How To (#03 March 2010)

Selling Non-Performing Loans — How to Structure the Deal

Tatiana I. Zamorska

This article gives an overview of certain key legal issues arising for Ukrainian banks that are contemplating the sale of non-performing loans. While such transactions are not yet widespread among Ukrainian banks, their number increased in 2009, and there are signs that this growing trend will be observed in 2010. The main barriers for these processes include legislation, which contains a number of gaps, and bureaucracy, i.e. the existence of a number of regulatory requirements, which are easy to implement in theory, but difficult to accomplish de jure in practice due to a lack of support from certain state regulatory authorities.

Structuring a deal on transfer of loans

Who is eligible to buy loans?

By virtue of certain currency control restrictions, transactions on the sale of non-performing loans (further — NPL) are commonly structured by Ukrainian banks with local unrelated entities (e.g. collection agencies) or related parties (i.e. companies belonging to the same group). In both mentioned instances, to mitigate the risk of the transaction being voided, the Ukrainian bank (hereinafter — the Bank) has to verify inter alia whether the buyer meets the requirements envisaged by the special legislation on financial services.

Specifically, pursuant to a “catch-all” provision contained in Article 4.1 (12)) of the On Financial Services and State Regulation of Financial Markets Act of Ukraine of 12 July 2001, any purchase of loan receivables for consideration may be viewed as the provision of a financial service. The Instruction of the Financial Services Commission No. 231 of 3 April 2009 and the Letter of the Financial Services Commission No.8701/11-12 of 8 July 2009 define three criteria for operations qualifying them as financial services:

  • financing of clients who concluded an agreement under which the right to claim cash debt arises; and
  • acquisition of the right to claim a debt in cash from the borrowers, including debts that will arise in the future; and
  • receipt of consideration for the use of financing made available to the client, including by way of discounting the amount of debt, split of interest amount, unless another way of compensation is not specified in the transfer agreement.

If the following criteria are met, the buyer of a NPL portfolio must be registered as a financial institution with Ukraine’s State Commission on Regulation of Financial Markets (hereinafter — the Financial Services Commission). At the same time, it is still unclear and it is a debatable issue among lawyers whether a transaction on transfer of loans at the nominal value can be structured with a Ukrainian entity which does not have the status of a registered financial institution. There are arguments in favor of both approaches, but given the current environment, in order to minimize the risks, Ukrainian banks tend to favor a more conservative approach and choose to contract with a financial institution.

From a practical point of view, although the statutory requirements for registration of a financial institution are rather straightforward and can be easily implemented in practice, the process of registration of the company as a financial institution with the State Commission on Regulations of Financial Services Markets is far from being transparent. Therefore, the number of companies registered as financial institutions operating as factoring companies appears limited.

The scope of rights to be transferred

Analysis of Ukrainian law suggests that for the moment there is no clearly defined framework restricting the parties in determination of the scope of rights that can be subject to transfer under the NPL sale agreement. In particular, the parties may consider the following available options, i.e.:

  • To transfer debt receivables under loan agreements (i.e. the rights to claim debt comprised of the claim of the principal, interest, fines and commissions). Such transfer would be governed by Article 656 (3) of the Civil Code of Ukraine.
  • To assign NPLs pursuant to a factoring agreement. Such transaction would have to follow the guidelines of Article 1077 of the Civil Code of Ukraine.
  • It is worth emphasizing that the transfer of the right to claim debt to the buyer of the NPL portfolio does not imply transfer of the obligations under the relevant loan agreements.
  • It is assumed that the obligation (i.e. provision of the loan) was fulfilled by the initial creditor [i.e. the Bank], and, therefore, the buyer of NPLs receives only the right which entitles him to receive the principal, interest and other payments due by the borrower under the loan agreement, as the case may be. Such rights of the buyer of the NPLs should not be construed as qualifying its activities as lending operations, which are subject to special rules and procedures a nd, in some instances, require licensing.

Transfer of NPLs denominated in foreign currency

In the event of transfer of NPLs denominated in USD/EURO, an issue arises regarding whether or not such a transaction is subject to currency control. It is generally known that the Resolution of the Cabinet of Ministers of Ukraine On the System of Currency Regulation and Currency Control and the Commercial Code of Ukraine contain certain regulatory restrictions with respect to operations between Ukrainian entities which involve transfer of title to foreign currency values. As a reminder, the term “currency operations” is defined in Article 1.2 of the mentioned CMU’s Resolution and includes, inter alia, “…operations related to transfer of title to currency values excluding operations in Ukrainian currency which are conducted between two residents…” Further, the CMU resolution indicates that any payments between two Ukrainian resident companies must be made only in Ukrainian hryvnyas. If payments are made in foreign currency between two Ukrainian companies, they are permitted only provided the relevant license of the National Bank of Ukraine (hereinafter — NBU) has been obtained for such operations.

The above legislative provisions and the practice of their interpretation in specific NPL transfer transactions suggest that, in theory, the transfer of loans denominated in foreign currency from a Bank to a Ukrainian buyer could be viewed as a “currency operation” (because it implicitly involves the transfer of title to foreign currency between the parties). However, provided that the transfer of such NPLs is made for consideration denominated in Ukrainian hryvnyas (i.e., it falls within the ambit of “operations in Ukrainian currency between two residents” because the settlements are made in UAH), the relevant transfer should not be viewed as a “currency operation” and, therefore, an NBU license does not seem to be required for transferring the NPLs from the Bank to the buyer of loans.

