The World Bank was at the forefront of the globalisation movement in the 20th century and is the subject of anti-globalisation protests to this day. (Photo by Ted Aljibe/AFP via Getty Images)

In the midst of an unprecedented global health and economic crisis, Pakistan is currently fighting to avoid paying $6bn to Australian mining company Tethyan. The fine, equal to almost two-thirds of the country’s annual healthcare budget, was levied as compensation for an investment of just $220m.

In recent years, investor-state dispute settlement (ISDS) has attracted increasingly critical attention. The Tethyan case is just the latest in a series of disputes that have seen investors pitted against governments, NGOs and citizens.

Efforts to reform ISDS are ongoing at the UN, but governments have tended to hold the system’s continued existence as beyond dispute. Yet, ISDS is little more than two decades old, and its origins are in many ways contingent on a small group of individuals. Meanwhile, opponents of ISDS frequently characterise it as a coup for big business, but struggle to explain why investors themselves so rarely speak up in its favour or why it was adopted by developing countries so readily.

Recent scholarship has shed light on the origins of ISDS, why it emerged as it did, by whose hands and in whose interests. Answering these questions is essential to understanding the legal architecture of FDI today – and its future.

The origins of investor protection

For as long as investors have sought out opportunities abroad, their governments have followed them.

Originally, the most effective means of protecting foreign investors was simply to make them no longer foreign. Where feasible, invasion, occupation and annexation were used to ensure that investors venturing abroad received the same treatment, under the same laws, as they did at home. In some cases, as in the US or Russian frontiers, this meant incorporation within the metropolitan state. In others, as in British India or Dutch Indonesia, it meant colonial rule.

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Annexation and colonisation, however, were often impractical. Between European states, a network of treaties was established that gave host states autonomy to set the rules governing foreign investors, so long as these rules were enforced fairly.

Beyond Europe’s shores, however, investors had little faith that governments could be relied upon. Where military conquest was impractical or unnecessary, European powers turned to informal imperialism.

In these corners of the globe, investment treaties replaced not gunboats, which remained ever-present, but governors’ mansions. This was the form that British rule took in China, for instance, where forced treaties granted British investors the right to be governed under English law.

The US, however, was the true pioneer of treaty-based imperialism – a result of its complex and contradictory relationship to race.

At the same time that European investors were pouring into the US, American capital poured into Latin America. As in Europe, US elites did not trust these largely non-white, ‘uncivilised’ territories to maintain a favourable investment climate if left to their own devices. Unlike in Europe, however, the spirit of the US’s post-Civil War constitutional settlement prohibited annexing territory without granting suffrage to its citizens – rendering any European-style formal empire unfeasible.

One solution was to fully incorporate these territories into ‘the Union’. This was the strategy of US sugar planters in the Kingdom of Hawai’i, who engineered a coup d’etat in 1893 and eagerly applied for annexation. Still steeped in racism, however, the US government was deeply uneasy about admitting a largely non-white state into the Union. It took more than four years of increasingly agitated string-pulling by the sugar planters for Hawai’i to be annexed.

Even when the US did acquire classic colonial possessions, it found itself unable to exploit them due to fears that they would eventually have to be absorbed as a state. When the US took over the Philippines in 1898, Congress moved swiftly to prevent foreign direct investment (FDI) flows into the archipelago so as to prevent the formation of a ‘Filipino lobby’ that would push for annexation.

As a result, the US extended its preferred principles of property rights not through direct colonial rule, but through treaties and diplomacy – with the threat of force always lurking in the background. In typical American fashion, the old doctrine of extraterritorial jurisdiction was rearticulated as one of universal principles. In this framing, the US was not extending its own law into these countries but bringing them up to civilised standards.

This found concrete expression in US foreign policy from 1905, when a civil war in the Dominican Republic threatened the interests of American sugar planters, bankers and bondholders. At the invitation of the incumbent regime, the US crushed the revolt.

