Jean Monnet Center at NYU School of Law

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A. The Basic Problem

When two parties enter into a contract in a domestic setting, we expect them to negotiate, subject to transaction costs, the most efficient possible agreement. [85] When a potential investor enters into an agreement with a host nation, however, the two will not generally arrive at the most efficient agreement.[86] The parties are unable to reach the optimal agreement because of the unusual nature of their relationship and the dual roles played by the host country. The host country is not merely one of the contracting parties, but is also able, through legislation, to establish and change the legal rules under which the investor must operate. Domestic legal structures, critical to the bargain struck between two private parties under domestic law, are no longer adequate. The central problem is that a sovereign state is not able to bind itself to a particular set of legal rules when it negotiates with a prospective investor. Regardless of the assurances given by the host prior to the investment and, importantly, regardless of the intention of the host at the time, if it later feels that the existing rules are less favorable to its interests than they could be, it can change them. It can also unilaterally change the terms of whatever agreement may have been negotiated with the investor. In a private setting there is relatively little risk that the legal rules will be changed in order to favor one party to the transaction because the government has little incentive to change the laws to suit one party to a contract. In the foreign investment context, however, the host government is a direct participant and has interests and objectives of its own that may conflict with those of the investor.

Because the host may decide to change the domestic laws to suit their own purposes, the investor cannot rely on those laws to protect his interests. The only alternative legal structure is international law.87 Unlike domestic law, the host cannot change the requirements of international law in order to suit itself. Unfortunately for both the potential investor and the potential host who wishes to reassure a potential investor, international law does not directly govern the relationship between states and firms. This is so because international law does not recognize private firms as actors on the international stage,[88] it recognizes only sovereign states. Because private firms are not recognized by international law, a contract that includes a private party is not recognized under international law. A potential investor can sign a contract with a host, but there is no remedy under customary international law if that contract is breached.

That potential hosts and investors cannot sign a binding and enforceable contract under international law explains why the debate over the protections afforded by customary international law was so important. Until the rise of BITs, there were few constraints, beyond those provided by customary law, on the behavior of host countries toward foreign investors. If the international community agreed that customary law did not require prompt, adequate, and effective compensation upon the taking of property, there would be no way for investors to achieve these protections. On the other hand, if it were accepted that the Hull Rule was international law, there would be no way for developing countries to except their own behavior from the rule -- after all, it is not possible for a country to derogate from customary law.[89]

Prior to the use of BITs, therefore, neither domestic nor international law offered potential host states the ability to bind themselves to a particular course of conduct vis-a-vis an investor. The two parties could, of course, sign a contract -- as was often done -- but that contract was recognized only at the domestic level and would, presumably, only be enforceable to the extent that the host country chose to allow it to be enforced. The investor had no legal protection against the host.

The lack of a mechanism to allow contracting between firms and states creates a dilemma that is sometimes referred to as a problem of "dynamic inconsistency." [90] Dynamic inconsistency describes situations in which a "future policy decision that forms part of an optimal plan formulated at an initial date is no longer optimal from the viewpoint of a later date, even though no new information has appeared in the meantime."[91] In other words, a plan that is optimal at one point in time will not be optimal at some later point. The problem is akin to wanting to "tie oneself to the mast" but being unable to do so. A certain strategy may be known to be the preferred one, but once it is undertaken, it will not be possible to stick to the initial plan unless some commitment mechanism has been established. [92]

B. Dynamic Inconsistency Applied to Foreign Investment

Turning to the particular problem facing foreign direct investment, one must consider how the lack of contracting options affects the incentives of a government in its dealings with a particular foreign investor. Initially, while negotiations with a firm are taking place, the government of a potential host country, by assumption, wishes to encourage the investor to invest in its country. The firm, on the other hand, would like to achieve the greatest possible return and will invest in the host country only if that country offers the greatest anticipated profit.[93] In a domestic law setting, and ignoring transaction costs, we would expect the investor to write a binding contract with the party that offered the most efficient location for its capital. The agreement would spell out the conditions on which the investment would take place and would provide for some division of the "surplus" (i.e., profit) from the investment between the investor and the host.[94] This division of surplus need not be stated explicitly, but could take the form of concessions and commitments on the part of each party. For example, the host may agree to offer certain tax advantages to the investor, it may agree to allow the repatriation of profits and it may waive certain import restrictions that are in place in the country. The firm, on the other hand, will provide benefits to the country in the form of employment, technology transfers, and so on. The firm might also agree to a set of conditions on its behavior. It might reinvest a certain percentage of profits in the business, may agree to certain labor and environmental standards, and may offer to provide some services to the community in which it is located.

