Diversification of Financial Instruments

By Armen Khachaturyan and Iryna Pokanay
Shevchenko Didkovskiy & Partners

Although the shocks from the collapse of the US mortgage market in early 2007 slowed down international capital markets towards the end of the year, Ukrainian companies still became hungry for international capital to overhaul old assets and further expand their operations.

International financial and capital markets, with their scrutiny and formality, discipline Ukrainian businesses and make them part of the global economy.

Based on the five-year history of Ukrainian corporate and municipal Eurobonds, loan participation notes (LPN) structures remain a viable option for those seeking long-term funds in large amounts. USD 100 million is historically seen as the minimum amount for a feasible Eurobond placement. There were 13 Ukrainian Eurobond issues with amounts ranging from USD 45.9 million to USD 500 million between February and August 2007.

Although the Ukrainian State Commission on Securities and Stock Market (SEC) attempted to initiate a reform of Eurobond regulation in Ukraine with the participation of a task force under its auspices, only a partial result was achieved. The new Securities and Stock Market Act (effective as of 3 May 2006) removed the requirement of denomination of corporate bonds only in Ukrainian currency. However, the relevant provision remains in the Commercial Code, leaving it unclear as to whether a direct issue is now possible.

As a result, Ukrainian offerings are usually structured as a limited recourse LPN with reliance on Rule 144 A and/or Regulation S under the US Securities Act of 1993. Rule 144A provides for the possibility of offer in the US to “qualified institutional buyers”. Regulation S provides for an offer outside the United States.

Under Ukrainian law, that Ukrainian banks can only draw from foreign banks or financial institutions, and municipalities can draw only from banks. Due to adverse interpretation of the rule in the Commercial Code that Ukrainian companies “may draw foreign currency loans from foreign financial institutions”, only foreign financial institutions may provide loans to Ukrainian entities. As a result, the risk exists of invalidation of a loan received from a lender that is not a bank or a financial institution. It remains to be seen whether the fiscal authorities and courts will consistently apply restrictive interpretation of the noted provision of the Commercial Code. However, technically, there seems to be a legal loophole.

Ukrainian civil law distinguishes between “loans” (kredyty) and “borrowings” (pozyky). Under the Civil Code of Ukraine, a “loan” is provided by a bank or other financial institution, which is consistent with the above-noted restriction under the Commercial Code, while a “borrowing” is not subject to such restriction. The relevant Regulation No.270 of the National Bank of Ukraine, dated 17 June 2004, applies registration requirements equally to loans and borrowings from foreign lenders. Thus, it can be argued that Ukrainian legislation allows Ukrainian entities (except for banks and municipalities, which are subject to special regulations) to receive funds from lenders that are nonfinancial institutions pursuant to agreements on borrowing.

Loans and borrowings from non-resident lenders must be registered with the NBU (notification of the NBU is required if the borrower is a bank). The NBU establishes an interest cap on the loans/borrowings from foreign lenders. The interest cap is tied to sovereign borrowings of Ukraine and covers not only the true interest but also extends to the lenders’ fees, default payments and other payments, costs and charges established under the loan. In 2007 interest caps ranged, depending on the term, from 9.8 to 11% p.a. for fixed rate facilities and were threemonth LIBOR plus 750bp for floating rate instruments. In June 2007 the NBU amended its loan registration rules with the intension of revising interest caps twice a year so that interest caps on the loans in foreign currencies of the first category, including USD, EUR, and GBP, equal the weighted average yield on Ukrainian state bonds in USD during the last two quarters plus 2% per annum. The proposed regulation aroused considerable opposition from Ukrainian banks, the most frequent visitors to international debt markets, which insisted that it is too restrictive (interest on external borrowings would be capped at around 9% based on then current trading levels) and would cause a shortening of banks’ debt-maturity profiles. According to the market’s overall criticism, collateral damage from the NBU’s strategy to lower the cost of foreign debt would apparently outweigh any benefit. The amendment was initially scheduled to come into force on 19 October 2007. However, as a result of persistent resistance from the market the NBU agreed to step back on interest cap regulation effective 1 January 2008, restoring the old regime under which interest caps on loans in foreign currencies of the first category are established by the NBU in consideration of an average spread between interest rates under sovereign and commercial borrowings on international financial markets and international ratings issued to Ukrainian borrowers. The NBU is committed to notify commercial banks on changes of inte rest rates by at least one month prior notice. Short-term borrowings (with less than one year maturity) by banks will be subject to softer regulation from 1 January 2008 with the possibility of funding before registration and effectiveness not dependent on registration with the NBU.

The prepayment under the loan is subject to interest cap applicable to the respective term of the loan. The registration of a loan amendment may be denied by the NBU if at the time of the amendment the interest rate under the loan exceeds the effective cap. Foreign-sourced loans guaranteed by the Ukrainian government are exempted from NBU registration, and loans from the EBRD are not subject to the interest rate caps established by the NBU.

Traditional bilateral loans are still often used when the borrower is able to provide a seal-proof security (e.g., a sovereign guarantee may give the green light to a significant loan amount). Syndicated loans remain an alternative to Eurobonds for borrowers seeking smaller amounts (USD 10-50 million) for a term of one to five years. The floating interest rate for Ukrainian syndications has been competitive, with the overall cost involving participation fees and commission often being cheaper than Eurobonds, with fewer pre-conditions (e.g., the borrower’s extensive financial accounts and rating are not required) and a shorter period for arrangement. During 2007, 22 Ukrainian borrowers have received syndicated loans in amounts ranging from USD 20 million to USD 512 million.

Project financing is also often used by large international banks and financial institutions (like the EBRD or IFC) as a well-developed finance technique mitigating common risks by sharing them with local sponsors of the borrower and repaying loan from the project proceeds.

The IPO has recently become a hot topic for academic reviews and discussions by practitioners at numerous domestic and international conferences. At a time when local capital markets are underdeveloped, a true domestic IPO is not yet an attractive idea for corporate finance strategists. Given the unequivocal prohibition of denomination of Ukrainian stock in foreign currencies and oppressive applicable regulations by Ukrainian securities supervisors, a direct IPO of Ukrainian shares on international markets is carried out through specially founded intermediate foreign companies by placements of private depositary receipts and “backed up” by Ukrainian assets. A foreign SPV then injects capital into the Ukrainian company through capital contributions or loans. Certain legal issues pertaining to depositary receipts remain a challenge and require special attention (e.g., beneficiary holding of shares under the depository agreement vs. “true ownership” of shares under Ukrainian law, split voting right by a depositary at the shareholders meeting of a Ukrainian issuer, discretionary proxy provision in the depository agreement regulating the management’s control of the issuer, or currency control requirements related to payment of dividends). Under Ukrainian taxation law, dividends paid by a Ukrainian stock company to a foreign shareholder, or interest paid by the Ukrainian company to a foreign lender, are subject to 15% withholding tax, which may be reduced by an applicable tax treaty.

Following the first successful USD 180 million residential mortgage-backed true-sale securitization by Privatbank in March 2007, a number of leading Ukrainian banks announced their intention to securitize pools of consumer finance receivables in the near future. A “true-sale” securitization will still be subject to complicated rules of Ukrainian collateral, currency control and banking regulations and its consistency remains to be tested in practice. On the other hand, the benefits of securitization may be beneficial, exploring the possibilities provided under Ukrainian law, in order to receive attractive financing alternative at a reduced cost of funds as a result of segregation of assets from the credit risk and higher credit rating of the securities issued by the SPV (which could be an obstacle to an unrated Ukrainian company entering capital markets and issuing debt in its own name).