Investment disputes in the era of the Fourth Industrial Revolution
Technological advance and resultant socio-economic “revolutions” have always triggered significant developments in international economic law.
In the 15th and 16th centuries, inventions in navigation and cartography and the discoveries of new lands and trade routes led to innovations in economic organization, the “commercial revolution”, globalization of trade and the beginnings of international trade law.
Invention of capital-intensive manufacturing processes in the 18th and 19th centuries, on the other hand, brought about the “industrial revolution”. This caused soaring demand for mineral resources, raw materials and labor, and with the invention of improved storage techniques and transportation led to dynamic growth in foreign direct investments, emergence of multinational enterprises, global value chains, and, in consequence, to the development of international investment law.
Further waves of technological advancements, i.e. the second industrial revolution, with its rapid expansion of transportation and communication networks, harnessing of electrical power and mass production, followed by the third industrial revolution, involving the invention and proliferation of computers, digitization of information, cellular technology and the Internet, led to the emergence of a truly globalized economy. A comprehensive system of international economic law has emerged as a result.
Currently, the World economy is on the brink of the “Fourth Industrial Revolution”. We are facing the emergence of what is referred to as the global “digital economy” or “Industry 4.0”1. Just like the previous ones, the current, fourth industrial revolution is expected to cause significant changes in the system of international economic law. Its impact might be particularly relevant for the evolution of international investment law and for the practice of investor-state dispute settlement practices.
The Fourth Industrial Revolution and its potential impact on investment law
The rules and principles of international investment law as we know them today were developed to address problems posed by traditional models of foreign direct investments made by multinational enterprises2. These investments would normally be motivated by MNEs’ desire to establish themselves in foreign markets (entry-seeking FDIs), to harness efficiencies in factor costs provided by such markets (efficiency-seeking FDIs), or to secure access to natural resources from overseas (resource-seeking FDIs). They would be heavy in physical assets, devised to bring returns only in the long run (“characterized by high capital expenditure and debt, stretched liquidity, high fixed costs and squeezed margins”3) and difficult, if not impossible to relocate or withdraw.
These typical characteristics of traditional foreign direct investments would shape the key principles of international investment law, in particular the meaning of the notion of “investment” eligible for protection, the principle of full protection and security and the principle of fair and equitable treatment, with its pivotal requirement of legal environment stability and respect for the investor’s legitimate expectations. The relevant tests of international investment law would arise from the clash between the investors’ desire for stability and freedom to operate in foreign territory without disruptive interference or expropriation on one hand, and on the other states’ desire to attract investments beneficial for the economy without losing the opportunity to follow changing regulatory policies in exercise of sovereignty over their own territory and natural resources.
But the way in which MNEs operate in the era of digital economy is significantly different from the traditional foreign direct investment model. The new modes of international business expansion, characteristic for Industry 4.0, create profound challenges and can make some of the detailed legal tests and guarantees developed in the practice of international investment law inadequate.
Digitalization as the force behind the Fourth Industrial Revolution
Emergence of the digital economy was enabled by digitization of information and interconnection – the fact that all sorts of potentially valuable data could now be collected, stored and shared on mass scale in digital form4. The next stage in technical development – digitalization brought about by rapid development of digital technologies – allows for real-time collection, processing and innovative use of so-collected masses of digitized information. Thanks to this, in Industry 4.0, valuable content (or even value as such, as in the case of blockchain technology) can be transferred and shared without the physical or organizational constraints characteristic of the traditional economy. Data and knowledge can be collected and analyzed on a previously unconceivable scale and with hitherto unimaginable speed and can be fed to constantly interconnected machines, which can act on it in real time.
As a result, companies can render services or sell digital products in foreign markets across ever more sectors while having virtually no, or close to no physical assets abroad. This obviously affects the practice of market access-seeking FDIs.
In addition, entire tasks or even whole business functions and professions can be automated and performed dramatically more efficiently anywhere in the World. This digitalization of value chains inevitably impacts on the pattern of efficiency-seeking FDIs.
On top of that, companies can often extract the “raw material of the information age” – data5 – from overseas territories without establishing any real physical presence therein. This has an impact on the pattern of resource-seeking FDIs.
In essence, it can be said that digitalization “breaks the nexus between foreign sales and foreign assets”6 making it possible for the new kind of MNEs – digital MNEs – to function globally without placing significant physical assets outside of their home jurisdictions, their home jurisdictions usually being in the highly industrialized states.
As reported by UNCTAD, digital MNEs make about 70 per cent of their sales abroad, with only 40 per cent of their assets based outside their home states7. In addition, the market capitalization of digital MNEs is largely attributable to intangibles such as brand, know-how and intellectual property8. According to the same report, almost two thirds of digital MNEs are based in the United States and only about 50 per cent of the subsidiaries of digital MNEs are foreign affiliates (compared with almost 80 per cent for other MNEs)9.
