Real Progress at Last
Revamped ASEAN divestiture obligation regulation
By Bill Sullivan
Thursday, December 6, 2018
One of the greatest impediments to foreign investment in the Indonesian mining sector is the divestiture obligation that applies to foreign-owned mining companies. Of particular concern to foreign investors has been the pricing of divestiture shares that must be sold to certain designated local parties exercising their first priority purchase right.
A recently issued regulation, however, indicates the Government may, finally, be moving to address at least some of foreign investors’ concerns about the divestiture obligation including the all-important divestiture price. If the regulation is interpreted and applied in the way that seems to be intended by the drafters of the same, this will represent significant progress.
In this article, the writer will review the new divestiture regulation and its revamped approach to the pricing of divestiture shares in particular as well as the possible implications of the same for foreign investment in the Indonesian mining sector.
The obligation imposed on foreign-owned mining companies and their foreign shareholders to divest 51% of the companies’ issued shares (Divestiture Shares) to local parties, in installments and commencing (in most instances) not later than the end of the fifth year of commercial production (Divestiture Obligation), has been one of the most troubling aspects, for foreign investors, of Indonesia’s current mining industry regulatory regime. This is because implicit in the Divestiture Obligation is the reality that foreign investors face the unpalatable prospect of losing control of their mining companies and giving up entitlement to a majority of any dividends declared by their mining companies within ten years of the commencement of production, despite having borne 100% of the exploration and development risk.
Perhaps even more off-putting than the Divestiture Obligation itself has been (i) the first priority right enjoyed by certain designated government and other local parties (Designated Indonesian Parties) to acquire the Divestiture Shares if foreign-owned mining companies do not find their own 51% local shareholders by the end of the fifth year of commercial production (FP Right) and (ii) how the price payable for the Divestiture Shares, by the Designated Indonesian Parties when exercising their FP Right (Divestiture Price), is to be determined.
The Designated Indonesian Parties, which may acquire the Divestiture Shares, are (in order of priority) (i) the Central Government, (ii) the relevant Provincial Government/Regional Government, (iii) State-owned Enterprises (BUMNs) and Provincial Government/Regional Government-owned Enterprises (BUMDs) and (iv) local Indonesian companies in which foreign parties do not and cannot hold shares (Private Non-PMA Companies).
Until 2017, the Divestiture Price was to be determined with regard to Adjusted Replacement Cost, something that was defined in Minister of Energy & Mineral Resources (MoEMR) Regulation No. 27 of 2013 re Procedures for Share Divestment Price Determination & Change of Investment Particulars (MoEMRR 27/2013) as being “investment”, during the period from the exploration stage to the date on which the Divestiture Obligation applied, less accumulated depreciation and amortization and less outstanding financial obligations as at the end of the year in which the Divestiture Obligation applied.
For many (albeit not all) foreign investors, the prospect of (i) having government related parties as the majority shareholders in their Indonesian mining companies and (ii) receiving a price for their Divestiture Shares totally unrelated to the market value of the underlying mining projects made Indonesia, quite simply, a “no go” destination for new mining investment.
In 2017, the Government appeared to recognize there were problems with the Divestiture Obligation and sought to allay foreign investor concerns about the determination of the Divestiture Price, in particular, by sissuing MoEMR Regulation No. 9 of 2017, dated 20 January 2017, re Procedures and the Pricing Mechanism for Divestiture of Shares in respect of Mineral and Coal Business Activities (MoEMRR 9/2017). MoEMRR 9/2017 replaced MoEMRR 27/2013.
Two of the most important changes to the Divestiture Obligation introduced by MoEMRR 9/2017 were in respect of (i) the determination of the Divestiture Price and (ii) recognizing the possibility of an Indonesia Stock Exchange listing (IDX Listing) being used to satisfy the Divestiture Obligation in the event that none of the Designated Indonesian Parties were interested in acquiring and able to acquire the Divestiture Shares (IDX Listing Alternative).
