When US company Metalclad took over a hazardous waste disposal site in Mexico, little did it know the problems it was letting itself in for. Local opposition and a merry-go-round of licence application brought work to a standstill. Charles Piggott reports

The story of US industrial insulation company Metalclad’s protracted and costly legal proceedings against the Mexican government will make sober reading for any would-be investor. Even though Metalclad was awarded around $16m (144m pesos) from the Mexican government late last year, its former president and chief executive officer, Grant Kesler, is anything but jubilant.

Compensation followed a North American Free Trade Agreement (Nafta) tribunal ruling that the Mexican government had effectively expropriated 2200 acres of land on which Metalclad had built a hazardous waste disposal facility.

“Our story should send a chilling message to every potential investor in Mexico,” says Mr Kesler, referring to his company’s eight-year struggle against the local authorities over the operation of a hazardous waste plant in Guadalcazar County in the central northern state of San Luis Potosí. Mr Kesler, who was president of the 68-year old, Nasdaq-listed company until last month and is now a consultant there, says corporate victory has come at a high cost. “In a sense we won in the end, since the ruling validated our actions, but really this was a Pyrrhic victory since it cost us more to win than it was worth.”

By the time the Mexican federal government eventually agreed to settle the case at the end of October last year, the international dispute had threatened to engulf not just Metalclad and the local authorities in the state of San Luis Potosí, but also Mexico’s federal government, the Nafta tribunal charged with resolving the dispute and the Canadian courts responsible for upholding the tribunal’s ruling.

Arbitration frustration

Five years after Metalclad began litigation against the Mexican government, Mr Kesler remains utterly frustrated, not just by the actions of the Mexican government, but also with the shortcomings of Nafta’s arbitration procedures. He feels that Metalclad has not been fairly compensated for the loss of revenue on its investment in Mexico. Mr Kesler says that on the basis of his personal experience, foreign investors should not rely on Nafta to protect them from unfair treatment by the governments of member countries. Mr Kesler says: “Nafta Chapter 11 is really there to protect the major corporations, even though I’m not so sure that it is the major corporations that need protecting so much.”

Government accused

Metalclad claims that actual losses on its Mexican venture caused by the actions of the local government, including discounted projected revenues, are closer to $90m. “This has had a devastating effect on our company,” says Mr Kesler. “We went from $130m to $11m.”

Metalclad’s problems began in the early-1990s, when it set an ambitious target of capturing 70% of Mexico’s growing hazardous waste management sector. The US company saw its opportunity in January 1993, when Mexico’s National Ecological Institute (INE) granted Mexican company Coterin a permit to construct a hazardous waste landfill site in the sparsely populated La Pedrera valley in the State of San Luis Potosí, around 70 kilometres from the city of Guadalcazar.

In May of that year, the state of San Luis Potosí also granted Coterin a land use permit for the landfill. However, this permit was subject to compliance with certain technical requirements and the caveat that the permit did not authorise the facility’s actual operation. Three months later, the INE issued a landfill operating permit for the site.

In August 1993, Metalclad bought an option to acquire Coterin and to construct and operate the facility. At the time, talk of Metalclad’s involvement was welcomed by high-ranking US and Mexican officials (including the late US Commerce secretary Ron Brown, US ambassador to Mexico James Jones and Luis Donaldo Colosio, the then Mexican secretary for social development, who was later assasinated while a presidential candidate). They praised the venture as an example of how Mexico’s environmental record could be improved under Nafta.

Machetes drawn

In September 1993, Metalclad exercised its option and took over Coterin. However, it also acquired a history of problems at the Pedrera valley site. The location of the hazardous waste site had caused strong local feelings from the start, and the problems had surfaced long before Metalclad took control. In 1991, local residents brandishing machetes took matters into their own hands, bringing work to a standstill when the company refused to obey a federal order closing the site. By the time Metalclad acquired Coterin, there were approximately 20,000 tonnes of hazardous waste material that had not been treated and needed to be cleaned up.

Initially, the federal government supported Metalclad’s bid to operate the hazardous waste site in San Luis Potosí. “There were differing views, but the federal government, within its jurisdiction, wanted this project to go ahead,” admits Hugo Perezcano, the head of the Mexican government’s legal team,. “Of course, back then, the federal government did not have all the information that it ultimately acquired in respect of Metalclad as the actual operator.”