In the absence of a contractual mechanism, however, it is not possible to write such a contract. This makes the investment problem much more difficult. Even if an investment is valuable enough to make it worthwhile for the country to commit to some form of concessions to benefit the investor -- favorable tax treatment, for example -- it cannot do so. The host country can do no more than make non-binding promises to the potential investor. If the investment takes place, it will be based on these promises and nothing more.

Once the firm has sunk its capital into the investment, the relationship between the parties undergoes a dramatic transformation. The host country, in particular, faces an entirely different set of incentives. It no longer needs to offer benefits sufficient to attract the investment, it only has to treat the investor well enough to keep the investment. The difference between the two time periods (before and after investment) comes about because both the host and the investor know that once the firm has made its investment, it typically cannot disinvest fully.[95] In other words, once it has invested, withdrawal would impose a cost on the firm. The host country can take advantage of this situation, and extract additional value from the firm by, for example, increasing the tax rate beyond the level that was agreed upon when the investment took place. Had the firm known that the tax rate would be higher than the agreed upon level, it may have chosen to invest elsewhere, or not to have invested at all. Once the investment is made, however, it may be cheaper for the firm to simply pay the higher tax rather than attempting to disinvest in order to reinvest in a different country.

To illustrate this point, consider the following simple numerical example. Suppose that a firm is considering investing in one of two potential host countries. Assume that the investment will cost $60 million for the initial investment and $10 million after that in order to pay for salaries, upkeep, and so on, regardless of which country is chosen.[96] In an effort to attract the investment, the potential hosts negotiate with the firm. Assume further that the firm eventually decides to invest in one of the two countries and that it has succeeded in extracting from that country a promise of a complete exemption from corporate taxes, and preferential access to power and water in the region in which it intends to build its facility. Suppose that, with these concessions, the investment is expected, to yield revenues of $100 million. The host has agreed to these terms because even without any tax revenues, and despite the disruption the investment may cause to the power and water supply, the gain in terms of employment, technology transfer, and so on makes the investment beneficial to the host. Under these assumptions, the host and the investor would be willing to sign a binding agreement committing themselves to the terms stated above. Because no such agreement is available, however, the host can change the conditions at any time. Consider the incentives of the host once the facility is built at a cost of $60 million. At this point, the firm anticipates a return of $100 million, and will have to spend only $10 million in additional expenses. Because the host is not bound by its agreement with the firm, however, it can alter the terms of their agreement unilaterally. For example, it can withdraw the promise of preferential access to water and power and it can impose a tax on the revenues of the firm. For concreteness, suppose that it imposes a tax of 40% on revenues. Rather than making $100 million in revenues, therefore, the firm may only make, say, $85 million due to the loss of access to power and water. Furthermore, 40% of this amount will be claimed by the tax authority -- making the after-tax revenue only $51 million.

Now, consider the reaction of the firm. Obviously, had it known that the host would behave in this way it never would have invested. The total cost of the investment was $70 million and it will earn only $51 million in revenues. Once the facility is built, however, we assume that the firm cannot recoup its investment by tearing it down, or even by selling it. It has two choices. It can continue with its plan to operate the facility and suffer a loss of $19 million, or it can close down the operation altogether and lose the $60 million that has already been invested. Obviously, the firm will choose to operate the facility in order to minimize its loses.

The problem is even worse than the above example suggests, however, because the host can impose any level of tax (or other mechanism to take value from the firm) it chooses. In the above example, the host can levy taxes of up to $75 million. Any tax of less than this amount will leave the firm with some return on its investment,[97] which will be preferred by the firm to a return of zero. Most importantly, the host can assess the firm's situation and select the maximum possible transfer of value that the government can demand without driving the firm out of the country altogether.

