The Trojan treaties

Farid Harianto

Something very interesting is brewing in Jakarta. Amid the global economic gloom, Indonesia stands out as one of the promising emerging economies. It will reach a trillion-dollar economy by this year or next, joining 13 other countries globally.

More remarkable is the result of a recent poll of 19,000 adults in 24 countries by Ipsos, a research firm, which found that Indonesians are the happiest people on the planet, as reported in The Economist on February 25. In fact, Indonesians are much happier than Brazilians, Australians, Americans and Europeans, according to the survey.

Despite the noise in the media, Indonesian politics is very stable. If there are complaints about leadership, such a complaint is not exclusive to Indonesia, considering what is happening in the US, the eurozone and in the Middle East. So in relative terms, it can be understood if Indonesians feel better off politically compared to other people in different parts of the globe.

Economically, Indonesia has emerged on the radar screen of global investors. Foreign investment jumped from about $3.4 billion to $7 billion in 2010, and is expected to reach $19 billion by the end of 2012. In the past five years, private equity funds specializing in Indonesia have reached $8-10 billion, reminding us of India seven and eight years ago. With the upgrading of our sovereign rating to investment grade level, we can expect that foreign capital will continue to flow into the country.

Globally, foreign direct investment (FDI) flows have grown steadily, from about $1.2 trillion in 2010 to an expected $1.6-2.0 trillion in 2012. About half of the FDI flows are going to emerging and transitional economies. Through FDIs, host countries benefit from the access to capital and technologies, while investing companies gain access to new markets.

One of the biggest risks investors have in making substantial FDIs is the real difficulty of protecting their rights from interference by foreign governments. Investors are particularly wary of getting entangled in disputes before a local court, especially when such a dispute is with the host government itself. The adoption of bilateral investment treaties (BIT) among countries is to provide a remedy for such a fear.

It is by no accident that the ever-increasing FDIs are also accompanied by an increasing proliferation of investment treaties. As of today, globally there is a network of over 3,000 bilateral (BITs), multilateral (MITs) and sectoral investment agreements, and counting. The pivotal feature of such an investment treaty is that it allows investors to bring a claim against the host state for violations of the treaty directly to legally binding international arbitration.

According to Mahnaz Malik, a scholar and international lawyer based in London, BITs are “the legal monster that let companies sue countries” and increasingly become a major headache for the host states, particularly emerging economies.

Indonesia has had a taste of the bitter medicine of international arbitration, with the infamous Karaha Bodas case. The case has become a symbol of the combination of ignorance, sloppiness in handling due process, mismanagement and even the rotten smell of a plot to let the claimant win against the government of Indonesia.

This was the second case after the CalEnergy arbitration against PLN and the Ministry of Finance in which Indonesia failed to address the arbitration process properly and even let the claimants undertake widespread lobbying and a media campaign to damage Indonesia’s already shaky reputation.
 
Imprecise, double-edged sword

No one disputes the benefit of FDI. The investment protection that FDI demands via BITs, however, can be utterly one-sided. BITs are idiosyncratic in that they grant private investors protective rights to bring claims against host countries, while the host countries do not get similar rights against the investor.

Under BITs or MITs, investors can rely on broad guarantees such as “full protection and security” and “fair and equitable treatment” by host countries. Often, the standards being used to define such broad descriptions are also imprecise, leaving much room for interpretation. Even the term “investment” itself is at times not well defined, giving investors the chance to invoke the protective agreement even though the case at hand is about mere commercial transactions such as normal trading.

One thing is clear. The aforementioned standards of treatment are interpreted in accordance with international law and if there is a differing interpretation with Indonesian law then the international law will prevail.

Unfortunately for developing countries such as Indonesia, there has been a marked lack of expertise and familiarity with regard to the drafting and negotiation of BIT. Many of the terms and clauses of BIT are not drafted with sufficient precision to be effective. As such, the BIT may unintentionally cover all types of assets and risk associated with the foreign investment.

Increasingly, investors can also contest a broad range of state conducts, including that of local governments, legislature and judiciary which they deem as in violation of the terms of the BIT. Recent reports regarding the UK’s Churchill Mining Plc. is a case in point.

The Asia Wall Street Journal reported on December 2, 2011 that the company was about to take the Indonesian government to international arbitration, claiming that it was unfairly stripped of a multi-billion-dollar coal discovery in East Kalimantan.

The case originated from a dispute over the sale and purchase agreement between Churchill’s subsidiary and a local company, Ridlatama Group. Arguing that it has been stymied by local courts and regulators, the London-based firm has threatened to seek arbitration under the UK-RI BIT.

In a similar vein, the latest government regulation (PP No 24/2012) requires foreign mining companies to divest their controlling stakes to national interests after their 10th year of commercial production. This new PP replaces the old one (PP No 23/2010) which stipulated that foreign mining companies should divest at least 20% of their stake after the fifth year of operation, but said nothing about mandatory divestment of controlling stakes. Without realizing it, such a regulatory change can now potentially be brought to international arbitration. One can never know.

The Churchill saga and the policy flip-flop in the mining sector offer a cautionary tale for any FDI into Indonesia’s booming commodities sector – representing about 17% of our GDP – and for the government to assume the consequences of potential arbitration.
 
