From Investors’ Arbitration to Investment Arbitration -Executive Version

The Challenges of Attracting Foreign Direct Investment for Latin America’s Sustainable and Diversified Economy: Lessons Learned From Ecuador Executive Summary Introduction For the last decade, Latin America has been an important actor in the growth of the world economy, experiencing economic growth rates, substantial reduction in overall poverty rates, as well as an important decline in extreme poverty. Additionally, since 1998 and with greater force in the past decade, the concentration of income has begun to give way. These improvements in income have not only arisen as a result of greater growth and the creation of more and better jobs, but also because of redistributive social policies undertaken by countries such as Ecuador. In spite of these advances, growth has been uneven and income inequality remains a challenge. In addition, even though there have been important economic and social advances in Latin America, there are concerns over the nature of this growth and its sustainability.

Much of Latin America’s economic growth is due to better terms of trade and undeniably better macroeconomic policies. In most cases, this growth was characterized by an increase in internal demand for goods and services caused by a greater flow of external resources and, undoubtedly, by the growth in exports mainly provoked by the increasing demand for goods and services in China, India and other emerging markets, as well as foreign financing and investment. The continuing challenge facing Latin America is how to increase productivity rates and restructure the productive matrix in order to have a more competitive export portfolio with greater added value, which in turn will make it possible to generate new employment opportunities and improve average wage and pay scales.

The challenge of increasing productivity and diversifying the economy is no easy task, and it requires coordination and synchronization between industrial, trade and investment promotion policies, as well as the generation of instruments and incentives to create business environments that foster innovation.

Even though portfolio and venture capital investments are generally considered important sources of funding, foreign direct investment (FDI) contributes with a combination of capital, technologies, and specialized knowledge, including

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technological externalities; these do not entail the two first sources of funding mentioned. It is not an automatic process, and a government should have coordinated policies in place so that FDI can create such technological externalities and promote the generation of local added value. One of the most important challenges lies in developing investment treaties and commercial agreements that leave enough space to apply these policies.

This challenge is even greater for countries with abundant natural resources, which require attracting foreign direct investment that also provides high-end technology, and are committed to protecting human and environmental rights. In the vast majority of countries in Latin America, oil and mining resources are located in regions that are ecologically diverse, economically underdeveloped, and predominantly inhabited by indigenous communities. In many of these regions, citizens suffered because companies disrespected their human and environmental rights, and national governments have not invested adequately in their social and economic development, nor provided the necessary regulatory oversight of these sectors so as to protect their rights.

In the application of industrial policy, attracting FDI that contributes to the generation of local knowledge and technology is necessary for success. This is why it is so important to establish and enforce not only institutional and legal frameworks but also instruments that make it possible to fulfill all of these objectives at once.

For decades, the accepted path to attracting FDI was through the signing of bilateral (BIT) or multilateral investment treaties. However, many of these treaties were signed without a full understanding or appreciation of the potentially negative consequences of doing so—such as the almost omnipotent power of international arbitrators to interpret these treaties; the lack of transparency in the process of arbitrations; and the reduced capacity of the state to implement oversight and monitoring policies.

At present, there are more than three thousand BITs and regional agreements for the protection of investments around the world, which provide the legal structure for the international system of investments; these have been subject to a large wave of criticism, especially in the past few years. States are increasingly facing more multimillion dollar complaints from foreign companies using the legal framework of BITs and an excessively costly nontransparent arbitration system where decisions cannot be appealed. Interpretations of the mandates contained in those treaties are lengthy and

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extensive, and their regulatory capacity can be frozen in some cases, all of which adversely affects sensitive sectors such as health, environment and human rights.

The policies for the attraction of FDI should be in line with the needs of public policies for the economic and social development of each nation. However, for the intent of attracting new investment to become real, big multinational companies demand legal and contractual conditions which reduce the capacity of the states to decide on these policies, and in many cases these kind of requirements question the sovereignty and independence of their judicial systems.

The proliferation of complaints against States has grown rapidly. This has caused several countries to take initiatives to assure a balance between national public interests and transnational private interests. Several countries have recently adopted measures to review or amend their investment treaties.

The United States spent several years reviewing its negotiation model of BITs, and after relying on the broad participation of public institutions, academia and experts on the matter to do so, has made some revisions. However, one of the most debated provisions, which remains intact, deals with the investor-state arbitration system, even though critics of the system, including Ecuador, have argued in favor of its elimination or reorganization. Also remaining is the obligation for States to offer “minimum standards of treatment,� without clarifying the reach of those standards. Finally, the elimination of restrictions on capital transfers also remains, and many consider this as binding the hands of governments in responding to, or avoiding, financial crises in their countries.