During the tribunal hearings, Metalclad argued successfully before the panel that both INE’s president and the director-general of Mexico’s Secretariate of Urban Development and Ecology (SEDUE) advised Metalclad’s management that, except for a federal operating permit, all required permits for the facility had already been secured by Coterin.

Local support lacking

Unfortunately for Metalclad, the company’s management failed to secure the same level of support at the local level. Although the then governor of San Luis Potosí, Horacio Sanchez Unzueta, at first denounced the project, after months of negotiation, Mr Kesler claims the governor appeared to come round to the idea of supporting the project. But Mr Kesler can give no adequate explanation of what happened next.

According to Metalclad, for no apparent reason, the state governor changed his mind again. Mr Kesler admits that there was some local opposition; however, he says the vast majority of the 850 adults within a 10-mile radius supported the project. “The opposition came from the other side of the mountain range, nowhere near the project” he asserts. He accuses the state governor of stirring up local sentiment against the project.

Luis Rodolfo Rodrigues is an environmental lawyer who has worked for the state government of San Luis Potosí for eight years and has had a longstanding involvement with the case of Metalclad. He says that Metalclad’s problem was that the US company never really made contact with the local community. “The biggest problem was that Metalclad didn’t win the trust of the local people. They didn’t trust Metalclad or the federal government. They felt they were not being told the truth about what would happen at the site.”

Encouraging signs

Despite the strong local opposition, the federal authorities reassured Metalclad of their support for the project. In the spring of 1994, Metalclad won an 18-month extension of the construction permit issued by INE and work began on the landfill site in May. Both state and federal representatives inspected the disposal facilities during their construction.

The federal government still maintains that the location in Guadalcazar County is suitable for a waste disposal site and that the right operator could have succeeded. Mr Perezcano says: “The federal authorities always believed, and continue to believe, that the site was suitable, that it met the technical, geological and other requirements and that operation could have succeeded.”

Mr Perezcano argues that the problem was Metalclad’s size and lack of experience, not the location of the waste disposal site. “Metalclad had absolutely no experience in the environmental sector at all, much less in the toxic waste sector. Many of the problems Metalclad faced in its operations were because of its own lack of experience and financial capability. Had it been a larger company, it could have undertaken to remediate the project, but being a very small company, they did not have the necessary monies to do that. They needed to operate [the facility] to generate some revenue.”

Mr Kesler contends that Metalclad’s facilities were built to the highest US standards. “It was a showcase facility,” he claims. However, Mr Perezcano dismisses Mr Kesler’s claim, describing the facility as “really a very basic construction”.

In the autumn of 1994, to Metalclad’s surprise and growing alarm, events took a rapid turn for the worse. The way Metalclad tell it, their story was soon to become every investor’s worst nightmare.

In October 1994, Guadalcazar’s city government ordered Metalclad to down tools and to stop all construction work on the site. The local authority claimed that Metalclad had failed to gain the relevant municipal construction permit. Metalclad would later argue before the Nafta tribunal that INE assured the company at this time that although no municipal construction permit was required, the federal agency would help Metalclad to gain the permit which could not be refused by the city government. On this basis, Metalclad applied to the city government for a construction permit.

Red tape cut

Hopes that the bureaucratic red tape would finally be cut were raised when two independent reports confirmed the suitability of the site, the first by the University of San Luis Potosí and the second by Profepa, the independent federal office for environmental protection. Since Metalclad believed it had INE’s approval to complete construction of the facility, it started construction work at the site once more.

However, the favourable conclusions of the independent reports were not enough to quell local opposition. At the hazardous waste disposal site’s opening ceremony, demonstrators effectively brought the operation to a standstill.

The facility then remained closed until November 1995, when Metalclad agreed to remediation measures that included the designation of some of its land as a reserve for native plant species, the establishment of a committee to monitor the remediation work, the commitment to provide semi-annual lectures on hazardous waste management, a discount for locally generated hazardous waste, free medical services to the Guadalcazar community and various contributions to local civic organisations.

However, despite the remediation agreement struck at the federal level, the city government’s cabinet, known as the cabildo, refused Metalclad’s request for a construction permit which was still outstanding. The city authorities also filed a law suit challenging the federal agreement with Metalclad and were successful in securing a preliminary injunction preventing the operation of the landfill site. The state governor proceeded by signing an order that the site be closed down, citing a geological audit that claimed that the facility risked contaminating a local water supply.

