Secured Lending: Selected Legal Issues

By Oksana Volynets and Zoya Mylovanova
Beiten Burkhardt

The development of the Ukrainian economy has led to an increase in the funding needs of business players which cannot be satisfied in full by local financial sources. As a result, there is growing interest on the part of Ukrainian borrowers in the international debt market. Among the variety of fund raising tools, borrowing from a syndicate (i.e. a group of banks that acts jointly, on a temporary basis, to lend money to a borrower based on a single loan agreement) is becoming an important source of funding for Ukrainian financial and corporate borrowers. Such lending practices have obvious advantages, such as reduced exposure risk for lenders resulting in a lower effective interest rate for the borrower, a fact that often offsets the transaction cost involved in implementing this relatively complex deal.

The general approach of foreign lenders is, to the extent possible, to have the structure of the transaction in line with customarily used practices, and to keep the transaction documents (e.g. facility agreement, fee letters, security agency agreement) in a standardized form. Unfortunately, local laws often make this difficult to attain.

One such complication arises where a syndicated loan is secured. Ordinarily, in such a case the standard structure provides for the use of a so-called “security agent”, or “security trustee”. A party to the loan agreement, usually a local bank, acts as a trustee for the pool of lenders holding in trust for the whole syndicate any security or funds (property) received on default. The involvement of an agent simplifies the structure, makes enforcement easier and ensures that all lenders have equal priority and may not enforce their security interest individually to the detriment of the syndicate as a whole.

Unfortunately, the concept of a security trust (security agency) is not recognized under Ukrainian law, leading to a number of logistical and legal complications. As a result, a generally used structure for syndicated deals, including the role of the security agent, must be directed to comply with Ukrainian law and domestic market realities.

It is a general expectation of lenders that matters related to the execution of any security documentation, perfection (registration) of the security and its enforcement, will be handled by the security agent upon instruction of the facility agent. In particular, it is understood that the security agent will individually sign the security documents and will register the encumbrance created in its own name. Any changes in the participants to the deal (e.g. due to assignment of the rights by a particular lender to a new bank, or syndication of the deal) should not result in any change to the security documentation or in the registration of pledge/mortgage. Upon default on the loan, the security agent is expected to enforce the security in the interest of all lenders. These traditional expectations, however, do not seem to fall within the legal framework for secured transactions which currently exist in Ukraine.

First of all, in order to be a party to the pledge/mortgage agreement, a mortgagee/pledgee must be a creditor to the obligation being secured. Similarly, it is generally understood that the person who should be registered in the respective encumbrance registry as a secured party should be an actual secured creditor (i.e. lenders and not a security agent). Moreover, regulations governing perfection (registration) of security interests explicitly provide that, where an “encumbering party” acts on behalf of other pledgees/mortgagees, its authority must be confirmed by powers of attorney. The latter requirement is applicable despite the fact that under the law, such authority can be confirmed by agreements, including, presumably, a standard security agency/ security trustee agreement traditionally used to document relationships of the security agent and lenders/facility agent.

On the basis of this, where a security agent signs the agreement in his own name, without disclosing the lenders, and the security interest is registered in the name of the security agent only, the priority of security interests created in favour of the undisclosed lenders presumably could be successfully challenged.

Certain risks, albeit presumably smaller, exist that the security interest created in favour of lenders could also be assailed. Where an agreement should be notarized, it would not necessarily go smoothly. Ukrainian notaries are generally unfamiliar with the idea of the security agency and need to be convinced that the party to the agreement (in our case the security agent) is indeed a creditor under the loan agreement, which is difficult to do. Thus, notarizing the security documentation would require extensive negotiations or involvement of a specific notary with experience in similar cross-border financial deals.

In other jurisdictions which, similarly to Ukraine, do not recognize security trusts (i.e. a number of civil law countries), the concept of “parallel debt wording” has been developed. Under the parallel debt clause of a loan agreement, the security agent receives the parallel (independent from the lenders and other parties) claim to the borrower for all payments due under the loan agreement.

This independent claim of the agent is then secured by the security documents. The parallel debt concept is not known in Ukraine, and its enforceability has not yet been considered by Ukrainian courts. However, on the basis of freedom of contract, such provisions are likely to be enforceable under Ukrainian law, based on several legal concepts well developed in Ukrainian law. Unfortunately, as discussed below, the use of parallel debt raises currency control issues, which ordinarily render such a concept not fully workable.

An alternative (additional) approach occasionally suggested is to justify the involvement of a security agency based on the notion of a traditional commission agreement. Even though commission agreements (i.e. agreements based on which an agent enters certain transaction in its own name but on behalf of an undisclosed principal) usually serve as grounds for entering sales and purchase agreements, there are no legal restrictions on using a commission as an authorization for other contracts. However, without being tested, it probably should not be relied upon as a full-proof legal basis justifying execution of security agreements directly by and registering the security interests created in the name of the security agent only, and not the actual secured parties.

Of course, the best option could be to make all lenders parties to security agreements and register encumbrances created in the name of all secured parties. The arrangement of the lenders providing for equal priority, procedure for the enforcement of security interest and for the allocation of enforcement proceeds would then be addressed by a security agency agreement and/ or inter-creditor agreement. However, even this arrangement is not without its pitfalls. Particular problems arise at the stage of security registration. Ukrainian law links priority ranking of the claims to the time of their registration. When registering encumbrances in favour of each lender separately, the slight difference in the time of entering the respective entry into the registry might lead to lenders having a different priority, which goes against the nature of syndicated loans. An alternative method (i.e. entering all lenders as secured parties under the same entry) is viewed as technically problematic, because the existing register entry form is ill fit to indicating multiple lenders/secured parties.

Difficulties with the perfection of security interests are not the only factor hindering the development of syndicated lending in Ukraine. There are also certain exchange control rules which need to be taken into account by foreign lenders and their legal counsels when structuring a deal.

First of all, in the case of a default the procedure for the enforcement of a security interest selected by lenders might have a bearing on how easy it will be to transfer the proceeds from enforcement abroad. Under Ukrainian law, the transfer of funds abroad might require a license from the National Bank of Ukraine (NBU). Consequently, payment of proceeds recovered from the debtor (be it through the sale of collateral or directly from the guarantor) should be structured in a method that falls within one of the exceptions to NBU licensing requirements. In particular, enforcement through the security agent based on the parallel debt wording only would probably not be the best solution, considering that a security agent would probably need an NBU license for the transfer.

Another issue to consider is what will happen if the enforcement were to result in the receipt of proceeds in Ukrainian currency. In order to be transferred to foreign lenders, Ukrainian currency would need to be converted into foreign currency, which then may be transferred abroad, subject to compliance with other exchange control regulations. NBU regulations governing the purchase of currency list a limited number of grounds for the purchase of foreign currency, and it is unclear whether the servicing bank would be able to process the order on foreign currency purchase. This issue is particularly relevant where a loan is secured by the pledge of contractual rights (receivables) in local currency and/or rights to UAH accounts.

Even though multiple solutions exist for resolving the issues discussed above, particular attention should be paid from the outset to the development of the proper security structure, to structuring the enforcement on default and to the wording of security documents.

The issues touched upon above are but a summary of selected legal matters which are relevant for a secured syndicated loan transaction. No doubt, amendments to current legislation addressing some of these issues would be highly welcome. Meanwhile, it is important for potential Ukrainian borrowers to become more familiar with the standard expectations of foreign lenders, as well as for foreign participants to educate themselves about the particular legal issues justifying deviation of transactions involving Ukraine from their standard arrangements.