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Asia Pulp and Paper: a business rationale based on debt entrenchment and financial expropriation



The paper analyses the rise and fall of the Indonesian conglomerate Asia Pulp & Paper, which became the largest pulp and paper producer in Asia outside Japan, then faced in March 2001 the largest default for a private group in an emerging country ($13 billion). Our analysis is based on financial data and field work in Indonesia, and includes knowledge about the forestry operations of the group that are key to understand its corporate governance with the alleged use of transfer pricing. It helps understand a specific economic rationality for the ultimate owners (Widjaja family) in a context of poor corporate and public governance. The pyramid structure of the group allows the ultimate owners to dilute their direct investment along a chain of intermediaries, while keeping control of the decisions and accounts. The main use of debts to finance the expansion of the group was also remarkable because it allowed the ultimate owners to prioritize short term profits in a sector where long term strategies are the rule. This short term horizon could be prioritized owing to a low cost access to natural forests in Indonesia for fiber supply to the giant pulp mills, and because the creditors' rights could never be satisfied due to poor law enforcement and the absence of a cross-border insolvency regime in the Asia-Pacific region. This detailed case study is a contribution to the theories of debt entrenchment and financial expropriation, which are key to understand the East Asian business models. It also illustrates how politics interfered in the ability of the group to survive, as the Indonesian government held back claims on domestic debts and influenced the debt restructuring process.
Asia Pulp & Paper: a business rationale based on debt entrenchment
and financial expropriation
Romain Pirard1
Rofikoh Rokhim
The paper analyses the rise and fall of the Indonesian conglomerate Asia Pulp & Paper, which
became the largest pulp and paper producer in Asia outside Japan, then faced in March 2001
the largest default for a private group in an emerging country ($13 billion). Our analysis is
based on financial data and field work in Indonesia, and includes knowledge about the
forestry operations of the group that are key to understand its corporate governance with the
alleged use of transfer pricing. It helps understand a specific economic rationality for the
ultimate owners (Widjaja family) in a context of poor corporate and public governance. The
pyramid structure of the group allows the ultimate owners to dilute their direct investment
along a chain of intermediaries, while keeping control of the decisions and accounts. The
main use of debts to finance the expansion of the group was also remarkable because it
allowed the ultimate owners to prioritize short term profits in a sector where long term
strategies are the rule. This short term horizon could be prioritized owing to a low cost access
to natural forests in Indonesia for fiber supply to the giant pulp mills, and because the
creditors’ rights could never be satisfied due to poor law enforcement and the absence of a
cross-border insolvency regime in the Asia-Pacific region. This detailed case study is a
contribution to the theories of debt entrenchment and financial expropriation, which are key to
understand the East Asian business models. It also illustrates how politics interfered in the
1 Centre d’Etudes et de Recherches sur le Développement International (CERDI),
ability of the group to survive, as the Indonesian government held back claims on domestic
debts and influenced the debt restructuring process.
Keywords: Asia Pulp and Paper; financial expropriation; debt entrenchment; Indonesia;
forestry; pulp and paper; corporate governance
Corporate governance refers to the control of the firm, its ownership structure, and the
disclosure quality (Shleifer and Vishny, 1997; Nam et al, 1999). It was widely discussed in
relation to the Asian crisis in 1997-98, because poor firm performance was assumed to be
related to bad corporate governance (Lemmon and Lins, 2003; Claessens et al, 2000a and
2000b; Mitton, 2002). In particular, the East Asian economic model was said to reveal a
"crony capitalism", with the presence of numerous family-controlled groups, a high
ownership concentration, a weak public governance, and poor monitoring of bank loans
(Claessens and Fan, 2003; Claessens et al, 2000; Krugman, 1998, Nam et al, 1999).
Some authors argued that certain corporate structures tend to increase the control of the firm
relatively to the ownership for the ultimate owners, which is an incentive to expropriate
minority shareholders and creditors (La Porta et al, 1999; Lemmon and Lins, 2003; Shleifer
and Vishny, 1997; Claessens et al, 2002). Moreover, under certain conditions related to the
ownership structure and the degree of law enforcement, the ultimate owners would
prioritarize a financing based on debts in order to maximize their own profits to the detriment
of creditors' (Bunkanwanicha et al, 2004).
The group Asia Pulp & Paper (APP) expanded impressively in the 1990s and became the
largest pulp and paper producer in Asia outside Japan, and one of the top ten producers in the
world. It attracted investors from all over the world in a context of "Asian miracle", and
because the giant pulp mills built in Indonesia were assumed to produce at the lowest cost in
the world (Barr, 2002). Surprisingly, the group announced a debt standstill on $13 billion in
2001, the largest default for a private group in an emerging country (Fallon, 2003). At the
same time, it was revealed that the industrial capacities had expanded at a much faster pace
than the forest plantations, thus representing a high risk that operations would not be
sustainable (Barr, 2001). Was APP a case of corporate failure due to miscalculations from the
decision-makers, or to an exogenous shock such as a drop of market prices? Available studies
showed the apparent lack of rationality in the decisions of the group, and the critical situation
it faces from both financial and wood supply points of view. However, we assume that
another explanation would be more convincing, which is based on the very rational behaviour
of the ultimate owners of the group. This rationality being related to their ability: i) to increase
their control of the decisions and accounts compared to their direct financial investments, ii)
to finance the expansion mainly with debts in order to reduce their own risks and to maximize
their short-term profits, iii) to benefit from a lax public governance context and a free access
to natural forests for supplying fiber to the pulp mills.
