Secured Obligations in Debt Transactions

As many people are aware, debt financing of business is a common phenomenon and companies actively use various sources of financing for supplementing their operating assets and for implementing large capital projects. For those reasons companies usually take out domestic or foreign loans, raise cash, increase their statutory capital, use intercompany loans, or financial aid.

All sources of financing may be divided into domestic and foreign. Of course, domestic sources are the most popular ones since it is easier to obtain a loan in Ukraine. But in recent years more and more projects in Ukraine are financed by international financial organizations/funds (IFOs). Taking into account the fact that not just big businesses but also small and medium size companies have access to such funding, it is predictable that interest in foreign sources will continue to rise.

However, one should bear in mind that IFOs fund only certain industries as preferential ones (agriculture, alternative energy, innovations, infrastructure projects, as well as special targeted microfinancing of small and medium companies). It is an important legal point that IFOs in Ukraine are international organizations, of which Ukraine is a member. There are also IFOs under agreements with which Ukraine undertook to maintain the legal regime extended to other IFOs. Such IFOs have official status in Ukraine and certain privileges in currency control and tax regulations.

If that is so, a business should understand that the main concern for IFOs when deciding whether or not to approve a credit line is the issue of securing the financing.

Despite the fact that Ukraine’s legal system is not stable and it is would not come as a surprise to anyone that major laws in Ukraine are amended every year, legal regulation of loans and security for obligations under such transactions is quite stable and has not seen major changes in recent years. The last noticeable improvements were changes adopted in 2018 designed to expand lending and, in particular, to strengthen the rights of creditors and introduce a new type of security called a trust ownership, which we will go into further detail below.

Before we move onto the features of security, it is worth giving a quick reminder about the general rule that any security obligation is of accessory nature and not an alternative to the primary obligation under a loan agreement.

In Ukraine, the most common types of security remain pledge (pledge of moveable property, inventory, property rights, rights to money funds in bank accounts), mortgage, as well as suretyships and corporate and banking guarantees.  When using these types of security properly it is important to keep some specific legal requirements and practice of their application in mind.

For example, a pledge agreement should refer to the description of property in order to identify its individual features as well as the amount and term of performance of the primary obligation, secured by the pledge, or a reference to the loan agreement.

It’s also worth noting that a pledge agreement can become effective via a simple signature affixed by the parties, while a mortgage agreement requires obligatory notarization.

Talking about mortgaging property, it is worth bearing in mind that banks usually ask for a market value of the property appraised by an expert, as well as documents confirming the mortgagor’s ownership right over the property (like a sale contract or balance sheet statement).

Even though the law allows the pledging of assets, ownership of which will be acquired by the pledger after execution of the pledge agreement, creditors, especially, foreign ones, find it critically important that the pledger possesses 100% ownership rights to the collateral at the time of execution of the pledge agreement as long as the lender’s primary objective is to avoid any restrictions and risks regarding the possibility of alienation and enforcement.

The general rule is that the pledger retains the right to manage and use the collateral but the creditor may insert certain restrictions in the agreement. For example, a change of location of the asset, the same as its replacement, may only take place upon the consent of the pledgee (except for inventory, which is regulated separately). However, banks sometimes agree to a more simplified procedure for approval. For example, by a simple notification to the bank about certain changes in the collateral (creditor’s tacit consent). It is still important to bear in mind that, according to the law, contracts with respect to alienation by the pledgor of the collateral, its remortgaging, leasing and the like are without the consent of the pledgee, null and void.

Suretyship vs Guarantee

Suretyship and guarantee are other popular types of security in Ukraine. Should the obligor breach an obligation secured by a suretyship, the obligor and the surety are liable towards the creditor as joint and several obligors. The surety is also liable towards the creditor to the same extent as the obligor is.

In contrast to the suretyship, a guarantee serves as an independent obligation and imposes secondary liability. Furthermore, the guarantor’s liability is limited only by the amount indicated in the guarantee. Please note that while the obligations of the guarantor are not dependent on the primary obligation, in the event that the guarantor pays under the guarantee he does not automatically acquire the creditor’s rights under the primary obligation, as, for instance, the surety does. The guarantor only enjoys the right of regress against the obligor within the limit of the amount paid under the guarantee.

