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Barriers to Investment in Ukraine

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Barriers to Investment in Ukraine

BARRIERS TO INVESTMENT IN UKRAINE

    Report presented to the EU-Ukraine Co-operation Committee

February 2001

European Business Association Barriers to Investment in Ukraine

    European Business Association, Kyiv, Ukraine c/o Esplanadna 20, 9 th fl. Kyiv 01023

    Tel (+38 044) 229 7777, fax 227 0626 office@eba.com.ua www.eba.com.ua

    The European Business Association was established in 1999 as a forum for discussion and resolution of issues facing the European private sector in Ukraine. As of February 2001, it brings together representatives of 143 companies operating in Ukraine.

    The Association is grateful to all members that contributed to the discussions, drafting and approval of this report, notably to the EBA committees on transport and customs, taxation, manufacturing and investment, and to the legal committee for their comments and suggestions. Particular thanks are due to representatives of Alstom, Altheimer & Gray, Arthur Andersen, the Austrian Embassy, Credit Lyonnais, Dusseldorf Chamber of Commerce and Industry, Euro-Ukraina Consulting, Hertz, Novo Nordisk, Philip Morris, Raffeisenbank, Scania, The Deane Group, Unilever, West Ukrainian Venture Partners, and Zovnishinformaudit for their assistance and advice on drafting.

    Additional information on the Association, its activities and members is available online at www.eba.com.ua..European Business Association Barriers to Investment in

    Ukraine

     1 1 May 2001

INTRODUCTION

    This report has been prepared in February 2001 by the European Business Association at the request of the Swedish Presidency of the European Union and the European Commission. The aim is to review some of the barriers to the investment process identified by members of the Association, and consider some ways forward based on practices adopted in many other parts of the world.

    A focus on barriers to investment necessarily gives this report an emphasis on negative features of the Ukrainian business environment. This does not mean that the Association fails to recognise the progress that has been achieved in Ukraine, the continued stability of the hryvna and the stabilisation of government finances being good examples of the latter. Nor should it imply that the Ukrainian authorities themselves are unaware of the problems; in many cases, resolution of these problems is a central part of current policy.

    Nonetheless, it is important to acknowledge that many difficulties with the investment process are longstanding and tenacious, and are reflected in consistently low levels of foreign direct investment. Ukraine has received, as of October 2000, only USD 3.7 billion in foreign investment since independence in 1991; Ukraine’s own estimate of its

    investment needs in the five-year period from 1996 was USD 40 billion.

    This report does not claim to be a comprehensive overview of all issues related to investment, and it re-states issues that have been raised before. It is, however, reflective of the views of the members of the Association, and also reflective of their readiness to work with the Ukrainian authorities to find constructive solutions to these problems.

    Working in Ukraine over many years, EBA members are aware of the potential of a large and resource-rich country. Those with whom they work, and those that they employ, have also become aware of the benefits that foreign investment can bring in terms of new technologies, expertise and capital. They reaffirm their willingness to support, through their activities in Ukraine, a sustained effort to create the business framework that can spread these benefits more widely within the Ukrainian economy.

SUMMARY

    A critical challenge for Ukraine is the attraction of significant new capital investment. International investment flows are huge, yet investors still face a choice about which opportunities to pursue and which to postpone or delay.

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    In evaluating these options, a company must be confident of its ability to generate a return commensurate with the risks taken. Availability of natural and human resources are key criteria in this decision-making process. However most important is a stable, clear and predictable business environment, where the legal, fiscal and commercial terms under which the investments are made are clearly defined, and consistently and fairly applied.

    This report notes some specific problems related to the business environment, and the Association respectfully submits its own suggestions on ways that these might be resolved. However, the specific points are secondary to two fundamental categories of risk associated with doing business in Ukraine. The Association considers that a concentration on these two areas is a necessary condition for the creation of an internationally competitive investment climate:

1. Decreasing intervention in the operation of private businesses.

    Excessive state presence, intervention and regulation is a pervasive encumbrance on the operation of private businesses, and market mechanisms in general. While many Western European countries have significant levels of public ownership, nowhere is this incompatible with a flourishing private sector. In Ukraine the private sector contributes less than a quarter of GDP; it needs to be given at least the chance to develop. To illustrate part of the problem: an EBRD survey in 1999 suggested that enterprise management in Ukraine spends up to 17% of overall management time in complying with government regulatory requirements; this finding coincides with the experience of EBA members.

