The illegality of investments in light of market access provisions

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1 Friedrich Rosenfeld* 1. Introduction Arbitral tribunals are often confronted with the question whether illegal investments, i.e., investments which do not comply with domestic law, enjoy protection under an international investment agreement. Market access provisions in international investment agreements can be decisive in answering this question: In the pre-investment phase, they determine to what extent host States can preemptively block illegal investments (see B.). In the post-investment phase, they may be successfully invoked as a ground to challenge the jurisdiction of the International Centre for the Settlement of Investment Disputes (ICSID) concerning disputes involving illegal investments (see C.). While illegality matters in both situations, there are significant normative and factual differences between the pre-investment and the post-investment phase (see D.). 2. Pre-investment phase Market access provisions determine to what extent host States can deny market access to illegal investments in the pre-investment phase. They do so by limiting * Dr. Friedrich Rosenfeld, Hanefeld Rechtsanwälte, Hamburg, Germany. Lima Arbitration N /

2 the otherwise existing free right to regulate the access of investments which host States enjoy under customary international law Under customary international law, States enjoy a free right to deny market access to illegal investments The customary right to regulate the admission of investment is regarded as a core aspect of State sovereignty 1 and economic self-determination 2. This is reflected in various non-binding soft law documents. A prominent historical example is the Charta of Economic Rights and Duties of States. 3 Taken in the context of politically tense relations between developing and developed countries, this resolution of the UN General Assembly was intended to contribute to the establishment of a New International Economic Order. 4 It confirmed that each State has a right to regulate foreign investments in accordance with its laws and regulations. 5 A more recent and less controversial endorsement of this right can be found in the World Bank Guidelines on the Treatment of Foreign Direct Investment, which were issued in 1992 in order to promote the flow of foreign direct investments. While calling upon States to encourage foreign direct investments, these guidelines confirm that [e]ach State maintains the right to make regulations to govern the admission of private foreign investments. 6 As part of their freedom to regulate the admission of foreign direct investments, host States are entitled to deny market access to illegal investments. 1 Schrijver, Sovereignty over Natural Resources, Balancing Rights and Duties, Cambridge 2008, p. 278; J.W. Salacuse, The Law of Investment Treaties, Oxford 2009, p. 191; M. Sasson, Substantive Law in Investment Treaty Arbitration, The Unsettled Relationship between International and Municipal Law, The Hague 2010, p. 200; A. Joubin-Bret, `Admission and Establishment in the Context of Investment Protection, in: A. Reinisch, Standards of Investment Protection, Oxford 2009, p. 9 (10); I. Gomez Palacio and P. Muchlinski, `Admission and Establishment, in: P. Muchlinski, F. Ortino, C. Schreuer, The Oxford Handbook of International Investment Law, Oxford 2008, p. 227 (228); A. Falsafi, `Regional Trade and Investment Agreements: Liberalizing Investment In a Preferential Climate, 36 Syracuse J. Int l L. & Com. ( ), 43 (79). 2 A. Farmer, `Towards a Meaningful Rebirth of Economic Self-Determination: Human Rights Realization in Resource Rich Countries, 39 N.Y.U. J. Int l L & Pol y (2007), 417 (417 ff.). 3 A/RES/29/3281, Resolution adopted by the General Assembly, 3281 (XXIX). Charter of Economic Rights and Duties of States, 12 December A/RES/S-6/3201, Resolution adopted by the General Assembly, 3201 (S-VI), Declaration on the Establishment of a New International Economic Order, 1 May A/RES/29/3281, supra note 3, Art Article II (3) World Bank Guidelines on the Treatment of Foreign Direct Investment, available at: italaw.com/documents/worldbank.pdf (last visited: 10 April 2012). 196 Lima Arbitration N /2013