Our analysis of APP's trajectory with the tools provided by the theory of debt entrenchment
and financial expropriation in East Asia allows us to go further than past studies. This is
important because APP's default has attracted much attention so far, and the resolution of the
case will impact on the willingness of foreigners to invest back in Indonesia. From a
theoretical point of view, this analysis also contributes to the literature about corporate
governance and financial expropriation. Indeed, this detailed study provides new and concrete
insights on the means for ultimate owners to manipulate firms for their own benefits. The
study sheds a different light on corporate governance and firm performance than econometric
studies on panels of firms. Our shared experience of both the political economy mechanisms
in Indonesia and the forestry operations (due to numerous field trips), gives us the opportunity
to explain APP case with new and first hand data.
The first section of the paper presents the theoretical framework including the so-called East
Asian economic model, the distinction between control rights and ownership rights, the links
between corporate governance and firm values, and the debt entrenchment mechanism. The
second section studies the case of Asia Pulp & Paper (APP), its history, corporate structure
and financing channels. The third and fourth sections analyse this case respectively from the
points of view of financial expropriation and debt entrenchment. The fifth section describes
the debt restructuring process for APP and analyses the role of the public governance context
in its outcomes. The sixth section investigates the legal issues and the seventh section
Theoretical framework: Ownership, control and use of debts in East Asia
During the 1980s and the 1990s the economic model in East Asia was praised for its positive
effects on the regional growth, and the World Bank published "The East Asian Miracle" in
1993 thus supporting the belief that a new efficient way of managing economies was born
(World Bank, 1993). Things changed with the Asian crisis in 1997: the very same
characteristics that were previously considered reasons for success, were afterwards blamed
for "triggering and aggravating the crisis" (Claessens et al, 2000a: 4). Weak corporate
governance and specific financing systems seemed to be a major factor leading to a
misallocation of capital and to poor decision-making processes in banks and corporations. In
their literature review on corporate governance, Claessens and Fan (2003: 2) concluded : "The
overall low transparency of Asian corporations […] with the prevalence of connection-based
transactions increasing desires among all owners and investors to protect rents […].
Resulting forms of crony capitalism, i.e. combinations of weak corporate governance and
government interference, [...] lead to poor performance and risky financing patterns".
Corporate governance in East Asia is characterized by both ownership concentration and the
large control by families. This control is held both on the groups (or conglomerates) with one
ultimate owner, and on the national economies with a limited number of families controlling a
large number of corporate assets. In Indonesia, Claessens et al (2000b) calculated that 61.7%
of total value of listed corporate assets were controlled by the top 15 families.
This control by families has to be distinguished from the ownership of corporations. La Porta
et al (1999) were the first to clearly differentiate ownership and control and to plead for
systematic investigations about the ultimate ownerhip of firms. They stressed the critical role
of the "ultimate owner" in the decision-making process, the identification of which implies to
trace the chain of ownership to find who has the most voting rights. These voting rights are
equal to the power of vote for the ultimate owner; but the ownership refers to the cash-flow
rights, i.e. the money invested in a company through the purchase of shares. Control can be
increased relatively to ownership through the use of pyramid structures, deviations from one-
share-one-vote, cross-holdings, and the appointment of managers and directors who are
related to the controlling family (Claessens et al, 1999). For instance, if A owns 30% of B that
owns 25% of C, then A owns 30% x 25% = 7.5% of C. But A controls 25% of B, which is the
weakest link from A to C.
The use of these ownership and voting rights is key to understand corporate governance in
East Asia: "East Asian firms also show a sharp divergence between cash-flow rights and
control rights - that is the largest shareholder is often able to control a firm's operations with
a relatively small direct stake in its cash-flow rights" (Claessens et al, 2002: 2742). The larger
the gap the larger the incentive for the ultimate owners to giver priority to their own interests
to the detriment of the smaller shareholders. Indeed, insiders control corporate assets and have
the power to expropriate outside investors "by diverting resources for their personal use or by
committing future unprofitable projects that provide private benefits" (Lemmon and Lins,
2003: 1445). According to Shleifer and Vishny (1997), the use of pyramid structures incites
ultimate owners to abuse of their position by "paying themselves special dividends or by
exploiting other business relationships with the companies they control".
Note that in Indonesia the ratio Ownership/Control was estimated to be 0.784 based on a
panel of listed companies (Claessens et al, 2000b). This ratio O/C is usually used as a proxy
for bad corporate governance, and the lower it is the worse the corporate governance is
assumed to be in theory (Bunkanwanicha et al, 2004). Many studies have empirically showed
that a higher separation between ownership and control was correlated to a lower firm value
(Lemmon and Lins, 2003; Claessens and Fan, 2003; Claessens et al, 2002; Claessens et al,
2000b). This phenomenon is even more obvious in crisis periods, as Mitton (2002) showed in
a study on five Asian countries studies separately. Unfortunately, the negative impacts of
these specific corporate structures on the firms' performance seem not to have improved
transparency with the adoption of international standards (Claessens and Fan, 2003).
Transactions with related parties and frauds still are possible, and sanctions are rare and
benign (Nam et al, 1999).
Others have showed that corporate governance was also linked to the debt structure. Using a
frim-level panel data of 500 firms from Thailand and Indonesia, Bunkanwanicha et al (2004)
observed that the higher the separation between control and ownership the higher the use of
debts for leverage. The justification of which might be that this higher debt leverage facilitates
expropriation in the economies where the institutions appear to be ineffective.
