13 September, 2012

 

As its laws and regulations continue to evolve rapidly, Mongolia presents an exciting investment destination. But foreign investors must accept the risks which come with the attractive growth prospects.

 

 

The rolling grasslands of Mongolia have witnessed many changes over the past centuries, but those that have taken place in the past two decades have been the most significant for foreign investors. In the short time since its peaceful democratic revolution of 1990 and its new constitution of 1992, the country has established a framework of commercial and corporate law and has attracted well-known global corporations.
 
Mongolia’s nominal GDP is said to be growing at around 30%, state coffers are “overflowing” (according to one firm of analysts) and expansion has been predicted at 19% in 2013 by the Central Bank. Although agriculture contributes a significant amount to Mongolia’s GDP (around 16% according to the latest figures from The Economist), the undisputed driver of growth is mining. Despite being hit hard by the global drop in commodity prices in 2009, the industry still contributes more than one-fifth of the country’s annual GDP. 
 
But the Mongolia story does not end there. Other, newer areas of opportunity are evolving quickly. 
 
“Mining is the principal reason that investors are there, but that is driving banking and things mining consumes, like telecoms, flights, infrastructure investment in roads and railways, housing and real estate,” explains Jason Elder, a Hong Kong-based partner of Mayer Brown JSM. 
 
Many lawyers agree that this expansion of follow-on sectors is beginning to attract a different kind of investor. David Wenger, head of corporate North Asia at Allens and chief representative of the firm’s Ulaanbaatar office, says that since his firm began working in Mongolia, its client base has broadened beyond energy and resources. 
 
“A lot [of growth] is coming from the mining services sector, but other business opportunities are arising. Mining is the starting point and other things are developing from that,” he comments.
 
Because of the nascent state of much of Mongolia’s infrastructure and support frameworks, however, getting an investment off the ground in any of these sectors could take considerable work.
 
“In order to set up a large production facility, you’ll need to bring in a lot of equipment and tools that may be hard to find locally. They have the land and the sunshine …  but the planning and logistical challenges are significant,” says Russell Murphy, head of US firm Harris & Moure’s office in Ulaanbaatar.
 
Make the right comparisons 
 
Despite the challenges, Mongolia could present an easier proposition than other comparable jurisdictions. Writing for the Oxford Business Group recently, Mike Aldrich, a Hogan Lovells partner who has worked in Ulaanbaatar for three years, acknowledged the Mongolian legal system’s shortcomings but stressed that the country provides “an unusual opportunity for foreign investors in a legal system surprisingly light on approval procedures, contending approval authorities, and internal or classified regulation.” He went on to emphasise the importance of comparing Mongolia to other emerging markets, rather than to more developed economies.
 
Aldrich makes an important point. Doing business in any emerging market can be difficult, and investors will inevitably encounter limitations in many areas of law and regulation, as well as with physical infrastructure. But reports from Mongolia suggest that the effort needed in getting established may be less than that encountered elsewhere. According to Murphy, although there is plenty of bureaucracy, dealing with it is relatively easy (perhaps easier than dealing with the traffic on the way to the relevant office).
 
“Of course, once you’re in business and running it, you will have challenges, but that’s part of being in an emerging market,” he says.
 
One measure of a country’s friendliness to foreign investors is how well the courts deal with any disputes which may arise. Here, Mongolia appears quite attractive in comparison to the alternatives in neighbouring jurisdictions such as China and Russia. They are reasonably transparent and “feisty with their independence” (according to one specialist). Disputes can be resolved quickly, provided there are no political issues involved and none of the litigants has resolved to dubious means.
 
“I have seen unbiased judgments in favour of foreign plaintiffs,” says Aldrich. “Generally those with clean hands prevail at the end of day, but these examples are relatively simple cases without any questions  about the facts or the law. Nevertheless, they are remarkable when compared with results elsewhere in continental Asia.”
 
The main challenges likely to be encountered when using the Mongolian courts are limited resources and inexperience. For example, the courts simply do not have a track record of dealing with high-stakes disputes. One reason is that most big international mining contracts were signed only five to seven years ago, and the mines they relate to are only just coming online. Another reason is that negotiating an out-of-court resolution with the other party – the government in the case of mining contracts – is regarded as preferable to risking a courtroom battle.
 
“High-profile mining deals usually get resolved at a very high level of government and to go to court locally is probably not that popular,” one source in Mongolia told Conventus Law.
 
Most questions over court-based litigation in Mongolia relate not so much to the quality of the judiciary as to experience. This is a problem which can only be resolved over time; meanwhile, international arbitration may be a viable alternative. Analysts say Mongolia’s is a consensus-based society with high regard for international practice, more similar to Japan than China. This means contract negotiations can be smoother, with less wrangling over boilerplate issues such as a third-country arbitration clause.
 
“In China, you could lose countless hours, if not days, over negotiations over a foreign dispute resolution clause … that doesn’t happen in Mongolia,” comments Aldrich.
 
