing domestic courts to hear disputes would allow for settlements between investors and host governments which are not provided for in arbitration. Needless to say, a country cannot intervene in another country to remake its judicial system. In my opinion, however, a country can encourage another country to improve neutrality and predictability of its judicial system.

Finally, the behavior of Japanese companies in Indonesia may be due to the protections afforded by host governments. If Japanese companies have advanced technologies and they are willing to transfer these technologies to the host country, they can obtain enough protection from the host government. If it is the case, there is no need to utilize arbitration. I would like to ask Professor Wells if this interpretation is possible.

Louis T. Wells
As for improving local courts rather than improving arbitration, it is a matter of which task is easier. I am less optimistic about improving local courts over the next decade. If anything, the prospects for such improvements are really in the long-term. However, there are things that could be done to improve arbitration in the short run.

As applied to foreign investment disputes, arbitration is a common law system. Two changes would be helpful. First, although arbitrators cannot act formally as mediators, they, like judges in a common law system, can in mid-process lay out parameters within which the parties to a dispute have a better chance to reach a negotiated agreement. For example, an interim conclusion that they will award something to the investor, but not the sum of investment and the NPV of future earnings can establish a narrower framework for a negotiated settlement. Additionally, a common law system works on precedent, and if there is no way of resolving conflicting precedents there is no way to build a common law. And clearer common law itself can encourage settlement, rather than litigation. .Precedents can be effective only if there is an appeals process to resolve conflicting decisions. One approach to building an appeals process is that of the WTO, which has an appeals "court" that is designed to be broadly representative of the WTO membership. Such an appeals process would create an investment arbitration system that would also allow evolution of law as parties' views change. As a third change, increased symmetry in arbitration would be useful mainly as a symbol. While host countries might not gain much by having the right to take investors to international arbitration, the option would make the system seem fairer.  And that is itself very important.

As for the lack of investment arbitration involving Japanese, one cannot explain the absence by arguing that Japanese firms do invest in risky industries. They have significant investments in infrastructure, and in risky countries where disputes have arisen. Also, there are Japanese investors that are not diversified; one cannot argue that all are diversified and thus avoid arbitration that might hurt their other businesses. In these ways, they seem quite similar to other international investors. But somehow, the Japanese have different attitudes and tend not to rely on arbitration to settle disputes.

Questions and Answers

Q: Why have the compilation of current arbitration cases not contributed to the preciseness of arbitration cases in terms of norms? Please give us your comments on the possible contributions of the compilation of current arbitration cases into forming a more precise interpretation of legal norms.

A: One problem with compilation is that it is very incomplete; there is no requirement that decisions and supporting arguments be made public. And, of course, there is no way, in the absence of an appeals process, to resolve inconsistencies in order to create norms. For example, there are a large number of cases against Argentina. Three have been decided, and two of those are very, very similar cases. The awards in those two cases are in conflict. One tribunal accepted Argentina's argument of "necessity," while the other rejected the "necessity" argument. This is only one recent example of many unresolved inconsistencies. Inconsistencies are also common in the calculation of awards.

Moving more toward a civil law system, where more norms were more specifically spelled out in legislation, or in this case, in multilateral agreements, would be fine, but the prospects for that actually happening are not very good, given the failures of all multilateral negotiations on investment thus far. Before home governments will accept a multilateral agreement, their investors must also accept that agreed norms are better for them than are ad hoc approaches. At this point, host and home governments have failed to agree on "legislation."

Q: It seems that only Japanese companies have succeeded in continuing their projects in Indonesia after the Asian Financial Crisis. However, why do European and American foreign investors continue to use arbitration?

A: CalEnergy/MidAmerican was leaving the energy business and probably could not have been persuaded to continue with the Indonesian projects. The parent company was being bought by an outside investor that wanted cash, so getting cash was the most important thing to it at that time. Enron, as well, was getting out of the business of hard assets and move into energy trading. Therefore, it was ready to get out of Indonesia. While there are currently some companies in arbitration that might well be interested in settlements, I doubt that any of the companies in the Indonesian arbitrations would have been amenable to settlement at all. They simply wanted as much money as they could get, and arbitration seemed to promise large sums.

