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NAFTA’S Chapter 11 and U.S. Trade Agreements

New York Law Journal

June 27, 2008
by Stephen L. Kass and Jean McCarroll

At the time President George H.W. Bush signed it in 1992, the North American Free Trade Agreement (NAFTA) seemed to many environmentalists to threaten hard-won U.S. environmental standards because of Mexico’s historically weak enforcement of its environmental (and other) laws.

To secure support from the new Clinton administration and approval by Congress, the NAFTA parties adopted a contemporaneous side agreement establishing the North American Commission for Environmental Cooperation (CEC), with a mandate to assess and report on the NAFTA parties’ enforcement of their environmental laws.

At the same time, however, U.S. investors concerned that investments in Mexico would be vulnerable to expropriation, either by direct governmental action or by burdensome regulation, sought protection through a special arbitration procedure set forth in NAFTA’s Chapter 11.

CEC vs. Chapter 11

The resulting tension between the CEC procedures (which encourage enforcement of environmental laws) and Chapter 11 (which imposes liability for discriminatory or confiscatory enforcement of environmental and other laws) has been a continuing source of concern for NAFTA observers. The current presidential race seems likely to focus increased attention on this and other NAFTA issues, especially since the United States has now included updated versions of Chapter 11 in new or pending bilateral trade agreements with Israel, Jordan, Chile, Singapore, Australia, Morocco, Bahrain, Panama, Korea, Peru, and Columbia and in its Central American Free Trade Agreement (CAFTA).

This column examines whether, as environmentalists feared, NAFTA’s Chapter 11 has proved to be an expensive barrier to environmental regulation.[1] Future columns will assess the performance of the CEC in encouraging environmental enforcement by the NAFTA parties and NAFTA’s broader role in the North American environment.

Chapter 11 Claims 

Chapter 11 requires the NAFTA parties to:

  1. afford U.S., Canadian, and Mexican investors “national treatment” (§1102);
  2. comply with international law (including “fair and equitable treatment”) in dealing with their investments (§1105); and
  3. refrain from acting in a manner that either expropriates investors’ property or is “tantamount to an expropriation” without compensation (§1110).

Investors aggrieved by a breach of these guarantees may seek damages, through arbitration proceedings, directly against the offending NAFTA party, bypassing sovereign immunity and providing a neutral forum insulated from the political pressures affecting host countries’ administrative and judicial systems.

Chapter 11 burst unexpectedly onto the environmental scene when several early awards compensated investors for damages resulting from government actions growing out of environmental disputes, often at the state or municipal level. Most notably, the arbitral tribunal in Metalclad v. Mexico (2000), awarded damages to the claimant, the owner of a hazardous waste landfill in Mexico, for local government actions that prevented the landfill from opening despite the Mexican federal government’s assurances that all necessary permits were in place. The Metalclad decision raised the possibility that arbitral tribunals under Chapter 11 might force the NAFTA parties to compensate investors for any diminution in investment value caused by environmental restrictions, exposing the parties to potentially massive liability and chilling their environmental enforcement. The language, if not the facts, of other early awards, such as S.D. Myers v. Canada (2000) and Pope & Talbot v. Canada (2001), also suggested that Chapter 11 could have such an effect.

The governmental actions challenged in Metalclad and S.D. Myers were environmental protection measures, but on the facts of those cases the arbitrators’ holdings were not unreasonable. The real threat of those awards lay in their expansive dicta, which might have permitted recovery even for scientifically grounded environmental laws applied equally to foreign and domestic companies. More recent Chapter 11 awards have substantially reduced that risk. Since the Metalclad, S.D. Myers, and Pope & Talbot awards, it appears that no Chapter 11 claimant has recovered damages for a governmental action related to the environment.

As discussed below, the United States prevailed in Methanex v. United States (2005), and the NAFTA parties have now adopted binding interpretations of Chapter 11 that make a number of important procedural reforms (decisions of Chapter 11 tribunals are now, at least in theory, publicly available and tribunals are encouraged to accept amicus submissions from nongovernmental organizations). Nevertheless, the only readily accessible public repository of Chapter 11 materials is a private Web site,[2] and private arbitrators, not courts, are still deciding the legitimacy of the parties’ domestic laws.

‘Methanex’

In Methanex, the claimant was a Canadian investor in U.S. methanol production facilities. Methanol is a chemical precursor of methyl tertiary-butyl ether (MTBE), an oxygenate that can reduce automotive emissions but has a propensity to contaminate groundwater. In response to concerns about MTBE’s effect on groundwater, the California Legislature commissioned the University of California to study the environmental effects of MTBE and alternative oxygenates, including ethanol, and required the governor to certify that MTBE either does or does not pose “a significant risk to human health.”