Where judgments need to be imported into Mongolia in order to enforce them (for example, where financing has been secured by collateral such as mining rights or real estate), there may be some uncertainty, however. The country is a signatory to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, so foreign awards should, in theory, be upheld. But there is no primary evidence of this having been done. 
 
“The concept of enforceability of foreign judgments does not have a long track record in Mongolia, given its relatively new government and recent foreign investment activity,” says Elder. “This uncertainty doesn’t mean that foreign judgments won’t be enforced fairly, just that more time is needed for the judiciary to show how it will react to requests by foreign investors to enforce foreign judgments against Mongolian counterparties.”
 
Aldrich says he has not seen any reports of foreign judgments being enforced, but also points out that he has never heard of any requests for recognition of foreign awards being denied. 
 
Confidence in complexity
 
But what of the laws that the courts are trying to uphold? It is fair to say that in any emerging market, an investor can expect to encounter a rapidly evolving legislative framework, and this can present some interesting challenges for lawyers. Although Mongolia’s legal system is based on a Germanic civil code, many of the newer laws have been inspired by, and draw heavily on, legislation from common law jurisdictions. Chris Melville, one of Aldrich’s fellow partners at Hogan Lovells, says this creates “somewhat of an uneasy marriage of different legal systems and cultures coming in to play”. 
 
More evidence of Mongolia’s rapid evolution can be seen in the recent introduction or revision of several business-related laws, including a new Anti-corruption Law in 2006, a draft revised Securities Markets Law in September 2011 and an updated Company Law in November 2011. 
 
The laws that govern complex finance arrangements are also very much under development. Recently, law firm Mayer Brown assisted a large bank on a capital deal intended to raise subordinated debt which it wanted to treat as core capital. The principles underscoring this kind of deal would be considered complex in other, more mature, jurisdictions; in Mongolia, there was additional complexity due to the fact that the relevant legislation was not yet established. 
 
Elder assisted on the deal. “The authorities were evaluating the treatment of different types of capital, and what constitutes core capital for the purposes of these kinds of transactions,” he says. “In these situations, you need to make sure the transaction is structured properly, and takes into account the views of the government and transaction participants, so it will withstand the test of time as legislation develops.”
 
It may be that Mongolian jurisprudence means that lawyers are able to deal with these kinds of issues more confidently than in some other developing jurisdictions, however. 
 
“I find I’m able to give clients a simple answer to relatively straightforward questions here more frequently than in China, for example,” says Aldrich. 
 
Chinese jurisprudence is based largely on the idea that unless the state has expressedly approved the specific act in question, it is doubtful whether the act is legal. By contrast, in Mongolia, if an act is not prohibited, it should in principle be permissible, says Aldrich
 
“I feel I can get to a more constructive stage with my clients here than I could in China, Vietnam or even Indonesia. In fairly complex transactions, if the structure doesn’t violate Mongolian law, it should work and when it’s tested the court will say ‘Yes, even though this is not something the state has [specifically] blessed, we view it as being enforceable’”. 
 
Strategic restrictions
 
Investors in mineral-rich, land-locked Mongolia should not, however, forget the economic statistics which show that this is a country which relies heavily on mining and natural resources. In this kind of economy, geopolitical considerations will often feature more prominently in a government’s approach to law-making, leading to additional risks. 
 
“You may sense there’s an explosion of interest in Mongolia across the board; there’s also a huge amount of uncertainty both from a regulatory and a political perspective,” warns Shearman & Sterling partner Andrew Ruff.
 
For example, the government has in the past felt the need to change a law quickly in response to actual or perceived threats to national sovereignty, with significant effects on foreign investors. Several unpopular laws were introduced in 2006, in an attempt to capitalise on high metal prices. One imposed a windfall profits tax of 68% on copper and gold sold above certain, rather low, threshold prices. Another awarded the government a share of between one-third and one-half of big mining projects. Those laws were repealed, but not before they had made foreign investors reconsider their Mongolia strategies.
 
The latest controversy happened in May 2012, with the enactment of the Law on the Regulation of Foreign Investment in Business Entities Operating in Sectors of Strategic Importance, commonly know as the Strategic Foreign Investment (SFI) Law. 
 
The law imposes a strict and cumbersome approval regime on foreign entities, saying they will need government approval for investments into “business entities of strategic importance” in certain sectors. This has created considerable uncertainty, with lawyers reporting a large number of clients asking for advice on the implications.
 
Most analysts believe, however, that the SFI Law is aimed mainly at state-controlled investors. Under the law, all investments in Mongolian companies by state-owned foreign enterprises will need government approval. An explanatory note published by the Ministry of Foreign Affairs and Trade states in part: ‘The underlying reasons for the speedy adoption of the Law were to ensure a healthy market system based on fair competition … and to prevent from [sic] a foreign, state-owned company gaining a dominating position in the strategic sectors of Mongolia.’
 