In doing so, President Theodore Roosevelt issued a general guarantee of protection for US investors in the country, promising that “chronic wrongdoing” would be met with the force of the US’s “international police power”. This guarantee did its work, and American investors flooded into the area.

The great unsettling

No sooner had the new system asserted itself than it began to crumble under the weight of historic events.

Intra-European FDI had flourished during the ‘Century of Peace’ which followed the Napoleonic wars. When the spell was broken in 1914, investors were shocked to find that European states’ respect for international property rights was merely an artefact of a gentler time.

Worse still, the First World War had fanned the flames of revolutions across the global periphery. From 1917 to 1921, revolution swept through the Russian Empire, China, Ireland, Mexico, Spain, Egypt and Malta, while Soviet republics were declared in Slovakia, Hungary, Iran, Mongolia, Germany and even the Irish town of Limerick.

The seeds of revolt had been planted decades earlier in the US’s informal empire. Having fought hard to win their independence from Spain, Latin Americans were loath to sacrifice it in the interests of American capital. In 1868, Argentine jurist Carlos Calvo challenged the US’s notion that there existed a universal minimum standard of property rights, asserting instead the right of states to set their own laws and to resolve disputes in domestic courts.

In the 1920s and 1930s, revolutionary governments in Russia, Mexico and elsewhere began invoking Calvo’s legal doctrine to justify their programmes of mass nationalisation – much to the chagrin of the impotent League of Nations.

Following the Second World War, the US set about constructing a new global architecture for capitalism. At the centre of this framework were to be three institutions: the International Monetary Fund, the World Bank and the International Trade Organisation (ITO).

As well as governing world trade, the ITO would have established international standards for investor protection. Capital-importing states recognised this as an assault on the Calvo doctrine, however, and successfully watered down the protections to such an extent that US investors turned from the ITO’s main backers into its most fervent opponents. The plan was quietly shelved.

Friendship, commerce and coups d’etat

Although they would have preferred the ITO to pass in its original form, US investors were not hugely disadvantaged by its failure. Their newly hegemonic home state was able to reliably enforce their rights around the world through the threat of sanctions and, where necessary, coups d’etat.

This system was highly successful, researcher Noel Maurer has found, winning at least market-value compensation in the vast majority of natural resource disputes. In other sectors, where fair market rates are more difficult to gauge, State Department records show that the majority of investors were satisfied with the compensation they received.

That is not to say that the system was ideal. The US government was frequently caught between the demands of investors and Cold War geo-strategy.

When Indonesian President Sukarno nationalised US assets, President Lyndon B Johnson pleaded with Congress to allow aid flows to continue, saying: “If we cut off all assistance, Sukarno will probably turn to the Russians.” Congress insisted on cutting off all assistance and Sukarno, as predicted, turned to the Russians. Correcting this strategic miscalculation required a US-backed coup, followed by the US-abetted genocide of at least half-a-million Indonesians.

In Cuba there was to be no second chance. After toppling the US-backed Fulgencio Batista regime and nationalising US assets, Fidel Castro nonetheless expressed interest in an alliance. Lobbying by furious investors, however, made this politically impossible for US President Dwight Eisenhower. Castro was rebuffed and turned, permanently, towards the USSR.

In both cases, it was in the interests of all involved to avoid full-on conflict. Lauge Poulsen, co-author of The Political Economy of the Investment Treaty Regime, likens investment disputes in this era to a game of chicken. Set on a course of mutual disaster, both countries may nonetheless refuse to blink if they believe that the other may do so first.

The problem in games of chicken is one of imperfect information – uncertainty about one another’s level of commitment. In terms of investment disputes, what this required was a set of mutually agreed principles by which to judge the merit of an investor’s claim in each case, principles which could serve as focal points in diplomatic negotiations.

In the immediate post-war years, the US sought to achieve just this through a network of Friendship, Commerce and Navigation (FCN) treaties. Lacking any means of enforcement, these FCNs served purely to grease the wheels of good-faith negotiations.

