FINANCING DEVELOPMENT

Project Finance Case Study - Zarafshan-Newmont Joint Venture

The Zarafshan-Newmont Joint Venture (the “Joint Venture”) produces gold from ore obtained from the Muruntau mine, located in the Kyzylkum desert of Uzbekistan (250 miles west of Tashkent). The Maruntau mine is one of the world’s largest open pit mines that exclusively produces gold, and ore has been stockpiled since 1969. In total, the mine is expected to have contained roughly 950Mt of ore. However, gold comprises a tiny fraction of the ore produced from the mine (roughly one ton of gold can be obtained from every 200,000 tons of ore). The Joint Venture uses a heap-leaching technique to process the raw ore and produce gold that is 99.9% pure and ready to be exported. The operation employs roughly 725 employees and has created several hundred million dollars of economic benefit.

Uzbekistan

Uzbekistan declared independence from the Soviet Union on August 31, 1991. The nation’s first and only President is Islam Karimov, a former Soviet party leader. Karimov won his initial election with 86% of the vote, but the election was declared a sham by opponents. After the election, Karimov cracked down on political opposition, and subsequent elections are widely regarded to have been unfair.

During the early 1990s a great deal of optimism surrounded Uzbekistan and many of the other CIS nations. The emergence of democracy, the end of the communist system, and the desperate need for capital made many eastern European nations appear to be attractive investment opportunities. Uzbekistan’s conservative approach to economic liberalization and privatization produced declines in GDP that were significantly smaller than the declines experienced by other former Soviet states, leading some commentators to praise the strategy.

Uzbekistan’s large untapped reserves of a number of minerals and hydrocarbons made it a particularly attractive destination for foreign investment. Uzbekistan has some of the world’s largest gold and uranium reserves, and also large reserves of natural gas, copper, and oil. Many observers believed that infusions of western capital and expertise would not only yield profits for investors, but also reduce poverty and precipitate further democratic reforms.

Despite these grounds for optimism, there were a number of grounds for concern. For one, corruption was rampant. Second, Uzbekistan has a history of human rights abuses, often directed at those who are openly critical of the government. The government has a history of jailing political activists who criticize it, and assaults carried out by hooligans are often believed to be sanctioned by the government. Religious organizations and their leaders are subject to illegal searches and arrests.In addition, populations near the border with Tajikistan have been forced to move against their will. (There are also large ethnic Uzbek populations in Tajikistan near the border with Uzbekistan, a situation that has led to some violence and calls to expand Uzbekistan’s territory to encompass these populations). Additionally, people in the country are trafficked to be used as forced labor in the construction and agricultural sectors, both within Uzbekistan and in surrounding countries.

Production process

Zarafshan-Newmont crushes the ore from the mine into fragments less than 3.7mm in diameter. A heap-leaching process is then employed, where the crushed ore is mixed with a cyanide solution which dissolves the gold contained in the ore. The cyanide/gold solution is then collected, and the gold is later separated. More detailed information regarding the technical aspects of the production process is available here.

The heap-leaching process produces 9 tons of waste for each ounce of gold. In other countries water containing cyanide has escaped from containment pools in a number of well publicized incidents, such as a 1992 spill in Colorado and a 1995 spill in Guyana. A spill at the Baia Mare mine in Romania in 2000 contaminated 2000 kilometers of the Danube River with cyanide. 1,240 tons of fish in Hungary were killed, and losses were also reported in Romania and Yugoslavia.

Market for gold

Gold has a wide variety of industrial and personal uses. 70% of the world’s gold is used in jewelry, 11% is used in industrial activities, and 13% is used for investment purposes. A long established global gold market exists, making gold an extremely liquid asset. However, despite diversified demand, the price of gold fluctuates substantially. During the 1990s the price of gold on world markets ranged from roughly $250 to $415, and historical highs have approached $850. Volatility in supply (only 145,000 tons of gold have ever been mined) and market speculation likely accounts for much of the fluctuation.

