"If you owe your bank a hundred pounds, you have a problem. But if you owe a million it has."

(John Maynard Keynes - British Economist and founder of the Keynesian School)

Introduction

Keynes' brilliant statement above can accurately describes one of the most crucial problems of international financing activities, i.e., overconfidence in giving loans to companies from emerging markets, which is highly risked, tends to create problems rather than improvements. Problems not only to the financial institutions involving in such financing activities but also to the debtors, as in the end both of them are facing losses, not profits.

This overconfidence, combined with a lack of supervision from the Indonesian authorities can be considered as one of the main factors of the financial crisis in 1997. In that fateful tragedy, an already huge amount of foreign debts which were borrowed recklessly by Indonesian private companies suddenly turned into an endless pool of debt where Indonesian companies were drowning frantically due to the crisis in Rupiah's value.

Some people blame the speculators for creating that disaster, but those speculators are only a part of many factors that formed the crisis back in 1997. Another crucial factor which is also very important is the management of Indonesian private foreign borrowings. Without proper supervision and good risk management, foreign borrowings might be troublesome to the monetary policy of Indonesia and also the sustainability of business activities. Considering the fact that the amount of Indonesian global debt offering transactions are increasing significantly, it might be worthwhile to see the relevant issues that we may face and the policy that should be taken to prevent or solve them.

Why Choose Foreign Debts? 

There are many reasons for raising foreign debts, but I know one obvious reason and that is the lower interest rate. As you may be aware, there is a big discrepancy of interest rate between the US Fed and Bank Indonesia and therefore, to certain extent, obtaining foreign borrowings is more commercially acceptable to Indonesian companies since they can get a lower interest rate.

Of course, if there is no financial crisis, this formula might work. Unfortunately, when the Rupiah's value fell into the depth of hell in 1997, the disaster is inevitable. By having too many debts in foreign currencies and without having any hedging mechanism, the majority of Indonesian companies fall into bankruptcy when they realize that their debts have increased tremendously in correlation with the fall of Rupiah's rate.

Hiding Behind the Scene: Old Regulations on Foreign Borrowings

It is ironic that many Indonesian private companies were crushed in a crisis caused by unmanageable foreign borrowings while the Indonesian Government has already been dealing with foreign borrowings for a long time. It was in 1972, when the President of Indonesia issued Presidential Decree No. 59/1972 on Foreign Commercial Borrowings ("PD 59"), an archaic regulation which has been almost totally forgotten by everyone though it is still a full binding regulation.

Under PD 59, certain restrictions were imposed upon Indonesian companies, such as:

• in case the borrowings involve the Government's guarantee, state owned companies are restricted to receive foreign borrowings without prior approval from the Minister of Finance (later on, the minister approval will be replaced by the approval of the Coordinating Minister of Economy, as the head of the Foreign Commercial Borrowing Team ("PKLN Team"), and the state owned companies are required to obtain prior approval from the PKLN Team before receiving any foreign debts, regardless of whether the Government acts as a guarantor or not to such foreign debts); and
• private companies must report their foreign borrowings in a periodical basis to the Ministry of Finance and Bank Indonesia.

What was the main reason for issuing this PD 59? The reason, I believe, is quite simple, i.e. to manage the currency risk of those debts by supervising those Indonesian companies. Most Indonesian companies receive their income in Rupiah, but when Indonesian companies receive debts in foreign currencies, they have an obligation to pay those debts in foreign currencies. Due to such discrepancy, there is always a currency risk, a time bomb which eventually will explode, destroying everything.

To cut it short, while the nominal amount of the foreign debts will not change, the real amount may change in correlation with the progress of Rupiah's value. If the Rupiah's rate increase, the companies are lucky, but if not, they will face some serious problems. Imagine if a company has too many debts in foreign denomination and at the same time Rupiah's rate falls drastically. With an increase in the actual amount of the debts and without significant additional income, could the company still afford to pay its debts? I don't think so. And if there are too many companies having the same problem, what would be the result? A financial crisis!

Therefore, in my opinion, foreign borrowings must be supervised, so that the risk can be maintained. Of course there is a question on how such supervision can actually prevent the crisis? Further, how should the Government balances the policy to maintain the flexibility for those private companies in raising foreign debts.

