Foreign Direct Investment Protections, Past, Present,

and Future; Do International Investment Agreements provide

High Level protections to International Investors
Laws 6916 – Research Essay Response

Zorba J. PARER

Introduction
This research essay critically discusses the following statement: “... even without
a multilateral code, capital-exporting states have managed to achieve through
networks of bilateral and regional treaties, the high level protection for foreign
investors that they long sought on behalf of international business.”

In examining this statement we must first look at the history of investment

protections to see how investors have protected themselves, and why the
modern system of treaties has emerged. Additionally it is important to consider
the motivations for Host states to allow foreign investment and behave in ways
which affect the value of investments, and why they would sign treaties allowing
Investors to bring direct action against them.

To critically discuss whether the modern investor protections achieve their goal
we must first define the meaning of the statement “...high level protection for
foreign investors...” What is the high level which has been sought? What are the
motivations that drive investors to undertake foreign investment? What are the
underlying economic variables which drive Investor, Host state, and Home state
action?

This essay then suggests an alternative model to the current system for the
protection of both small and large enterprises, which provides controls on
investment for both Host states and Home states.

The History of International Investment Protections

Investment and Trade are often bound together in history, as often as
Investment and War. Which one precedes the other is not always clear. As early
as Alexander the Great, Greece, Persia, India, and China were linked through the
bonds of war, trade, and investments, and it is in India and China where the
modern Investment Treaty system laid its roots.

The Colonial Period

A brief look at the Colonial period provides us with an understanding of an
extreme in terms of interstate actions regarding investments and trade. It also
shows us the seeds of modern bilateral treaties. The trajectory set in this early
period by the form and nature of the actions and the treaties, has carried
through the intervening period (Early 1800s-1958) to the emergence of the
modern BIT system (Germany and Pakistan - 1959), despite a rejection that they
formed a basis for International Customary Law.
A weakening of the Spanish and Portuguese navies in the late 1500’s led other
European powers to establish spice trade routes with India. In 1595 the Dutch
East India Company sent out its first trading ships to trade silver for pepper1.
After a number of successful, i.e. profitable, yet risky forays into East India, both
the English and Dutch, on recognition of the dangers of hostile natives, pirates,
and other hazards of the sea, formed trading cartels to spread the risk. The
English first formed the East India Company (EIC) as a monopoly enterprise
granted by Queen Elizabeth the First on December 31 1600. The Dutch East
India Company was granted a monopoly and interestingly Sovereign authority to
negotiate treaties and the right to raise and maintain armies.

In the following examination this essay reviews the circumstances and outcomes
of the EIC in India and China. These examples are important as they demonstrate
the kind of effects trade and investment can have in a system regulated by force
and custom.

The East India Company in India

The EIC defeated the Portuguese at the Battle of Swally in 1612 which raised
their reputation with the Indian Emperor and allowed them to initiate discussions
on the establishment of a long term base of operations in India. In 1615 Sir
Thomas Roe was sent on a diplomatic mission by King James the First to
establish a treaty with the Mughal Emperor Nuruddin Salim Jahangir. After three
years of negotiation the Emperor responded with a letter of friendship to King
James II within which the nubs of the modern BIT can be seen.

The treaty, or Firman tor Coja Arabs House2, provided the following protections
which are in part reflected in modern BIT:

1. protection for English subjects in India;

2. permission for the English to land armies for defence of their persons and
their goods, and a commitment of frigates in defence against the
Portuguese;

3. permission for the English to buy or hire any house in Indian ports for
them to dwell and house their goods “sufficiently and safely” that “the
Governor should assist them and procure for them a safe and quiett (sic)
habitation.”;

5. remuneration to an English tenant of remaining rent, paid in advance to

any landlord, with whom an English tenant fell out of favour;

7. permission for the English to land goods and traffic in any manner they
see fit, and that officials may not detain any goods longer than necessary
to account for customs duty to be paid, and that only once;

1 Ames, Glenn (2008) The Globe Encompassed The Age of European Discovery 1500-
1700.
2 Full text of Sir Thomas Roe’s embassy:
www.archive.org/stream/embassysirthoma01fostgoog/embassysirthoma01fostgoog_djvu.
txt
 9. protection of linguists and brokers from molestation;

11.that in the case of complaints “the Governors and Cazies of the place
should doe (sic) them speedy justice and protect them from all Injuries or
oppressions whatsoever and should ayd (sic) and entreat them as friends
with curtesie (sic) and honor (sic)...”