The European Commission has also shown some concern. The European Union has announced that the Commission is working to implement improvements in two specific areas: 1) Explaining and improving the investment protection rules with the purpose of achieving legitimate public policies (current investment treaty rules conflict with European Union agreements that confer the right of parties to regulate these policies); 2) Improving the manner in which the dispute settlement system operates, including preventing investors from bringing complaints considered frivolous, making the arbitration system more transparent, dealing with conflicts of interest, and introducing safeguards for the parties.

Ecuador is bound by its new Constitution, which has been in place since 2008, to renegotiate or denounce the bilateral treaties it has negotiated. This paper explains

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the lessons learned from the Texaco-Chevron case in the historical context of Ecuador and how they influence these negotiations.

The Case of Ecuador

The relationship between Texaco-Chevron and the Republic of Ecuador began in 1964 with the exploration for petroleum in an important area of Ecuador´s Amazon region, which resulted in Texaco forming part of a consortium charged with the exploration and exploitation of petroleum in an area of approximately 500,000 hectares of Amazonian rainforest.

Texaco, acquired by Chevron in 2001, had the role in the consortium of being the sole operator of oil exploitation locations during 25 years. In June of 2004, Chevron and Texaco filed suit against the consortium partner Petroecuador (the government-run oil company) on the basis of a clause included in the joint operation agreement (known as JOA), signed in 1964 by Gulf and Texaco, the two original participants. Texaco-Chevron alleged that Petroecuador was also subject to a clause that obligated the non-operating parties to compensate the operator for any sentence decided against it. Ecuador opposed such arbitration before a New York Federal Court. On July 24, 2009, the judge overseeing the case accepted Ecuador’s position that Petroecuador did not have to enter into arbitration with Chevron-Texaco. The Supreme Court of the United States denied hearing the case, ratifying the decision pronounced by the lower courts.

During the time in which Texaco was in charge of the exploration and exploitation of hundreds of oil wells in the Ecuadorian Amazon, it neither observed the technical recommendations for remediation published in 1963 by the American Petroleum Institute, nor did it use the modern remediation system it itself had patented. Texaco, in order to reduce costs, used a system with serious negative consequences for human life and the fragile Amazonian environment.

As a result of these practices, there have been multiple legal actions presented in courts around the world.

On one side, there are several litigations only between private actors.

Indigenous people started a suit in a New York District Court against Texaco just a couple of years after the oil company finished their operation duties. In this case, which 4

began in 1993, the plaintiffs were seeking (i) compensation for damages and losses, (ii) judicial protection to remediate pollution and contamination of the environment, and (iii) compensation for physical damages and damages to the property caused by contamination. After nearly 10 years, the case ended when the U.S. courts agreed with Chevron’s argument, based on the forum non-conveniens legal doctrine, that the case should instead be heard in Ecuador, not the U.S. The same plaintiffs then filed an action in Lago Agrio, Ecuador, where they sought the same environmental remediation as in the original case filed in New York. In general terms, their petition included the eradication or removal of contaminating substances that are still threatening the environment and the health of the inhabitants.

After a legal process that took approximately seven years, on February 7, 2011, a judge in Ecuador declared Texaco-Chevron guilty of contamination and ordered payment by Chevron. The Court of Appeals ratified the judgment, and so did the National Court of Justice, but reverted the punitive damages ordered by the Ecuadorian Judge. On November 12, 2013, Chevron was ordered to pay the amount of $9.5 billion to the plaintiffs. Chevron subsequently presented a request to the Constitutional Court of Ecuador in December 23, 2013, requesting the cancellation of the environmental award against the company. To this date, the petition is pending.

In 2013, Chevron filed a civil lawsuit in New York against the plaintiffs’ lawyers and other related parties under the "Racketeer Influenced and Corrupt Organizations Act" (RICO).

Chevron's intent with this action was to obtain a decision from the Court of the Southern District of New York stating that the Lago Agrio plaintiff’s lawyers had acted fraudulently and affected the judgment of the Ecuadorian courts. This case sparked controversy and criticism in international law specialized circles, as it is generally accepted that there is no court in the United States with jurisdiction on the judicial system of another country. Another critical legal issue in the RICO case is whether US law even allows a private party to obtain "injunctive" relief in a RICO case. Chevron says it does. The RICO defendants and others say it does not.

In early 2014, a decision by presiding Judge Lewis A. Kaplan agreed with Chevron. The RICO defendants have announced their intention to appeal the decision to the US Second Circuit Court of Appeals.