3 Friedrich Rosenfeld Importantly, they are not bound by any non-discrimination obligations in doing so. As has been confirmed in various decisions, customary international law contains no general prohibition of discrimination which would require host States to treat foreign investors equally. 7 The legal situation under customary international law is thus different from the one under BITs which may contain obligations to provide market access under conditions of national treatment and most-favored-nation treatment Market access provisions may limit the customary right to regulate the admission of illegal investments The customary right to deny market access to illegal investments may be limited by admission clauses that explicitly grant investors a right to market access. The right of investors to market access thus mirrors the limitation of the host State s regulatory powers to deny market access to illegal investments. As will be shown further below, the extent to which host States give up their regulatory power to the benefit of investors depends on the concrete type of admission clauses: Investment control model Admission clauses following the investment control model are rather weak and leave host States considerable discretion to deny market access to illegal investments. 10 As indicated by their name, such admission clauses distinguish themselves by confirming the wide powers of host States to control the flow of investments. The German Model BIT, for example, provides in relevant part: 7 Grand River Enterprises Six Nations v. USA, Award, 12 January 2011, para. 209; Alex Genin, Eastern Credit Limited, Inc. and A.S. Baltoil v. The Republic of Estonia, Case No. ARB/99/2, Award, 18 June 2001, para See also A. Falsafi, supra note 1, p. 79; C. Annacker, `Protection and Admission of Sovereign Investment under Investment Treaties, 10 Chinese J. Int l L. (2011), 531 (548). 8 See below, B.II. 9 For a more comprehensive classification of admission clause see United Nations Conference on Trade and Development, International Investment Agreements, Key issues, Volume I, New York and Geneva 2004, UN Doc UNCTAD/ITE/IIT/2004/10, p. 148 ff. 10 A. Joubin-Bret, supra note 1, p. 11. This model is also referred to as controlled entry model (J.W. Salacuse, supra note 1, p. 196; I. Gomez Palacio and P. Muchlinski, supra note 1, p. 240) or as post entry model (A. Newcombe and L. Paradell, Law and Practice of Investment Treaties, Standards of Treatment, Aalphen aan den Rijn et al. 2009, p. 134). Lima Arbitration N /

4 Each Contracting State shall in its territory promote as far as possible investments by investors of the other Contracting State and admit such investments in accordance with its legislation. 11 Similar clauses are contained in many other European BITs. 12 The use of formulations such as shall or as far as possible emphasizes that the obligation to promote foreign direct investments is an obligation of means which is only breached in exceptional circumstances such as deliberate attempts to discourage the flow of foreign investments. 13 This was recently confirmed by the arbitral tribunal in White Industries Australia Limited and The Republic of India, where the following market access provision was at issue: 14 Each Contracting Party shall encourage and promote favourable conditions for investors of the other Contracting Party to make investments in its territory. 15 India argued that this provision would require each of the Contracting Parties to take concrete, positive steps in the interests of investors. 16 The arbitral tribunal rejected this position. 17 In passing, it held that it was inclined to agree that the pre-establishment obligations pursuant to this provision lack sufficient content to be treated as a stand-alone, positive commitment giving rise to substantive rights. 18 A second reason why admission clauses following the investment control model give host States considerable discretion to deny market access to illegal investments is their explicit reference to the host State s domestic laws. Such renvoi to domestic law can also be found in Peruvian BITs. The BIT between Germany and Peru, for example, stipulates in relevant part: 11 Article 2 (1) German Model BIT Not all European BITs contain admission clauses following the investment control model. See for example Art. 1 (9), 2(2) and 3(1) of the Italy Nicaragua BIT. 13 A. Newcombe and L. Paradell, supra note 12, p White Industries Australia Limited (Claimant) and The Republic of India (Respondent), Final Award, UNCITRAL Arbitration in Singapore under the Agreement between the Government of Australia and the Government of the Republic of India on the Promotion and Protection of Investments, 30 November Ibid., para See para White Industries further set out that this provision would give rise to three specific obligations vis-à-vis foreign investors. See ibid. 17 See para Ibid., para Lima Arbitration N /2013

