Jean Monnet Center at NYU School of Law

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As discussed in Part III, the behavior of developing states presents an apparent inconsistency. On the one hand, they have repeatedly sought to establish a norm that leaves significant power in the hands of the sovereign state in its relations with investors, makes it impossible for states to enter into binding contracts with foreign investors and, therefore, leaves the dynamic inconsistency problem unresolved. On the other hand, developing countries have willingly and, indeed, enthusiastically, signed BITs with developed countries. These bilateral treaties effectively undermine precisely the independence and control that the countries have fought hard to protect. In this section, we will consider and reject the possibility that developing countries have simply changed their views on the subject or that they use customary international law as a bargaining chip to extract more in the negotiation of BITs. We will then consider another possibility -- that LDCs face a prisoner's dilemma in which it is optimal for them, as a group, to reject the Hull Rule, but in which each individual LDC is better off "cheating" and agreeing to prompt, adequate, and effective repayment. Indeed, it will be argued that each individual LDC is motivated to accept conditions that offer investors much more protection than does the Hull Rule.

A. Have Developing Countries Changed Their Position?

One possible explanation of the behavior of LDCs is that they have come to conclude that they will be better off if they allow themselves to be bound through a contractual mechanism with investors. These countries may have simply come to conclude that the dynamic inconsistency problem is sufficiently severe that the loss of sovereignty implicit in BITs is worthwhile in order to capture the benefits of foreign investment.

This theory is unsatisfactory for at least two reasons. First, the existence of BITs has overlapped considerably with efforts of LDCs to discredit the Hull Rule. The first BIT was signed in 1959, when West Germany established a treaty with Pakistan.[105] By the mid-1970s, West Germany had concluded over forty bilateral investment treaties.[106] The major efforts to undermine the Hull Rule at the multilateral level took place during the 1960s and 1970s.[107] In other words, during the very period when the General Assembly was voting in support of the sovereignty approach,[108] large numbers of developing countries were prepared to sign bilateral treaties, and many of them had already signed such treaties. If developing countries had changed their views on the value of commitment mechanisms and binding agreements, we would expect BITs to appear only sometime after the General Assembly voted 109 to 1 in favor of the 1973 Resolution on Permanent Sovereignty over Natural Resources,[109] and after the adoption of the New International Economic Order and the Charter of Economic Rights and Duties. Nor can it be argued that the countries signing BITs and those fighting against the Hull Rule are different subsets of countries. Both the movement against the Hull Rule and the BIT movement have included a majority of developing countries.

Furthermore, had developing countries decided, as a group, that it served their interest to provide greater protections for foreign investors, they could have adopted additional General Assembly Resolutions or signed multilateral agreements to that effect. They have done neither.

B. Other possibilities

Before presenting what I believe to be the most promising explanation for the paradoxical behavior of developing countries, two other possible explanations are considered.

Consider first the view of Sornarajah, who argues that developing countries, after successfully tearing down the Hull Rule, adopted BITs in reaction to the confused status of foreign investment and the uncertain protections afforded to it by international law. "[K]nowing the confused state of the law, [countries] entered into such treaties so that they could clarify the rules that they would apply in case of any disputes which may arise between them."[110] Put another way, although a developing "state subscribes to a particular norm of international law, it is prepared to treat the nationals of a state with which it has entered into a bilateral treaty in accordance with the norm which has been agreed to in the treaty."[111] Sornarajah views BITs as acceptable because they are the product of negotiations and because they serve to clarify the rules governing international investments. Implicit is the consent-based argument is the presumption that consensual agreements make it likely that the developing state will do better than it would under the Hull Rule.

The claim that the treaties are better than the Hull Rule because they are the product of negotiations and based on consent is unsatisfactory. Even if we leave aside the fact that it is more appropriate to focus on outcomes than on procedures, BITs hardly qualify as paradigmatic examples of negotiations between equally well positioned parties. Negotiations typically begin with a model treaty, prepared by the developed country, which leaves room for only minor changes on a case-by-case basis. Furthermore, although the notion of treaty by consent may seem inherently better than rules imposed against the will of developing countries, it appears that BITs actually provide more protection to investment than international law ever has.[112] In addition, by allowing binding and enforceable contracting between a host government and an investor, BITs give potential investors the ability to use their significant bargaining power prior to investment in order to extract value from the potential host. Finally, with respect to the claim that BITs bring desirable clarity to investment regulation, it is difficult to understand why LDCs would undermine the Hull Rule -- which provided a clear rule regarding the protection of foreign investment -- only to adopt BITs in order avoid the legal ambiguity generated by the demise of the Hull Rule.