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On the other side, there have been litigations involving Chevron and the Republic of Ecuador. In December 2006, Chevron filed an arbitration notice based on the Ecuador-United States BIT, arguing that the Ecuadorian courts had violated the treaty by not resolving seven commercial cases that Texaco had presented against the Republic in the early 1990’s related to the operations of the consortium. The court assumed jurisdiction on December 1, 2008, and in a partial award issued on March 30, 2010, the court determined that Ecuador had not complied with section II (7) of the Investment Treaty and was responsible for damages caused to Chevron. However, the tribunal also concluded that the Ecuadorian court system was neither unfair, corrupt nor acting with prejudice against Chevron.

In September 2009, Ecuador received notice for an arbitration process before the Permanent Court of Arbitration of the Hague, under the UNCITRAL arbitration rules, in which Chevron claimed denial of justice, unfair and unequal treatment, and discrimination by Ecuador. This case is currently expected to run until April 2015. (For additional information on these cases, please refer to the full version of this paper published on the Embassy of Ecuador’s website).

Although the final results of these cases and related appeals are still pending, the history of Ecuador’s relationship with Texaco-Chevron leaves many lessons for Ecuador and the world in countless fields, especially regarding human rights, international relationships, corporate ethics, international law and international arbitration.

Lessons learned Today, Ecuador’s main challenge resides in the transformation of its production matrix in order to make it greener and knowledge-intensive. By investing in this new paradigm, the extraction of natural resources will be conducted responsibly, and new standards will be created for attracting FDI. In order to attract responsible FDI without facing the challenges described, Ecuador needs to renegotiate its BITs. Also, as we have discussed, Ecuador needs to implement continued reforms to its industrial policy in order to diversify its economy. The implementation of this policy needs to be compatible with those treaties. These challenges are not minor, and therefore the lessons learned from the Chevron case need to be known and understood by the international community, so it too can join Ecuador’s efforts to find solutions to the current investor-state arbitrator system as well as to renew the commitment to find binding human and environmental codes of conducts for multinationals.

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In particular, Ecuador believes that reform of the international arbitration system should address the legitimacy, consistency and predictability of the system, with respect to the following topics: 1) Transparent selection of dedicated arbitrators as opposed to the current system in which arbitrators are typically lawyers with their own private practices and who often defend companies as clients themselves, which can result in potential conflicts of interest; 2) Establishment of an appellate body within the arbitration system; 3) Incorporation in investment treaties investors’ obligation to file claims only after local resources have been exhausted; and 4) Incorporation in investment treaties of the right of States to exercise their regulatory capacity on important public policy issues related to health, environment and industrial policy, among others.

Also, states should work together to limit the immense power that arbitrators currently have in the interpretation of treaties while the system is being reformed, because even if countries decide to leave the system, all treaties have survival clauses of between 10 and 15 years.

Finally, we would like to highlight the effort carried out by Ecuador and collectively by the Union of South American Nations (UNASUR) to reform the arbitration system and correct the aforementioned problems. Ecuador has led an initiative to create a center for arbitration under the umbrella of UNASUR that will resolve disputes facing investor-state relations, with the aim that different investors and other states outside the region will be able to eventually use the center as it grows and matures. We hope this effort is implemented and becomes a valid option so that investors and states can access transparent and fair mechanisms for resolving disputes.

Strengthening Ecuador’s Regulatory Framework Ecuadorians are now aware of the enormous responsibility they have in order to protect biodiversity for future generations. One of the most powerful lessons learned in our country after decades of oil exploitation and its consequences on the environment, which is why we are implementing a new development model of “good living”, based on the ancestral Quechua philosophy of balancing the satisfaction of our needs with nature.

In this respect, Ecuador, one of the world’s 17-mega diverse countries, took the unprecedented step in 2008 of providing constitutional rights to nature. This was not an easy task, but it is showing results. Between 2008 and 2013, the National Judicial Council registered 1,164 cases filed in connection with crimes against nature, of which

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550 were resolved and 614 cases are pending settlement. So far in 2013, there have been 570 cases, of which 278 cases were resolved.

There are many advances in the strengthening of Ecuador’s policymaking and regulatory capacity. The Government of Ecuador has been implementing a state reform that has three principles: 1) institutional reform, 2) managing for results, and 3) training of human talent in the public sector. The National Secretariat for Planning (SENPLADES) has been working on defining policies and models that make it possible to evaluate in detail the impact that investments have on the country’s natural resource sectors, including by prioritizing public investment at all stages of the investment cycles, designing public institutional strength to support their adequate implementation, and ensure transparency in the relationship with communities, profitability levels, and others.

Among other reforms, the institutional reform of the Ecuadorian Executive branch has been accompanied by an audacious transformation of the Judicial branch following a national referendum held in May 2011.

A vast majority of voters showed their support for a constitutional reform that opens the doors to transforming and reorganizing the Ecuadorian legal system, comprised of five basic goals considered to be part of the Strategic Plan for the Judicial Office 2013-20191.