In this treaty we can see the beginnings of investor protections in terms of “full
protection and security”, “fair and equitable treatment” and to some degree
protection of investments vis-à-vis expropriation of rents by landlords. These
protections flowed from the establishment of permanent trading ports. The
ability for Sir Thomas Roe to enter negotiations with the Emperor was not based
on the benefits flowing from capital investment, nor on the basis of goods which
the Emperor desired, but rather on political terms due to the demonstration of
naval supremacy by the British.

We see here an international investor in the form of the EIC, convincing the
English sovereign to send a mission to formulate an investment treaty. The Host
state in this case conceded to significant protections for the English investors,
not because of economic gain, but because of the demonstration of military
might. The Home state in this case allowed monopoly protection of the trade
route, on the basis of significant potential national income and in recognition of
the great risks posed by the endeavour.

In 1757 the EIC used force of arms to defeat the Nawab of Bengal and his French
allies at the Battle of Plassey, and established Company rule in India. Further
military action consolidated this position and the EIC become directly involved in
the governance of India in 1772 with the appointment of Governor-General
Warren Hastings. The EIC ruled India until the British government took control in
1858 with the signing into law of the Government of India Act 1858.

Under the protections provided by numerous treaties and British rule in India, a
number of large scale infrastructure investments were made possible, including
the establishment of the Indian Rail and Communication systems. These systems
were financed by the British and aided greatly to the industrialisation of India.
India regained its’ Sovereign independence in 1947 with the passing of the
Indian Independence Act, however British investments in Indian remained, and
continued to provide large profits for the UK. British investments in India
continue to this day, although the flow of investment capital is now beginning to
reverse. Many Indian magnates are now extending their investment base back
into Europe, and are finding very favourable conditions for investment in
England.

The Opium Wars and the Unequal Treaties

In the early 1800s the demand for Chinese tea and other products had become
the new market for the European powers. The EIC looked to open this
opportunity and began to trade opium grown in India for Chinese tea. Opium was
the stock of choice given a large Chinese demand and a lack of silver available to
the EIC.
The Chinese Qing dynasty enforced very strict regulations on trade with
foreigners. International trade was only permitted at the port of Canton, and only
with appointed persons who acted as trading proxies. The growth of the use of
Opium alarmed the Qing dynasty and led to a ban on its use. The problem
became so pronounced that the Emperor appointed Lin Zexu to eradicate the
trade and use. Lin Zexu (Lin Tse-hsü) captured a number of English traders with
Opium and demanded that the English Governor destroy all stocks of opium in
exchange for the English captives. On July 3 1839 the destruction of 1.1 million
metric tons of opium began. This series of events sparked the First Opium War.

The British seized Hong Kong and proceeded to conquer a number of key
Chinese ports, including Shanghai. In 1842 the Emperor agreed to the signing of
the Nanking Treaty, where again we see the echoes of modern BIT.

The Treaty of Nanking contained thirteen articles of which articles 1, 2, 4, and 5

show a very close resemblance to many modern BIT terms.

Articles 1 and 2 show us an early version of full security and protection: Peace
between the UK and China, and their subjects “shall enjoy full security and
protection for their persons and property within the dominions of the other.”
Article 2: British subjects allowed to reside for the purpose of trade “without
molestation or restraint” in the towns of Canton, Amoy, Foochowfoo, Ningpo, and
Shanghai.

Articles 4 and 5 show us that compensation is payable for a direct taking: That
the Emperor of China will provide payment of six million dollars in compensation
for opium destroyed in March 1839. Article 5: Abolishment of the Hong traders,
allowing British traders to conduct business with anyone they should choose. The
emperor of China to pay the British Government three million dollars owed
traders by now insolvent Hong traders.

The treaty of Nanking had been concluded in some haste given the nature of the
hostile activities preceding negotiations. It was followed up by the Treaty of
Bogue which clarified, extended and provided regulations for the intent of the
Treaty of Nanking. Importantly for the discussion of international investment are
Articles VII and VIII of the Bogue treaty.