Rudolf Dozer advances a slightly different explanation. He claims that developing countries are prepared to accept the Hull Rule in the context of BITs because of the "special benefits that developing countries enjoy under such treaties."[113] This view, like Sornarajah's, is difficult to reconcile with the content of most bilateral treaties. There is little in such treaties that inures to the benefit of the host countries.

C. A Strategic Analysis of LDC Behavior

LDC behavior can best be understood through a strategic analysis of the incentives facing developing countries individually and as a group. In order to explain the apparent paradox of the struggle against the Hull Rule as customary international law and the simultaneous embracing of BITs that mandate even stricter investment protections, one must realize that developing countries have different interests when they behave as a group than they do when they behave individually. In other words, the decision of individual countries to sign bilateral agreements is not a sign that these agreements are in the interest of LDCs as a group. In order to demonstrate why this is so, this section compares the effect of a regime governed by a network of BITs and one governed by the Charter of Economic Rights and Duties. It first considers the efficiency implications of each regime, and then examines the impact of each regime on the distribution of the gains from investment.

1. Efficiency considerations

a) BITs

Under most BIT arrangements, contracts between investors and host countries are binding on the later at the international level. Failure to respect the terms of the agreement is a violation of the bilateral investment treaty and, as such, a violation of international law. If such a violation occurs, the treaty gives the investor the right to pursue a remedy through arbitration by an international tribunal.[114] Assuming that the international tribunal grants relief similar to that which would be granted by a court in a domestic dispute (recall the BIT typically requires prompt, adequate and effective compensation for any "expropriation" which, because of the broad definition of investment, includes the breach of the terms of an agreement), the BIT regime will generate an incentive scheme that is reasonably efficient.[115]

More important than the measurement of damages, however, is the fact that the BIT framework, by providing a binding contractual mechanism, allows the parties to avoid the dynamic inconsistency problem. Because the investor has access to an impartial dispute settlement mechanism that is capable of ensuring compliance by the host, the investor can be confident that any agreement made by the host will be honored. In essence, the treaty establishes a framework that resembles a domestic legal system -- contracting is possible and contracts will be upheld and enforced by a court. As a result, the cost of investing is reduced, and investment in developing countries is more attractive. As a result, BITs provide an efficient regulatory scheme for foreign direct investment decisions.

Consider the incentives facing an individual developing country. Assume, for the moment, that the market for the resources of that countries (raw materials, labor, governmental regulations, location, and so on) is characterized by many sellers and many buyers of the resources. In such a market, the demand for the "goods and services" of a particular LDC will be highly elastic -- meaning that a small reduction in price will lead to a very large increase in demand. In the investment context, this implies that a country can, by credibly offering more favorable conditions to potential investors, attract a large increase in investment. In the context of foreign investment, the change in "price" comes about through a reduction in the conditions imposed on the investor. Fewer such conditions reduce the cost of investing. From the perspective of the individual country, this change in "price" will lead to a net gain because the increase in investment will more than make up for the slightly lower level of benefits the country receives from each dollar invested. For an individual country this is a desirable outcome. A single country, therefore, will find it worthwhile to make the conditions on which it allows foreign investment more favorable to the foreign investor.

Without a BIT, however, the country cannot make credible promises to potential investors. A country's desire to attract investment, therefore, will cause it to negotiate and sign BITs. Specifically, an individual country will find it advantageous to adopt a BIT if the treaty allows it to commit itself to honor agreements made with investors. An individual country will, therefore, be eager to sign BITs.

Based on analyses similar to the above discussion, many commentators have concluded that a regime which allows developing countries to contract with investors is preferred to the sort of regime advocated by developing countries in their United Nations Resolutions. The general thrust of the argument is that a contracting regime increases the number of efficient investments, which in turn leads to greater global wealth and, therefore, is the preferred regime. Furthermore, many commentators argue that a contracting regime is also in the interest of developing states because it allows them to offer incentives that will increase investment and well-being in their countries. It is also suggested that, under a regime of binding contractual agreements between hosts and investors, a developing country that does not want to be bound by a negotiated agreement can simply choose not to make such a commitment. The requirement of consent, the argument goes, ensures that LDCs will be better off.

b) The Charter of Economic Rights and Duties

Under the rules of the Charter of Economic Rights and Duties, on the other hand, some degree of inefficiency is introduced. Recall that under the Charter, the security of an investment would be dependent on the goodwill of the host state. Investment would not enjoy any protections against actions by the host, except the discipline provided by the market for foreign investment.[116] While these reputational concerns may provide non-trivial protection in many cases, investors would still have cause to be concerned about expropriation and other, less dramatic, actions by the host state. That is, the investor would face a dynamic inconsistency problem, as discussed in Section V.

