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By: Simon Butt and Luke Nottage (University of Sydney Law School)

[with a shorter version at http://www.eastasiaforum.org/]

Professor Chris Findlay recently wrote on the East Asia Forum about ‘Australia’s FDI challenges in the Asian Century’, highlighting problems reported recently by ANZ Bank and Qantas in the region. His proposals including ‘innovation in negotiating modalities’, including a possible new plurilateral agreement in the WTO that would cover all investments (not just in some services sectors). That’s a nice idea, but it’s proving hard enough to complete the current round of Doha Round negotiations. In light also of recent problems in Indonesia, the Australian government should meanwhile reconsider its abrupt policy shift last April regarding an important protection found in most of its bilateral and regional Free Trade Agreements (FTAs) and bilateral investment agreements (BITs): investor-state arbitration (ISA).

Australia’s first BIT came into effect on 11 July 1988, with China, followed by one with Vietnam in force from 11 September 1991. All Australia’s investment treaties with Asian states provide for investor-state arbitration (ISA) allowing foreign investors to bring direct claims before international tribunals if host states breach substantive commitments made in the agreements, rather than mobilise their home states to bring an inter-state claim (as under the WTO regime). Admittedly, Australia’s BIT with China only allows ISA claims related to expropriation of the foreign investor’s assets by the host state; but as China has emerged as a major exporter (not just) importer of capital, its treaties have provided for full-scale ISA protections since the late 1990s. ASEAN member states have also come to incorporate extensive ISA provisions even as among themselves. A recent illustration is the ASEAN Comprehensive Investment Agreement, signed in 2009 and in force from this March.

Yet the ‘Gillard Government Trade Policy Statement’ of April 2011 has eschewed ISA for Australia’s future investment treaties. Initially there appeared to be scope to interpret the Statement, consistently with the 2010 recommendations of its own Productivity Commission, as allowing ISA under stricter conditions - at least with treaty partners having less developed domestic law frameworks for investment protection and dispute resolution. But over the last year the Gillard Government has clarified that it did mean to go beyond the Commission’s recommendation, by not agreeing to ISA in any future treaties, although without seeking to renegotiate or terminate any of Australia’s investment treaties.

One rationale given for the Government’s policy shift was that Australia’s outbound investors had never filed a treaty-based ISA claim, and had not shown much interest in this protection. In fact, a proceeding under the Australia-India BIT had been filed and was won recently by an Australian mining company. It complained that Indian courts’ very lengthy delays in trying to enforce an arbitral decision gained through a separate commercial arbitration claim, against its joint venture partner, violated India’s commitments given in the BIT with Australia. In addition, the Australian Chamber of Commerce and Industry has voiced concern about the TPS stance on ISA, most recently in the context of already-complex negotiations by Australia and other Asia-Pacific states towards an expanded Trans-Pacific Partnership Agreement (‘TPPA’).

Recent regulatory changes in Indonesia provide a further example of challenges facing foreign investors in the region. On 21 February 2012 the Indonesian government issued a Regulation (Government Regulation 24 of 2012) that requires majority or wholly foreign-owned companies holding mining licenses in Indonesia to divest a majority share of the company to an ‘Indonesian participant’ after ten years of production. An Indonesian participant must own 20 percent of the foreign company within the sixth year of production; 30 percent after the seventh year; 37% after the eighth; 44% after the ninth and, by the end of the tenth year, a minimum of 51%. For many foreign investors, this will mean a mandatory divestment of equity.

An offer to purchase the share must first be made to the central government. If the central government is not prepared to purchase the share, then it must be offered to the provincial government or city/county government. If they refuse also, then the shares are to be offered by auction to (in order of priority) a State Owned Enterprise, a Regional State Owned Enterprise, or a national company. Failure to divest according to this schedule can lead to suspension of production and even revocation of the mining license.

The concept of divesting foreign interests in Indonesian mining enterprises is certainly not new. The 2009 Mining Law required a divestment after five years of production, but did not specify the required amount of the divestment. A 2010 Regulation required that Indonesian participants hold 20% equity in foreign-owned mining operations after five years of production, but did not require further divestments. The new Regulation goes much further by requiring divestment of a majority share. However, mining companies operating in Indonesia have long had divestment obligations under Contracts of Work with the Indonesian government. For example, in 2003 BP and Rio Tinto divested their majority shareholding in PT Kaltim Prima Coal, as required under their 1982 contract with the Indonesian government. And in 2011, USA’s Newmont divested 51 per cent of its share in Newmont Nusa Tenggara, as required by its 1986 contract.

