Russia Remains Difficult Market to Project Finance Precious Metals Mining Project
Michael Pabst, Mayer Brown LLP (December 2, 2000)
(Published in Mining Finance magazine)
The Julietta Project demonstrated that well structured Russian mining projects can be financed by commercial banks. However, there are many hurdles along the way and Russia remains a difficult market for sponsors and lenders alike.
Many of the difficulties faced by lenders and sponsors in Russia are not unusual for a project finance transaction in an emerging market. However, due to a legal heritage and culture derived from Russia's communist past, combined with the measures introduced following the Russian crisis in 1998, the solutions to these problems are often more complex, time consuming and, ultimately, more expensive than those found in other jurisdictions.
Some of the difficulties associated with the development and project financing of precious metals mining projects are discussed below.
- Sale of mine output: This issue has given rise to a number of difficulties over the past few years. For example, in 1998 it was reported that a subsidiary of Kinross Gold Co was forced to stop production at its Kubaka mine as a result of difficulties in selling gold and silver produced at the mine.
Russian law requires precious metals to be sold either locally to a federal agency (Gokhran) or to an authorised Russian bank. Gokhran has a right of first refusal to purchase all precious metals produced in Russia, or offshore through an authorised Russian bank. Some local government agencies (e.g. in Magadan) also have a right of first refusal to purchase precious metals produced within their jurisdiction. Importantly, a percentage of the precious metals sold either locally (e.g. to Gokhran) or offshore through an authorised Russian bank must be paid for in roubles. The actual percentage paid is determined by the Central Bank of Russia and is normally a significant amount (more than 50%) of the project output. This leads to an additional cost in transferring roubles into hard currency. There is also the risk that the Central Bank may increase the percentage of the precious metals that must be sold for in roubles or that roubles may not be convertible into hard currency or that the Dollar/Rouble market may not be liquid enough to purchase hard currency.
- Currency Issues: Ownership of foreign currency by Russian citizens and commercial entities is highly regulated following the crisis of 1998.
The amount of foreign currency that may be held by mining project companies is a matter of negotiation with the Central Bank of Russia. A typical structure would involve permission to hold an offshore and an onshore Dollar account. The offshore account can be kept either with the foreign branch of a Russian bank or with a foreign bank. The Central Bank will only permit a limited amount of foreign currency to be held in the offshore account. The Central Bank has also indicated that it is more comfortable with an offshore account being held in a foreign branch of a Russian bank - meaning they will allow more funds to be held offshore in Dollars. This has obvious credit implications and would need to be weighed up by sponsors and lenders. Normally, an onshore Dollar denominated account can only be used for Dollar payments that are due to be paid within seven days of the transfer from roubles into Dollars. The remaining funds owned by the project company must be held in roubles. This could be a significant amount of money and project companies need to structure their working capital with this issue in mind.
- Security of Tenure: A number of existing and proposed mines are or have been the subject of privatisation. There have been at least two (Dukat and Sukhoi Log) well publicised cases that have demonstrated some of the serious difficulties associated with privatisation of Russian mining enterprises.
Russian law prescribes a number of key requirements for privatisation and their violation may provide grounds for invalidation of the privatisation. These requirements include the following elements:
- the privatisation of the enterprise must not be restricted;
- the relevant state bodies must have approved the privatisation;
- the privatisation procedures to be followed and privatisation options selected must be in accordance with certain detailed regulations;
- the proper evaluation and publication of information; and
- the proper establishment of the enterprise to be privatised.
The rules for each of these elements are detailed and require a significant amount of due diligence. Obviously the invalidation of a privatision would be catastrophic, and lenders and sponsors should be careful to pursue a detailed due diligence process to minimise the risk of the privatisation of a mining project being set aside.
- Security: Russia has a number of mandatory laws that cause difficulties for lenders taking security over the assets of a mining project.
It is very difficult to take effective security over bank account balances which are crucial to a project financing. It is also not possible to take security over mining licences and lenders are prohibited from taking security over business interruption insurance, which is also critical to many mining projects
The lack of security over these types of assets is particularly disastrous if the project company becomes bankrupt and third party creditors have a claim against the project company. In the event of a bankruptcy, third party creditors will have an equal claim to project lenders against such insurances, bank account balances and mining licences. In order to avoid this situation, lenders should ensure that the project company is only permitted to incur a very small amount of third party debt.
Enforcement by secured creditors is also very difficult in Russia. Enforcement without a court order is virtually impossible and obtaining a court order can take a significant amount of time.
- Inurance: Like many other emerging markets, Russian insurance law only permits Russian entities to take out insurances with Russian insurance companies. Although not an unusual requirement in an emerging market, Russian insurance law has some added complexities that must be dealt with by sponsors and financiers.
Lenders in particular are normally reluctant to take on the added layer of local risk that results from insurances being issued by a local company. The normal method of avoiding this risk is to require the local insurance company to take out facultative re-insurances of the underlying insurance policies with an international reinsurer (e.g. Lloyds). The local insurer is also required by lenders to grant a security assignment over such reinsurances in favour of the project lenders. This gives the project lenders the comfort of a direct claim (via the assignment of reinsurances) to an international insurer, rather than a local insurer.
This structure, whilst viable in Russia, is not desirable. Generally speaking, contracts (including insurance agreements) between two Russian entities must be governed by Russian law. This gives rise to an added layer of Russian risk as lenders and sponsors will be accustomed to insurance policies issued under English or United States law. Further, it is not clear that Russian insurance law is comparable to English or US law, or that Russian insurance law recognises standard international insurance concepts such as a "lender's interest" clauses or loss payee provisions. Additionally, the assignment of reinsurances requires the special permission of the Russian Central Bank which is both difficult and time consuming to obtain.
In any event, there is some doubt as to whether such an assignment is enforceable - Russian law does not permit the benefit of a reinsurance contract to be transferred to any entity other than a Russian insurance company. It is not clear if this would also extend to any debts payable under such a re-insurance policy (which is normally the subject of the assignment of re-insurances).
Finally, as a practical matter, payments of claims under Russian insurance policies must be paid in roubles, adding another level of currency risk to the project.
One method for lenders to mitigate some of the risks mentioned in the preceding paragraphs is to obtain some form of offshore insurance for the lenders' (as opposed to the project company's) insurable interest, e.g. through a "non-admitted" or "difference in coverage" policy. Unfortunately such a policy does add an additional cost to the project. It also adds a level of complexity to the insurances, as it is necessary to co-ordinate any offshore insurances with any local policies.
- Conclusion: Although Russia remains a difficult market, project finance transactions are possible. Unfortunately, the "solution" commercial banks will most likely require for a number of the risks outlined above is an increased return (i.e. margin) and/or additional sponsor support (i.e. through the assumption of some risks).