CHAPTER 7 REDUCING POLITICAL RISK

• Jurisdiction: United States

International Resources Law: A Blueprint for Mineral Development
(Feb 1991)
CHAPTER 7
REDUCING POLITICAL RISK
CHARLES MERCEY
N M ROTHSCHILD & SONS LTD
London, England

Introduction

1. This paper is principally concerned with how the political risk of mining investments in developing countries can be reduced through financing, guarantee and insurance mechanisms. However, it begins by examining the role which can be played by investment agreements both in reducing the overall political risk to which a project may be exposed and in creating conditions favorable for the introduction of "project secured" finance, thereby allowing the investor to lay off a substantial portion of the remaining political risk on lenders (or their insurers or guarantors).

2. The particular risks with which I am concerned are:-

(i) Expropriation, either outright or "creeping", without fair and reasonable compensation;

(ii) Non-expropriatory adverse changes in the host country's fiscal and regulatory regime;

(iii) Interference with the investor's ability to export, to retain foreign currency sale proceeds and/or convert domestic currency receipts and remit these;

(iv) Insistence by the host government that a project lender (or its guarantor) lend "new money" to the government as part of a sovereign debt rescheduling;

(v) Damage to property and/or inability to operate due to war or political violence; and

(vi) Abrogation by the host government of contractual arrangements entered into with the investor.

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This list is not exhaustive but nevertheless encompasses the commonly understood political (as opposed to commercial or technical) risks of investment.

3. My paper is also concerned principally with means of reducing, or laying off political risks in developing countries; this is not intended to suggest that such risks are peculiar to LDCs or necessarily always greater in such countries. It is arguably the opposite in the case of certain risks. For instance, the frequency and magnitude of tax changes is probably greater in developed countries (witness changes in European oil tax regimes over the last two decades) as is the risk of adverse regulatory changes in the environmental, health and safety areas. However, certain circumstances tend to prevail in developing countries which cause political worries to loom larger in the minds of potential investors. Depending on the country, these may include:

• A history of unconstitutional changes of government;

• Political violence (perhaps combined with a lack of central government control);

• A judiciary whose independence is questionable; and

• Chronic problems with remitting interest, profits and capital.

Lastly, many natural resource projects are so large in relation to the host LDC economy or the company involved that this gives rise to unstandable investor concerns regarding future discriminatory treatment by government and its own inability to "diversify away" its exposure to this risk.

The role of agreements with host governments

4. Not all developing countries are prepared to enter into investment agreements with developers; where they are, their contents and legal form vary considerably. In this section I shall discuss:

• The practical protections afforded by investment agreements in the areas of convertibility and transferability, non-discrimination, preconditions to termination and "economic stability";

• The pros and cons of enactment (ratification) of investment agreements; and

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• The benefits conferred by having an Investment Agreement, even when unilaterally abrogated.

5. Foreign exchange: Most mining and oil projects in developing countries are export orientated with hard currency sale proceeds, meaning that classic convertibility/transferability risk only arises if and to the extent that the mining company is required to bring sales proceeds onshore (or if its ability to export product is curtailed). So long as the company is not required to repatriate export proceeds, it avoids having its export earnings pooled with the host country's general foreign exchange reserves and consequently becoming reliant on the Central Bank to provide dollars when it wishes to make interest, capital or profit transfers overseas, either for its own account or that of lenders to the project. Restrictions on, or delays in acquiring foreign exchange are thereby avoided. This is of considerable comfort to lenders to projects in certain countries, who value contractual rights to hold project sales proceeds offshore in a segregated dollar account and are not prepared to bear the risk that the host central bank fails to convert local currency to meet dollar debt service.

6. A key element in reducing convertibility/transferability risk in an export orientated project (and increasing the likelihood that project lenders will bear these risks on their loans) is therefore to obtain rights, within the investment agreement:

• To export and sell the product overseas; and

• To retain the ensuing foreign currency sale proceeds offshore, to the extent not required to meet local expenditures.

Both rights are now commonly conceded in developing countries which enter into investment agreements routinely. However, obtaining them in countries which have no such tradition is not always easy. Acquiring the right to market product freely overseas often involves overcoming resistance from a government-owned marketing board or public or private sector processors (or would-be processors) of the product. This is often particularly difficult with gold projects where, in many countries, the sole legal buyer is the local central bank (eg. in Zimbabwe). Obtaining rights to retain proceeds offshore following export can also be

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difficult because it runs counter to many central bankers' and economic planners' stronger prejudices, as well as sometimes giving rise to political opposition due to the preferential position it may confer on the larger, foreign exporter as compared to his smaller, locally-owned counterpart. In certain countries (e.g. Papua New Guinea) the political issue is defused to some extent by having a general obligation to remit and convert dollar sale proceeds which is then subject to exceptions covering, inter alia, foreign debt service, offshore capital and operating costs, and dividend/profit remittances associated with the project. The disadvantage from the investor's perspective of this approach is that it renders him vulnerable to the omission of valuable (and perhaps to a lender, essential) items from the list of exclusions.

7. Non-discrimination: Certain governmental actions, whilst not explicitly expropriatory, may be directed selectively at the project and have the effect of materially reducing the value of the investment or the investor's control over it. Examples of such "creeping expropriation" are the imposition of penal charges for government services, very high rates of duty for key imported items or imposition of unusually high levels of minimum wages. One means of reducing this risk is to pre-agree in the investment agreement the level of charges, duties etc (or, if possible, agree their non-applicability to the project). However, although this may be essential and easily negotiable in the case of (say) imported feedstock to a refining or smelting project, it is never possible in an agreement to cover exhaustively all the means...