There has been much speculation during the past several weeks about a potential liberalization of the Law of Mongolia on the Regulation of Foreign Investment in Business Entities Operating in Sectors of Strategic Importance (the "Strategic Foreign Investment Law" or the "SFI Law") that was enacted on 17 May 2012. On 8 April 2013, a proposal to amend the SFI Law appeared on Parliament's official website (the "Draft Amendment"). The Draft Amendment is reportedly scheduled for discussion this week by Parliament. This follows on from reports that the Cabinet approved a draft version of the Regulations on Receiving and Determining Applications by Business Entities Operating in Strategically Important Sectors (the "Draft Implementing Regulations") in early March. The Draft Implementing Regulations have yet to be published in the official state gazette but have been circulated unofficially among Government departments and businesses in Mongolia.

The SFI Law has had a material impact on investor confidence in Mongolia. We provided our analysis of the law, along with our English translation, in client alerts dated May and June 2012. In those client alerts, we highlighted certain areas in the law that might be clarified through the legislative process or by way of the promulgation of implementing regulations. Our optimism at the time was underscored by the title of the first of these client alerts where we queried whether the SFI Law was only a temporary inconvenience. Nearly one year later, the ongoing lack of clarity of the terms of the substantive law and the absence of straightforward application procedures and approval criteria mean that foreign investors and their advisors are still left with insufficient guidance. The Draft Amendment and the Draft Implementing Regulations do not provide the much-needed answers. As a consequence, the inconvenience is not temporary, and the risks of non-compliance still largely undefined.

Background

The SFI Law provides for a mandatory approval process for certain acquisitions of Mongolian companies by foreign investors. The law applies to acquisitions conducted on an on-shore or off-shore level for business entities operating in sectors of strategic importance ("BESIs"). The SFI Law define BESIs broadly as Mongolian companies engaged in businesses in the minerals, banking and finance or telecoms/media sectors. Parliament or the Cabinet is the relevant approval authority depending upon the terms of the acquisition.

Further, the SFI Law applies to all acquisitions by any non- Mongolian state-owned enterprise in any business sector regardless of the percentage of equity acquired (or the percentage of state ownership in the foreign acquirer).

Under Article 4.7 of the current SFI Law, Parliament must approve an acquisition when a foreign investor acquires more than 49% of the equity of a BESI and the investment exceeds 100 billion Mongolian tugrugs ("MNT") (approximately US$ 72 million at the exchange rate of today's date). All other acquisitions are subject to the approval of the Cabinet.

Article 8.1 of the SFI Law also imposes a notification requirement in the event a foreign company acquires between five percent and one-third of a BESI or otherwise triggers the provisions of Article 6.1.7 of the SFI Law with respect to a BESI (please refer to our analysis in our May 2012 alert.) Such notification must be made to the state administrative agency for foreign investment within thirty days of the acquisition.

The consequences of non-compliance are potentially severe. Among other measures, the authorities may revoke any licenses issued to the Mongolian company that is the ultimate target of the acquisition.

The SFI Law stipulates that applications for approval are to be submitted to the state administrative agency for foreign investment. This function has been assumed by the Foreign Investment Registration and Regulation Department ("FIRRD") under the Ministry of Economic Development (the "MED"), which has taken a robustly conservative approach in dealing with applications and inquiries related to the SFI Law. We are unaware of any approvals issued through FIRRD for an investment project that falls within the scope of the SFI Law. Further, it appears that in the absence of implementing regulations, FIRRD has refused to accept any applications that even tangentially relate to the three economic sectors specified in Article 5.1 of the SFI Law.

The Draft Amendment

Contrary to some reports in the media, the scope of the Draft Amendment, accessed at www.parliament.mn on today's date, is narrow. It amends Article 4.7 of the SFI Law by stipulating Parliament as the approval authority only in those transactions where a non-Mongolian state-owned enterprise acquires more than 49% of the issued shares of a Mongolian company. The Draft Amendment removes investments by foreign private investors from the scope of Parliamentary approval and deletes the MNT 100 billion threshold in its entirety.

The changes do not mean that foreign private investors are free from a formal approval process, since acquisitions falling within the scope of the SFI Law will nevertheless have to be approved by the Cabinet, or the MED under the Draft Implementing Regulations, as explained below. Some comfort is provided insofar as the approval process for foreign private investment is removed from the purview of a government organization that is not always in session and has to consider other matters of national importance.