Article VII amplifies the terms of the Nanking Treaty Article II “...Without
molestation or restraint...” to include the meaning “...that ground and houses;
the rent and price of which is to be fairly and equitably, arranged for,
according to the rates prevailing amongst the people...” This article shows
us the beginning of the Fair and Equitable treatment has in its beginnings as a
form of National Treatment in relation to property valuation.

Article VIII states that China, having granted other foreign nationals similar rights
to British nationals (in the treaties of Wanghia (USA) and Whampoa (France)),
would provide that “...additional privileges or immunities to any of the subjects
or Citizens of such Foreign Countries, the same privileges and immunities will be
extended to and enjoyed by British Subjects...” This is in essence the core of
Most Favoured Nation status.

In the brief examination of these Colonial experiences it can be seen that Home
state investors sought protection from other sovereign states interfering with
their trade, stable ports for trading, establishment of factories, control of
manufacturing, protection from harm, equal treatment to nationals of Host
states, and equal treatment with regards to other third party nation states. We
can also see that Host states agreed to these protections in the Colonial period,
either because of tactical or strategic advantage, or due to coercion.

reduction of the importance of the spice trade and the emergence of the
Industrial era, led to new developments in the nature and form of international
investments and the protections provided.

The Emergence of the Modern Era

The pre and post war period are also of significant interest as the world of
economics was entering a golden age with Keynes and contemporaries
establishing economics and finance as a science. They expounded the
advantages of macro economic reform to establish global trading infrastructure,
internationally floated currencies, exchange of capital for currency stability,
fiscal policies for stimulus and restraint, and other tools which are the bread and
butter of modern Federal reserves. The mechanisms of this theoretical economic
model as implemented by Sovereigns have been seen as threat to investors.
Taxes, currency manipulation, inflation, and interest rate fluctuations to name a
few, can have a major impact on the profitability of foreign investments.

The modern era of international investment comes off the back of both the
conflicts of WWI and WWII, the establishment of the United Nations and the New
World Order, the development of economics as an empirical field of study, the
victory of capitalism over communism in the cold war, and an explosion of Neo-
liberalism leading to global economic liberalisation. Modern international
investment must be seen in the broader context of international law and global
economic trends.

International treaties of all species were, and are, under the study and mandate
of the UN for codification into a cohesive and agreeable body of international
laws. These treaties include topics of State Responsibility, Code of Offences
against peace and security of mankind, State responsibility for wrongful acts,
and the Vienna Convention on the Law of Treaties. Under this New World Order
the use of state power to seize private property is rare, and the use of arms to
further economic goals is banned, and typically results in serious sanctions from
the majority of nation states.

The primary difference between earlier protections for investors and the modern
state of affairs is the ability of the investor to unilaterally initiate action against a
Host state3. Where earlier law was based on the principles of state

3 A law for need or a law for greed?: Restoring the lost law in the international law of
foreign investment. M. Sonarajah
responsibilities, and customary international law, the new treaty system
empowers investors to a level not seen since the decline of the early Mercantile
entities. Another major difference between early Mercantile firms and modern
Multi National Enterprises (MNE) is that the prior were sanctioned by the Home
state with Sovereign powers, or at least a good deal of Home state participation,
and to some degree controlled directly by Home state Sovereigns.

The emergence of a global society, the ease of trans-national communication

and transport, development of a global marketplace, and an increasing
acceptance of International Law, has increased the liberalisation of economic and
investment policies in many countries4. These and other factors have led to MNE
moving from arms length market strategies, to investment oriented vertical
strategies5.

The use of BIT as a threat to obtain positive outcomes for investors is perhaps
more effective than the implementation of arbitration action. The case of Ghana
and mining6, and other examples, shows that the threat of action can be
sufficient to force a political decision in favour of foreign investors, in order to
maintain the perception of a nation being open and friendly to foreign investors.
The fact that the period from 1989 to 2009 has seen an explosion of BIT and a
massive increase in FDI flows (trillions of dollars), set against the comparatively
small number of arbitration actions taken (around 400) shows that other
remedies are sufficient, or that the threat of arbitration alone is effective in
obtaining Host state remedies.