“The cabildo was not happy with the guarantees for the people, either from the federal government or from the company and refused permission on that basis” says state lawyer Mr Rodrigues. “Since neither Metalclad nor the Mexican company before it really took the trouble to talk to the local people, they were worried that they were not being told the truth.”

However, at the same time that Metalclad’s waste disposal plant was being closed by the local authorities, the company was being encouraged to expand its operations by the federal agencies. Despite the local authorities’ effective block on the project, INE issued another permit allowing Metalclad substantially to increase the capacity of the landfill from 20,000 to 120,000 tonnes a year. However, this permit was never fulfilled and the facility remained dormant as a result of the injunction and the local authority’s order that Metalclad still did not have the required municipal permit.

Governor’s riposte

Then, in what Mr Kesler describes as “the governor’s parting shot”, he declared the site part of an ecological zone before handing over office to his successor. “His last act as governor was to declare 60,000 acres of cactus an environmental reserve,” says Mr Kesler bitterly.

On October 4, 1996, frustrated by the antics of the local authorities, Metalclad began legal proceedings that would eventually call for international arbitration under Nafta Chapter 11, the part of Nafta dealing with investment provisions and rules on expropriation. Lawyers acting for Metalclad argued that Mexico’s federal government was responsible under international law for the conduct of its political subdivisions and that the local authorities of San Luis Potosí and Guadalcazar had violated Nafta sections 1105 and 1110.

Nafta section 1105 requires that investments are accorded “fair and equitable” treatment in accordance with international law. Section 1110 prohibits any party from directly or indirectly expropriating investments, or taking any measures “tantamount” to expropriation, without compensation.

According to Metalclad, once the company had called for international arbitrators to decide if Mexico was in breach of the Nafta Treaty, the Mexican authorities turned the dispute into a personal fight. Allegations of untoward behaviour began to appear in local press coverage. Mr Kesler recalls: “Once we had brought the action against Mexico, they tried to turn it into a personal attack on us and on our character. Among other things, they tried to show that we had engaged in attempted bribery.”

Employees testify

According to Mr Kesler, the Mexican authorities also approached former employees from the past 10 years to ask them to testify against their former employer; two former directors made statements against Metalclad.

Finally, in August 2000, a Nafta tribunal held in Vancouver, Canada voted unanimously in favour of Metalclad, ruling that the Mexican government had violated both sections 1105 and 1110 of Nafta. The tribunal ruled that the actions of the Mexican state and municipal authorities entailed a breach by Mexico of its obligations to give fair and equitable treatment to Metalclad’s investment under Nafta article 1105. Furthermore, it ruled that by permitting the actions of the municipal authorities, Mexico’s actions were tantamount to expropriation of Metalclad’s investment under Nafta article 1110, since those actions “effectively and unlawfully prevented the claimant’s operation of the landfill”.

The three-judge panel, which included prominent lawyers from the US (a former US attorney general), Mexico and the UK, also found that Metalclad had secured all required permits from the Mexican federal authorities to construct and operate a hazardous waste facility. Metalclad was therefore entitled to compensation, including interest, for its losses from the Mexican government. The panel ordered the Mexican government to pay $16.7m in compensation.

In making the award, the panel concluded that the federal government had “failed to ensure a transparent and predictable framework for Metalclad’s business planning and investment”. The panel also found that, regardless of their concern about the environmental impact of the waste disposal site, the local authorities had acted outside their powers. The belated creation of an environmental reserve by decree of the state governor on its own amounted to an act of expropriation of Metalclad’s property.

A hollow victory

Although the ruling went in Metalclad’s favour, Mr Kesler is disappointed the panel rejected the company’s claim for damages on the basis of projected future earnings, since the site was not deemed to be a going concern. (Damages were assessed on the basis of Metalclad’s actual investment.)

At first Mexico refused to accept the ruling, arguing for an appeal on procedural grounds. On October 27, 2000, the government filed an application to have the award set aside with the Supreme Court of British Columbia in Vancouver, designated a neutral court under the Nafta agreement. However one year later, Mexico gave up its appeal and agreed to pay the $16m in compensation to Metalclad.

In accepting the ruling, Mexico conceded its responsibility for the actions of local authorities. Although the federal government agreed to settle the case on the basis that a large proportion of Metalclad’s $90m claim had been set aside, the Mexican federal government still takes issue with some of the implications of the ruling.

The head of Mexico’s legal team says that the government’s main concern was that the Nafta tribunal was attempting to act outside its proper jurisdiction. Mr Perezcano says: “Our biggest concerns involved the tribunal exceeding its jurisdiction and pretty much legislating new obligations into Chapter 11 and into Nafta as a whole.”