5 Friedrich Rosenfeld Cada una de las partes contratantes promoverá dentro de su territorio las inversiones de nacionales y sociedades de la otra parte contratante y las admitirá de conformidad con sus leyes y reglamentaciones. 19 Even if this market access provision does not contain hortatory formulations such as shall or as far as, it unambiguously expresses that the admission of investments is contingent upon compliance with domestic laws and regulations. In the absence of a right to market access under customary international law, such renvoi to domestic law is lawful and does not affect the supremacy of international law. 20 Host States even retain the liberty to change their domestic laws and to thereby affect the extent to which foreign investments are admitted. 21 The degree of liberalization may therefore vary over time under admission clauses following the investment control model Combined national treatment and most-favored-nation treatment model Market access provisions following the combined national treatment and mostfavored-nation treatment model 22 may contain a greater limitation of the host State s regulatory power to deny market access to illegal investments. Pursuant to this type of admission clauses, host States have to grant market access on a non-discriminatory basis. Investors have a right to those benefits that have been granted to other parties, be it nationals of the host States or other investors. 23 The US Model BIT, for example, while not containing a separate admission clause provides for national treatment 24 and most-favored-nation treatment 25 with regard to the establishment and acquisition of investments. Similar provisions can also be found in other investment agreements including the Canadian Model BIT 26 as well as the North American Free Trade Agreement (NAFTA) Art. 2 (1) del Convenio entre la República del Perú y la República Federal de Alemania sobre Promoción y Protección Recíproca de Inversiones (emphasis added). The unofficial English translation of this provision is: Each of the Contracting Parties promotes in its territory investments of nationals and corporations of the other party and admits them in accordance with its laws and regulations. 20 M. Sasson, supra note 1, p A. Joubin-Bret, supra note 1, p This model is also referred to as liberalized entry model (J.W. Salacuse, supra note 1, p. 196) or as pre-entry model (A. Newcombe and L. Paradell, supra note 12, p. 137). 23 J.W. Salacuse, supra note 1, p See article 3 US Model BIT See article 4 US Model BIT See articles 2 and 4 Canadian Model BIT. 27 See articles 1102, 1103, 1108 and 1114 NAFTA. Lima Arbitration N /

6 The investors right to market access under conditions of non-discrimination mirrors the limitation of the host States regulatory powers. As concerns illegal investments, host States are in principle only entitled to deny market access, provided that this is done on a non-discriminatory basis. This is, however, subject to the following caveats: First, market access obligations following the combined national treatment and most-favoured-nation treatment model typically provide for exceptions. 28 The US Model BIT, for example, refers to a negative list of certain activities or matters in its Annex, to which the obligations to provide national treatment and most-favored-nation do not apply. 29 In that regard, host States keep regulatory freedom to deny market access to illegal investments. Second, there are certain investment agreements, which only provide for a best effort obligation to accord investors national treatment and most-favorednation treatment. Pursuant to Article 10 Energy Charter Treaty ( ECT ), for instance, Contracting States shall only endeavor to accord investors national treatment and most-favored-nation treatment. The position of investors with regard to market access is thus rather weak and comparable to the legal situation under market access provisions following the investment control model. 30 The denial of market access to illegal investments does not constitute a violation of Art. 10 ECT. Third, there arguably exist further exceptions, where investors cannot claim market access for their illegal investments, even if similar investments of other investors have been admitted by the pertinent host State. One might imagine a situation where the host State has committed a violation of international law e.g. fundamental rules of international environmental law by granting market access to a specific investment. If, in this situation, a further investor demanded market access for a similar investment, a norm conflict would arise between the obligation to provide non-discriminatory treatment on the one hand and the prohibition to grant market access to the illegal investment on the other. The resolution of this norm conflict could lead to the result that the investor has no right to market access L. Markert, `The Crucial Question of Future Investment Treaties: Balancing Investors Rights and Regulatory Interests of Host States, European Yearbook of International Economic Law, Special Issues: International Investment Law and EU Law (2011), p. 143 (152). 29 See article 14 US Model BIT J.W. Salacuse, supra note 1, p On techniques for dealing with norm conflicts in international law see UN Doc. A/CN.4/L.682, Fragmentation of International Law: Difficulties Arising from the Diversification and Expansion of International Law, Report of the Study Group of the International Law Commission, Finalized by Martti Koskenniemi, 13 April Lima Arbitration N /2013

