Foreign Direct Investment in Gold Mining in the Developing Countries: An Analysis of Award and Implementation of the

1. Foreign Direct Investment in Gold Mining in the Developing Countries: An Analysis of Award and Implementation of the Contract of Works System in Indonesia By Balbir Bhasin

2. Purpose & Scope of Study Key Question: What changes does a developing country need to make to its foreign investment policy, law and the implementation process with respect to mining, so as to make it more conducive for foreign investment and achieve a long term balance between the needs of the investor and those of the country?

3. Research Questions • What are the real and perceived problems faced by foreign investors when negotiating and bidding for contracts? • What changes need to be made in the structure of CoWs, and the awarding process that results in greater transparency and benefits both the foreign investor and the host government? • What are the political limitations to implementing these changes?

4. Research Design • Main research paradigm is hermeneutics using two instrumental case studies for evaluation and interpretation. • Documentary analysis and unstructured interviews will be the main instruments for data collection.

5. Fundamental Structure of CoW • Conjunctive Title: This grants the right to the contractor to proceed to mining exploitation as and when a commercial discovery is made without further approvals; the rights and obligations of the contractor covering all stages of the undertaking – from general survey and exploration all the way to production and marketing of the product – are stipulated in the contract. 2.Lex Specialis Treatment: The CoW guarantees that, once approved by the government, the terms and conditions of the contract will not be subject to any subsequent changes to the general laws and regulations of Indonesia.

6. 1st Generation of COW • Negotiated in toto with Freeport. Only one contract signed in 1967. • Covered an area in Irian Jaya centered on the Ertsberg gold deposit discovered by the Dutch in 1936. • Exploration period 2 years; Feasibility Study period of 6 months; Construction period of 3 years; and Operating period of 30 years following commencement of commercial production. • Company given the right to keep its books in US dollars and to retain offshore the proceedings of sales in foreign currencies. • Most generous contract in favor of the foreign investor and Freeport has been carrying out a successful mining operation since. • Tax holiday of first 3 years after commencement of production. • Exemption on most other taxes and from royalties on copper and gold. • Company given full management and control on all matters related to exploration and mining operations.

7. 2nd to 6th Generation1967 to 1997 • Introduction of export and property taxes. Restriction on exemption from import duties. • Processing (including smelting and manufacturing) of material to be within the country. • Increased indirect taxation through Withholding Tax and Value Added Tax. • Required to have an Indonesian partner at the outset. • Imposition of import duties on spare parts • Freeport agreement generated tremendous interest in the international mining community. • Large scale general mining began.

8. 2nd to 6th Generation1967 to 1997 • Contracts changed: abolition of tax holiday, increase in corporate tax rates, payment of royalties, land rent and other taxes added. • Specifications of number of Indonesians to be employed. • Equity shares to be offered to Indonesians (rose from 20% to 51%) • Imposition of new royalty scheme based on fixed US dollar amounts per units of contained metal. • Increase in land and building taxes. • Increase in amount of security deposit and minimum expenditure levels. • Imposition of royalties by the province concerned for industrial minerals used to construct the mine. • No guarantee of purchase of product by the government in case of an export ban.

9. The Busang Scam and Aftermath (1996-7) • Bre-X, a small Canadian company purchased Busang site in East Kalimantan in March 1993 from an Australian company. • The players were de Guzman, a Filipino geologist, John Felderhof, a Dutch born Canadian citizen, and David Walsh, a Canadian businessman. • They bought the claim for $86,000 and proceeded to claim the biggest gold find of all time. • In 1996, company made public announcements raising estimate of lode size from 2.5 million oz., to 30 to 70 million oz. To eventually 200 million, which would be worth $70 billion at current prices. • Claims were backed with “salted” ore samples – a technique of sprinkling gold dust on the core samples to fool assayers. • Bre-X stock prices skyrocketed – from a “penny stock” to $200 in September 1996.

10. The Busang Scam and Aftermath (1996-7) • Walsh & Felderhof sold around $83.5 million of Bre-X stock and moved to the Cayman islands. • Big players became involved: Investment bank J.P. Morgan was a Bre-X advisor. Freeport-McMoran came in as a partner in February 1997 and promised to spend $1.2 billion to excavate the mine. Boston’s giant fund, Fidelity Investments was Bre-X;s largest investor. • In Indonesia, there was a mad scramble to get a piece of the action: Barrick Gold of Canada joined forces with Suharto’s eldest daughter. Bre-X hired as consultant a company linked to the President’s eldest son. The President’s close confidante, Bob Hasan intervened to force a final deal that included a 30% stake in the mine for himself, 15% for Freeport (who was to kick in $400 million to take operational control of the project); 45% for Bre-X, and 10% for the Indonesian government.

11. The Busang Scam and Aftermath (1996-7) • Fraud was discovered when Freeport hired Strathcona Mineral Services of Toronto to make an independent assessment. • The bubble burst and de Guzman was found dead, apparently suicide by jumping out of helicopter. • Bre-X stock plummeted from C$26.80 to C$3.30 to about Canadian 8 cents. • Big and small investors lost $2 billion. Result: • Indonesian and Canadian authorities were embarrassed! • All contracts would give the government a free, open-ended, 10% stake. • Government would get a share of capital gains on overseas stock markets. • New contracts would require full Indonesian management within 6 years of operation.