As an aside, note that changing the tax rate is not the only method through which the host can extract value. Once the investment is sunk, the host has a range of options from which to choose in order to maximize its own benefit from the investment. It can, obviously, abide by the non-binding promises it made, in which case it will receive the benefits to which it implicitly agreed when it negotiated prior to the investment. At the other extreme, it could simply expropriate the investment of the firm entirely and attempt to run the enterprise itself. Under this scenario, the country would receive the benefit of running the business itself, including all the profits it could generate, as well as the benefits that the firm had agreed to provide.

There are two categories of costs facing a country that chooses to expropriate outright. The first is that the government (or the private parties to whom the government gives or sells the enterprise) may be much less able to run the facility than was the original firm. After all, when the assets are expropriated, the managers will depart, taking a substantial amount of human capital with them. It is unlikely that the host government will be able to run the business as well as the investors who built the facility. This will impact on both the profits that the enterprise will generate (if any) and the level of spillover benefits that will be provided (employment, technology transfer, etc). A second cost is the international cost that the action will entail. The firm whose assets have been taken will undoubtedly complain to its home country, and that country may take action.[98] Indeed, if the expropriation is severe enough, even countries whose nationals have not been affected may sanction the host country. In addition, the expropriation will be noticed by other firms who, as a result, may be hesitant to invest in the future.

An intermediate course of action for the host is to attempt to squeeze more value out of the firm, while allowing the firm sufficient revenue to ensure that it does not attempt to disinvest.[99] This can be done in a wide variety of ways, including changing the tax rate, restricting the repatriation of profits, imposing new labor or local content requirements, and so on. This approach, which is sometimes called "creeping expropriation," allows the country to take advantage of the existing management and their skills, thus avoiding the major costs of an outright expropriation, while still extracting value from the enterprise.[100] Because the assets have not been seized, and because it is difficult to identify where the right of a government to set policy crosses over into unreasonable conduct, it is also much less likely that this sort of action will provoke significant sanctions by the home country of the investor. It also leaves the enterprise in the hands of the investor who will typically be the best able to run the firm. It may, therefore, be preferred to outright expropriation. It is worth noting that the attractiveness of this final option may offer a partial explanation of why outright expropriation is now uncommon, and why dispute settlement between host countries and foreign investors is a topic of some import.

The "intermediate" option of extracting value without expropriation is the most relevant for the study of current foreign investment. Outright expropriations are now very rare, but disputes between foreign investors and host countries are common. Any allegation of wrongdoing made by the investor must turn on the notion that the host has breached some part of the implicit or explicit agreement under which the firm made its initial investment.

For any irreversible investment,[101] then, the host country will be able to demand a higher payment after the investment takes place than it could have demanded prior to the moment when the capital was invested. This is so because the investor will invest only if it expects to receive revenues that are greater in present value terms than its total costs. Prior to the investment, total costs include both those costs that are irretrievable once the investment is made and all other costs. Once the investment has been made, however, the investor will not include the sunk (irretrievable) costs in its calculation because those funds are lost regardless of the decision. Once the investment is made, therefore, it is possible to extract at least up to the value of the sunk costs without making it profitable for the firm to withdraw.

When the firm and the potential host begin negotiations regarding a potential investment, the firm is, of course, aware of the dynamic inconsistency problem. As a result, it may be very hesitant to invest, and, indeed, may simply choose not to do so. The potential host country, on the other hand, wants the investment and rather than have the investor decide against investing, would be willing to bind itself in some way to behavior that will encourage the investment. Because there is no contracting mechanism available, however, the host no longer has any reason to keep its promises once the investment is made. It can extract value from the firm as discussed above.

Given the above, one may ask why there is any direct foreign investment, and why the investment that takes place is often treated very well. The reason is that the above description is based on a single investment decision. In reality, countries want to maximize their returns over longer horizons. They may resist the temptation to seize assets today in order to create or maintain a reputation for treating investment well. In this way, it is more likely that future investment will be attracted. They may also resist the temptation to extract value from the firm if they fear that sanctions will be imposed by the home country of the investor.[102] The repeated nature of the investment decision changes the incentives of the host country. It does not, however, completely remove the dynamic inconsistency problem. When the host country considers the reputational effect of its actions, it must weigh the gains from breaching its contract with the firm[103] against any lost benefits due to reduced efficiency within the firm, the cost of any sanctions by other countries and the effect of the action on its reputation. A priori, there is no reason to think that this balancing establishes an efficient set of incentives for the host. Potential investors are likely to still be wary of foreign investments because they lack the protections offered by domestic law.

