"If you owe your bank a hundred pounds, you have a problem. But if you owe a million it has."

(John Maynard Keynes - British Economist and founder of the Keynesian School)

Introduction

Keynes' brilliant statement above can accurately describes one of the most crucial problems of international financing activities, i.e., overconfidence in giving loans to companies from emerging markets, which is highly risked, tends to create problems rather than improvements. Problems not only to the financial institutions involving in such financing activities but also to the debtors, as in the end both of them are facing losses, not profits.

This overconfidence, combined with a lack of supervision from the Indonesian authorities can be considered as one of the main factors of the financial crisis in 1997. In that fateful tragedy, an already huge amount of foreign debts which were borrowed recklessly by Indonesian private companies suddenly turned into an endless pool of debt where Indonesian companies were drowning frantically due to the crisis in Rupiah's value.

Some people blame the speculators for creating that disaster, but those speculators are only a part of many factors that formed the crisis back in 1997. Another crucial factor which is also very important is the management of Indonesian private foreign borrowings. Without proper supervision and good risk management, foreign borrowings might be troublesome to the monetary policy of Indonesia and also the sustainability of business activities. Considering the fact that the amount of Indonesian global debt offering transactions are increasing significantly, it might be worthwhile to see the relevant issues that we may face and the policy that should be taken to prevent or solve them.

Why Choose Foreign Debts? 

There are many reasons for raising foreign debts, but I know one obvious reason and that is the lower interest rate. As you may be aware, there is a big discrepancy of interest rate between the US Fed and Bank Indonesia and therefore, to certain extent, obtaining foreign borrowings is more commercially acceptable to Indonesian companies since they can get a lower interest rate.

Of course, if there is no financial crisis, this formula might work. Unfortunately, when the Rupiah's value fell into the depth of hell in 1997, the disaster is inevitable. By having too many debts in foreign currencies and without having any hedging mechanism, the majority of Indonesian companies fall into bankruptcy when they realize that their debts have increased tremendously in correlation with the fall of Rupiah's rate.

Hiding Behind the Scene: Old Regulations on Foreign Borrowings

It is ironic that many Indonesian private companies were crushed in a crisis caused by unmanageable foreign borrowings while the Indonesian Government has already been dealing with foreign borrowings for a long time. It was in 1972, when the President of Indonesia issued Presidential Decree No. 59/1972 on Foreign Commercial Borrowings ("PD 59"), an archaic regulation which has been almost totally forgotten by everyone though it is still a full binding regulation.

Under PD 59, certain restrictions were imposed upon Indonesian companies, such as:

• in case the borrowings involve the Government's guarantee, state owned companies are restricted to receive foreign borrowings without prior approval from the Minister of Finance (later on, the minister approval will be replaced by the approval of the Coordinating Minister of Economy, as the head of the Foreign Commercial Borrowing Team ("PKLN Team"), and the state owned companies are required to obtain prior approval from the PKLN Team before receiving any foreign debts, regardless of whether the Government acts as a guarantor or not to such foreign debts); and
• private companies must report their foreign borrowings in a periodical basis to the Ministry of Finance and Bank Indonesia.

What was the main reason for issuing this PD 59? The reason, I believe, is quite simple, i.e. to manage the currency risk of those debts by supervising those Indonesian companies. Most Indonesian companies receive their income in Rupiah, but when Indonesian companies receive debts in foreign currencies, they have an obligation to pay those debts in foreign currencies. Due to such discrepancy, there is always a currency risk, a time bomb which eventually will explode, destroying everything.

To cut it short, while the nominal amount of the foreign debts will not change, the real amount may change in correlation with the progress of Rupiah's value. If the Rupiah's rate increase, the companies are lucky, but if not, they will face some serious problems. Imagine if a company has too many debts in foreign denomination and at the same time Rupiah's rate falls drastically. With an increase in the actual amount of the debts and without significant additional income, could the company still afford to pay its debts? I don't think so. And if there are too many companies having the same problem, what would be the result? A financial crisis!

Therefore, in my opinion, foreign borrowings must be supervised, so that the risk can be maintained. Of course there is a question on how such supervision can actually prevent the crisis? Further, how should the Government balances the policy to maintain the flexibility for those private companies in raising foreign debts.