Asia Pulp & Paper: the largest default for a private group in an emerging country
The rapidity of the Indonesian Pulp and Paper expansion was impressive during the 1990s.
Indonesia's production in this sector moved from 0.5% to 3% of the world total between 1988
and 2003. The country was still ranking 27th and 30th in the world respectively for the
production of pulp and paper products in 1988, but it became a prominent player in about a
decade, ranking 9th and 12th in the world respectively as a pulp producer and a paper and
board producer in 2003 (APKI, 2004; Several reasons contributed to this
scenario: the vast natural forests available to the mills and making these the world's cheapest
producer of pulp (Christopher Barr, pers. comm., CIFOR); the context of the “Asian Miracle”
in past decades that attracted international investors in this promising region (Jacques Daubas,
pers. comm., BNP Paribas); the national policy in favor of the pulp and paper industry as an
exporter and provider of foreign currency (Hill, 1994).
Asia Pulp & Paper (APP) is the major producer in Indonesia, and it became the second top
producer in Asia outside Japan in a decade. Its total pulp capacity in Indonesia moved from
410,000 ton/year in 1991 to 2,485,000 ton/year in 2001, with two huge pulp mills – Indah
Kiat and Lontar Papyrus – located on the island of Sumatra. According to APP Annual Report
1999, the group has 15 production and converting facilities in Indonesia, 12 in China, four in
Singapore, two in the United States and one each in India, Mexico and Malaysia. APP
markets its products in more than 65 countries on six continents.
The great expansion of APP began to attract negative comments in 2000 when Barr (2000)
reported that the industrial capacities had not been followed by sufficient investments in forest
plantations. The consequence of which being that APP mills "face growing fiber supply
deficits over the next 5-7 years" thus making the expansion highly risky or even unrationale.
The year after, the group fell and called a debt moratorium on US$13.9 billion. Financial
problems had followed wood supply problems, but the story was far from ending and the
restructuring process is still questioned in 2006.
The ultimate owner of APP is considered to be the Widjaja family (Fallon, 2003) who is well
known as a major player in the Indonesian economy through the Sinar Mas Group, which was
founded by Eka Tjipta Widjaja. The two groups APP and Sinar Mas are not strongly
connected in legal terms (through cross-shareholdings for instance), but they are all controlled
by the same Widjaja family. APP was incorporated in Singapore in order to have better access
to international financial markets. As Figure1 shows, the real control of APP is actually
similar to that of Sinar Mas, as the Widjaja family uses nominee companies established in
‘fiscal paradise’ countries in order to enjoy various benefits and hide their identity.
[Insert Figure 1: structure of the Widaja family's ownership in pulp and paper companies
Source: Financial reports 2003 for Indah Kiat-Lontar Papyrus-Pindo Deli-Tjiwi Kimia, Jakarta Stock Exchange,
Surabaya Stock Exchange and JSX Watch 2003
* Matthew and Gelder, 2001a]
Since the beginning, companies related to the Widjaja family have used both banks and
capital markets to finance their projects. Locally, the Widjaja family used credits from state-
owned or private affiliated banks. Internationally they were also capable of raising substantial
funds through bank syndicates from all over the world. According to the former director of
corporate finance of a dominant player in the international banking sector, bankers in the
1990s considered the name of Widjaja as a guarantee in itself, due to his reputation as a
successful and reliable business partner: "When we approved the credit for millions of US
dollars, we just signed and never asked in detail about the risks of the business" (confidential
interview held in Jakarta on 21 December 2004). International banking was very liquid then
and bankers were very optimistic about conglomerate project investments: "It was only after
the Asian crisis that the international banking sector began to make more careful analyses.
By that time, international investors were already facing losses for some of their credits and
marketable securities such as commercial papers or bonds" (ibid).
APP was solicited aggressively by international banks and investment banks, which soon
realized that APP was the most frequent issuer in the emerging markets. In short, in Southeast
Asia, APP was the top prospect on most banks’ target client list (Fallon, 2003). Salomon
Smith Barney, in 1998, advised buying APP shares and stressed that the crisis in Indonesia
had had a positive impact on APP, due to the fact that its mills generated dollar revenues
while most of its operating costs were in rupiah. The volatility of pulp and paper prices would
only impact in the short term (Dillon and Waite, 1998).
Almost one year later, in June 1999, Morgan Stanley Dean Witter issued an outperform rating
and reported that APP was well positioned for Asia’s recovery (Spencer et al, 1999). In
November 1999, Morgan Stanley reported, "Asia Pulp & Paper: Here Comes the Cash
Flow!". As investors were worried about the company’s ability to repay or finance its US$1.4
billion debt amortization that would come due in 2000, the report commented that the
company would be able to generate enough cash flow in the following year to cover all its
financial obligations (Choi et al, 1999).
According to Goei Siaw Hongi, former chief analyst of Nomura Securities Indonesia, investor
enthusiasm to buy and hold the bonds of conglomerates is common. In the case of APP and its
subsidiaries, investors primarily considered the Widjaja family’s reputation for successful
business management. Beside this consideration, the bonds were also issued with a very
attractive interest rate, higher than market rates. The analyst also stressed the usual conflict of
interest when financial analysts were involved in bond sales, and consequently made overly
favourable comments: "It could happen that the analysts made their analysis in order to push
the sales, as the bonds were issued by the same securities companies". Moreover, investors in
the 1990s were attracted by the Pulp & Paper industry in Indonesia because they were aware
of the abundant natural resources available.
