Indonesia’s Supreme Court darkens Jakarta’s Year of the Bond

Publicity surrounding the forthcoming visit of President George W Bush Monday to Jakarta may overshadow the latest abuses of the legal system by Indonesia’s Supreme Court to protect domestic borrowers seeking to avoid their contractual bond obligations. But the court’s latest decision could hamper the ability of the government to attract the investment it needs for growth and job creation.

The focus of concern is a controversial ratification by Indonesia’s Supreme Court, announced last week, of a 2004 district court decision to annul US$500 million in US-registered bonds issued by an Indonesia-based subsidiary of Asia Pulp & Paper. APP staged the largest default in Asian history in 2001, stopping service on US$13 billion worth of debt. Indonesian companies began suing creditors in the wake of the 2004 decision, alleging international bond houses tempted them into issuing the debt in exchange for fat fees in the first place – and getting heard in Indonesian courts.

The Supreme Court actually made its decision allowing the annulment of the bonds of PT Indah Kiat Pulp & Paper Tbk on June 21, although the ruling wasn’t released until last week. It is the latest in a string of judicial rulings over recent months that have raised serious concerns about the validity of Indonesia’s attempts to free itself from the corruption that has dogged the government and the courts for decades.

In October the courts freed former dictator Suharto’s eldest son despite the fact that he had been convicted of ordering the murder of the high court justice who sent him to prison on corruption charges. The court also presided over the acquittal of former House of Representatives speaker Akbar Tanjung in a graft case against what appeared to be overwhelming evidence and has turned a blind eye to a growing number of other bribery and corruption cases.

With Indonesia still recovering from the financial chaos of the 1997 Asian financial crisis, the news of the ruling on the bond default has ominous overtones for institutional investors who recently have developed a strong appetite for Indonesian bonds. Despite a dramatic hike in domestic fuel prices and high interest rates, investors have snapped up a record $3.5 billion in bonds this year as macroeconomic performance has improved and President Susilo Bambang Yudhoyono has attempted to repair the government’s credibility.

Indonesia has become one of the largest bond markets in Asia at least for investors with short memories as buyers are attracted to low prices and inversely high yields despite the fact that the bonds are rated little better than junk by global rating agencies. Trimegah Securities, Indonesia's biggest investor in corporate bonds, reckons the corporate debt market is worth over US$7 billion. Investors reap returns of 8.17 percent and need to convert dollars into rupiah to buy the local bonds. This has helped to stabilize the rupiah exchange rate at around 9,000 to the dollar.

More companies are turning to the bond market to raise funds because the banking sector remains reluctant to provide large loans to industry. Although many recapitalized banks are awash in liquidity, most fear being hit yet again by nonperforming loans. Thus both government and existing corporate bonds have become primary investment options not only for the country's pension funds, but also for local and foreign mutual fund managers.

Debt is king

The story of Indah Kiat’s bonds began in the 1980s with the ethnic Chinese Widjaja family, which controls the Singapore-based Sinar Mas Group. Sinar Mas in turn owns APP, one of the world's largest paper companies For years, APP and its companies tapped the international capital markets, raising money through bonds, convertible bonds, share offerings and loans. The bonds that attracted most interest in APP's distressed debt were those of its main operating companies. After all, they actually produced pulp and paper and generated substantial revenues.

APP's bold expansion into global bond markets culminated with a 1997 bond issue with a rare, for Asia, 30-year maturity. The leverage drove returns on equity ever higher, thus perpetuating the rosy scenario. The Widjayas used debt to leverage the value of their companies and subsidiaries, raising funds in the capital market while retaining majority control by restricting the share issues.

In February 2001, however, PT Pabrik Kertas Tjiwi Kimia, an APP subsidiary, failed to meet two bond interest payments totaling US$43 million, leading to a severe loss of confidence in APP's financial position. Less than a month later, APP unilaterally declared a moratorium and stopped servicing its debt. In April 2001 APP announced that it had failed to include a $220 million loss on two currency swap contracts in its financial statements, quickly followed by an official announcement that earlier financial statements for 1997 to 1999 "should not be relied upon".

