Legal Aspects of Investment in Kazakhstan (Tengizchevroil's Experience) S.Yelyubayev (Ж.С.Елюбаев) The Speech at the KIOGE`99 Conference (Almaty, October 6-7, 1999)

Zh.S.Yelyubayev (Ж.С.Елюбаев)

The Speech at the KIOGE`99 Conference

 (Almaty, October 6-7, 1999)

Legal Aspects of Investment in Kazakhstan
(Tengizchevroil's Experience)

The Constitution of the Republic of Kazakhstan adopted on August 30, 1995, in a national referendum proclaimed Kazakhstan a democratic, secular and law-based society. Hence the need to develop new free-market relationships, to become part of the world economic setup, and to promote international economic cooperation. The country’s Constitution, which recognizes and protects private property and free enterprise, provides the legal framework for developing an economy of an open type.

Over the last few decades, the world has seen further internationalization of different national economies. One major internationalization trend in the world of business is export of capital, including foreign investments. In this context, we are pleased to note that Kazakhstan has been increasingly active in developing its external economic ties over the past few years. According to official statistics, in the period 1993 through 1998 the gross and net inflow of direct foreign investments totaled 7.9 billion and 6.5 billion US dollars, respectively. An analysis will show that foreign direct investments came mostly in joint ventures' authorized capital stock, money contributed to companies taken over by foreign investors, and bonuses, if such were agreed when the deals were made.

According to official government sources, the leading direct investors include the U.S. (44.2%), South Korea (16.4%), Britain (6.5%), Turkey (6.5%), France (5.0%), Japan (4.0%), Italy (2.4%), and Canada (1.6%).

Kazakhstan is now host to big multinationals and other foreign entities, including Chevron, Mobil, British Gas, British Petroleum, Total, and Amoco, among others. According to the European Bank for Reconstruction and Development (EBRD), Kazakhstan is among the leading CIS recipients of direct foreign investments per capita in aggregate terms - close on $165.

At the same time, the investment climate in Kazakhstan calls for major change. A lot needs to be done to deal with the factors hampering efforts to attract foreign investments. There are quite a few impediments. Although Kazakhstan compares favorably with most of the other CIS countries in this respect, the investment risk rating in Kazakhstan, according to Western estimates, remains high on account of political and economic risks - apart from lots of other factors acting as a brake on the investment process, such as:

· Kazakhstan's current system of taxes and tariffs and the very concept of taxation, which is employed chiefly for collection and accumulation of funds by the Government;

· an insufficiently reliable insurance system for covering foreign investments against commercial and political risks;

· foreign investors' limited freedom to choose insurers;

· lack of infrastructural, transport, telecommunications and other facilities necessary for normal business operations;

· low business standards of national counterparts;

· corrupt practices in public administration;

· organized crime and a number of other factors.

The instability of the law likewise hampers the inflow of foreign investments. Before starting to invest in a country, any foreign investor will first look at its laws, which must clearly set out the investor’s rights and responsibilities, guarantees, and ways of protecting his interests. This being so, the task before a country eager to see more capital flow in from abroad must be to develop an adequate and stable system of laws to govern business activities, a system that would have no inherent inconsistencies and would provide the appropriate environment for foreign investors to exercise their rights and defend their interests - that is, promotion of investment flows requires a strong legal framework that should be based on the entire system of legislation of the host-country.

One dimension of great importance in this context is business law, which, for the most part, has already taken shape in Kazakhstan. The country now has a codified legislative instrument that provides the basis for the further development of the business law which governs the market economy - i.e. the Civil Code (General and Special). Revolving round the Civil Code are those statutes and statutory presidential decrees which define the legal status of corporations and property rights and regulate entrepreneurial activities, privatization, and other aspects of the country’s economic life:

· «Business Partnerships»;

· «Joint-Stock Companies»;

· «Limited Liability Partnerships and Double Liability Partnerships»;

· «Official Registration of Companies»;

· «Licensing»;

· «Privatization»;

· «Bankruptcy»;

· «Mortgage»;

· «Real Property Registration and Transactions»;

· «Commodity Exchanges»;

· «Securities and Stock Exchanges»;

· «Protection and Promotion of Private Enterprise»;

· «Promotion of Competition and Restrictions on Monopolies»;

· «Individual Entrepreneurship»;

· «Imports-Related Protection of Domestic Market»;

· «Government Support for Small Businesses»;

· «Unfair Competition»;

· «Safeguards for the Rights of Individuals and Companies to Free Enterprise».