Predictably, many miners argue that ten years is insufficient for them to make a sufficient return on their investment. They also complain about the uncertainty the Regulation brings. In particular, some miners operating under a Contract of Work with less onerous or no divestment provisions fear that they will be required to renegotiate their Contracts to comply with the regulation’s mandatory divestment provisions. On this, the government appears to have given mixed signals. Some officials, such as Mining Ministry Director General for Mineral and Coal Thamrin Sihite, have said that the regulation only applies once the Contract of Work has expired or when an extension to that contract is sought. Others, such as Deputy Mining Minister Widjajono Partowidagdo have said that Contracts of Works can be renegotiated whenever the government deems necessary.

Miners have also faced difficulties with the divestment process. It is often hard to find a tier of government or Indonesian company with sufficient funds to purchase the stake. In addition, if funds are available, national and regional governments sometimes bicker over which of them should get first priority to buy it. (Local governments argue that control should be theirs because the operation takes place within their locale. National governments are keen to obtain a share of these often lucrative investments.)

The main problem with the divestment policy, miners and Indonesian economists point out, is that it significantly reduces the desirability the Indonesian mining sector for investors. Mining contributes 17 percent to Indonesia’s GDP and a significant proportion of Indonesia’s foreign direct investment (3.6 billion of $20 billion in 2011). If Indonesia wants to increase its economic growth from 6.5 to 8 percent, then it simply must attract more foreign investment, including in the mining sector.

One explanation for the stance is ‘resource nationalism’ – a response to demands from Indonesians, particularly those who live near mining sites for, as one senior Mining Official put it, ‘a share of what the companies are earning’. Indeed, the preamble of the Regulation explicitly states that one of its rationales is to allow more Indonesians to participate in mining. It may be part of a broader wave of political nationalism, which many within government, and various political parties, support. They believe, probably quite rightly, that this enjoys wide appeal amongst the electorate, who will be going to the polls in 2014.

Exploitation of natural resources by foreigners is not publicly popular anywhere in the world, but in formerly-colonial states such as Indonesia, it has greater currency. Article 33 of the Constitution, which requires the state to control natural resources and important public utilities, reflects this sentiment. The provision was drafted on the eve of the declaration of Indonesian independence and was retained intact during four rounds of constitutional amendments in the post-Soeharto era.

It is also significant that under the 1967 Mining Law’s so-called ‘Contract of Work’ framework, the Indonesian government did not simply grant mining licenses to mining companies. Instead, the Minister appointed mining companies as contractors to, subject to any conditions imposed by the Minister, carry out mining activities that had not been or could not be carried by the government or a national company. (In practice the Contracts initially contained conditions very favourable to the foreign investor who would inevitably have been very close to Soeharto’s inner circle.) The new rules, however, take government control one step further – to majority ownership of the mining entity itself, should the state so desire.

Reporters and other commentators, including several in Australia, have emphasised that Indonesia is not alone in seeking to renegotiate the terms for foreign investments especially into the mining sector, which is booming worldwide. The 2010 Productivity Commission Report did note briefly the dramatic increase in FDI into Australia’s mining sector over the last decade. Accordingly, a factor behind the TPS policy shift may have been the Gillard Government’s intuition that no longer offering ISA would not significantly detract from inbound FDI or jeopardize entire treaty negotiations.

However, at least Australia’s newfound aversion to ISA only affects future treaties. Foreign investors presently retain substantive protections as well as ISA rights, including Australian investors into Indonesia under a BIT signed and in force in 1993, as well as the ASEAN-Australia-New Zealand Free Trade Area FTA in force from 2010. Such considerations presumably influenced the Gillard Government as well, although as existing treaties reach their terms Australian investors will lose protections, and already the TPS stance complicates the negotiation of new treaties (like the TPPA). It also risks putting Australian investors in a less competitive position than investors from third countries into Asia, where those third countries are maintaining or expanding investment treaties that include ISA protections.

By contrast, the new Indonesian measure may have retrospective effect. Furthermore, by targeting just foreign investors it differs from other measures typically adopted by resource-rich states seeking to claim a larger share of revenues from mining. Those are usually done on a basis that is (at least formally) non-discriminatory, such as raising taxes levied on mining companies – affecting the profitability of domestic as well as foreign investors.

Thus, compared to measures introduced or mooted recently by other states, the new Indonesian regulation seems much more likely to violate substantive commitments made under various investment treaties or FTAs, generating significant potential for ISA claims. Admittedly, a concatenation of legal and especially pragmatic factors suggests that the international treaty law framework is much more likely to structure informal settlements than to result in full-scale ISA proceedings. Yet the framework provides important baselines agreed between states, as we will elaborate in a sequel to this blog posting. Australia’s new stance eschewing ISA in future treaties risks undermining a system that has become widely known and accepted even in Asia, creating a serious risk of destabilizing sustainable cross-border investment flows particularly over the medium- to long-term.

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