Crux (#03 March 2015)

The Age of Commotion

The turbulence within the Ukrainian banking system and policy of the National Bank of Ukraine are at the epicenter of public attention. Almost like in 2008, the banks and their clients have become hostages of imbalanced credit policies and insufficient risk analysis. “Clearance” of the sector and unconventional consolidation is already on its way.

On the other side, the dramatic depreciation of the national currency, almost absent international funding, entailed local and cross-border restructuring of debts. It raises many issues regarding lenders’ rights protection when the currency control measures hinder their confidence and secured assets are located in the annexed Crimean peninsula or Anti-terrorist operation zone.

In recent years, corporate borrowers have increasingly received loans from abroad. In 2014 a new wave of international restructurings began. What methods of international debt restructuring are usually applied? Which of the proven methods of international experience cannot be applied to Ukrainian borrowers due to restrictions on the part of Ukrainian legislation?

Artem Shyrkozhukhov,

associate, Avellum Partners

As every Tom, Dick and Harry is dis­­cussing Ukrainian problems, there is no wonder that problems are avalanching upon businesses too. Coupled with their own internal issues, some borrowers see no other option than to seek debt restructuring. In 2014, we entered the age of restructurings where so far there have been one visible stream and an undercurrent.

By the visible stream I mean restructurings of Eurobond issues with 6 deals closed last year and a few more likely to follow. Ukrainian businesses sought and got approval of bondholders to exchange all or some of the existing notes for notes with extended maturities and other terms amended. Negotiations with syndicated and bilateral lenders proactively or in the face of existing defaults have been the undercurrent and obviously remain confidential for the time being. However, I expect that there will be more of those in 2015. The biggest legal challenge for restructurings is that Ukrainian law on consensual restructurings is far from perfect. Many lenders are looking for an instrument like the scheme of arrangement under English law that would work in Ukraine and be recognized in major jurisdictions abroad. Although a prototype emerged after the 2013 revisions of Ukrainian insolvency law for general corporates, this instrument is still in its infancy with many pitfalls which may render it not very attractive. For now, no such tool even exists for banks which are subject to a different insolvency regime. It is a high time for Ukrainian legislation to develop in this area.

How do you assess the efficiency of existing restrictions on foreign exchange regulations? How does the ban on the early repayment of loans by non-residents affect relations between Ukrainian borrowers and foreign creditors?

Gabriel Aslanian,

counsel, Asters

The protective measures declared to be temporary and introduced by the National Bank of Ukraine (the NBU) in late 2013 to rescue the hryvnia from the effects of Ukraine’s geopolitical conflict with Russia and the resulting economic crisis were enhanced throughout 2014 and are in force to this day. Apart from the mandatory NBU registration of cross-border loan agreements, whose requirement was introduced long before the current events, there were relatively new rules significantly affecting the currency regime applicable to cross-border financing.

One of the new rules most frequently criticized across the market is the mandatory sale of foreign currency proceeds. With certain exemptions (e.g., made for transactions involving international financial institutions, of which Ukraine is a member), this requirement applies to 75% of any foreign currency proceeds of Ukrainian companies. In cross-border financing transactions, the mandatory sale requirement has resulted in additional conversion costs for local recipients using the foreign currency proceeds for payments under other cross-border contracts.

In early 2014, the NBU prohibited purchase of foreign currency for early repayment of loans, whose limitation was later substituted with a general prohibition of prepayment of the cross-border loans. On a case by case basis, the prepayment prohibition was applied by the NBU to interim payments under loan agreements if such payments were made ahead of the schedule of payments previously notified to the NBU. The prepayment prohibition has been in force for a year now and has proved to substantially affect Ukrainian borrowers’ regular settlements with foreign lenders.

How can the situation with troubled banks be improved? Do you expect consolidation of the banking system? Will the state attempt to return banks’ debt to depositors and creditors by distributing the shares of troubled banks? Are there any other ways in international practice of settling the debt of troubled banks? Are they acceptable for Ukraine?

Denis Kulgavyi,

associate, Aequo

Apparently, it is not the number of small banks itself that caused the ongoing banking crisis in Ukraine but the “pocket” nature, the low asset quality and poor management of those failed banks. Consolidation of the banking system would definitely have a positive effect on resolving the crisis (and this is what’s being reiterated to Ukrainian authorities by IMF). In fact, consolidation has already been launched but takes a special form in Ukraine. What happens now is more of a squeezing out of unviable banks than a “classic” consolidation. Although the existing bank resolution scenarios are generally in line with best world practice, in reality the Ukrainian Deposit Guarantee Fund ends up with the liquidation scenario in most cases due to no interest of potential investors caused by the lack of liquidity in the system and low quality of assets. Less “painful” options — such as acquisition of an insolvent bank or its assets and liabilities by an investor can hardly be implemented in practice. We see no apparent need to implement any additional resolution instruments at this stage. In particular, the bail-in mechanism common in some banking systems is not now timely in Ukraine. Obviously, where the chances to rehabilitate an insolvent bank are minimal an exchange of deposits for shares is not just a solution. In terms of possible ways to improve the legal framework the focus should be moved to the stage preceding the resolution itself, when a bank is only classified as “problematic” by the NBU. At this early stage shareholders often strip the bank of assets. Such abuse is feasible due to the absence of effective preventing mechanisms (such as the regulatory authorities taking over the management in a pre-failed bank by the regulatory authorities and bringing beneficiaries to personal liability for the misuse). These issues are now the focus of the National Bank and, hopefully, a new legal framework will be in place soon.