The host, of course, would share the costs of the dynamic inconsistency problem. A developing country would not be able to commit itself credibly to respect agreements with investors and would, therefore, have a reduced ability to negotiate with prospective investors in order to attract investment. This will drive up the cost of investment and cause profitable investments that both the host and the investor wish to undertake to be foregone because they are not rendered unprofitable by the dynamic inconsistency problem. This is an inefficient result.

As discussed above, therefore, an individual LDC will be in favor of signing a BIT which allows it to make a credible commitment to a potential investor. Because, for an individual country, investment is sensitive to the cost of investing, the country can expect benefit from an increase in investment that exceed the costs imposed by the fact that the country can now bind itself to conditions that favor investors.

This paper does not dispute the fact that global wealth will be maximized under a contracting regime. It does, however, challenge the notion that developing countries will be better off under such a regime. By allowing firms and investors to contract with one another, we are not only encouraging efficient projects to take place, we are also affecting the distribution of the benefits from those projects. Although a regime, like the BIT regime, that allows for binding contracts will maximize global wealth and provide the most efficient investment regulation scheme, an efficiency analysis, by itself, is insufficient to conclude that BITs are preferred over a regime with fewer protections for investors.

2. Distributional Considerations

a) The BIT Regime

The previous section points out that by allowing contracting prior to the investment, we achieve the efficient outcome. This is so because as countries compete for investment, the country that offers the firm the greatest return on its investment will be able to attract the investment. Thus the capital will find itself in the country in which it can earn the largest return - which is the efficient outcome.

Although the BIT regime leads to a larger global gain than the Charter regime, it is likely to offer developing countries, as a group, a lower level of welfare. For the host county, the competition to attract investment - competition that is possible because BITS allow the host to make binding commitments -- is welfare reducing. Imagine two or more countries competing to attract a potential investor. Each country will make concessions to the potential investor, and is able to do so through a BIT. A country whose offer is insufficient to attract the investment has an incentive to increase the concessions it offers as long as the benefits of the investment for the country exceed the costs of attracting it. The result, therefore, is a bidding up of the concessions made to the investor. Ultimately, if the market for the resources of the developing countries is competitive, potential hosts will bid against one another until the benefit enjoyed by the host due to the investment is zero. Only then will it be impossible for the country that stands to "lose" the investment to offer the firm a more attractive package while still profiting from the investment. Once the incentives for the firm have been bid up to the point where the country stands to make no net gain from the investment, the firm does not have to share any of the surplus with the host and can, therefore, simply choose the location that offers the highest overall return.

The distributional impact of this bidding contest is dramatic. The country that receives the investment will have won the competition to attract the capital, but will gain little from its victory. The benefits to the country generated by the investment (in the form of employment, technology transfers, tax revenues, and so on) will be offset by the incentives and concessions that were needed to attract the firm (tax breaks, reduced pollution and employment regulations, and so on).[117] In other words, like in any competitive market, the seller - here the host country - receives no economic profit. The entire profit is enjoyed by the investor.

Taking into account the behavior of all countries, then, potential host countries who have signed BITs will bid down the conditions on which they allow investment in an attempt to attract as much investment as possible. Ultimately, the price paid may be bid down to the point where countries are indifferent between having the investment and not having it. Due to the competitive nature of the market, the benefits of investment will all go to the investor, leaving no surplus for the host.[118]

Despite the fact that individual countries want to sign BITs, as demonstrated in section VI.C.1.a, therefore, LDCs as a group will be better off if they are unable to contract with investors and are, therefore, unable to offer, in a binding way, concessions to investors in for investment conditions. To see why this is so, it is important to recognize two things. First, every potential host faces the same incentives and will try to make itself a more desirable location for foreign investment, relative to every other country. Second, developing countries as a group will be competing for a limited pool of investment. It is true that reducing the cost of investment in all LDCs simultaneously will stimulate some additional investment. Individual countries, however, are also driven to offer more attractive conditions to investors in order to attract investment away from one another. Because the shift of investment from one country to the other is not a gain for LDCs as a group, any policy changes designed to compete for existing investment dollars reduces the overall welfare of developing countries -- some benefit is lost because the host country gets less from the investment, and nothing is gained because the policy affects only the distribution of investment.