The study concluded that MTBE creates a risk of water contamination and that the best alternative would be nonoxygenated gasoline. Because federal law required that gasoline contain oxygenates, the study concluded that the next best alternative was gasoline with ethanol as an oxygenate. After public hearings, California Governor Gray Davis certified that MTBE posed a significant risk to human health, and ultimately California banned MTBE as a gasoline additive. Since California was unable to obtain an exemption from the federal oxygenate requirement, one effect of the MTBE ban was to increase ethanol use in California.

The claimant alleged that California violated the §1102 “national treatment” and §1105 “fair and equitable treatment” requirements of Chapter 11 by banning MTBE with the intent to favor domestic ethanol producers over foreign methanol producers. It also claimed that California had violated §1110 by destroying the value of a substantial portion of its investment. The core of the claimant’s allegations was that any environmental justification for California’s MTBE ban was merely a pretext for economic protectionism.

The tribunal, however, found that California’s MTBE ban was motivated by the “honest belief, held in good faith and on reasonable scientific grounds, that MTBE contaminated groundwater and was difficult and expensive to clean up.”[3] (The tribunal also refused to infer from Governor Davis’ receipt of a campaign contribution from Archer Daniels Midland, an ethanol industry participant, that California intended to favor the ethanol industry over the methanol industry.) Having rejected this central argument, the tribunal had little difficulty disposing of the claimant’s claims under §§1102, 1105 and 1110.

In particular, the tribunal rejected the claimant’s §1110 claim that California’s conduct was tantamount to an expropriation. Under international law, said the tribunal, “a nondiscriminatory regulation for a public purpose, which is enacted in accordance with due process and, which affects, inter alios, a foreign investor or investment is not deemed expropriatory and compensable unless specific commitments had been given by the regulating government to the then putative foreign investor contemplating investment that the government would refrain from such regulation.”[4]

The tribunal then held that California’s MTBE ban was nondiscriminatory, for a public purpose, and enacted in accordance with due process, and therefore not an expropriation. The tribunal also held that an investor may rely on a government’s representations of nonregulation only to the extent such reliance would be reasonable. Neither California nor the U.S. federal government had represented to the claimant that it would not regulate MTBE and, the tribunal said, it would have been unreasonable to rely on such a representation in any case since chemical compounds are often heavily regulated for health and environmental reasons.

If followed by future tribunals, this language in the Methanex decision should offer significant protection to governments resisting §1110 expropriation claims resulting from bona-fide environmental initiatives. Interestingly, the Methanex tribunal does not appear to have considered whether California’s MTBE ban deprived the claimant of all economically viable uses of its investment, perhaps because California’s MTBE ban merely decreased the size of the U.S. methanol market. 

Other Awards

Another recent Chapter 11 award, Fireman’s Fund Insurance Co. v. Mexico (2006), further clarifies the reach of §1110. The claimant there argued that the Mexican government had expropriated its investment in debt instruments issued by a Mexican financial institution. In this instance, the tribunal held that a government action is not an expropriation unless it results in a substantially complete deprivation of the claimant’s economic use of property rights (or distinct parts thereof). Like the Methanex tribunal, the Fireman’s Fund tribunal held that, when considering whether a government measure is a valid regulation or a compensable expropriation, tribunals should consider whether the measure is discriminatory, whether it is within the government’s police powers, and whether the measure is bona-fide. The Fireman’s Fund tribunal also stated, however, that the effects of the government’s actions control for the purpose of determining its nature, not the government’s intent.  

In GAM Investments Inc. v. Mexico (2004), the claimant owned stock in GAM, a Mexican sugar refining company. The Mexican government explicitly expropriated several of GAM’s sugar mills, which allegedly constituted all of GAM’s productive assets. The tribunal nevertheless rejected the claimant’s expropriation claim, holding that the claimant failed to prove that the Mexican government had totally destroyed the value of its investment since GAM could seek compensation for those expropriations under Mexican law. While this may appear to run counter to the purpose of Chapter 11, it does make clear that the availability of a functioning judicial system and a recognized judicial remedy will help protect the NAFTA parties from Chapter 11 claims.[5]

Two other arbitral tribunals have rejected efforts by claimants to extend Chapter 11’s protections beyond the cross-border investment context. In Canadian Cattlemen for Fair Trade v. United States (2008), Canadian beef producers sought compensation for economic losses they suffered when the United States closed its border to Canadian beef in an effort to ward off bovine spongiform encephalopathy (BSE), also known as “mad cow disease.” The tribunal held that it lacked jurisdiction over this claim because Chapter 11 protects only investors of one NAFTA party that make investments in the territory of another NAFTA party. The tribunal held that the extent to which the relevant market is integrated between the two parties is irrelevant.

