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- Julian Khorunzhyi
Senior Partner, Ario Law Firm
Co-developer of Bankruptcy Proceedings Code of Ukraine
Julian Khorunzhyi: “I don`t expect a flurry of bankruptcies in Ukraine due to the full-scale war with Russian Federation. It’s just not profitable”.
How is the bankruptcy sector in Ukraine coping with the Russian offensive, and why is even such a blow to the economy unlikely to lead to mass bankruptcies among domestic businesses and ordinary Ukrainians? Let’s analyze the most pressing issues.
The First Shock and Consequences
Like the entire legal market, the bankruptcy field in the first months of full-scale Russian aggression almost stopped. The number of insolvency cases opened from March to May 2022 is no more than a dozen. And the consideration of proceedings in bankruptcy cases, which were opened before the start of the great war, are simply “hung in the air”.
A certain revival of the bankruptcy sphere in Ukraine took place around June-July when the country had recovered from the shock of the first months and expelled the invaders from the north of the country.
And today, in view of almost 9 months of the great war with the Russian Federation, it is possible to draw conclusions about the consequences that this aggression has for the Ukrainian economy and, accordingly, the bankruptcy market. So, let’s go through the main ones.
Temporary Occupation: Consequences
Due to the occupation of a part of the territory of Ukraine, companies are suffering significant financial losses. Some businesses were forced to stop operations. A significant part of these companies have lost their assets altogether due to their physical destruction.
Business on the Territory that’s Controlled by Ukraine: Consequences of the War
Businesses located in Ukrainian-controlled territory have a slightly better situation, except for those whose property was damaged or destroyed during hostilities.
For example, business surveys conducted in the first months of a full-scale war showed that at the beginning of the Russian invasion, the percentage of those who were forced to suspend their activities reached 70%. However, this percentage gradually decreased and today a significant part of companies has resumed work and continues to work.
Logistics: the Consequences of the War
It should be taken into account that the disruption of logistics chains has significantly affected business activity in Ukraine. Companies were forced to quickly find a solution to this problem and change logistics (both within the country and in matters of export and import of goods).
Some enterprises have relocated to safer regions of the country, which also influenced their activities.
Personnel Issues: Consequences
The number of employees decreased, because some of them have joined the Armed Forces of Ukraine, some have changed their place of residence on the territory of Ukraine, and some have gone abroad.
Accordingly, on the one hand, we observe a rise in unemployment in the country, and on the other, a shortage of qualified personnel.
The situation on the financial market and rapid inflation caused by all the above factors should be added to the above consequences.
Thus, Russian aggression hit the solvency of almost all Ukrainian businesses. But that’s not all, because a significant part of this business operated on credit before the full-scale war. And now, considering inflation, devaluation of the national currency and the corresponding increase in the discount rate, which entailed an increase in interest rates, servicing the debts of enterprises has become very difficult.
Banks and Debtors
In private conversations, some bankers told me that they were in no hurry to take any measures to collect debts, they tried not to raise interest rates on loans, keeping them at the pre-war level. In this way, the banking sector kept business afloat so that it could at least somehow service loans.
However, even such measures could not stop the growth of the level of NPLs in the loan portfolios of banks. So, in the summer of 2022 (!!! for the first time since 2018), financial institutions began to record an increase in the share of non-performing loans. Until then, the level of NPLs in the banking system was only decreasing. The minimum indicator was reached at the beginning of 2022 – 26.7%. According to the National Bank of Ukraine, as of 1 September 2022, the share of NPLs was 30.8%.
At the same time, in addition to objective reasons (deterioration of borrowers’ solvency), the increase in the level of non-performing loans has another basis.
Representatives of the financial sector have repeatedly mentioned the activation of unscrupulous debtors. There are rare cases when borrowers, referring to the war, hide collateral assets to prevent the bank from collecting them. Such debtors justify their refusal to service a loan by the fact that, for example, their movable property is destroyed or located in a temporarily occupied territory. Although in fact, this property works effectively in the regions that are controlled by Ukraine.
Also, it should be noted that since the beginning of the full-scale war, the terms of classifying loans as problematic are beginning to finish only now.
In October-November, financial institutions will form the reserves and, accordingly, at this time, they will begin to actively work with those debtors who are either hopeless or those who engage in some kind of fraud and do not return either collateral or funds.
I predict that sometime in December we will see whether the banking sector can really influence the number of bankruptcies in Ukraine.
To Go, or Not to Go… Into Bankruptcy, that is the Question
In my opinion, in today’s reality, the opening of bankruptcy cases for creditors is more of a shot in the foot than a solution to the problem of debt non-payment. The fact is that stable economic indicators and a favorable investment climate are necessary for the effective repayment of creditor claims, including at the expense of property sold at auctions. But should we have to explain that the warring country has considerable problems with attracting investments?
Although, for the sake of justice, I cannot but point out that even now there are examples of successful privatization processes. After the launch of privatization in September 2022, which has been in “standby mode” since the start of the full-scale war, some lots are selling for 2-3 times more than the originally announced value. Interesting assets remain interesting even during the war. But if we talk about the mass sale of property as part of bankruptcy procedures, not every asset can attract a potential investor.
Therefore, I do not rule out that only the number of appeals from creditors with applications to open a bankruptcy case may increase. But in some cases, this will be connected exclusively with the motivation of debtors to fulfill their obligations, and not with a real desire to go to court and open a bankruptcy case. In today’s circumstances, due to the unpredictability of the situation, some borrowers are not ready to part with money (even if they have it). Similar appeals for the opening of bankruptcy cases can be a kind of “bluff” in order to avoid a lengthy court procedure within the framework of the usual court proceedings for debt collection.
