Ukraine: Transnational Lending Structure: Ukrainian Case

Emerging markets require capital inflows and are sensitive to any outflows. Implementing structural reforms in the economy, the government and regulators in Ukraine face this dilemma and always need to balance the interests of capitalism’s "invisible hand" and sustainable growth of institutional development. The convertibility of capital accounts remains a critical issue before the Ukrainian economy graduates to "market status" under the laws of its major trading partners.

Overall, the Ukrainian government and parliament have been acting act on the premise that the emerging market in Ukraine is attractive enough per se, being geographically close to the EU, having rich mineral resources, relatively inexpensive and skilled labor, good transit opportunities, etc. The regulatory regime for foreign investment emphasizes the procedural side; the laws and regulations related to foreign investment are inclined to stress governmental control rather than guarantees and compensation to foreign investors. It is expected, therefore, that the change of government that occurred during the Orange Revolution will foster investment inflow, however certain restrictions on repatriation of capital will remain and may have inertia to develop further.

That being said, one may rightfully conclude that despite their low capitalization, Ukrainian banks enjoy a large market share of corporate financing in absolute terms or when compared with other East European countries. Corporate borrowers strive for larger and cheaper financing, even when using it to repatriate capital.

This material is based on the assumption that borrowing is made at arm's length or has the purpose of an arm's length transaction. The object of this article is to overview certain legislative obstacles that transnational lenders may face when applying their traditional loan facilities structures.

Ukrainian companies and individual entrepreneurs are generally capable of borrowing (entitled to borrow under the law) from foreign lenders. As a general condition, the parties should be able to enter into the loan transaction under their respective constitutional documents and under the law. The recent legal reform has made foreign lending controversial. Despite praise, the new Ukrainian Civil Code does not address international finance operations and leaves issues of foreign trade operations in limbo. Moreover, the Civil Code defines the loan arrangement as an operation between a borrower (individual or corporate) and a "bank or other financial institution." In other words, borrowing from a lender that is not a bank or financial institution would not qualify as a loan operation and the parties to the transaction would find themselves under an uncertain regulatory regime. In the worst case scenario, the operation may be invalidated due to the parties’ incapacity to enter into the loan agreement.

To ensure that the lender is a bank, the borrower may review the lender’s banking license and articles of association. The definition of a "bank" is provided in Article 2 of the "Banks and Banking Activities" Act dated 12.07.2000 (the "Banking Act") which stipulates (i) a banking license and (ii) constitutional and exclusive licensed capacity to attract funds from individuals and legal entities and allocate funds accordingly, as well as to open and maintain bank accounts. Obviously, foreign banks do not fall within this scope – the National Bank licenses only legal entities incorporated under the laws of Ukraine.

Dealing with financial institutions is a bit more complicated. They are defined in Article 1 of the "Financial Services and State Regulation of the Financial Services Markets" Act dated 12.07.2001 (the "Financial Services Act") as legal entities that (i) in accordance with law provide (ii) one or more financial services and (iii) are registered by the regulatory body. Financial institutions include, but are not limited to, banks, mutual funds, credit unions and other companies that provide financial services only. This, however, does not exclude other companies from providing loans under Ukrainian law, i.e. from being financial companies, as the law generally allows any legal entity to enter into any type of transaction not otherwise prohibited. Thus, for a legal entity to become a financial institution, it needs to provide financial services and apply for registration with regulators – the State Commission on Regulation of Financial Services Markets of Ukraine (the "FSC").

The law defines financial services as "operations with financial assets" and such services can be generally interpreted as transactions with monetary means, including commercial and interest-free loans. Moreover, lending of money by means of attracted (borrowed) funds - typical activity of banks and credit unions - must be licensed in Ukraine. Loan subsidies to Ukrainian subsidiaries (or loan vehicles for repatriation of profit) also fall under the definition of financial services. The conclusion, on one hand, is disappointing; unless an entity is in the register of financial institutions, it may not be a lender under a loan agreement.

