Regulatory Chill and the Effect of Investor State Dispute Settlements

Legal conflicts between multinational firms and host governments are often decided by international arbitration panels - as opposed to courts in the host country - due to provisions in international investment agreements known as Investor State Dispute Settlements (ISDS). Critics fear that investor protection such as ISDS make governments reluctant to adopt appropriate policies (regulatory chill). In this paper I develop a theoretical model in which the outcome of cases brought to court is uncertain due to the vagueness of the law protecting investors and a court’s inability to correctly identify a state of nature with certainty. I show that from a world welfare perspective there is no underregulation, only an overregulation problem. However, from a national welfare perspective “frivolous” lawsuits may lead to regulatory chill. I also identify conditions under which ISDS can lead to a Pareto improvement which involves simultaneous changes in compensation payments and protection rights relative to a national court.