Coal prepayments in Indonesia - time to review?

Recent Indonesian court decisions may have dealt a further blow to the country's already beleaguered coal industry. It was widely reported that, on 4 April 2016, the Central Jakarta Commercial Court had in the ongoing Indonesian court-supervised debt restructuring (Penundaan Kewajiban Pembayaran Utang ("PKPU")) for Asmin Koalindo Tuhup (AKT) excluded a US$101m claim from its offtaker, Noble's subsidiary Noble Resources International Pte Ltd.

In brief, Noble Resources had provided AKT with an advance payment in expectation of future deliveries of coal from AKT pursuant to an offtake agreement. The payment was secured by a pledge over coal in AKT's mine. AKT subsequently reneged on the offtake agreement. The Administrator for the PKPU ordered for the annulment of the offtake agreement but the order did not include the requirement for any monies paid or coal delivered (if any) to be returned to the respective parties.

This may seem like a victory from AKT's perspective but it is unlikely that the other Indonesian coal miners will be celebrating. Coal is one of Indonesia's largest exports, however it fell 22.9 per cent in 2015 (y/y) to 294.2m tons from 382m tons in the preceding year. It was sold for nearly US$200 per ton in 2008 but can now only sell for around a quarter of that figure. The prospect for coal is not burning as brightly as before – it is now labelled as one of the most polluting fossil fuel options due to its high carbon content. Once the darling of the financing world, big banks like Bank of America, Citigroup, Credit Suisse, Morgan Stanley, JPMorgan Chase and Wells Fargo are now retreating or limiting their exposure to the coal industry.

The arguments raised by Hotman Paris Hutapea on behalf of AKT (a subsidiary of Borneo Lumbung Energi & Metal), and apparently accepted by the Central Jakarta Commercial Court, have resurrected the spectre of nationalistic arguments being used as grounds for an Indonesian coal producer to invalidate claims by its international creditors. In the AKT case, the following arguments were used to reject Noble's debt claim as creditor under its offtake agreement with AKT:

• Under the coal contract of work (CCoW), which is a contract of work for coal mining, the Indonesian Government retains title to coal until point of sale in Indonesia or point of export. The Government is entitled to first royalty from the proceeds.
• The coal does not belong to the coal company until it is mined and the royalty paid, therefore it cannot be provided by a producer as security.
• The prepayment advances by Noble to AKT are therefore unsecured. However, even as an unsecured debt, it would be prejudicial to other unsecured creditors to allow the offtaker to prove alongside them.

The first two points seem logical – a producer cannot grant security over an asset that it does not own. So, in the absence of such security, the advances made by Noble should be unsecured. However, the logic on the third point is not immediately obvious. It is not illegal for an offtaker to buy coal in advance of delivery and this is common market practice. Why then should it be "prejudicial" for an offtaker to prove alongside other unsecured creditors when the producer fails to refund the advance payment to the offtaker?

Some press reports have gone on further to suggest that the prepayment facility is in fact a disguised loan which did not comply with the same regulatory/reporting requirements as a commercial loan. This allegation seems rather harsh. An advance payment under an offtake agreement can be distinguishable from a loan. Under a loan, the main objective of a lender is to require the principal and interest to be repaid in cash. Under a coal prepayment agreement, the main objective of the offtaker is to be repaid by deliveries of coal. Any refund of the advance payment may only be triggered if the right quality and quantity of coal is not delivered on time in accordance with the offtake agreement.

A possible reason for rejecting Noble's claim may be that it was thought that an advance payment creates a right to receive the coal in due course but not an immediately due and payable debt. We do not know whether this line of argument is applicable for the AKT case but it should not be fatal for all prepayment structures. Most offtakers are cognisant of the fact that the key risk of a prepayment structure is that the producer may not produce and/or deliver the coal as promised. To address this risk, a properly drafted offtake prepayment agreement should contain a "backstop clause" – such that if the producer does not deliver the coal by a certain deadline, it will trigger the obligation for the producer to refund the advance payment. If the producer refuses to repay or refund the relevant amounts to the offtaker, the offtaker should have every right to prove alongside other creditors.¹

One of the consequences of the AKT case may be that offtakers will require their advance payments to an Indonesian producer to be documented by way of a loan. If so, this is unfortunate, as it may not reflect the commercial intention of the parties. It could also increase the cost of financing from a producer's perspective, as the loan will need to be charged at an arm's-length rate of interest which is subject to withholding tax on justifiable transfer pricing principles. Such costs would inevitably be passed on to the party most in need of financing – the producer.

Leaving aside the potential merits of the arguments raised in the AKT case, the recent court decision in AKT is generally troubling on many levels. The coal industry doesn't need any more bad publicity. Producers are facing tough times raising financing – it is not prudent for a mining producer to invalidate claims from its key trading parties. Most mining producers require some form of financing to develop and operate its mines. When liquidity in the international debt capital market is limited, big traders offer a good alternative source of financing. Such prepayments can be attractive to the producer, as it not only provides financing but also secures a buyer for the producer's coal.

It may be too early to describe the AKT case as a "nuclear holocaust" for commodity prepayments – this is still an ongoing litigation. Furthermore, it appears that Noble has fired a subsequent salvo. It has been reported that the Singapore High Court has granted Noble's injunction against AKT, barring the miner from selling to other parties the coal which Noble has paid for in advance under the offtake agreement.

However as a note of caution even if Noble secures a foreign court judgment in its favour, such judgment cannot be enforced in Indonesia directly. To enforce one, a new lawsuit must be filed in an Indonesian court. The foreign court judgment may be introduced as evidence in the new proceedings, although in principle the Indonesian court will not be bound by the findings of a foreign court.

The commodity market is looking at this case with keen interest. It has implications beyond the coal market, as prepayment is a common form of financing for producers of other commodities. It would be unfortunate if a producer is permitted to renege on its agreement and sell the commodity originally promised to an offtaker pursuant to the coal prepayment agreement to another party for a more attractive price without any consequences.

In the meantime, the following are tentative conclusions which we can draw from the AKT case:

• Firstly, do not take security over the unmined coal or the CCoW for any debt or there is a risk that it may be deemed as ultra vires if the Indonesian Government has not granted permission for such action. There are other forms of security which you can typically take under such an arrangement.
• Secondly, when you enter into an arrangement which may result in a debt being owed to you by an Indonesian party), make sure you obtain a notarised acknowledgement of indebtedness – this is conclusive evidence in the Indonesian courts, and the administrators do not have discretion to ignore this. However be careful when you draft the document to avoid any allegations of double dipping – ie. that the producer can recover both the debt and demand delivery of coal.

Please also read our article "International debt instruments in the Indonesian Courts – prepare for the unexpected" where we describe the tactics commonly used by debtors to challenge the obligations set forth in international credit documents and suggest ways in which these might be overcome.