    2. Increasing consistency, stability and uniform application of legislation.

    Ukraine has a vast body of legislation and regulation, some of which is contradictory, some on occasion introduced retroactively, without any clear hierarchy of legislative acts to establish precedence. Interpretation, enforcement and execution of legal acts is far from predictable across the country.

    The often-discussed issue of corruption in Ukraine is a symptom of the failure to make adequate progress on these two problems. To assist with their resolution, the EBA urges the Ukrainian authorities to pursue a consistent objective of increasing regulatory transparency and business liberalisation. Where possible, Ukraine should look to adopt international standards on a whole host of issues from accounting and banking through to health, safety and the environment. If such measures can be introduced, rigorously applied and enforced, Ukraine can do much to gain the confidence of both foreign and domestic investors.

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SPECIFIC BARRIERS TO INVESTMENT IN UKRAINE

1) MARKET ENTRY

Property ownership

    The Ukrainian authorities recognise the need for clarification of property ownership in general, and ownership of land in particular. The current situation is that while ownership of buildings and other structures on land is normally allowed, sale and purchase of land remains difficult, if not impossible. Industrial property rights (trademarks, patents) are difficult to enforce, and intellectual property in some cases remains unprotected.

    The land code in force dates back to March 1992; it declares state ownership as the principle form of land ownership and forbids foreign ownership of land. The 1996 Constitution is less restrictive, stipulating that the right to land ownership is guaranteed for citizens and legal entities of Ukraine. An uncertain legal base has meant that subsequent presidential decrees on land have failed to encourage real estate transactions, and the situation regarding foreign investors is particularly unclear.

    The Verkhovna Rada is considering a new land code; the present draft prohibits foreign ownership of agricultural land, and prohibits sale or purchase of land until 2010.

Measures advocated by the EBA:

    Adoption by the Rada of a new land code that will give substance to the constitutional recognition of private property. All other legal acts should be brought into line with the new code.

    Establishment of an effective and comprehensive registration system for land and for fixed assets to remove uncertainties over title, including tax liens which are currently not required to be recorded under applicable Ukrainian laws.

    Adoption by the Rada of a civil code that can be the foundation of a system of enforceable property rights.

    Co-ordination of the different legal acts governing intellectual property rights, including the civil code, criminal code, customs code, procedural norms and specific legislation, to ensure a level of protection and enforcement in line with international standards.

Legal status of unfinished constructions

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    Due to the lack of sufficient legal regulation and difficulty of establishing ownership with respect to objects of unfinished construction, such objects are effectively excluded from the immovable property market. Their use as collateral or debt security is also extremely difficult.

Measures:

    Adoption of legislation to clarify the legal status of objects of unfinished construction, in particular the procedures for establishment, registration and transfer of ownership, and methods of valuation.

Land lease

    The current land code establishes land lease as the main option for foreign entities. Leases are limited to a maximum of two 49-year terms, and the rent payable is often

    much more expensive for foreigners than for Ukrainian users. Such discrimination is possible because the existing legislation on payments for use of land gives the local authorities complete discretion to establish levels of rent.

Measures:

    Adoption of legislation that would guarantee non-discrimination and equal rent for the state-owned land of the same quality for both local and foreign land users.

Privatisation

    Thus far, foreign participation in the privatisation process has been limited. The main deterrents have been discriminatory pricing requirements, a lack of transparent procedures, exhaustive investment obligations, and the fact that few of the most attractive enterprises were included in the privatisation process.

    The privatisation programme for 2000-2002 looks to correct all of these perceived weaknesses, and explicitly targets long-term strategic and foreign investors. However, the State Property Fund still lacks the authority to ensure that the process is fully predictable.