Structure of the Deal

Parties

State Committee for Geology and Mineral Resources of the Republic of Uzbekistan
- (25% stake - $12 million)
- State entity of the Republic of Uzbekistan that makes arrangements for geological research to increase the availability of minerals for mining and processing industries, and exercises state supervision over geological operations.
Navoi Mining and Metallurgical Combine
- (25% stake - $12 million)
- State entity of the Republic of Uzbekistan that explores, mines, and produces a wide range of minerals, machines, and construction materials. The operation is one of the world’s largest producers of both uranium and gold.
Newmont Mining Corporation
- Founded in 1921, Newmont Mining is the largest gold company in the world. While still producing some copper and silver, in 1987 the company divested most of its non-gold operations in a restructuring. Newmont has been publicly traded on the NYSE since 1925, and is also traded in several foreign markets. Newmont’s headquarters is located in Denver, Colorado (where they moved in 1989). Today the company employs roughly 15,000 workers around the world.
Newmont Uzbekistan Limited
- (50% stake - $24 million)
- A Cypriot subsidiary of Newmont Mining Corporation. Newmont Uzbekistan Limited is wholly owned by the Newmont Mining Corporation.
Zarafshan-Newmont Joint Venture
- Project company created for the sole purpose of conducting the operation. The State Committee for Geology and Mineral Resources, Navoi Mining and Metallurgical Combine, and Newmont Uzbekistan own 100% of the company.
European Bank for Reconstruction and Development (EBRD)
- The EBRD was established in 1991 when communism was crumbling in central and eastern Europe and ex-soviet countries needed support to nurture a new private sector in a democratic environment. The EBRD's mandate is to help build market economies and democracies in countries from central Europe to central Asia. In fact, it is only permitted to work in countries that "are committed to democratic principles." The EBRD also states that "Respect for the environment is part of the strong corporate governance attached to all EBRD investments."
- The EBRD is owned by 61 countries and two intergovernmental institutions. It invests mainly in private enterprises, usually together with commercial partners. It also works with publicly owned companies, to support privatisation, restructuring state-owned firms and improvement of municipal services.
- The EBRD provided $105,000,000 in loans to Zarafshan-Newmont Joint Venture to complete the project.

Agreements

The parties were bound by a number of contracts. The most important were the following:

Loan Agreement:
- Commits EBRD to make available to the Joint Venture a loan up to $105,000,000. The State Committee for Geology and Mineral Resources of the Republic of Uzbekistan, Navoi Mining and Metallurgical Combine, and Newmont Mining Corporation guaranteed the loan. Several different types of loans were made available through the bank, each carrying different interest rates and obligations.
Collateral Agreement:
- Affirmed the right of the Bank to have priority in seizing the Joint Venture’s assets in the event of foreclosure. States duties placed on the Joint Venture in accordance with its acceptance of the loan.
Sponsors’ Performance, Subordination and Ownership Retention Agreement:
- Requires each Sponsor to do everything in their power to ensure that the other Sponsors fulfill all of their obligations. The Agreement also prohibits Sponsors from acting outside of the best interests of the project and indemnifies the EBRD against actions taken by the Sponsors.
Insurance and Designated Accounts Assignment and General Security Agreement:
- Limits the rights of the Joint Venture in the event of default, and further elucidates the rights of the Bank to seize assets. States how receivers may be designated and their rights.
Uzbek Sponsors' Completion Agreement:
- Requires the two Uzbeki Sponsors to repay the loans from the EBRD should the Zarafshan-Newmont Company fail to make payments. The rights of the Bank and responsibilities of the two Sponsors are clearly detailed.
Newmont Completion Guarantee Agreement:
- Serves the same function as the Uzbek Sponsors' Completion Agreement, but binds Newmont (USA) to be responsible for failed loan payments as well.
Pledge of Compensation and Rights of Ownership of Zarafshan-Newmont Joint Venture:
- Outlines the restrictions placed on the Sponsors regarding their ability to transfer ownership of assets that could be used to repay the EBRD. The Pledge also states the affirmative steps that the Bank could take should the Sponsors not act to maintain ownership.