FDI Economic Theory

MNE actively engage in investment, with the OLI7 and LLL8 theories largely
accepted as a basis for the motivation to enter into FDI. The OLI theory holds
that companies enter because of Ownership Advantage + Location Advantage +
Internalisation Advantage. The Location Advantage of the OLI equation includes
consideration of the Political situation. A company seeking to enter a foreign
domain may be prohibited marginally or critically due to the Political factor
(considered within the Location Advantage considerations) of the OLI equation.
The existence of an International Investment Agreement (IIA) may enable them
to protect against the risk through Political Risk Insurance, or have sufficient
confidence that the threat of arbitration action would provide a stabilising affect
on the Host state political situation.

The differentiation topology expounded by Dunning (1993) of MNE FDI strategies

are broadly discussed in economic literature and are defined as Natural-Resource
Seeking, Market Seeking, Efficiency Seeking, Knowledge Seeking and Strategic
Asset Seeking9. This topology expands the motivation of why MNE would seek a
particular location, i.e. a Foreign Investment, for the expansion of their

4 OECD Foreign Direct Investment and Economic Development 1997; Stephen Thomsen.
5 “Re-evaluating the Benefits of FDI” John H Dunning
6 From regulatory chill to deep freeze; Lyuba Zarsky
7 Dunning 1994
8 Dragon Multinationals: new players in 21st Globalisation; John Mathews 2006
9 Managerial Issues in International Business; Felicia M Fay, Eleanor J Morgan.
enterprise. In our early discussion of Colonial enterprises it is clear that they
started as Natural-Resource seeking, using arms length market transactions, and
expanded to be Efficiency Seeking vertically internalised enterprises. India and
China essentially had resources which were highly valued in the European
market. The traders then found it more efficient to own and operate the factories
and agricultural assets which produced these products.

A major component of the economic theory surrounding FDI is that it can be both
beneficial and detrimental depending on its mode of implementation and the
specific circumstances of the Investor, the Home state, and the Host state.
Dunning argues that FDI succeeds where an alignment of MNE strategic goals
with the Host state National Comparative advantage exists. In this light it
becomes clear why countries do not wish to sign up to multilateral agreements.
Establishing bilateral agreements allows sovereign states to align their national
interests and comparative national advantages, with the counterpart nation.

Variables which substantially affect FDI in a practical sense have been variously
examined10. The affect of exchange rate, taxation variation, institutions, trade
protections, trade effects, are all variables in the FDI. In looking at the empirical
data, it is clear that nothing is clear. Extricating the effect of various variables on
the affect of FDI is difficult due to the limited data set (~30 years and ~200
countries), the broad range of variables, and the lack of consistency across the
spectrum of policy, governance and other political vectors, has prevented the
development of a universally accepted mathematical model of IIA affects on FDI.

Interestingly the variables of exchange rate, taxation, and trade protections

listed above may be affected by an IIA depending on the implementation of
terms in the IIA and the taxes, exchange rates, or trade protections which are
implemented thereafter11. From the perspective of using claims of treaty breach
of IIA clauses to recoup losses due to Host state policy implementation, the
International Investor obtains significant scope to bring a claim, or use the threat
of such claims to chill regulatory changes or provide exemptions for the MNE in
question. Given the rising number of claims and practitioners in the field, many
governments are reconsidering their IIA provisions, which for years were left idle
in the background as a measure of last resort.

IIA alone are not likely to encourage or discourage investors to enter into foreign
investment. Australia and the USA are party to a FTA which does not include a
chapter 11 investment section. Here again it can be seen that the benefits to
international investors in both states is sufficient to encourage such investment,
and that the national policy and legal protections are seen as sufficient. Recent
successful actions against Host states, particularly developed Host states, can
also be argued as a reason for the USA and Australia to avoid inclusion of such
private remedies against their Sovereignty.