    In addition, more could be done to prepare the companies for privatisation in ways that could re-assure possible investors, with debt restructuring a priority.

Measures:

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    Strengthen the independent status of the SPF within the Cabinet of Ministers to increase the credibility of the case-by-case privatisation process; adopt legislation defining the limits of SPF authority and scope of its functions.

    Alongside debt restructuring, the SPF to ensure that social assets in the enterprise are transferred to local authorities, that full information on the enterprises is available, and that satisfactory shareholder protection be written into the enterprise charter prior to privatisation (see also corporate governance issues below)

    The Government and the SPF to adopt and regularly update a clearly stated investment policy to indicate to current and prospective foreign investors those enterprise objects and sectors in which it clearly has no intention of divesting, and those from which it seeks to exit, either gradually or in the short-term.

Corporate governance and shareholders’ rights

    A further explanation for limited foreign participation in the privatisation process and in the Ukrainian securities market has been weak provisions for and enforcement of shareholders’ rights. Current legislation allows or does not sanction effectively such

    machinations as share dilution, asset stripping and diversion of profits. In addition, the concept of fiduciary duty of company directors is poorly developed.

Measures:

    Adoption of a new law on Joint Stock Companies (a draft has been submitted to the Rada) and similar legislation for other types of enterprise.

    Enforce current laws that permit and encourage cumulative rights voting to protect minority shareholders as well as those laws requiring shareholders’ consent for fundamental transactions at properly convened shareholders’ meetings.

    Require by law that majority shareholders must appoint a proxy in instances where they cannot attend the general shareholders’ meeting (thereby preventing any decision by the shareholder body), and subject the majority shareholder to penalties or fines in cases where they fail to reasonably comply with such requirement.

    Protect investors’ pre-emptive rights, especially in instances of control transactions. Persons acquiring a control block of shares should be required to offer to purchase shares at fair market value from all remaining shareholders, unless the shareholder body votes to waive this right.

Information, accounting standards

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    Investors need to be in a position to compare possible investments, and this requires comparable information. The current accounting standards for enterprises in Ukraine do not provide reliable signals for the allocation of capital, and necessitate substantial extra costs in preparing an investment. Ukrainian Accounting Standards (UAS) are a step forward and are not intended to contradict international standards, but Ukrainian financial statements still have only limited credibility and use.

Measures:

Strengthen the use of IAS and GAAP, at least for the ‘listed’ companies. Training

    on IAS application for Ukrainian accountants / auditing profession.

    Introduce clear rules of information disclosure to third parties by banks, investment funds, investment companies, enterprises and non-bank financial institutions. Establish and enforce sanctions for non-disclosure by such entities.

    Adopt and incorporate substantive standards for audits that conform with international audit standards and publish them officially.

Anti-monopoly procedures

    The thresholds for acquisitions and mergers triggering an anti-monopoly investigation in Ukraine are relatively low. In practice this means that that nearly all equity investments and foundations of joint ventures, or the acquisition of shares in existing Ukrainian enterprises require approval from the Competition authorities. The investigation is lengthy and requires submission of a large number of documents. In practice, this process can hinder and delay registration of a business entity even in cases where competition concerns are insignificant.

    Measures:

    Streamline the information requirements for an AMC investigation; examine the thresholds to bring them into line with real competition concerns; ensure that the Committee has the administrative resources to complete investigations both competently and without undue delay.

Company establishment/registration

    Despite certain deregulation efforts, the existing procedures for state registration of a new company are still excessively complicated and time consuming.

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    Moreover, local authorities responsible for registration often introduce requirements not provided by law (such as mandatory prior clearance through the tax police). The so-called post-registration procedures require numerous filings and applications to various agencies and authorities (tax, employment, pension, social security, etc.).

Measures:

    Adoption of legal regulations with the aim of simplification of the existing system to allow for company registration by filing with a single registration authority.