Current Condition: Not Much Improvement

Interestingly, there isn't much improvement since the fateful 1997 crisis. As I've seen during my practice, Indonesian companies are still happy to pursue foreign debts, whether through bilateral or syndicated loan agreements arranged by foreign commercial banks or issuing notes to international investors arranged by investment bankers. Submitting reports to the PKLN Team, the Ministry of Finance and Bank Indonesia for Indonesian private companies or obtaining PKLN approval for state owned companies before getting their foreign debts have become administrative obligations which have no value other than to secure a clean legal opinion from lawyers.

This is indeed a sad news, yet inevitable. Due to the lack of implementing policy, the PKLN Team has forgotten their own task, and I have a solid evidence for this. In one transaction, we were asked to give a presentation to members of the PKLN team on the roles and authorities of the PKLN Team relating to PKLN approval. I must say that this is quite hilarious.

That's why, it does make sense when I heard a rumor that the Government intends to revoke the 1972 and 1991 regulations. Why preserving regulations which don't have any efficacy, regulations which only create administrative problems for private companies and state owned companies when they are trying to raise foreign debts?

True, we cannot maintain ineffective regulations, but in the case of foreign debts, I believe that the Government is missing the main point. Such administrative measures were created to protect the interest of those Indonesian companies! Rather than revoking those regulations, why not improving their implementation? But I guess, the Government may have their own thoughts, and I assume that this is related to the separation of tasks between the Government, as the guardian of Indonesian fiscal policy, and Bank Indonesia, as the guardian of Indonesian monetary policy.

Latest Regulations on Foreign Borrowings

After going through an enduring period, Bank Indonesia issued Bank Indonesia Regulation No. 10/7/PBI/2008 on Foreign Borrowings of Indonesian Non-Bank Companies on 19 February 2008 which was further followed up by an implementing regulation in the form of a circular letter on 22 December 2008. Basically, this regulation requires Indonesian non-bank companies to submit periodical reports (annually or semi annually) concerning their financial viability (this include the submission of a report on their financial ratio and their financial statement) and risk management analysis before they obtain foreign borrowings in any form whatsoever. The regulation also requires these Indonesian non-bank companies to obtain ratings from local or international rating agencies for each debt that they would obtain. Those who are interested to see the form of the report can see it here.

The purpose of this regulation is to ensure that Indonesian companies have sufficient consideration and a proper risk analysis in determining whether they should pursue loans from foreign parties, whether they are banks, other financial institutions, or bonds investors. Bank Indonesia states in this regulation that foreign borrowing is one of the major factors which may affect the Indonesian monetary stability and the sustainability of the Indonesian economic development, and therefore proper supervision is needed.

In my opinion, this regulation is quite balanced. I don't think that it can significantly affect the flexibility of Indonesian private companies in raising foreign debts. On the other hand, the regulation might provide various useful guidelines for the companies in conducting proper analysis before they get those foreign debts. In other words, this regulation is a further advancement to the old 1972 and 1991 regulations which only required submission of simple reports.

The regulation also imposes sanctions in the form of warning letters and announcements to the public (domestic or international). This is a good move from Bank Indonesia and the sanction should be more effective than any other penal sanctions, since reputation is very valuable in the market, and no companies dare to risk their good reputation for unclear benefits. It should be noted though that the sanctions will be effective on 1 January 2010.

I have high hopes on the further implementation of this regulation. Getting many global debt offering and other international financing deals are good for lawyer's business. However, it is also important to ensure that we are not advancing these companies toward doom because of reckless debt policy. Bank Indonesia should be strict when it deals with this reporting obligation to ensure the compliance of the Indonesian companies. After all, these regulations are made to protect their interest in the long term and the regulation can be a good nudge for them.

I have discussed Law No. 24/2009 on National Flag, Language, Emblem and Anthem ("Law 24/2009”) in my post dated 27 August 2009. However, I feel that my analysis on the issues related to this Law 24/2009 is not complete, I am not satisfied with the legal analysis in my previous post and in practice, the impact of this Law is greater than I've ever thought to be. Thus, I believe that I must revisit the issues on Law 24/2009 and provide a deeper analysis in this blog.

Our main issue revolves around Article 31 of Law 24/2009. The first paragraph of this Article requires the use of Indonesian language in agreements involving state institutions, Indonesian government authorities, Indonesian private institutions or Indonesian individuals. The elucidation of Article 31 paragraph 1 states that an agreement in this context includes international agreements made within the framework of public international law.