What is the general practice of fulfilling surety agreements pertaining to credits? What problems do lenders face in foreclosure cases?

Igor Reutov,

attorney, Gramatskiy & Partners

In Ukraine loans are commonly secured by mortgage, surety or lien, whereas floating charges are rarely accepted by the providers of credit facilities. Analyzing general tendencies in the operation of secured loans it should be observed that almost in all cases sureties strive to avoid performance under collateral agreements. Thus when a creditor triggers the procedure of enforcement of a security he often faces impediments erected by a surety. Generally, sureties undertake to challenge collateral agreements and further to transfer ownership in the assets which are subject to lien to affiliated companies. It is noteworthy that a lien (or a mortgage) usually does not involve transfer of possession to a creditor, thus the latter has no actual control over the assets of a lienee or a mortgagor. Although all types of security interests over real estate and chattels are subject to state registration (the former is registered mandatorily, the latter — voluntarily), such registration can be challenged by the interested parties. In attaining these purposes sureties are “assisted” by the courts which deliver dubious decisions. It should be mentioned that a court decision enters into effect 10 days after its delivery (if not appealed), or immediately after a court of appeal has issued its ruling. Submission of the second appeal does not deprive a court decision of its force. Therefore, by the moment the court of cassation overrules a dubious decision the assets which are subject to lien (or mortgage) have already been dissipated in most cases.

What are trends of judicial practices in settling disputes on the invalidation of loan agreements?

Alexandra Fedorenko,

senior associate, Antika Law Firm

The financial crisis caused a situation where a lot of people found themselves unable to service their loan. Due to this a number of loan disputes with banks as well as cases with the participation of the banks are increasing day by day. One of the instruments that borrowers use to terminate relations with the bank is to declare the loan agreements as null and void through legal proceedings.

Nowadays, court practice on this issue has been established and it is quite definite. General practice shows that the courts render decisions in favor of banks during attempts to declare agreements in foreign currency as null and void. Such practice was established taking into account the position of the Supreme Court of Ukraine according to which reasonable grounds for a bank to give a loan in foreign currency is its general license to perform foreign currency operations.

At the end of 2014 the Supreme specialized court rendered a decision to stipulate that if a bank fails to provide the consumer with full information on loan terms, preliminary average cost of the loan in written form prior to conclusion of the loan agreement it is considered as a violation of p.2 of p.1 of Article 11 of the On Consumer Rights Protection Act of Ukraine. Having rendered such a decision, the cassation court assumed that such a violation was considered to be unfair related to the borrower, contradicted the principle of voluntariness as well as led to significant misbalance of contractual rights and obligations and made the position of the consumer even worse.

What priority legislative changes are expected in the banking legislation in view of the implementation of the EU — Ukraine Association Agreement?

Yevgen Blok,

senior associate, Integrites

The EU — Ukraine Association Agreement directly stipulates that Ukraine shall approximate its legislation to that of the EU and in particular to those elements of EU acquis referred to in Annex XVI to the Association Agreement.

In the banking sector Ukraine shall, within 6 years from the date of EU — Ukraine Association Agreement, implement the provisions of 13 Directives into national legislation. Among others, Ukraine shall enact provisions of the following EU Directives: Directive 2006/48/EC relating to the taking up and pursuit of the business of credit institutions (recast); Directive 94/19 EC on deposit-guarantee schemes; Directive 2009/110 EC on the taking up, pursuit and prudential supervision of the business of electronic money institutions; Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (revised) and others.

It is worth mentioning that Ukraine has already taken certain steps to implement some provisions of EU Directives into national laws. For example, the amendments to regulation of e-money adopted by the NBU in July 2014 and providing for limitations regarding amounts of e-money to be used within a calendar year, in principle reflect the provisions of the respective EU Directives. Following the CMU’s action plan on implementation of the EU — Ukraine Association Agreement for 2014-2017, the primary legislative amendments into the banking sector would apply to preventing money laundering and financing of terrorism through the financial system.

To what extent is Ukraine’s default probable and what implications can it imply for the banking system?

Nazar Chernyavsky,

partner, Sayenko Kharenko

Many people were talking about sovereign debt default of Ukraine throughout 2014, but there were no major payouts scheduled last year and the country entered 2015 in the same shape. On the contrary, in February 2015, along with another round of Minsk peace talks, the country was promised a lucrative USD 40 billion bailout package from the IMF and the countries standing behind it, with the first USD 16 billion coming directly from the IMF. Slightly before that, the Finance Minister indicated that Ukraine was going to hold consultations with the holders of its sovereign debt with a view to restructure it, and that news has not caused any major commotion in the market.

At the same time, one of the conditions of the bailout package was the successful track record of implementing reforms, and Ukraine has yet to demonstrate this. So far, none of the donors has expressed happiness with the pace or substance of the reforms by the new Ukrainian government.

There are more factors to take into account — in particular, whether the Russian debt holders (or the holder, which is deemed to be the Russian state) would agree to any restructuring. It is not likely that Ukraine would repay USD 3 billion to Russia now, at least for political reasons. The default on those notes would cause cross-default on most of the other debt instruments, and whoever were to run any wide scale debt restructuring would have to find a way to carve out that debt from the relevant cross-default provisions.

Accordingly, so as to avoid default on its obligations Ukraine will face the tough task of showing to the whole world that it can be trusted and just needs a little bit of time (and extra money) to overcome its hardships, so that in the long run it can provide a better return.

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