Even after APP showed that it was having difficulty repaying its debts, investors continued to
buy bonds related to the Widjaja family, in Duta Pertiwi (the property division; the bonds
were oversubscribed), and even in the pulp and paper sector. This was because some financial
analysts speculated that a portion of this new debt would be used to pay off the group’s short-
term debts.
Financial expropriation: a corporate governance leading to commercial transactions
with related parties
As financial analysts were aware before the great expansion of APP, the Widjaja family was
very keen on using related parties for commercial transactions. This way of doing business is
known for allowing and encouraging commercial contracts driven by the interests of the
ultimate owners, rather than resulting from a normal market process (Lemieux and Wixted
1998). This can be done with the use of transfer pricing, which is a well-known technique that
consists of a transaction between two related entities, with a price based on strategic factors
rather than market factors. It is a means for the stakeholders to declare profits or losses at
whichever company they choose.
Hundreds of companies have been created within the Sinar Mas conglomerate, both to
enhance efficiency and to control sales prices between related companies. As a consequence,
the ultimate owners were and still are in position to prioritize their own interests and even
capture profits for themselves. This would be done to the detriment of investors in the major
listed companies when the share value decreases; and to the detriment of creditors when loans
are not repaid. As companies controlled by the Widjaja family are in perpetual business
relations with each other, accumulating ‘transactions with related parties’, outside investors
are not in a position to interfere, either because they have only minority rights or are creditors.
Applying the framework we presented in the first section about the divergence between
ownership and control and its impact on the firm performance, we first calculated the voting
rights and the cash-flow rights in the case of Indah Kiat (see Table1), which is the flagship
pulp mill of the group APP. We see that ownership rights by the ultimate owner are diluted
along a chain comprising APP Global and subsidiaries, then APP Co. Ltd (with 66.33%), then
APP Inv. Ltd and Purinusa Ekapersada (with 57.38%), and finally Indah Kiat (with 52.72%).
Another chain comprises APP Global and subsidiaries, then APP Co. Ltd (with 66.33%), then
Purinusa Ekapersada (with 36.6%), and finally Indah Kiat (with 52.72%). And a third chain
goes directly from APP Co. Ltd to Indah Kiat (4,2%). As a result, the money directly invested
by the ultimate owner would be around 35% but his control rights would remain at more than
50%. The effect of which was clearly demonstrated by Lemmon and Lins (2003: 1466), who
used a sample of 800 firms in eight East Asian countries, and found that "Cumulative stock
returns of firms in which managers and their families separate their control and cash-flow
rights through pyramid ownership structures are lower by 12% during the crisis period
compared to those of other firms. Further, we find that the stock return underperformance
associated with pyramid ownership structures is present only in firms where the management
group also has a high level of control. The underperformance increases to about 20% points
for these firms".
[Insert Table 1: Ownership rights and control rights of Widjaja Family for APP Indonesia
The relations between compagnies controlled by the Widjaja family are recapitulated in a
matrix presented in Pirard and Rokhim (2006). The matrix proves that these transactions
concern the wood supply, energy supply, chemicals supply, the marketing of the pulp and
paper products both to domestic and international markets, insurance, the construction of
infrastructure, finance, etc. Refering to our framework, we assume that these transactions
serve the interests of the ultimate owners in priority due to the divergence between control
and ownership.
For example, in 1995 Lontar Papyrus mill signed an agreement with Wirakarya Sakti
plantation, which states that the pulp mill has the obligation to finance the plantation company
as needed and without any limit (ostensibly for establishing, maintaining and harvesting the
plantation), and through the provision of interest-free loans. The agreement also states that the
pulp mill is the plantation’s priority client for wood sales, at a price to be decided and with
payment in advance. Through the late-1990s, APP mills presumably used these agreements to
purchase wood at very low costs, amounting to little more than the cost of harvest and
transport to the mill. However, this agreement was amended in early 2001 and is valid for
another 30 years. All advances paid to Wirakarya Sakti are presented as non-current assets.
The same type of agreement has been signed between Indah Kiat mill and Arara Abadi
plantation. Both parties also agreed that the ‘loans’ provided by Indah Kiat shall not be offset
against the company’s payment obligation from the purchase of pulpwood from Arara. In the
financial reports, it is presented as ‘non current advances to related parties.’
It is important to stress the consequences of such agreements, as the plantation companies are
believed to be owned exclusively by the Widjaja family members. As currently structured, the
agreement is totally in favour of the plantation company, and very unusual in the sector. It
permits these plantation companies to operate at very low costs (all the more so if the loans
are not actually repaid), and to sell their production at very high prices as the mills are
affiliated. These transactions lack transparency, presumably on purpose, and the profits
generated from these are impossible to calculate precisely. However, we will use some
assumptions to estimate these gains in the following sections.
Debt entrenchment: a corporate governance leading to the capture of short-term profits
by the ultimate owners
Access to early financial reports and bond prospectuses from the 1990s allowed us to verify
some assumptions about the Widjaja family’s real strategy: securing short-term profits with
rapid and large expansion of capacity, and delaying costs with longer term debts (bank loans
or bonds).