The New International Economic Order

The US FCN programme soon stalled, but the unsettling of international investment law continued apace. 

As countries won political freedom, they generally found themselves lacking any real economic independence. Most gallingly, their colonial masters had frequently signed away their natural resources on ludicrously generous terms. These newly independent states were in no mind, or position, to pay compensation for the nationalisation of these plundered assets. Instead, they began to expropriate foreign assets in record numbers.

The issue reached a climax in 1974 when, riding high on the back of inflated commodity prices, developing states teamed up in the UN to propose the Calvoist New International Economic Order (NIEO). Among other things, the NIEO asserted states’ right to expropriate foreign assets, to pay compensation according to domestic laws and to arbitrate disputes in domestic courts.

Thanks to the diplomatic and military power of their government, US investors continued to receive full compensation in practically all cases of expropriation. However, in Europe, the NIEO produced a sense of crisis.

The response of Western jurists was a particular source of concern. “Some influential international lawyers in the West thought that full compensation was not applicable in the case of Russia,” says Nicholás Perrone, author of Investment Treaties and the Legal Imagination.

“During the interwar period, they argued that international law could not have rules that could prevent a country from choosing its own economic system. One of the things that investors in the 1960s feared the most was that they could apply that same doctrine to the post-colonial moment.”

Since at least the Suez debacle of 1956, French and British investors had become increasingly aware of their governments’ inability to reliably defend their assets from expropriation. The NIEO seemed like their worst nightmare come to life.

German investors, however, had had more foresight. By the end of the Second World War, they had lost almost all their overseas assets to seizure by the Allied powers. Militarily and diplomatically neutered, the German government was incapable of wresting them back. 

Keen to reassure its wary investors, West Germany instituted a government-backed expropriation insurance scheme, backed up by a network of bilateral investment treaties (BITs) – similar in form to the US’s FCNs. The declaration of the NIEO led directly to the UK’s adoption of the BIT and the acceleration of France’s nascent programme.

Enter Hermann Josef Abs

There was another view of what investment treaties could be, a view that would come to exert a powerful hold over the development of international investment law.

Instead of serving as coordination devices for informal diplomatic negotiations, this view held that investment treaties could serve as contracts between investors and their host government, signed on the investor’s behalf by their home state. Such treaties would not just be warm words, but would give investors the ability to sue states that violated their commitments.

The way the consultations on ICSID were organised in the 1960s suggests that the World Bank was very, very aware of the potential that these countries, if they actually deliberated at this convention, were unlikely to sign it. Taylor St John, author

This system, ISDS, emerged from the halls not of Congress or Whitehall but the International Chamber of Commerce (ICC) in Vienna. Some investors had signed contracts with states that allowed for ISDS, and through the interwar years the ICC arbitrated many such disputes. Yet, the ICC found that there was no way of forcing states to pay their fines, and that the number of investors with such contracts was anyway limited.

In 1947, the ICC proposed a charter that would effectively extend ISDS to all investors while also making arbitrators’ decisions truly enforceable. The plan failed, but the ICC did manage to get its enforcement mechanism passed by the UN, in 1958, as the New York Convention.

ISDS decisions were now enforceable, but the number of investors covered by the system remained small – limited just to those who had signed contracts allowing for it, or were covered by domestic laws. There was also no standard for how arbitrations were to be conducted, or what rules states would have to abide by.

The baton was picked up by Hermann Josef Abs, a prominent West German banker and industrialist. As a director of Deutsche Bank during the war, Abs had helped to oversee the expropriation of Europe’s Jews; as a director of poison gas manufacturer IG Farben he had had no small culpability in their extermination.

Abs, however, was outraged by a different crime – the wartime seizure of Germany’s foreign assets. In response, Abs set about reworking the ICC’s 1947 proposal into what he called a “Magna Carta for capitalism”. In 1957, Abs toured Europe and North America advocating his plan as a solution to the growing insubordination in the Global South, later teaming up with Shell’s Sir Hartley Shawcross.