12. 7th GenerationResponse to Busang • Only 38 of 6th generation applications were approved, mostly with major companies. • 260 applications were pending, most were Canadian juniors. • Cash security deposits were now required. • Final area to be no more than 62,500 hectares. • Refunding of security deposit was made more difficult and lengthy.

13. The Collapse of the Indonesian Economy • Asian Financial Crisis - mid 1997 • Decline of Indonesian Rupiah from Rp2,400 (to $1) to 4,000 to 6,000 to 10,000 to 16,500 on January 22, 1998 • Riots and student protests • Suharto resignation on May 21, 1998 • Vice President Habibie - No progress • New Elections 1999 - Democracy & Fragmentation - Timor, Irian, Aceh, (Racial)

14. Proposed 8th Generationfor applications after 1st November 1997 • Security of Tenure provisions eroded. • Severe increase in payment of royalties. • Local governments allowed to tax and charge. • Bank-ability of CoW reduced the ability to raise finance. • Absolute power to government in granting approval of plans and designs relating to construction, operation, expansion, modification and replacement of facilities within the contract area. • Severe changes made to Contract Area, Feasibility Study Period, Construction period, and Operating Period. • Release of Security deposit further delayed. • Company no longer has the right to all the necessary licenses and permits. • Limits rights of companies to bring in expatriate employees. • Force Majeure now completely in favor of the government. • Companies now required to contribute to community development.

15. Case Study OneP.T. Danau Toba Mining, North Sumatra • Project is called Sibolga and covers 659,738 hectares. • Foreign entity is Normandy Anglo Asia Mining. a JV of the Normandy Group of Adelaide, Australia and Anglo American PLC of Great Britain (Anglo) which is a consolidation of Anglo American Corporation of South Africa and Minorco SA of Luxembourg. It is associated with De Beers Consolidated Mines Limited. • Normandy Group is capitalized at $3.5 billion and Anglo and its associates in excess of $20 billion, • Indonesian partner is PT Austindo Nusantara Jaya (Austindo) and is controlled by Julius Tahija, an 80 year old Ambonese Christian and his two sons. • The shareholding is 90% Normandy and $10% Austindo. • Authorized capital is $200,000, with paid up capital being $50,000. The Indonesian contribution of $5,000 was contributed to Normandy as a loan. • The joint venture agreement between the two parties explicitly states that Normandy would control and manage the project. • The site was selected based on recommendation of one of the company’s contract geologists who had explored the area earlier.

16. Case Study TwoP.T. Tambang Tondano Nusajaya North Sulawesi • Project is called Tondano and covers an area of 297,200 hectares. • Foreign entity is Aurora Gold Limited of Perth, Western Australia and has a market capitalization of $210 million. • The local partner is again P.T. Austindo Nusantara Jaya, the same partner with Normandy. • Aurora has an equity stake of 85% and Austindo 15%. • Aurora has a facility of $10,000,000 available to the venture. An equity loan of $60,000 was made available, out of which $15,000 was advanced. • For security, Aurora is pledged all shares of Austindo in the JV. • The site is an extension of an already existing mine that Aurora holds under a separate and earlier CoW. (PT Meares Soputang Mining, 4th generation, 1986).

17. Case Studies Conclusions • Dealing with Govt. officials and bureaucracy remains a slow and inefficient process, • Security clearance process is tedious and costly, • Most serious problem is one of illegal miners, and damage to environment by them • Local government officials are demanding payments and hampering work, • Problems in obtaining clearance from Forestry Department for exploration due to conflict of interest

18. Research Findings • Investment in mining in Indonesia has come to a halt due to the prevailing situation. • First time ever, independent survey done by PriceWaterhouseCoopers in Dec. 1999 and 2000 confirmed this. • Major issue is the breakdown in law and order. • Foreign investors’ risk has been increased considerably. • Risks are: • Rising country risk • Rising security risk • Rising legislative risk • Rising inconsistency in policy • Rising costs of doing business • Others: bureaucratic inefficiency and poor infrastructure development

19. Recommendation for Reform • Proposed 8th Generation CoW needs to be re-evaluated • Mineral royalty rates need to be adjusted to world standards • Regional autonomy legislation needs to be implemented intelligently • Local government taxes and charges need to be more balanced • “Ring Fencing” Concept needs to be replaced with “One Company - Multiple CoWs” • Regional participation in sharing of benefits needs implementation • Long term stability and application of the contract needs to be ensured.

20. Lessons for Developing Countries • Contract of Work system works! • Need to understand the long term and special nature of the mining industry • Political stability - mandatory for resource development • Good governance can only come through transparency • Risks must be managed for mutual benefit • Need to understand the benefits and intricacies of foreign investment in resource development • The rule of law is an absolute must • Minimize political and regulatory risk for the foreign investor in mining • Transparency and good governance is a pre-requisite to encouraging DFI • Need to restructuring regulatory bodies and procedures thus creating the environment for sustainable DFI

21. In Conclusion Will the CoW system survive? Inter-regional competition may create a competitive market oriented climate where regions will compete on such factors as transparent government with less corruption and giving the locals direct benefits.