Securing Creditors' Interests under International Commodities Trade/Finance Transaction in Ukraine

27 06 2007

I. INTRODUCTION
Structured commodity finance in Ukraine is an important area of growth for the banking and corporate sectors. The increased demand results in part from the development of industry and trade and the need to finance such development. In recent years Ukraine has been witnessing economic growth despite persistent political instability in the country. With all the political risks and within the limitations of applicable laws, the most widely used means of obtaining financing on affordable terms and conditions is structured commodity finance, the popularity of which has recently been growing among foreign financial institutions.

There are a number of definitions of structured commodity finance. Generally speaking, structured commodity finance may be defined as a commoditybased financing technique, specifically designed for commodity producers and trading companies doing business in developing markets. The structure of the deal itself contains two essential parts: (1) the first one is that there should be arrangements which ensure that if a transaction proceeds normally, the financier is automatically reimbursed - the loan is therefore selfliquidated; (2) the second part is the arrangement by which, if anything goes wrong, the financier is ensured recourse to some assets as collateral.

By their very nature these types of transactions give rise to a number of risks that the financier has to bear in mind, such as, insolvency of a producer or distributor, problems in realizing the security of the transaction, or even discovering that the commodity that had been financed is no longer in existence. These risks need to be secured. One of the key features that characterize commodity finance transactions of this variety is that they normally involve security over commodity stocks as a part of the package granted to a financier in respect of the borrower's indebtedness. Another consequence of this is that the very security being offered to the financier acts also as the means by which the debtor's indebtedness will be repaid. In other words, repayment of the loan will depend greatly on the debtor's ability to sell the very goods, which are at the care of the security. These specific features usually make it harder for the financier to control or monitor the security.

We have experience providing legal support for structured commodity finance transactions that dealt with the trade of a variety of goods - grain, steel products, and energy resources. The purpose of this article is to highlight some of the legal aspects of the most common problems encountered in commodity financing relating to Ukraine and to examine some of the ways in which the parties can mitigate the risks.

II. STANDARD STRUCTURE OF THE DEAL
In most cases foreign financial institutions choose to provide loan facilities for financing the trade of Ukrainian commodities not directly to Ukrainian borrowers, but rather through off-shore SPV companies. There are number of reasons for that. Under Ukrainian legislation loans obtained from foreign creditors, except so-called commercial credits, are subject to registration by the National Bank of Ukraine prior to actually obtaining such loans. Thus, any loan obtained as commodity finance from an international financier is subject to registration by the National Bank of Ukraine before any payments are made under the relevant loan facility agreement. In addition, the National Bank of Ukraine establishes a maximum interest rate that can be applied under a foreign loan agreement. Should the interest rate under a foreign loan agreement exceed the maximum interest rate established by the National Bank of Ukraine, such as agreement will be refused registration.

Another point is that Ukrainian currency control regulations in practice make it difficult for a Ukrainian company to assign export proceeds to a foreign financier. At the same time, assignment of export proceeds is very often an important part of the security package for the structured commodity finance. In accordance with Ukrainian legislation, proceeds obtained from export shall be credited to the borrower's account within 90 (ninety) calendar days (the so-called '90-day rule') from the day of such export (i.e., when the goods crossed the custom territory of Ukraine).1 In other words, the currency control regulations require that the money due under the export contract should be paid to the borrower within 90 days 2 after the goods leave the Ukrainian territory. Applied to structured commodity finance transactions, this means that the proceeds from export should first be put in the borrower's / exporter's account and then be transferred to the foreign financier's account as repayment under loan facility agreement. Formally, a Ukrainian borrower may open a bank account for this purpose with a foreign bank, but it needs to obtain a license from the National Bank of Ukraine.

Financing through an off-shore SPV gives some level of flexibility to both financier and importer, but it needs to be properly secured in order to give the financier not only flexibility but the feel of comfort as well, and the level of comfort depends to great extent on how the goods and transaction itself are secured.