b) The Regime of the Charter of Economic Rights and Duties

Consider the example of two countries competing for a potential investor, as discussed above. Assume, however, that there is no way for either country to make a binding commitment to the investor. That is, there is no BIT in place in either country. Although the investor cannot obtain any guarantees, he may still decide to invest. After all, the countries in question have reputational concerns that encourage them to treat investment well, and the investor can also take steps to protect itself. For example, the investor might enter into a joint partnership with the host so that the host has a strong incentive to let the investor maximize profits; the investor might place a few critical operations abroad so that if the investment is seized the host will stand to gain very little; and the investor might demand a signed agreement which, although not binding under international law, may cause the host international embarrassment if it treats the investment poorly.

Most importantly, the investor may choose to invest without any binding commitments from the host country because LDCs offer advantages that are unavailable in the investor's home country (e.g., low labor costs, favorable environmental or labor laws, locational advantages, natural resources, and so on). The risk that the host will attempt to seize value from the investor can be thought of as a random tax. The investor knows that he may or may not be subject to this tax. He will invest despite this risk if the benefits are sufficiently large.

If the investment takes place despite the absence of a BIT, whichever country receives the investment will then be able to extract some value from the investor. The amount of value extracted will depend on the reputational concerns of the country and the value that can be extracted from the firm. As a result, the host will gain much more than it would in a world of BITs.

The critical difference between the individual country analysis and the group analysis is the sensitivity of investment to the cost of investing. For a single country, it is reasonable to assume that the foreign investment decisions regarding investment in that country are relatively sensitive to the cost of investing (i.e., the elasticity of demand is sufficiently high). The absence of a contracting regime will increase the cost of investment to potential investors and, all else equal, will reduce the amount of investment significantly. The increased cost of investing prompted by the dynamic inconsistency problem leads to a large reduction in the total amount of foreign investment because the potential investor can invest in a different developing country that offers similar advantages and that has a contracting regime through, a BIT. The investment that would otherwise have been made in the country will simply move to a different developing country that can make a binding agreement.[119] Because investment levels in a single country will be higher if it is possible to offer the investor more protections, being able to agree to a binding contract would be useful for the individual country. The potential host would avoid the dynamic inconsistency problem by committing not to extract additional value after the investment takes place.

For developing countries as a group, however, the sensitivity of investment demand is likely to be much lower. Consider a particular firm that is considering an investment in a developing country. If the cost of investment rises in one country, it is likely that the firm could find another country that also meets its needs. On the other hand, if the cost of investment rises in all developing countries, the firm must either invest despite the increased cost or abandon its intention to invest in a developing country. Because the advantages offered by one developing country are much more likely to be found in another developing country than in a developed country, the firm is much more likely to invest in a developing country despite such an increase in the cost of investment.[120] In other words, investment will be much less sensitive to the cost of investing (i.e., the elasticity of investment will be lower) when we consider LDCs as a group rather than individually.

Because investment decisions, with respect to investment in LDCs as a group, are relatively inelastic -- meaning that a change in price leads to only a small change in the amount invested -- a large amount of foreign investment will take place even in the absence of a binding contractual regime between host governments and firms. That is, although the ability to contract might attract some additional investment, the difference between the amount invested under a contracting regime as compared to a non-contracting regime would be small.[121]

Consider the implications of price-insensitive investment for the interests of capital importing states.[122] If capital importers, as a group, can implement a system under which contracts between investors and host governments are not recognized under international law, it becomes impossible for any single country to overcome the dynamic inconsistency problem. In other words, one country cannot bid against another country in order to attract foreign investment. Offering more attractive terms to investors would be futile in such a world because both the potential host and the potential investor know that those offers are not binding and, therefore, not credible. Regardless of the agreement that might be reached between an investor and the host state, once the investment is in place, the host can abrogate the agreement and impose whatever conditions it chooses, including expropriation, as long as it pays "appropriate" compensation. The dynamic inconsistency problem will increase the expected cost of investment, and will, therefore, deter some investors. Given the assumption that investment decisions are not price sensitive, however, there will be only a modest reduction in investment relative to a contracting regime.