The proposal was ambitious. Like the US’s FCN treaties, its definition of expropriation included “indirect expropriation”: excessively burdensome regulation or taxation that fell short of actual seizure. One contemporary critic noted: “It is difficult to determine where indirect deprivation of property ends and, for instance, taxation, planning legislation or property law reform begins.” 

Unlike either the US or European treaties, however, the Abs-Shawcross proposal would be enforced through ISDS: investors would be able to sue states at an international tribunal.

How the World Bank squared the circle

Abs took the proposal to the European Economic Community (EEC), suggesting that the group could withhold aid from countries that refuse to sign up. The EEC, however, was not interested in taking up such a controversial proposal, which one contemporary pointedly described as “a statement of banker’s terms sought to be elevated to the dignity of law”. 

A watered-down version was put forward by the OECD in 1962, but this succumbed to opposition from capital importers Greece and Turkey.

The dream appeared to be going nowhere. For the plan to work, it needed the support of capital-importing states in the Global South. For this, the OECD turned to the World Bank. 

The World Bank adopted the strategy the ICC had taken a decade earlier – it stripped the proposal of its most controversial elements, the minimum standards against which states would be held, leaving only a set of rules governing the procedure of arbitration, setting up the International Centre for the Settlement of Investment Disputes (ICSID) in 1965 as a venue for this purpose. Yet, even winning consent for ICSID would require tact.

“The way the consultations on ICSID were organised in the 1960s suggests that the World Bank was very, very aware of the potential that these countries, if they actually deliberated at this convention, were unlikely to sign it,” says Taylor St John, author of The Rise of Investor-State Arbitration.

“There were four regional conferences, but the World Bank claimed it couldn’t circulate records between these conferences because that would be ‘too expensive’. So you have, for instance, an Argentine official making what could be persuasive arguments against ICSID, and Indian and Nigerian officials saying very similar things – but these three officials did not get to hear each other, so they could not form a united opposition.”

The strategy was an overwhelming success. Of the 30 founding members of ICSID, just nine were from high-income countries – with 17 being from Africa alone.

Contemporary observers were impressed, noting that the World Bank had managed to “commit the governments of capital-importing states, without unduly rousing their susceptibilities as sovereign and equal members of the UN. They have come as near as is possible to the point of squaring this particular circle”.

The rise of ISDS

For the system to become fully operational, however, states still needed to bind themselves to substantive obligations. The strategic innovation of the World Bank was to leave this stage to bilateral negotiations between states, avoiding the united resistance of the capital importers.

The German and Swiss governments were aware of this strategy as early as 1962, and Swiss industry groups by 1966. Yet, these two pioneers of BITs chose not to include ISDS in their treaties. Instead, they pursued BITs that operated in a similar way to the US FCNs: as focal points for diplomatic negotiations, rather than legally enforceable commitments.

Germany feared that ISDS would remove its discretion over whether to pursue claims and thus “turn every case of expropriation into an international litigation with political relevance”. This was exactly the problem that frustrated US State Department officials in 1974, when several US aluminium investors launched contract-based ICSID disputes against Jamaica – a close ally, but one at risk of being pushed into the Soviet orbit.

It may have been lobbying by World Bank officials, and particularly ICSID secretary-general Aron Broches, that overcame European opposition. Early adoption of ICSID arbitration in European BITs closely followed Broches’s lobbying tour of the continent’s capitals, and the clauses these governments inserted into their treaties were almost identical to those model clauses that Broches carried with him.

Broches’s influence stemmed not only from his close working relationships with European governments, but from his role as a World Bank official – a role that gave him credibility in the developing world. British BIT negotiators noted that, if negotiating partners seemed hesitant about the ICSID clause, it could be useful to mention that Broches had approved its wording.