The tribunal in Bayview Irrigation District v. Mexico (2007), rejected the U.S. claimant’s argument that its rights to take water from the Rio Grande constituted an investment in Mexico. Acknowledging that water rights can constitute property subject to expropriation, the tribunal noted that Texas, not Mexico, granted the claimant’s water rights and that, while Mexico ceded title to some water flowing through Mexican tributaries to the United States in a 1944 treaty, the claimant could not enforce that agreement between the Mexican and U.S. governments. Therefore the tribunal dismissed the proceeding for lack of jurisdiction.

A contrary result in either of these cases could have cast a significant shadow over environmental protection efforts by exposing governments to liability for the extraterritorial impact of their environmental initiatives. The Canadian Cattlemen and Bayview decisions confine Chapter 11’s scope to the cross-border investment context, as its drafters intended.

Pending Cases 

Several Chapter 11 cases with environmental implications remain pending in Canada and the United States The cases arising in Canada concern mines, offshore oil exploration and production, Canada’s phase-out of the insecticide lindane, and Canada’s softwood lumber export regulations. The claims arising in the United States concern mining of gold reserves in a California location that local Native Americans consider sacred, sub-seabed nuclear waste disposal, and U.S. regulations of softwood lumber imports.

The extent to which the tribunals in these cases follow the promising trends discussed above will likely determine Chapter 11’s ultimate impact on bona fide environmental protection efforts. If these tribunals follow the restrained approach of recent tribunals, they likely will award damages only in cases where governments have acted in a discriminatory manner, significantly impaired property values despite reasonable reliance by investors on authorized governmental representations, or ignored due process in applying purported environmental standards to such investors. Absent those factors, arbitrators under Chapter 11 are likely to continue to protect the NAFTA parties from liability for genuine and nondiscriminatory environmental initiatives.

Other Trade Agreements

NAFTA’s Chapter 11 has been carried over, in substantially the same form, into the more recent CAFTA (intended to encourage free trade among Central American and selected Caribbean countries) and at least a dozen bilateral U.S. trade agreements. While it is too early to speculate on the arbitral jurisprudence likely under those agreements (there are only two such awards to date under CAFTA, neither of which involves the environment), both CAFTA and the new bilateral agreements contain a number of procedural advances over NAFTA’s Chapter 11.

These include provisions for public notices of arbitral claims (though not always awards), encouragement of amicus participation by nongovernmental organizations with expertise in the issues being arbitrated, and, in the case of the U.S.-Korea Agreement, potential in-country hearings and proceedings in the host-country language - all intended to make the proceedings more accessible to the public and to afford arbitrators a better understanding of the policy reasons for the environmental or other governmental measures at issue.[6] 

While helpful, these procedural reforms are not a substitute for balanced recognition by arbitrators of the broad discretion that international law affords governments in addressing environmental challenges without having to compensate either domestic or foreign investors for the cost of environmental protection. Despite its shaky start, NAFTA’s Chapter 11 provides some basis for hope that thoughtful arbitrators can contribute to a fair balancing of these claims and, by so doing, help advance both free trade and environmental protection.


Stephen L. Kass and Jean M. McCarroll, together withClifford P. Case, direct the environmental practice group at Carter Ledyard & Milburn.  Bryan J. Hall, a second-year student at Cornell Law School, and Shannan Powell, a first-year student at Touro Law School, assisted in the preparation of this column.

Reprinted with permission from the June 27, 2008 edition of The New York Law Journal © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.

Endnotes


[1] We noted Chapter 11’s potential impact on environmental protection in a series of columns published in 2000 and 2002. See “NAFTA’s Chapter 11: Regulatory Takings Revisited,” NYLJ, Sept. 11, 2000; “The ‘Metalclad’ Decision Under NAFTA’s Chapter 11,” NYLJ, Oct. 27, 2000; and “NAFTA’s Chapter 11: Environmental Claims,” NYLJ, July 8, 2002.

[2] Chapter 11 materials are available at www.naftaclaims.com, published by Todd Grierson-Weiler, a Canadian attorney who has acted as counsel and as an expert in several Chapter 11 proceedings.

[3] Methanex Corporation v. United States, Final Award of the Tribunal on Jurisdiction and Merits, Part III, Chapter A, pp. 51-52 (Sept. 7, 2005).

[4] Id., Part IV, Chapter D, p. 4.

[5] In its final award in International Thunderbird Gaming Corp. v. Mexico (2006), the tribunal held that if an investor has no legitimate expectation of operating its business, government actions that prevent it from doing so cannot constitute expropriation. The Thunderbird claimant had sought to operate slot machines, which were illegal in Mexico. Although the claimant obtained a letter from the Mexican authorities stating that its machines constituted legal games of skill (as opposed to chance), the claimant obtained the letter by misrepresenting the nature of its machines. The tribunal held that the claimant could not reasonably have relied on the letter and thus had no basis for an expropriation claim.

[6] Trade agreements are available at www.ustr.gov, published by U.S. Trade Representative.



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