Another important thing to mention is that unlike in other countries, in Ukraine guarantees can only be issued by banks, other financial institutions or an insurance company. Therefore, Ukrainian companies may not act as guarantors under obligations of other companies through corporate guarantees, which are a widely used instrument abroad. Still, Ukrainian banks often accept guarantees of foreign parent companies issued as security for obligations of their Ukrainian subsidiaries under loans of such subsidiaries. Such guarantees are accepted under the laws of the jurisdiction of the parent company, usually in the form of an unconditional irrevocable demand guarantee.

Important Recent Legislative Changes

Substantial improvement in the mechanisms of securing obligations and lowering of risks has taken place recently. First and foremost, for creditors, certain conflicts of law have been removed. Earlier on, the legislation provided that a pledge/suretyship terminated with the termination of the primary obligation in the event of liquidation of the obligor, or in case the amount received out of the out-of-court settlement under pledge agreement was insufficient to fully satisfy the claims of the pledgee. Via recent changes in legislation such barriers have been removed and, in particular, creditors have acquired the right to receive the shortfall at the expense of other property belonging to the obligor.

It used to be that the scope of the pledgee’s claims was limited by the contractual value of the collateral defined by the parties. These restrictions have now been done away with and according to the practice, now the contractual value bears a primary informational role and in case of the enforcement procedure a creditor can obtain the ownership right on the collateral under the market value estimated by an independent valuation company or in the event of sale of the collateral to determine the price with a potential buyer.

Recent changes also revolved around the grounds for termination of the suretyship in the event of change in the primary obligation without the consent of the surety. In particular, if the scope of the obligor’s liability has increased, the suretyship is not terminated now and the surety remains liable for breach of obligation by the obligor within the limit that existed prior to the change in the obligation.

Another legislative change was the change of the regulations with respect to determining the term of validity of the suretyship in the event that the suretyship contract does not set one, or if the term of performance of the primary obligation is not set, or is set as the moment of presentation of a demand. In such case, the suretyship ceases to be effective if the creditor has not made a claim against the surety within three years (term used to be one year) following the end of the term of performance of the primary obligation. Banks often determine the term of validity of the suretyship by adding such a three-year period to the term of the primary obligation.

A Trust — New Type of Security

This new type of security was introduced in autumn 2019 exclusively for loans, primarily to promote lending by banks and to minimize the risks borne by creditors. It entails the transfer of property into ownership of the creditor for the duration of the trust agreement and the right of the creditor to sell the property on its behalf should the obligor fail to perform its obligations under the loan agreement. A trust is recognized as a type of ownership right over property with certain limitations on the right to use and transact with it. The creditor that received the property into trust (trustee) may not unilaterally sell such property, except in order to enforce against it, nor may he use it as the trust property continues to be used by the trustor or a third person.

A trust may cover any property that can be enforced against, except for securities and corporate rights.

At its core a trust is very similar to a pledge/mortgage. The main differences are the independence of trusts from laws on pledges and mortgages and the ability of the parties to define the terms of the agreement and the procedure for enforcement against the trust property, the right of the creditor to independently determine the asset’s sale price. Such a right of the creditor is very different from relations of the parties to a mortgage or pledge, where the price is determined by the mutual agreement of the parties or an appraiser based on the common prices of the property, and where the opportunities for any abuses by the creditors are reduced. Among other advantages for the creditor is the possibility to assign the right to the trust property (provided that a notarized consent of the trustor is given).

It is worth pointing out a provision of the law, which provides for the obligation of the trustee to enforce against the trust property in the event of its own liquidation or bankruptcy.

As you can see, the wide range of choice of types of financing and types of security is definitely a positive fact and enables companies to choose the most suitable option in a particular business situation, whether it’s supplementing working capital or long-term financing of large corporate projects.