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Metalclad in Mexico (B)

Despite its problems in San Luis Potos (SLP), Metalclad remained excited about the Mexican waste industry.1 By early 1997 the company was operating eleven waste transfer facilities in as many Mexican states and had plans to expand its operations. With the vast majority of Mexicos hazardous and nonhazardous wastes going untreated and often dumped illegally, the market opportunities were huge. As the dispute resolution process under the North American Free Trade Agreement (NAFTA) proceeded (discussed below), the company rolled out new projects. In February 1998 the company announced the beginning of construction on a non-hazardous waste landfill and treatment center in the state of Aguascalientes (Exhibit 1). Shortly thereafter the companys President and CEO, Grant Kesler, said that Metalclads Mexican subsidiary was in the process of finalizing a deal to purchase a site for another hazardous waste treatment and landfill facility elsewhere in central Mexico.2 In its annual 10-K filing in mid-March, the company declared that it expected to achieve profitability in both its US and Mexican operations in 1998, the beginning of substantial returns following tens of millions of dollars in investment.3 Chronically short of funds and showing persistent net operating losses due to its expansion plans, the company found its NAFTA claim expenses adding substantially to its financial burden (Exhibit 2 and 3). As a result, the company found itself short of funding for the Aguascalientes facility and relied in part on financing from the construction company while it sought a long-term capital source for the $10 million facility.4 The deal itself looked like a winner to Metalclads management. The states governor, Otto Granados, had implemented an ambitious and successful campaign to attract foreign investment. By the late 1990s, the state was producing some 300,000 tons of industrial waste. Much of this was being illegally placed in a city dump in the state capital, a site that sat on top of a major aquifer. Granados, sympathetic to Metalclads problems in San Luis Potos, invited the company to invest in a proper treatment facility and landfill for the state. After much study, a site was selected in the municipality of El Llano, fifteen miles from the capital. Housing some 17,000 residents, the area was one of the few potential sites found suitable for the project in this small central Mexican state.5 Having learned a valuable lesson from its experience in SLP, Metalclad moved to line up political support, particularly from local residents, before construction began. As part of its strategy, the company approached Julia Carabias, head of the federal Ministry of the Environment, Natural Resources, and Fisheries (SEMARNAP). An ally in Metalclads attempts to open the hazardous waste facility in San
This case is designed to be used with Metalclad in Mexico (A), which provides a discussion of Metalclads problems in the Mexican state of San Luis Potos. 2 John ODell, Heard on the Beat: Metalclad Expands in Mexico Despite Expropriation Tiff, Los Angeles Times, March 11, 1998, p. D-10. 3 Anonymous, Metalclad Announces Filing of Its Annual 10K Report and Improvement in Revenues, PR Newswire, April 16, 1998. 4 Ibid. 5 Sam Quiones, Mexicos Wastelands, MB Magazine, April 1999, p. 44-45; Interview with Grant Kesler, President and CEO of Metalclad Corporation, April 25, 2001.
1

Copyright 2002 Thunderbird, The American Graduate School of International Management. All rights reserved. This case was prepared by Professor Patrick Cronin, with assistance from Michelle Jenkins, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