10 A Review of the Empirical Literature on FDI Determinants; Bruce A Blonigen

11 The Global Governance of FDI Madly Off in All Directions; Luke Eric Peterson, May
2005
Two Examples from the Aerospace Sector in Australia

Eurocopter/Australian Aerospace in the Tiger Dispute

An example of a MNE engaging in modern FDI is Eurocopter. Eurocopter acquired
Australian Aerospace in a Market Seeking effort designed to assuage
protectionist political sentiments and provide Australian industrial participation
as a component of an offer to sell advanced military helicopters into Australia. In
making sales to any government a company exposes itself to a number of
additional risks. These risks largely involve the exposure of sensitive and
valuable intellectual property. A set of unique State immunities means the
balance of power largely favours the acquiring government in an arms contract.
The existence of an IIA assists in equalising this balance of powers. The
rebalancing is not necessarily in the execution of the arbitrational process, but
the threat of the action.

In 2007 the Australian Government elected to enact a stop payment clause in

the acquisition contract of the Armed Reconnaissance Helicopter (ARH) due to
delays in the delivery of the program. Enacting this clause had a significant
effect on cash flow available to Australian Aerospace (AA), and had a significant
effect on their reputation. In response AA elected to declare a Dispute with the
Government. This was a Commercial contract dispute.

The Government was in a very strong position from a contractual perspective,

however AA was only at the beginning of what may have become a very long,
complicated, and politicised, dispute process. The Government was motivated by
a desire to acquire the helicopter system, maintain its obligation to expense
funds in accordance with regulations, and ensure positive public sentiment in
light of ever present failures in military acquisitions.

While the Australian Government was showing that it was willing to be firm in
enacting acquisition contracts, EADS was equally showing that they could make
things very unpleasant for the Government by enacting commercial and legal
disputes. A failure to resolve the dispute may well have led to a claim of treaty
breach, particularly if the Government had used clauses in the contract to claim
the IP necessary to complete the manufacture, delivery, and operation of the
helicopters.

In 2008 the Australian Government and Australian Aerospace resolved the

dispute and agreed to a revised contract which has set the ARH program on a
new course. The program is now seen as success story, the Government can
claim they have a solid contract which delivers value for money, and AA can
claim that they are on schedule, albeit a new, longer schedule.

Lockheed Martin in Australia

Lockheed Martin (LM), a global market leader in the aerospace sector, has
recently setup a subsidiary in Australia for the initial purpose of supporting the
through life support contract of the LM C-130J Hercules platform. LM has
previously limited its activities in Australia to arms length trade in selling aircraft
and systems to the Australian Government. LM has also had a significant arms
length market engagement for the purposes of developing Australian
components of its global support network.

Despite a lack of a BIT or a chapter 11 component of an FTA, LM has initiated the

LM Australia Limited activity. It would appear that the benefits of having a local
subsidiary, and faith in the Australian policy and governance, are sufficient to
encourage the investment in Australia. Additionally, establishing a beach head
enterprise on a relatively small contract may indicate a desire to be more
intimately involved in future support programs, in particular the highly
anticipated acquisition of LM Joint Strike Fighter.

Discussion
IIA do not exist in isolation. They are one variable in a larger economic, policy,
strategic, commercial, and social equation. Investors were originally, and to
some degree still are, protected by their Home states ability to project power
through diplomatic, trade, and at last resort military forces. Investors are now
protected by Host states desire to encourage capital investment which if focused
into the right sectors can encourage growth and bring wealth and benefits to the
Host state.

The “high level of protection sought by Investors” is a desire to seek control, or

at least obtain predictability, of the variables in the cost/benefit equations which
lead to the decision to enter into an Investment. While IIA do not provide the
ultimate protection from risk in a foreign investment, they do provide a powerful
tool, for ensuring that the use of sovereign power is not abused. Until the mid-
1990s the protections were seen as a source of relief from extreme state abuse,
more recently they have been used to control the OLI elements relating to
changes to the taxation, regulatory, and policy changes affecting a particular
investment.

Whilst the common use of MFN clauses since the Treaty of Nanking has created a
virtual multilateral treaty system, the use of MFN clauses in European treaties is
being reduced or removed. The argument for European Union members to
remove the MFN clauses is that the investment protections provided to the EU
members being extended to other countries outside the trading block would
significantly diminish the power of Brussels to control the fiscal policy of the
Union.