Current Condition: Not Much Improvement

Interestingly, there isn't much improvement since the fateful 1997 crisis. As I've seen during my practice, Indonesian companies are still happy to pursue foreign debts, whether through bilateral or syndicated loan agreements arranged by foreign commercial banks or issuing notes to international investors arranged by investment bankers. Submitting reports to the PKLN Team, the Ministry of Finance and Bank Indonesia for Indonesian private companies or obtaining PKLN approval for state owned companies before getting their foreign debts have become administrative obligations which have no value other than to secure a clean legal opinion from lawyers.

This is indeed a sad news, yet inevitable. Due to the lack of implementing policy, the PKLN Team has forgotten their own task, and I have a solid evidence for this. In one transaction, we were asked to give a presentation to members of the PKLN team on the roles and authorities of the PKLN Team relating to PKLN approval. I must say that this is quite hilarious.

That's why, it does make sense when I heard a rumor that the Government intends to revoke the 1972 and 1991 regulations. Why preserving regulations which don't have any efficacy, regulations which only create administrative problems for private companies and state owned companies when they are trying to raise foreign debts?

True, we cannot maintain ineffective regulations, but in the case of foreign debts, I believe that the Government is missing the main point. Such administrative measures were created to protect the interest of those Indonesian companies! Rather than revoking those regulations, why not improving their implementation? But I guess, the Government may have their own thoughts, and I assume that this is related to the separation of tasks between the Government, as the guardian of Indonesian fiscal policy, and Bank Indonesia, as the guardian of Indonesian monetary policy.

Latest Regulations on Foreign Borrowings

After going through an enduring period, Bank Indonesia issued Bank Indonesia Regulation No. 10/7/PBI/2008 on Foreign Borrowings of Indonesian Non-Bank Companies on 19 February 2008 which was further followed up by an implementing regulation in the form of a circular letter on 22 December 2008. Basically, this regulation requires Indonesian non-bank companies to submit periodical reports (annually or semi annually) concerning their financial viability (this include the submission of a report on their financial ratio and their financial statement) and risk management analysis before they obtain foreign borrowings in any form whatsoever. The regulation also requires these Indonesian non-bank companies to obtain ratings from local or international rating agencies for each debt that they would obtain. Those who are interested to see the form of the report can see it here.

The purpose of this regulation is to ensure that Indonesian companies have sufficient consideration and a proper risk analysis in determining whether they should pursue loans from foreign parties, whether they are banks, other financial institutions, or bonds investors. Bank Indonesia states in this regulation that foreign borrowing is one of the major factors which may affect the Indonesian monetary stability and the sustainability of the Indonesian economic development, and therefore proper supervision is needed.

In my opinion, this regulation is quite balanced. I don't think that it can significantly affect the flexibility of Indonesian private companies in raising foreign debts. On the other hand, the regulation might provide various useful guidelines for the companies in conducting proper analysis before they get those foreign debts. In other words, this regulation is a further advancement to the old 1972 and 1991 regulations which only required submission of simple reports.

The regulation also imposes sanctions in the form of warning letters and announcements to the public (domestic or international). This is a good move from Bank Indonesia and the sanction should be more effective than any other penal sanctions, since reputation is very valuable in the market, and no companies dare to risk their good reputation for unclear benefits. It should be noted though that the sanctions will be effective on 1 January 2010.

I have high hopes on the further implementation of this regulation. Getting many global debt offering and other international financing deals are good for lawyer's business. However, it is also important to ensure that we are not advancing these companies toward doom because of reckless debt policy. Bank Indonesia should be strict when it deals with this reporting obligation to ensure the compliance of the Indonesian companies. After all, these regulations are made to protect their interest in the long term and the regulation can be a good nudge for them.

I have discussed Law No. 24/2009 on National Flag, Language, Emblem and Anthem ("Law 24/2009”) in my post dated 27 August 2009. However, I feel that my analysis on the issues related to this Law 24/2009 is not complete, I am not satisfied with the legal analysis in my previous post and in practice, the impact of this Law is greater than I've ever thought to be. Thus, I believe that I must revisit the issues on Law 24/2009 and provide a deeper analysis in this blog.