Pride of place is held by legislation on banking and insurance. A document that has immediate bearing on property ownership, including arrangements with foreign investors, is the April 14, 1995 Presidential Decree with a force of law titled «Government Taxes and Other Mandatory Payments.»

Other important instruments of business law include statutory presidential decrees - «On Land» (December 22, 1995), «On Oil» (June 28, 1995), «On Subsoil» (January 27, 1996), and some others.

Kazakhstan’s legislature has enacted a block of subordinate legislation that governs business activities involving other countries and directly concerns foreign investments: the Exchange Control Act December 24, 1996, the External Borrowing and Foreign Debt Management Act April 10, 1997; presidential decrees with the force of law «On Customs» of June 20, 1995 and «On Special Economic Zone» of January 26, 1996; the presidential decree «On Liberalization of Foreign Trade» of January 11, 1995, Kazakhstan Government Resolution #1037 «Goods and Services Export and Import Procedures» of June 30, 1997.

So, Kazakhstan has developed a ramified and interrelated system of legislation which enables regulation of business efforts involving foreign companies and individuals in the Republic of Kazakhstan. Within this body of law, we need to identify those regulatory and statutory instruments which apply directly to foreign investments. These are Foreign Investments Act December 27, 1994 and Government Support for Direct Investments Act, which provide for:

· a system of privileges and preferences (narrowly targeted at particular investors); and

· availability of a single government agency authorized to act for the Republic of Kazakhstan in dealing with investors.

In order to be entitled to any such privileges or preferences, an investor has to sign a contract with the Foreign Investments Agency. Such investors, referred to in the law as «approved investors,» will be eligible under the contract for privileges and preferences designed to facilitate their investment projects, such as:

1. Government grants in kind (property or non-property rights of the Republic of Kazakhstan conveyed to the investor in forms other than money, with appropriate title;

2. Exemption from land tax and from property tax for a period of up to five years starting on the contract execution date;

3. Exemption from income tax for a period of up to five years as of receipt of taxable income, but for no more than eight years as of the contract execution date;

4. Full or partial exemption from customs duties on equipment and materials required for investment projects.

However, the immense positive potential enshrined in the legislation on direct investments might remain dormant because it contains certain principles which, if applied, could negate this positive charge and produce negative results.

For one thing, the Direct Investments Act is clearly biased, reflecting, in some of its aspects, the interests of the Investments Agency rather than investors. Indeed, privileges, preferences, grants, guarantees and safeguards will only be available to approved investors, i.e., those who will have signed a contract with the Agency. Then again, the contract wholly and entirely depends on the Agency, which selects an investor, checks whether the investor is suitable, lays down the terms of the contract, monitors its performance, and imposes penalties. It is again the Agency that decides on privileges, preferences and grants on a case-by-case basis, among other things. We believe that, given this procedure, the policy designed to promote investments might, if anything, cause the emergence of a powerful bureaucratic monopoly in the way of potential investors.

Second, the Direct Investments Act is underpinned by a flawed methodological tenet - i.e., preferences will be granted to investors selected at the discretion of a government agency («selective support»). In the context of a market economy, laws must stem from an opposite premise, i.e., equal opportunities and equal privileges for all investors without exception. What’s more, they must be granted automatically by virtue of the law, an arrangement that would be most effective in preventing corrupt practices in government bureaucracies.

Third, tax benefits deserve special mention. The basic principle of tax law is that it is universal. The old legislation provided no individual tax privileges. But the changes made to tax laws have eroded this principle, giving rise to what is called «contractual taxes.»

