Hapless Leviathan: a critical look at investor-state dispute settlement

By Cho Hee-kyoung

As the month of August drew to a close, it seemed that the long-running dispute between Lone Star, a private equity fund from Texas, and the government of South Korea was finally coming to an end. The international arbitration tribunal established to hear the investor state dispute case brought by Lone Star ordered the Korean government to pay it $216.5 million in damages plus interest.

Lone Star has become a byword in Korea for predatory foreign capital: one that acquires a valuable local asset at a fire sale price, then sells it shortly thereafter making a large profit and exiting the country. In Lone Star's case, it was not enough that it had made over a 325 percent return on its initial investment in Korea Exchange Bank (KEB). To add insult to injury, Lone Star claimed that it could have made much more money had it not been for the unauthorized/inappropriate intervention by the Korean government.

The latest arbitral award from the arbitration panel constituted under the rules of the International Centre for Settlement of Investment Disputes or ICSID, the World Bank arbitration center based in Washington, stems from the sale of KEB shares by Lone Star to Hana Bank. Lone Star attempted to sell its stake in KEB to various parties: initially to Kookmin Bank for $7.3 billion in 2006; then to HSBC for $6.3 billion in 2008. However, because there was still ongoing litigation regarding Lone Star's initial acquisition of the KEB shares and whether that was completely legitimate, the Korean government delayed its regulatory approval for the sale.

In 2011, as a result of the conviction for stock price manipulation, Lone Star was ordered to sell down its stake in KEB to below 10 percent. It ultimately sold the stake to Hana Financial Group for $3.3 billion after first signing the deal in 2010 for $3.9 billion. Given that Lone Star originally paid $1.2 billion for its stake in KEB, the rate of return on investment works out to be more than 40 percent per annum over eight years. Even the legendary Berkshire Hathaway's average annual rate of return is 20 percent.

However, dissatisfied with the $2.1 billion profit it made, Lone Star sued the Korean government in 2012 under a bilateral investment treaty that Korea entered into with Belgium-Luxembourg back in 1973 and renewed in 2006. A bilateral investment treaty typically provides foreign investors with certain legal protection, including the right to "fair and equitable treatment" and "full protection and security," as well as a prohibition against "arbitrary and discriminatory treatment."

Accordingly, a foreign investor may sue the host state if it believes that it has suffered harm as a result of not receiving the protection promised by these amorphous standards. Furthermore, the investment treaty also typically includes something called an investor state dispute settlement or ISDS provision, which allows the foreign investor to bypass the local courts and access international commercial arbitration. The Korea-Belgium Luxembourg investment treaty includes such an ISDS clause.

The ISDS is a strange animal that runs counter to the norms of international law and ― dare I say ― even the principles of natural justice. It grants private parties the right to sue a sovereign nation in a forum other than the host state's domestic courts using laws other than domestic laws; the proceedings are kept confidential despite the fact that they touch upon matters of national importance; even the tribunal is appointed by the parties which potentially compromises the rule against bias.

Many people are under the impression that international arbitration is conducted by some kind of permanent-standing international tribunal of some sort. That is not the case. The arbitrators are usually Anglo-American lawyers who have built their careers in international commercial business which aggravates the potential bias issue.

Special protection for a foreign investor may be necessary to induce foreign direct investment in the event of uncompensated expropriation by the host state government or where the legal system of the host state is not fully developed or protection for private property is weak. But it is not intended nor should it be used to protect a foreign investor from all investment risks, which even in a domestic context include government and regulatory risks.

An investor making investments in a foreign country usually does so with the expectation of a higher return. The universal truth in investing is that higher returns carry higher risks. What ISDS does is allow a foreign investor to transfer all its investment risks to the host state and ultimately to the host state taxpayers regardless of the nature of the risk. This is discrimination against other domestic investors as opposed to foreign ones.

The Justice Ministry has declared that it would seek an annulment of the Lone Star arbitral award. Lone Star arbitration is not the only international commercial arbitration the Korean government has to contend with.

There are currently half a dozen international commercial arbitration proceedings against the Korean government including one by Elliott Investment Management relating to the Samsung C&T and Cheil Industries merger and the role of the National Pension Fund thereof. Increasingly, foreign individuals and not only corporate entities are using ISDS to make claims against the government.

All the more reason for the government to take measures to protect itself better, from the exclusion of ISDS provisions in future investment treaties and to renegotiating existing treaties to limit the use of paper companies as investment vehicles and to narrow the scope of liability. The Leviathan in the 21st century is far from the Hobbesian giant.

Cho Hee-kyoung (hongikmail@gmail.com) is a professor at Hongik University College of Law.