Foreign investments by digital MNEs
This does not mean, however, that digital MNEs do not invest abroad. Rather, it is that the “economic contribution of MNEs is becoming less tangible in the digital economy”10. But as already mentioned, conducting business globally in the Industry 4.0 era requires access to intangible sources of value, and these might have to be sought abroad.
Data is one obvious example. Even though the largest digital MNEs can sell their products and services all over the World from quarters located in a single developed state, they would not be the companies that they are without the ability to collect and process data from users spread throughout the World, including locally in developing countries. And the “winner-takes-all” principle governing competition in the digital economy makes the ability to obtain local data not an option or advantage for a digital MNE but a prerequisite for its market survival.
Knowledge is another example. Silicon Valley can be the global capital of the digital economy. NewTech companies operating from there, however, cannot afford not to tap into intellectual resources available in other geographic locations. Without this, they would risk losing their positions as quickly as they gained them. Hence, many investments made by digital MNEs abroad are knowledge-seeking FDIs.
The phenomenon of “innovation at the edges” additionally makes it necessary for digital MNEs to be able to cooperate effectively with entities (partners or consumers) located at the edges of their networks, i.e. also abroad. The strength of many of the biggest digital MNEs is in their ownership of networks, which allow disruptive innovations to happen on the edges of those networks (e.g. the success of Apple and its platform rests on its cooperation with countless app developers spread around the World).
Hence, even though foreign investments made by digital MNEs are light in physical assets, they are not inexistent or insignificant. They simply have a different international footprint. Targeted more at “soft capital” (intangible sources of value), they are also vulnerable to different kinds of interference.
Investments by digital MNEs also create different kinds of tensions and challenges in the relations between them and their host states.
Technologies based on big data analytics allow for unprecedented social control and influence. They form powerful tools in the hands of corporations and may lead to the kind of alignment of interests of foreign investors and their home states characteristic for the era of XVII century European commercial expansion11. In other words, some of the largest digital MNEs of today might become the modern versions of the Dutch, British or French East India Companies of the XVII century. This might lead to the same kind of conflicts between MNEs, whose interests are aligned with the interests of their home states on one hand, and host states protecting their sovereignty on the other. “Data sovereignty” may be an even more politically sensitive issue in such conflicts than “sovereignty over national resources” was in the tensions between MNEs of the past and their host states.
Other new technologies – in particular the blockchain technology – could undermine the very foundations of traditional institution of the state as such, emancipating whole areas of social activities from traditional state influence and control. This will certainly trigger both legitimate concerns of state institutions about public security and safety of individual users of such technologies on the one hand, but on the other temptations on the part of those institutions to abuse state powers to hinder the development of politically disruptive technologies and protect traditional state prerogatives. This dynamic and tension is already visible, for example in recent regulatory crackdowns on bitcoin exchange platforms. These interventions are certainly motivated in great part by security and consumer safety concerns. Equally justified, however, are the concerns of advocates of the rule of law and civic society that government agencies may actually be yielding to the temptation to abuse powers in order to prevent disruptive developments and discourage investors who are honestly pioneering the blockchain technology from developing it further. In this sense, the test of whether states will adhere to the rule of law and duly respect entrepreneurial rights and freedom in the digital economy era or will adopt an abusive, populistic approach is already underway.
Finally, digital technologies cause dramatic market disruptions. These sometimes result in sudden changes to competition equilibrium, with the fall of old and rise of new business titans, as well as tectonic social structural shifts (inequality, disintermediation, unemployment, etc.). These developments will most certainly trigger attempts on part of the states to protect “national champions” and “soften the blow” for social groups affected by the market processes caused by advancements in technology. Inevitably, these efforts will clash with the interests of digital MNEs.
The Fourth Industrial Revolution will certainly not cause the disappearance of traditional FDIs. Needless to say, the entire backbone of the digital economy – its telecommunication infrastructure – has to be developed, at least for now, by way of traditional, tangible and capital heavy investments.
The growth of Industry 4.0, however, will certainly lead to the emergence of a whole area of cross-border economic activity which will apply pressure on the traditional concepts of international investment law. Suffice it to say, that 10 out of the top 100 MNEs on the list compiled by UNCTAD are NewTech MNEs and that their wealth, significance, market reach and power are growing rapidly12.
As in all times of disruption, the answer to pressures posed by the digital economy in the area of international investment law should be to go back to this law’s core values. Interpreted from that perspective, traditional doctrines and principles of international investment law can easily address the needs and challenges posed by foreign direct investments of digital MNEs.
The principle of full protection and security can ensure that “soft capital” and intangible sources of value on which the digital economy is built are duly safeguarded by the state.