The Constitution of Kazakhstan and the Civil Code specify how the country should treat foreign companies and individuals. In particular, article 3 section 7 of the Civil Code provides that «foreign companies and individuals and stateless persons are entitled to be given the same rights and shall bear the same responsibilities as civil legislation imposes on Kazakhstan companies and individuals, unless acts of legislature provide otherwise.» This leads us to infer that there was no particular need for a separate piece of legislation on foreign investments.

With the Direct Investments Act on the statute books, the task is to dovetail it with the Foreign Investments Act. The Direct Investments Act is unclear on whether it applies separately and independently of the Foreign Investments Act or in conjunction with it. This is an impermissible lack of clarity. The two pieces of legislation need to be properly dovetailed and also harmonized with the presidential decrees on oil, subsoil, licensing, privatization, etc.

There have been quite a few problems with foreign investors in respect of applicable law. The catch here is in deciding the law of which country should govern investment-related activities - that of Kazakhstan or that of the investor’s home country or that of a third country. As the Foreign Investments Act offers no solution to the issue of applicable law, the current approach relies on the relevant general procedure laid down in the Civil Code.

Chapter 61 article 1084 of the Civil Code provides that the law applicable to civil and legal relationships involving foreign companies or individuals or compounded by any other alien element must be determined on the basis of the Civil Code or other legislative instruments of the Republic of Kazakhstan or international agreements ratified by the Republic of Kazakhstan and accepted international practices. Further provisions of this Chapter decree that it is possible to rely on the law of another country subject to the regulations set by the Kazakhstan Civil Code. Thus, the Republic of Kazakhstan has acknowledged at the legislative level that the law of another state may be applicable to business dealings and other activities in the Republic of Kazakhstan.

In this context, it would also be appropriate to mention the safeguards which a foreign investor is now entitled to in the event of legislative change. For instance, article 6 of the Foreign Investments Act is one of the better known and highly controversial. It reads that «if the situation of a foreign investor worsens as a result of some change in the law and/or the execution of international agreements and/or some change in their terms and conditions, foreign investments shall for a ten-year period be subject to the law effective at the time of investment, and, in the case of investments made under long-term (over 10 years) contracts with authorized government agencies, till the expiration of the contract, unless the contract provides otherwise. Where the worse situation a foreign investor is brought about by a changed law and/or by the execution of international agreements and/or some change in their terms and conditions, some terms and conditions of the contracts with the foreign investor and the authorized government agency representing the Republic may be modified by mutual consent with a view to balancing the business interests of the parties.»

These statutory provisions concerning contracts chiefly apply to oil and other contracts that have to do with subsoil use.

Further guarantees necessitated by legislative instability are set forth in the Decree on Oil, too. Article 2 section 5 states that licenses issued and contracts executed prior to the Decree on Oil taking effect and enactments by Kazakhstan government bodies all remain valid. But this provision concerns contracts made before the Decree on Oil came into force, while contracts signed thereafter are governed by the provisions of article 57 of the Decree, which stipulate that no legislative change or amendment prejudicial to the interests of Contractor will apply to the licenses issued or contracts executed prior to such change or amendment.

This provision is important primarily in terms of taxation of businesses involving foreign investors. However, it is tax regulations that, unfortunately, have seen changes that seem at variance with the Decree on Oil; witness the April 24, 1995 statutory presidential decree «On Government Taxes and Other Mandatory Payments» (hereinafter referred to as «Decree on Taxes»). Under article 94-3 of the Decree (as worded in the December 31, 1996 Act) «if the law is altered after the Contract Execution Date in a way that makes further compliance with the original terms of the contract impossible or leads to a major change in its general terms and condition of doing business, then the subsoil user and representatives of a competent agency and a tax authority may make such changes or amendments to the contract as may be necessary for the business interests of the parties to be restored to what they were at the time of contract execution, with any such change or amendment to the contract to be made within 60 days following written notice to the tax authority or the subsoil user.»

Thus, the important provisions of article 6 of the Foreign Investments Act happened to be changed by the Decree on Taxes. It now stops short of putting contracts within the purview of the law applicable at the time investments were made, mentioning only the right to change some of the contract terms in the event of tougher tax laws in order to restore the business interests of the parties to original status.

