It was already understood that something should be done with non-performing loans in the Ukrainian bank system as of the end of 2015, when the National Bank discovered that the real volumes of banks’ distressed debts were much bigger than the ones declared. The change in the risk assessment procedure, which was reflected in Resolution No. 351 of the National Bank, was all it took to understand that share of non-performing loans was as high as 56%, and not 20% or 30%.
The situation was aggravated by military action, devaluation of the hryvnia and the overall economic crisis. All these downturns in the economy in no way helped to resolve the situation.
The Law of Ukraine “On Financial Restructuring”, which came into force on October 19, 2016 (hereinafter – the “FR Law”) became one of the proposals for resolving the issue. This Law is aimed at out-of-court settlement of the distressed debts of legal entities. It provides for a number of regulatory and tax benefits aimed at encouraging a bank and a borrower to enter into negotiations.
Unfortunately, the FR Law failed to fully resolve the issue of non-performing loans. This was due not only to the very lengthy adoption of the Law itself and its even longer implementation, but also the structure of distressed debts of Ukrainian banks.
Loans to relatives, sometimes to dummy companies which have no interest in restructuring, make up a huge share of distressed debts. Furthermore, loans made to individuals (for example, as seen in the PrivatBank portfolio) to which the FR Law does not apply, make up a large share of distressed debts.
A new draft law on debt management (hereinafter – “DM draft law”) is aimed at supplementing the instrument for combating distressed debts. While final work on the draft law continues and it is still to be submitted to Parliament, we can already evaluate the innovations it will introduce in legislation.
First of all, the draft law provides for the introduction of a new type of business – debt management companies (hereinafter – the “DMCs”), which are meant to assume the distressed debts of banking institutions. According to the idea enshrined in the draft law, banks will be able to comfortably sell their distressed assets to DMCs, thereby getting rid of the heavy burden of financial indicators and debt provisioning.
Both acts bring a great deal to the legal environment, changing not only business models, but also provisions in civil law. Thus, it is interesting to follow the innovations proposed by it for solving the issue in question.
The FR Law proposed nothing new in terms of the composition of parties. Its main goal is to allow borrowers and banks to arrive at other, softer terms of debt repayment and to repay debt it in the foreseeable future.
Its particularity is in the fact that the procedure for financial restructuring (and, therefore, all benefits and advantages) can only be initiated if at least 50% of all creditors – the borrower’s financial institutions have agreed to it. But then, financial institutions play the key role in the process on approval of terms as they have more rights than all other creditors.
The FR Law also provides for the possibility of participation by a special subject – an investor. An investor may participate in the debt settlement process for the purposes of refinancing the debt or part of it. In this case, the investor is vested with the general rights of any other participant of the procedure.
The DM draft law, by contrast, proposes to solve the situation with distressed debts by transferring “distressed” assets to new creditors – debt management companies.
A DMC is a financial company which has obtained a license in accordance with the established procedure and has an authorized fund of at least UAH 30 million. In addition, the DM draft law sets quite serious requirements as to the transparency of the structure of such a company.
Apparently, DMCs will be mainly engaged in purchasing distressed assets from banks and bank management. It is clear that due to the high requirements set for DMCs, not everyone will be able to engage in such business, and former banking sector entities are likely to be the main beneficiaries of DMCs.
At the same time, the DM draft law introduces one more subject – a collateral manager as a completely independent participant in collateral legal relations. It provides for introducing appropriate amendments to the Civil Code of Ukraine.
A collateral manager is a legal entity who, for a fee and in the interests of a creditor, acts as a pledge holder under a commitment. It is expected that this company will act in the interests of one or a group of creditors, having all the rights of a pledge holder, yet fulfilling the terms of an agreement between it and a creditor.
Participation in such an entity will hardly help to solve the issue of “distressed assets” in the banking sector, but it will certainly help banks to build their legal relations when granting new loans in a different way.
Both acts provide for a wide range of instruments, which, according to legislators, should help to establish more efficient work on the settling of distressed debts.