[Insert Table 2: Evolution of net profits (losses) for APP's principal Indonesian mills'
consolidated accounts]
It is striking to see that the shift from profits to losses happened very suddenly, after many
years of high profits, as shown in Table2. From 1993 to 1999, the profits generated by Indah
Kiat, Tjiwi Kimia, Pindo Deli and Lontar Papyrus amounted to, respectively, $735,974,000,
$487,838,000, $123,015,000 and $168,760, coming to a total of $1,515,587,000. These profits
are realized and registered at the mill level, but they do not include those realized from the
domestic sales of the pulp and paper products though companies controlled by the Widjaja
family (like Cakrawala Mega Indah), or when the products are marketed to APP-owned mills
in China, or even through the wood supply from Widjaja-related plantation companies.
This latter aspect, namely the complete control of the wood supply to the mills, is both very
important and controversial. Due to the lack of transparency, there was no official information
on the plantation companies’ ownership, but past investigations have shown direct links to the
Widjaja Family. We accessed the companies registration board in Jakarta, and found that
Arara Abadi and WIrakarya Sakti are owned fully by the children of Eka Tjipta Widjaja, the
founder of Sinar Mas.
From the financial reports of the mills it is not possible to know precisely the price paid for
the wood, as the transactions are divided in several categories, and the exact volumes of wood
are not specified. However, the mills from the start have mainly purchased wood from the
conversion of natural forests inside the plantations’ concessions, or of palm oil concessions
affiliated to the group. The production costs have been very low, but may increase
dramatically from 2005 onwards as the volume of wood from plantations will increase rapidly
due to the scarcity of remaining natural forests to convert.
We tried to estimate the price paid for the wood by Lontar Papyrus and Indah Kiat for several
years (Table3). For this, the Bond Prospectus gave us the percentage of wood purchased by
Indah Kiat to affiliated suppliers from 1996 to 1999, and the financial amounts paid by Indah
Kiat and Lontar Papyrus to affiliated suppliers. For the years 2002 and 2003, we could only
guess that most of the wood was coming from the affiliated companies, as huge deforestation
is taking place in affiliated concessions, and as trees planted in these concessions were
starting to be logged at a higher scale than ever before. Moreover, a report by WWF Indonesia
(2004) on the timber consumed by APP shows that a major source of wood is from locally
obtained clearcut permits, with some of these permits held by affiliated entities. Where non-
related companies or cooperatives hold these permits, our own investigations in the field show
that affiliated suppliers can buy the wood before selling it back to the mills. Sometimes they
can even carry out the logging operations.
Estimations of the price paid by the mills for the wood do not pretend to be precise, as public
information are scarce. However, they show a trend to an increase of this price, and this can
not be entirely justified by a shift from Mixed Tropical Hardwood to Acacia. Indeed, natural
forests still represent the bulk of the fiber supply in 2002 and 2003. Moreover, Pirard and
Irland (2006) show that this price is unusually high compared to the costs of wood production.
[Insert Table 3: Estimated price for wood bought from affiliated suppliers ($/m3)]
For recent years, according to our own investigations in the field, and assuming shares of
wood coming from forest conversion and plantations at 70% and 30% respectively, the
production costs range between $20 and $25/m3 at most. The resulting profit captured by the
wood supplier may then be in the range of $15 to $30/m3. Yet, for our estimates of the profits
(a rent, in fact) captured at the wood supply level, we use a very conservative figure of $5/m3.
In reality, it could be several times higher. Over the years, the total rent captured amounts to
more than $300 million with our conservative assumptions (Table4). It is plausible that, in
reality, this rent is over $1 billion.
[Insert Table 4: Wood consumption by Indah Kiat and Lontar Papyrus, and corresponding
rent for wood supply companies between 1993 and 2003]
We have already stressed the crucial role of debts in APP’s expansion in the 1990s. Table5
recapitulates the evolution of the debt burden for the principal Indonesian mills, and shows
the regular increase of these debts, not only generally but also for each of the mills. Some
years show a rapid increase, and correspond to the construction of new production lines:
1994, 1995, 1998, 2000. Note that these debts increased rapidly relatively to the capital: from
1993 to 1997 the debt to equity ratio increased steadily from 1.4 to 1.8. In 2003, this ratio
reached 3.7.
[Insert Table 5: Evolution of debt burden (principal plus interest payable during the year) for
APP’s principal Indonesian mills]
Restructuring process: a public governance context in favor of the ultimate owners
"Why did things turn out this way?". That may have been the question on the minds of most
of the investors when APP announced how severe its financial situation was. After years of
significant benefits and continuous expansion, and the regular payment of debts, the group
suddenly defaulted in 2001. In fact, signs were already there in 1999 when the government
found negative features concerning the Sinar Mas-affiliated bank, Bank Internasional
Indonesia (BII).
This bank, part of the Sinar Mas Group, faced difficulties because of its non performing loans.
BII issued credits for Sinar Mas companies in many sectors, and financed APP’s expansion.
This was partially illegal, as the amount of loans to related parties issued by the bank was
higher than what was allowed by Indonesian law. The case was never brought to court, but on
28 May 1999, the principal owner (the Widjaja family) was ordered to solve the liquidity
problems with the repayment of the loans before 15 April 2001. This was an oral agreement
As IBRA (on behalf of the Government of Indonesia) took care of BII’s non performing loans
in its attempt to rescue the Indonesian banking system after the Asian crisis, it eventually had
$1.3 billion of APP’s debts in its portfolio. Initially the Widjaja's pledged shares in APP to
IBRA as collateral for the Sinar Mas related-party loans. At that time, APP's share price was
close to one dollar. However, by late-2000, APP's share price had fallen below US$0.25, and
the GoI became concerned that it did not have adequate collateral. Finally, the Widjaja family
had to sign a Shareholder Liability Settlement (PKPS Agreement) with IBRA, which implied
that a company with bad loans from a bank that was recapitalized by IBRA had to pledge
assets. As a consequence, the Widjaja family pledged 145% of their debt to IBRA (equivalent
to US$1.9 billion), using APP’s corporate assets (Musa and Suta, 2004). The new deadline
was 15 April 2003.