Perturbing trends

From Indonesia’s perspective, there are a few developments that deserve scrutiny. The number of international arbitration cases has swollen dramatically in the past few years. Statistics from the International Center for Settlement of Investment Disputes (ICSID) —an autonomous entity under the World Bank – indicates that the number of international arbitration cases has increased from only 69 cases in the period 1972-1999 to 103 cases in 2004-2005, 134 cases in 2005-2009 and 74 cases in the two-year period of 2010-2011.

The latest case was the claim by Rafat Ali Rizvi against the government of Indonesia in 2011. Clearly the trend toward the use of international arbitration to seek relief from cross-border investment disputes is increasing.

The second trend pertains to the increasing number of multilateral rather than bilateral investment treaties. Ms. Malik wrote that with the Lisbon Treaty, which transferred FDI competencies from EU member states to the EU, policies on existing BITs involving EU member states were under review. This would effectively affect about half of the world’s BITs.

Similarly, the US and Canada have also worked out a much more precise model for investment protection agreements under the umbrella of the North American Free Trade Agreement.

Likewise, ASEAN adopted in February 2009 an ASEAN Investment Agreement to promote and protect intra-regional investment.  ASEAN also recently concluded the ASEAN-New Zealand-Australia Free Trade Agreement that contains a comprehensive chapter on investment protection.

If emerging economies such as Indonesia found difficulty in drafting and defending itself against BITs, it becomes much more problematic when they are dealing with a multilateral treaty, as it effectively diminishes sovereign control over what is being negotiated and agreed upon.

Another interesting development is the increasing number of countries which want to review their BITs and MITs, given their many shortcomings. It has been reported that South Africa has conducted a thorough review of all of its BITs, and has ceased concluding new agreements. Other countries, notably from Latin America, have withdrawn from ICSID altogether. Bolivia has been reported to be reviewing its 24 BITs and would like to restrict the definition of “investment” and to include stipulation for technology transfer and the use of local inputs and, most significantly, to oblige investors to use local courts for dispute settlement.

In fact, Indonesia has been quoted as a pioneer in terms of limiting the scope of investment by restricting the application of its BITs to only those investments admitted in accordance with the 1967 Law on Investment or its subsequent amendments. Yet, the wordings of the BITs, such as the UK-Indonesia BIT, at times are loosely defined, providing copious ground for arguments under international jurisprudence.
 
Wake-up calls

UNCTAD’s data indicates that Indonesia has so far signed 62 BITs, 45 of which are effective. There is apparently no basic template with clear explanatory notes that can provide guidelines, clarity and consistency for those BITs. While several of those BITs have limited their application (in accordance with the Law on Investment No 1/1967 and its subsequent amendments), others do not have such clear restriction.

Under the BITs, Indonesia pledges not to take any arbitrary, grossly unfair or discriminatory measures against foreign investment. Furthermore, Indonesia may also promise not to treat any third state investors any better than investors in the home state. Effectively, investors in such a case may be able to rely on the “most favored nation” doctrine and invoke more favorable commitments in other Indonesian BITs. Thence, the argument for limited scope of the BITs can be problematic.

Clearly, there have been accumulated bodies of knowledge in international law that must be understood by Indonesian officials who draft and negotiate BITs, be they from the Ministry of Foreign Affairs, the Indonesia Investment Board (BKPM) or the Ministry of Justice and Human Rights. The drafting of any BIT ideally also takes into account the perspective of international litigation specialists who are knowledgeable about international dispute resolution. Judging from the existing BITs, it appears there is need to beef up the institutional capacity to draft and negotiate BITs across the board.

In a broader sense, BITs are a guarantee by the government not to violate the terms of the BIT. Given the broad and sometimes vague definition of what is being guaranteed, it sounds like all-risk insurance, a guarantee for unspecified risk by the government. Given that such a BIT entails significant cost to taxpayers (remember Karaha Bodas), it is very surprising that the Ministry of Finance has been involved only in the margins. This needs to change.

The currently on-going arbitration claim by Rafat Ali Rizvi against the government represents the first claim under an Indonesian BIT, in this case the UK-Indonesia BIT of 1976. As Indonesia is increasingly receiving more FDIs, one can only expect that investors may challenge any measures undertaken by the government to regulate such FDI inflows for the public benefit. As such, the Rafat case does raise an alarm: it shows how foreign investors — even declared convicts and fugitives — can take advantage of Indonesian BITs to dispute sound public policy. As ridiculous as it sounds, the case also incurs a significant cost to the government just to defend the obvious.

We undoubtedly do not want to transform our BITs into a Trojan horse that will finally inflict wounds and defeat upon us. Yet, BITs may end up as “Trojan treaties” if they go unchecked. We need to promote FDI and do so smartly.  And we do need smart BITs. As it goes now, we clearly need to re-evaluate our existing BITs to identify the key risks involved, and to identify remedies. A better and more consistent template for BIT guidelines is imperative, with clear explanatory notes.

Indonesia seriously needs to build its institutional capacity in drafting and negotiating investment treaties. We also need a critical mass of Indonesian lawyers who are knowledgeable and have expertise in international dispute resolution. We need research centers at our universities to support our bureaucracy for such undertaking. And we need to build these related institutional capacities very fast, before the Trojan treaties open up the gate for the army of international lawyers knocking on our door and claiming substantial damages.

If that happens, Indonesians may not be the happiest bunch of people on earth anymore.