7 Friedrich Rosenfeld Liberalization model Market access provisions following the liberalization model may effect the greatest limitation of host States regulatory powers to deny market access to illegal investments. This type of admission clauses implies a positive commitment of the host State to grant market access to foreign investors. 32 A prominent example for an admission clause providing for sectoral liberalization is Art. XVI General Agreement on Trade in Services (GATS). This provision stipulates that in sectors where market access commitments are undertaken, WTO members shall accord services and service suppliers of any other Member treatment no less favorable than that provided for under the terms, limitations and conditions agreed in its Schedule. XVI GATS covers investments. 33 This follows from Art. I (2) (c) and Article XXVIII (d) GATS. Pursuant to Art. I (2) (c) GATS, trade in services comprises the supply of a service through the commercial presence of a service supplier of one member in the territory of any other member. Art. XXVIII (d) GATS defines a commercial presence as any type or business or professional establishment within the territory of a Member for the purpose of supplying a service. To the extent that they have undertaken specific commitments, WTO members are therefore bound to liberalize their economies with regard to services and service suppliers. Accordingly, they can be prevented from denying market access to illegal investments, unless one of the exceptions contained in the GATS justifies the denial of market access. Such exceptions are foreseen in Art. XIV GATS and Art. XIVbis GATS. 3. Post-investment phase The relevance of market access provisions does not cease once an investment has been admitted. Instead, market access provisions containing an accordance with the law clause may be successfully invoked in the post-investment phase to challenge ICSID s jurisdiction over illegal investments See T. Pollen, Legal Framework for the Admission of FDI, Utrecht 2006, p See also United Nations Conference on Trade and Development, International Investment Agreements, supra note 9, p I. Gomez Palacio and P. Muchlinski, supra note 1, p. 245 f. 34 See S. Schill, `Illegal Investments in International Treaty Arbitration, 11 No. 2 The Law and Practice of International Courts and Tribunals (2012), 281 (281 ff.). Lima Arbitration N /

8 3.1. Market provisions containing an accordance with the law clause may limit the consent to arbitrate Support for this view can be found in the decision Inceysa Vallisoletana S.L. v. Republic of El Salvador. 35 The facts underlying this case were the following: In 1999, the Spanish company Inceysa Vallisoletana S.L. ( Inceysa ) successfully participated in a public bid for contracting mechanical inspection services, which had been organized by El Salvador s Ministry for the Environment and Natural Resources ( MARN ). 36 After signing a concession contract with MARN, Inceysa acquired various properties in El Salvador. Subsequently, various problems arose among the parties, and the concession contract was not properly fulfilled. In 2003, Inceysa therefore initiated ICSID arbitration and claimed damages for an alleged contractual breach and expropriation on the part of El Salvador. 37 In defending its rights, El Salvador requested the arbitral tribunal to decline jurisdiction on the grounds that Inceysa had obtained its investment by fraud. 38 It argued that the protection under the investment treaty between Spain and El Salvador would be limited to investments made in accordance with the laws of El Salvador. 39 The arbitral tribunal endorsed this view. It held that States could limit their consent to arbitrate by various means. 40 Among others, a limitation of consent could be based on an accordance with the law clause contained in the chapter on promotion and admission. 41 Such a market access provision was contained in Art. II of the BIT between El Salvador and Spain. 42 The arbitral tribunal further established that Inceysa had committed fraud during the bidding process among others by presenting false financial information during the tender, making false representations, submitting false documents and hiding facts in violation of the applicable bidding rules. 43 It therefore came to the conclusion that the dispute would not fall within its jurisdiction. 35 Inceysa Vallisoletana S.L. v. Republic of El Salvador, ICSID Case No. ARB/03/26, Award, 2 August 2006, para Ibid., paras. 22 ff. 37 Ibid., para. 1, Ibid., para Ibid., para Ibid., para Ibid., para Ibid., para Ibid., para Lima Arbitration N /2013