States that adopted ISDS in this era generally saw it as a technical innovation and a complement to interstate bargaining – not the emergence of a new, litigation-based system. Indeed, the adoption of ISDS in BITs from 1968 had practically no immediate effect: it took until 1987 for ICSID to hear its first treaty-based dispute.

This may be why there is precious little evidence that investors were heavily involved in either the creation of ICSID or lobbying for the use of ISDS in BITs. The only evidence of corporate lobbying is largely fragmentary and circumstantial. Yet, absence of evidence is not evidence of absence.

“One of the things that I have confronted is how we interpret silence,” says St John. “Does it mean that they weren’t active, or does it mean that we haven’t found the places where they might have been having conversations and really trying to be active?”

In a book released in February, Nicholás Perrone pieces together these fragments, arguing that they do add up to show sustained interest in the system from investors – at least those with links to the extractive sector.

The 1990s and the big bang

By the 1990s, everything would change. Not only would ISDS fan out across the globe, but it would take on a new meaning – one much closer to that intended by Abs, Shawcross and the ICC.

Just as the 1970s boom in commodity prices had empowered the Global South to imagine and demand a New International Economic Order, so the collapse and debt crisis of the 1980s shifted the ground from underneath their feet. Moreover, with the collapse of the USSR many of those developing countries that had championed the NIEO suddenly lost a key source of aid, trade and diplomatic protection.

Together and separately, these two historic shifts produced, in country after country, governments eager to enter into the US orbit and to attract foreign investment. Taken by surprise at its sudden victory in both the East and the South, the US sought to lock in the reforms being pursued by these governments by repurposing its BIT programme – finally taking full advantage of ISDS.

For a number of reasons, the availability of ISDS in investment treaties is unlikely to factor into most firms’ decision-making about where to locate factories or mines or other physical assets. Taylor St John

Rather than serving as informal focal points for diplomatic negotiation, with ISDS as a minor technical addition, these treaties would primarily serve as instruments to legally bind states into certain policies.

In Poland, the US rushed to sign a BIT with reform-minded Communist general Wojciech Jaruzelski, locking in his liberalisation agenda before the country’s elections could take place – elections that seemed likely to transfer power to the trade union Solidarność, an unknown quantity in Washington.

In Argentina, the debt crisis had produced a hyperinflationary spiral to which the government responded with a slate of pro-investor reforms, including mass privatisation and the pegging of the peso to the dollar. The US offered President Carlos Menem a BIT, which would serve domestically as a tangible sign of success, in exchange for signing up to ISDS – disavowing the Calvo doctrine once and for all, while also locking his reforms into international law. After much to-ing and fro-ing, Menem agreed.

Smaller developing states were undergoing similar reorientations, seeking rapprochement with the West in exchange for finance and investment. Bilateral investment treaties were seen as one way of signalling their new loyalties and, crucially, attracting inward FDI. 

The sudden surge in demand for Western investment made these countries keenly aware that they were in competition with one another, setting off an explosion of BITs – and a rapid extension of ISDS across the globe.

In his interviews with developing country negotiators, Lauge Poulsen found that investment promotion was the overwhelming reason for their desire to commit themselves to ISDS. Signing a BIT was seen as a credible guarantee to foreign investors that they would not be expropriated, which would both lower the risk to them directly and reduce the price of investment insurance.

This belief in the investment-promoting power of the BIT was encouraged above all by the World Bank, despite the absence of evidence to support it. In 1990, the World Bank surveyed Western investors to gauge the importance of ISDS in their decision-making, but found that only “professional advisors, such as accountants or merchant bankers, would be people to concern themselves with such minutia”.

The British government also privately acknowledged that it was “‘probably unrealistic to expect an individual investor to be greatly concerned about [ISDS]”, but in public proclaimed that ISDS would “encourage further substantial investment in the Third World”.