Luis Potos, Carabias pledged support for the Aguascalientes project. To facilitate the process, Carabias assigned a full-time liaison from her ministry and traveled herself to the state to publicly demonstrate her backing. Locally, Metalclad arranged more than forty meetings to explain the project to every relevant group it could find. Over twenty such groups, including non-governmental organizations, farmers, state and local officials, and academics were consulted. At the end of this process, little opposition had been voiced and the requisite permits were issued to construct and operate the facility.6 An August 1998 opening was expected. During the summer, however, political problems emerged. At the national level, the Ministry of Foreign Trade and Industrial Development (SECOFI), representing the Mexican government in the NAFTA dispute, pursued a no holds barred offensive against the company. Behind the scenes SECOFI officials effectively pressured the government-connected Mexican bank Banobras to withdraw its support for the Aguascalientes project. While the bank was not putting up any money (only a letter of credit as a guarantee), it did provide important political backing to the project. Additionally, a SECOFI representative quietly (but unsuccessfully) exerted high level pressure on SEMARNAP to withdraw support as well.7 Even more important, the facility became the object of considerable debate within the state. Elections were slated for August and the facility became a political football in the race for mayor of El Llano. The candidate from the opposition National Action Party (PAN) attacked his opponent for his affiliation with Mexicos dominant political party, the Institutional Revolutionary Party (PRI). It was the outgoing PRI mayor and PRI governor (Granados) who supported the project and the PAN candidate charged that it posed a health risk to local residents. This fight soon spilled over into the gubernatorial campaign. Felipe Gonzlez, the PAN candidate, used Granados approval to attack his PRI rival. Gonzlez declared that he would never allow a dump to be built. Stung by party ties to the man who had approved the facility, the PRI candidate, Hugo Olivares, stated that he wouldnt support it either. Local residents took their cues from the politicians and began to vigorously oppose the project. Even though the National Ecology Institute (INE) had issued a permit, the local representative of its parent ministry, SEMARNAP, now vocalized his opposition.8 In late September, a group of residents blockaded the road leading to the facility. Granados, now a lame-duck in office, refused to intervene. 9 Company officials announced a halt to construction efforts, nearly two weeks before completion. Work was also suspended on three additional projects in other parts of Mexico. At this point the company had invested some $40 million in Mexico. The company met with state and local leaders throughout the third and fourth quarters of 1998, hoping to get the project restarted. In its 10-Q filing for the third quarter, the company declared that it expected smoother relations with state and local officials once new administrations took office in December. Seeking sufficient funds to see it through the following year, the company considered a range of proposals. However, the most favorable ones failed to materialize and the company rejected the rest. Instead, it opted for an austerity plan to conserve its capital. Meanwhile, costs associated with the NAFTA claim kept mounting.10

What little opposition there was came from some businessmen who objected to having to pay to dispose of their waste. Quiones, p. 45; Kesler interview. 7 Kesler interview. 8 INE functions in a manner similar to the US Environmental Protection Agency. 9 Quiones, p. 46. 10 Joel Millman, Metalclad of US Calls a Halt to New Investment in Mexico, Wall Street Journal, October 1, 1998; Anonymous, Metalclad Files Quarterly Results, PR Newswire, November 23, 1998; Anonymous, Metalclad Announces Dates for Completion of its NAFTA Arbitration and Further Progress in Mexico, PR Newswire, January 29, 1999.
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The NAFTA Claims Process