On the other hand, the Economic Code of Ukraine (aka the Commercial Code) in Article 388 provides for the general right of Ukrainian legal entities (without limitation to commercial enterprises) to borrow from foreign lenders. The term "foreign financial institutions" used by the Economic Code in this instance differs from the terminology used in other laws. Although "financial institution" is generic for "foreign financial institution," the latter term is not used anywhere else but in the Economic Code. Foreign lenders exploit this loophole to argue that direct lending is possible without FSC registration (and licensing, as the case may be). The argument, in essence, stems from the National Bank of Ukraine regulation on foreign currency loans from non-residents: the lender should qualify as a financial institution under the laws of its incorporation (residency). For example, an Austrian bank that lends to a Ukrainian company must qualify to lend under Austrian laws and this will be sufficient to lend in Ukraine.

The issue becomes further complicated when the parties use complex financing, involving creation of special purpose vehicles (SPV), assignments of the lender’s rights, trusteeship structures, etc. Such structures and SPVs are usually not financial institutions as far as their core activities are concerned.

This argument has yet to be tested by Ukrainian courts, however foreign insurance companies have already encountered a direct prohibition on sale of insurance policies to Ukrainian customers. Under Ukrainian laws, the FSC has more leverage on insurance activity, but the legal ground for prohibiting unlicensed financial services is the same. Simple as it is, such argumentation cannot be stretched any further; conducting any other banking activity in Ukraine would require a banking license. Besides, the argument does not involve the choice of law provisions of the lender’s jurisdiction, which may require the lender to comply with Ukrainian lending regulations.

At the same time, the FSC has enacted regulations on financial services by legal entities that are not financial institutions under Ukrainian law. Such a legal entity, regardless of residency, must file for the FSC record if it provides financial services and (i) the amount of a single transaction exceeds UAH 80,000 (approximately USD16,000) or (ii) within each calendar year it concludes three or more agreements on financial services with customers. Prima facie, foreign lenders do fall within this definition and thus will have to adhere to the restrictions sooner or later. Like no other type of financial services, Ukrainian laws allowed lending by individuals and corporations, foreign and local, until the end of the 1990s when financial lenders were only corporations limited by tax laws. Historically, the legislative codification of the financial services regulatory system took until mid 2001 and many of the provisions have yet to be implemented.

This situation remains unresolved in another respect as well. The National Bank’s regulations on international lending practices do not address the issue of FSC licensing or registration at all. The fact remains that the Financial Services Act and Banking Act require licensing of lending activities in Ukraine, despite the National Bank’s authority to regulate licensing and banking activities in the country. It also may be argued that the National Bank of Ukraine regulation on foreign currency loans does not relate to the borrowing transaction per se, but to foreign currency regulations and control. Thus, the "foreign financial institution" argument exploited by foreign lenders may appear as dictum or secondary issue in a court’s ruling on foreign lenders’ capacity to provide loans in Ukraine.

Ukrainian foreign currency laws and regulations give wide leeway to regulatory activities by government agencies. The rationale behind this is that Ukrainian economic institutions remain emerging and require extensive work to secure the sustainability of the hryvnia and the convertibility of current and capital accounts. The system of control is based on a 1992 Decree of the Cabinet of Ministers, which has the effect of an act. Although outdated in some respects, this system provides for comprehensive control over foreign currency circulation in the Ukrainian economy.

Foreign currency transactions may be conducted only by licensed banks or under individual license of the National Bank of Ukraine, unless they fall under listed exceptions. Receipt of loans and payment of interest thereon falls under the exceptions and such transactions do not require licensing unless "their terms and amounts exceed the limits established by Ukrainian legislation" (Currency Regulation and Control Decree, Article 5(a),(в)). The laws of Ukraine do not provide for any particular limit on terms or sums of loans in foreign currency. However, the National Bank of Ukraine effectively limits foreign borrowing by requiring comprehensive loan agreement registration prior to receipt of funds. This registration requirement is established through the all-encompassing authority of the National Bank of Ukraine to determine "importing, transferring and wiring from abroad as well as exporting, transferring and wiring abroad procedures" (Article 3 of the "Currency Regulation and Currency Control System" Decree). The requirement to register all loan agreements arguably places excessive burden on Ukrainian borrowers, nevertheless the respective regulation has never been subject to dispute in court.