Legalisation of documents

    One of the serious impediments for a foreign investor establishing presence in the Ukrainian market is the requirement for legalisation of virtually all documents originating from a foreign country by a consular institution of Ukraine in that country..

Measures:

    Ukraine should join the Hague 1961Apostille Convention so that the documents notarised abroad in the manner provided by the Convention are admitted in Ukraine without their legalisation by Ukrainian consular offices abroad.

Legislation on production sharing and concessions

    Ukraine has now adopted workable legislation both on production sharing and on concessions, along with some essential enabling regulation necessary for its operation. Such legislation has been an effective formula in many countries for jump-starting investment in key sectors, notably in the energy sector and in infrastructure. It is a proven means of reducing the perceived risks of investing in an otherwise rapidly evolving fiscal and legal environment.

    The Ukrainian legislation in both these areas remains untested as investors remain nervous about the business climate in general. The Association looks to the Ukrainian government to promote conditions that will allow both production sharing and concessions to operate in Ukraine.

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2) FINANCE

Banking system

    The banking system in Ukraine still plays a marginal role in savings and lending. Despite the National Bank’s success in managing the stability of the national currency, public confidence in banks remains low. A new law on banks and banking activity was passed in 2000 that looks to correct many of the flaws in the regulatory framework.

    The approach to bank regulation is occasionally misdirected. Banks are required to submit a huge quantity of data on their activities; technical violations are treated seriously, yet the wealth of information has not always been used effectively to forestall serious problems with local commercial banks. Another administrative burden on bank operation is the frequent demands from the tax authorities for broad categories of information on clients and payments.

Measures advocated by the EBA:

    Rationalise bank supervision, with a concentration on key areas such as enforcement of minimum capital requirements, capital / asset ratios, loan classification and provisioning, and lending to related parties.

    Increase confidence in the banking system by having effective mechanisms for dealing with banks in trouble, including the possibility of bankruptcy. In addition, adopt regulation specifying a code of conduct and fiduciary duty for bank employees and shareholders.

    The government should refrain from giving state guarantees to commercial banks for foreign credit lines; nor should it use political pressure to affect the lending decisions of commercial banks.

    Re-affirm confidence in the independence of the National Bank by stipulation that the NBU Board is competent to make recommendations only.

    For the EU, a public information campaign on the introduction of the Euro for January 2002. Without greater awareness and access to detailed information, there is a danger of disruption to the work of EU companies.

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Capital markets

    Capital markets in Ukraine are not developed to the extent that they act as an efficient channel for investment. Equity capitalisation in Ukraine is equivalent to around Euro 1.3 billion, around 0.05% of the total figure for emerging markets. Participants in the securities market are now calling for decisive measures to prevent trading of the most attractive Ukrainian securities being drawn to larger and more liquid regional competitors in Berlin, Vienna, Istanbul, Moscow. To improve the investment climate for capital formation in Ukraine, three important elements need to be enhanced: information disclosure, self-regulation, and enforcement.

Measures:

    Improve standards of corporate governance and shareholder rights, including enhanced information disclosure practices and financial information quality improvement, as outlined above.

    Strengthen the capacity and authority of the State Commission for Securities and Stock Markets to regulate and enforce applicable securities laws both in relation to the markets and the financial intermediaries, including the investment funds, securities traders, and large enterprises (regardless of the identity of their shareholders). The Commission should issue and follow a clear statement of enforcement priorities for all Securities Commission offices, to avoid repeated use of scarce resources on small infractions and petty cases not posing a significant threat of harm to investor shareholders.

    Develop and implement a plan of action for delegating regulatory functions, especially licensing and qualifications’ certification, to the professional self-regulatory

    organisations to increase prospects for adequate self-regulation of exchanges and market professionals.

    Monitor self-regulatory sanctioning practices to ensure their effectiveness.

    Adopt a Securities Commission regulation On Private Placement, simplifying registration and placement of new securities issues for investment purposes.

    Transform existing depositories into one Central Depository Institution (with non-governmental ownership) to provide safe and effective services for the market, including securities ownership registration and protection.

Secured lending

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