Compensation for Regulatory Expropriation Under NAFTA: Mexico and the Metalclad Case

Jaime Palafox
Skadden, Arps, Slate, Meagher & Flom, LLP

Introduction
In 1994, as a result of intense negotiations over a three-year period between Canada, Mexico and the United States, the North American Free Trade Agreement ("NAFTA") entered into force. With the NAFTA came several new mechanisms to deal with the environmental issues that might arise as a consequence of liberalized trade and increased investment between the NAFTA countries. Most of the environmental measures that finally made it into the text of the NAFTA responded to the preoccupation, expressed by groups in the United States and, to a lesser extent, in Canada, that the reduction of barriers to trade and investment in the NAFTA countries would make investors choose to relocate their operations to Mexico–a country with less stringent environmental enforcement, according to these groups–in order to lower the costs of compliance as compared with those in their own countries.

While there may still be a debate as to whether the concerns that prompted the creation of environmental protection mechanisms in the NAFTA were well-founded, recently, there have been other non-environmental provisions of the NAFTA that have come under scrutiny due to their potential effect on environmental regulation in the NAFTA countries. Indeed, some of the investor protection mechanisms of the NAFTA, particularly article 1110, although not meant to do so, may have created a new venue for litigation challenging environmental laws and regulations issued by local and national governments in Canada, Mexico and the United States. Under article 1110, an investor may seek compensation from a member government when governmental actions tantamount to an expropriation take place in a NAFTA country.

The first claim seeking compensation under the provisions of article 1110 was filed in 1997 by Metalclad Corporation, a U.S. company, and involves actions taken by the State of San Luis Potosi in Mexico. The matter is already undergoing review by a dispute resolution panel appointed under the venue of the World Bank’s International Centre for Settlement of Investment Disputes ("ICSID"). The Metalclad case arose out of a dispute over the siting of a hazardous waste disposal facility located in San Luis Potosi, Mexico. The facility has been barred from operating under local laws (though it appears to have complied with all applicable federal permits required under Mexican environmental laws). The Metalclad case appears to be Mexico's version of the "not-in-my-backyard" ("nimby") syndrome, but with an added NAFTA twist. If Metalclad succeeds in obtaining compensation from the Mexican government, this case may create a precedent for litigation related to environmental regulation in the NAFTA countries.

Hazardous Waste Regulations in Mexico
Mexico has made great strides to develop a regulatory framework that will enable it to appropriately deal with environmental matters. This regulatory framework was strengthened in February 1988 with the enactment of the Mexican General Law of Ecological Balance and Environmental Protection (the "General Environmental Law"). As Rodrigo Armada-Osorio and Daniel Basurto have explained above, Mexico’s General Environmental Law establishes national environmental policy, and creates a framework for dealing with environmental issues, including environmental impact assessment, air pollution, water pollution, hazardous waste management, and the protection of natural resources; it also sets out the distribution of jurisdiction over environmental matters among the federal, state and municipal governments. Mexican environmental protection measures are further defined by the enactment of regulations, which set rules regarding a particular media (i.e., water pollution, air pollution, etc.) and Mexican Official Norms (Normas Oficiales Mexicanas or "NOM’s"), which set out the specific criteria and technical parameters under which a particular media will be regulated. In November 1988, as described by Daniel Basurto in a previous article, Mexico enacted its regulations for treating, handling and disposing of hazardous waste.

According to the General Environmental Law, in Mexico, the Federal Government has exclusive jurisdiction over the regulation of hazardous waste, including the siting of hazardous waste landfills. While the General Environmental Law sets the policy with regard to the jurisdictional aspects for permitting hazardous waste disposal facilities in Mexico, local, state and municipal governments have had to bear the burden of dealing with the political pressures derived from the "nimby" syndrome.

The size of the un-treated hazardous waste problem in Mexico is large. According to Mexico’s Ministry of Environment, Natural Resources and Fisheries ("SEMARNAP"), approximately eight million tons of hazardous waste are generated in Mexico annually, of which only 25 percent receives any kind of treatment. In recent years, as Mexico has looked for ways to deal with its overload of untreated hazardous wastes, the Federal Government began permitting hazardous waste landfills in various parts of the country, sparking confrontations between federal and local authorities over the siting of such facilities. As authorized by law, SEMARNAP, through the National Institute of Ecology ("INE"), has issued permits authorizing the siting and operation of hazardous waste landfills; however, these landfills have had to contend with the vigorous opposition of local communities that do not want such facilities located next to them. While hazardous waste landfill permitting is a federal prerogative, local authorities, sensitive to the concerns of their constituencies, have in some cases responded by trying to use local laws and ordinances to prevent the location of federally-authorized hazardous waste landfills close to their communities. This tension between the different Mexican governmental agencies has led to the closure of two of the three federally permitted hazardous waste landfills in Mexico. In Metalclad, local authorities used their authority to issue building permits and create state ecological reserves to prevent the operation of the hazardous waste landfill built by Metalclad in Guadalcazar, San Luis Potosi.

