Problem Issues with the Return of Assets to Insolvent Ukrainian Banks

At the start of 2014 there were 180 active banks in Ukraine, but in the early part of 2020 just 75 active banks remained. 105 banks ceased their activities in the last 6 years. Most of them were declared insolvent by the state-run National Bank of Ukraine, and the Deposit Guarantee Fund commenced the procedure of their withdrawal from the market thereafter. Most of these banks went into liquidation and, as a result, in the period of 2014-2019 34 banks were liquidated by the Fund, and as of the start of 2020 61 banks found themselves in the process of liquidation.

At the time when banks are declared insolvent they usually do not have liquid assets, and existing assets are booked at an unreasonably high value. The liabilities of such banks are normally much higher than the value of their assets, which makes it impossible to meet creditors’ claims out of the assets available in these banks.

Therefore, the main objective of the Fund with regard to all such banks is to return the assets illegally withdrawn from them, in line with the Fund’s powers set out by the Law of Ukraine No. 4452-VI On Individuals’ Deposits Guarantee System of 23 February 2012. For this purpose, in addition to the usual measures of collecting debts from borrowers and other debtors of insolvent banks, the Law provides the Fund with special permits, namely:

– Identification of void contracts entered into by insolvent banks and application of the consequences of their nullity;

– Claiming damages from persons related to insolvent banks subject to certain conditions.

The first measure provides for identification of void contracts, concluded by a bank within one year prior to the date of introduction of temporary administration in the bank, and application of the consequences of nullification of such contracts, in particular: reclaiming the bank’s property (funds) transferred under such contracts, or claiming indemnification of the property’s value. The Fund is obliged to reveal void contracts within the period of temporary administration of the bank, and has the right to apply the consequences of nullity of contracts during the entire period of a bank’s liquidation.

Inter alia, the contracts are considered by the Fund to be void in the following cases:

– The bank pledged its highly-liquid assets to ensure fulfillment of the bank’s obligations under previously concluded bank deposit or bank account agreements with subsequent acquisition of such assets by the pledgee subject to extrajudicial procedure provided for in pledge agreements;

– The bank assigned to third parties its claim rights under credit agreements, secured by highly liquid assets, with a significant discount or significant delay in payment for the assigned claim rights, or with setting off payment against the funds of third parties within the bank when the bank did not have sufficient funds in its correspondent accounts in the other banks.

After void contracts are identified, the Fund begins the procedure of application of consequences of their nullity, which means returning the assets withdrawn from the bank under such contracts. With regard to real estate the Fund approaches the respective state registrar of rights to real estate requesting restoration of the bank’s right to ownership to certain objects of immovable property in the relevant state register. But in most cases it appears that the owner of this property has been repeatedly changed, and the state registrar refuses to restore the bank’s ownership rights. If this is the case, the respective dispute regarding title to the property arises, which becomes the subject-matter of long legal proceedings, and in many cases court decisions do not go in favor of the bank. This means that the procedure of return of assets, withdrawn under void contracts, does not work properly due to gaps in legislation and it’s time to carry out a substantial review of legislation.

The second measure used by the Fund to return illegally withdrawn assets from insolvent banks stipulated by paragraph 5 of Article 52 of the Law, according to which the Fund has the right, in the event of insufficient assets in an insolvent bank, to claim indemnification of damages from the bank’s related persons whose actions or inaction resulted in the bank’s or bank creditors’ losses, and/or from the bank’s related persons who directly or indirectly materially gained due to such actions or inaction.

The filing of a claim for damages against an insolvent bank’s related persons whose actions or inaction caused damage to the bank and/or bank creditors is not a very successful measure for ensuring the return of assets that have been illegally withdrawn from a bank. The issue here is that the related persons of such a bank are usually bank officials, and with regard to illegally withdrawn assets they normally fulfill verbal instructions given by the bank’s beneficial owners, do not receive real benefit from the withdrawn assets, except for salaries and other remuneration (very often unofficial), and are not able to indemnify the damages.