II. TAKING SECURITY OVER THE GOODS
Ideally, the security package should provide the creditor (a) an opportunity to react promptly and effectively against the borrower's default, which in fact means to enable the creditor to enforce its claim against secured goods in the most effective manner and, if possible, without resorting to the court proceedings, and (b) if for some reason it is not possible to enforce its claim against the secured goods - to have in addition a security instrument that would allow the creditor to bring a claim against a company that has assets; normally it is a company that acts as guarantor for the debtor's obligations.

Where the financier wishes to take security over the goods themselves, there are a number of legal issues that arise. The first to be taken into account is the importance of the legal regulations in the place where the goods are physically located. Whatever law and jurisdiction may be selected for financing agreements, the effect of security over the goods will be governed by the law of the place where the goods are located (lex situs). In other words, if the goods are located in Ukraine, you need to enforce your claim against the goods under Ukrainian law and the availability of such enforcement directly depends on whether the security instruments meet the formal and substantial requirements of that law.

Security of goods can take a variety of different forms. In general there are two different groups: pledges and ownership. Ownership or title to a commodity as a means of security is hypothetically the best option of the financier. However, often lenders prefer that their customers hold ownership title of the goods given the formalities that ownership in foreign jurisdictions can sometimes involve. For instance, financial institutions as foreign entities may be unable to export or sell the commodities due to the necessity to comply with certain formalities; as well, such ownership of the goods may be subject to taxation or licensing problems. For these reasons, financiers will often prefer not to take title as the means of security.

(A) Pledges

As a result of the complications relating to ownership outlined above, many financiers prefer to take a pledge over the goods as security. In many cases a pledge involves the delivery of possession of goods as security until payment. Creation of a pledge involves the transfer of possession over the goods, whether actual or 'documentary' possession (or so-called constructive possession). In addition the borrower retains title over the goods. Before effecting a pledge over the goods, a financier will need to satisfy itself that the borrower is the existing owner of the goods under Ukrainian law. Normally, it should be done through some due diligence process. The financier rarely takes actual physical possession of the goods but instead will take 'documentary' possession by taking control over the goods, for example, by taking delivery of a warehouse receipt or by taking delivery or endorsement of a document of title, such as bill of lading. Under Ukrainian law the pledger (that is the borrower) may not sell or dispose of in any manner the pledged goods without the prior written consent of the pledgee (that is the financier), unless otherwise provided by law or a respective pledge agreement. Properly formalized contractual documentation and verification of the rights of third parties to the commodities, which are subject to pledge, allows the financier to recover theirclaims quite effectively.

It is important to note that Ukrainian law allows the parties to the pledge agreement to determine in the agreement itself the way and the manner in which the creditor's claim may be enforced against the secured goods; this may also provide for the out-of-court proceedings. It is advisable to take this opportunity and provide for this in the agreement in order to avoid resorting to the court for the purpose of enforcement against the pledged goods.

It is also important to have the pledge registered with the State Registry of Encumbrances of Movable Property. Absence of registration does not affect the validity of the pledge agreement, but registration does provide the creditor with additional benefit and securing. Registration of the pledge gives the creditor priority rights with regard to the pledged property. If the pledge is not registered and the debtor sells the goods that are subject to pledge, the purchaser of such goods will be deemed as a purchaser in good faith and, therefore, the creditor will not be entitled to invalidate this sale and claim the goods back. The creditor will be entitled only to claim damages from the borrower. In fact, the absence of registration of the pledge agreement makes the level of control over the goods by the creditor considerably lower.

Thus, to make the pledge as effective a legal instrument of security over the goods as possible, it should contain all the essential provisions stipulated by Ukrainian law for the pledge agreement, the title of the pledger to the goods should be carefully verified, the agreement should be in writing and, advisably, it should be registered with the State Encumbrance Register.