Article 31 paragraph 2 of Law 24/2009 further states that if the agreements involve foreign parties, the national language of those foreign parties and/or the English language can also be used. Furthermore, the elucidation of Article 31 paragraph 2 states that if agreements are executed in multiple languages, i.e.: Indonesian language, the national language of the foreign party and/or English language, each version is equally original.

Although the above provisions look simple, they have triggered significant legal problems, i.e.:

• whether Indonesian companies are obliged to use Indonesian language in their commercial contracts since Article 31 paragraph 1 and its elucidation are not particularly clear on whether (i) the term “Indonesian private institutions” includes Indonesian companies or Indonesian branches of foreign companies; and (ii) the term “agreements” includes private commercial contracts;
• suppose they are obliged to use Indonesian languages, what would be the legal impact for any failure to do so? Is this is a mandatory obligation or merely an administrative requirement?
• with respect to dual languages contracts, whether “equally original” means that each contract must be executed as original (not merely translation) and if yes, whether the parties to such contract can choose non-Indonesian language as the governing language.

In practice, the impacts are disastrous, especially in relation to commercial contracts made between Indonesian and foreign parties. Most foreign parties fear that the failure of using Indonesian language in their contracts might cause the contracts to be annulled by operation of law due to breach of mandatory legal obligation. As a result, they act conservatively and request that the contracts must be executed in dual languages. Not only that this choice of action significantly delays the transactions completion and increases the parties’ costs, it also imposes unnecessary risks and liabilities, particularly because certain complicated contracts such as Indenture, Trust Deed and EPC Contracts are too technical to be perfectly translated into Indonesian language (which is a very young language compared to English). As a result of this and without any definitive meaning on the concept of “equally original,” parties are running the risk of executing a contract with misleading or incorrect terms and conditions.

While the fear is understandable, in my opinion, acting conservatively does not solve the problems and there are better ways to solve them rather than executing all contracts in dual languages format. First, we should refer to Article 40 of Law 24/2009 which stipulates that the use of Indonesian language will be further stipulated in Presidential Regulations. I appreciate the fact that the provisions of Law 24/2009 are still valid even without those Presidential Regulations. However, it also indicates that the provisions of this Law is not yet complete, which in fact is true. As a matter of Indonesian legal principle, when the text of the law is not clear, parties to a contract should not interpret the law for the detriment of any of the parties. If a party tries to annul a contract due to failure of using Indonesian language where each party to that contract is aware that having such Indonesian version would most probably cause adverse effect, it shows that such party has bad faiths and in my opinion the court should not grant the claim. After all, why forcing the parties to use Indonesian language if it does not give any clear benefit to them?

Second, Law 24/2009 does not provide for any sanction for failure to comply with the above requirements, and it is arguable under the general Indonesian legal principle that when a law provision does not have any sanction (or the sanctions are merely administrative), the failure of performing such provision cannot affect the validity of a legal act, i.e. the contract. This has been made clear in a famous landmark case where the Supreme Court decided that the failure of submitting a report on foreign loan (which is an administrative requirement under Bank Indonesia regulations) cannot be used as a valid reason to annul a credit agreement made between an Indonesian debtor and foreign creditors. While I understand that there is a previous case on the similar matter where the credit agreement was annulled, the latter precedent should prevail since it is in accordance with the correct interpretation of law and is closer to fairness, i.e. it is completely ridiculous and unfair to the creditors to invalidate a credit agreement due to the failure of the debtor to submit some administrative reports.

Therefore, I would suggest that in case a contract involves Indonesian and foreign parties, the parties should not execute a dual languages contract without first performing a complete analysis on the advantages and risks of having such format. Suppose they conclude that having a dual languages contract is not a viable option, I would suggest them to insert a clause stating that they have agreed to execute the contract in non-Indonesian language and that they will execute an Indonesian language version of the contract when the implementing regulations clearly oblige them to do so. This mechanic would be useful to prevent any party having bad faiths from trying to annul the contract.

On the "equally original" phrase, my suggestion is that the Parties involved must also insert a clause concerning governing language. It is indeed unclear on whether the equally original means that each language should be deemed as applicable. However, when in doubt, the Parties should not use an interpretation that harms them. In addition, why don't we refer to the freedom of contract principle? The Parties should be able to agree on the governing language of the contract, and therefore eliminating any risks to have misleading or incorrect terms. However, the main question would be: if the Parties execute the Indonesian language contract for the sake of complying with Law 24/2009 and the governing language of such Contract is non-Indonesian, what is the purpose of having an Indonesian version in the first place? Is not this a waste of time and money? The Government should answer this big question.