Hence the practical question of whether this provision applies to contracts dating back to the time before the Decree on Taxes. It clearly follows from the general tenets of legal theory that this provision is not retroactive and that it is article 6 of the Foreign Investments Act that is fully applicable to the earlier contracts. As this was a major cause for concern among foreign investors, the law-makers came up with a solution. The December 21, 1995 statutory presidential decree and then the December 31, 1996 Act amended the Decree on Taxes, so article 179 section 2 now has the following wording: «The terms of taxation set forth in those subsoil use contracts between the Government of the Republic of Kazakhstan or its authorized agency and national or foreign subsoil users which date from the period prior to January 1, 1996 and those subsoil use contracts subjected to mandatory tax-related review which date back to January 1, 1996 through October 1, 1996 shall remain valid until expiration.»

Yet another lingering and extremely controversial issue is whether or not article 6 of the Foreign Investments Act should apply to joint ventures. This calls for differentiated solution with an eye to various types of guarantees offered to foreign investors. It is our firm belief that joint ventures such as Tengizchevroil do fall within the purview of the Act. Among other things, the Act grants certain guarantees - yet some of them not directly to the foreign investor, but through joint ventures set up by him with foreign participation. These are just those cases where guarantees are given in respect of «foreign investments» (article 6 - Guarantees Against Legislative and Political Changes; article 7 - Guarantees Against Expropriation; article 8 - Guarantees Against Unlawful Acts by Government Agencies and Officials; and article 13 - Guarantees During Government Inspections.

Today, joint ventures (JV) provide the most popular and, in some cases, the only vehicle for foreign investment. Going back once again to article 6 of the Foreign Investments Act, we should note that this provision was written into the Act with the sole purpose of safeguarding the interests of a big foreign investor, using, among other arrangements, joint ventures, having first carried out a feasibility study with due regard to the applicable legislation in effect at the time of the contract/agreement was made. For instance, if increased taxes on a JV affect the standing of a foreign investor the host-country should give the JV the same treatment in terms of taxation as the JV enjoyed when it came into being. We are happy to note that the same approach is favored by the Kazakhstan Ministry of Finance Chief Tax Inspectorate, which in its letters #12-10-3-12/674 of February 2, 1996 and #12-10-3-12/2174 of April 24, 1996 - Re Taxation of Businesses with Foreign Investments acknowledged that it was possible to apply article 6 of the Act to businesses with foreign participation.

So much for investments in subsoil use projects. As seen from the foregoing, the statutes and regulations on business activities which have appeared over the last few years are full of contradictions, which account for their incorrect and diverse interpretations. One remedy for the current situation on the legal front is to review all of the country’s regulatory and statutory instruments to see if they are consistent with the Constitution and to do away with contradictory provisions, codifying them as a systematic body of law. It is imperative always to remember that an ill-advised law-making boom could leave the country without any legal control to speak of and trigger chaos in all areas of life, which would put off potential investors, especially in those sectors which do not generate quick profits.

While on this subject, I would like to tell you about some of the difficulties our company has experienced in implementing the promising and well-known Tengiz Project. Tengizchevroil (TCO), of course, is the Kazakh-American joint venture developing the Tengiz oil and gas field. It was set up as a limited liability partnership in April 1993 under an agreement between the Government of the Republic of Kazakhstan and the world-famous Chevron oil corporation. Chevron was the first major investor on the Kazakhstan economic scene, so the project attracted the attention of quite a few foreign companies, especially those concerned with subsoil use. Chevron’s success in Kazakhstan did much to build the country’s business image, indicative as it was of its favorable investment climate and a measure of economic and political stability, unlike in other CIS nations.

Over the six years of its very successful operation in Tengiz, TCO has considerably improved its overall performance, increased capital investment in its main production facilities and infrastructure, upgraded management, and trained a lot of employees in modern management techniques appropriate for a market economy. This year has brought a change in the TCO partnership line-up, with Mobil corporation and the Russian-American LUKARCO becoming TCO co-owners - alongside the Republic of Kazakhstan, represented by the National Oil Company Kazakhoil, and Chevron.