Our main issue revolves around Article 31 of Law 24/2009. The first paragraph of this Article requires the use of Indonesian language in agreements involving state institutions, Indonesian government authorities, Indonesian private institutions or Indonesian individuals. The elucidation of Article 31 paragraph 1 states that an agreement in this context includes international agreements made within the framework of public international law.

Article 31 paragraph 2 of Law 24/2009 further states that if the agreements involve foreign parties, the national language of those foreign parties and/or the English language can also be used. Furthermore, the elucidation of Article 31 paragraph 2 states that if agreements are executed in multiple languages, i.e.: Indonesian language, the national language of the foreign party and/or English language, each version is equally original.

Although the above provisions look simple, they have triggered significant legal problems, i.e.:

• whether Indonesian companies are obliged to use Indonesian language in their commercial contracts since Article 31 paragraph 1 and its elucidation are not particularly clear on whether (i) the term “Indonesian private institutions” includes Indonesian companies or Indonesian branches of foreign companies; and (ii) the term “agreements” includes private commercial contracts;
• suppose they are obliged to use Indonesian languages, what would be the legal impact for any failure to do so? Is this is a mandatory obligation or merely an administrative requirement?
• with respect to dual languages contracts, whether “equally original” means that each contract must be executed as original (not merely translation) and if yes, whether the parties to such contract can choose non-Indonesian language as the governing language.

In practice, the impacts are disastrous, especially in relation to commercial contracts made between Indonesian and foreign parties. Most foreign parties fear that the failure of using Indonesian language in their contracts might cause the contracts to be annulled by operation of law due to breach of mandatory legal obligation. As a result, they act conservatively and request that the contracts must be executed in dual languages. Not only that this choice of action significantly delays the transactions completion and increases the parties’ costs, it also imposes unnecessary risks and liabilities, particularly because certain complicated contracts such as Indenture, Trust Deed and EPC Contracts are too technical to be perfectly translated into Indonesian language (which is a very young language compared to English). As a result of this and without any definitive meaning on the concept of “equally original,” parties are running the risk of executing a contract with misleading or incorrect terms and conditions.

While the fear is understandable, in my opinion, acting conservatively does not solve the problems and there are better ways to solve them rather than executing all contracts in dual languages format. First, we should refer to Article 40 of Law 24/2009 which stipulates that the use of Indonesian language will be further stipulated in Presidential Regulations. I appreciate the fact that the provisions of Law 24/2009 are still valid even without those Presidential Regulations. However, it also indicates that the provisions of this Law is not yet complete, which in fact is true. As a matter of Indonesian legal principle, when the text of the law is not clear, parties to a contract should not interpret the law for the detriment of any of the parties. If a party tries to annul a contract due to failure of using Indonesian language where each party to that contract is aware that having such Indonesian version would most probably cause adverse effect, it shows that such party has bad faiths and in my opinion the court should not grant the claim. After all, why forcing the parties to use Indonesian language if it does not give any clear benefit to them?

Second, Law 24/2009 does not provide for any sanction for failure to comply with the above requirements, and it is arguable under the general Indonesian legal principle that when a law provision does not have any sanction (or the sanctions are merely administrative), the failure of performing such provision cannot affect the validity of a legal act, i.e. the contract. This has been made clear in a famous landmark case where the Supreme Court decided that the failure of submitting a report on foreign loan (which is an administrative requirement under Bank Indonesia regulations) cannot be used as a valid reason to annul a credit agreement made between an Indonesian debtor and foreign creditors. While I understand that there is a previous case on the similar matter where the credit agreement was annulled, the latter precedent should prevail since it is in accordance with the correct interpretation of law and is closer to fairness, i.e. it is completely ridiculous and unfair to the creditors to invalidate a credit agreement due to the failure of the debtor to submit some administrative reports.

Therefore, I would suggest that in case a contract involves Indonesian and foreign parties, the parties should not execute a dual languages contract without first performing a complete analysis on the advantages and risks of having such format. Suppose they conclude that having a dual languages contract is not a viable option, I would suggest them to insert a clause stating that they have agreed to execute the contract in non-Indonesian language and that they will execute an Indonesian language version of the contract when the implementing regulations clearly oblige them to do so. This mechanic would be useful to prevent any party having bad faiths from trying to annul the contract.