(B) Warehouse Certificates/Warehouse Receipts

Warehouse certificates or warehouse receipts, as mentioned above, is one of the ways in which the rights of 'documentary' possession may be given to a pledgee (that is the creditor). Warehouse receipts are often assumed to be the document of title similar to a bill of lading. Under Ukrainian law the warehouse certificate/ receipt is not a document of title; transfer of the warehouse certificate/receipts does not mean transfer of the title to goods. The bank will need to take a pledge over the goods themselves and will hold the warehouse certificate/receipt as evidence of its rights of possession or right as a pledgee.

Under Ukrainian law there are the following types of warehouse documents: (a) twofold warehouse certificate, (b) simple warehouse certificate, and (c)warehouse receipt. Twofold warehouse certificates consist of two parts, a warehouse certificate itself and a warrant certificate, and these can be separated from each other. The pledge of the goods, accepted for storage under the twofold warehouse certificate, arises as of the moment of conclusion of the pledge agreement and when the warrant certificate is separated for the purpose of the pledge and transferred to the creditor. The holder of the simple warehouse certificate may pledge the certificate itself and in this case the simple warehouse certificate must be transferred to the creditor (pledgee). If the holder of the simple warehouse certificate decides to pledge the goods instead of the certificate itself, the simple warehouse certificate needs to be changed into a twofold warehouse certificate.

It should be noted that only certified warehouses are entitled to issue the types of warehouse documents mentioned above. I would say that at present the Ukrainian regulations relating to the warehouse certificates/receipts is much better developed today than previously when only the so-called Form 133 was in circulation as a type of the equivalent of warehouse receipt. At the same time the recently introduced system of warehouse receipts/ certificates does not solve all problems inherited from the 'Form 13' and still does not make warehouse receipts flexible and commonly used instruments for securing the financing of commodities. In practice, the number of certified warehouses is still limited and warehouse documents established by special law are still not in wide circulation.

(C) Forwarders Certificate of Receipt (FCR)

We have a number of cases where financing for commodity trade was provided against forwarder's certificate of receipt (FCR), which means that FCR was used as a primary security instrument. You probably know that the FCR is a tool that was originally developed by the International Federation of Freight Forwarders Associations (FIATA). Briefly speaking, in FIATA terms, the FCR means that a forwarder issuing FCR (a) acknowledged receipt of certain goods, (b) assumed control over the goods with irrevocable instructions to forward them to a foreign purchaser named as consignee in the document (which means that the goods are beyond control of the exporter), and (c) must follow the instructions of the holder of original FCR.

The question is how reliable is FCR as a security instrument for commodity finance in Ukraine. The answer based on our previous experience is that the financiers accepting FCRs as a mean of security still need to be quite careful since, in our opinion, FCR does not provide the holder with an appropriate level of security. Undoubtedly, FCR is quite a flexible and convenient instrument for the purpose of short-term financing, but in Ukrainian practice it is associated with a number of risks. The regulation of the professional activity of the freight forwarders in Ukraine is of very poor quality. No regulations similar to those of FIATA as yet exist in Ukraine. In fact, Ukrainian formal regulations do not support the intended purpose for which FCRs were originally developed and introduced.

We represented foreign financial institutions and importers in a number of disputes arising out of FCRs issued by Ukrainian freight forwarding companies. Only in one case did the forwarding company respect the FCR and its obligation arising thereof. In all other cases, when the cargo simply disappeared, all forwarding companies refused to recognize the FCR as a valid and binding document under Ukrainian law. They argued that the instructions of the FCR holder with regard to the cargo are not binding upon them since they have a written agreement with a principal (exporter or cargo owner) and only instructions of the principal shall be validly accepted. Of course, in case of conflict between the financier holding the FCR and the principal having the written agreement with the forwarder, the latter almost always accepted the instructions of the principal. At the same time, this position contradicts one of the key purposes of the FCR, which is that the goods accepted by the forwarding company under FCR become beyond control of the exporter (cargo owner).