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The first goal establishes “Ensuring transparency and quality in the provision of legal services,” through the development and strengthening of orality and immediacy in procedural laws, improvement of the imprisonment on remand and substitute measures systems, and the creation of audience control units.

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The second and third goals contemplate optimal access to justice and driving permanent improvement and the modernization of services through the development and strengthening of a national mediation system, the decentralization of legal services, and the efficiency and efficacy of legal processes.

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Goals four and five establish the institutionalization of meritocracy in the Judicial Office and fight against impunity and corruption, contributing to citizen safety.

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As of 2012, when the Judicial Office reorganization process began, Ecuador has become the country with the largest percentage of investment in the Judicial Office in relation to the general budget of the state in the region2.

We consider that these deep reforms that have led the Ecuadorian State to recover its capacity to formulate, regulate and control public policies should have models for the assessment of sustainable foreign investment, especially in the strategic sectors of the economy. For this assessment to be made, it is imperative to go beyond the models that only focus on evaluating economic effects and based on financial assessment tools. When it comes to the participation of FDI in strategic sectors, we have learned from the Texaco-Chevron case that choosing technology is a crucial matter that needs to be assessed, and that the States should count on their own capacities to analyze and assess different alternatives. We strongly suggest that States work with international institutions and universities at the technological frontier of research to create an independent academic network that can aid countries in their analysis and evaluations of these technologies.

Finally, informed and apolitical participation by civil society as well as transparency in the process of the selection of technologies for harvesting natural resources and strategic partners to participate in the exploration and exploitation, are vital in order to avoid repeating the mistakes of the past. We believe that transparent and civic monitoring and follow-up exercises are crucial to the success of future exploration processes.

This includes a great effort being undertaken to implement a legal framework oriented to promote investment. This legal framework is the Code of Production, which was approved by the National Assembly in December 2010, and became effective in January 2011. This legal framework contains the rules that regulate the role of the state and the private sector in the economy, as well as economic policies, instruments and incentives to achieve a green and diverse production matrix with added value and based on the exploitation of certain prioritized sectors, and with an incentive also dedicated to a more balanced regional growth. Thus, the Code includes general incentives, such as lowering income tax from 25% to 23%, implementing regulations for the facilitation and efficiency in customs and logistics processes, eliminating minimum and income tax for investments made in certain prioritized sectors, and creating special development economic areas for the transfer of technology, logistics and manufacturing for export products. These special economic areas come with income tax and tariff incentives for periods of time lasting up to 15 years.

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Additionally, the Code of Production offers investors the possibility to sign an investment agreement between the investor and the Ecuadorian State, which allows them to obtain a warranty over the incentives established in the code, as well as the possibility of international dispute arbitration, except in the case of disputes related to tax policy.

Lastly, the Code also includes a package of incentives for the technological innovation of medium enterprises, the adoption of green and eco-efficient processes above the standards established by the Ministry of Environment, as well as incentives to reinvigorate depressed areas, mostly rural, of the country.

Regarding trade policy, it is important to secure access of manufactured products to current markets as well as to reach agreements to access new ones with high growth potential. It is also necessary to foster the development of public-private innovation ecosystems.

Ecuador recognizes that investment in higher education, science and technology is a crucial part of the process. For this reason, the country has initiated a deep reform of higher education and educational restructuring, so as to promote the formation of advanced human talent and the development of research, innovation and technological transfer.

While there are great advances in Ecuador, there is an ongoing need to conduct a self-learning process through the evaluation of the design and implementation of industrial public policies, as well as their institutional framework, effectiveness and impact, in order to ensure institutional learning and guarantee the scalability and sustainability of efforts.

Conclusion In conclusion, it is important to emphasize that Ecuador has committed to strengthening its institutions to avoid the occurrence of another experience similar to the Texaco-Chevron case. The devastating environmental and human catastrophe resulted from irresponsible exploitation, weak institutions, the nonexistence of international obligations for corporations in terms of compliance with human and environmental rights, the lack of adequate local hydrocarbon laws, and deep external technological dependence. These conditions no longer exist in Ecuador.

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As globalization shortens the distance between countries and corporations and as we come to the realization that 20th century progress has taken a toll on our planet, it is time we all evaluate what worked and what did not, and move forward with a commitment to a regulatory and legal framework suited for 21st century progress as well as 21st century protection of what we hold most dear. The international community, members large and small, must change the ways that corporate social responsibility is measured. It must include provisions that value human rights equally with profits, or it will remain flawed. Those who do not learn from history will be doomed to repeat it and we, Ecuador working with the international community, cannot let this come to pass.

Nathalie Cely S. and Gustavo DomĂ­nguez Â

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