Investing in Third World Countries

I HAD AN INTERESTING discussion not long ago with a woman who lives in Southeast Asia. Her husband died of a heart attack a few years ago, and she is now running what is left of his business interests. One of her husband’s former business interests was a gold-mining operation in a particular Asian country. (If you don’t mind, dear readers, I would just as soon not get specific about the particular people or places. You will understand why in a moment.)

Putting Together a Play

This woman’s husband (let’s call him Richard, not his real name) had spent several years and several million dollars putting the gold-mining operation into play. Richard had retained a number of geologists to assist with the exploration. He hired local attorneys and notaries to patent his mineral and mining claims in the various provincial and national offices. He paid all the fees and “service charges” (ahem…), and considering the culture, was entirely scrupulous about his efforts. Richard made accommodations with many of the local residents, and actually secured the support of a number of influential local village elders and politicians for the project. Richard and his associates engaged in active prospecting, to include extensive drilling and assaying. Richard had lined up resources and manpower to do the actual work. And after all of this, the gold-mining project was on the cusp of finally turning over the rocks and digging up the gold.

Losing Everything

Then one day, a very serious-looking man arrived at Richard’s office. The serious-looking man informed Richard that there had been certain “irregularities” with the original patents for the mineral claims. Due to these irregularities, the National Ministry of Lands and Minerals had reviewed the entire basis for the mineral and mining claim, and administratively determined that it was void. Thus all title and interest in the mineral claim reverted, as a matter of law, from Richard’s business entity to the state. 

Furthermore, said the serious-looking man, it appeared that certain “other interests” had filed “correct patents” on the mineral claims. These patents were pending at the time of the administrative determination of reversion of Richard’s interests. Thus immediately after the declaration of reversion in title from Richard’s interest to the state, title to the mineral parcels at issue was awarded, “by operation of law,” said the serious-looking man, to the “other interests.” In short, Richard had lost everything. All of Richard’s work was essentially forfeited to the state, and title quickly transferred to new owners.

“Litigate or Liquidate”

The serious-looking man informed Richard that he was “extremely sorry” about the situation, but “there is nothing to be done at this stage.” Indeed.

Richard contacted a number of attorneys in the national capital of this particular country, and explained the situation. Several attorneys heard him out, and then politely apologized and stated that they would be unable to represent or assist him “due to conflicts of interest.”

One attorney eventually agreed to assist Richard, after a fashion. The attorney offered his opinion as to how Richard had been cheated out of his claims through an elaborate ruse and scheme. “You have been robbed and looted under color of law,” said the attorney. “These people who did this are scoundrels.” The attorney then laid out Richard’s options: “You can litigate, or you can liquidate.” 

Richard asked the attorney how much each option might cost in terms of legal fees. The attorney quoted a price to litigate of $1 million. “And it will take several years of your life, with no guarantee of success,” he added. And then the attorney added, helpfully, “Liquidation will cost about the same, and you will get some justice faster. But you probably will not be able to do business in this country for several years afterward.”

Richard then said to the attorney, “But I don’t understand. How can I ‘liquidate’ my interests if they have been forfeited to the state and redistributed to another set of mining interests? What is there to liquidate, and to whom?”

The attorney looked Richard straight in the eye and said, “I do not mean for you to liquidate your interests in the Western legal sense. You are not going to try and recover money in court from the people who have cheated you. I mean that it is possible to arrange to liquidate the people who have done this to you. You will obtain some measure of justice. But after you do so, you will have to leave the country for a couple of years. Maybe you can come back some time in the future and restart your project.”

Richard declined to accept the attorney’s offer to assist in “liquidating” his problems. Richard went to another attorney who filed a claim in the national courts. Richard’s claim was sidetracked at every opportunity within the court bureaucracy, and eventually dismissed. Along the way, Richard resigned himself to his loss, and went about with other business efforts. The stress of what occurred may have contributed to his eventual heart attack and death, but then again, sometimes it is just your time. We know not the moment or the manner of the Almighty.

Blind Justice

What we do know is that people expect some level of fair play and predictability when it comes to the investment and business climate in any particular locale. In general, capital migrates to places where it can find a safe harbor. This requires a legal system in which contracts are enforced and property is protected. When disagreements and disputes arise over business or personal issues, which they almost always do, you want to be in a place where the problems can be resolved rapidly and efficiently. You want to be in a place where you can obtain blind justice, and not a place in which justice is blind.

Risky Business

All business ventures entail some measure of risk, but some are riskier than others. What prompts me to think about this is the seemingly unending series of accounts of business risk going bad in the less-developed parts of the world. 