On the "equally original" phrase, my suggestion is that the Parties involved must also insert a clause concerning governing language. It is indeed unclear on whether the equally original means that each language should be deemed as applicable. However, when in doubt, the Parties should not use an interpretation that harms them. In addition, why don't we refer to the freedom of contract principle? The Parties should be able to agree on the governing language of the contract, and therefore eliminating any risks to have misleading or incorrect terms. However, the main question would be: if the Parties execute the Indonesian language contract for the sake of complying with Law 24/2009 and the governing language of such Contract is non-Indonesian, what is the purpose of having an Indonesian version in the first place? Is not this a waste of time and money? The Government should answer this big question.

In the end, we can conclude that the existence of Law 24/2009 brings more problems than benefits in practice, particularly in relation to the use of Indonesian language. While, we can argue and use several solutions to solve the issues brought by Law 24/2009, it should be noted that there are no bullet proof mechanisms here. The courts could always have a different interpretation. So, let us hope that the Government can give us a better solution through the implementing regulations and the courts can decide based on the correct and fair interpretation of the law while we are waiting for the implementing regulations.

At last, the long awaited draft amendment to the VAT law has been passed by the Indonesian legislative board (the "New VAT Law"). You can see the soft copy here. The law will be effective as of 1 April 2010. The most important thing here is the fact that the New VAT Law recognizes the existence of Islamic finance and exempts VAT for transactions that fall under the term of Islamic finance. Article 1A Paragraph (1) h of the New VAT Law states that with respect to delivery of taxable goods by taxable entrepreneur in the context of Islamic financing activities, such delivery shall be only considered between the taxable entrepreneur and the party needing such taxable goods. While the elucidation of this Article does not provide specific explanation, it gives an example of a murabahah transaction for a vehicle financing, where an Islamic bank buys a car from a taxable entrepreneur based on an order from the Islamic bank customer. In this example, the New VAT Law acknowledges that under such Islamic financing structure, the Islamic bank would need to purchase the vehicle first and then resell it to its customer, however the New VAT Law further confirms that the delivery of such car is considered to be directly done from the taxable entrepreneur to the Shari'a bank customer. In other words, we can conclude that the New VAT Law acknowledges the role of the Islamic financial institutions as financial intermediaries. In addition to the above, Article 4A Paragraph (3) d of the New VAT Law states that financial services are exempted from VAT. The elucidation of such Article further states that the definition of financial services include Shari'a based financing, whereas the financial services may be in the form of: (a) leasing, (b) factoring, (c) credit cards, and (d) consumer financing. Although the above wordings are not clear enough to capture all kind of Islamic financing structure, I am still very happy with this new development as I believe that the New VAT Law might be the right trigger for bringing the Indonesian Islamic finance to a new level. As you may be aware, before the enactment of this law, there is a huge confusion within Islamic finance players on whether their transactions are actually exempted from VAT or not. To add the confusion, in most of the time, the tax authorities were silent on the tax treatment. In short, it was like sitting on a deadly time bomb. In my opinion, there should not be any confusion in the first place, since from the accounting perspective, these Islamic financing transactions are recorded as ordinary financing transactions in the balance sheets of companies that receive such Islamic financing (substance over form) . In other words, there would be no record of sale and purchase or sale and lease back transactions in the financial statements since those structures are merely used to satisfy the Shari'a aspect and do not reflect actual transactions. However, a risk is a risk and without having any tax advisor who is brave enough to issue a clean tax opinion, most Islamic financial institutions were not eager to develop the business in Indonesia. Thus, there are no significant development of Indonesian Islamic finance until today. Hopefully, this should be no longer the case. In addition to the above, further implementing regulations are still needed to resolve the remaining issues as provided below:

• Will there be any criteria to determine the transactions that fall under Islamic finance transactions? I guess the Government will need to stipulate such criteria to avoid any moral hazard from business players who are trying to avoid paying VAT under the disguise of Islamic financing transactions.
• It is unclear on how Ijarah transactions (lease structure) will be treated under the New VAT Law, since there is no transfer of beneficial ownership in an Ijarah transaction. Should the transaction be considered as an ordinary lease transaction? Surely not, but I would like to know how this will be solved from tax perspective.
• While Ijarah Muntahia bit Tamlik financing structure (sale and lease back) should be accommodated under Article 4A Paragraph (3) d of the New VAT Law, it seems to me that this article only applies to leasing companies. What about IMBT financing provided by other kind of Islamic financial institutions, such as Islamic banks? Is there any requirement for securing a leasing company license before the exemption works?
• What about Sukuk? From the original wordings, it seems that the New VAT Law only covers plain vanilla Islamic financing transactions conducted by Islamic banks.

I guess that would be the preliminary issues related to the New VAT Law. I will give more updates on this subject after the Government has issued further implementing regulations.

Please see here. This is the first time I am mentioned in a footnote. While there is nothing extraordinary with this, I am happy and appreciate the writer for using one of my articles (written with my partner) as a source of reference for his paper. There are still many things to come from the Capitalist Lawyer, and I'm planning to make all of those things happen.

Today is my 26th birthday, so in this special day, instead of writing and analyzing things, let me tell you some of my wishes and random thoughts on my most beloved subjects, law and lawyers. Enjoy!

1. I believe that laws should be made by professionals not some common people, i.e. the parliament, and I wish that we could achieve that as soon as possible. Of course, the process of recruiting those professionals should be made as democratic and transparent as possible. If not, then we would only have another despotic government.
2. I wish to have a virtual data base that has complete legal references and sources which have been systematically organized and all I need to do to find them is by one click. That would be glorious.
3. I wish that I could have more time in learning all the new things about law. Law is a never ending process, continuously evolving in order to achieve perfection. It is really frustrating that I can't follow all of those new developments.
4. Being a lawyer requires great intelligence, perseverance, persistence, and diligence, but none of them would be helpful if you don't have the passion.
5. Good lawyers love to be challenged, great lawyers surpass those challenges. However, always remember the golden rule of lawyers: Do not take responsibilities more than you are being paid for.
6. Never underestimate the usefulness of inputting your time sheets daily.
7. Commercial pragmatists are the next generation of lawyers, those who can smoothly combine superb legal knowledge with deep commercial understanding of the client's business.
8. Lawyers are consultants and therefore our job is to help our clients in making decisions not to make decisions by ourselves. See the golden rule above.
9. If you're only looking for the money, you should not work as a lawyer, since there are other jobs that will give you better income with less working time. But, if you're looking for a respectable profession that can satisfy your pride, you have come to the right place.
10. If you have worked as a lawyer for years and you still can't gain the trust of your clients, you should stop and pick another career. Without client's trust there would be no business development, no business development means no advance in career, so why bother working as a lawyer?
11. Doing you best is not enough to reach the top. Always try to surpass your own standard and never be satisfied with your performance even when you think that you have reached the top, there is always a room to grow, a room for improvement. Like my partner once said: "I could never be fully satisfied with my associates since I fear that once I tell them how satisfied I am, they would cease to improve their qualities."

If I could only complain one thing on the process of doing an initial public offering of shares in Indonesia, that must be the requirement for a proposed listed company to obtain from its creditors a waiver of any restriction on such company's capacity to pay dividends to its shareholders or any restriction of dividends payment on the subsidiaries level, provided that the proposed listed company income depends on the payment of dividends from its subsidiaries.

You will be amazed to know that this is not based on a strict regulation, rather it came from an unwritten policy of the Indonesian Capital Market and Financial Institution Supervisory Agency ("Bapepam-LK"). According to Bapepam-LK officials, when a company is trying to raise funds from the public, such company should be able to pay dividends to its shareholders since such dividends will become the main source of income for its shareholders. Therefore, any restrictions for dividend payment should be eliminated as well.

Okay, to certain extent the argument makes sense, but such argument is too simple to be used as a reason for forcing those proposed listed companies to obtain a waiver of their dividend payment restrictions. As far as I know, from the investors perspective, there are two main ways to obtain income from the capital market: (i) payment of dividends, or (ii) capital gain, i.e. buy low, sell high. In other words, dividend is not the only source of income, and in practice, not all investors focus on getting the dividends.

