Don't abuse me: the prudential quandary

Mike Alberti over at Remapping Debate has published an investigative piece that looks at the financial services provisions of the Korea FTA. He reports:

Most free trade agreements contain a so-called “prudential carve-out” section that is designed to protect a country’s right to regulate its economy. The “Financial Services” Chapter of the FTA contains such a provision ...

Public Citizen’s Tucker wrote in an email that the net effect was the prudential carve-out section was “self-cancelling.” True exceptions to trade agreements would, in contrast, “clearly allow countries reprieve from their obligations under the agreement if the exception’s requirements are met.”...

According to Joshua Meltzer, a Global Economy and Development fellow at the Brookings Institution, who has written in support of the FTA, the limiting sentence of Article 13.10 is merely designed to “make sure that you basically don’t use prudential regulation as a disguise to get out of your commitment.”

The argument that prudential defense clauses are intended to root out abuse has been made elsewhere, and it is no more convincing this time around.

Prudential Language vs. True Anti-Abuse Provisions

Here again is the text of the prudential provision in the Korea FTA:

a Party shall not be prevented from adopting or maintaining measures for prudential reasons, including for the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system. Where such measures do not conform with the provisions of this Agreement referred to in this paragraph, they shall not be used as a means of avoiding the Party’s commitments or obligations under such provisions.

Compare this with the language of the chapeau (top paragraph) of GATS Article XIV, which WTO panelists have argued are indeed anti-abuse provisions:

Article XIV: General Exceptions  

Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where like conditions prevail, or a disguised restriction on trade in services, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any Member of measures:

(a)        necessary to protect public morals or to maintain public order;(5)

(b)        necessary to protect human, animal or plant life or health;

(c)        necessary to secure compliance with laws or regulations which are not inconsistent with the provisions of this Agreement including those relating to:

(i)        the prevention of deceptive and fraudulent practices or to deal with the effects of a default on services contracts;

(ii)        the protection of the privacy of individuals in relation to the processing and dissemination of personal data and the protection of confidentiality of individual records and accounts;

(iii)        safety;

(d)        inconsistent with Article XVII, provided that the difference in treatment is aimed at ensuring the equitable or effective(6) imposition or collection of direct taxes in respect of services or service suppliers of other Members;

(e)        inconsistent with Article II, provided that the difference in treatment is the result of an agreement on the avoidance of double taxation or provisions on the avoidance of double taxation in any other international agreement or arrangement by which the Member is bound.

Or take a look at GATT's Article XX, the chapeau of which states:

Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures: [of, for instance] (a) necessary to protect public morals;...

The panel in the U.S.-Gambling case wrote that:

6.574    The Appellate Body in US – Gasoline also stated that the chapeau to Article XX of the GATT 1994 has been worded to prevent the abuse of exceptions under that Article:

"The chapeau by its express terms addresses, not so much the questioned measure or its specific contents as such, but rather the manner in which that measure is applied. It is, accordingly, important to underscore that the purpose and object of the introductory clauses of Article XX is generally the prevention of 'abuse of the exceptions of [what was later to become] Article [XX].'  This insight drawn from the drafting history of Article XX is a valuable one. The chapeau is animated by the principle that while the exceptions of Article XX may be invoked as a matter of legal right, they should not be so applied as to frustrate or defeat the legal obligations of the holder of the right under the substantive rules of the General Agreement. If those exceptions are not to be abused or misused, in other words, the measures falling within the particular exceptions must be applied reasonably, with due regard both to the legal duties of the party claiming the exception and the legal rights of the other parties concerned."...

6.581    To sum up these interpretive principles, the chapeau of Article XX of the GATT 1994 addresses not so much a challenged measure or its specific content, but rather the manner in which that measure is applied, with a view to ensuring that the exceptions of Article XX are not abused.  In order to do so, the chapeau of Article XX identifies three standards which may be invoked in relation to the same facts: arbitrary discrimination, unjustifiable discrimination and disguised restriction on trade.  In our view, these principles would also be applicable in relation to Article XIV of the GATS.

Article XIV sets up, depending on the subparagraph, a set of necessity or "relating to" requirements - hurdles that Public Citizen certainly opposes, so we're not advocating for their inclusion in a new prudential carve-out.

But the chapeau of GATS Article XIV also has the standard anti-abuse language: "constitute a means of arbitrary or unjustifiable discrimination between countries where like conditions prevail, or a disguised restriction on trade in services..." A prudential carve-out focused on ferreting out abuse a la GATS Article XIV would have something like this language:

a Party shall not be prevented from adopting or maintaining measures for prudential reasons, including for the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system, subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where like conditions prevail, or a disguised restriction on trade in services.

Recognizing the importance of financial services regulation, we've advocated language which would give a vital additional margin of deference to regulators:

a Member shall not be prevented from adopting or maintaining measures relating to financial services it employs for prudential reasons, including for the protection of consumers, investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial services supplier, or to ensure the integrity and stability of the financial system. For greater certainty, if a Party invokes this provision in the context of consultations or an arbitral proceeding initiated under the Dispute Settlement Understanding, the exception shall apply unless the Party initiating a dispute can demonstrate that the measure is not intended to protect consumers, investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial services supplier, or is not intended to ensure the integrity and stability of the financial system.