In Russia, the news from the Far East has to do with the Ministry of Natural Resources revoking the environmental permits of, respectively, ExxonMobil and Shell Oil Co. on their Sakhalin-1 and Sakhalin-2 projects. These are two major oil and gas development projects that have already cost on the order of $20 billion, with much more yet to be spent to bring them online. The original production agreements were inked in the mid-1990s with the then-government of Russia, so the companies are now about 10 years into their efforts.

The Russians claim that both projects have caused extensive damage to the natural environment, to a degree that merits revocation of the environmental permits. Russian environmental groups and authorities have accused both oil companies of taking inadequate safety measures on the projects, and of releasing large volumes of industrial waste into the waters near Sakhalin Island. According to a recent account in Moscow News, “Russia’s Natural Resources Minister Yuri Trutnev said on Monday, Oct. 16, that major sanctions may be imposed against the operator of Sakhalin-2 oil and gas project Royal Dutch/Shell.” The Russian authorities have tossed about damage claims in the order of $50 billion (yes, billion, with a “B”) against just Shell. Exxon is also encountering similar threats of sanctions for alleged environmental damage.

Curiously, this abiding concern for the natural environment comes from the same Russian government that, for example, has control over scores of decommissioned, Cold War-era nuclear submarines that are tied to piers and literally rusting away into radioactive hulks. This is the same Russian government that is accepting for disposal trainloads of toxic waste generated by industries in Western Europe. So whence comes this newfound outrage and environmental consciousness at reports of spilled lubricating oil and dead fish near Sakhalin?

Reinventing the Past

In all likelihood, the Russians are attempting to pressure Exxon and Shell to renegotiate their 1990s-era production agreements. This is part and parcel of Russia’s ongoing effort to reassert, if not to recapture, state control over its strategic energy sector. During the years immediately after the collapse of the Soviet Union, much of the natural resource base of Russia fell into the hands of non-state actors. The Russians under Vladimir Putin want to reinvent this past. 

The two Sakhalin oil and gas projects are among the largest single foreign investment projects in Russia, which is a very big place. But that has not stopped the Russian government from playing hardball against some of the largest Western oil companies. The Russian government is apparently prepared to weather whatever diplomatic storm ensues. The Russians’ annulment of the 2003 Sakhalin Environmental Expert Review (SEER), applicable to the Shell project, evoked strong dissent from Dutch, British, U.S., and Japanese officials. (The natural gas from Sakhalin-2 was intended for the Japanese marketplace, hence the protest from Japan.) The Russians have not altered their stance.

The Russians have the advantage of geography and jurisdiction. They own and control the resources. They have a national energy strategy that places a premium on state control of energy resources. They know that they are in control of events. And they are patient. So having reinvented their past, they are now inventing their own energy future.

Once I Built a Railroad

But this new sense of elevated business risk is not occurring just in big countries like Russia, asserting state control over big oil and gas projects. The government of the much smaller nation of Guatemala, for example, recently violated the terms of a significant railroad privatization agreement that was enacted by a previous Guatemalan administration. 

In August 2006, the government of Guatemala took the extraordinary step of unilaterally declaring an essential element of the country’s 1998 railroad privatization, the lease of the rolling stock, as being “against the interests of the State” (the term is “lesivo”). The current rolling stock contract was formalized in 2003, as an accessory element of the main railroad concession (a “usufruct” agreement), previously entered into in 1998. The railroad concession to the U.S.-investor-owned Ferrovias Guatemala (FVG) was not only approved by the government of the previous time, but also ratified in 1998 and 2003 by Guatemala’s congress.

A usufruct agreement is a grant from one entity to another of the right of use and enjoyment of some asset. That is, it is a grant of the right to enjoy the use of and income from another’s property, but without destroying, damaging, or diminishing the property. In this case, FVG was granted a usufruct over the rail bed and what remained of the track and rolling stock of an old railroad operation, which was minimal. (Almost all of the railroad ties were gone, as were many stretches of rail. There were even squatters who had built dwelling structures on the right of way.) This usufruct-type of arrangement is different than a production concession, such as is the case with a grant of a mineral, or oil- and gas-producing concession that will deplete the underlying resource.

In the past eight years, FVG has poured millions of dollars into rehabilitating century-old rail bed, track, and rolling stock of an otherwise decrepit and abandoned rail line that connects the Atlantic coastline with Guatemala City. The newly refurbished rail freight corridor has become a competitive option for both importers and exporters in Guatemala. The improved rail service has offered significant competition to trucking firms, while reducing the very significant risk of loss due to pilferage or hijacking. Rail service has reduced traffic volumes on the adjacent highways, resulting in statistically measurable lowering of traffic accident numbers. And rail service is also significantly more energy efficient than motor freight on a ton-mile basis.

Brother, Can You Spare $2 Million?

