Investing in Ukrainian banks
June 2016 | EXPERT BRIEFING | FINANCE & INVESTMENT
The Ukrainian economy has struggled over the last couple of years. Depreciation of the national currency, the annexation of the Crimean Peninsula, military conflict with Russian-led troops and the drop in prices in the external commodity markets have all adversely affected the Ukrainian economy. Naturally, factors such as these have all had an impact on the banking sector. The number of non-performing loans has increased significantly. Banks have lost their assets in Crimea and Eastern Ukraine. During 2013-2015, the share of foreign investors in the capital of Ukrainian banks also decreased.
In the midst of it all, the National Bank of Ukraine (NBU) initiated a clean-up of the banking system, targeting in particular ‘toxic’ banks and those banks that fail to comply with Ukrainian laws. Since 2014, roughly a third of Ukrainian banks have been recognised as insolvent.
At the same time, most of the remaining banks are significantly undercapitalised. The NBU has carried out a special stress-test designed to determine the amount of additional capitalisation required and, as a result, imposed the obligation on the banks to obtain the necessary financing.
Against this backdrop, Ukrainian banks have found themselves in a difficult situation. Regulators have pressed them on the one hand to increase capitalisation, while, on the other hand, banks often lack appropriate tools to overcome this issue. For example, debt-to-equity conversions, commonly used in Western jurisdictions, do not work properly in Ukraine. While Ukrainian law provides the ability to convert indebtedness into equity, this must occur according to a special procedure, adopted by the Securities and Exchange Commission, which has not yet been adopted. Therefore, the mechanism does not work as well.
Nevertheless, as often happens, banks have found a way to deal with it in practice. The NBU has adopted a special regulation allowing Ukrainian banks to make early repayments for cross-border indebtedness (which is generally prohibited), but only if the repaid funds are subsequently injected into the capital of the bank in question.
Undoubtedly, such a development represents progress, since (as time has showed) it has allowed banks to carry out de facto debt-to-equity conversions and significantly increase the quality of their capital.
However, the procedure is far from perfect and difficult to implement. Such a procedure does not provide for a possibility to set off the indebtedness against the obligation to inject funds into the capital, but requires actual movement of the funds. In essence, a bank (debtor) has to repay the full amount of the indebtedness and the lender then has to return them to the bank as a contribution into equity. Additionally, in order to carry out this procedure, a bank-debtor has to obtain special permission from the NBU, which also requires submission of an extensive set of documents.
Despite the above flaws, the procedure made debt-to-equity conversion possible in Ukraine (at least for banks).
It is understood that a contribution of additional funds into capital requires the bank to increase its share capital. Normally this is quite a lengthy procedure and requires substantial efforts and expense to carry out, especially if there are many minority shareholders in the bank. To address this issue, parliament adopted the Law of Ukraine on Measures Aimed at Capitalisation and Restructuring of Banks. The law provides for an expedited procedure of a share capital increase, which now can be completed within 6-8 weeks instead of 6-8 months as was the norm. This is, no doubt, a great step toward additional capitalisation of Ukrainian banks.
Another issue that is usually important to a foreign investor is the ability to apply a foreign law, usually English law, to a transaction. This is generally possible, despite the fact that the debt-to-equity procedure is heavily regulated by Ukrainian imperative norms and because banks are regulated entities. In particular, it is possible to govern the subscription agreement with English law. This undoubtedly provides additional comfort to foreign investors, who are used to instruments such as warranties and indemnities, and offers the ability to choose a convenient dispute resolution forum. In such a case, typically a portion of the subscription agreement provisions governing the issue of additional shares will be governed by Ukrainian imperative norms, while all other provisions are governed by English law.
Last but not least is the issue of how to properly regulate relations between the shareholders of a bank. Commonly, if an investor converts indebtedness into equity of the bank, he does not acquire 100 percent of the shares. Therefore, experienced investors insist ona separate shareholders’ agreement (at least between majority shareholders).
However, historically, the operation of shareholders’ agreements in Ukraine has been rather difficult. Moreover, currently a Ukrainian court may not recognise a choice of English law as the governing law of the agreement. While there is a draft law to improve the regulation of shareholders’ agreements drawn up for a Ukrainian company, it has not yet been adopted.
Historically, this limitation has been circumvented simply by structuring the agreement on an offshore level using offshore companies. Unfortunately, this solution does not always work in banking M&A deals. Banking regulations impose strict requirements in respect of the corporate structure of a bank. In particular, the offshore company may not be a shareholder of a Ukrainian bank, if that company has existed for less than three years and has losses in every reporting period for the last three years. These norms motivate investors to acquire shares in a Ukrainian bank directly without using special purpose vehicles.
Such regulations add another layer of complications to the deal. However, it is possible to address this issue.
In such cases, two shareholders’ agreements can be concluded: (i) an agreement between the shareholders on the foreign level; and (ii) a separate agreement between the bank and the investor on the Ukrainian level (using English law).
Thus, the shareholders regulate their relations on the foreign level without the limitations of Ukrainian laws. Such an agreement may be enforced in jurisdictions where shareholders’ agreements are recognised. At the same time, it may be void from the perspective of Ukrainian courts (and may be very difficult to enforce in Ukraine).
In this context, the separate agreement on the Ukrainian level plays an important role. Usually it contains additional obligations for a bank, which reflect investors’ rights under the shareholders’ agreement on the foreign level. However, careful wording must be used in such a structure, as there is still a risk that the separate agreement may be considered void in Ukraine (especially if it contains provisions that are contrary to Ukrainian imperative norms).
In summary, a banking M&A deal in Ukraine may be structured in such a way as to provide a certain level of comfort to foreign investors despite unfavourable Ukrainian court practices. This may be achieved by a combination of both Ukrainian and English law instruments. The fact that the banking sector in Ukraine was one of the most active sectors in the Ukrainian market, despite all the hurdles, further proves this point. Indeed, several insolvent banks have been acquired by investors, in particular, PJSC Astra Bank and PJSC Ukrgazprombank. Other solvent banks have received additional financing from international financial institutions. In particular, the European Bank for Reconstruction and Development (EBRD) has acquired 30 percent of PJSC Raiffeisen Bank Aval and increased its shareholding to 40 percent in PJSC Ukrsibbank.
Yuriy Nechayev is counsel and Andriy Romanchuk is an associate at Avellum. Mr Nechayev can be contacted on +380 44 591 3355 or by email: firstname.lastname@example.org. Mr Romanchuk can be contacted on +380 44 591 3355 or by email: email@example.com.
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Yuriy Nechayev and Andriy Romanchuk