MoEMRR 9/2017 provided that the (i) maximum Divestiture Price, in the case of Divestiture Shares offered to the Central Government and the relevant Provincial Government/Regional Government, and (ii) base Divestiture Price, in the case of Divestiture Shares auctioned to BUMNs, BUMDs or Private Non-PMA Companies was, henceforth, to be the fair market value of the Divestiture Shares but not taking into account the underlying mineral or coal resources/reserves of the relevant foreign-owned mining company (No Resources/Reserves Consideration).
At first sight, MoEMRR 9/2017’s recognition of “fair market value”, as the appropriate basis for determining the Divestiture Price, seemed to be a very significant development and certainly an improvement on the previously mandated “proportional recovery of investment” only basis. However, the significance of this development was, on closer inspection, substantially diluted by excluding the underlying mineral or coal resources/reserves from the calculation of “fair market value”. As commonly understood, the “fair market value” of a mining project is almost entirely reflected in the assessed market value of the mineral or coal resources/reserves underlying that mining project. In other words, the No Resources/Reserves Consideration made the MoEMRR 9/2017 “fair market value” concept more or less meaningless in determining the Divestiture Price.
The justification advanced, by the Government, for the No Resources/Reserves Consideration was that this was mandated by Article 33(3) of the Indonesian Constitution which is reflected in the preamble to Law No. 4 of 2009 re Minerals & Coal Mining and is often interpreted as meaning that only the State can own mineral or coal resources/reserves while so long as they remain in the ground.
The Government has now reconsidered the Divestiture Obligation and the appropriateness or otherwise of the No Resources/Reserves Consideration in determining the Divestiture Price. This reconsideration is set out in MoEMR Regulation No. 43 of 2018 re Procedures and the Pricing Mechanism for Divestiture of Shares in respect of Mineral and Coal Business Activities (MoEMRR 43/2018).
MoEMRR 43/2018 came into effect on 25 September 2018.
MoEMRR 43/2018 amends but does not replace MoEMRR 9/2017.
MoEMRR 43/2018 makes a number of material changes to how the Divestiture Obligation is implemented. Unquestionably, however, the most significant change is to the determination of the Divestiture Price.
The wording of MoEMRR 43/2018 is characterized by an unfortunate lack of clarity and precision in various critical places. This all too common problem with regulations in Indonesia means that the writer has had to sometimes made “educated guesses” as to what the drafters of MoEMRR 43/2018 were actually intending to provide for in the case of particular sections. As a consequence, other interpretations of various sections of MoEMRR 43/2018 are also possible.
2. Divestiture Price
2.1 Overview: The Divestiture Price is now to be determined on the basis of “fair market value” but without taking into consideration the mineral or coal resources/reserves of the relevant Production Operation IUPK/IUP holder except for that part of the mineral or coal resources/reserves that can be mined during the validity of the relevant Production Operation IUPK/IUP (New Fair Market Value) (Article 14(2) of MoEMRR 43/2018).
New Fair Market Value is now to be calculated using two alternative methods as follows:
(a) the discounted cash flow method reflecting the economic benefits to be derived by the relevant Production Operation IUPK/IUP holder until the end of the validity period of the relevant Production Operation IUPK/IUP (Alternative 1); and/or
(b) the comparison of market data method (market data benchmarking) (Alternative 2) (Article 14(3) of MoEMRR 43/2018).
Once New Fair Market Value has been determined in accordance with Alternative 1 and/or Alternative 2, this New Fair Market Value becomes:
(a) the highest possible Divestiture Price in the case of Divestiture Shares offered to the Central Government, the relevant Provincial and Regional Governments, BUMNs, BUMDs or a special purpose vehicle formed or appointed by MoEMR and owned by the Central Government, the relevant Provincial and Regional Governments, a BUMN and/or a BUMD (Government SPV); or
(b) in the event none of the Central Government, the relevant Provincial and Regional Governments, BUMNs, BUMDs or a Government SPV are interested in acquiring and able to acquire the Divestiture Shares, the “base” (i.e., lowest possible) Divestiture Price for Divestiture Shares offered to Private Non-PMA Companies by way of auction (Article 14(4) of MoEMRR 43/2018).
