Having considered in my last column the political and geographic risks of doing business in emerging markets, this week I will turn my attention to the risks arising from fiscal instability. These are an important consideration when doing business in an emerging market, especially one where the prices of the main commodities, oil and gas, are extremely volatile.
As a commercial lawyer, your prime objective when drafting a contract is protecting your client’s interests; and a cornerstone of that objective is protecting profit. Fiscal risk will be uninsured and may cause significant damage to the client’s commercial bottom line if it is not managed by prudent contractual provisions. Fiscal risk will also be more prevalent and acute in an emerging market.
It is vital to anticipate how it may arise and understand the circumstances to which it may be attributable; I have provided some examples below by way of illustration.
As a new market emerges, tax revenue (in other words, the ‘government slice’) is an important factor in the equation for calculating profit earned by both operators and the supply chain. During a recession, governments will be looking at ways to reduce sovereign debt and increase public revenue. Highly profitable industries which trade in resources of national interest will always be a focal point for government efforts to put more money in the public purse.
When providing goods or services in an emerging market, the contractor’s key fiscal concerns will be the most basic:
- keeping cost structure stable in order to maintain profits
- when profits are earned, getting paid, and
- when paid, maximising the opportunity to move earned profits out of the emerging market.
Any contract of a longer duration in an emerging market carries the risk that a government may change the fiscal regime – whether in the form of increased taxes on revenue and profit, increased customs charges and duties on goods and materials, as well as any number of other increased costs attributable to establishing and maintaining a business presence in a country, such as owning property, procuring insurance, and increasing the percentage of personnel and property that is sourced locally.
Typically, the latter is known as “local content requirements” and many emerging markets have adopted detailed legislation that prescribes how much “local content” a business must establish and maintain in order to qualify to do business. In view of this risk, any contract of a longer duration in an emerging market must be carefully drafted to anticipate this risk and, if it should arise, provide for proper allocation between contractor and operator.
Getting the contract right in respect of the risks highlighted above may allow a party to maintain profits; however, the contractor may face an additional challenge when it comes to getting paid. A contract in an emerging market may require the support of financial instruments in the form of standby letters of credit, bank guarantees or escrow agreements in order to provide for payment security. Performance bonds or guarantees may also be required in order to provide security of supply chain performance (whether imposed by the government or demanded by an operator or prime contractor).
One final concern will be repatriating profits earned abroad, the value of which may be greatly diminished if proceeds are trapped ‘in country’. Many emerging markets in the oil and gas sector are known as “Article 14 countries”, an expression coined by the International Monetary Fund agreement allowing exchange controls for transitional economies.
The exchange controls in an emerging market typically will include restricting the amount of currency that may be imported or exported, banning the use of foreign currency within the country, banning locals from possessing foreign currency, fixing exchange rates, and restricting currency exchange to government-approved exchangers.
The risk of these types of controls in an emerging market must be carefully considered for any long term and high value contract. If the risk is recognised, a party to a contract must think about the commercial effect and, if possible, make appropriate provision for risk allocation.
Greg May is a partner and service sector specialist in the oil & gas team at Brodies LLP.
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