It is much more effective to claim damages from a bank’s related persons who gained materially, whether directly or indirectly, due to the actions or inaction of bank officials. But even in this case the Fund faces certain difficulties. The issue here is that the ultimate debtors of an insolvent bank are usually fake legal entities, which were specifically set up to hide the illegal withdrawal of assets from the bank. Granting loans to such legal entities without their intent to repay the funds they received or alienating the bank’s property for the benefit of such entities are the so-called “last events” of illegal withdrawal of assets from the bank, due to which the bank becomes insolvent. However, subsequently such assets (money or other property) are repeatedly transferred or alienated respectively to other persons, and through a series of transactions such assets are finally used by concrete persons to repay their indebtedness to the bank and release liquid assets pledged to the bank to secure this indebtedness. By acting in this way such persons hide the so-called “first events” of assets withdrawal from the bank in the form of initially received funds and materially gain by using these funds.

In practice it goes like this:

– Person 1 receives a loan from the bank and uses it for certain purposes (first event);

– At the time of repayment of this loan the bank grants a new loan to Person 2, which is not legally related to the bank (last event);

– Person 2 transfers the received funds to Person 1 as payment for investment certificates or shares of fake legal entities or under any other VAT-free transactions;

– Person 1 uses funds received from Person 2 to repay the debt owed to the bank.

As a result respective funds were withdrawn from the bank, the debtor under the outstanding loan is legally an unrelated person to the bank, and a potentially related person to the bank materially gained from these funds, because he/she used borrowed money for a specific purpose and repaid debt owed to the bank out of funds received from the bank by another borrower.

The described case is very straightforward; it is not difficult to identify the person who materially gained from funds withdrawn from the bank. But in practice such simple cases of funds flow from the last event to the first one are almost non-existent. Bank-related persons use much more complicated schemes involving a lot of legal entities, including fake ones. The flow of funds from the last event to the first one usually takes quite a long time (1-5 years), the number of transactions with funds is huge, operations are complicated, funds are transferred to other banks, split up into small amounts and transferred many times to various persons in different banks, both in the form of financial transactions (financial aid, payment for shares, investment certificates, etc.), and in the form of payments for goods and services. The bank itself may be taking an active part in transactions not only in the form of granting loans but also in the form of payments for promissory notes and other securities in fake legal entities.

Having traced the flow of funds from the last event to the first one it is possible to identify the persons who actually materially gained out of these funds, but it’s not enough to claim indemnification of damages from such a person. By Law such claims must be addressed to the person who is legally related to the bank, though in practice it is very hard to prove such relationship. The beneficial owners of insolvent banks do their best to break the legal relationship to the bank of those persons who materially gained from the assets withdrawn from the bank. Therefore, even having identified the persons who materially gained from the assets withdrawn from the bank, very often all attempts to trace the legal relationship of these persons to the bank fail and, finally, it appears that these persons are not legally related to the bank, although it is quite clear that the connection of these persons with the beneficial owners of the bank exists, though such connection is informal without the possibility to prove it. In this case it is not possible to apply the provision in paragraph 5 of Article 52 of the Law and claim indemnification of damages caused to the bank from the bank’s related persons.

Therefore, it seems that the provision stated in paragraph 5 of Article 52 of the Law is somehow outdated. Due to this situation an insolvent bank’s related persons, who materially gained from assets illegally withdrawn from the bank, can easily escape respective liability. Amendment of this provision of the Law stipulating that claims for indemnification of damages, caused to an insolvent bank, can be addressed to any persons who materially gained out of assets, illegally withdrawn from a bank, is long overdue. At the same time, certain exclusions to this rule should also be introduced to eliminate the responsibility of those persons who received withdrawn funds on a legal basis as payment for goods and services that really were supplied.

Investigation of the circumstances of first events, tracing the flow of funds withdrawn from insolvent banks and identification of persons related to an insolvent bank who materially gained from funds withdrawn from the bank is one of the main objectives of carrying out forensic audits of insolvent banks, which are in the process of liquidation by the Fund. Such an audit is carried out at the Fund’s request by a group of independent specialists including, but not limited to, bank auditors, lawyers, forensic investigators, property evaluation experts and IT specialists. The results of forensic audits are used as much as possible by the Deposit Guarantee Fund to recover losses incurred by insolvent banks.