Federalism and international investment disputes

One of the more politically controversial aspects of international investment protection treaties is the liability of a State when political sub-divisions are found to have breached that State’s treaty obligations to foreign investors.

This issue is particularly significant in federal States, such as Canada, the United States, Australia or Germany, among others, where sub-national governments exercise internal jurisdiction in many areas of economic regulation. But the issue is not confined to federal States. Regional and municipal governments in unitary States also exercise considerable power over local economic activity and can equally bring that State into conflict with its multilateral or bilateral treaty obligations.

As sub-units increasingly enter into the regulatory domain in matters such as environmental protection, consumer safety, public health, and land use, they can find themselves up against foreign investors that have treaty rights protecting those investments. These investment treaties typically give foreign investors the right to invoke binding arbitration against States for measures that fail to meet accepted international standards, or are discriminatory or where expropriation occurs without full compensation[1].

The State’s national government bears the legal responsibility toward outside investors under these treaties. However, it is the laws, regulations and policies of sub-national governments (provinces, states, regional and municipal governments) that are increasingly engaging the full responsibility of the State.

Growing international disputes

Some of these issues have been around for a while in the GATT/WTO context, where disputes were brought by member States as a result of sub-national measures that offended another State’s trade obligations. Included were GATT challenges launched against Canada’s provincial liquor board practices by the European Union and the United States in the 1980s and early 1990s[2]. While these involved provincial laws, Canada as a whole, as the GATT Contracting Party, was held to account. With the possibility of Canada’s trading partners withdrawing trade benefits, liquor board practices were brought into line by the various provinces and the offending measures were eventually corrected.

In the investment field, NAFTA panels have made it clear that the national governments of the State bear responsibility for actions of their sub-national units. This was confirmed in an early NAFTA arbitration proceeding brought by American investors against Mexico for regulatory measures enacted by a local government[3]. Currently there are ongoing NAFTA investment disputes against Canada involving measures enacted, not by the federal government, but by various Canadian provinces[4]. As well, recent NAFTA arbitrations brought by investors against the United States involved state and local, rather than national, measures[5].

The trend in these NAFTA investment disputes—as in investment agreements in other parts of the world—is increasingly about challenges over sub-national, regional and even local measures as opposed to national laws and regulations of the State concerned. As the legal embodiment of the State, national governments are bound internationally by actions of their political sub-units and are thus exposed to investor challenges against measures they had nothing to do with. It is anticipated that local measures will be an increasing source of investor-State disputes in the years ahead.

This phenomenon was brought home in Canada in 2009 when the Province of Newfoundland and Labrador expropriated the local assets of Abitibi-Bowater, a U.S. forest products company. While the expropriating measure was entirely provincial, the company launched arbitration proceedings against the federal government of Canada under NAFTA Chapter 11, alleging various breaches of investor-State obligations under the treaty. Eventually the case was settled with the Canadian government paying C$130 million in compensation to Abitibi[6].

The Province was not involved in the settlement and, so far as is known, has paid nothing. There has been no information as to whether or indeed how Ottawa will seek to recover the settlement money from the Province, notwithstanding that it was the Province’s law that led to the investor’s claim. One could fairly say that by rights the Province should be responsible for reimbursing the federal treasury.

The case illustrates the tensions between local interests and those of the State as a whole when investment disputes arise. What happens when political sub-units take actions that put national governments off-side their foreign investment obligations? How large is the exposure of national governments to investor claims in an era where increasingly widespread sub-national and local regulation—environmental, health, consumer protection, etc. —runs up against the rights of foreign investors guaranteed by the State under international investment protection agreements?

Global proliferation of foreign investment agreements

The NAFTA provisions at issue in the Abitibi-Bowater case mirrored the same kinds of obligations contained in countless bilateral investment treaties (BITs), foreign investment protection agreements (FIPAs) and international investment agreements (IIAs). Regardless of their title, the standard model ensures that foreign investors are guaranteed against unfair, inequitable or discriminatory treatment and have assurances that, when expropriation occurs, they can get full and prompt payment to compensate for the value of the expropriated assets[7].

These treaties typically contain provisions requiring national governments to take “necessary measures” to ensure sub-national compliance with treaty obligations[8]. Even where this requirement is met as an internal matter, the sub-units are not treaty parties and are not subject to the international legal obligations placed on the State at large[9].

Growing controversy

While good faith might suggest that sub-national units will normally comply with the decision of an international tribunal (for example, by withdrawing a law or regulation or bringing it into conformity with the treaty), they might not do so willingly or completely or on a timely basis. It is unclear how far that kind of disagreement might go and whether the national government might have to pursue internal legal proceedings to enforce an arbitration award. In Canada, for example, it’s doubtful if recourse to domestic courts could successfully enforce such an investment tribunal’s decision requiring changes to local laws to comply with Canada’s treaty obligations.

Similar tensions apply in the United States, where some commentators have been critical the erosion of the States’ constitutional power as foreign investors have challenged state measures that, while within their constitutional realm, are exposed to being found to be inconsistent with the bilateral and multilateral treaty obligations of the United States[10].

Some thoughts for the future

It seems reasonable to conclude that investment disputes are more and more likely to involve challenges by foreign parties to sub-national and local regulation under these bilateral and regional agreements. To better understand the extent of this phenomenon, further research on the number and types of investment arbitrations involving sub-national measures around the globe would be desirable. That would be an important first step in further understanding the nature and depth of the issue explored in this article.

Even without a firm set of empirical data, the challenge for States with or without federal systems is to be cognizant of these issues and to settle—at minimum—some kind of internal agreements or protocols whereby state, regional and local governments are held to account and accept responsibility for compliance when the State at large is found in breach of investment treaty obligations through those sub-national actions.

The problem in the Canadian and U.S. contexts, and possibly others, is that there are no internal, constitutional provisions that allow the federal government to seek reimbursement where compensation is paid to an investor but where the province or state is responsible for the impugned measure. In Canada, Ottawa cannot constitutionally turn around and bring legal action to force a province to reimburse the federal treasury for arbitration awards made against Canada for actions of that particular province.

This is a conundrum and poses a difficult issue for federal States. It merits further consideration whether it is possible to move toward some kind of direct form of engagement between foreign investors and the relevant political sub-units in these investment treaties. No doubt this raises difficult issues of State responsibility and sovereignty. Nonetheless, in light of the increasing involvement of sub-units in areas that directly affect foreign investment, this is a subject that needs exploring.

Author: Lawrence L. Herman is Counsel at the Toronto-based firm of Cassels Brock & Blackwell LLP and practices international trade and investment law.