Recent empirical studies have confirmed that, as the World Bank’s early surveys suggested, ISDS has practically no impact on investor decision-making. One reason for this is that the exorbitant cost, both reputational and financial, of launching an ISDS dispute limits its appeal to all but the largest companies. Those with more than $1bn in annual revenue and individuals with more than $100m in personal wealth have received 94% of all ISDS compensation.

“Certainly, there are firms that have used the system quite successfully, but, for a number of reasons, the availability of ISDS in investment treaties is unlikely to factor into most firms’ decision-making about where to locate factories or mines or other physical assets,” says St John.

The globalisation backlash

In 1995, with the BIT frenzy at its height, commercial lawyers began to take notice. “Explorers have set out to discover a new territory for international arbitration,” wrote arbitrator Jan Paulsson. “They have already landed on a few islands, and they have prepared maps showing a vast continent beyond.”

Paulsson noted that BITs had quietly extended ISDS to a vast number of foreign investors, frequently coupled with an expansive, US-style definition of “expropriation”. These two trends, Paulsson wrote, “could thus greatly expand the scope of arbitrable disputes”.

A trickle of lawsuits quickly became a flood. Across the Global South, governments began to feel the bite of treaties whose enforceability they had severely underestimated. Governments in the Global North, meanwhile, had not expected to be sued themselves – least of all over benign environmental or health legislation.

Canada soon found itself sued over its ban on a toxic gasoline additive, while Germany was sued over restrictions on coal-fired power plants and Australia over its requirement for plain packaging on cigarettes. Canada and Germany both settled the cases and backtracked on their regulations, while Australia won – at a cost of almost $24m in unrecoverable legal fees.

Experts have since voiced fears that the coming years may see countries sued for actions taken to control the Covid-19 pandemic, or to support the transition to clean energy.

In his 1995 article, Paulsson noted that the emerging system was fragile, passing as it had largely under the radar of governments and their citizens. He wrote: “Future prospects for this development in international arbitration may depend on whether national governments – many of whom may not have appreciated the full implications of the new treaty obligations discussed in this article – take fright and reverse their tracks. 

“That may in turn depend on the degree of sophistication shown by arbitrators when called upon to pass judgement on governmental actions. Arbitration without privity is a delicate mechanism. A single incident of an adventurist arbitrator going beyond the proper scope of his jurisdiction in a sensitive case may be sufficient to generate a backlash.”

Backlash there was. Ecuador, Bolivia and Venezuela have withdrawn from ICSID, while countries including South Africa, Indonesia and India have unilaterally terminated many of their BITs. 

Yet, each backlash has fallen short of a total renunciation of ISDS. Although Bolivia, Ecuador and Venezuela all withdrew from ICSID, they remain party to other arbitration fora that have sprung up in the decades since 1965, and have yet to denounce the New York Convention. While South Africa, Indonesia and others have terminated many of their BITs, they remain bound into ISDS through other means – domestic laws, contracts and trade agreements.

“These officials are facing two audiences,” says St John. “On the one hand, for their domestic audience they want to say things that will help them get re-elected or assuage public anger. On the other, with various international constituencies they are probably facing a variety of other pressures and may not want to do anything that might damage their reputation.”

Multilateral reform efforts are currently under way at the UN, but the discussions are tending towards either procedural tinkering or, the EU’s preference, the creation of a permanent, multilateral court

The loudest voice in the negotiations appears not to be investors, but the community of commercial lawyers that has sprung up around the system and whose livelihood depends on its continued existence.

Groups representing ISDS practitioners have made up the majority of non-governmental attendees at every session of the UN’s ISDS reform group. The latest session, concluding in February, was attended by 42 practitioner groups, compared with just six business lobby groups and a single representative of the international trade union movement.

If the EU gets its way, ISDS may evolve into a more rational system – potentially even one that benefits more than a small minority of investors. Yet, it would also represent a further step towards the fulfilment of a dream which, at its inception, was dismissed as a “statement of banker’s terms sought to be elevated to the dignity of law”.