Mr Perezcano is also concerned at the panel’s attempt to reverse domestic legal precedents, particularly those concerning the jurisdiction between federal and state authorities in issuing building permits. “We do not want international tribunals to step into the shoes of domestic courts.” Mr Perezcano adds: “In effect, what the Nafta tribunal did was to ignore or reverse previous [Mexican] judicial decisions. That sets a dangerous precedent.” He argues that while international tribunals should decide international law, they have no authority to rule on domestic laws that apply, for example, to the issuance of licences.

Chapter 11 under fire

Opponents of Nafta argue that Chapter 11 has made government authorities an easy target to legal challenges from companies which believe their property or business value has been affected by government actions. The implication is that national powers to act on issues such as the environment, public health, labour and employment and natural resources may be weakened by the growing number of companies seeking to litigate under free trade agreements such as Nafta.

José Luis Siqueiros, professor of law at the National University of Mexico and one of the three arbitrators involved in the case of Metalclad, believes government powers are not threatened, provided arbitration panels stick closely to Nafta’s terms. He says: “It is my view that Nafta’s article 1105(1) should not be interpreted too broadly but in conjunction with article 1110 (1) of the same treaty, on a case by case basis. Each party to the instrument should accord to the investors a treatment in accordance with international law, including fair and equitable treatment.

“Therefore, when internal law, such as a municipal authority, denies a foreign investor any rights covered by a treaty concluded by the recipient state, that is, international law, it must be assumed that such state has taken a measure tantamount to an indirect expropriation of the investment.”

Nevertheless, environmentalists and other public interest groups are still concerned that an international arbitration panel that has closed its doors to outside third-party representation has the power to over-rule a local authority and the domestic courts on environmental matters. Even Metalclad’s lawyer, Clyde Pearce, admits: “The process ought to be more open to the public.”

Some argue that the panel’s decision, regardless of the facts in the case of Metalclad, has downgraded local authorities’ power to act on their environmental concerns. Like the Mexican government, environmentalists do not want governments or domestic courts to lose power to international tribunals. As far as the interpretation of Mexican environmental and other laws are concerned, these should have been heard before Mexican courts, say environmentalists. In reaction to the Metalclad ruling, environmental organisations such as Greenpeace have labelled Nafta a “corporate assault” on local environmental regulation.

On the other side of the argument, proponents of free trade point out that under Nafta section 1114, national governments are permitted to ensure that investments meet that country’s environmental standards. In the case of Metalclad, since federal agencies had already granted the relevant permits, the arbitrators ruled that Mexico was in fact satisfied with the project’s environmental impact.

Unfortunately, it appears that little has been gained for the environment by stopping Metalclad from operating the hazardous waste facility in Guadalcazar County. The state of San Luis Potosí still faces the task of clearing up Metalclad’s hazardous waste site at an estimated cost of between $5m and $25m. “The site is still contaminated and no-one is looking after it,” says state environmental lawyer Luis Rodolfo Rodrigues. “Neither the state nor federal authorities have the money to clean up the contaminated land and this is a big problem, not just for the state, but for the federal government as well.” When asked whether he thinks another foreign company would step into the breach, Mr Rodrigues says: “I don’t think foreign companies will take the risk of coming to San Luis Potosí, although if they did, they would have no problem now.”

Greenpeace wades in

Not everyone takes at face value Metalclad’s claims to be on the side of the environment. Greenpeace, for example, claims that Metalclad concentrated on expanding the capacity of the site rather than cleaning up the existing 20,000 tonnes of toxic waste left by Coterin that had not been handled properly. Greenpeace also expressed concern over toxic leakage and supported opposition to the project on the basis that Mexican environmental standards governing site selection for a toxic landfill had been violated by the project.

However Metalclad argues that the clean-up operations were always conditional on receiving permission to operate the site since it needed to create the revenue necessary to meet the clean-up costs. Says Mr Kesler: “The greatest irony is that the Nafta ruling is held up as being anti-environment. Metalclad never produced one grain of hazardous material. Instead we created the capacity to dispose of 300,000 tonnes of hazardous waste in Mexico.” Mr Kesler argues that by even the most conservative estimates, Mexico needs at least three more hazardous waste sites: “Mexico creates around 10 million tonnes of hazardous waste per year and only 10%-12% of this is disposed of properly. ”