Since its inception, TCO has timely paid all taxes and made all other mandatory payments to the Republic of Kazakhstan. TCO has never delayed employees’ pay, which is the highest in the country’s oil and gas sector. It provides bonuses, free meals three times a day with a wide choice of sustaining food, good living accommodation, grants for employees and their children to study at colleges and universities, and excellent recreational facilities. For example, the TCO rotational village boasts an indoor swimming-pool, the second largest in Atyrau Oblast, plus a gym with exercising equipment, and tennis courts. TCO is pursuing a major housing assistance program, giving employees interest-free 10-year loans to buy housing, with over 7 million dollars’ worth of loans already disbursed under this program. Jointly with the World Bank, TCO has been offering credit facilities to small and medium-sized businesses in Atyrau Oblast.

Now a few words about TCO’s contribution to the development of the Kazakhstan economy. In the year of its formation, 1993, TCO directly and indirectly invested $99 million in the country’s economy; in 1994, the figure was $237 million. The figures for the subsequent years were as follows: $148 million in 1995, $266 million in 1996, $436 million in 1997, and $416 million in 1998. About as heavy investment is expected this year.

As part of its large-scale community assistance program for the region, TCO has built a hospital, bakery and boiler-house in Atyrau, 20 dwelling-houses in the town of Kulsary as part of flood relief effort, and an ambulance service clinic also in Kulsary - all now functioning or turned over for occupancy. TCO has donated about 600 computers to schools and other educational establishments. Quite recently, as part of preparations to mark the 100^th anniversary of Kazakhstan’s oil industry, TCO gave the city of Atyrau two million dollars in assistance for the renovation of the bridge across the Ural River, plus another two million dollars to refurbish city buildings and improve its roads - all that apart from other community assistance projects being pursued by the company in the region. These efforts have been in every way supported by the National Oil Company Kazakhoil, which looks after the interests of the Republic of Kazakhstan in the Tengiz Project, as well as by the foreign partners investing in the project - i.e., Chevron, Mobil, and LUKARCO.

Yet, for all these good results, I would also like to highlight the kind of problems we run into almost daily.

The Tengiz Project Agreement defines the obligations of the partners regarding certain payments, taxes, royalty, customs procedures, foreign exchange transactions, hiring of expatriate labor, and other matters essential for normal dealings with government agencies in the Republic of Kazakhstan in connection with TCO operations in exploration, production, processing, transportation and export of oil and other associated hydrocarbons.

The six years of TCO business efforts and the practical application of the Tengiz Project Agreement provisions have revealed a number of problems central to the controversies which have soured the relations with the Republic of Kazakhstan Government bodies and other agencies of the state.

One bone of contention is the Tengiz Project Agreement, which is construed differently by different parties. For instance, under article 12(A) of the Agreement some of its provisions must prevail when at variance with Republic of Kazakhstan laws, instructions, rules or procedures - regardless of whether such statutes or regulations existed at the time the Agreement came into force or they took effect after the Effective Date of the Agreement or will become enforceable in the future. To implement the stated intention, the Republic of Kazakhstan promised to take such steps as might be required to give these provisions of the Agreement the force of law.

The Republic of Kazakhstan, on behalf of itself and all its central and regional authorities, ministries and other government departments, also acknowledged the prevalence of some provisions of the Tengiz Project Agreement over national legislation, in particular, those concerning foreign exchange transactions and customs procedures; payment of royalty, taxes and other mandatory charges; export of oil and other hydrocarbons; and the conduct of its business and hiring of its staff without any requirement to obtain any further consents, approval, allocations or licenses or have any expert review conducted. The Republic of Kazakhstan also agreed that none of such formalities (which should be understood as inclusive of rule-making) shall add to, delete or otherwise alter the substance of the Agreement and other Major Documents.

