Indonesia’s Supreme Court recently upheld the decisions of lower courts when it said that a $500 million bond transaction was invalid, even though the transaction adopted a common offshore structure for raising debt funding. We talk to long-term Jakarta-based Herbert Smith corporate partner, David Dawborn, to help understand the ramifications of the decision.To start with, can you explain the background?
The case involves three bond issues, amounting to $500 million, made by Indah Kiat International Finance (Indah Kiat BV) in 1994. The bonds were issued to foreign bond purchasers in order to raise foreign currency finance and were guaranteed by PT Indah Kiat Pulp & Paper Tbk (Indah Kiat), an Indonesian listed company.
In March, 2001, the Asia Pulp & Paper Group (which both Indah Kiat BV and Indah Kiat were part of) announced a unilateral standstill on debt repayment. The result: Indah Kiat BV defaulted on its obligations to make repayments due under the bonds. Further, Indah Kiat refused to honour its obligations as the guarantor of those payments.
In November 2003, Indah Kiat issued proceedings against several defendants, including the trustee, noteholders and underwriter, in the Bengkalis District Court in Indonesia. The claim sought a declaration that the transaction structure was invalid based on the notion that it was improperly engineered in contravention of Indonesian company, tax and security/mortgage laws and to the detriment of Indah Kiat.
Now, three years on, the Supreme Court has upheld the lower court decisions finding in favour of Indah Kiat, declaring that all the transaction documents relating to the Indah Kiat bond transaction, including the principal New York law bond documents, are invalid as a matter of Indonesian law.Was the Indah Kiat bond a typical offering, or was this a particularly fancy set-up?
The Indah Kiat transaction was - and remains - a commonly used successful structure for raising offshore foreign currency finance, both in Indonesia and globally. It enables an Indonesian borrower to gain access to foreign debt funding without having to perform an IPO in Indonesia. As the structure does not involve any major offering of securities in Indonesia, it has never been questioned by the Indonesian capital markets regulator, Bapepam. The principal finance documents, including the guarantee by Indah Kiat, which are governed by New York law, have been upheld by courts offshore. Also, Indah Kiat was itself advised extensively by experienced international and local counsel and accountants throughout the transaction. Even Indonesian state enterprises have used the same structure in their offshore debt capital raisings.Surely this will put off investors?
The surprising decision has certainly raised eyebrows and is questioned by many financiers and lawyers in Jakarta and around the region. The particular Supreme Court panel has effectively allowed a bond issuer to default on the repayments of a large bond issue, at the expense of the bond holders. So this has increased apprehension about the real state of judicial reform in Indonesia because the Supreme Court failed to protect the interests of bond investors, in favour of legitimising a bond issuer’s tactic of invalidating previously acknowledged debt obligations. Fortunately, there’s no system of binding judicial precedent under Indonesia’s civil law system so the decision is not binding in other cases. However, the Supreme Court’s decision could throw doubt upon the validity of other bond offerings using similar a structure.
But I’ve talked to dozens of investors, and basically they are so far taking the view that this is emerging market risk. They’ve factored it in. The spreads offered are good on Indonesian high yield debt, so they’ll go with it and see what happens.Is it possible for the government to step in, in the legal process, in some way?
I am aware that several investor and bondholder groups have raised concerns directly to senior Indonesian ministers about the decision and its implications. Privately, many Indonesian borrowers also regret and have raised concerns about the impact of the decision creating higher cost of borrowings.
A number of the defendants in the case are in fact considering a final challenge to the decision through an extraordinary appeal step known as ‘judicial review’ to another Supreme Court panel. Obviously, it is hoped, given the increased public and international attention on the matter, that a carefully considered decision from the new panel, taking into account the broader impact on Indonesia, will emerge from this process.
Although there is separation of judicial authority in Indonesia so direct government intervention is not possible, it is hoped that the Indonesian government will respond appropriately to this decision as part of its efforts to speed up judicial reform and improve the reliability of the system. The government consistently refers to its commitment to improving legal and judicial reform as part of its concerted effort to attract back foreign investors. Let’s see.
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