Opportunities for Investing in Non-performing Loans in Ukraine
More than half of all Ukrainian banking sector loans are currently non-performing, which makes Ukraine very attractive to NPL investors. As reported by the National Bank of Ukraine (NBU), from the beginning of November 2017, the ratio of non-performing loans (the NPLs) in Ukraine constituted 56.5% and amounted to UAH 587 billion, which is approximately EUR 18 billion. The level of NPLs in Ukraine remains higher than in any other European country, including Cyprus and Greece.
The slow cleaning up of the Ukrainian banking system from NPLs relates to the economic crisis that hit Ukraine in 2014, as well as to the gaps and inconsistencies in Ukrainian legislation. As a result, Ukrainian banks accumulated NPLs on their balance sheets, even though it required high provisioning. Based on numerous discussions on the market, one of the potential solutions to the problem of toxic loans is setting up asset management companies, which would acquire the NPLs from Ukrainian banks for market prices. However, until this discussion transitions into a stage of implementation, the most viable option for Ukrainian banks to get rid of bad loans appears to be outright sale.
Despite the fact that NPLs attract both Ukrainian and foreign investors, there are a number of legal and practical issues, which should be assessed before the purchase takes place. Some of these issues are addressed below.
Assignment under local loans: regulatory issues
Ukrainian lenders mainly use assignment or factoring for the outright sale of their claims under loan agreements governed by Ukrainian law. Ukrainian banks prefer factoring to avoid certain regulatory risks. Historically, there has been uncertainty in Ukraine as to whether the discounted sale of loans amounts to factoring and, as a result, can only be carried out in favor of the banks and licensed financial institutions (e.g. factoring companies). Although factoring is a trade finance instrument, it started to be incorrectly applied on the Ukrainian distressed debt market. Notwithstanding the inconsistent court practice in relation to discounted sale of NPLs, there is also a developing practice of selling NPLs by way of assignment, including to non-financial institutions. Although this option entails certain risks, they can be effectively mitigated through proper structuring of the assignment documentation and overall transaction.
Additionally, due to the cleaning up of the Ukrainian banking sector in 2014-2016, the Deposit Guarantee Fund of Ukraine (the DFG) became a big actor on the Ukrainian distressed debt market. The NPLs of Ukrainian insolvent banks are traded when such banks are in the process of liquidation. Until the beginning of 2017, such NPLs could only be sold to other banks or licensed financial institutions. From 21 January 2017, the above requirement was abolished. Currently, any legal entity or individual (including non-resident) can purchase NPLs of insolvent banks under the assignment agreements through tenders organised by the DGF. Such approach was additionally confirmed by the DGF in its clarification letter. These developments can also be used as an argument in favor of banks using the assignment option to sell their claims to non-financial institutions outside of insolvency proceedings.
Notwithstanding the above improvements, the market is still awaiting legislative changes which would clarify the provisions on factoring and assignment of claims under the loans and would clearly distinguish between these two instruments. Such developments could potentially boost Ukrainian NPL sales, which could further help Ukrainian banks to clean up their balance sheets from NPLs and restore lending.
Assignment under cross-border loans: currency control issues
Ukrainian banks are not the only party facing the problem of defaulting Ukrainian borrowers. Foreign banks often found themselves in a situation where they had to decide what to do with the NPLs extended to Ukrainian borrowers.
Sale of claims under cross-border loans in the main bring currency control issues to the forefront. Usually, if a NPL is traded between non-residents, the transaction documentation is governed by foreign law. At the same time, if the borrower under NPL is a Ukrainian entity, Ukrainian currency control rules would apply. To obtain a cross-border loan, a Ukrainian borrower is required to register such a loan with the NBU. Similarly, any substantial amendments to such loan, such as change of lender, also require registration with the NBU. Without the NBU registration of a lender’s change, a borrower is unable to make any payments to a new lender.
Until recently, only Ukrainian borrowers could initiate such registration, which was especially problematic in relation to assignment (transfer) under NPLs. In the absence of cooperation from the borrower, a new foreign lender could not be registered as a new lender and, thus, faced additional enforceability risks. From April 2017, the lenders themselves can initiate the NBU’s registration of a lender’s change. The NBU registration of a new lender requires cooperation from the initial lender. Both initial and new lenders must jointly apply for the NBU registration of a lender’s change and submit a number of documents to a borrower’s servicing bank. These documents include some sensitive information. For example, information on the lender’s ownership structure and ultimate beneficial owners. In addition, the change of a lender under cross-border loan triggers the requirement to carry out an additional examination by a borrower’s servicing bank and the NBU. Despite these enhanced requirements, recent legislative developments generally simplified the registration of the lender’s change, which was a significant step forward into the further development of the NPL market in Ukraine.
Conversion of domestic loans into cross-border loans and vice versa
If a foreign lender purchases claims under NPL from a Ukrainian lender, the acquired NPL would become a cross-border loan, and subsequently require registration by the NBU from the outset. Without obtaining NBU registration, a borrower would be unable to make cross-border payments to a new foreign lender. From April 2017, NBU registration is possible without the borrower’s cooperation if the initial lender under the NPL (a seller) is a Ukrainian bank and a Ukrainian borrower has a bank account opened with that bank.
In such case, NBU registration can be initiated by the Ukrainian bank (a seller).
Upon transfer of claims under the NPL from a Ukrainian lender to a foreign lender, the loan would be subject to certain NBU requirements, such as maximum interest rate limitation. The NBU sets this limitation for loans between foreign lenders and Ukrainian borrowers. If the borrower’s payments under such loan other than the repayment of principal exceed the limitation, the NBU would refuse the registration of a loan agreement. In this regard, NBU regulations allow the new foreign lender to unilaterally waive accrual of interest or other payments in full or in part (e.g. with regard to an excess amount) by notifying the borrower. Furthermore, the maximum interest rate limitation would not apply to payments, which were payable and accrued under the domestic loan prior to the assignment.
In the opposite situation, if a Ukrainian lender purchases claims under cross-border NPL from a foreign lender, NBU registration requirements would no longer be applicable. Upon transfer of claims under the NPL to a new Ukrainian lender, the existing NBU registration would be subject to termination. Given that cross-border loans are usually denominated in a foreign currency, the currency of further payments by the borrower in favor of a new Ukrainian lender should be considered separately. A Ukrainian borrower would only be able to make foreign currency payments to a new Ukrainian lender under the acquired NPL if such lender obtains an individual or general NBU licence for the foreign currency transactions.
Otherwise, the transaction should be structured in a way which would allow a new lender to claim payments from a borrower in Ukrainian currency.
Recent legislative changes provided more opportunities for investing in NPLs extended to Ukrainian borrowers by foreign lenders. The Ukrainian distressed debt market is also being revived, although in anticipation of additional legislative improvements.
NPL sale transactions should be structured by taking into account the above regulatory and currency control issues. Additionally, structuring NPL transactions requires accurate consideration of a wide range of legal and practical issues, such as due diligence of loan documentation and security package, including assignability and enforceability of claims under loan and security documentation, deficiencies of such documentation, banking secrecy issues, currency control issues applicable to payment for claims, etc. Even though Ukrainian laws still contain some gaps and inconsistencies, NPL sale transactions can go smoothly subject to careful structuring.
By Tetiana Mykhailenko is an associate at AVELLUM,
Anastasiya Voronova is an associate at AVELLUM