The most interesting and potentially important aspects of Section 14 of MoEMRR 43/2018 are (i) what is meant by “except for that part of the mineral or coal resources/reserves that can be mined during the validity of the relevant Production Operation IUP/IUPK” and (ii) how Alternative 1 and Alternative 2 are to be applied in practice.
2.2 Limitation on No Resources/Reserves Consideration: The use of the words “except for that part of the mineral or coal resources/reserves that can be mined during the validity of the relevant Production Operation IUP/IUPK” seems to be intended as a “carve out” from or “work around” the No Resources/Reserves Consideration in MoEMRR 9/2017 which, until now, has made MoEMRR 9/2017’s recognition of “fair market value”, as the proper starting point for determining the Divestiture Price, a source of confusion and frustration for mining companies, foreign investors and their professional advisers. As understood by the writer, the drafters of MoEMRR 43/2018 are recognizing (for the first time) that mining companies do, in fact, have some right to or interest in at least that part of the mineral or coal resources/reserves underlying their mining projects which can realistically be produced during the term of the relevant Production Operation IUPKs/IUPs. While this may seem “blindingly” obvious to mining companies, foreign investors and their professional advisors, the drafters of MoEMRR 43/2018 are actually being quite brave in confronting one of the most fundamental positions of Indonesia’s extreme resource nationalists; namely, that Article 33(3) of the Constitution leaves no room for private ownership of minerals or coal still in the ground. It is perhaps not surprising then that Section 14(2) of MoEMRR 43/2018 stops short of actually using the word “ownership”.
2.3 Alternative 1: When it comes to the alternative methods for determining New Fair Market Value, as set out in Article 14(4) of MoEMRR 43/2018, it is necessary to “read a lot into” the words used in order to arrive at a sensible outcome that takes the determination of New Fair Market Value beyond the limitations of MoEMRR 9/2017. The writer would suggest, however, that the reference to “discounted cash flow” in the wording of Alternative 1 indicates that what the drafters of MoEMRR 43/2018 have in mind is probably an Alternative 1 approach to determining New Fair Market Value that may be summarized as:
(A X B – C)/(1 + i)t where:
“A” is the estimated mineral ore/coal production over the remaining term of the relevant Production Operation IUPK/IUP;
“B” is the estimated average market price of the estimated mineral ore/coal production over the remaining term of the relevant Production Operation IUPK/IUP;
“C” is the estimated production and other costs, including taxes and non-tax state revenue payable to the Central, Provincial and Regional Governments, that will be incurred by the relevant Production Operation IUPK/IUP holder in respect of the estimated mineral ore/coal production over the remaining term of the relevant Production Operation IUPK/IUP;
“i” is the discount rate; and
“t” is the remaining term of the relevant Production Operation IUPK/IUP.
2.4 Alternative 2: Just what is meant by “comparison of market data (market data benchmarking”) is also very difficult to say with any high degree of certainty. Again, however, trying to give a sensible meaning to the wording of Alternative 2, in light of common industry practice for valuing mining projects, the writer would suggest that Alternative 2 may be intended to refer to the common industry practice of valuing a mining project that can be summarized as:
D X E where:
“D” is an industry or market accepted fixed US$/Rp amount per ton, notional allowance/value for mineral or coal resources/reserves still in the ground and which notional allowance/value is intended to reflect, in very general terms, the estimated future market price of the relevant mineral or coal as well as the likelihood or otherwise of the mineral or coal resources/reserves underlying a particular mining project ever being produced and sold; and
“E” is the estimated quantity, in tons, of the relevant mineral or coal resources/reserves underlying a particular mineral or coal project although, presumably, the quantity, in tons, of the relevant mineral or coal resources/reserves has to be limited to the quantity, in tons, of the established or proven mineral or coal resources/reserves that can be produced over the remaining term of the relevant Production Operation IUPK/IUP so as to comply with Section 14 of MoEMRR 43/2018.
