SUMMARY UPDATE ON LEGAL FRAMEWORK FOR BUSINESS OPERATIONS IN UKRAINE
Irina Paliashvili, Chair, Legal Affairs Working Group
U.S.-Ukraine Business Council (USUBC)
President and Senior Counsel, RULG - Ukrainian Legal Group
Kyiv and Washington, D.C. February, 2008

In light of the fundamental and systematic economic reforms needed in Ukraine and an on-going sharp increase in foreign and domestic investment, it is imperative to ensure that Ukraine’s legal system is prepared to serve as a modern and adequate legal basis for the economy. 

The current legal basis is not only inadequate, but to a large extent it sabotages the development of a market economy in Ukraine.  It is archaic, chaotic, and at times absurd.

The market responds to this situation in a healthy way – it tries to stay as far away as possible from the legal and regulatory regime and from the corrupt judiciary, while ignoring their more absurd rules and instead following modern business practices. 

This creates a widening gap between what is written in the books and understood by those who administer the law (government authorities, regulators, judges) and the business community. 

At first, this may seem like a reasonable truce, which at least does not prevent the steady development of the market in Ukraine.  But this solution is not harmless – it forces non-compliance, greatly increases the risks of doing business, artificially provokes commercial disputes, and creates a breeding ground for such ugly trends as corruption, lack of enforcement, corporate raiders, lack of corporate governance, etc.

For many years, the business and legal community (EBA, AmCham, etc.), international organizations and institutions (OECD, UNDP, EBRD, IFC, etc.), foreign governments (USAID, EU’s TACIS Program and others) and think tanks (International Centre for Policy Studies (ICPS), Institute for East West Studies, etc.) have worked to conduct an inventory and evaluation of everything that has gone wrong with the legal and business climate in Ukraine and to make recommendations. 

The latest excellent study, "Encouraging Trade and Foreign Direct Investment in Ukraine", authored by Keith Crane and F. Stephen Larrabee of the Rand Corporation, was just presented at the USUBC Annual Meeting in Washington in December, 2007.

The main priority for the new Government, therefore, should be to act, and to act swiftly and decisively.  Ukraine’s legal system, and consequently the business climate, can be improved immediately and dramatically just by cancelling the most archaic and damaging legislation, using the so-called “guillotine” principle, which worked successfully in other countries that undertook modernization reforms.   

Some of the problems are of course fundamental, cannot be resolved in isolation and require unified political will and tremendous systematic efforts.  These problems include overall outdated, contradictory, ambiguous and poor quality laws and regulations, excessive, inefficient and poorly qualified bureaucracy, and a corrupt and underdeveloped judicial system. 

At the same time, there are a number of specific problems described below that can be resolved much faster, having tremendous positive impact on the business climate:

• Underdeveloped corporate legislation, and in particular the absence of key market laws, such as a Law on Joint-Stock Companies and a Law on Limited Liability Companies.

 

• An anti-market Commercial Code, and flawed Civil Code, which are in fundamental conflict with each other (simply abolishing the Commercial Code would have a major positive impact).

• Chaotic, arbitrary, excessive and incredibly costly overregulation and interference by the authorities in all spheres of business.  This is loosely referred to as the “permits system”, or by the broader, internationally known term “regulatory governance”.  Various Ukrainian Governments made several half-hearted attempts at deregulation, but in the absence of true political will, they generally resulted in more overregulation and more chaos.  The highly publicized Government effort to eliminate several thousand regulatory acts back in 2005 failed because the cancelled acts turned out to be archaic documents, which had little to do with business regulation and were not applied in practice in any case.

 

• A complicated tax system and multiple tax bureaucracies, with the worst offenders being VAT and unjustifiably high social taxes.  Two key problems with VAT: (i) on-going problems for exporters trying to obtain export VAT refunds; and (ii) imposition of 20% VAT on in-kind contributions by foreign investors into the charter capital of Ukrainian companies, introduced in 2005, which represents a 20% non-refundable tax on bringing in-kind foreign investments into Ukraine.

• Lack of liberalization of the currency regime and financial sector, including such unnecessary obstacles and hidden charges as: (i) overregulation of ordinary financial activities (for example, in order to issue a simple parent guarantee, a company needs to be registered with the State Commission of Ukraine for the Regulation of Financial Services Markets of Ukraine); (ii) the requirement that any sale-purchase of Ukrainian securities (even outside of Ukraine between non-residents) must be carried out only with the participation of a Ukrainian securities trader; (iii) excessive licensing requirements by the National Bank of Ukraine (NBU) with regard to foreign currency transactions and payments outside Ukraine; (iv) draconian requirements of the NBU as to international loans; (v) the outdated and anti-business 180-days rule, and many others.

 

• Constant negative interference by the National Bank of Ukraine with the investment regime.

• Inconsistent Government policies discouraging foreign investment in the vital energy sector. Although a first-ever Production Sharing Agreement was concluded in 2007 with the U.S.-based Vanco, most of the energy, and especially oil & gas, sector remains virtually close to foreign investors.  Moreover, in 2007, the Government declared unlawful the traditional method of joint activity agreements by which foreign investors have participated in natural resources exploration and development, and drove out foreign investors by introducing restrictions and price controls on the sale of natural gas extracted in Ukraine.

 

• Unnecessarily broad and ambiguous antimonopoly legislation, which over-regulates economic concentrations, which in turn forces companies to seek the Antimonopoly Committee of Ukraine’s prior approval of actions that really have no bearing on competition in the Ukrainian market at all.

• Lack of intellectual and industrial property protection, especially at the enforcement level.

 

• On-going moratorium on sale of agricultural land and restrictions on land ownership by foreign investors.

• On-going ambiguity with regard to property rights.

 

• Increasing corporate raids.

• Delays in WTO accession, which in turn delay the Free Trade Agreement (FTA) with the European Union.

 

All of these problems, although constantly and loudly criticized by the business community, have been neglected by several generations of the country's leadership.  There has been no Government so far willing to develop a strategic program of reforms for the legal and regulatory regime, and it remains to be seen whether the new Government will make a serious and honest effort to address them. 

The good news, however, is that the business community has not given up, and demand for reform is reaching critical mass.

One of the major market tendencies, which will inevitably result in the modernization of the legal and regulatory regimes, is the immense hunger of Ukrainian companies for growth. This is equally true for multi-industry giants, medium-size companies and for small businesses. 
All of them are looking for financing on both the domestic and international markets through IPOs, mergers & acquisitions, strategic and portfolio investment, issuance of corporate debt instruments and direct borrowings from domestic and international lenders, etc., and can no longer tolerate the obstacles created by the archaic legal regime and bureaucracy. 

The several sporadic positive developments of the last two years, such as the adoption of a modernized version of the Law on Securities and the Stock Market, adoption of several progressive laws within the process of Ukraine’s WTO accession, adoption of stronger anti-piracy optical media licensing rules, creation of a regulatory framework for mortgage lending, liberalization of incorporation procedures, etc., were similarly driven by the business community and international organizations and institutions.
2008 will be the pivotal year in the desperately needed reforms and modernisation of Ukraine’s legal regime and business climate for two main reasons: first, because the business community no longer wants or can afford to tolerate obstacles created by the legal chaos and inefficient bureaucracy, and second, because the new Government will be unable to remain in power while ignoring the demands of the business community.