In January 1997, citing its rights under Chapter 11 of NAFTA, Metalclad had filed a Notice of Claim with the International Center for the Settlement of Investor Disputes (ICSID), a member of the World Bank Group. In its complaint, Metalclad charged that the Mexican government had violated a variety of its NAFTA obligations. These included non-discriminatory treatment of foreign investment (national treatment) as well as most-favored-nation treatment (Articles 1102 and 1103). The claim also stated that Mexico had failed to treat foreign investors (in this case, Metalclad) according to fair and equitable treatment provisions in international law (Article 1105). Finally, the company alleged that the Mexican government had expropriated the companys investment in violation of the procedures specified in Article 1110. This article limits expropriation acts to those that serve a public purpose, are conducted on a non-discriminatory basis, and that follow due process of law.11 The companys claim was duly approved and registered and a tribunal was constituted in May 1997. The three-member panel was comprised of one member from each country that was a party to the dispute (in this case the US and Mexico) with an agreed upon third member serving as chair. In its 10Q filing for the second quarter of 1997, the company announced that Mexico would be given 90 days to reply once the company had filed all documents supporting its claim. The company expected to file their claim by September and have a final ruling from the panel in the first quarter of 1998.12 In mid-October, the company filed a memorial containing over 1000 pages. Metalclad asked for $90 million in compensation, a sum representing its investment as well as foregone profits. In December, Mexico received an extension for filing its counter-memorial and submitted its response in February 1998. However, not all exhibits were translated and re-submissions of this material delayed the process until mid-July 1998. Surprised by the volume of material as well as the nature of the arguments made, Metalclad filed a request to respond to the counter-memorial in April and was given a June 30, 1998 deadline.13 After subsequent rounds of filings and replies, Mexico was given a March 19, 1999 deadline for submitting its rejoinder. This deadline was extended twice at Mexicos request and the rejoinder was submitted in early May 1999. For Metalclad, the decision would ultimately come too late. By early 1999 the company had had enough. A decision was made to cut the companys losses, sell its Mexican operations and refocus its strategy on the United States. For its part, the Zedillo administrations waste policy was finished as well. After aggressively supporting investment in the waste industry, the federal government was backpeddling furiously in the face of state and local level opposition to particular projects. By the end of 1997, halfway through its six-year term, the administration had quietly backed down on an ambitious program to encourage the development of regional waste recycling and treatment centers. Within the environmental bureaucracy, personnel supporting the old policies were pushed out or left on their own. Permitting of waste facilities and the release of environmental regulations ground to a halt. By the beginning of 2000, Mexicos presidential election campaign was in full swing. This led to a decision to put the hazardous waste issue on hold. It would be left to Mexicos next administration.14
Anonymous, First Chapter 11 Requests for Arbitration with Mexico Filed, North American Free Trade & Investment Report, March 31, 1997. 12 Anonymous, Metalclad Announces Quarterly Results and New Project Financing, PR Newswire, August 14, 1997; At the beginning of the claims process, Kesler believed that the proceedings would take no longer than the 90-day limit imposed on government-to-government disputes under NAFTA. Kesler interview. 13 According to Kesler, the Mexican government had elected to bury the company in paperwork and also exerted pressure on various Mexican witnesses to provide evidence supporting the governments position. Mexican officials even complained to the US government when the US Ambassador to Mexico provided statements that bolstered Metalclads case. Subsequently, the US State Department issued a rule requiring all embassy personnel worldwide to obtain prior approval before participating in private litigation. Kesler interview. 14 Quiones, p. 44; Sam Quiones, Down in the Dumps, Latin Trade, March 2000, p. 72.
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A full hearing on Metalclads claim was eventually held in Washington, DC from August 30 to September 9, 1999. At the hearing, Mexican officials, including Carabias, from all levels of government testified in support of their governments position. At the center of Mexicos case was the argument that the local government, which denied Metalclad a construction permit for its SLP facility, was constitutionally empowered to make this decisioneven on environmental grounds. Metalclads lawyers argued that no other such construction permit had ever been required of anyone before or since in the state. What is more, under the Mexican constitution, the federal government was vested with complete authority over hazardous waste permitting. In early February 2000, ICSID officials notified each party that the panelists were delaying their ruling, citing the complexity of the case. A decision could now be issued no earlier than mid-April. On August 30, 2000 the panel made public its ruling. In a unanimous decision, the panel upheld the companys contention that Mexico had violated Metalclads rights under Articles 1105 and 1110 of NAFTA. In a strongly worded ruling, the tribunal declared that the Mexican government had failed in its duty to provide a transparent legal environment for Metalclad and in doing so had violated an international legal obligation to provide fair and equitable treatment.
The Tribunal understands this [transparency] to include the idea that all relevant legal requirements for the purpose of initiating, completing and successfully operating investments made, or intended to be made, under the Agreement should be capable of being readily known to all affected investors of another [NAFTA] Party. There should be no room for doubt or uncertainty on such matters. Once the authorities of the central government of any Party (whose international responsibilities in such matters has been identified in the preceding section) become aware of any scope for misunderstanding or confusion in this connection, it is their duty to ensure that the correct position is promptly determined and clearly stated so that investors can proceed with all appropriate expedition in the confident belief that they are acting in accordance with all relevant laws. [NAFTA Tribunal Decision, from paragraph 76]15

Additionally, the panelists ruled that, separate from the fair and equitable treatment issue, Mexico had violated its obligations relating to expropriation. The denial of the permit by the local government was improper.
Even if Mexico is correct that a municipal construction permit was required, the evidence also shows that, as to hazardous waste evaluations and assessments, the federal authoritys jurisdiction was controlling and the authority of the municipality only extended to appropriate construction considerations. Consequently, the denial of the permit by the Municipality by reference to environmental impact considerations in the case of what was basically a hazardous waste disposal landfill, was improper, as was the municipalitys denial of the permit for any reason other than those related to the physical construction or defects in the site. [NAFTA Tribunal Decision, paragraph 86]16

The panelists ordered the Mexican government to pay Metalclad $16.7 million in compensation. This figure represented the value of the lost investment plus accrued interest. Because the facility was not yet in operation (and thus not a going concern), the company was not eligible for compensation for lost profits.17 Having spent $4 million pursuing the NAFTA claim, Kesler termed the decision Pyrrhic. This is a token amount of money that doesnt really reflect the value of the project, Kesler remarked. The

15 Cited in Editor, Putting Teeth into NAFTAs Fair Treatment Provisions, Latin American Law & Business Report, October 31, 2000, p. 30. 16 Ibid. 17 International law requires a three-year period of operation to be considered a going concern. Kesler interview.

