Asia Risk: inside Indonesia’s derivative battles

Asia Risk, November 2009

The backlash against foreign banks and their derivative contracts has reached Indonesia. Four foreign banks have been on the sharp end of district court decisions in Jakarta this year annulling contracts they had struck with Indonesian exporters. The trend raises a host of questions, about sanctity of contract, the Indonesian judicial process, and the appropriateness of the products in the first place.

It is estimated that as many as 50 derivative contracts may be in dispute in Indonesia today, but seven stand out. Two involve the local institution Bank Danamon, which has found itself in litigation with PT Esa Kertas Nusantara, a paper manufacturer, and PT Elnusa, an upstream oil and gas business. The others all involve foreigners: HSBC has twice this year ended up in the South Jakarta District Court, once with PT Toba Surimi Industries and once with PT Fresh On Time Sea Food, both seafood exporters. JP Morgan lost a case in the same court against PT Kalbe Farma, a pharmaceutical group, as did Citibank, whose contract with palm oil group PT Permata Hijau Sawit was annulled in a particularly humbling judgment in September. And Standard Chartered, in the Central Jakarta court, also found its contract annulled, this time with PT Nubika Jaya, an oleochemical manufacturer.

The courts have been nothing if not consistent, and that’s a worry to foreign banks and the industry bodies that represent them. “The part that has concerned the banks is that in all the cases that have been reported, none have been upheld: they have all been declared null and void,” says Jacqueline Low, senior counsel for Asia at the International Swaps and Derivatives Association, Inc.

There are differences between the cases, but there are some basic themes in common. They typically involve fairly straightforward derivatives, forward contracts designed to protect exporters against movements in the currency – but, crucially, in most cases these forwards have been callable, and generally only by the bank, not the company. Courts, in turn, have in several cases found these contracts unlawful because they considers them speculative, and therefore in breach of a Bank Indonesia circular (although, troublingly, the circular came out after any of these contracts were signed). Other cited reasons are because the transactions were explained in English and not Bahasa; because the contract itself breached the company’s own master agreement with the bank; or because the risks were not properly explained, or the contract was signed by the wrong person.

Several issues arise along the way here, but it’s helpful first to have an understanding of the Indonesian legal system. Indonesia follows civil law, unlike the common law approach in Hong Kong and Singapore; one consequence of this is that there is no doctrine of binding precedent, so each court decides what it thinks is sensible based on the merits of each case, and without having to follow anyone else’s previous ruling. That also means rulings can appear inconsistent.

One key element of the Indonesian Civil Code is Article 1320, and this has been used in a number of the court decisions to rule contracts null and void. Article 1320 is actually a lot like common law. It requires that, for a contract to be valid, there must be consent of the parties, capacity to conclude an agreement, there must be a specific subject and an admissible cause. “Admissible cause” is the tricky bit, and it roughly equates to what is called lawful purpose in common law. “Lawful purpose in common law you would say: if you have a contract to kill someone, that’s not lawful purpose,” says Low. “But in Indonesia, the interpretation of the district courts has been that if you breach any regulation in Indonesia, your contract is in breach of this requirement.” Lawyers for Indonesian companies have sought to benefit from this attitude by flagging things like the language issue or by portraying contracts as speculative. “In a number of these cases it was held there was a breach because the transaction was not explained in Bahasa – for example, that the term sheet was not in Bahasa. Therefore the contract is null and void because you have breached an Indonesian regulation.”

The most alarming aspect of some of these decisions has been that they have been ruled unlawful since they breach Circular Letter of Bank Indonesia No. 10/42/DPD – which was dated November 27 2008, well after any of these contracts were signed. The circular stipulates that purchases of all foreign currencies against the Indonesian rupiah can only be performed for non-speculative purposes. (The wording here reflects Bank Indonesia’s view that it is only really concerned about things that impact the currency, not the behaviour of Indonesian companies in their derivative purchases, which is outside BI’s remit.) That opens up a whole other question of definition but for the moment appears to exclude callable forwards, whose callable feature, in some people’s view, renders them no longer hedging but speculative instruments.

But this ruling from Bank Indonesia does not appear to have been intended to apply retrospectively. “How can a transaction which pre-dated this regulation be required to comply with it?” asks Low. For this and other reasons, most foreign houses have appealed and all are expected to do so, first to the High Court and then if necessary to the Supreme Court.

There is also concern that in some of the contracts, the parties had opted for disputes to be adjudicated in England under English law, but the Indonesian district courts have instead accepted the case filed by the Indonesian company and applied Indonesian law. JP Morgan and Kalbe Farma, Indonesia’s largest pharmaceutical company, structured their derivative contract under English law, and when Kalbe defaulted, the case was first heard in London, where JP Morgan won, with a US$19.2 million award. JP Morgan then took the decision to Jakarta to get it enforced, where the Central Jakarta District Court instead granted a provisional judgment in favour of the Indonesian company in June. Separately, Kalbe countersued JP Morgan for $120 million in another district court in South Jakarta, partly for alleged damage to its reputation, although it is understood this suit has been dropped to focus on JP Morgan’s appeal, which will now go to the high court.

To understand the intricacies of these disputes, let’s look at one in detail: the Citibank/Permata Hijau Sawit case. Both sides declined to comment on this transaction but by speaking to a number of people familiar with the case and the court hearing, Asia Risk has been able to assemble what it believes is a reflection of both sides of the dispute.