The Draft Implementing Regulations

The Draft Implementing Regulations are materially identical to a draft previously circulated in November 2012. As a draft that has yet to be published in the official state gazette, whilst they provide some guidance about the future regulatory process, they are certainly not binding. They are also significant for the issues that are still uncertain. The main focus of the Draft Implementing Regulations is to describe the documents required and the approval procedure.

Approval Authorities and Classification of Strategically Important Sectors

The Draft Implementation Regulations state that the MED is in charge of receiving, reviewing, making recommendations on and/or decisions for applications submitted for approval under the SFI Law. Both the Minister of Economic Development and the minister in charge of the relevant sector are to prepare a detailed list that defines with greater specificity those business activities that are strategically important under the SFI Law.

Accordingly, the SFI Law is the only source of authoritative guidance for identifying strategically important sectors. As noted above, these are the broad areas of minerals, banking and finance and telecoms/media. On the basis of the Parliamentary discussions immediately preceding the enactment of the SFI Law, we know that Parliament intended to include oil and gas projects within the term "minerals."

As a matter of practice, it appears that the MED has sought to expand the scope of these terms beyond their plain meanings. For instance, we understand that FIRRD refuses to receive applications to renew or extend the business scope of companies to include mining support services, such as equipment leasing, construction, technological assistance and drilling on the basis that such activity will fall under the "minerals sector" and therefore will be subject to the SFI Law.

Application Documents

Article 3.1 of the Draft Implementing Regulations sets out the documents to be submitted in support of an application for approval. These include forms for completion of information on the parties and the transaction, copies of a BESI's registration documents, certificates of registration and reference letters for the foreign investors, draft transaction documents and financial statements of the relevant parties. Further, the MED may request submission of such additional documents as it deems necessary. It remains the case that the Mongolian BESI itself rather than the proposed acquirer must submit the application for approval, which is not standard in international cross-border transactions. It further raises a procedural dilemma if the acquirer is looking to incorporate a greenfield BESI.

The Draft Implementing Regulations require a tentativelyagreed form of the underlying acquisition agreements to be submitted for approval. This requirement is unusual. It would more comport with international practice if the parties were to submit fully executed acquisition agreements which provided for the requisite SFI Law approval to be a condition precedent for closing of the transaction. There is the risk that the documents submitted for approval may differ from those actually signed. Further, there are confidentiality concerns as well as the prospect of FIRRD reviewing commercial terms beyond its purview.

Application Procedure

Upon submission of the application, the MED may request further documents if deemed necessary or issue a response to the application. Further, the MED may obtain comments and conclusions/recommendations from state authorities for the application, such as the Ministry of Mining for minerals, the Bank of Mongolia for banking or the Information, Technology, Post and Communications Authority for telecoms. In each case, the relevant state authority must respond to the MED within 20 days.

Notification of Responses

The Draft Implementing Regulations further set out the procedures for notifying applicants regarding the official response. The Cabinet secretariat will forward a parliamentary approval to the MED while approval by the Cabinet will be forwarded to the MED within three working days of its issuance. In all other cases, the MED will directly notify applicants of its decisions.

Some Unanswered Questions

The Draft Amendment and the Draft Implementing Regulations leave many questions raised by the SFI Law unanswered.