Q: Japan tends to negotiate BITs with countries with which it has a strong investment relationship already. If a Japanese company was being asked to renegotiate a contract in a country that was not strategically important to Japan, do you think that it would then be inclined to initiate arbitration?

A: Although the number of Japanese BITs is somewhat limited, it is expanding rapidly.  In many investments, Japanese companies are covered by BITs directly, or indirectly through holding companies.

I would caution against suggesting arbitration as a route for more Japanese companies to take. While they should understand that the option exists, it might not be wise to encourage them to use it, because of the bitterness that comes out of the process. I have argued elsewhere that host countries should consider giving preference to Japanese companies because of their general reluctance to take disputes to arbitration. Their tendency to try to work out something that both parties can live with should make Japanese investors attractive to host countries.

Q: How many years do you think would be needed to re-enter the country after a hostile arbitration?

A: It depends on how much publicity there was. Indonesia, a democracy with a free press, had quite extensive coverage of the disputes in the wake of the Asian Financial Crisis. If those investors were to try to return in the next 10 years, the newspapers would remember and remind people of what they saw as inappropriate behavior.

Q: In terms of the Indosat case, how much and under what conditions does local ownership matter in terms of investing in a risky project like this? What would have been different if Indosat had pursued arbitration?

A: There was no press coverage of the nationalization of Indosat. The deal covering the amount of compensation to ITT also included an understanding that the company would not talk to the foreign press or complain about its treatment in Indonesia. In terms of the importance of local ownership, if the Suharto government had not fallen, the investors in the 1990s power plants would have been protected by their partners. The Suharto family would have made sure the projects remained profitable, because they would have benefited themselves. The one company that did not have a powerful political partner had a local businessman as a partner who was considered uncorrupt. His presence may not have provided strong political protection, but he knew the system well and was skilled in doing business without corruption. Moreover, the Suharto family partners became liabilities once Suharto fell; the untied partner remained an asset. If one can guarantee that the president will stay in power, local ownership by relatives and cronies of the president can be very useful; otherwise, they can become liabilities.

A Harvard Business Review study showed that joint ventures were more likely than wholly owned subsidiaries to be expropriated. This seemingly perverse finding may be due to the fact that investors are more likely to take on partners in ventures that are already risky. That is, in industries that are more likely to be expropriated anyway.

Q: In terms of asymmetry, while it is true that only foreign investors can initiate arbitrations, it was assumed that a host government could at any time initiate a case in domestic courts against a foreign investor it felt was in violation of contract. You criticize this analysis by saying that the judgments of local courts are not enforceable because the investors' assets are held abroad. Is this true, given that investors, particularly in energy and mining, tend to have large amounts of assets held in the host state?

A: I think that symmetrical treatment is important as a symbol, because having arbitration as a one-way option does not look good from a political point of view.  There are cases, however, when the option of having the state initiate arbitration can be useful. Some of the cases that a country might bring against an investor concern projects that are incomplete. If the state is "right," it may have access to limited assets within its borders to satisfy any judgment. Moreover, many infrastructure projects are renegotiated on investors’ initiatives, often before the project is even completed. The suspicion is that many investors underbid in the tender process, counting on their ability to renegotiate once they get the deal. A little more symmetry would potentially give the host government the chance to penalize that kind of behavior. While host governments may not actually go to arbitration often, the option gives the government a greater feeling of control and a little more bargaining power in the process.

I believe that having symmetry is as important as having an appeals process. Symmetry may be harder to get. The large number of bilateral investment treaties already in place would have to be modified. In contrast, it may be easier to create an appeals process.

One of the arguments for the finality of arbitration is that the process was supposed to be quick and cheap. As it turns out, arbitration of investment disputes are neither quick nor cheap. This does not mean that arbitration is bad. There is really no alternative to it as long as investors do not trust host countries' courts and host countries are not willing to go to the courts of investors' home countries. But making it function better should be the goal. Symmetry and an appeals process would be helpful.

*This summary was compiled by RIETI Editorial staff.