The above discussion considers some of the impact of the dynamic inconsistency problem on the host country. We now consider its effect from a global perspective. In global terms, the efficient outcome is achieved if investment takes place where it will earn the greatest total return. We know that, absent transaction costs, this outcome is achieved when the parties are able to contract with one another and when a breach of contract is accompanied by expectation damages.104 There is no reason to think that the situation described above approximates this globally efficient outcome. The dynamic inconsistency problem will discourage investment that would be desirable because the firm realizes that the host will squeeze additional value from the firm after the investment is made -- causing the firm to avoid certain investments altogether. Furthermore, in cases in which the host is considering expropriation, it does not face expectation damages. Instead, it faces the combination of lost future investment, and sanctions from foreign countries. There is no reason to think that these sanctions are similar to expectation damages -- implying that the decision to breach the contract with the investor will not be made efficiently.

[85] See Ronald H. Coase, The Problem of Social Cost, 3 J.L. & ECON. 1 (1960).

[86] This discussion assumes that there is no BIT governing the investment.

87 We ignore, for present purposes, the possibility of extraterritorial application of domestic law from a country other than the host.

[88] See HENKIN, PUGH, SCHACHTER & SMIT, supra note 28, at 344 (stating that multinational corporations "are not international legal entities.").

[89] A country can, of course, be a "persistent objector," but it cannot choose to have the law apply to it in some contexts and not in others.

[90] See Finn E. Kydland & Edward C. Prescott, Rules Rather than Discretion: The Inconsistency of Optimal Plans, 85 J. POL. ECON. 473 (1977) (presenting a model of dynamic inconsistency in the optimal taxation of domestically owned capital); OLIVIER J. BLANCHARD & STANLEY FISCHER, LECTURES ON MACROECONOMICS 70-75, 592-615 (1989).

[91] BLANCHARD & FISCHER, supra note 90, at 592.

[92] Game theorists refer to dynamic consistency as a sub-game perfect equilibrium. See ANDREU MAS-COLELL, MICHAEL D. WHINSTON, & JERRY R. GREEN, MICROECONOMIC THEORY 268-282 (1995).

[93] Imagine, for example, a firm choosing to build a new production facility and seeking the lowest cost location for that facility.

[94] This is just the familiar Coase theorem -- private parties will achieve the efficient outcome by contract if there are no transaction costs. See Coase, supra note 85.

[95] By this I mean that if the firm choose to leave the country immediately after investing, it will not be able to recoup all of its investment. Indeed, it may be able to recoup only a very small fraction of its investment. This is, in part, because at least some portion of the investment (and perhaps a very large portion) is made in capital that can only be used in this one project. This can include specialized machinery, training of employees, and so on. For an empirical examination of the effect of irreversible investment on foreign direct investment, see Andrew Guzman & Aart Kraay, Uncertainty, Irreversibility, and Foreign Direct Investment (1996) (unpublished Ph.D. dissertation, Harvard University).

[96] In order to keep the example simple, all figures are stated as lump sums. They can be viewed as the discounted present value of the stream of costs and revenues that the investment faces.

[97] Our example continues to assume that the investment earns $85 million in revenues once the power and water concessions are withdrawn, and has costs of $10 million.

[98] See supra pages 11-13.

[99] This is the option presented in the numerical example above.

[100] The term "creeping expropriation" may be misleading. The government may take only a single action and may not be interested in increasing the amount of expropriation as time goes on.

[101] An investment is irreversible for our purposes if withdrawal from the investment yields less than the full value that was invested.

[102] Note that if Resolution 3201 (stating that no sanctions can be applied against a country that has carried out an expropriation), see supra pages 20, applied to actions taken by a state against a foreign investor, the costs of such actions would be reduced and the actions themselves made more attractive to host countries.

[103] Although there is no enforceable contract, as discussed above, I will hereinafter use terms such as "breach" and "contract" in order to simplify the discussion. It is important to remember, however, that there is no official enforcement mechanism.


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