Whereas the principle of fair and equitable treatment and the international law of expropriation of foreign investments can guide states’ approaches to reconciling data sovereignty and the host state’s legitimate goal of protecting its citizens’ privacy, on the one hand, with the rights of MNEs investing heavily in collection and processing of data on the other. Similarly, the standards for regulation of sensitive NewTech business activities (e.g. B2C FinTech or MedTech activities) can well be derived from this principle, if only it is interpreted in good faith and reasonably. At the same time, the law on abuse of the investor-state dispute resolution process can be used to prevent digital MNEs from using the procedure to unduly hinder states’ legitimate regulatory efforts or to secure for themselves the ability to abuse freedom resulting from regulatory gaps. The international law of human rights can also continue to be a useful measure for setting the right balance between the legitimate interests of investors and the rights of societies in host states. Some more rights – in particular the right to privacy – may just have to be added to the catalog of human rights directly relevant for the exercise.
Other challenging issues will probably be those concerned with the material scope of application of international investment law in the digital economy era. The fact that digital MNEs’ contribution to the economies of foreign states in which they operate is “lighter” and “softer”, i.e. less tangible and visible in terms of development of permanent physical assets or job creation, raises questions about when activities by such MNEs should qualify as foreign investments eligible for protection under international investment law.
The same issues are caused by so-called servicification and the emergence and proliferation of alternative modes of governance in digital MNEs. Digitalization has led to fragmentation of value chains and outsourcing of production functions to contractors, which perform those functions as a service. Should establishments based on non-equity relationships, which are characteristic for the digital economy, be eligible for investment law protection? Can a long-term contract, as concluded by a global contract manufacturing organization with a local manufacturer, be considered an investment, with the state’s interference with this or refusal to enforce it constituting illegal interference with a foreign investment? Given that such contracts are often coupled with long-time commitment of the principal to support the contract manufacturer, with exchange of know-how and intellectual property, and with allowing the contract manufacturer access to client and supplier base, it is difficult to see why this should not be the case. An investment, even though intangible, can still be very valuable for the host state’s economy and difficult to withdraw, and might, therefore, need the full protection of international investment law. These kinds of questions, however, will arise more and more often when applying investment law in Industry 4.0.
It might be the case that the relevance of international investment law to the digital economy will be less than with traditional industry. Part of the process triggered by digitalization of the economy can probably be more appropriately referred to as a second commercial revolution than as a fourth industrial revolution. In a sense, digitalization has opened new trade routes and uncovered a whole new word of valuable “spices” in a similar way to 15th century innovations in navigation. Therefore many issues faced by the global economy as a result of the recent wave of technological advancements are issues which should be addressed by the international law of free trade, which is concerned with access to markets and free movement of goods, rather than the law of foreign direct investment, which deals with proper treatment of foreign permanent business establishments by the host state. Most likely, however, growth of the digital economy will simply lead to further convergence of international economic law.
There are two sides to digitalization. It allows MNEs to operate globally, while concentrating most of their tangible investments in their home state. But it also makes investments made by such MNEs, even only in their home states, vulnerable to challenges from competitors operating from abroad. Because of the phenomenon of “loss of place” which is the peculiar characteristic of Industry 4.0 (the ability of digital entrepreneurs to create value or impact regardless of location and borders)13, investments made by digital companies in their home states have the potential to benefit or harm the entire global economy. This can make some of those companies either benefactors or villains of the entire global economy, despite the fact of their limited physical foreign presence. The proper functioning of Industry 4.0 will thus depend as much on international investment law, as on development of trade law and proper inter-agency cooperation (e.g. in the fields of antitrust, financial supervision, taxation etc.).
The pace of developments in international economic law, including in investment law and dispute resolution, is unlikely to match the speed of recent technical innovation. It will certainly, however, be faster than ever.
Stanisław Drozd, adwokat, Dispute Resolution and Arbitration practice, Wardyński & Partners
1 K. Schwab “The Fourth Industrial Revolution. What it Means and How to Respond”, available at: https://www.weforum.org/agenda/2016/01/the-fourth-industrial-revolution-what-it-means-and-how-to-respond/
2 Investment and the Digital Economy – UNCTAD World Investment Report 2017, p. 158.
3 Investment and the Digital Economy – UNCTAD World Investment Report 2017, p. 163.
4 OECD Digital Economy Outlook 2017 available at: http://dx.doi.org/10.1787/9789264276284-en
5 A. Ross “The Industries of the Future”, page 152.
6 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page 172.
7 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page xiii.
8 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page 162.
9 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page 174.
10 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page 185.
11 K. Milles “The origins of International Investment Law”, page 33.
12 Investment and the Digital Economy – UNCTAD World Investment Report 2017, page 161.
13 OECD Digital Economy Outlook 2017, page 26, available at: http://dx.doi.org/10.1787/9789264276284-en