The non-cash form of loans also places an effective restriction on the banks that may hold borrowers’ accounts. A borrower's bank must have a general license issued by the National Bank for transactions in foreign currency. Most Ukrainian banks hold such a license, but lenders should be aware that it is not automatically granted to a banking institution holding a general business license. Besides, a Ukrainian borrower that has run into difficulties in its foreign trade operations may not be able to borrow from a foreign lender if government agencies have penalized the borrower by individual regime of the foreign economic activity. Consequently, the borrower may not be able to refinance itself directly, however an SPV usually settles the problem.

The foreign currency received from a lender on accounts at a Ukrainian bank is subject to mandatory sale as established by regulations of the National Bank of Ukraine. Currently, 50% of the loan facility must be sold on the interbank currency exchange (UICE or UMVB) within five days of receipt. Due to the limited number of participants and frequent interventions by the National Bank, rate fluctuations caused by the large supply of borrowed money may negatively affect the borrower's financial status. Accordingly, to repay the loan and interest thereon, the borrower often has to purchase foreign currency on the UICE and bear the risk of fluctuations. Moreover, as the borrower usually does not have direct access to the UICE, it must act through an agent bank and pay commissions and fees for the agent services.

The laws of Ukraine also require registration with the National Bank of Ukraine of any service contracts that provide for service fees in excess of €50,000, or equivalent. The registration requirements are comparable to those for the loan agreement. Any price deviations from generally accepted practices may require additional expertise to substantiate such price. The arrangement services (mandate letters, arrangement fees, legal fees, trustee services and other associated expenses) on the financing are usually not registered separately - that is, apart from registration of the loan agreement. However, as long as these services constitute a separate function of the lender or its affiliate (i.e. acting as the borrower's agent rather than as a lending party), the National Bank of Ukraine may arguably require additional registration of the service agreement and substantiation of the fees paid.

Unlike in any other cross-border transaction, a loan agreement with a Ukrainian borrower must comply not only with Ukrainian laws (acts of parliament, that is) but with Ukrainian regulations as well. This peculiar requirement concerns the currency transactions regime - a sensitive issue for the Ukrainian economy. Requirements of the Economic Code (Article 388 referring to compliance with regulations) and of the "Foreign Economic Activities" Act dated 19.04.1991 (Article 6 referring to compliance with laws) should always be born in mind. This is especially important for loan agreements under which the parties attempt to avoid uncertainties of Ukrainian laws by choosing foreign (non-Ukrainian) law to govern the agreement. The most commonly used foreign laws are those of the main financial centers of the lending world: English law, U.S. law (e.g. State of New York), and German Law. Although a huge source of export capital, Japan is not proactive in the Ukrainian capital market. There are only one or two transactions contemplated, both based on Japanese government (or government-backed) development programs.

The form of a loan agreement should comply with both Ukrainian laws and the laws of the place of its formation. Under Ukrainian law, loan agreements must be in writing and registered with the National Bank of Ukraine prior to disbursement of funds. Thus, the currency and registration requirements are to be strictly observed or the parties may face invalidation of the agreement altogether. In particular, the loan should be granted only in a non-cash form and, as mentioned above, from a qualified financial institution regulated by the laws of the respective jurisdiction. Performance under the loan agreement requires specific documents provided for by Ukrainian regulations. Proof of receipt of funds would be originals or certified copies of the payment documents. Moreover, the structure of the loan may only include two types of facility:

1. import (pre-export) finance, where the lender directly pays the exporter abroad for export of goods to Ukraine, and the borrower assumes the obligation to repay the loan, and
2. direct transfer of funds to an account of the borrower in Ukraine or abroad.

Issues of notes directly by Ukrainian companies are subject to registration with the Ukrainian Securities and Exchange Commission or special resolution of the Government of Ukraine, which no Ukrainian issuers, except the sovereign, have been able to procure. The structure of bond financing, therefore, has been limited up to now to subordinated loans through an SPV or through an underwriter acting as an issuer.