The Metalclad Landfill
By reconstructing accounts from various sources, it is evident that in 1988, a Mexican company, Confinamiento Tecnico de Residuos Industriales ("Coterin"), received authorization from federal environmental authorities in Mexico to operate a hazardous waste transfer station in Guadalcazar del Rio, San Luis Potosi. The transfer station was authorized to receive and temporarily store hazardous wastes prior to their shipment to a hazardous waste disposal site. The Coterin facility operated for a number of years, but was not only temporarily storing hazardous wastes but also accumulating a substantial amount of such wastes without, it would appear, any intention of sending them to another facility for disposal.

Around 1992, after receiving complaints from local community members (made public, apparently, at a visit of then-President Carlos Salinas de Gortari), Mexican environmental authorities inspected the operation of the Coterin hazardous waste transfer station and found approximately twenty thousand tons of hazardous wastes that had not been properly disposed of. The transfer station was permanently closed by PROFEPA and emergency measures were taken to prevent any soil or groundwater contamination. The site was not cleaned up, however, because neither the owners of the facility nor the government possessed the financial resources to do so. Apparently, in order to ensure the clean-up of the facility, Mexican environmental authorities worked out a deal by which they would issue the appropriate permits for a landfill to be operated by Coterin. The company would then be able to properly dispose of the hazardous waste already found at the Coterin transfer station and could operate the facility going forward. Prior to 1993, Coterin received all federal permits needed to operate a hazardous waste landfill in Guadalcazar; Coterin also applied for a land-use permit – which was issued by San Luis Potosi authorities in 1993 – and a building permit from municipal authorities in Guadalcazar. In the case of the municipal building permit, the Guadalcazar municipal authorities did not respond to Coterin's application, either denying or approving the building permit request.

In September 1993, Metalclad, which at the time was trying to build a hazardous waste incinerator in the San Luis Potosi area, signed a contract to buy one hundred percent of Coterin’s shares, apparently, in order to take advantage of its hazardous waste landfill operating permit. The Coterin landfill had not yet received approval of its building permit application.

In 1994, a new governor was elected in San Luis Potosi. After concerns were expressed by community members with regard to the safety of allowing a hazardous waste landfill to be operated in Guadalcazar, the new governor responded by commissioning studies related to the risks presented by the project, and by pressuring federal environmental authorities for additional review of its safety. Such studies, done with the participation of several research institutions in Mexico, found that the Guadalcazar area was an appropriate area for the siting of the hazardous waste landfill.

While the controversy between the San Luis Potosi government and Metalclad regarding the siting of the Guadalcazar landfill continued to grow, in 1995, with all of the federal and state permits in place, but without a municipal building permit, Metalclad commenced construction of the Guadalcazar landfill. In November of that year, SEMARNAP issued a permit for the operation of the Metalclad facility, conditioning its operation upon the clean up, by Metalclad, of the hazardous wastes still located at the Coterin hazardous waste transfer station. Soon thereafter, Guadalcazar sought a permanent injunction against the operation of the Metalclad landfill from a federal district court in San Luis Potosi and requested that the district court determine whether Metalclad could operate its landfill without a municipal building permit. A letter denying the building permit – apparently, issued in late 1995 – was attached to the injunction request. The district court issued the permanent injunction and Metalclad has not been able to operate the landfill pending the outcome of the lawsuit filed by Guadalcazar.

On January 2, 1997, Metalclad submitted its notice of claim to the ICSID Secretariat charging that Mexico violated several NAFTA provisions, including those governing national treatment (Art. 1102), most-favored nation treatment (Art. 1103), performance requirements (Art. 1106) and expropriation and compensation (Art. 1110). Metalclad charged that state officials had not granted the corresponding permits "...due to political differences with the state and local governments in question..." and that it had invested over $25 million in the construction of the landfill, and lost revenues of over $30 million. On January 13, 1997, ICSID registered the notice and notified Mexico and Metalclad to move ahead with the appointment of arbitrators to hear the dispute. A decision in the Metalclad arbitration is expected soon.