Timeline/Outcome

February 1992: Newmont becomes one of the first overseas companies to enter into a joint venture in the former Soviet Union when it signs the Zarafshan agreement with Uzbekistan.
Summer 1993: The European Bank for Reconstruction and Development (EBRD) and Barclays approve loans for the project.
Fall 1993: The Zarafshan-Newmont joint venture breaks ground.
May 1995: The Zarafshan-Newmont begins production. Production is expected to continue for 18 years.
December 1995: Zarafshan-Newmont reaches full production levels of 1 metric ton of gold per month.
Summer 2005: Uzbekistan changes its tax laws to end the tax benefits offered to some foreign companies.
March 2006: Uzbekistan informs ZN that tax laws will be changing.
June 2006: Uzbek tax authorities deliver a $49 million bill in back taxes from the last four years.
August 2006: Zarafashan-Newmont challenges the bill in an Uzbek court and the court rules in favor of the Uzbek tax authorities, seizes the company’s assets and halts gold exports.
August 2006: Bankruptcy proceedings begin and a temporary manager is appointed.
September 2006: The Supreme Economic Court upholds the earlier court rulings regarding the tax claims and dismisses an appeal by the joint venture.
October 2006: Navoi Regional Economic Court in Uzbekistan adjudges ZN gold mining joint venture bankrupt. Sale of the JV’s assets is scheduled for December.
October 2006. Zarafshan-Newmont initiates two arbitration proceedings against Uzbekistan.
December 2006: Auction of Zarafshan-Newmont assets is postponed after only one bid is received.
January 2007: Auction is once again postponed, this time because no bids are made.
March 2, 2007: Scheduled auction of ZN assets is canceled due to lack of interest. Starting price is just over $140 million and creditors refuse to lower that price.
July 2007: Newmont announces that the dispute has been settled and that the government of Uzbekistan has agreed to pay it $80 million.

Risks

The Project Sponsors needed to consider a number of factors that had the potential to negatively impact the project. The complexity of the project, as well as circumstances particular to Uzbekistan, necessitated a large due diligence effort on behalf of all of the parties.

Currency risks

Inconvertibility – The government of Uzbekistan maintained strict control over the country’s currency. The country also faced budgetary and balance of payment pressures.

How is this risk assigned in the deal documents?
What recourse is available to the Joint Venture if the government does not permit the proceeds to be converted into US dollars?
Section 3.08 of the Loan Agreement requires that all payments be deposited into an offshore account. Who does this provision affect?
Should the EBRD be responsible for any of this risk?
Can the government guarantee the convertibility of the profits? How would this impinge on Uzbekistan’s sovereignty.

Devaluation – During each year of the period from 1991 to 1995, GDP growth in Uzbekistan was negative. The government employed fiscal policies to overcome budgetary shortfalls that encouraged inflation.

How is the risk of devaluation mitigated?
How will each party be impacted by currency fluctuations? See Loan Agreement § 3.01

Supply Risks – The project requires large quantities of several inputs, notably water, power, and gold ore. Ensuring a steady supply of these and other crucial materials is essential to ensure that the operation remains profitable.

Are the supply agreements sufficient to ensure a steady supply of necessary inputs?
- See the Legal Due Diligence Report.
What recourse does the Joint Venture have if needed inputs are not supplied?
- See the Legal Due Diligence Report.
Are the mechanisms used to determine the prices of inputs clear?

Demand risks

Although there is a relatively stable world demand for gold, the price can fluctuate considerably. Further, Uzbekistani controls on exports may impact the Venture’s ability to sell refined gold.

Is the Joint Venture a low cost producer?
- See Documentation Relating to the Project Financing for Zarafshan-Newmont Joint Venture Gold Heap Leaching Project, § 22.
Are proper provisions in place to relieve parties of their obligations should the price of gold drop below the level of production costs?
Would Zarafshan-Newmont be able to effectively sell the refined gold in the event that Navoi declined to purchase it?
Will the demand for gold expand throughout the life of the project?
- See Documentation Relating to the Project Financing for Zarafshan-Newmont Joint Venture Gold Heap Leaching Project, § 22.
Did the Sponsor’s take appropriate steps to forecast the gold market throughout the life of the project?
- See Documentation Relating to the Project Financing for Zarafshan-Newmont Joint Venture Gold Heap Leaching Project, § 22.
Does the Sales/Purchase Agreement place Zarafshan-Newmont at a competitive disadvantage?
- See the Legal Due Diligence Report, § 13-15.

Environmental risks

The heap-leaching process used in the venture involves storing large quantities of cyanide solutions. Accidents at other gold production facilities around the world have resulted in environmental damage costing millions of dollars.

What steps were taken to identify and abate these risks?
- See Documentation Relating to the Project Financing for Zarafshan-Newmont Joint Venture Gold Heap Leaching Project, § 19.
To what environmental standards is the project being held?
Do you think that transnational standards such as those embodied in the Equator principles would have been more appropriate?
How would each party be affected if an environmental breach were to occur?
Did the parties adequately protect their own interests in the event of such a breach?
Whose interests are served by holding the project to high environmental standards?
Could the venture have been structured differently to create stronger incentives to avoid environmental damage?