Despite this stated aim, on paper the SFI Law has a big effect on all foreign companies. Its unclear drafting also means it is hard to know what exactly qualifies as a state-owned entity or what size of acquisition would be enough to trigger the approval requirement. The Foreign Investment Agency has not yet issued any implementing regulations, meaning approvals have ground to a halt mid-stream in some cases.
 
“The new law says you need approvals for certain types of transactions, but the process will be issued pursuant to regulations,” comments Elisabeth Ellis, Minter Ellison’s partner in charge of Mongolia operations. “At the moment, it’s a bit of a hiatus.” 
 
While Wenger agrees that all foreign investors will need to understand and beware of the new regime established by the SFI Law, he says his firm would not necessarily advise clients to hold back. 
 
“If people have an immediate investment objective, we would seek to engage with the government to get that objective done according to the legislation as it stands today,” he says. He is also upbeat about the Mongolian government’s ability to resolve outstanding issues with the SFI Law and develop a workable regime that allows both private and state-owned entities to invest.
 
“I’m confident the government will get things largely right and will allow investment to go forward in a way that is more regulated than before,” Wenger says. “All politicians in Mongolia, and the vast majority of the public welcome foreign investment as a way of getting the best out of their country.” 
 
Aldrich agrees. “I believe all this will be sorted in the fullness of time” he says. “I’m optimistic that Mongolia will achieve consensus and not turn against foreign investors – they are really keen to have high-profile investors.”
 
Encouragingly, the Ministry of Foreign Affairs and Trade’s explanatory note to the SFI Law begins with the statement that ‘The “Golden Middle” in the interests of Mongolia and investors will be attained’ and ends by affirming that ‘The Government is set to create the rules [to support the SFI Law] that are not unnecessarily costly and bureaucratic’. 
 
Clearly Mongolia has a legitimate interest in protecting the way foreigners invest in the country and exploit its resources, and the SFI Law reflects this interest. However, as it stands, the new law adds a new burden for foreign investors, and could change the attractiveness of commercial deals for some. While admitting this, Elder feels the new burden is a reasonable one given the huge opportunities that are available in Mongolia.  
 
“The key is balancing opportunities with risk. With the new foreign ownership limitations, the Mongolian government didn’t take away the ability to invest, or expropriate assets or anything extreme like that,” he says. “The final law reflected many of the concerns raised by the foreign investment community, including exemptions for certain smaller transactions and not making the new regulations retroactive in application.”
 
According to Mongolia’s constitution, the state must make “fair payment of compensation and costs” if it were to confiscate or requisition citizens’ private property, and lawyers say Mongolia has remained committed to this principle in the two decades since the constitution came into effect. Furthermore, one of the main frustrations investors encounter in Mongolia – unclear legislation – can be seen as a symptom of a functioning democracy. 
 
“The fulcrum of power is parliament – what parliament decides is the hub of what influences the business environment,” Aldrich explains. “At times, parliament enacts laws that are a bit difficult to explain or rationalise.”
 
No gain without pain
 
Although many of the typical emerging market risks are present in Mongolia, in some areas investors will also find a refreshingly high level of transparency and fairness, and a welcoming society which in general is keen to be cosmopolitan and adhere to international standards. 
 
“Investors favour Mongolian companies in certain sectors such as natural resources and finance, and are pleasantly surprised by the strength of their management,” says Shearman & Sterling partner Won Lee. “Most have gone to school overseas, speak fluent English and are very savvy. Investors appreciate that and give them more credibility.”
 
But foreign investors should not forget the special geopolitical risks involved. The class of investors who are used to working in politically sensitive but high-reward sectors, such as mining, are arguably more focused on longer term outcomes and will be more prepared to put up with short-term ups and downs. 
 
“The reality is that serious players appreciate that this is part of doing business in many places where there are natural resources,” says Ellis
 
On the other hand, those investors who are beginning to enter Mongolia to chase new opportunities outside of mining, or put money into securities, may have a lower appetite for this kind of risk. Although the SFI Law may not affect them directly (it covers only the mining, bank finance and telecoms sectors), the message it sends about the government’s propensity for sudden legislative change could be quite daunting.
 
Those investors may also be concerned about the longer-term effects of a booming mining sector on other areas of Mongolia’s economy. In a recent presentation, AME Group, a firm of mineral economists and supply chain analysts, listed commodity price risk as one of the main concerns for investors. This risk could arise from the effects of an unbalanced economy and so-called Dutch disease – a phenomenon in which increasing exploitation of natural resources leads to a strengthening of the currency and a consequent decline in the manufacturing sector as exports become more expensive for other countries to buy.
 
All investors and their legal counsel must watch closely how the government deals with these issues, and keep an eye on the evolution of legislation and the court system. As Aldrich puts it: “For the faint hearted investor, this isn’t the place.” But for those willing to persevere, the rewards will be great.
 

 

For further information, please contact:

 

Phil Taylor, Conventus Law

editor@conventuslaw.com

 

 

Follow Conventus Law on Twitter @conventuslaw

 

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