Once an investment is made, the firm and the host state face one another in a new negotiating posture. The host has the power to unilaterally change the conditions under which the firm operates and the firm's only defenses are the ability to stop operations and pull out of the country[123] and the reputational concerns of the host. It would, therefore, be possible for the host to extract considerable surplus from the firm through increased tax rates, restrictions on the repatriation of profits, domestic content regulations, and so on. LDCs, therefore, are better off. Although there may be a small reduction in total investment, developing countries will gain much more from each dollar of foreign investment that does take place.

3. Understanding the Results of the Analysis

We can represent the above discussion as follows. Under a contracting regime, the firm seeks "bids" from countries that hope to attract its investment. It then chooses a bid and signs a binding contract with the country that has made that bid. Only then does it invest, by which time the host is bound to the contract. In this way, potential host countries must bid against one another and can be expected to bid down the "price" of their resources to the point at which they earn zero profit.

Under a regime without contracting, however, the order of events is different. The firm must first commit itself to a particular country by investing. Only then does the country choose the conditions under which it will allow the firm to operate. The host faces some constraints. It must provide the protections to which investment is entitled under international law, it must not impose conditions that are so arduous that the investor will prefer to pull out rather than continuing to operate its business, and it must consider the effect of its actions on its reputation and on future investors. Despite these constraints on its choice of conditions, the host is in a much better position under the no-contract case than it is under the contract case.

Even if there is less investment under the no-contract case, capital importing countries may still be better off because they capture a larger fraction of the gains from the investment. Of course, any individual country would prefer to be able to offer a contract to potential investors because it could then attract much more investment at the expense of other capital importing countries. Capital importing countries as a group, however, would be worse off if contracting were allowed.

An alternative way to understand the above discussion is to recognize that the presence or absence of binding contracts changes the competitiveness of the market. If there are binding contracts, every potential host country must compete for the investment -- leading to the competitive result and zero profit for the "seller." A country that does not offer competitive conditions will receive no investment. Without contracts, however, there is no competition. The investor's demand for the resources of LDCs as a whole is likely to be inelastic since LDCs offer a set of resources that are very different from those offered by developed countries, implying that the total amount of investment will be similar to the amount that would exist under a contracting regime. The host is in the position of a monopolist and can extract monopoly rents.

The host is able to extract rents because, once the investment is made, the host is in the position of a monopolist. It can choose to set the "price" for its resources at the level that maximizes its own return. The basic theory of monopoly pricing teaches that a monopolist will set a price that is above the competitive price in order to extract monopoly rents. The result, of course, is a reduction in the demand for the resources, a loss to the buyer (here, the investor), and increased profits. Overall, there is a net loss, referred to as a "deadweight loss."[124] In this context, the host will demand more value from the investor than it would in a competitive environment. Thus, to the extent potential hosts compete against one another for investment, and to the extent this leads to a competitive markets for the resources offered by potential hosts, it should be expected that hosts will seek to extract value from the firm after the investment takes place. Because the investor has made an irreversible investment, it cannot easily withdraw from the country -- making its demand for those resources very inelastic indeed.

D. Understanding the Results of the Analysis

The above discussion offers considerable insight into the behavior of developing countries with respect to the United Nations Resolutions and BITs. Within the United Nations, developing countries are able to cooperate and pursue an international legal structure that prevents contracting between firms and states and that provides only minimal protection to investment. Cooperation in this forum is easy because the General Assembly acts as a single body, and there is nothing to be gained by refusing to cooperate. The General Assembly, therefore, provided capital importing countries with an excellent forum in which to advocate for the dismantling of the Hull Rule and the "adoption" of a much more lenient rule with respect to expropriation and other conflicts between investors and host countries.

If such a regime were to be accepted as international law, it would force investors to invest before the terms of the relationship are specified. Although individual countries would like to "cheat" by signing contracts with investors prior to the investment, those contracts would be void under international law and, therefore, would not offer investors any additional security. In other words, cheating would not be possible and LDCs would be able to raise the "price" of access to their resources.