Legal/political risks

Power in Uzbekistan is concentrated in the executive branch of the government, making it easy for law to be changed abruptly. The Zarafshan-Newmont project would only remain a profitable venture if government regulations and taxes remained favorable.

How did the Venture seek to avoid the risk of government interference?
- See the Joint Venture Agreement, § 2.4.4.2
Do the parties have much power to avoid such changes?
Does the EBRD assume any risk of changes in the law?
- See the Sponsors Completion Guarantee and the Loan Agreement.
What binding effect does the Decree of Cabinet Ministers have?
Can the government’s guarantees prohibit future legislation from taking effect?
- See Joint Venture Agreement
What future events would justify the government’s imposition of additional taxes or regulations?
How much can Zarafshan-Newmont realistically expect the government of Uzbekistan to limit their future autonomy?
What recourse would the Venture have if the government did impose high taxes or burdensome regulations?
What insurance, if any, was obtained to mitigate this risk?
What recourse would be available to the insurer?

Expropriation risks

Uzbekistan, formerly part of the Soviet Union, promoted a government controlled economy. Development of extractive industries and divestment from the agricultural sector were considered central to the government’s economic development plan. The Zarafshan-Newmont project was the first major foreign investment in the country following independence, so there was no prior history of government conduct to provide guidance.

What assurances did the government give that expropriation would not occur?
- See Decree of Cabinet Ministers
How much risk remained allocated to the Joint Venture?
- See § 2.5 of the Joint Venture Agreement
Was the Joint Venture sufficiently insured against this risk?
What legal recourse would be available to the Joint Venture in the event of an expropriation?
- See § 6.01(e)(1) of the Loan Agreement
What additional steps could have been taken to either a) mitigate the financial risks caused by an expropriation, or b) provide incentives for the Uzbekistan not to expropriate assets?
Would the risk of expropriation have been lower were the Uzbeki government more democratic, or if the benefits of the Joint Venture were distributed broadly throughout the country?
How much weight should be afforded to government guarantees?

Risks of political violence

The government of Uzbekistan has an authoritarian history, and opposition parties have contested all national elections. Concentrated Uzbek populations live in several adjacent nations, leading to fears of border disputes.

Is the Venture sufficiently insured against production stoppages caused by political violence?
Does financial support from the EBRD ease concerns of political violence?
What other considerations must Newmont (USA) take into consideration regarding the risk of political violence?
Will the Joint Venture itself mitigate or increase the risk of political violence?

Human rights risks

Uzbekistan has a history of using forced labor to complete construction projects. The Zarafshan-Newmont project would further the government’s development plans as well as provide a significant source of income, both strong incentives to ensure that the project would be completed on time.

What are the consequences to each party if human rights violations are alleged?
Would the use of forced labor violate any applicable human rights obligations?
What steps, if any, were taken to ensure that human rights abuses did not occur?
Did the government of Uzbekistan provide any assurances that human rights violations would not occur?
- See Documentation Relating to the Project Financing for Zarafshan-Newmont Joint Venture Gold Heap Leaching Project, § 54-55.
What difficulties would arise in obtaining such assurances?
Would Newmont (USA) face legal sanctions for human rights abuses committed by the either the government of Uzbekistan or the other Sponsors?
- For more analysis of this issue see Eric Marks, Avoiding Liability for Human Rights Violations in Project Finance, 22 Energy L.J. 301.
How would Newmont (USA) be affected by human rights violations in Uzbekistan that are not associated with the Venture?

Dispute Resolution

Given the high degree of risk associated with the project, as well as its complexity, disputes were likely to arise. Decisions regarding what forums and which law would be used could have a large impact on what remedies would be available and what types of issues could be litigated. The legal system in Uzbekistan was undergoing rapid change, and was not independent from the other branches of government.

What choice of law provisions governed each aspect of the project, and why?
- Loan Agreement – § 7.07
If violations of international law are alleged (i.e. expropriation occurs without proper timely compensation), what forum will be used to litigate the proceedings?
- Would the government of the United States be able (or willing) to intervene on Newmont’s behalf?
Are there relevant treaties that govern how investment disputes between the parties must be resolved?
Could a foreign forum pass judgment on the legality of a change in Uzbekistan’s laws?
Which matters, if any, would best be litigated in Uzbekistan’s courts?
Should the parties exhaust local remedies before seeking foreign or international adjudication?
What are the costs and benefits of resolving disputes in arbitration rather than courts?