When, in March 2001, APP called a debt moratorium, the total debt was US$13.9 billion.
Negotiations were then initiated with more than 200 creditors, mostly from the United States,
Europe and Japan. During the 1990s, APP’s Indonesian operations reported substantial
profits, but when APP ran into problems, it told creditors the cash had been fully used. Since
the debt moratorium, restructuring negotiations have been coloured by controversy and
countless legal challenges.
On 7 November 2001, the Widjaja family agreed with IBRA to give personal guarantees
against APP and Sinar Mas debts, and signed a formal document. According to the
information we obtained from IBRA staff, the Widjaja family chose to do so in order to gain
time. If they had not, they would have had to hand over their assets (pulp and paper mills
located in Indonesia) to IBRA. This means that at that time, the restructuring process was
based not only on corporate liabilities but on personal liabilities too.
Soon after that, in 2002, I Putu Gede Ary Sutya was replaced as Chairman of IBRA by
Syafrudin Tumenggung. This change of management, influenced by Megawati Sukarnoputri's
recent election as President of Indonesia, resulted in a change of strategy for APP’s debt
resolution, and the personal guarantees of the Widjaja family disappeared in the process.
Indeed, IBRA decided to enter into a global debt restructuring negotiation and to abandon the
guarantees it was holding from the Widjaja family and the Sinar Mas Group.
Subowo Musa, a former senior manager at IBRA under I Putu Gede Ary Sutya, told us that
this happened at the behest of the international creditors. Indeed the IMF, on behalf of these
creditors, pressured IBRA to engage in a restructuring involving all creditors at the same
level. "It seemed that international creditors were jealous of IBRA because it had these
guarantees from the Widjajas" (Subowo Musa pers. com.).
In 2001, APP announced that a $220 million loss on two currency swap contracts had not
been included in the financial statements, although they had previously been audited by
Arthur Andersen. In 2002, the audit report by KPMG revealed that one of its Indonesian
subsidiaries, Pindo Deli, had spent US$170 million in cash to buy a huge piece of land
through a Widjaja family-related company. Creditors were upset, as the deal made no
economic sense, particularly for a company that was supposedly facing such a financial crisis
(FEER 14/02/2002). These two examples were the first of several cases of ‘suspect’
operations that made investors lose confidence in the management and the reliability of the
financial statements between 1997 and 1999. This is very much in line with the words by Fan
and Wong (2002): "It is important for policymakers and regulators to understand how the
concentrated share ownership structure in East Asia is associated with incentives for firms to
reduce accounting information quality".
On 15 June 2002, IBRA and Export Credit Agencies (ECAs) signed the agreement to arrange
the restructuring as soon as possible and also to increase the control of APP companies by the
ECAs. Then, on 15 September 2002, there was an agreement that creditors participating in the
Master Restructuring Agreement (MRA) could put financial controllers in APP companies.
Even IBRA acknowledged that this was ineffective. We should be aware too, that the same
year the Deutsche Bank filed a lawsuit in Singapore to appoint a judicial manager, and APP
managed to avoid it.
Negotiations continued, with several agreements signed during the process, but IBRA was
finally considered as too lenient in its approach, contrary to other creditors who were trying to
bring the case to court. It resulted in an official protest by 11 ambassadors to Indonesian
President Megawati Soekarnoputri, stating that IBRA was apparently influencing the
negotiations in favour of the Widjaja family and to the detriment of the creditors. Finally, the
Master Restructuring Agreement (MRA) was signed on 30 October 2003, concerning $6.7
billion of APP Indonesia’s debts. Increasingly, the creditors agreed with the document
(mainly the ECAs at the beginning, but 93% by the end of 2004), as further legal action seems
Not entering into the financial details of the MRA, one has to be aware that several core
elements of the MRA clearly favored the Widjaja's: i) the payment of the debts was planned
during a period longer than fifteen years, ii) until the beginning of the repayment the accrued
interests were not included and therefore represent a new financial subsidy to the group, iii)
the control of operations was not altered and the ultimate shareholders are still in position to
decide of the group's strategy. In short, the MRA did not make a substantial modification to
the core reasons why the group followed a rationale that already badly impacted on
Indonesian natural forests, on Indonesia taxpayers, and on investors all around the world.
Some creditors did not enter into the MRA with APP, and in at least one case, they pursued
legal action. In early 2005, litigation commenced in New York by GE Capital, Oaktree and
Gramercy Adviser was still ongoing (GE Capital finally signed the MRA in 2004). The
litigation could eventually lead to the seizure of APP’s corporate assets, namely the Indah
Kiat and Lontar Papyrus pulp mills, and this is the reason why APP countered with a legal
action through the local courts in Sumatra (where the pulp mills are located). Yan
Partawijaya, director of the Sinar Mas Group, said that APP will not cooperate with any
creditor that decides to keep filing lawsuits because a majority of the creditors have already
signed the restructuring agreement (Bisnis Indonesia, 24 January 2005). At the same time,
APP asked the creditors to delay the effective date of the agreement until April this year
(2005), because of the ongoing litigation. The latest decision in New York, on 7 February
2005, was in favour of APP.
