Each week, In Theory takes on a big idea in the news and explores it from a range of perspectives. This week we’re talking about multinational corporations. Need a primer? Catch up here.

Sadie Blanchard is a private law fellow and research scholar in law at Yale Law School.

There has been a lot of criticism of trade and investment treaties as jeopardizing the sovereignty of developing nations. But the relationship between economic agreements and sovereignty is more complicated than many critics acknowledge.

Let’s begin by clarifying what we mean by sovereignty. We presumably do not mean a sitting government doing whatever it wants. The sovereignty we care about is democratic sovereignty — the ability of a government to function as the agent of a people. Economic globalization at times promotes and at times threatens democratic sovereignty.

Take, for instance, treaties providing for arbitration of disputes between states and foreign investors. States and investors go to arbitration only if the government agrees to do so in a treaty or a contract with a foreign investor. Entering into such an agreement is itself an exercise of sovereignty. Governments do this to encourage foreigners to invest, as a sort of promise to treat them fairly. Investors often fear that once their investment is “captive” in a country, the government may seek to change the terms of the bargain. Local courts might be corrupt, biased against foreigners or controlled by the other branches of government. By agreeing to arbitrate disputes, a state can make itself less risky to potential investors.

Such an agreement can, in principle, reflect the will of the democratic sovereign. However, when a government enters into an agreement to treat foreign investors in certain ways, it may or may not be acting in accordance with the democratic will. This is an example of a principal-agent problem. The government (the agent) has the power to act on behalf of the people (the principal), but it might instead act in ways that advance its own interests.

A government might want to induce foreign investment to promote technological progress, increase incomes or improve employment and infrastructure, or it might be enriching itself at the expense of its people. It might be pursuing an economic strategy that it views as in the people’s interest but which, because the government is undemocratic, does not have the people’s support. The simple existence of an arbitration agreement does not tell us which is the case.

Some critics argue arbitration agreements leave arbitrators with too much discretion to challenge the actions of sovereign states. Criticism is often directed toward high-profile lawsuits brought by investors challenging regulation in the public interest — such as tobacco company Philip Morris’s claims against Australia’s and Uruguay’s tobacco regulations. Both of those claims were rejected by the arbitrators. In fact, arbitral tribunals have rarely upheld challenges to the kind of public interest regulation at issue in the Philip Morris cases. But little attention is offered to arbitration decisions in which government officials acted in ways that most people would agree are wrongful.

In one such case, a U.S. company challenged a Canadian environmental regulation that banned the export of industrial waste chemicals to be remediated at the company’s facility just across the U.S. border. Canadian regulators had found no risk of environmental harm from exporting the waste. Internal communications revealed that the ban was motivated by the environment minister’s promise to Canadian waste-remediation firms that she would close the border to protect them from competition, which is a clear violation of the North American Free Trade Agreement (NAFTA).

The Canadian case demonstrates how arbitration can actually promote democracy where domestic institutions are weak: The official acted beyond the scope of her authority as an environmental regulator to favor a special interest, and the arbitration revealed her wrongdoing. In general, the standards applied by arbitration tribunals tend to be highly deferential to democratic decision-making, typically scrutinizing whether the challenged government action was taken in good faith and in accordance with domestic law.

While the Canadian case could probably have been handled fairly by domestic courts, it is not difficult to see how a developing country with a corruption problem and a poorly functioning court system might see democratic gains by resorting to arbitration. Independent tribunals might encourage countries to improve the quality of their court systems. The safety they imply might increase the pool of foreign investment in countries that otherwise would attract only investors likely to behave in morally hazardous ways. This could reduce corruption and cronyism.

Nonetheless, a legitimate question remains: What should the international community do about the possibility that arbitration tribunals might go too far? Some recent treaties include provisions, such as Article 18 of the investment treaty between China and Canada, that empower governments to agree to interpretations of the treaty that are binding on arbitrators. But such provisions might not improve democratic responsiveness. They might instead ease constraints on self-dealing politicians or inject other geopolitical considerations between the two states into the mix.

Another proposal is to create one or several permanent investment courts. There has not yet proved to be sufficient political will to sustain such courts, and there are questions about whether they could operate neutrally and effectively.

Some recent investment treaties affirm the state’s right to regulate and clarify broad language. For example, a requirement to treat investors fairly and equitably might describe more specifically what fair and equitable treatment entails. Such sensible reforms to reduce arbitrators’ discretion are a promising way forward.

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