The Role of Democratic Governance and Indirect Expropriation in International Investment Treaty Violations/Uluslararasi Yatirim Antlasmalarinin Ihlalinde Demokratik Yonetisim ve Dolayli Kamulastirmanin Rolu.

• Author: Carlson, David

Introduction

Democracies are viewed as favorable treaty partners, and there is a fairly accepted consensus that democracies violate international investment treaties less than non-democracies. (1) Democracies should limit expropriation risk of foreign investments by constraining executive power and reducing investment uncertainty (2) This expectation is partially confirmed empirically; we see in the left panel of Figure 1 that democracies are more likely to sign international investment treaties, such as bilateral investment treaties (BITs). The right panel of Figure 1, however, demonstrates that democracies are just as likely to be a defendant in investor-state arbitration. Why do democracies sign more investment agreements if they are just as likely as non-democracies to violate those agreements?

We suggest that this paradox is driven by the various motivations that states have to protect investors, encourage future investment, discourage capital flight, but most importantly maintain domestic political support. For example, the Spanish company Tecnicas Medioambientales Teemed, S. A. owned a site for the containment and treatment of hazardous waste near the Mexican town of Hermosillo. This investment was protected under the Mexico-Spain BIT. The facility caused massive public uproar in 1997, and the public organized sit-ins to prevent trucks carrying the hazardous waste from entering the facility. (3) Local opponents challenged the site's technical viability, the lack of public participation in decisions regarding the facility, and the facility's proximity to the town. Because of the public controversy, the Mexican government refused to reissue the license for the site in November 1998, and Tecmed formally claimed that this was equivalent to expropriation and in breach of the Mexico-Spain BIT. Tecmed filed suit in the summer of 2000, and after a draining arbitration, the Spanish investor was awarded $5 million on May 2003. (4) Public pressure to act in favor of local domestic interests, at the peak of Mexico's democratic transition, impacted the Mexican government's decision to violate the international investment treaty.

Because citizens can credibly hold government leaders accountable through democratic elections, we argue there is a systematic difference in the propensity of democracies and non-democracies to pass legislation that potentially breaches investment treaties. We suggest that democracies are more likely to violate investment treaties, purposefully or not, because democratic elections pressure politicians to represent the broad interests of citizens. Therefore, we hypothesize that democratic governments will appear more likely to violate investment treaties as their time in office increases because they are more likely to pass legislation that may infringe on investment agreements.

We test our theory using data from the Investor-State Law Guide to measure perceived bilateral investment treaty violations. These public filings provide a better measure of potential treaty violations than other measures to date, including international arbitration, because they capture perceived violations that never make it to court, as well as violations that are disputed in ad hoc tribunals. (5) W e show that democracies, on average, are more likely than non-democracies to be perceived as BIT violators. In particular, we derive an explicit functional form that demonstrates that the empirical relationship is strictly driven by the delayed effect of legislation that governments pass that cumulatively increases the risk of violating investment treaties. Importantly, our findings are robust to arbitration cases that are 1) eventually filed in court and 2) filed in venues other than ICSID, such as the International Chamber of Commerce (ICC) and Stockholm Chamber of Commerce (SCC) from the Investor-State Dispute Settlement (ISDS) database. (6)

The theoretical and empirical implications of this article qualify the widely held belief that democracies are less likely to violate international obligations that they have accepted, primarily due to their defining characteristics: broad governance and credible elections. We purposefully do not, however, advocate for regime type as a primary explanation of investment treaty violations. We argue, instead, that the credibility of elections and delayed implications of policies that appeal to a broader base are important sub-components of democracy that are worth studying. We hope our theory and empirical evidence spur future work that can more precisely test the relationship between the cycle of credible elections and indirect expropriation of foreign investment.

Incentives for Democracies to Sign and Violate BITs

Signing a BIT is often interpreted as a signal to the international investment community. It is largely assumed that states are in competition to attract foreign investment, so BITs offer an opportunity for states to increase their credibility by protecting international investors from the potential policies of the state in which these investments are made through dispute settlement mechanism (DSMs). (7) Though there is mixed evidence that these treaties actually promote FDI, there is stronger evidence that states sign them with the intent to promote international investment. (8) Many investment treaties may not actually lead to foreign investment in certain industries, so governments may not have consequential opportunities to expropriate. (9)

BITs may, therefore, be thought of as a bargain between political actors and business interests. Both parties know that harmful policy to business interests may need to be passed in the future. Acknowledging this, governments are not necessarily tying their hands per se; they are agreeing to pay damages to business interests if such policies are passed. And democratic governments are likely aware of their potential to pass legislation in the future that violates trade agreements because democracies push for more carve outs in treaty obligations. (10)

It seems intuitive as to why a democracy would have the incentive to sign a BIT. Across regime types, generally, there is a strong need to attract foreign investment many reasons. The investment benefits the host economy, overall, and does so through direct investment in the country, providing employment opportunities, increasing product availability and decreasing consumer cost, etc. Maybe the most important interests these treaties benefit, however, are the elite business interests. Economic elites, in general overlapping prominently with the political elite, have a strong desire to secure their assets and attract FDI. Both are accomplished with the signing of a BIT, because these companies that are protected by the treaties are often a conglomerate of stake holders. Therefore, governments have multiple incentives to sign. BIT participation may increase FDI through the commitment to either abide or pay damages, benefitting the economy and the government directly, may appease elite interests benefitting the government in the short-term, and arguably is beneficial to the general population through increased employment opportunities, increased consumption ability, and more.

That said, even though BITs are beneficial in the short-term, there is often eventually a backlash from the citizenry. As the Mexico example above illustrates, this backlash could be due to environmental or regulatory concerns. The backlash may also be due to economic nationalism and protectionist views, anti-globalization as an attempt to secure jobs and avoid outsourcing, or other ideological concerns. These concerns are much more likely once a treaty has been passed. Most citizens do not even know what a BIT is, let alone with which countries their home country has signed, the stipulations of the agreements, the damages that need to be paid when in violation, or what constitutes a violation. It is generally once the treaty is in force, and the ramifications are realized, that the general population may take issue with the obligations. This is unlikely to vary based on regime type conditional on confounders. However, a democracy is much more likely to appease the interests of the public, and this likelihood ought to increase as the threat of credible elections near, and/or the longer the government or individual politicians are in power. (11)

The notion that democracies have greater incentives to violate BITs stands in contrast to the common assumption that democracies are inherent treaty-compliers due to greater political constraints. (12) We agree that an important reason for why democracies have traditionally been thought of as treaty compliers is that as the number of "veto players" increases, the propensity of a government to directly seize assets that violate an investment treaty should theoretically decrease. Democratic governments, however, can still violate investment agreements in different ways. For instance, Graham and Kingsley show domestic political constraints reduce the likelihood of direct expropriation, but these political restraints do not impact governments' propensity to engage in transfer restrictions of investment agreements, which are often a sub-component of BITs. (13)

In fact, the vast majority of disputes in contemporary investment litigation do not arise from the direct...