For all intents and purposes, “D” is really just a “rough and ready” or “back of the envelope” approximation of (B – C) /(1 + i)t in Alternative 1. Typically, “D” will be a lesser or a greater amount depending upon whether the relevant mineral or coal project has, in the jargon of the JORC Code, (i) only a less certain mineral or coal resource – indicated/inferred/measured or (ii) a more certain mineral or coal reserve – probable/proven as this determines the degree of confidence in “E”.
It is also possible that Alternative 2 may be a much more generic method that is intended to allow the New Fair Market Value of a particular Indonesian mining project and, hence, the Divestiture Price to be determined by way of having regard to how other mining projects in Indonesia and elsewhere, with broadly similar geological, logistical, risk, state of development and other factors, have been valued in the context of sales and purchases or other like transactions.
2.5 Relationship between Alternative 1 and Alternative 2: Somewhat frustratingly, MoEMRR 43/2018 does not give any guidance as to in what circumstances each of Alternative 1 and Alternative 2 should be used or who makes the determination as to which of Alternative 1 and Alternative 2 should be used in any particular situation. It may be the intention of the drafters of MoEMRR 43/2018 that, in fact, both Alternative 1 and Alternative 2 should be or can be used, in any particular situation, so as to produce a range of possible valuations, rather than just one definitive valuation, as a starting point only for calculating New Fair Market Value.
3. Other Material Changes
3.1 Issuance of New Shares/Sale of Existing Shares Allowed: Although it has always been understood to most probably be the case, MoEMRR 43/2018 now makes clear that the Divestiture Obligation may be satisfied by either (i) the relevant Production Operation IUPK/IUP holder issuing new shares to the Designated Indonesian Parties or (ii) having existing foreign shareholders of the relevant Production Operation IUPK/IUP holder transfer part of their shareholding to the Designated Indonesian Parties (Article 2(4a) of MoEMRR 43/2018).
3.2 Removal of Central Government Authority to Finally Determine Divestiture Price: MoEMRR 43/2018 has removed the previous ultimate authority of the Central Government to determine the Divestiture Price where (i) the FP Right is triggered, (ii) the Divestiture Shares are first offered to the Central Government and (iii) the Central Government wants to purchase the Divestiture Shares but (iv) the parties cannot agree on the Divestiture Price. This leaves unclear, however, what happens in such a situation. It may be the intention of the drafters of MoEMRR 43/2018 is that, in the absence of any agreement on the Divestiture Price, MoEMR will appoint an independent assessor to determine the Divestiture Price and the determination of the independent assessor will be binding on the parties. In this regard, it is to be noted that MoEMRR 43/2018 retains the previously granted right of the Central Government to appoint an independent assessor for the purpose of facilitating negotiations between the parties as to what the Divestiture Price should be (Article 5(2) of MoEMRR 43/2018).
3.3 Removal of Requirement for Auction: Where (i) the FP Right is triggered, (ii) the Divestiture Shares are eventually offered to BUMNs and BUMDs and (ii) several BUMNs and/or BUMDs want to purchase the Divestiture Shares, MoEMRR 43/2018 has removed the previous compulsory auction mechanism for determining which BUMN or BUMD will be the ultimate purchaser of the Divestiture Shares. MoEMRR 43/2018 now provides that, in the case of multiple interested BUMNs and/or BUMDs, (i) MoEMR will co-ordinate the determination of how the Divestiture Shares are to be allocated among the interested BUMNs, (ii) the relevant Governor will co-ordinate the determination of how the Divestiture Shares are to be allocated among the interested BUMDs and (iii) MoEMR will determine how the Divestiture Shares are to be allocated among the interested BUMNs/BUMDs if there are both interested BUMNs and interested BUMDs (Article 8(6), (7) and (8) of MoEMRR 43/2018).