In the end, we can conclude that the existence of Law 24/2009 brings more problems than benefits in practice, particularly in relation to the use of Indonesian language. While, we can argue and use several solutions to solve the issues brought by Law 24/2009, it should be noted that there are no bullet proof mechanisms here. The courts could always have a different interpretation. So, let us hope that the Government can give us a better solution through the implementing regulations and the courts can decide based on the correct and fair interpretation of the law while we are waiting for the implementing regulations.

At last, the long awaited draft amendment to the VAT law has been passed by the Indonesian legislative board (the "New VAT Law"). You can see the soft copy here. The law will be effective as of 1 April 2010. The most important thing here is the fact that the New VAT Law recognizes the existence of Islamic finance and exempts VAT for transactions that fall under the term of Islamic finance. Article 1A Paragraph (1) h of the New VAT Law states that with respect to delivery of taxable goods by taxable entrepreneur in the context of Islamic financing activities, such delivery shall be only considered between the taxable entrepreneur and the party needing such taxable goods. While the elucidation of this Article does not provide specific explanation, it gives an example of a murabahah transaction for a vehicle financing, where an Islamic bank buys a car from a taxable entrepreneur based on an order from the Islamic bank customer. In this example, the New VAT Law acknowledges that under such Islamic financing structure, the Islamic bank would need to purchase the vehicle first and then resell it to its customer, however the New VAT Law further confirms that the delivery of such car is considered to be directly done from the taxable entrepreneur to the Shari'a bank customer. In other words, we can conclude that the New VAT Law acknowledges the role of the Islamic financial institutions as financial intermediaries. In addition to the above, Article 4A Paragraph (3) d of the New VAT Law states that financial services are exempted from VAT. The elucidation of such Article further states that the definition of financial services include Shari'a based financing, whereas the financial services may be in the form of: (a) leasing, (b) factoring, (c) credit cards, and (d) consumer financing. Although the above wordings are not clear enough to capture all kind of Islamic financing structure, I am still very happy with this new development as I believe that the New VAT Law might be the right trigger for bringing the Indonesian Islamic finance to a new level. As you may be aware, before the enactment of this law, there is a huge confusion within Islamic finance players on whether their transactions are actually exempted from VAT or not. To add the confusion, in most of the time, the tax authorities were silent on the tax treatment. In short, it was like sitting on a deadly time bomb. In my opinion, there should not be any confusion in the first place, since from the accounting perspective, these Islamic financing transactions are recorded as ordinary financing transactions in the balance sheets of companies that receive such Islamic financing (substance over form) . In other words, there would be no record of sale and purchase or sale and lease back transactions in the financial statements since those structures are merely used to satisfy the Shari'a aspect and do not reflect actual transactions. However, a risk is a risk and without having any tax advisor who is brave enough to issue a clean tax opinion, most Islamic financial institutions were not eager to develop the business in Indonesia. Thus, there are no significant development of Indonesian Islamic finance until today. Hopefully, this should be no longer the case. In addition to the above, further implementing regulations are still needed to resolve the remaining issues as provided below:

• Will there be any criteria to determine the transactions that fall under Islamic finance transactions? I guess the Government will need to stipulate such criteria to avoid any moral hazard from business players who are trying to avoid paying VAT under the disguise of Islamic financing transactions.
• It is unclear on how Ijarah transactions (lease structure) will be treated under the New VAT Law, since there is no transfer of beneficial ownership in an Ijarah transaction. Should the transaction be considered as an ordinary lease transaction? Surely not, but I would like to know how this will be solved from tax perspective.
• While Ijarah Muntahia bit Tamlik financing structure (sale and lease back) should be accommodated under Article 4A Paragraph (3) d of the New VAT Law, it seems to me that this article only applies to leasing companies. What about IMBT financing provided by other kind of Islamic financial institutions, such as Islamic banks? Is there any requirement for securing a leasing company license before the exemption works?
• What about Sukuk? From the original wordings, it seems that the New VAT Law only covers plain vanilla Islamic financing transactions conducted by Islamic banks.

I guess that would be the preliminary issues related to the New VAT Law. I will give more updates on this subject after the Government has issued further implementing regulations.