Notification of consent of the borrower

Regardless of the respective category of loan agreements (e.g. car loans, mortgage loans), the consent of the borrower to the transfer (assignment) of loans is not required. Furthermore, it seems that the receivables can be transferred by assignment without notifying the respective debtor(s). However, if no notification is made, such debtor(s) may continue discharging the relevant funds to the assignor [i.e., the Bank], rather than to the assignee [i.e., the buyer of NPLs] and such performance will be recognized as valid. The debtor may, therefore, refuse to discharge to the buyer [i.e. a collection agency/factoring company] the assigned funds unless the Bank and/or the buyer have provided the debtor with documentary evidence of the assignment.

The law does not establish the specific form of a notice to the debtor(s) regarding the assignment of receivables under the NPLs. However, with respect to a factoring transaction, the law (i.e. Article 1082 of the Civil Code of Ukraine) requires that a notice to the debtor must be in writing and specify the monetary claim which was assigned and identify the factor (i.e., the assignee).

In the event of transfer of the loans secured by mortgage, the Bank will be required to comply with Article 24 of the On Mortgage Act of Ukraine, which obliges it to notify borrowers regarding the assignment of the relevant loans within 5 days subsequent to such assignment.

Banking secrecy

The On Banks and Banking Act of Ukraine and On Information Act of Ukraine requires Ukrainian banks to maintain banking secrecy, i.e. not to disclose information regarding the activity and financial condition of the client [i.e. the borrower] and personal data about the client which, if disclosed, could cause material or moral damages. Transfer of NPLs by the Bank could be treated as the disclosure of information about clients to the buyer of NPLs. However, under the law, disclosure of a banking secret to third parties is prohibited unless the borrower has expressly agreed to it. Accordingly, in the absence of such consent, the validity of any agreement on the transfer of a NPL portfolio could be challenged.

It is also worth noting that there are conflicting provisions in the Civil Code and the On Mortgage Act of Ukraine where assignment of loans appears possible without receiving the consent of borrowers. However, at the same time, the Bank cannot disclose any information about the borrowers and loans without the consent of the borrowers. It is not fully clear, therefore, how the Bank could transfer the NPLs to the buyer without receiving relevant consent from borrowers as the transfer of the loans would inevitably entail the transfer to the buyers of documents confirming the Bank’s rights to the transferred loans (i.e., the information containing the banking secret).

Summing up the above, although it could be argued that under the general provisions of the Civil Code, the Bank is permitted to transfer NPLs to the buyer of the loans without receiving the consent of the borrowers, there is a certain theoretical risk that such transfer could be viewed as breaching Ukrainian banking secrecy and personal data protection laws. In the worst case scenario, the Bank may be required to reimburse the borrowers damages caused by the disclosure of confidential information and the validity of the agreement for the transfer of the NPLs could be challenged.

Transfer of rights to collateral

With respect to the NPLs that are secured by a pledge or mortgage, the Bank and the buyer of the loans have to specify in the transfer agreement that the Bank transfers to the buyer the rights to the collateral related to the relevant loans.

Pursuant to Article 513 of the Civil Code of Ukraine, the form of the agreement for transfer of rights to collateral must follow the form of the initial pledge/mortgage agreements. Therefore, if the initial collateral agreements were notarized then the relevant pledge transfer agreements must also be certified by a notary. Also, if the relevant pledges were recorded in the relevant State Registers of Encumbrances to Movable or Immovable Property, then the relevant pledge/mortgage transfer agreements should also be recorded in the relevant register. If information about the assignment of rights to the pledges/mortgages was entered in the relevant state register, this would enable the buyer of the loans to maintain priority of its rights to the collateral over other creditors of the same borrower.

Finally, it is important to note that if a special “mortgage note” (zastavna) was issued to the Bank with respect to the mortgages then the assignment of such mortgages (and the relevant loans) should be performed in accordance with the special procedure established by Articles 24-26 of the On Mortgage Act of Ukraine.

As for notification or consent of the borrower (or a guarantor), it appears that there is no statutory requirement for notification of the borrower/guarantor and, consequently, no deadline is envisaged for doing so.

Open litigation and execution proceedings

The assignment of rights under loan agreements may have an impact on any open litigation with the Bank’s borrowers, i.e.:

  • As regards the loans granted to individuals, according to Article 27 of the On Civil Procedure Code a substitution of a party to court proceedings appears possible. i.e. the Bank can transfer its procedural rights (i.e., the rights to participate in court proceedings) to the buyer of the loans at any stage of court proceedings.
  • As regards loans granted to legal entities — according to Article 25 of the On Commercial Procedure Code, the substitution of a party to a court case in the event of the assignment of rights to another party, would not be possible. Also, pursuant to existing court practice (namely: the Resolution of the Higher Economic Court of Ukraine of 12 January 2006, case No.5/109; and the Resolution of the Higher Economic Court of Ukraine of 26 April 2006, case No.20-9/065), the agreement for the transfer of loans where the execution procedure has been commenced by the Bank may be voided by the court. However, the decisions of courts appear vague and contain no clear arguments as to the grounds for voiding of relevant loan assignment agreements.

Should the case be at the execution stage at the moment of the assignment of NPLs, applicable to both commercial (i.e. where legal entities are involved) and civil court proceedings (where an individual is involved), no substitution of the creditor as a result of the debt assignment would be possible.

By way of summary, when planning a transaction on sale of non-performing loans, it is advisable to consider not only the legal implications arising for the parties from the specific transaction, but to also evaluate relevant tax and accounting aspects, which could also have a significant impact on the deal structure.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG Ukraine.

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