This recognizes that there may be instances where trade restrictiveness (disguised or not) could be a by-product of the regulatory process. Moreover, it notes that a WTO panel shouldn't be put in the position of having to assess the "likeness" of surrounding conditions or "arbitrariness" of measures to save the economy.

Application of measure

So, what is it about the existing prudential language that makes it self-cancelling? Look at the second sentence: "Where such measures do not conform with the provisions of this Agreement referred to in this paragraph, they shall not be used as a means of avoiding the Party’s commitments or obligations under such provisions."

The use of the phrase "used as a means of avoiding" in the prudential defense context bears certain resemblance to the Article XIV "are not applied in a manner." But there are differences between the two. The latter focuses on how a compliant or non-compliant policy might, in its application, constitute protectionism. The former establishes a means-end relationship: does a non-compliant policy lead to non-compliance?

A prudential carve out that focused on the abuse-through-application of the underlying measure could have stated something like "Measures under this paragraph shall be applied on a non-discriminatory basis."

Burden of Proof and Double Jeopardy

The chapeaus of GATT Article XX and GATS Article XIV refer to instances where a domestic policy measure has already been deemed not in compliance with trade obligations; the defendant government has invoked and made a prima facie case of why an exception (such as the necessity of defending public morals) should apply; and the panel then has to consider whether the exception (once granted on a preliminary basis) is being abused. Typically, the burden of proof in these three moments shifts from complainant, to respondent, to complainant. Or, as the Antigua panel stated:

6.450    In US – Wool Shirts and Blouses, the Appellate Body stated that the burden of proof rests upon the party, whether complaining or defending, who asserts the affirmative of a particular claim or defence.   Accordingly, a party seeking to invoke Article XIV of the GATS bears the burden of proof to demonstrate that the various elements comprising a defence under this Article have been fulfilled.

But under the prudential provision, the panel would have already ruled that the challenged "measures do not conform with the provisions" of the FTA. When a respondent government tried to invoke the exception, it would be caught in a sort of "double jeopardy." Say a country institutes a size cap on the financial sector. If it works, it will definitely help the member avoid their "commitments or obligations under the" FTA or GATS. It will only be if the policy does not work (i.e. it is not effective), that the policy will not be helping the country avoid its "commitments or obligations under the" FTA or GATS. Put a different way, the commitment or obligation is to refrain from limiting the size of the financial sector. If you're limiting the size of the financial sector, you are violating your commitment or obligation.

Indeed, rather than comparing the prudential second sentence to the chapeau of GATS Article XIV, it may be more appropriate to compare the prudential second sentence to the text of GATS Article XIV(c). The latter references the consistency of the underlying measure with GATS obligations, much as the second sentence of the prudential measure. The Antigua panel's treatment of Article XIV(c) is instructive:

we note that Article XIV(c) provides a non-exhaustive list of laws or regulations "which are not inconsistent with the provisions of this Agreement". The list refers to laws and regulations for the prevention of deceptive and fraudulent practices or to deal with the effects of a default on services contracts;  the protection of the privacy of individuals in relation to the processing and dissemination of personal data; and the protection of confidentiality of individual records and accounts; and safety.  Accordingly, laws and regulations other than those that fall within the list may be relied upon in justifying a GATS-inconsistent measure under Article XIV(c) provided that those other laws and regulations are WTO-consistent... 

Antigua submits that, to the extent that US state gambling laws are inconsistent with the GATS, they cannot be invoked as the basis for a defence under Article XIV(c)...  

The United States has noted that most of the state gambling laws upon which it relies in justifying the Wire Act, the Travel Act and the Illegal Gambling Business Act under Article XIV(c) are those challenged by the Antigua in its Panel request. However, the United States has provided us with no specific discussion of why and how the various state laws are WTO-consistent other than to say that Antigua has failed to make out a prima facie case with respect to those laws and that, therefore, their WTO-consistency can be presumed. In the Panel's view, this assertion is not enough to discharge the United States' obligation to demonstrate that it complied with the requirements of Article XIV(c)...  

In summary, the Panel finds that the United States may not rely upon state gambling laws in making its defence under Article XIV(c) because the laws of four US states upon which the United States seeks to rely have been found to be inconsistent with US obligations under the GATS in these proceedings.

While the appellate body reversed the specific finding as to the GATS consistency of the state laws referenced in the quotes above, they upheld the finding of the applicability of XVI(2) to the federal Internet gambling ban. And the panel's logic is instructive: if the panel has already ruled that a measure is GATS-inconsistent, then this obliterates a country's ability to invoke an exception that hinges on GATS consistency.

Conclusion

In sum, the prudential defense measure could have been written in any number of ways to make it an anti-abuse provision rather than a self-cancelling exception. These options were not taken. A WTO or FTA panel will have limited jurisprudence to consult to establish precisely what it means, but they're unlikely to simply import the anti-abuse GATT Article XX chapeau and GATS Article XIV chapeau jurisprudence, given the differing language. (The panel would note that the U.S. negotiators would have been very familiar with the standard GATT anti-abuse language, dating to 1947. If the negotiators had intended to have an anti-abuse provision, they could have used that language.) They're also likely to consider therefore past interpretations of GATS Article XIV(c), an exception provision which refers explicitly to the GATS consistency of the underlying measure.