BITs, however, provide a mechanism through which individual countries can easily "cheat" on this "cartel" of capital importers. By signing a BIT, the potential host country agrees, in a binding treaty under international law, to refrain from expropriation and to respect any contracts that it signs with investors. Derogation from such a contract then becomes a violation of the treaty which is, in turn, a violation of international law. In other words, the contract becomes binding because the BIT elevates a breach of the contract to a violation of international law. Signing such a treaty is, as already mentioned, in the interest of any single capital importing country, which may explain the popularity of the BIT. On the other hand, the treaties are harmful to capital importers as a group because it leads to a world in which contracts between firms and host states are binding.

The history of BITs and, indeed, of opinions on the protection of foreign investment generally, are consistent with the analysis presented in this section. First, we note that BITs are bilateral rather than multilateral. If LDCs supported the principles of compensation that are enumerated in BITs, they could promote them through multilateral efforts, including General Assembly Resolutions, multilateral codes of conduct, and multilateral treaties. The absence of multilateral efforts is consistent with the theory of strategic behavior presented in this paper.

It is noteworthy that no two developed country's have signed BITs with one another. While it may be true that investors are usually less concerned about expropriation by developed states, these investors nevertheless may have legitimate concerns about the contractual arrangements and the conditions under which they made their investment. One explanation for the North-South nature of BITs is the bargaining power of the two sides. Without a BIT, a particular developing country may enjoy a much lower level of investment. Investment in a developed country, on the other hand, is much less likely to be sensitive to the presence of such treaties.[125] Developing countries, therefore, are much more eager to reach an agreement on investment with major capital exporting countries and those countries can, in turn, demand very strong protections for their foreign investors.[126] This explains the presence of clauses that enforce contracts between a private actor and a sovereign state.

Finally, we must consider whether or not it is reasonable to assume that investment in developing countries would continue even if LDCs were unable to make binding commitments. Because the lack of a method for creating binding contracts has the effect of raising the costs of investing, we are asking whether it is reasonable to assume that the demand for the resources of LDCs is relatively insensitive to changes in the cost of investing. In other words, we are asking whether developing countries, if they behave as a group, have monopolistic power. If they do not have monopolistic power, potential investors faced with the dynamic inconsistency problem will simply choose to invest in developed countries -- where the risks to the investment may be considered less severe. The assumption can be justified on at least two grounds. First, although developing countries and developed countries share certain traits, there are enough identifiable traits of developing countries that are different from those of the developed world to support our assumption. For example, labor in developing countries is often extremely inexpensive relative to developed countries. Even the threat of an increase in the wage rate in an LDC may not deter an investor because even if there were a substantial increase in the cost of labor, it would remain below that of the developed world. Similarly, developing countries have natural resources that do not exist in developed countries, or that are not as abundant. In addition, the legal and regulatory climate of developing countries may be more advantageous for investors.

The second reason why the assumption of monopolistic power is reasonable is empirical. Even before the rise of BITs, firms frequently invested in developing countries.[127] This demonstrates that even in the presence of the dynamic inconsistency problem, firms were prepared to invest. That is, firms were prepared to invest even though they knew that the host could extract value from them after they had invested. This is precisely what is meant by market power -- the investor chooses to invest even though she knows the host will extract more than the initially agreed upon amount.

[105] See Jeswald W. Salacuse, Bit by Bit: The Growth of Bilateral Investment Treaties and Their Impact on Foreign Investment in Developing Countries, 24 INT'L LAW. 655, 655 (1990).

[106] Interestingly, all of those treaties, and, indeed, all bilateral treaties signed to date, have included at least one developing country. No two developed countries have chosen to sign a BIT between themselves.

[107] See supra Part III.B.1.

[108] See supra pages 18-21.

[109] See supra page 19.

[110] M. SORNARAJAH, supra note 4, at 233.

[111] M. Sornarajah, supra note 4, at 90.

[112] At a minimum, BITs often explicitly require that investment be given all the protections afforded by international law.

[113] Dozer, supra note 4 at 567.

[114] See, e.g., VANDERVELDE supra note 74, Art. X (1994) ("Any dispute between the Parties concerning the interpretation or application of the Treaty, that is not resolved through consultations or other diplomatic channels, shall be submitted upon the request of either Party to an arbitral tribunal for binding decision . . . .").

