Sovereign Policy Flexibility for Social Protection: Managing Regulatory Risk in IIAs

This Report focuses on the design of regulatory risk in international investment agreements (IIAs), and its counterpart treatment in investment arbitral practices. It demonstrates that the uneven conception and treatment of regulatory risk in investment arbitrations stands to threaten the basic premise of regulatory predictability in IIA design. IIAs do not intend to entrench static or hermetically sealed regulatory frameworks, but rather, are designed to enable States Parties to the IIA as well as investors (as third-party beneficiaries of the IIA), to mutually, fairly, and transparently predict and estimate the economic returns and risks of investment. Thus, while the substantive standards of protection in the IIA provide criteria for future legal assessment of host States’ conduct towards investors, they must also be seen to establish the regulatory boundaries that States Parties to the IIA deem acceptably predictable for the duration of any investment to be covered under the IIA.Part I (Regulatory Predictability in IIAs: Paradoxes over Policy Flexibility) of this Report describes the evolving substantive content and structural architecture of IIAs, and shows how various strategies have been deployed to maintain and constrain the regulatory prerogatives of a host State – from substantive standards (e.g. legality clauses, stabilization clauses, exceptions clauses, expanded definitions of investment and treaty applicability provisions, balance of payments provisions, among others), to procedural devices (e.g. dependence on jurisprudence constante in tribunal interpretations, State Parties’ joint decision mechanisms, authoritative interpretations and treaty compliance monitoring devices). As will be seen in Part I, these strategies rarely differentiate between regulatory risk in ordinary business cycles, and regulatory risk endogenous to financial or economic crises. A crystal example of the lack of differentiation may be seen from the disparate analytical treatment of regulatory risk in the issues of indirect (creeping) expropriations vis-a-vis non- compensable regulatory takings, as against the issue of 'legitimate expectations' under the fair and equitable treatment (FET) standard. As investment arbitrations have shown, it has become entirely possible for a tribunal to find that, while a host State is not liable for indirect expropriation when it imposes a regulatory change, the same regulatory change may be found to have violated investors’ 'legitimate expectations' and thus lead to a breach of the fair and equitable treatment standard, for which the host State is (often and problematically) found liable for compensation. Rather unusually, the value of compensation for these FET breach is frequently pegged at the level of the same indirect expropriation claim that the tribunal previously rejected.Part II (Managing Regulatory Risk from Social Protection Measures) proceeds to show that the estimation of regulatory risk from the design of IIAs can, and should, foreseeably include States Parties’ continuing dynamic obligations under the International Covenant on Economic Social and Cultural Rights (ICESCR). It shows, first, that the due diligence process can be revised to identify areas of host State policy flexibility that should be anticipated during the life of an investment as part of ICESCR compliance - Host States’ ICESCR compliance are now susceptible of empirical investigation and inclusion in investors’ regulatory risk assessments. Second, the ICESCR may have utility as an interpretive device read into the IIA – whether as part of the interpretation of standards of 'treatment' made obligatory upon States Parties, or within the process of valuation of compensation for breaches of non-expropriation standards of the IIA. Finally, Part II also posits that an investor’s home State which is a party both to the ICESCR as well as any given IIA, assumes counterpart duties to ensure the extraterritorial application of the ICESCR to its nationals in other jurisdictions, including a duty to ensure that such nationals do not act in ways that cause States to violate the fundamental obligation to ‘respect’, ‘protect’, or ‘fulfill’ ICESCR rights.Part III (Regulatory Risk Assessment for Diverse Investment Assets) then shows that different types or forms of investment require an appropriate analysis of the valuation method for each form. The assessment of regulatory risk for hedge funds, for example, may be tied more to generally to the assessments of a country’s macroeconomic political risk (usually based on inflation, the risk-free rate of a government security, among other variables). By contrast, it may be more appropriate to perform a regulatory regime assessment that is industry-specific for foreign direct investments (such as physical infrastructure or utilities), particularly where the regulatory process will entail inevitable impacts on ICESCR compliance. As seen in recent developments in Socially Responsible Investment (SRI) benchmarking and the UN Principles on Responsible Investment, it is not impossible to assess regulatory risk with a view to indexing the host State’s continuing social protection obligations under the ICESCR.In the Conclusion (Shedding the Myth of Static Investment Regulation in an Era of Social Protection), this Report shows that, while regulatory predictability is a key objective of IIAs, it need not exclude dynamic host State regulations so long as the latter can be transparently tracked and verified by States Parties to the IIA. The kind of regulatory risk that should be deemed rightly compensable under IIAs should be tailored more towards host State conduct that prohibitively creates moral hazards and incentivizes adverse selection (fueled by the information asymmetry that favors the host State), ultimately resulting in violations to investors’ due process rights and foreseeable contractual expectations. The fundamental task of new IIA design must enable both investors and States Parties to endogenously factor in the costs of policy uncertainty as a result of the continuing demands upon host States to comply with the ICESCR. In this sense, ‘dynamic’ host State regulations (or the degree of policy flexibility that must be maintained to ensure that a State’s social protection measures to comply with the ICESCR remain in place during the life of an investment), should not be prohibited or penalized ex ante, as compensable breaches of an IIA. Where States Parties and investors have been transparently informed at the outset of this continuing dimension of regulatory risk on the ultimate price of investment, there can be no justifiable claim to compensation.