Rewriting the rules

Indonesia’s first directly elected president, Susilo Bambang Yudhoyono, took office in 2004. A key part of his agenda was to implement legal and regulatory reform with the aim of increasing economic activity and in particular foreign investment. As such, expectations for his presidency came from the investment community as well as the electorate. But has Yudhoyono delivered on his pledge?

Indonesia has a population of 225 million and vast natural resources. Many of the world’s major companies operate there. The country’s oil and gas reserves have placed it in the centre of the liquefied natural gas (LNG) industry in Asia. It has significant reserves of high-grade coal and minerals, particularly nickel, that make it a global player in these commodities. Aggressive expansion by a number of Asian economic superpowers and the resultant competition to secure greater supplies of energy and raw materials has increased the value and importance of these resources.

Derived from Dutch law, Indonesia essentially has a civil law system based on codes and legislation. Judicial precedents are not binding, nor are they systematically published. Legislation and codes comprise a statement of principles rather than the detailed provisions found in UK legislation. Regulation in Indonesia is also ubiquitous and much ultimately relies on official interpretation and practice.

Dutch colonial rule ended in the late 1940s and was followed by the rule of nationalist strongmen who governed with the support of the armed forces. One of the key challenges now facing the elected government in Jakarta is the lack of clear political and legal authority to push through the types of reform needed. A related issue is the effect of regional autonomy, another post-Soeharto era development. Regional inconsistencies remain an all too familiar trap for the overseas corporates that are active across the country.

Investment in Indonesia must be made through a locally incorporated entity. Under the investment law, foreign investors may only establish or acquire shares in private companies that have been approved as foreign capital investment companies. The relevant approval is obtained from the Capital Investment Coordinating Board – or BKPM as it is known.

BKPM approval is only given if the sector in which the company operates is ‘open’ to foreign investment. Theoretically, all sectors not covered in the ‘negative list’ – a separate regulation detailing sectors closed or restricted for foreign investment – are open to foreign investors. However, as is frequently the case in Indonesia, the practice is somewhat different, with ‘technical departments’ that are responsible for overseeing a particular sector playing a key role in the decision-making and approval process. Inter-agency teams, including senior government ministers, are working to eliminate this duality and coordinate the formulation of investment policies and further sector reforms.

Legislation does recognise many of the fundamental concepts familiar to foreign investors, including limited liability of owners, separation of ownership and management, majority shareholder control, distributions to be made from profits only, and shareholders’ entitlements being deferred in the event of bankruptcy. The investment law, the companies law and the negative list were repealed and re-enacted in amended form in the course of 2007. Despite prolonged discussion leading up to these reforms, in reality little of substance was altered overall.

Public companies are regarded slightly differently under the regulatory regime. Generally speaking, they fall outside the scope of foreign investment restrictions and can be a means of investing in Indonesia, with the benefit of greater flexibility under the foreign investment rules.

Public companies in Indonesia are, however, subject to additional regulation by the capital markets supervisory body Bapepam-LK. The relevant regulations can be restrictive and inflexible. At present there is no effective means by which a company can issue new shares or other equity instruments without a full pre-emptive issue with tradeable rights. The acquisition of a controlling stake in a public company will also trigger a mandatory bid for the remaining shares. This can require the purchaser to match the best price over the previous 90 days – on thinly traded shares this pricing can be highly arbitrary.

A number of factors continue to inhibit economic activity, including M&A transactions and where such far-reaching consequences may not have been intended or appreciated. Employment regulations are a notable example and are overdue for reform. The activities of Indonesia’s competition watchdog, the Commission for the Supervision of Business Competition (KPPU), is another area where concerns are developing.

The KPPU is responsible for administering the fair competition laws which were first introduced in 1999. The law includes a prohibition on mergers or acquisitions that result in ‘unfair competition’. This has been ignored in practice so far, as the legislation assumed the introduction of regulations to add further details. Years later these regulations still do not exist. In an effort to remedy this situation, the KPPU itself has prepared a draft of the regulations and is pressing for these to be approved.

The concept of the KPPU reviewing corporate transactions based on an ill-defined notion of unfair competition is unwelcome. The 2007 investigation into Temasek’s acquisition of interests in two Indonesian mobile phone operators did not allay concerns. The KPPU found that Temasek had breached a prohibition against holding ‘majority shares’ of more than one company in the same sector. This decision was made notwithstanding the fact that Temasek’s indirect interest in each of the companies was less than 50 per cent.

In spite of the many challenges facing Indonesia, the country has clearly made great progress over the past few years. Peaceful reform is accepted and a vigorous and influential civil society plays a key role in monitoring these changes. Indonesia is a country where successful deals require time, effort and commitment. An investment or transaction based on quality legal advice and robust legal documentation is eminently achievable, but it should not be forgotten that relationships, negotiation and discussion remain the tool to resolve issues that arise. If the right balance can be struck, the opportunities for foreign and local investors in Indonesia are many.

David Dawborn is a partner and Brian Scott a senior associate with Herbert Smith. Both are seconded to the firm’s associated Indonesian law firm Hiswara Bunjamin & Tandjung
who took office in 2004. But has Yudhoyono made good on his pledge to open up the economy? By David Dawborn and Brian Scott