A legal context leading to the protection of the ultimate owners
Our understanding and description of the APP strategy needs to include legal issues for at
least two reasons : the group has announced a debt standstill in 2001 but has been able to
avoid any seizure of its assets or replacement of the group controllers; legal actions initiated
by creditors have generally failed and the debt restructuring has been an out-of-court
APP is a multinational with a holding, subsidiaries, and financial companies located in
numerous countries, in Singapore, Indonesia, China, Europe or countries known for their lax
fiscal regulations, such as Cayman Islands. An efficient move by the creditors to put the group
back on its feet, means that all its entities have to be involved as a whole. Unfortunately,
"Countries across Asia, whether they are developed or emerging economies, have at least one
thing in common : they do not have adequate laws to deal with the insolvency of
multinational corporate collapse" (Asian Development Bank, 2004: 1). The consequences of
this lack of adequate laws to deal with multinationals, such as APP, are at least three :
- First, the risk stands that the transfer of profits among the group entities is in favour of
some stakeholders only, and to the detriment of the others. This risk is real according to our
analysis of the group management, and the multiplicity of transactions between affiliated
(formally or not) companies. It has been minimized, however, through the decision to include
the holding and the principal Indonesian operating companies (PIOCs) in the same debt
restructuring process that led to the Master Restructuring Agreement (MRA) in late 2003.
- Second, when the indebted holding company is located in a country with a reliable
legal system in order to attract investments (APP holding company is incorporated in
Singapore), but its assets are owned by subsidiaries located in countries with poor law
enforcement, then the lack of cross-border insolvency regime does not allow the holding
company creditors to seize its assets. In a report by the World Bank in 2001, the problem for
creditors to enforce their rights was stated as follows : "The bankruptcy process in Indonesia
does not pose a credible threat to recalcitrant debtors" (Drum 2001 : iii). Actually,
Indonesia's Bankruptcy Law was amended in 1998, as a result of the economic crisis and in
order to address the plethora of corporate failures. It created the Commercial Courts, the first
being in Jakarta, responsible of dealing with the lawsuits filed by creditors. But the first cases
were handled improperly, and the reliability of the courts has been widely questionned
because of the lack of expertise and rampant corruption. Moreover, a report observes that the
number of suits filed in these courts was in regression in 2002 (APEC, 2003).
- Third, the lack of possible coordination between legal systems and courts located in
different juridictions is a reason in itself to refuse any law enforcement against debtors. This
point is crucial and was perfectly illustrated by the judgment against the complaint by the
Deutsche Bank in Singapore in 2003. As the creditor was calling for the appointment of a
judicial manager in APP, the Judge agreed with such a claim but rejected it with the following
words : "I am not at all optimistic that the task can be so easily achieved by such a route.
That may well be the case under our system of law but may not be under Chinese or
Indonesian law, given the anticipated opposition from creditors of those subsidiaries to the
judicial management order in the first place, as well as the conflict in opinions from the
parties' Indonesian and Chinese legal advisers [as to whether the Singaporean court judgment
would be recognized]" (quoted in ADB, 2004: 25).
The complex financial structure of APP, the diversity of creditors and minority shareholders,
the enormous quantity of debts (including bonds), have led lawyers to conclude that "Perhaps
no restructuring in Asia today better illustrates the challenges of completing a complex, out-
of-court, multi-juridictional workout than APP" (Cooper and Brown, 2003: 11). Concretely,
creditors have organized themselves in two Committees but this proved to be ineffective:
Export Credit Agencies and commercial banks eventually became aware of their divergent
financial interests, and secured bondholders were in conflict with the unsecured ones.
Negotiations were thus delayed for a long time, and different strategies emerged with some
creditors going to the courts, others accepting the terms designed by APP, or some even
separating the Chinese debt from the Indonesian one.
Delays were in favour of APP of course, and could be anticipated before the conflicts
emerged between creditors during the restructuring negotiations. Indeed, judgments in many
country's Commercial Courts can be appealed at the Supreme Court, and the final decision
could be rendered several years after (APEC, 2003). If the short-term strategy of the ultimate
owners is the right hypothesis, then this capability to indefinitely postpone the enforcement of
legal decisions, through sanctions such as the seizure of assets or the real control of the
operations by creditors, clearly works in favor of the owners' interests.
APP’s trajectory since the early 1990s has been very impressive for several reasons. Focusing
at first on Indonesia to develop a pulp and paper empire in order to become one of the top ten
producers in the world, the group achieved its objective owing to very lax attitudes on the part
of investors both from Indonesia and abroad. The context of the early and mid 1990s, with the
so-called ‘Asian miracle’ and the Indonesian government’s official policy of pushing
industries with a clear export-oriented stance, and the availability of huge forest areas for
conversion, permitted the extraordinarily fast expansion of APP’s capacity. This expansion
has been mainly based on debts, either through bond issuance or bank loans. The financial
reports and prospectuses clearly show that long-term debts were the major financing vehicle,
and that self-financing through profit reinvestment or share issuance was relatively small.
The combination of such a financing structure, huge capacity and cheap raw materials
resulted in very significant benefits until 2000. Our research estimates these at more than $1.5
billion for the four principal APP companies located in Indonesia from 1993 to 1999. The
turning point occurred in 2000, even though 2001 is the well-known year when APP
announced a debt standstill. This is clearly not related to the Asian crisisii, contrary to what
some analysts have declared, but rather to a decline in international pulp and paper prices. The
argument that the dollar-denominated debts contracted by the group to finance its expansion
explain the deficits does not hold up for us either. Its production costs are mainly in local
currency, and, as it is export oriented, its sales are mainly in dollars. We also found out that
local sales were priced according to international prices in dollars. And financial analysts
were still rating the group well at the end of the 1990s, conscious of the group’s formal
comparative advantages. Then what happened?