APP has since paid less than $330 million in interest and $188 million in principal payments on the US$13 billion debt to creditors since 2005 when a debt revamp was finally inked. US based hedge funds. Gramercy Advisors LLC and Oaktree Capital Management LLC hold approximately $800 million in bonds issued in 1994 and 1995 by two such Asia Pulp units, Indah Kiat and PT Lontar Papyrus Pulp & Paper Industry

But if investors thought international pressure would result in the return of their funds, the Indonesian courts quickly disabused them of that notion. Rather than seeking debt workouts, in November 2003 Indah Kiat and Lontar started litigation in Indonesia alleging that their debt transactions were illegal under Indonesian law and seeking more than $2 billion in "damages." the bondholders were threatened with fines of $100,000 per day for attempting to enforce the bonds.

Although Indah Kiat had willingly participated in the issuance of the bonds, received the funds raised by them and provided the collateral used to induce investors to provide the funding, they later claimed the bond issuance was a 'deceptive scheme' set up by the agent, Morgan Stanley the underwriter, and the depositary to generate fees.

In September 2004 the Bengkalis District Court bought into this notion and invalidated the bonds. Two weeks earlier another provincial court had ruled that $550 million in bonds issued by Lontar were also invalid.

Not just vultures

The respected US-ASEAN Business Council, whose members include 150 of the Fortune 1000 American companies that trade and invest in the ASEAN region, along with the Securities Industry Association complained jointly to the US Ambassador to Indonesia in 2004 about 'troubling developments' from proliferating legal actions against U.S. institutional bondholders and financial institutions.

They cited the APP subsidiary cases and similar aggressive action in Indonesian courts by PT Barito Pacific Timber, PT Danareksa Jakarta International, PT Aryaputra Teguharta and Tri Polyta Indonesia. The method of operation in each case was similar. Debt transactions willingly entered into were claimed to be illegal under Indonesian law and the bondholders threatened with massive claims for damages.

As investors' risk perceptions now become more closely aligned with the actual level of investment risk in Indonesia there is a likelihood, at the very least, of some foreign capital outflows from and reduced foreign capital inflows

Asked later about the rationale of listing on the New York Stock Exchange in 1995, Richard Green, APP'S then-executive director of corporate finance, said that listing in a jurisdiction known for its rigorous reporting requirements, would help when the company went to the market again. "If you list in New York you have to compete with the best."

The truth, however, is that the company’s real need was to avoid being saddled with the Indonesian risk factor it later helped so much to generate and which now rears its head yet again thanks to the Supreme Court decision scrapping that portion of APP's debt.

Nowhere to run

Previous administrations have repeatedly sided with the Widjaya family against major creditors who lobbied hard for outside scrutiny of APP's cash flow and management. Several groups filed lawsuits in the US against APP, alleging fraud. The main thrust of the allegations was that APP indulged in cover-ups so that major shareholders were bereft of true information on the state of the balance sheet.

Nonetheless, the Widjayas’ day of reckoning may still come, at least as far as their obligations over the bonds in question. Melissa Obegi, counsel for Oaktree Capital, pointed out after the Bengkalis verdict that the New York State Supreme Court, with jurisdiction over the bonds, awarded a $353 million judgment against the Indonesian companies, which entitles them to pursue APP's assets wherever they can find them.

"Unless APP chooses to retreat from global commerce entirely, they will have to continue to deal with us,' she warned at the time. However, media attention to the latest development has flushed Asia Pulp out into the open and last Friday the company offered to invite the two U.S. hedge funds to join its debt-revamp plan.

But in the meantime the Widjayas remain untouchable and very rich while creditors, investors, minority shareholders, the government and ultimately the Indonesian people themselves, are hung out to dry.