The National Bank of Ukraine also sets the ceilings for the interest rates on fixed and floating rate loans (inclusive, arguably, of other forms of debt), currently being as follows:

1. for floating interest loans: 3 month US dollar LIBOR + 750 basis points, or equivalent;
2. for fixed interest loans: borrowings up to 1 year - 9.8%; 1 to 3 years - 10%; and over 3 years - 11%.

For interest ceiling calculation purposes, the NBU also includes commissions, fees, penalties and other payments under the loan agreement. Although the NBU claims that its ceilings relate to sovereign borrowing (by the Government of Ukraine), it is interesting to note that Ukrainian banks lend US dollars at 13-14% interest rates on 3-year loans. These interest rates are free of disbursements and fees payable on arrangement of the loan.

Borrowers will not be able to transfer funds from Ukraine to pay interest, service fees or principal, unless every currency restriction above is satisfied. The only exception is sovereign borrowing and government-backed loans.

Another difficulty may face the common mechanism for payment of loan arrangement fees and related services. The offset mechanism may not work, as the National Bank of Ukraine requires that the funds repaid by a borrower correspond to the funds "actually received." Lawyers disagree over the risks associated with this gray area. Moreover, another regulation of the National Bank requires that the borrower apply for a single permit each time to offset claims in foreign currency. Therefore, it may be advisable that the borrower pay for the loan-related services in advance or on the same day as disbursement of the loan funds.

In relation to arrangement fees and related services provided by an arranger, Ukrainian borrowers also generally request certificates of services rendered or of works completed to evidence fulfillment of obligations under the contract in foreign currency. For international contracts, settlement in foreign currency is subject to severe penalties under provisions of the "Settlements in Foreign Currency" Act of 23.09.1994. In effect, this act makes it illegal for Ukrainian companies to pay advances for services in foreign currency, unless the advance period is 90 days or less. Any delay in receipt of services or return of consideration would subject the Ukrainian payer to a penalty calculated as 0.3% of the advance per each day of delay.

Gross up provisions in a loan agreement are another terra incognita for the regulatory regime in Ukraine. "Gross up" usually refers to the borrower's obligation to indemnify the lender from risks of changes in tax legislation or application thereof by agreeing to an increased interest rate payable on the loan facility. To provide a brief background, a Ukrainian borrower must withhold 15% of the Ukrainian profits tax from the interest payments to the foreign lender or the maximum rate under the Double Tax Treaty. Ukraine's over 50 effective treaties provide a lower rate of the withholding tax on loan interest, usually up to 5%, which mirrors the tax practice of the counterparty. Withholding on payments to UK residents, however, is as low as 0%; interest for Austrian and German borrowers is taxed at a 2% rate if paid to financial institutions, and 5% if paid to any other lenders. Application of lower withholding rates is subject to various conditions and exceptions with the least interpretation and application in the Ukrainian legal system. Therefore, flaws in tax regulations on gross up provisions are usually interpreted in favor of lenders. Until courts uphold the gross up clause, however, lenders are advised to have additional indemnification clauses in loan agreements.

Sophisticated lenders regularly use assignment of rights and obligations under loan agreements, which has yet to be tested thoroughly by courts of Ukraine. It is also expected that courts will interpret the collateral issue - definition of lender (see discussion in the previous section). The same applies to choice of foreign courts for dispute resolution. In the draft law currently being considered by parliament, parties are allowed substantial leeway for choosing the dispute resolution rules. However, the new Civil Code and Economic Code do not provide for conflict of law rules and make choice of judicial forum a gray area of law. Besides, unlike the arbitration clause, the jurisdiction and judgments of foreign courts will probably not be recognized by Ukrainian courts.

The commercial structure of the loan facility may be subject to three general types of restrictions: the general capacity of the lender, foreign currency restrictions, and limitations on the terms of the agreement - common for the Ukrainian legal system as well as specific for financial borrowing. Incompliance usually has a simple consequence - invalidation of the agreement. Past financing transactions, the financing needs of Ukrainian borrowers and the stakes of involved foreign lenders will provide support for the corresponding legal reform. As a result of legal and regulatory reform, it is anticipated that Ukrainian borrowers will secure smooth access to foreign lending resources.