Efficient Contracting between Foreign Investors and Host States: Evidence from Stabilization Clauses

Bilateral investment treaties are agreements between sovereign states that give broad protections to investors and investments made within the jurisdiction of the other state. The prevailing view in the academy and practice is that developing countries sign bilateral investment treaties in order to reassure investors from developed states that their investments will be safe from changes in domestic law. Without these “credible commitments,” investors would be deterred from making investments, depriving developing countries of foreign capital. This Article disputes that view by demonstrating that foreign investors and host states effectively contract around the risk of changes in the law. This Article applies transaction cost economic theory to the most comprehensive empirical study of stabilization clauses (provisions intended to manage post-investment changes in domestic law) recently conducted under the auspices of the World Bank\u27s International Finance Corporation. The analysis shows that investors and states demonstrate principles of efficient contracting even without the protections of bilateral investment treaties (BITs). This finding adds to current research focusing on the “credible commitment” story. The Article concludes that (1) BITs can be explained as instruments developed and developing states use in their competition for markets and capital and (2) differences in the reasons states execute BITs raise significant doubts about conclusions drawn based on aggregate phenomena