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Partner, Konnov & Sozanovsky
Contract Law in Ukraine: Regulatory Framework for Financial Leasing
For many people in Ukraine, 2019 was a year of high expectations. Still, with a major shake-up of the country’s government and loud promises made at the highest level to improve the overall business climate and offer better investment opportunities, there is still a long road ahead. There has certainly been notable progress made in terms of digitalization, but trade reforms are yet to demonstrate the importance of cross-border cooperation in ensuring easy customs clearance procedures, harmonization of compliance rules, and border control efficiency. Improvement of court efficiency and judicial reforms targeting the quality, speed, and access to justice should be another important area where we have to demonstrate tangible progress.
Other than that, in order to demonstrate how things are going at the moment in terms of contract enforcement, let us take financial leasing as an example.
So why financial leasing, exactly? Leasing is generally regarded as a solution that enables difficulties arising from an inappropriate economic environment to be overcome. Namely, expensive and limited funding, the bureaucracy of the banking system, enabling businesses to obtain the right to use, with minimal initial financial efforts, machinery, equipment, technological equipment, that will generate increased productivity, profitability and increased profits. Talking of Ukraine, there is undoubtedly great demand for industrial engineering vehicles locally, and with not enough money to purchase machinery outright, many prefer to spend less in the long run by owning it, building equity through ownership. This is especially true for machinery that will be owned for five to ten years or more. That is where financial leasing arrangements step in.
The legal framework for financial leasing in Ukraine was established in 2008, and has not undergone any major changes since then. The main piece of legislation that governs financial leasing in Ukraine is the Law of Ukraine No. 723/97-ВР On Financial Leasing (the Financial Leasing Act), and the truth is it does have many drawbacks. For instance, some provisions of the Financial Leasing Act are vague and can be interpreted in different ways. What is more important is that it offers inadequate legal protection to contracting sides, both the lessor and the lessee.
For the lessee, the challenge is often due to the fact that almost any violation of a typical leasing agreement, as it is presented by the lessor, allows for termination of the agreement without granting the right to remedy the breach, however insignificant the violation might seem. That said, termination of a leasing agreement means that the lessee loses the right to receive ownership of the leased asset, as well as all leasing payments accrued before termination.
On the other side, the lessor, when concluding a financial leasing agreement, wants to be sure that he/she is safe from or is able to effectively mitigate any unforeseen emergencies and potential risks, and can reasonably expect to receive what he/she is entitled to under the agreement. At the same time, on many occasions vague and ambiguous provisions of the law have made it possible for dishonest lessees to dispute the validity of a financial leasing agreement and, in case of a favorable court decision, to escape their payment obligations under such agreements.
Article 16 of the Financial Leasing Act can serve as an example of a legal rule that offers lots of room for abuse. In particular, it provides that leasing payments may include: (a) payment to compensate for a part of the price of the leased asset; (b) remuneration due to the lessor for the leased asset; (c) compensation of interest on the loan; and (d) other expenses of the lessor directly in connection with the performance under a leasing agreement.
Such wording of the law enabled courts to interpret it in various ways. In some cases, the courts stated that the types of leasing payments, as listed in the agreement, must be in strict correspondence with the provisions of the law. In other cases, the courts regarded this provision as a non-binding, advisory statement. As a result, despite the fact that prices and payments under the majority of leasing contracts in Ukraine were historically pegged to a foreign currency, Ukrainian courts were until recently quite consistent in their unwillingness to award the currency exchange difference to lessors. Hence, leasing companies were not able to compensate their losses under the existing leasing contracts caused by the rapid devaluation of the Ukrainian national currency. That’s not to mention the financial burden of loans taken to provide operational financing for day-to-day operations, often denominated in foreign currency.
That said, in the last 2-3 years court practice has gradually become more consistent. With regard to disputes regarding the validity of and performance under financial leasing agreements, Ukrainian courts tend to rule that: (1) it is legal to denominate leasing payments in a foreign currency; (2) if a financial leasing agreement is terminated and a leased asset is returned to the lessor, the lessee is liable to pay the leased payments accrued prior to such termination, lower payments to compensate for the price of the leased asset (but if such payments have already been paid by the lessee, they shall not be reimbursed); (3) a rule that allow the lessor to claim lease payments at double rate in case of late return of the leased asset, may not apply to financial leasing.
Over the last few years, companies that operate in the financial leasing sector have encountered many challenges. Some of those were due to the rapid downfall of the Ukrainian economy, and thus were common for other companies doing business in Ukraine, while others were specific to the leasing business. Apparently, the country, which is de facto at war (although the conflict was more or less dormant in 2019), cannot offer a favorable business environment. Many businesses, especially in heavy machinery and the construction industry, have fallen dramatically since 2014. Taking into account the fact that industrial companies have always been key clients for financial leasing companies, the general effect on the leasing business was severe. The blow was worsened by legal restrictions that followed the occupation of Crimea in 2014 by Russia and war in Eastern Ukraine. Among those were mobilization (in particular, military duty) and international sanctions prohibiting certain transactions with respect to Crimea.
As to the military transport duty introduced by Article 6 of the Mobilization Law, its purpose was to satisfy the transport needs of the Armed Forces and other military formations during a special period for vehicles and technical equipment. For leasing companies providing for the operation of industrial engineering vehicles (especially in Eastern Ukraine) and their clients this military transport duty resulted, on many occasions, in temporary expropriation (but for an uncertain term) of their property for defense needs. In this respect, there was big concern among the business community that total nationwide mobilization means, for many participants, the risk of bankruptcy and liquidation. Luckily, this scenario did not happen, but there was much work for legal specialists to ensure that the military transport duty was enforced in accordance with established legal regulations.
Warfare and occupation, which resulted in de facto loss by the leasing business of key clients operating in Crimea and Ukraine’s eastern industrial regions, also generated international sanctions. Some of those backfired on Ukrainian leasing companies, and it was a peculiar example of how globalization may influence private business in different jurisdictions. In the main, it was about Executive Order No.13685 of
19 December 2014 by which the President of the United States of America ordered prohibiting measures with respect to the Crimean peninsula of Ukraine.
Consequently, US shareholders forced their Ukrainian subsidiaries to terminate all contracts with customers registered in Crimea despite this causing huge losses. Although many other legal options had been discussed, including novation of such contracts to other lessors, primarily in Russia, or assignment of proceeds thereunder, the schedule was very tight and many chose to simply forgive all the debt owed to them by their Crimean clients and give away the leased machinery.
It is interesting that those Crimean lessees who formally moved their businesses to mainland Ukraine and acquired new registration, as required by the Law of Ukraine On Establishment of the Free Economic Zone Crimea and Special Aspects of Economic Activities on Temporarily Occupied Territory of Ukraine, were therefore unable to benefit from the US prohibiting measures with respect to Crimea. Their leasing contracts remained valid and binding.
Overall, there is huge demand for positive changes in the industry. A new law on financial leasing has been in the pipeline for many years, waiting to be adopted by the Ukrainian Parliament. Many experts believe that it should improve state regulation of leasing activities, step up protection of the rights of consumers of financial services, and bring Ukrainian legislation into line with European practice and best world experience.