[115] See supra p. 43. With respect to actions prohibited by the BIT, as opposed to those actions that also specify some form of damages, the efficient result will generally not be achieved. For example, Article VI of the model U.S. BIT prohibits performance requirements, but does not specify a remedy should a country implement such requirements. If, for example, the investor can quickly and easily prevent such requirements from being put in place -- perhaps because the dispute settlement mechanism operates quickly and its rulings are followed by the host -- then performance requirements will never be put in place. This will be inefficient in situations where the benefit of a performance requirement outweighs the loss to the firm. If the country could, instead, simply pay the firms expectations damages, the result would be more efficient. It may, or course, be possible for the country and the firm to negotiate an agreement whereby the firm accepts performance requirements in exchange for some payment. In that situation, the outcome may be efficient, although there will always be the concern that the requirement is forbidden by the treaty and the host is, therefore, in violation of international law.

[116] In other words, if a country takes actions that are harmful to foreign investment, other firms will observe the actions and may choose not to invest in the future.

[117] To see why this is so, imagine two countries, called country A and country B, bidding for a certain investment project. Suppose the project offers benefits to the country equivalent to $100 million. In an attempt to attract the firm, the countries will bid against one another. Suppose that country A ultimately gets the investment. This will only come to pass if country B fails to offer the investor a more attractive arrangement than that which country A has offered. Faced with the possibility of losing not getting the investment, country B will be prepared to offer the firm any concessions, as long as the cost to country B is less than $100 million. Country A, of course, has the same incentives. The winner of the competition, therefore, must offer concessions that cost $100 million. Otherwise the other country could offer the same concessions and include some additional benefits for the firm. Only when the concessions cost the country $100 million will the "losing" country refrain from offering an even better deal tot he investor.

[118] This is referred to as a "Bertrand equilibrium." Under a Bertrand equilibrium, two or more sellers compete with one another by lowering prices. The result is that prices are driven down to the point at which they are equal to cost. The result is that the sellers receive no profit from the sale -- all surplus goes to the consumers. See MAS-COLLEL, WHINSTON, & GREEN, supra note 92.

[119] Note that this analysis is somewhat different if investment takes place over a period of time and is based on an ongoing relationship. In such a situation, the investor commits, in a sense, to investing in the country by making the initial investments. As more investment is made in a particular country, the cost of directing one's investment toward a different country may increase. Two results are possible in such a case. If the investor knows that he is entering into a long term relationship with the host, he may demand protections from the very beginning. That is, the investor may anticipate the protections he will need in t he future and incorporate them into the initial agreement with the host. If, however, the investor either does not anticipate a long term relationship or is unable to predict the concerns he will have in the future, the initial agreement may offer less protections than he will want at a later stage in the relationship with the host. Once initial investments are made, the country will have significant bargaining power and will be able to extract surplus from the firm. This is so for the same reason that the host can extract value if there is no BIT - once the investment is sunk, it is costly for the firm to disinvest. The host can, therefore, extract value without driving the investor out.

[120] Put another way, we assume that LDCs offer a set of resources that are different from those offered by developed countries.

[121] It is, of course, possible to imagine situations in which even a single country may enjoy a demand for its resources that is relatively insensitive to the cost of investing. A contemporary example may be China where, in recent years, there has been tremendous desire on the part of western capital to enter the Chinese market. Because China is perceived to have certain unique benefits (including access to the more than one billion potential consumers), it may not need to compete for investment. That is, it may be able, without greatly affecting demand, insist on concessions from potential investors that are similar to what it would implement in the absence of BITs and after investment had taken place. A country in such a situation will not suffer the welfare loss described in this paper (or, at least, will not suffer as large a loss) because there is competition among firms to invest and the country has sufficient market power - even with a BIT - to extract a portion of the expected surplus from the investment. Most developing countries, however, are not so fortunate and must compete with other LDCs for investment.

[122] I will assume that these states are not only net capital importers, but are only capital importers -- implying that firms from these countries do not engage in any foreign investment of their own. This assumption is made for simplicity and does not affect the qualitative nature of the results.

[123] The firm may also have the ability to simply scale down operations, without pulling out completely. On the other hand, if the firm decides to leave the country altogether, the host may chose to impose limits on what they can take with them -- including whatever funds are in the host country.


[125] This is both because the home country of the investor is much more likely to be able to retaliate by taking actions against the foreign investors from the offending state that are operating in the home country, and because the reasons for the investment are less likely to be closely tied to production costs such as labor and regulatory conditions, and much more likely to be related to other factors such as the presence of a large market, human capital, and so on.

[126]Although BITs nominally impose symmetric obligations, North-South BITs are typically between countries with such different levels of outward foreign investment that only one side's behavior toward investors is significantly affected.

[127] See supra p.1.

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