The recent, adverse Guatemalan government action against FVG came remarkably quickly on the heels of a request for arbitration initiated by FVG under the terms of the 1998 usufruct agreement. FVG sought arbitration after failing to reach a negotiated agreement over the improper diversion by the government of Guatemala of over $2 million from a railroad infrastructure trust that was funded entirely by FVG for the purpose of maintaining and improving the nation’s rail infrastructure. That is, instead of being used to maintain and improve Guatemala’s railroad infrastructure, these funds have been siphoned off to support 40 Guatemalan government personnel whose responsibility is to “monitor” the privatized FVG rail operation and its 100 employees.

In the short term, the adverse action of the Guatemalan government cannot force FVG out of business. But its action has placed additional pressure on FVG by making its customers and suppliers wary of doing business with the railroad. The unilateral government action has come at a time when Guatemala is suffering from extensive damage to its transportation infrastructure due to weather events of recent years. And FVG is also coping with the loss of its entire Mexican rail traffic base at the border station of Tecun Uman due to damage to Mexico’s railroad infrastructure last year as result of Tropical Storm Stan. There is no obvious benefit to any party for the government of Guatemala to get into a legal fight with FVG over misspent trust fund money. But such is still the case.

The apparent purpose of the Guatemalan government action is twofold. In the short term, the government is attempting to force FVG to withdraw from the arbitration process and avoid shining any further spotlight on the government’s improper diversion from the $2 million infrastructure trust fund. Over the longer term, the government is apparently attempting to recover control of certain assets granted under the previous usufruct concession, and turn these assets over to other well-connected entities. It is the beginning of a backdoor expropriation of foreign capital.

The Emerging Pattern

In each of the examples above, whether it is Russia pressuring the likes of Exxon and Shell over Sakhalin, or Guatemala bullying a small railroad operation, there is an emerging pattern that is not friendly to long-term Western investment. Let’s expand on this theme.

There are several separate elements that define the environment for foreign investment in most non-Western states. These are natural conditions and resources; infrastructure; human resources and expectations; and governmental and legal conditions. It is difficult to control the natural conditions and resources. These are what they are. You deal with what you have to work with. But each of the other elements presents a mixture of possibilities and impediments, and of opportunities and constraints. 

The Short List of Business Pathologies

Western investors in underdeveloped regions ought to be familiar with these business realities, but sometimes it is a shock to encounter them up close and personally. So here is the short list of the perils to investment, as self-contained as possible. Each can merit its own article, if not volume, but please bear with me while I provide just a summary:

  • Often, the Western investor will encounter a local managerial class whose upper ranks have roots in a previous era of extensive state control over property 
  • The legal system offers ill-defined property rights at best, with governmental and legal systems that are simply unaccustomed, and not geared, to protecting such rights 
  • Often, whether in Russia or Central America or elsewhere, one encounters business practices attuned to Marxist accounting habits which, being rooted in a labor theory of value, undervalue resource inputs 
  • And there are powerful interpersonal, often family- or clan-based, networks that work informally and often outside the law 
  • There is a general lack of official accountability except when top leaders forcefully intervene to impose goals
  • Other business pathologies at work in the less developed world include the practice of strong and even authoritarian rule from the Presidential Palace. This can lead to arbitrary and capricious decision-making, compounded by unfair rules concerning the otherwise critical state functions of regulation and taxation 
  • Couple this with inadequate institutions for collecting taxes and adjudicating disagreements about taxes and other regulatory concerns 
  • Add in rather poorly developed banking and central banking systems, working in a system in which the bureaucrats are inexperienced at formulating and implementing monetary or fiscal policy 
  • Throw into the mix the problems associated with poorly defined shareholder rights (especially those of minority shareholders) and rights that are often ignored in practice 
  • And all of these foregoing problems exist in a business culture that accepts what one can call, euphemistically, “rent-seeking,” if not outright corruption as normal practices.  

What Is One to Do?

If one is going to do business in such environments as described above, these are some of the risks. And what is your level of risk tolerance? Of course, there is no substitute for being there, becoming involved, learning the language, and immersing oneself into the culture. The difference between success and failure may be in one’s ability to develop the necessary relationships to maintain a long-term focus.

Even then, having exercised the best of faith in all of your dealing, the most careful efforts may be derailed (no pun intended, considering the story from Guatemala above). And when things go wrong, what are your protections? Will your home government assist you? It is easy to mock and speak with disdain toward the “imperial” aspects of North American, European, and even Japanese national relations with nations that form the rest of the world. But when your investment starts to go south, what are you going to do? Will you litigate? Oh really? Against whom, and in what forum? Or will you ever be faced with the prospect of, as the saying goes, “liquidating”? These are questions for which you ought to have thought about the answer long before you ever begin. In a world of depleting resources, these matters present issues that will only grow in importance.

Until we meet again…
Byron W. King
October 17, 2006

The Daily Reckoning