9 Friedrich Rosenfeld 3.2. Conditions, under which market access provisions may limit the consent to arbitrate While other arbitral tribunals have confirmed this decision, it should not lead to the conclusion that every form of illegality may limit the consent to arbitrate under market access provisions containing an accordance with the law clause Qualified violation of domestic law Above all, arbitral tribunals have tended to decline their jurisdiction only in case of a qualified violation of domestic law. As an example, one might adduce the decision in Desert Line Projects LLC v. The Republic of Yemen. 45 Here, Yemen argued that the arbitral tribunal should decline jurisdiction on the grounds that Yemen had never accepted Claimant s investment in accordance with the applicable laws and regulations. 46 The arbitral tribunal rejected this argument. It held that references to domestic law are only intended to exclude investments made in breach of fundamental principles of the host State s law, e.g. by fraudulent misrepresentations or the dissimulation of true ownership. 47 Such qualified illegality would not have been alleged, let alone proven, by Respondent. 48 Similar considerations were put forward by the arbitral tribunal in Mr. Saba Fakes v. The Republic of Turkey when interpreting the admission clause in the Netherlands Turkey BIT. The arbitral tribunal rejected Respondent s position, pursuant to which any violation of the host State s laws would result in the illegality of the investment within the meaning of the BIT. 49 It held that [i]t would run counter to the object and purpose of investment protection treaties to deny substantive protection to those investments that would violate domestic laws that are unrelated to the very nature of investment protection See also G. Bottini, `Legality of Investments under ICSID Jurisprudence, in: M. Waibel, A. Kaushal et al. (eds), The Backlash against Investment Arbitration, p. 297 (298 ff.); S. Schill, supra note 34; U. Kriebaum, `Chapter V: Investment Arbitration Illegal Investments, in: C. Klausegger, P. Klein et al. (eds), Austrian Arbitration Yearbook (2010), 307 (318 ff). 45 Desert Line Projects LLC v. The Republic of Yemen, ICSID Case No. ARB/05/17, Award, 6 February Ibid., para. 92 f. 47 Ibid., para Ibid., para Mr. Saba Fakes v. Republic of Turkey, ICSID Case No. ARB/07/20, Award, 14 July 2010, para Ibid. Lima Arbitration N /

10 In support of its decision, the arbitral tribunal explained that a host State can take appropriate actions against unqualified violations of domestic law within the framework of its legislation. 51 The arbitral tribunal s reasoning was thus guided by a teleological interpretation of the relevant BIT Illegality at the time of admission Not only the nature, but also the timing of the illegality is important for the assessment of an arbitral tribunal s jurisdiction. Jurisprudence indicates that only the illegality at the time of admission of an investment may limit the consent to arbitrate. Support for this view can be found in the decision Aguas del Tunari, S.A. v. Republic of Bolivia. 52 Here, the arbitral tribunal explicitly noted that the reference to domestic law in the market access provision referred to the compliance with domestic law at the time of admission. In other contexts, arbitral tribunals have also confirmed that legislative changes after market access have no impact on the scope of protection under an investment agreement and hence an arbitral tribunal s jurisdiction. As an example, one might look at the decision Gustav Hamester GmbH&Co. KG v. Republic of Ghana where it was held that only the illegality at the time of initiation of the investment, as opposed to the illegality during the performance of the investment, would have an impact upon the arbitral tribunal s jurisdiction No estoppel Finally, it has to be noted that host States may be estopped from raising violations of their own law as a jurisdictional defense. This was confirmed by the arbitral tribunal in Fraport AG Frankfurt Airport Service Worldwide v. Republic of the Philippines. 54 Here, it was held that [p]rinciples of fairness should require a tribunal to hold a government estopped from raising violations of its own law as a jurisdictional defense when it knowingly overlooked them and endorsed an investment which was not in compliance with its law Ibid. 52 Aguas del Tunari, S.A. v. Republic of Bolivia, ICSID Case No. ARB/02/3, Decision on Respondent s Objections to Jurisdiction, 21 October 2005, para Gustav F W Hamester GmbH & Co KG v. Republic of Ghana, ICSID Case No. ARB/07/24, 18 June 2010, para Fraport AG Frankfurt Airport Services Worldwide v. The Republic of the Philippines, ICSID Case No. ARB/03/25, Award, 16 August Ibid., para Lima Arbitration N /2013