Furthermore, waiving the restriction of such dividend payment may significantly affect the possibility of securing a financing from financial institutions. As you may be aware, for companies, there are three ways of raising funds, i.e. (i) debt financing, (ii) equity financing, and (iii) hybrid financing (the combination of debt and equity financing). Some financial institutions would require its debtors to limit their payment of dividends to ensure that the debtors could have sufficient funds to repay their debts to these financial institutions. From my experience, there were some cases where the proposed listed company had to repay its debts because its creditors did not agree to waive the dividend restriction. If the debt is not huge, than that wouldn't be a problem, but if the amount is huge, the company will face a serious problem as getting the creditors approval might not be easy and the financial condition of the company may also be compromised.

I always believe that capital market regulations should focus on transparency, on how disclosures about the condition of publicly listed companies should be made, not on how they should perform or doing its business activities, that is the role of the management and that is why they are being paid. Forcing proposed listed companies to waive their dividend restrictions is essentially the same with limiting their choices between debt and equity financing, and I am sure that this is not efficient!

In my opinion, the most important thing is that the proposed listed companies have disclosed in their prospectuses that they have several debts and in those debts, they are being limited to pay dividends (fully or partly). If proper disclosures have been made, it is up to the investors decision on whether to invest in such companies or not. That would be the ideal things to have in Indonesia.

Unfortunately, this Bapepam-LK unwritten policy has not been revoked until today. The only thing that we could do now is to lobby Bapepam-LK and make them understand on this issue. Protecting Indonesian investors is very important, but we should also do that in a proper way, not by limiting the options of publicly listed companies, which in some cases, is actually counterproductive.

In the third and also the last part of my article, we will discuss the actual implementation of Kelsen's theory of law and why such theory matters. If you have read all of my previous related posts and you are still reading this post, I must first congratulate you for your persistence and patience. I hope this article would be useful to help you in understanding the basic characteristics of the law. 

In my opinion, the most important contribution of Kelsen's theory is the theory that the validity of the laws does not depend on their contents or the values represented by those contents but on: (i) how they were established (i.e. whether they were made based on a correct mechanism set out by higher norms), and (ii) the validity of the higher level's norms which enable those laws to be created. What are the implications? No matter how bad a law is drafted or no matter how ridiculous a law is, as long as the above requirements have been satisfied, a valid law is always a law and people should obey such law. 

Now, before you claim that I am a supporter of despotic governments who issue laws without any check and balance mechanism, please hold your tongue. If we know and understand that a valid law is still valid even though it is a very, very bad law, we must do our best to prevent such thing from occurring. Kelsen's theory is very useful here because it brings us to the cold reality, i.e., there is always a chance that a law is a bad law, and when such bad law is validly issued, it will become a valid bad law. Then, whether people like it or not, they would need to obey such bad law. 

Of course people can always disobey that law, but then they would live under the mercy of the officials who implement such law. While there are also mechanisms to review those bad laws in some countries, until a final and binding verdict is issued, those bad laws are still deemed to be valid, and there is no guarantee that the results would be in favor of those who oppose the enactment of such laws. 

The next important contribution from Kelsen's theory of law is the theory that essentially, law is the product of men, it is not created by divine powers or supreme intellects. While this concept has been already recognized under the positive theory of laws, Kelsen brings the concept to the next level. Again, this has a deep relationship with his concept about the validity of the law. By rejecting the theory that law is derived from specific values created by divine powers or morality, Kelsen established the concept that the validity of the law is not related to its content. I couldn't less agree. The reason is simple, we can easily assess whether a law is made through the correct mechanism but we can't asses the correctness of a moral or religious value that becomes the underlying principle of the law. Determining the validity of the law based on its values would be horrendous because we do not have a universally acceptable standard and people could always challenge the validity of the laws by too many reasons. 