In fact, the losses were related more to the global oversupply of pulp and paper products on
the international market, an increase in production costs (for unclear reasons), losses due to
foreign exchange rates (registered in the financial reports but not always realized), and other
unspecified reasons (the financial reports specify ‘other costs’ without being any more
The analysis of the financial reports and bond prospectuses of the principal Indonesian
companies under APP gave us the elements for the construction of a matrix, recapitulating the
different types of ‘transactions with related parties’. These transactions concern the wood
supply, energy supply, chemicals supply, the marketing of the pulp and paper products both to
domestic and international markets, insurance, the construction of infrastructure, finance, etc.
The impressive list of these transactions indicates that the ultimate owners made use of
transfer pricing to move profits, as they have total power of decision.
We looked in particular at the wood supply aspect, and discovered that APP finances the
establishment of plantations by the companies presumably owned by the Widjaja family
directly, with interest-free loans and without any restrictions. We also estimated the relatively
high prices paid by APP pulp mills to these plantation companies, and concluded that this
system provides an opportunity to create profits to the detriment of APP itself (but to the
advantage of the ultimate owner). Based on very conservative assumptions, we calculated that
these profits could represent at least $300 million from 1994 to 2003 for the two principal
Indonesian pulp mills, Indah Kiat and Lontar Papyrus. In reality, it could be several times
APP’s trajectory can be well understood only if one chooses to see it from the point of view
of the ultimate owner and the Sinar Mas Group. According to economic theory on debt
entrenchment and minority shareholders’/creditors’ financial expropriation, APP may have
been created and structured by the Widjaja family in order to enjoy complete control over the
decisions and accounts (voting rights), with relatively small direct investment (cash flow
rights). This means that these ultimate owners of both the Sinar Mas Group and APP were
able to - on their own - decide on the strategy, the commercial agreements and partners, and
control the accounts. At the same time the investment of their own capital remained relatively
low compared to their power.
Taken together this suggests that APP might be a profitable businessiv, but that the corporate
governance resulting from its ownership and financial structure is a key incentive to minimize
the profits (either by hiding or moving the profits to other entities). Moreover, since APP
defaulted on its debt in 2001, creditors have sought to secure the group's profits to repay
IBRA, the Indonesian agency created during the crisis with the mandate to rescue the banking
sector, was the first stakeholder to identify APP’s financial problems. It did so in 1999 when
it took over the Sinar Mas-affiliated bank BII, and realized that APP was reluctant to repay its
loans to BII. But IBRA’s management of the case has been controversial. Its strategy has
changed over the years: it put pressure on the Widjaja family when the latter were forced to
pledge their personal assets against BII’s non performing loans, and it had the power to seize
corporate assets at the APP level; but then it associated all the creditors in a global negotiation
that led to a restructuring of the debts without any asset guarantees; and finally it sold its debts
at discounted prices to unclear entities suspected of being Special Purpose Vehicles under the
control of APP’s ultimate owners. Taken together this suggests that IBRA’s strategy has been
strongly influenced by the ultimate owners, who were able not only to enjoy very favourable
agreements, but also cancel part of their debts.
In most countries with strong commercial laws, such cases are being taken to the courts of
justice. This point is crucial. The theory we discussed in this paper would not be valid where
the legal system is functioning, and where a bankruptcy law would force the ultimate
shareholders (or at least the group) to render their personal assets (or at least the corporate
assets). We showed how the negotiation and restructuring processes seemed to be
manipulated to the advantage of the Widjaja family, but we also have to stress the fact that the
creditors who have tried to file lawsuits have always lost their case. Last year, over $550
million in bonds issued in 1995 by APP International Finance Company B.V. and
unconditionally guaranteed by Lontar Papyrus and APP, under the laws of New York, were
invalidated by a local district court in Sumatra. The major lawsuit initiated in New York by
GE Capital, Oaktree and Gramercy Advisers, who together hold $319 million in debts at
Lontar Papyrus, has been rejected. Two major reasons explain why no legal ways can be used
to solve the case. First, the absence of a cross-border insolvency regime does not allow courts
to act efficiently in this direction. Second, the real weakness of bankruptcy laws and
enforcement in Indonesia acts as a shield for APP to keep control of its assets.
In conclusion, Asia Pulp & Paper seems to illustrate the theories saying that the divergence
between ownership and control through pyramid structures corresponds to poor corporate
governance and leads to lower firm performance. Its detailed analysis further shows the
concrete mechanisms that allow ultimate owners to expropriate minority shareholders; as well
as external creditors who suffer from debt entrenchment and the capture of short term profits
by the ultimate owners. The business rationale that we show is a threat to external investors in
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i Jakarta, December 2004.
ii The group enjoyed great benefits from 1997 to 1999 during the crisis.
iii A confidential source told us that the creditors’ adviser KPMG Singapore had made a study showing that the
registered costs were inflated. As quoted in Cooper (2003), creditors have criticized the restructuring plan for some
reasons including the lack of “protections preventing cash leakages”.
iv Other Pulp & Paper groups in Indonesia make profits when APP accumulates deficits.
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