It all depends on intentions. Unscrupulous debtors have traditionally found it advantageous to initiate bankruptcy proceedings against themselves directly or, as it was most often the case, through the appeal of “affiliated” creditors.
However, in my opinion, those debtors who have really suffered because of the military aggression of the Russian Federation will not have a significant interest in entering the insolvency procedure. A much more interesting option for them will be receiving compensation from Russia. By choosing bankruptcy, the result will be the liquidation of a legal entity, and accordingly, the impossibility of applying for compensation from the Russian Federation in the future. Both processes (the bankruptcy procedure and compensation from the Russian Federation) will be stretched over time. It should be understood.
I do think that the situation will remain unchanged for those businesses that were not directly affected by the hostilities. The dynamics of self-initiated bankruptcies among such companies will remain at the pre-war level, with a certain margin of error.
It is also necessary to consider the real cost of the bankruptcy procedure for both the debtor and the creditors. And it’s not cheap.
Therefore, in my opinion, on the one hand, the number of economic bankruptcies (defaults) will be significant, but on the other hand, the number of bankruptcy court cases will not increase highly.
The Bankruptcy Market: a Response to the War
Of course, bankruptcy cases will continue to be opened. However, given the above, I don’t think we will see a statistically different jump in the number of cases of this type from the pre-war level.
We had the opportunity to repeatedly make sure that crises do not directly influence the rapid increase in insolvency cases.
For example, during the financial crisis of 2008, many experts predicted an increase in the number of bankruptcies, but in fact they have decreased. The reason, as already mentioned above, is the reluctance of businesses to invest in assets (which are realized as part of such cases) during turbulence in the economy.
It is economic growth and stability that encourage such processes much more.
They were in Bankruptcy, and Now there is a War
Another pressing question. And what should be done with those enterprises that were in the process of bankruptcy and then destroyed or significantly damaged during the war? This topic was already raised during the development of the relevant legislation. But so far the law can’t clearly answer this question, I would recommend not to give a gift to the aggressor country and in no way close such cases. Debtors and creditors should not be deprived of the opportunity to receive compensation from Russia for property that it destroyed.
As for the companies that were in bankruptcy proceedings before the war, and currently find themselves in the temporarily occupied territories, the situation here is different. Currently, such cases are simply “hang in the air” due to procedural nuances. In order to conduct an auction for the sale of the bankrupt’s property, it is necessary to carry out an inventory and assessment of such property. But it is simply impossible to do this at the moment, as well as to hold an auction. Therefore, such proceedings will continue to “hang” until there is a military or political resolution of the issue.
The Bankruptcy of Individuals and the War
In the case of individual bankruptcies, there are no fundamental changes either. As in a business situation, banks understand the situation to a greater extent and do not put pressure on debtors. What’s more, quite numerous Ukrainians from among borrowers are currently serving in the Armed Forces of Ukraine. And this is the reason for suspending the proceedings in bankruptcy cases in court. You should also not exclude the reputation component. I doubt that bankers would now go to court to collect loans from military personnel.
I cannot ignore the fact that preparations are taking place for voting in the second reading of a draft law on the forgiveness of credit obligations to individuals if their pledged property is destroyed because of hostilities.
Legislation and the War
The war did not stand in the way of legislative work in the bankruptcy field.
The Ario Law Firm team participated in the working group for the development of draft law No.4409, which was voted on in the first reading even before the start of the full-scale invasion of the Russian Federation and is now being prepared for a repeat second reading. I think that soon the changes proposed by the draft law will be voted on.
This draft law provides for several changes to the Bankruptcy Procedures Code of Ukraine:
- Strengthens responsibility for untimely appeal to the court, initiation of bankruptcy proceedings;
- Resolves the issue of strengthening joint and subsidiary liability;
- Regulates issues regarding the approval of the rehabilitation plan;
- Brings the provisions of the Bankruptcy Procedures Code into compliance with the Economic Procedure Code of Ukraine, Laws of Ukrinae “On Prevention of Corruption”, “On Management of State-Owned Objects”, “On Privatization of State and Communal Property”, “On Court Fee”, “On Executive proceedings”;
- Regulates some controversial issues regarding the sale of assets of bankrupts at auctions – the rules for conducting the first repeat and second repeat auctions are more clearly defined;
- The procedure for the sale of state property changes. In case of adoption of the draft law, state-owned enterprises with debts will first be put up for privatization auctions. And if these auctions do not take place, then only after that a bankruptcy case will be opened and the further sale of assets will already be carried out within the scope of this case.
When we worked on this draft law, there were many proposals, and the working group was quite large. That is why we have not reached an agreement on other fundamental issues. Currently, they continue to be worked out and will be included in the new draft law, which is planned to be prepared before the beginning of the new year.
Another legislative initiative, in the development of which our team has also participated, is bill No.7442, which aims to adapt bankruptcy procedures to the realities of wartime. The draft law has already been adopted in the first reading.
In addition to the technical aspects related to the actions of the participants in insolvency cases in wartime, this draft law provides for the establishment of a kind of soft moratorium on the opening of bankruptcy cases.
In particular, the courts are invited to refuse to open proceedings in a case if the debtor objects to its opening, and his failure to fulfill his obligations relates to military operations, or his production facilities are located in temporarily occupied territory or in the war zone.