There are also other consequences of Kelsen's theory. I know that some prominent legal scholars believe that laws should reflect the values of the society where the laws were enacted. To certain degree, that might be correct, but not always. Imagine the new Qanun in Aceh that permits stoning for adultery. You can see my related post here. The Qanun makers stated that the Qanun is issued in accordance with the cultural believe of the Aceh's society. Assuming that this is true, can we accept this kind of law as the right one? I would say no! And I believe that most people would say the same. According to Kelsen's theory, the Qanun is a valid law. But how about those who believe in the relationship between law and society. Would they have the same view about the validity of this absurd Qanun? Kelsen's theory enables us to have a scientific method in assessing the validity of the law and we should be grateful for that. 

Last, but not least, Kelsen's theory of law helps us to understand the nature of the hierarchy of laws which is very useful when we need to analyze different ranks of law and determine the validity of a law's provision. In Indonesia, Kelsen's concept has been implemented in Law No. 10/2004 on the Stipulation of Regulations where it states the basic hierarchy of Indonesian regulations and stipulates that the power of a regulation corresponds with its level in such hierarchy. There are a huge number of laws out there and there is always a possibility that some laws contravene other laws. 

This is especially right when we are dealing with the laws of a developing country where the laws are not well harmonized. Without a clear concept of the hierarchy of law, we would be confused in determining which law should be applied where there were two or more contradicting laws. By using the hierarchy of laws and the fact that this concept has been implemented in Indonesian regulations, we would have a solid basis in determining the applicability of valid laws in accordance with its level in the hierarchy, i.e. lower level laws cannot have provisions that contravene the provisions of the higher level laws. If such contravening provisions exist, the provisions of the lower level laws should be deemed as inapplicable. I encourage all lawyers to learn and to fully understand this concept as this is one of the basic skills in doing their job analyzing the regulations. 

We have discussed some important implementations of the Pure Theory of Law and I hope that the discussion can enlighten us with respect to the nature and function of law. In the end, law is the product and tool of men, and therefore, it is up to us to make a law that can bring the greater goods to the society. We also know the danger of having a valid bad laws and we must do our best to prevent such thing from ever happening. Therefore, in the future, I hope, that the drafting of laws could be done by professional legal drafters supported by greater participation of the society.

I can't stop laughing with this great piece of article from Greg Mankiw. Sigh, if only the Nobel Committee also gives Nobel Prize in laws, I should also be able to make this parody, hahaha. Anyway, it's a very good parody which questions why Obama is named as the winner of the Nobel Peace Prize. Enjoy, and don't forget to see the link in his post.

Here is a very concise article about the role of the Government. A must read for those who would like to understand policies differences between the "big" and "small" government. I can understand why most people will be in favor of the "big" government" during the term of crisis. We love saviors aren't we? For most of us, those smart looking officials seem to have all what it takes to save the country (and ahem, I'm not referring to the officials of my country).

Well, you better think again. I agree that the government must have a role in the development of a country, or else why we need to have a government in the first place? But we must also acknowledge the limitations of the government. They are, after all, made from the people and they definitely could not know and understand everything, including the entire risks and benefits of their policies. A good government should know when to stop making policies to avoid over regulation which could turn into a mess in the long term, or even in the short term.

By the way, hat off to Mr. David Brooks for his intelligent and easy to understand analogy.

In the first part of my article, we have discussed the basic concepts of Hans Kelsen's Pure Theory of Law. In this second part, we will discuss the concept of Norms, and the relationship between efficacy and validity of the law.

Norms, the Hierarchy of Norms, and the Basic Norm 

A discussion on Kelsen's theory of law wouldn't be complete without discussing the Norms. As I've said previously, according to Kelsen, the law can be viewed as a specific social technique and as a norm. What is a norm? Kelsen describes norm as a rule expressing the fact that somebody ought to act in a certain way, without implying that "anybody" really wants the person to act that way. Further, Kelsen also defines norm as an impersonal and anonymous command (this is made by Kelsen to counter argue John Austin's definition of law, i.e. law as a command from a sovereign). 

From his definition, we can conclude three important concepts: (i) a norm is a rule that provide certain "guidelines" to its intended subject whereas such intended subject is ought to follow such "guidelines", (ii) a norm is neutral, it is not representing the will and interest of certain people or entity, and the most important thing is (iii) the validity of the norm is not related to the entity which stipulate such norm (that's why it is considered as an impersonal and anonymous command) but on the validity of the norm which gives authority to such entity. 