NAFTA’s Investor Protection Provisions
While the Metalclad arbitration is based on various grounds, the claim that has brought the most attention to the proceeding is grounded on the expropriation and compensation provisions of Article 1110 of the treaty. This article states that:

"No Party may directly or indirectly nationalize or expropriate an investment of an investor of another Party in its territory or take a measure tantamount to nationalization or expropriation of such an investment, except when such actions are taken (1) for a public purpose, (2) on a non-discriminatory basis, (3) in accordance with due process of law and Article 1105 (1)(which refers to an investor right to fair and equitable treatment in accordance with international law), and (4) on payment of compensation as stipulated in Article 1110."

Compensation paid under Article 1110 must be estimated using the fair market value of the expropriated investment, immediately before the expropriation took place and without reflecting any change in value prior to the date of expropriation derived from knowledge about the impending expropriation. Additionally, Article 1114(1) establishes that nothing in Chapter 11 shall be construed to prevent a party from adopting, maintaining or enforcing any measure otherwise consistent with Chapter 11 that it considers appropriate to ensure that investment activity in its territory is undertaken in a manner sensible to environmental concerns.

Article 1110 of the NAFTA identifies three government actions that are deemed expropriatory and will give rise to compensation: (1) direct expropriation; (2) indirect expropriation; and (3) measures tantamount to expropriation. While the language regarding direct expropriation is straightforward and characterizes the most common cases of expropriation, the language of the article that covers indirect expropriation and measures tantamount to expropriation may have created problems for the NAFTA governments by allowing for compensation for expropriation stemming from a governments’ regulatory efforts. NAFTA does not define what is considered an indirect expropriation or a measure tantamount to expropriation, and, at least for the moment, has left such determination with the arbitration panels that may be instituted to hear Chapter 11 complaints.

While there is no clear definition as to the meaning of both terms, a November 1998 memorandum addressed to its Mexican and U.S. counterparts by the Canadian Department of Foreign Affairs and International Trade outlined the key issues related to the interpretation of the indirect expropriation and measures tantamount to expropriation language. The Canadian government stated that the following governmental actions could constitute examples of indirect expropriation: confiscatory taxation, incremental measures with a cumulative expropriatory effect or revocation of or failure to renew licenses or approvals necessary for the enterprise to operate. In that memorandum, the Canadian government recognized that there is no clear way to distinguish between compensable takings and non-compensable regulation in Chapter 11, and that any attempt at a "hard and fast" clarification or test could be arbitrary. The Canadian government did, however, suggest a possible interpretation of principles to define the scope of Article 1110. The Canadian proposal, although not publicly announced, suggests five principles: (1) that liability for expropriation does not require transfer of title to the State; (2) that liability may arise whenever acts attributable to a State deprive a foreign investor of property rights of value, irrespective of whether the State has obtained anything of value; (3) that liability may be found where a State subjects a foreign investor or investment to such unreasonable interference with the effective enjoyment of property notwithstanding that the acts or measures in question are not labeled expropriations or nationalizations: (4) that the intent to expropriate or the absence thereof on the part of the State is not necessarily determinative of a finding of liability; and (5) that customary law recognizes the acts or measures that may have an impact on the value of property rights are not expropriatory where such acts or measures are non-discriminatory and within the normal exercise of a State’s regulatory prerogative. Americas Trade, Feb. 11, 1999, at 20, 21. The Canadian proposal is a first step to define the scope of Article 1110 but certain issues, such as what would constitute a measure within the normal exercise of a State’s regulatory prerogative, remain to be resolved.

There have not been any public discussions held by Canada, Mexico and the United States with regard to the interpretation of the expropriation and compensation provisions, though the three countries have met several times over the past two years to discuss the issue. Press reports regarding such negotiations suggest that the United States is internally analyzing its position on the clarification of Article 1110, while Mexico’s position has been that the text of the NAFTA should not be open for discussion, even if only to interpret the agreement. Americas Trade, Sept. 9, 1999, at 1, 13-14. If the NAFTA members do not break the deadlock, it is possible, given the requirement of consensus among the three parties to make decisions within the NAFTA, that the interpretation of Article 1110 will be left with to the arbitrators.