As part of financial restructuring, banks can convert foreign currency debt into hryvnia, forgive debts in whole or in part, negotiate payment with a debtor of a loan by instalments for whatever length of time, set the interest rate at any level. A restructuring plan agreed between a debtor and creditors can include provisions on the transfer of property or part of property as debt repayment, as well as on conversion of debt into a debtor’s authorized capital. Should tax arrears and the debt charge be less than one-third of the debtor’s outstanding debt, the tax authority will take part in the procedure and is obliged to agree upon the restructuring plan regardless of whether it wants to.
According to the DM draft law, DMCs will be able to restructure debts on any terms, forgive debt in whole or in part, will have the opportunity to use a debtor’s asset for debt repayment, or to receive this property into ownership. DMCs will be able to include claims as collateral for their own bonds, resell debts or provide a debtor with additional financing and offer it to continue the servicing of a loan.
As we can see, both acts significantly supplement the ability of banking institutions by new ways of resolving distressed debts.
Needless to say, in order to resolve the distressed debt situation it is necessary, in addition to the new instruments, to propose additional incentives for the market.
By implying that banks are the main place for stimulating the process, the FR Law proposed that banking institutions violate certain standards set by the NBU. In particular, should a bank participate in financial restructuring, it can violate the liquidity coverage ratio, maximum credit exposure ratio per one counterparty, investment ratio and the ratio of foreign currency position limits.
Understanding the fact that a huge part of distressed assets is concentrated in state-owned banks, legislators provided that a state-owned bank could participate in the procedure pari passu with any other commercial bank, including the right to forgive debt.
According to changes to the Civil Code, the Law of Ukraine “On Mortgage”, the Law of Ukraine “On Securing Creditors’ Claims and Registration of Encumbrances”, in case of transfer of part of property to a creditor as debt repayment, the remainder of an obligation, as well as any mortgage or pledge, will not be terminated. The same applies to a guarantee, which in the procedure may not be terminated 6 months after the maturity date.
The FR Law further provides for tax benefits for the parties, namely the absence of VAT in case of transfer of property as debt repayment, as well as opportunity for a bank to pay income tax by instalments in connection with a reserve write-back.
The DM draft law has a wider application than its friend, which has come into force, and, therefore, introduces lots of new articles to effective legislation in one go. Thus, it supplements the chapter entitled “Law of Obligations” of the Civil Code with a large number of options in terms of the transfer of a creditor’s rights. In particular, should a creditor to an obligation change, all the rights related to a security shall automatically pass to the new creditor. At the same time, it is now possible to assign claims in so far, under the condition and in any configuration available to the parties. Debt may be assigned for a fee, and later it will be possible to assign future claims.
However, substantial tax benefits for the operations stipulated by the DM draft law are the biggest advantages of it. The latest version of the draft bill that is under development envisages exemption of DMCs transactions from VAT in most cases, and the companies themselves – from corporate income tax until 2023. Such benefits will allow DMCs to close non-performing loans on terms that are least damaging to debtors.
Both acts are very innovative within existing legislation and provide the market with a huge amount of incentives to deal with the current level of distressed debt. However, taking into account widespread application and possible consequences for the economy, preference should perhaps be given to the DM draft law.
Needless to say, the FR Law has already taken a huge step in the direction of the market and helped to settle a significant amount of distressed assets in our banking system. It contains unprecedented benefits for the Ukrainian economy and incredible solutions in civil legislation. Nevertheless, the DM draft law can do even more. And this is only due to its widespread application.
Sure, the DM draft law is still far adoption and enactment. However, if it is adopted in its current version, it will be able to fully launch the secondary market of distressed assets for the debts of both legal entities and individuals.
As a result of the transfer of distressed debts to third parties for management, Ukrainian banks will be able to fully discharge their reserves and use the released funds to develop new lending services, thereby providing the economy with more affordable debt instruments.
At the same time, the economy will have a completely new type of business – transparent and understandable to a foreign investor. Therefore, positive changes brought by the new draft law may have a much greater impact on Ukrainian society in the long-term future.
Sergii Papernyk, Head of banking & finance and FinTech,
exclusively for “Jurist & zakon” №13, 06.04.2018 – 12.04.2018