Following Kelsen's way of thinking, the validity of a norm (let us call it as Norm No. 1) shall be determined by the validity of the norm having the authority to create/establish Norm No. 1 (let us call this second norm as Norm No. 2) in accordance with the procedures stipulated by Norm No. 2. Logically, Norm No. 2 should have a higher level than Norm No. 1 and both should exist in the same order/system. If not, how can Norm No. 2 create and determine that Norm No. 1 is valid? Thus we've seen the birth of the Hierarchy of Norms. Pretty simple, eh? The process shall be repeated until we reach the highest level of the Hierarchy of Norms, where we will find the Basic Norm. What are the characteristics of the Basic Norm? 

Let me give you an example: Why we stick with the 1945 Constitution and consider it as the basis of all laws stipulated in Indonesia? It is not a sacred document created by God, in fact it is a document made by a bunch of people that we call as the Indonesian founding fathers, which was later amended by the Indonesian parliament. It was once replaced by another constitutions and then we returned to use it using a decree of a president which is obviously has a lower status than the constitution. Yet, we're still using the 1945 Constitution and we still believe that all regulations in Indonesia should not contravene the 1945 Constitution and that all regulations in Indonesia obtain their validity since the 1945 Constitution allows the stipulation of laws and regulations. Yes, 1945 Constitution can be considered as a Basic Norm, but is it valid because it corresponds with justice or the interest of all Indonesian people? Not necessarily. It was not even drafted by the entire Indonesian people, rather it was made by a committee whose most members were appointed by Japanese government. It is without doubt that some Indonesian people might have different views with the idea of such committee and the content of the 1945 Constitution. Even the drafters of the 1945 Constitution and its amendments could have different views among themselves when they draft the 1945 Constitution. 

So why? Why we still use the 1945 Constitution? The answer lies in Kelsen's theory, the 1945 Constitution is valid and becomes the source of all Indonesian laws because we assume that the 1945 Constitution is valid. That is the only logical explanation, the principle of legitimacy. That's why Kelsen acknowledged in his "General Theory of Law and State" that the Basic Norm of a legal order can be replaced by a revolution which include the so-called coup d'etat. 

Validity and Efficacy of the Law 

Before we move on, let me explain first the meaning of efficacy. Efficacy of the law means the effectiveness of such law with respect to its effect to the society, i.e. the degree to which the law is being actually complied by the society. It is common for us to see laws which are so ineffective that the existence of those laws mean nothing to the society, and other type of laws which are very effective and have a high rate of compliance. The main question is, can we consider a law that is not efficacious as a valid law? In Kelsen's opinion, consistent with his theory, the efficacy of the total legal order is a condition for the validity of the relevant Norms, but not the reason for their validity, because the validity of a Norm depends on whether it is created in a constitutional way or not (please refer to above discussion on the Hierarchy of Norms). Therefore, the degree of compliance of law does not affect the validity of such law. In other words, it is possible for us to have a valid law which has a low degree of compliance or no compliance at law. 

One example that I could think of would be the regulation that obliges companies that have trade business licenses (SIUP) to submit periodical reports to the Department of Trade. Based on my experience, the percentage of non-compliance for this particular obligation reaches 99.9999%. Pretty amazing! 

There is more to it. Kelsen also acknowledged that a law/norm wouldn't be valid anymore if the total legal system has lost its efficacy. Theoretically, this is correct. Suppose the current Indonesian legal system loses its efficacy, say because of a revolution, where the 1945 Constitution is entirely dismissed and replaced, and the government has been toppled up. Unless there is a new constitution having a transitional provision which says that the remaining laws remain to be valid, we would lose the legal basis to consider that such remaining laws are still valid. However, since the possibility of having such worst case scenario is very rare, we could stick to the basic principle of the Pure Theory of Law, i.e. the efficacy of the law does not affect the validity of such law. I believe that this is a very important concept having significant practical implications, and we shall further discuss such implementation in the last part of my post, where we shall also discuss the implementation of other parts of Kelsen's Pure Theory of Law.