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biggest losers of all are the Mexican people who continue to live in a country that produces 10 million tons of hazardous waste a year and has only one facility in the whole country to handle it.18 Mexico promptly appealed the ruling. In accordance with the mutually agreed-upon terms for hearing the claim, a judge with the British Columbian Supreme Court held hearings in March 2001. In May, he issued a split decision, upholding the illegality of the expropriation but criticizing the claims panel for giving private companies too much protection on the issue of transparency. The judge also cut the award to $15.6 million. In the immediate aftermath of the ruling, both Metalclad and the Mexican government expressed unhappiness and each vowed to appeal. However, subsequent discussions took place, ending in an agreement by the Mexican government to pay the reduced judgment. In late October 2001 the Mexican government gave Kesler and Metalclad a check for slightly more than $16 million and the company handed over title to the property in San Luis Potos.19

Anthony DePalma, Mexico is Ordered to Pay a US Company $16.7 Million, New York Times, August 31, 2000, p. A4. Kesler provided the amount spent on the case. 19 Anon., Eye on Investors, Mexico Pays U.S. Company, New York Times, October 29, 2001, p. A4.
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Exhibit 1

Map of Mexico

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Exhibit 2

Metalclad Corporation Consolidated Balance Sheets, 1991-2000 (in $000s)

12/31/00 12/31/99 354 NA 3,966 114 NA NA NA 779 416 5,630 336 NA 336 NA 4,906 NA NA 26 10,898 NA 2,167 62 NA 722 NA 1,146 4,098 NA NA 310 123 NA NA 4,531 NA NA 658 67,660 -59,871 NA -2,080 6,367 10,898 769 NA 1,645 162 NA NA NA 779 422 3,777 358 NA 358 NA 4,816 NA NA 23 8,974 NA 899 43 NA 499 NA 2,411 3,852 NA NA 360 106 NA NA 4,317 NA NA 486 64,331 -58,106 NA -2,054 4,657 8,974 12/31/98 520 NA 829 177 NA NA NA NA 352 1,877 272 NA 272 NA 9,096 NA NA 43 11,288 NA 636 19 NA 914 NA 4,597 6,166 NA NA 1,202 52 NA NA 7,419 NA NA 3,057 57,405 -53,908 NA -2,685 3,869 11,288 12/31/97 1,511 NA 1,415 161 NA NA NA NA 470 3,557 87 NA 87 NA 7,846 NA NA 43 11,533 NA 860 20 NA 453 NA 521 1,854 NA NA 1,500 NA NA NA 3,354 NA NA 3,006 56,963 -49,129 NA -2,660 8,179 11,533 12/31/96 05/31/96* 3,074 NA 2,479 314 NA NA NA NA 668 6,535 5,319 NA 5,319 1,542 NA NA 697 838 14,931 NA 1,665 230 NA 1,876 NA 45 3,816 NA NA NA NA NA NA 3,816 NA NA 2,912 55,582 -44,644 NA -2,736 11,115 14,931 7,344 NA 2,298 326 NA NA NA NA 216 10,183 5,463 NA 5,463 1,194 NA NA 753 109 17,702 NA 1,150 37 NA 2,141 NA 70 3,397 NA NA 240 NA NA NA 3,636 NA NA 2,873 54,991 -41,364 NA -2,435 14,066 17,702 05/31/95 381 NA 2,338 374 NA NA NA NA 1,223 4,316 5,267 NA 5,267 243 6 595 144 139 10,710 NA 2,752 1,119 NA 2,213 NA 114 6,197 NA NA 8,636 2,050 NA NA 16,884 NA NA 1,589 29,044 -34,584 NA -2,222 -6,173 10,710 05/31/94 1,146 NA 2,436 365 NA NA NA NA 1,044 4,991 4,053 NA 4,053 155 31 775 7,253 1,052 18,311 NA 1,977 433 NA 1,855 NA 18 4,283 NA NA 8,755 2,662 NA NA 15,701 NA NA 1,169 20,644 -19,185 NA -18 2,610 18,311 05/31/93 328 NA 2,575 322 NA NA NA NA 662 3,887 641 NA 641 155 54 412 NA 319 5,469 220 1,030 100 NA 700 NA 212 2,262 NA NA 4,733 192 NA NA 7,186 NA NA 789 11,840 -14,292 NA -53 -1,717 5,469 05/31/91 377 NA 3,623 641 NA NA NA NA 2,447 7,089 283 NA 283 623 120 75 NA 114 8,303 2,117 1,636 598 NA 794 NA 252 5,399 NA NA NA 357 NA NA 5,755 NA NA 655 8,011 -6,118 NA NA 2,548 8,303