11 Friedrich Rosenfeld While this award was later annulled, the ruling on estoppel was confirmed in Desert Line Projects LLC v. The Republic of Yemen. 56 Depending on the individual circumstances of the given case, the positive act of admitting investments may therefore reduce the extent to which States can invoke the illegality of investments as a jurisdictional defense. 4. Comparison While illegality matters in the pre-investment as well as in the post-investment phase, there are significant normative and factual differences between the two situations Normative differences To begin with, it has been shown above that only a qualified violation of domestic law may limit the host State s consent to arbitrate in the post-investment phase. There are good reasons to argue that such restriction would not apply in the pre-investment phase: Unless stated differently in the pertinent investment treaty, every violation of domestic law should give host States a right to deny market access. This is because customary international law grants host States a free right to regulate the flow of foreign direct investments in the pre-investment phase. As a principle of international law, such customary right should not be deemed to have been tacitly dispensed by host States. 57 Among others, this has been confirmed by the ICJ in Elettronica Sicular S.p.A. (ELSI) (U.S. v. Italy) 58 as well as by various arbitral tribunals. 59 The same rationale warrants a narrow interpretation of market access provisions in the pre-investment phase. 60 A second normative difference results from the fact that host States are free to change their domestic laws in the pre-investment phase. Thereby, they can affect the extent to which foreign investments are admitted. By contrast, the 56 Desert Line Projects LLC v. The Republic of Yemen, supra note 45, para A. Falsafi, supra note 1, p Case Concerning Ellettronica Sicula S.p.A. (ELSI) (United States of America v. Italy), I.C.J. Judgement of 20 July 1989, p. 15 (42). 59 Grand River Enterprises Six Nations v. USA, Award, 12 January 2011, para. 209; The Loewen Group, Inc. and Raymond L. Loewen v. United States of America, ICSID Case No. ARB(AF)/98/3, Decision on Hearing of Respondent s Objection to Competence and Jurisdiction, 5 January 2001, para Cp. A. Falsafi, supra note 1, p. 80. Lima Arbitration N /

12 scope of protection will remain unaffected by legislative changes in the postinvestment phase. Finally, and most obviously, the principle of estoppel typically finds no application in the pre-investment phase, since the admission of the investment which marks the end of the pre-investment phase is often the first positive act of the host State. Accordingly, there is typically no basis for holding a host State to be estopped from denying market access to illegal investments Factual differences The normative differences between the pre-investment and the post-investment phase reflect the different economic interests at stake. Investors who are not granted market access due to the predicted illegality of their investment might lose transaction costs and opportunities to make profit. However, they do not risk losing their investment as such. The potential damages arising from the refusal of market access in the pre-investment phase are thus significantly lower than the potential damages that may result from a denial of protection in the postinvestment phase. 5. Conclusion Market access provisions can be decisive for the assessment whether illegal investments enjoy protection under an international investment agreement. This especially holds true for market access provisions with an accordance with the law clause. In the pre-investment phase, they determine to what extent host States can preemptively block illegal investments. In the post-investment phase, they may be successfully invoked as a ground to challenge the jurisdiction of ICSID concerning disputes involving illegal investments. Importantly, however, there are significant normative and factual differences between the pre-investment and the post-investment phase. These will have to be taken into account when assessing the illegality of investments in light of market access provisions. 206 Lima Arbitration N /2013