3.4 Grant of Central Government Authority to Determine Divestment Scheme: Further to 3.3 above and where the Central Government, the relevant Provincial/Regional Governments and/or multiple BUMNs/BUMDs are interested in jointly purchasing the Divestiture Shares, MoEMR is given the authority to determine the divestment scheme and the Divestiture Share allotments of the interested parties, which divestment scheme may involve the establishment of a Government SPV to acquire the Divestiture Shares and which Government SPV will be jointly owned by the interested parties (Article 9A of MoEMRR 43/2018 ).
3.5 Express Provision for Due Diligence: Designated Indonesian Parties, interested in purchasing Divestiture Shares by way of exercise of their FP Right, are now granted the express right to carry out due diligence on the relevant Production Operation IUPK/IUP holder and its mining project, with the relevant Production Operation IUPK/IUP holder being obliged to allow and otherwise cooperate with the Designated Indonesian Parties in carrying out their due diligence enquires (Article 10A of MoEMRR 43/2018).
4. No Change
Except as set out in 2 and 3 above, MoEMRR 43/2018 leaves the Divestiture Obligation and the procedures for carrying out the Divestiture Obligation unchanged from MoEMRR 9/2017. More particularly, the limited availability of the IDX Listing Alternative introduced by MoEMRR 9/2017, in the event that none of the Designated Indonesian Parties are interested in acquiring and able to acquire the Divestiture Shares, remains unchanged.
5.1 Timing: The timing of the issuance of MoEMRR 43/2018, in late September 2018, is interesting as this was contemporaneous with the announcement that the principal agreements in respect of the proposed sale and transfer of majority ownership of PT Freeport Indonesia (PTFI) to PT Inalum and other Regional Government parties had finally been signed. It is hard to believe this timing was wholly coincidental.
It may well be that the issuance of MoEMRR 43/2018 was at least, in part, necessary to justify the ultimately agreed purchase price of US$3.85 billion for (i) Rio Tinto’s PTFI production share interest and (ii) the additional shares in PTFI needed to eventually give local parties 51% of the issued shares of PTFI. Just how PTFI would be valued was already a key issue in the discussions between the Government and FCX-McMoran Inc (FCX) in August - September 2017 when FCX and the Government issued competing press releases/position papers. In its 29 August 2017, press release, FCX emphasized that the price for 51% of PTFI would be “fair market value” while studiously avoiding saying anything about just how this “fair market value” would be determined and, more particularly, whether or not it would include any allowance for the mineral resources/ reserves in Papua that PTFI has established/proved up. This was a clear point of departure from the Ministry of Energy & Mineral Resources (ESDM) press release of 29 August 2017 which said nothing about the price for 51% of PTFI even as a “technical matter” still to be discussed. In a subsequent position paper, dated 28 September 2017, the Government said the price for 51% of PTFI would be calculated on the basis of (i) the benefit of mining business activity and (ii) over the period up to 2021 only (being the end of the current term of PTFI’s Contract of Work). The writer would point out that these two elements are central to the description of the Alternative 1 methodology, for valuing the Divestiture Shares of Production Operation IUPK/IUP holders, that is now set out in Article 14(3) of MoEMRR 43/2018.
5.2 Implications for Foreign Investors: The only changes made by MoEMRR 43/2018 that are likely to be of substantive and immediate interest to foreign investors are (i) the reworking of the “fair market value” concept, for the purpose of determining the Divestiture Price, so as to take account of at least that part of the mineral or coal resources/reserves underlying their mining projects which can realistically be produced during the term of the relevant Production Operation IUPKs/IUPs and (ii) specifying Alternative 1 and Alternative 2 as the permitted methodologies for determining New Fair Market Value.