Permata Hijau Sawit is a palm oil exporter based in Medan on the island of Sumatra. Like all exporters, it has exposure to currency movements; crude palm oil prices are quoted in dollars but its domestic expenses are in rupiah. It is understood that it has had a relationship with Citi for hedging since around 2001, and has certainly entered into foreign exchange contracts with Citi for a number of years.

At some stage, Citi began to promote callable forwards to the finance department of Permata. Part of the dispute is understood to be that Citi insists this is a hedging tool, whereas Permata has argued that apart from a six week period at the start of the transaction, the contract is not suitable for hedging but is in fact risky and unfair. This is chiefly because, from the seventh week onwards, the bank has the right to call but the company does not; from the bank’s perspective, the call feature is a consequence of the fact that the customer sells an option along with the transaction which then gives a boost to the contract’s spot rate. Once the rupiah’s value started to deteriorate through October and November 2008, Permata became unhappy with the contract and the impact it would have. A crucial point here is that Permata has claimed the contract was sold to someone in their finance department – a company secretary who also has responsibility for hedging – who did not comprehend the risks and who, furthermore, should not have been in a position to sign the contract anyway because the master agreement between company and bank was not signed by her. Citi is understood to be highly dubious of any attempt to present this person as either junior or unable to understand the contract. Permata also argued that the master agreement set a maximum limit to exposure which this contract was already either breaching or likely to do so, and therefore should not have been sold to it.

Meetings followed between the bank and the company in which Citi is believed to have offered restructuring suggestions, which Permata rejected as equally or more risky for the company. Around this time, Permata also contracted Bank Indonesia, which held another meeting with both Citi and Permata in November; the regulation mentioned above was partly a consequence of this meeting.

Things became more acrimonious. All banks are required to supply to Bank Indonesia with a rating for each corporate customer it supplies based on their performance, with one being best and five the worst. Creditor banks then have to deposit a certain percentage with Bank Indonesia reflecting their exposure to this customer, and the amount they have to deposit increases as the rating declines. Citi put the rating on Permata down from 1 to 3, which had a major consequence for Permata’s main creditor, Bank Mandiri, which would then have had to put much more capital aside to Bank Indonesia. It is understood that Mandiri itself lobbied Bank Indonesia (companies can’t deal with the bank regulator directly) to argue that this was a special case, an argument that Bank Indonesia accepted. One odd consequence of this development was that when the suit headed for court, Permata originally named Bank Indonesia in it – a situation it reversed on the encouragement of bankers.

By now, the case was destined for litigation, with Citi saying the cost of closing out the position would be $23 million. Lawyers were by now looking for ways to weaken each others’ cases, which is where the Bahasa argument comes in: the issue of language isn’t really the point in any of these cases, just something that’s been thrown in to the mix by lawyers. Instead, what’s really at issue is the suitability of the product as a hedging tool and the question of whether a product with such high potential exposure should ever have been sold.

The district court in the Citi case effectively annulled the contract. Although the reported sums appear huge, they need to be examined: the court ordered US$10 million from Citi to Permata and Rp97.2billion from Permata to Citi, but that’s not an award, it’s just a return of the funds each had exchanged in the earlier weeks of the contract (at the time there was no net settlement permitted on derivative contracts in Indonesia so the whole notional amount has to be transferred to the counterparty). There were also reports of US$545,525 in damages being awarded to Permata, but that’s wrong too: it’s Permata funds that were held with Citi, reflecting a standby letter of credit. Instead, the damages that were awarded were a requirement that Citi rehabilitate the reputation of Permata through an announcement in two national newspapers – following its attempt to downgrade Permata’s rating. Unsurprisingly, Citi is doing nothing of the sort pending appeal, and none of the funds have been exchanged.

The next stage of the saga will be to see what the higher courts do. There’s no doubt that these contracts were signed, so it’s really a question of whether the courts decide that the products themselves were unlawful, and whether the various technicalities raised in district courts pass muster higher up (it’s hard to imagine that the argument about breaching a circular that hasn’t yet been issued will go without challenge, for example). While it’s common to knock the Indonesian judiciary as corrupt, a more important point is perhaps the level of expertise with FX and derivative transactions that can be expected in an Indonesian district court, coupled with the difficulty of explaining such transactions in Bahasa to an Indonesian judge. “In fairness, part of the difficulty is lack of understanding,” says Low. Nevertheless, the appointment of Hotman Paris Hotapea by Indonesian clients including Kalbe Farma is likely to add another level of drama to legal proceedings: Hotman, known well to Australians for his attempts to get the Schapelle Corby drug smuggling case re-opened, is not so much merely a lawyer as a human whirlwind of dramatic press conferences and wild remarks.

In any event, “there is an inherent in-principle objection as to whether the decisions are correct,” Low says. “Banking regulations are not that easy to comply with and frankly no bank will have 100% compliance all the time. If you say any breach invalidates a contract, that’s a very new position to take and will significantly alter the banks’ risk assessment of contract enforceability.

“In the past banks proceeded on the basis that if I have breached a bank regulation I will be sanctioned by Bank Indonesia and fined – perhaps even my licence gets revoked, but those are the consequences, between me and my regulator. No-one ever took the position that breach of regulation would invalidate a contract.”

For the moment, foreign banks are pulling right back on their derivative sales, troubled by uncertainty about what is permitted and the sanctity of contract even in the deals that are allowed. It may turn out that the revival in the rupiah allows many of these disputes to be resolved painlessly anyway. But none of this will help the development of hedging instruments in Indonesia.