Precedent Under Chapter 11 of NAFTA
Although the Metalclad dispute was the first arbitration instituted under NAFTA’s Chapter 11 investor protection provisions, four other cases have been filed since that action was brought. The four cases are: (1) the S.D. Myers case, which relates to a temporary Canadian ban on exports of PCB’s and where the plaintiff seeks the payment of $20 million in damages; (2) the Sunbelt case, brought by a U.S. company against Canadian restrictions on water exports, which seeks to recover damages in the amount of $220 million; (3) the Pope & Talbot case, where a U.S. company seeks to recover $30 million for damages allegedly caused by provisions of the Canadian-U.S. agreement on lumber trade; and (4) the Ethyl case, where a U.S. company sought payment of $250 million in damages related to the application of Canadian restrictions on the international and interprovincial trading of MMT, a fuel additive. With the exception of the Ethyl case, all the other cases brought under the Chapter 11 dispute resolution mechanism have not yet been resolved. The Ethyl case is particularly relevant because the Canadian government, in response to the filing of an arbitration dispute by Ethyl Corporation, settled with the company for $13 million and revoked a measure which prohibited the international or interprovincial trade of MMT– a gasoline additive, which was manufactured by Ethyl in the U.S. and sold in Canada through a wholly-owned Canadian subsidiary. The case raised fears among environmental groups that governments would be willing to change regulations that have an environmental purpose, in order to avoid the risk of having an arbitral decision issued against them in by a Chapter-11 arbitration panel. These fears may be even greater if the number of cases increases rapidly and the potential for Chapter 11 arbitration becomes a factor in deciding whether to enact a particular regulation.

Conclusion
The decision issued in the Metalclad case may be key in defining whether the regulatory expropriation language in Article 1110 of the NAFTA will create a new venue for environmental litigation. Even without a decision on Metalclad, it is clear that if the NAFTA member countries do not define the reach of Article 1110, we should expect a new body of decisions that will help create an additional environmental litigation and compensation tool within the NAFTA. It is likely that the number of complaints brought seeking compensation for regulatory expropriation will increase. Without an agreement among the NAFTA parties the interpretation will be left with ad-hoc arbitration panels.

A decision issued against Mexico in the Metalclad case may well amount to the payment of damages for up to $90 million – the amount sought by the company to date, which includes its initial investment plus its lost earnings. Considering that the budget of the Mexican environmental ministry amounts to approximately one billion dollars a year, it is possible that the payment of a large arbitration award may lead toward diminishing or slowing the permitting process for hazardous waste landfills by Mexican officials. This seems rather a perverse effect of the "nimby" syndrome, particularly in a country that has a recognized problem with the appropriate disposal of such wastes. And, if we consider that, potentially, most of the investment in the hazardous waste management sector in Mexico is likely to involve foreign investment – the other two hazardous waste landfills in Mexico are foreign-owned – given the large amount of investment required to build and operate them, the likely immediate outcome of the Metalclad case may be the filing of more Chapter 11 environmental cases against Mexico. Currently, another hazardous waste landfill located in Hermosillo, Mexico faces closure related to community opposition, even though it had been properly permitted by Mexican federal authorities.

The choice of Chapter 11 arbitration in order to receive compensation for regulatory expropriation is likely for foreign investors since Chapter 11 may present a more lucrative alternative to repair any damage suffered as a result of governmental actions. Under Mexican law, the concept of regulatory takings is not yet prevalent, and the calculation of compensation for any expropriation is not based on fair-market-value. Chapter 11 would constitute a definite advantage for foreign investors in expropriation cases. The disparity of treatment between Mexican and foreign investors with regard to regulatory expropriation, given the difference between Mexican law and the NAFTA provisions, although not widely-discussed among Mexico’s legal community, may result in Mexico moving toward accepting the concept of regulatory expropriation as actionable expropriation in a court of law.

If anything, the Metalclad case points out the need for Mexico to enter into an internal discussion as to the distribution of jurisdiction on environmental matters between the federal, state and municipal governments. Without such constructive discussion, which should be taken up with the appropriate judicial authorities, if necessary, the occurrence of other Metalclad-like cases is high. From the perspective of environmental policy and protection, the prevalence of regulatory takings in Mexico, with or without equitable compensation, will likely be a detrimental factor in the development of the much needed infrastructure for resolving environmental problems, including the appropriate handling of hazardous waste. At the same time, Mexico needs to find a way to make environmental permitting more responsive to community concerns so as to relieve pressure from local governments that have to directly face those issues.