The fact that MoEMRR 43/2018 leaves unchanged the magnitude of the Divestiture Obligation, such that foreign investors will still be compelled to give up majority ownership of their mining projects, not later than ten years after the commencement of commercial production, means that the Divestiture Obligation remains highly prejudicial to the interests of foreign investors. Likewise, given MoEMRR 43/2018 does not address the issue of foreign investors being immediately limited to a maximum of 49% equity ownership upon acquiring an existing Production Operation IUPK/IUP holder which is not already a foreign investment (i.e., PMA) company, the Divestiture Obligation (as interpreted and applied by ESDM) continues to be a significant disincentive for foreign investment in the local mining industry.
MoEMRR 43/2018 does not make clear whether, in taking into account (for New Fair Market Value purposes) that part of the underlying mineral or coal resources/reserves which can realistically be produced during the term of the relevant Production Operation IUP/IUPK, the “term” of the relevant Production Operation IUP/IUPK includes the current term only or both the current term and permitted extensions or renewals of the relevant Production Operation IUPK/IUP. Depending upon just which of these competing interpretations is ultimately shown to be correct, the Divestiture Price implications are likely to be very significant in many cases.
Perhaps the least satisfactory aspect of MoEMRR 43/2018 is the woeful lack of clarity as to just what is meant by Alternative 1 and Alternative 2 as the newly permitted methodologies for determining New Fair Market Value.
While so long as foreign investors and their professional advisers are largely left to guess (i) what is meant by the “term” of the relevant Production Operation IUP/IUPK and (ii) just how Alternative 1 and Alternative 2 will be interpreted and applied in practice, there will be entirely understandable concern that the Divestiture Price may still, ultimately, be determined in a way that is not consistent with normal industry practice for valuing mining projects and is otherwise prejudicial to the interests of foreign investors. ESDM needs to urgently provide detailed guidance as to how it will interpret and apply Alternative 1 and Alternative 2.
Summary and conclusions
MoEMRR 43/2018 should be seen as representing progress in addressing at least two of the long-standing concerns of foreign investors regarding the Divestiture Obligation; namely, the definition of “fair market value” and the calculation of the Divestiture Price. Assuming ESDM interprets and applies Alternative 1 (with its recognition of discounted cash flow as a permitted methodology for calculating New Fair Market Value) in a manner generally consistent with the mining industry’s understanding of what is meant by the discounted cash flow approach to price determination, this will be a significant step forward.
MoEMRR 43/2018 has the potential to make a difference to how at least some foreign investors view the Divestment Obligation and the equitable nature or otherwise of the same. In this regard, foreign investors’ long-standing objections to the Divestment Obligation have always been as much if not more so about the inequitable nature of the Divestment Price as they have been about the magnitude of the Divestiture Obligation per se.
All foreign-owned Production Operation IUPK/IUP holders are, very arguably, benefiting from what FCX managed to negotiate with the Government regarding the determination of the purchase price for 51% of PTFI. In this regard, the similarity between the wording of Alternative 1, in Article 14(3) of MoEMRR 43/2018, and the description, in the Government’s 29 September 2017 position paper, of how the purchase price for 51% of PTFI would be calculated, is striking indeed.
Notwithstanding that MoEMRR 43/2108 fails to address various other concerns regarding the Divestiture Obligation, MoEMRR 43/2018 should be seen as a case of the “glass being half full” rather than a case of the “glass being half empty”. Any and all material progress in reducing the disincentives to foreign investment in the Indonesian mining industry is unquestionably a good thing.
This article has been written by Bill Sullivan, Senior Foreign Counsel with Christian Teo & Partners and Senior Adviser to Stephenson Harwood LLP, and first appeared in the November-December 2018 issue of Coal Asia magazine. Christian Teo & Partners is a Jakarta based, Indonesian law firm and a leader in Indonesian energy, infrastructure and mining law and regulatory practice. Christian Teo & Partners operates in close association with international law firm Stephenson Harwood LLP which has ten offices across Asia, Europe and the Middle East: Beijing, Dubai, Hong Kong, London, Paris, Piraeus, Seoul, Shanghai, Singapore and Yangon.