FISCAL YEAR ENDING ASSETS Cash Marketable Securities Receivables Inventories Raw Materials Work in Progress Finished Goods Notes Receivable Other Current Assets Total Current Assets Property, Plant & Equipment Accumulated Dep Net Property & Equipment Invest. & Adv. To Subs Other Non-Current Assets Deferred Charges Intangibles Deposits and Other Assets Total Assets LIABILITIES Notes Payable Accounts Payable Cur Long Term Debt Cur Port Cap Leases Accrued Expenses Income Taxes Other Current Liabilities Total Current Liabilities Mortgages Deferred Charges/Inc Convertible Debt Long Term Debt Non-Cur Cap Leases Other Long Term Liabilities Total Liabilities Minority Int (Liab) Preferred Stock Common Stock Net Capital Surplus Retained Earnings Treasury Stock Other Equities Shareholder Equity Tot Liab & Net Worth

*Metalclad changed its fiscal year to mirror the calendar year in 1996. Source: Company 10-Ks from the Global Access database.

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Exhibit 3

Metalclad Corporation Consolidated Statements of Income, 1991-2000 (in $000s)

12/31/00 17,769 15,753 2,016 NA 3,501 -1,485 NA -217 NA -1,702 NA NA NA NA -1,702 -63 -1,765 6,581 $1.50 12/31/99 13,422 11,605 1,816 NA 3,437 -1,621 NA -351 NA -1,971 NA NA NA NA -1,971 -2,228 -4,199 4,859 $5.69 12/31/98 10,009 8,620 1,388 NA 2,977 -1,588 NA -187 NA -1,775 NA NA NA NA -1,775 -3,003 -4,778 30,569 $4.06 12/31/97 8,971 7,686 1,285 NA 3,348 -2,063 NA 62 NA -2,001 NA NA NA NA -2,001 -2,610 -4,610 30,064 $10.93 12/31/96 5,519 4,816 703 NA 2,608 -1,905 NA 199 NA -1,706 NA NA NA NA -1,706 -1,574 -3,280 29,123 $18.12 05/31/96* 11,445 10,335 1,110 NA 5,732 -4,622 NA -638 371 -5,630 NA NA NA NA -5,630 -1,150 -6,780 28,733 $31.87 05/31/95 17,952 18,110 -158 NA 6,971 -7,129 NA -6,498 1,771 -15,399 NA NA NA NA -15,399 NA -15,399 11,691 $18.75 05/31/94 16,055 18,405 -2,350 NA 2,157 -4,507 NA 458 844 -4,892 NA NA NA NA -4,892 NA -4,892 11,691 $35.00 05/31/93 7,272 9,738 -2,466 NA 925 -3,391 NA 22 274 -3,643 NA NA NA NA -3,643 NA -3,643 7,890 $43.75 05/31/91 21,593 18,131 3,462 NA 3,362 101 NA 312 303 109 44 NA NA NA 65 -1,041 -976 7,326 $11.25

FISCAL YEAR ENDING Net Sales Cost of Goods Gross Profit R & D Expenditures SG & A Inc Before Dep & Amort Depreciation & Amort Non-Operating Inc Interest Expense Income Before Tax Prov for Inc Taxes Minority Int (Inc) Invest Gains/Losses Other Income Net Inc Before Ex Items Ex Items & Disc Ops Net Income Shares Outstanding Closing Stock Price

*Metalclad changed its fiscal year to mirror the calendar year in 1996. Source: Company 10-Ks from the Global Access database.

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