Legality of Investment

Some investment treaties contain a provision that defines qualifying investments as those made, accepted or established “in accordance with the [host State’s] laws” or include a separate clause requiring the qualifying investments to be made “in accordance with the laws and regulations” of the host State.¹ These provisions have been understood to limit the scope of application of the investment treaty and thus the State parties’ consent to arbitration.² The legality requirement has however been distinguished from investment admission or permission prerequisites.³

Whether the requirement of legality should be presumed where the applicable treaty contains no such explicit provision or clause is controversial. Some tribunals have found that, even in the absence of a legality requirement, the legality of the investment is a prerequisite for their protection under the applicable investment treaties.⁴ Others have denied reading such an implied condition into the treaty text.⁵

The legality requirement has been taken into consideration when determining the definition and the existence of an investment.⁶ Under this approach, illegally acquired assets are not considered as an investment. Other tribunals have refused to follow this approach.⁷ See further Definition of investment, Salini test, Jurisdiction ratione materiae.

Not all violations of the host State’s laws will place the investment beyond the protection of the investment treaty.⁸ Instead, the scope of the legality requirement covers:

1. non-trivial violations of the host State’s legal order;⁹
2. violations of the host State’s foreign investment regime;¹⁰ and
3. fraud - for instance, to secure the investment or profits.¹¹

If a given violation is not severe enough to render the acquisition or establishment of the relevant investment void or invalid under the applicable law (e.g. trivial registration or notification defects), it will be difficult to argue that it places the investment outside the scope of the investment treaty.¹²

Moreover, proportionality of the sanction¹³ and failure of the host State to prosecute the alleged illegality may also be considered by the tribunals in the context of legality requirement.¹⁴ To this extent, tribunals have considered that the absence of protest or prosecution by the host State creates legitimate expectations for investors, estopping the host State from asserting an illegality defence.¹⁵

The investor’s conduct and the exercise of due diligence by the investor have also been taken into account by tribunals.¹⁶

Violations of the host State's laws and regulations that occur after the investor has acquired or established the investment do not, as a rule, place the investment outside the scope of the investment treaty.¹⁷ However, they may have an impact on the assessment of the merits.¹⁸ When investments are made through a series of acts, tribunals have considered that all of these acts must be legal, going beyond a simple evaluation of the final act completing the establishment of the investment.¹⁹

It is uncontroversial that the question of whether the investor made an investment lawfully is to be assessed under the applicable municipal law of the host State.²⁰ This does not mean, however, that the procedural rules applicable to establishing illegality (e.g. rules of civil or criminal procedure) will apply. The procedure remains governed by the relevant arbitration rules and the lex arbitri.

In addition, one could posit circumstances of trans-border criminal activities, in which the laws of other jurisdictions, e.g. the law of the investor’s home State, may become relevant. In addition, in cases where a tribunal is faced with allegations of serious violations that are against international public policy, the question of illegality may be governed by the so-called “truly international public policy”.²¹

The widespread nature of a certain criminal activity in the host jurisdiction is not in principle a valid argument that justifies illegality.²² Tribunals are hardly impressed by an argument that for instance corruption is a usual business practice in the host State and therefore should not be held against the investor.²³

When an investment treaty contains a legality provision, disputes arising out of an investment acquired or established in violation of the host State’s law will generally be outside the treaty’s scope and thus beyond the jurisdiction of the arbitral tribunal constituted under the treaty.²⁴ Violations of municipal law that fall outside the scope of the treaty’s legality provision do not affect the tribunal’s jurisdiction but may be relevant for the analysis of the merits.²⁵

However, there is criticism with regards to treating the legality requirement as a jurisdictional issue as a matter of principle.²⁶

Where no express provision is present in the treaty, however, the consequences of illegality are less clear.²⁷ There are three approaches in the case law:

1. illegal investments are considered outside the scope of the applicable treaty irrespective of the existence of an express wording to that effect. Thus, the illegality constitutes a bar for the tribunal’s jurisdiction;²⁸
2. although not an issue of jurisdiction, illegal activities that constitute a violation of the international public policy (e.g. corruption) render the investor’s claims inadmissible in investment arbitration;²⁹
3. illegality should be assessed as part of the merits of the dispute, e.g. as a possible justification for the host State’s measures against the investor.³⁰

While the general burden of proving that the investment was made is on the investor, an allegation of illegality must generally be proven by the respondent State that raises the defence.³¹

The issue of the standard of proof applicable to establishing illegality is controversial.³² Three main approaches are discernible from the relevant case law:

1. since illegality is a serious allegation it should be proven with clear and convincing evidence, or a similar heightened standard;³³
2. the standard of proof is not different from the one that applies in relation to other allegations in investment arbitration, since the consequences of a finding of illegality in investment arbitration is not comparable to that of the domestic criminal proceedings, where heightened standard may be applicable;³⁴ and
3. given that illegality, and especially the cases of corruption, are notoriously difficult to prove, no direct evidence may be available, and thus, the tribunal may be guided by circumstantial evidence, such as red flags.³⁵