Of course, given the confidential nature of the Tengiz Project agreements, I cannot go deeper into their provisions for more detailed explanations, yet I will point out that all of these agreements were approved by a special Republic of Kazakhstan presidential decree and special Government resolutions in the absence of an adequate legal framework at the time the agreements were signed, which took place in early 1993, as I have already mentioned. Therefore, we strongly believe that these agreements have the status of a specific regulatory and statutory instrument designed to govern the relations between a polity and a business entity, an instrument which came about at a time of legal vacuum as the country was just starting to adopt free market principles.

For all that, the country’s authorities - more often local than central - relying on their own constructions of Tengiz Project agreements occasionally generate controversies that take a lot of time and effort to settle. Today I would like to tell you about some unlawful acts by government agencies and individual bureaucrats.

The customs authorities, for one - ignoring the fact that the Tengiz Project agreements entitle TCO to a number of important privileges and preferential treatment in respect of oil exports and customs clearance of inbound and outbound equipment, goods and materials - have quite often bred impediments to such activities, pointing to laws and regulations adopted after the Effective Date of the Tengiz Project agreements. Some of those controversies led to litigation, TCO winning most of those court cases.

The country’s migration service, local departments of the Ministry of Labor and Social Security, and Interior Ministry outfits - all have been employing discriminatory practices for the past two years in respect of TCO’s expatriate workforce, threatening expulsion of foreign workers and refusing to understand that TCO enjoys special treatment in hiring and using foreign labor.

The Prosecutor’s agencies of every jurisdiction, from the lowest local level all the way to the General Prosecutor’s Office, acted in breach of the effective presidential decree which prohibits interference in the activities of businesses when they carried out more than a dozen inspections of TCO sites in 1998 alone to see if the company was in compliance with environmental and employment laws. This year, prosecutors’ offices, month in, month out, have been demanding lots of various documents regarding environmental protection on TCO sites. Meddling in company administration and encroaching on the rights of TCO management, the former Prosecutor of the Zhylyoi Region, Atyrau Oblast, would check and take exception to just about every company plan or procedure for organizational restructuring, downsizing, or employee termination for misconduct, yet all of his protests were dismissed as unwarranted and unlawful.

Given their excessive preoccupation with politics (I don’t want to talk about the courts’ corrupt practices without clear proof, even though there are some indications on this score) plus the judges’ refusal to understand the specific nature of free market economics in the context of inadequate legislation, employment law, first and foremost, the courts wrongfully handed down reinstatement judgments on more than 70 employees most of whom had been terminated as part of a downsizing plan in compliance with all applicable requirements of employment law, with the rest discharged for misconduct, such as alcoholic intoxication at work. All those decisions of the local courts were overturned by the Kazakhstan Supreme Court as unlawful and unwarranted - proof positive that TCO’s stand on the issue had been legally correct all along.

Over the last 18 months, local state-run power companies have been trying to force TCO to pay them large amounts of money for their own organizational needs, making references to Ministry of Energy by-laws to justify their demands. When we refused to accommodate them, the Atyrau regional watchdog concerned with electric-power generation, Gosenergonadzor, would often make it difficult for TCO to put its power facilities into operation, dragging their feet on expert reviews and other prescribed procedures.

Tax inspectors and other fiscal agencies in Atyrau Oblast have repeatedly threatened and attempted to seize TCO’s local bank accounts without sufficient legal grounds. And that despite the fact that TCO is the only local company which has always paid fully and on time all statutory fees and charges and has never delayed employees’ pay, as well making pension-related and other obligatory payments.

These and other unlawful acts by government agencies or individual bureaucrats make the investment climate in the country less attractive, frightening off potential investors who might be willing to invest in Kazakhstan and thus help the country’s economic development. Indeed, even big investors such as Chevron have run into lots of snags - sometimes created by the authorities themselves, at the local level especially.

It is to be hoped that the passing of new laws to govern activities on the economic front, their systematic codification, and pro-active and positive efforts by the President and Government of the Republic of Kazakhstan and the Akims at all levels will combine to facilitate the country’s economic recovery and promote the well-being of the Kazakh people.

In closing, I would like to say that the Republic of Kazakhstan, for all its current difficulties, remains one of the more attractive Eurasian nations for forward-looking investors.