  • Definitions of Strategically Important Sectors. As noted above, FIRRD has rejected applications for foreign invested companies that do not fall within a foreseeable definition of "minerals," "banking and finance" and "telecoms/media." In particular, support services for minerals companies, such as leasing, construction and design, and so forth have been treated as minerals companies. An expansive definition of banking and finance and telecoms/media raises the same risk.
  • Review criteria. Article 7.3 of the SFI Law states that during its review, the state administrative agency for foreign investment will consider subjective topics such as (a) national security interests, (b) ability of the applicant to comply with Mongolian law and local business codes, (c) anti-competitive or monopolistic consequences, (d) "significant" impacts on national budget or state policy and (e) adverse impacts on the strategically important sector in question. The Draft Amendment and the Draft Implementing Regulations do not provide any objective basis for conducting a review in light of such subjective criteria. This subjectivity potentially lessens the attraction of Mongolia as a destination for foreign direct investment.
  • Notification Process for BESI Acquisitions Not Subject to Approvals. As noted above, Article 8.1 of the SFI Law requires notification of an acquisition of a BESI within certain thresholds. The Draft Amendment and the Draft Implementing Regulations do not specify the notification procedures even though non-compliance could potentially result in the revocation of the Mongolian target's licenses.
  • Offshore Transactions. The Draft Amendment and the Draft Implementing Regulations do not resolve the question of securing the requisite approval for BESIs that are publicly listed. In the normal course of trading on an exchange, a foreign investor in a BESI may find its shareholding in breach of the SFI Law once certain equity thresholds are passed. Further, the ability of Mongolian companies listed overseas to attract stateowned investment, e.g., through pension funds or sovereign wealth funds, would be limited by a legal requirement to obtain prior Cabinet approval. This also may negatively impact on potential IPOs in the future.
  • Taxation. Offshore transactions triggering the SFI Law entail payment of tax obligations of the parties. However, there is no discussion about the extraterritorial reach of such authority.
  • Managerial Control. Aside from the objective criteria of acquiring 33% of the equity of a BESI directly or indirectly, Article 6.1 of the SFI Law stipulates certain contractual controls on the management of a BESI that in turn trigger the approval process. This opens the door to subjective criteria about the type of "transactions" that fall within the ambit of this requirement.
  • No definition of a Foreign State-owned Enterprise. While the Draft Amendment provides some clarity about the identity of the approval authority, there is no definition of what constitutes a foreign state-owned enterprise.
  • Domestic Procurement. Article 3.8 of the SFI Law raises the concern that the Government of Mongolia would implement a local content requirement for any suppliers of goods and services to a BESI. While the Draft Amendment and the Draft Implementing Regulations are silent on this point, many domestic companies have begun to implement a requirement that such suppliers be joint ventures with the Mongolian party having equity control. This development poses a concern about Mongolia breaching its WTO commitments through discriminatory treatment.

The Impact

Compounded by the delay in its implementation, the SFI Law has effectively halted foreign direct equity investment in the minerals sector, the principal driver of the current economic development of Mongolia. Some statistics suggest that foreign investment in 2012 dropped by 40% on a year-on-year basis. Further, economic growth decreased to 12.3% from 17.5% in 2011. In practice, the Draft Amendment is significantly narrower in scope than we understand was expected by the private sector. Lastly, the Draft Implementing Regulations do not provide answers to important questions arising from the SFI Law. Although there are ongoing discussions and concerns in respect of the impact of the SFI Law, the actions needed to reduce uncertainty and ease administrative burden have come at a slower pace than the rate at which foreign investor confidence is being lost.

Conclusion

One year ago, we stated our conviction that Mongolian officials would take a less reactive and more sensible approach to foreign investment projects after the general election in June 2012, basing our views, in part, that Mongolian politicians are often pragmatic businessmen and understand the value of capital for the development of an emerging economy. With hindsight, it appears that this expectation was overly optimistic.

The Government of Mongolia heralded its so-called Chinggisbonds as a panacea for its revenue problems and some have overly castigated foreign investment. It appears that some in the Government of Mongolia may have lost sight of these bonds as a foreign debt that has to be repaid, regularly and on time, without regard to the vicissitudes of the local economy. The risk of failing to meet these debt obligations remains fully on the Mongolian side, unlike a foreign investment project where foreigners share the risk of the development too. The issuance of the Chinggis-bonds may have helped created the image of fast and easy money to solve immediate concerns for obtaining revenue to pursue infrastructure projects. But history shows that there is no such thing as fast and easy money. Rather it is sadly reminiscent of the same attitude that led Mongolian nobles and officials in the Bogd Gegeen's government to fall prey to Manchu moneylenders in the late 19th and early 20th century. By absorbing both debt and equity in a proper balance, the Mongolian economy could achieve its potential far more rapidly while heeding the warnings of the ard proverb: "debt acquired – worms in a silken robe."

We will provide further updates on the Draft Amendment and the Draft Implementing Regulations as more information becomes available. In the meantime, as always, foreign investors should ensure that that they have an objective analysis of the legal risks and commercial benefits that may arise in the context of their investment projects in Mongolia. Such risks and benefits are "moveable feasts" in all emerging jurisdictions and need to be monitored and understood dispassionately.