The removal of the Investment chapter in the Australian USA FTA indicates a
possible reduction in the importance of IIA in the future Global Economic system.
As nations become more confident in the governance of Host states, and the
fairness applied to each others nationals by their respective jurisdictions, along
with a reduction in the efficacy of military action and increased respect for
international law, it is likely that the removal of IIA will expand. The protections
granted in IIA cause issues for sovereign agencies, where they can be removed
based on a trust in the partner nation game theory suggests that it will be
removed.
High level protection of foreign investors does exist, and is increasing, in today’s
ever growing global economy. The contribution of IIA to these protections,
particularly for large MNE, is clearly evidenced by the fact that they seek and are
granted awards by arbitrational panels. The protections available to Small to
Medium Enterprises (SME) are more due to a knock on affect, rather than their
ability to take direct Investor-State arbitration. In the context of expanding
international investment, and an increasingly integrated global economy, IIA will
continue to be important for some time to come.

That reform is needed to develop a true international investment legal system is

clear to many commentators12. What shape this body of law should take is
however not ultimately clear. It seems obvious from the body of literature on the
subject that foreign investment is an important part of increased standards of
living in developing nations, global economic integration, international economic
stability, and peaceful commercial conduct.

That the relevance of a particular Nation state for MNE is diminishing also seems
clear. Nation states and their agents (public servants and politicians) are
frequently less sophisticated than MNE operating within their auspices. That MNE
should be reliant upon such agents to undertake action on their behalf is unlikely
to meet the expectations of the MNE. Whatever Sovereign states may undertake
in terms of FDI, it seems clear that the influence of MNE is likely to have an
equal, if not greater, influence on the future state of International Investment
Law.

Conclusion
As to the primary question asked in this essay; the above examination clearly
shows the answer is yes and no. High levels of protection against political
instability are available to enable International Investors to undertake their
enterprises. The extent to which BIT or FTA, in a practical sense contribute to
those protections is clearly less important than other variables. In an evolving
sense the BIT and FTA are being used to control the other more important
variables of the FDI equation and are playing an increasing role in the reduction
of risk to investors, and hence an increase in the level of protection available to
investors.

Alternative System of Protections

Within the international framework a lot of energy is devoted to the protection of
large MNE. Indeed the running of an investor state arbitration is a costly affair.
Within this environment there is a distinct stratification of protections.

Small to Medium Enterprises (SME) with limited resources are significantly

exposed both due to their inability to absorb costs and their lack of resources to
undertake an arbitration action, the cost of which would almost certainly exceed
any damages being claimed. These enterprises benefit from the current IIA
system in terms of its overall effect on policy position of a particular host nation.

12 A law for need or a law for greed?: Restoring the lost law in the international law of
foreign investment. M. Sonarajah
Large MNE with significant resources have the ability to offset tariffs, taxes, and
other costs by reshuffling their business structures. Where this is costly, they
have the resources to undertake arbitration actions. These enterprises do not
have legal identity in the international legal environment, yet are in many
instances more able to defend themselves than small sovereign states. The
threat of removing themselves from a particular National market is often as
powerful a statement as the threat of arbitration. These companies often have
business plans which require long investment periods (ergo 50 year mining
leases) to extract enormous profits (billions of dollars). The threat of arbitration
which would claim these profits as damages, obviously have a significant affect
on policy decisions in host nations, particularly developing nations.

A possible solution to this is a two tier system; with small enterprises protected
by a IIA which allows state arbitration against a Government enterprise set up to
handle disputes, and the large MNE being granted Home state Sovereign
instruments to directly negotiate enterprise specific treaties with Host states, as
was the case with Mercantile enterprises.

The minor nature of cost implications due to SME claims would allow the Host
state to provide compensation where there business models are affected by
policy changes, without major financial risk to the Government. Within the
context of SME it would be significantly easier to negotiate a multilateral
agreement, given that the potential impact on States is more controllable with
smaller capital investments.

MNE would be able to directly protect their positions. The granting of Sovereign
instruments by the Home state could be established in a way to ensure that
abuses are prohibited, and withdrawal of those instruments possible.

This two tier system would enable protection of investors and Host states in a
transparent and viable way. It would also re-inject Home states into the process
in a way that ensures MNE are not free of jurisdiction by way of corporate
structures. It also ensures that a regulatory framework could be established in
order to ensure corporations are accountable to more than there privately
defined and interpreted codes of conduct.