In one court case we represented a well-known foreign bank, which is quite heavily involved in structured commodity finance in Ukraine. The bank held the original FCR, but there was a conflict with the borrower, who at the same time was the exporter and the principal for the forwarding company. The borrower was instructed to ship the cargo contrary to the instruction of the bank. The cargo disappeared. The bank decided to go to court with a claim for damages against the forwarding company. It was a difficult exercise for us to prove before the court that the FCR gives rise to some obligations of the forwarding company to the bank, in whose name the FCR was issued and who held the original FCRs. We lost in the first level court. However, we were quite successful in the appellate court, in the Highest Commercial Court, and finally, in the Supreme Court of Ukraine. Thus, this case went through all the court levels of Ukraine. The court of appellate and the courts of cassation supported our arguments and ruled that the FCR is binding upon the forwarding company, and as a result awarded the clients damages in the amount of about four million U.S. dollars based on the breach by the forwarding company of the obligations arising out of the FCR. What was quite unique for the Ukrainian legal system was that the ruling of the courts was based principally on internationally accepted trading usages, customs, and practices. This was really precedent-setting decision for the Ukrainian court system. Thus, in the end the Ukrainian court in practice recognized the FCR as a valid and binding instrument; however, to get this result, we had to go through all court levels, which took a lot of time.

What to do if, nevertheless, the FCR is offered as a security and the financier intends to accept it? First, make sure that the FCR is issued by a FIATA member, which in the worst case scenario, gives you an opportunity to refer to the FIATA rules. Second, accept FCRs only from reputable Ukrainian forwarding companies. Third, carefully check the text of the FCR that is to be offered as a security, and check the agreement between the forwarding company and its principal (exporter of goods, or whoever). Require the elimination of any inconsistencies to the effect that the bank's instruction with regard to the cargo is following the principal's instructions. Do not use the FCR as the only means of the security; combine it with another measure, such as a pledge of assets, or other available securities depending on the case.

III. GUARANTEE / SURETYSHIP

It is a very common practice now that financiers do not limit themselves to security over the goods only. They want to have in hand a legal instrument allowing them, in the worst case scenario, to bring a claim against the Ukrainian exporter, or producing company, or the borrower?s parent company, companies which have the real assets. For this purpose a foreign bank normally uses some kind of guarantee to be signed by the Ukrainian company, and that guarantee is normally governed by foreign law. There are a couple of observations regarding this. Whatever laws are chosen for the purpose of such a guarantee, the rules of Ukrainian laws relating to the personal status and legal capacity of the guarantor need to be taken into account. This means that if a Ukrainian company has no status as a financial institution it cannot issue a guarantee and act as a guarantor. Instead, the suretyship agreement may be signed with a Ukrainian company under which the surety will be jointly liable with the borrower. Such suretyship agreement has the same legal effect as a guarantee. The validity and enforceability in Ukraine of the suretyship agreement depends on the validity of the principal obligation, which is a loan agreement. For some reason the foreign banks are usually reluctant to have the formal loan agreement with the borrower. In practice it may cause problems when enforcing the claim against the surety because it would be necessary to prove in a Ukrainian court the existence of a valid loan agreement that had been secured by the suretyship.

IV. CONCLUSION

As a general rule a financier tends to apply a combination of techniques to get the best security. In order to cover risks associated with commodity finance transaction, financiers sometimes suggest applying repurchase measures in which the title of the commodity is temporarily transferred from the borrower to the special purpose vehicle of the financier and is retained for a certain period of time; that is, until delivery to the ultimate purchaser under the agreements between the borrower and this purchaser.

Afterwards, the title to the commodities is transferred back to the borrower who then sells the commodity and uses the accumulated proceeds to pay off the loan. But in our practice this 'repurchase' technique with creation of SPV is rarely used by foreign banks.

Unlike many other methods of secured financing, commodity financing transactions undoubtedly carry some specific risks. The financiers can, however, take steps to mitigate these risks by fully understanding the legal issues that the security arrangement gives rise to. Issues such as those relating to risk management and mitigation are set to become even more important with the European Union giving effect to the new Basel II Banking Accord. Changes to the capital adequacy requirements for banks will inevitably have an impact on the structure of loans for commodity finance and the costs of borrowing funds.

LCMonitor, Volume 9, Issue 2, June 2007
Author: Oleg Alyoshin