Ukraine Financial Sector Review 2004

UKRAINE FINANCIAL SECTOR REVIEW 2004 Financial Sector Analyses Part II June 2004 Ukraine Financial Sector Review 2004 Financial Sector Analyses Part II Legal and Regulatory Environment - Ann Wallace Banking Sector - Melville Brown Corporate Governance - Demir Yener Debt Markets - Robert Strahota Financial Sector Development: The Need for Good Legislation and Effective Enforcement By Ann Wallace, J.D., M.B.A. Project Manager Ukraine International Business Standards − Corporate Governance Project FMI/USAID May 5, 2004 1 A basic premise for the effective functioning of the financial sector of any country is the development of core legislation and effective enforcement of the norms of the legislation. A well functioning legal and judicial system is critical to the development of the economy and builds the trust necessary for a competitive market economy. While legal traditions vary among countries, there is general recognition that in developing economies there is a “wide gap” between the formal provisions of the legislation and effective implementation. This “wide gap” is clearly evident in Ukraine and further complicated by the fact that the development of certain sectors of the economy has outpaced the legislative framework. The business environment in Ukraine is characterized by a weak legal system, and excessive red tape and unnecessary government interference in the process. The lack of meaningful reform has resulted in Ukraine’s failure to obtain recognition as a market economy, “The strength of laws in Ukraine lies hinders its accession to WTO, and helped keep in the fact that they do not work.” foreign direct investment below its potential. Volodymyr Matveev, Verkhovna Rada Deputy. The major hindrances to integration of Ukraine into the international economy are a lack of political will at both the executive and parliamentary level. This has resulted in failure to adopt the necessary legal framework for real economic growth coupled with the lack of an independent judiciary trained in the laws that govern a competitive market economy. The Ukrainian judiciary suffers from low wages, often-nonexistent court space and equipment, and a heavy caseload, all of which contribute to an institutionalized system of “telephone justice.” I. The Role of the Government and the Judiciary in Financial Sector Development A brief review of the current legislative and judicial systems is essential to understand the factors that hinder economic development and the establishment of the rule of law in Ukraine. Key conclusions include: • Activities to date have placed emphasis on economic reform on a random basis without the necessary legal framework to support and sustain this development. • Significant legislative, procedural and enforcement gaps in the fundamental legislation hinders establishment of a well regulated financial sector, providing the legal flexibility necessary to meet the rapid changes experienced in a developing market economy. • The legislative process is slow and opaque with little or no public involvement leading to patchwork laws that support the cronyism evident in the parliament, which is reinforced by government interference in the judicial system. • Judicial enforcement is equally slow and opaque with limited public availability of written decisions and court decisions that lack legal reasoning or explanation. 2 Since Ukraine’s independence in 1991, it is Effective Financial Sector Legislation estimated that over 1770 laws have been enacted that 2000 govern all aspects of transforming the society and Jan • Bankruptcy Law Dec • Law on Banks and Banking economy of the country. In the last five years, over 2001 100 laws and substantive amendments have been Jan • Law on National Program on adopted that directly affect the financial sector. The Small Business Support Apr • Law on Collective Investment dramatic changes in the political, economic and Institutions social relationships resulting from this explosion of Aug • Law on Financial Services and State Regulation of Financial legislative enactments has resulted in unprecedented Services Market strains on new institutions created to oversee these Oct • Law on Individual Deposit Insurance Fund new laws, and the judiciary called upon to enforce Nov • Law on Insurance the new laws. The challenges facing Ukraine in 2002 developing a rational legislative framework that Jan • Law on Credit Unions Feb • Law on Economic Competition promotes economic growth are numerous: Protection Aug • Law on Innovation Activity Dec • Law On Conception of State • Laws are too often internally inconsistent, Program on Adaptation of lack clear definitions and standards for a Ukrainian Legislation to European Union Legislation functioning market economy and conflict with other laws and regulations; 2003 Jun • Law on Prevention of Money Laundering • Few laws contain international legal norms Oct • Law on Basics for State and standards that promote recognition of Regulatory Policy in the Sphere of Business Activity Ukraine as a market economy, or 2004 membership in the WTO; Jan • Civil Code • Commercial Code • Gaps in the legislation promote telephone • Law on Mortgage justice and fail to address the requirements • Law on Mortgage Financing, Transactions with Consolidated for a well-regulated capital market; Debt and Mortgage Certificates • Law on Financial and Credit • Enforcement provisions are either lacking or Mechanisms and Property based on Soviet era concepts in which the Management in Homebuilding and Real Estate Transactions administrative, civil or criminal punishment • Law on Ensuring Creditors’ do not address or fit the violation resulting in Claims and Registration of Encumbrances little or no effective enforcement or • Law on Mandatory State deterrence; Pension Insurance • Law on Non-Governmental • International legal concepts are provided in Provision of Pensions • Law on Financial Leasing the legislation with little understanding by Jul • Law on State Registration of the legislators, the judiciary or the regulator Legal Entities and Natural Person-Private Entrepreneurs as to the meaning of these market economy concepts leading often to misinterpretations of the law or enforcement of merely technical violations rather than substantive violations; and • Conflicts between the new Civil Code and the Commercial Code result in lack of a clear, easily understood and enforceable legal framework. The World Bank and other international donor organizations, including USAID and the TACIS Ukrainian-European Policy and Legal Advice Centre (UEPLAC), have 1 worked extensively in the area of legal reform with some evident successes. 1 Since 2001, USAID/FMI International Business Standards and Corporate Governance Project has held regional seminars for the judiciary on issues related to the Law of Ukraine on Business Associations and Securities and 3 However, many of the issues noted continue to present a roadblock to a rational legal framework and effective implementation of the rule of law. Civil Law Regime. Ukraine, like many European countries, is a civil code jurisdiction in which its Civil Code establishes the basic provisions of the laws of the country with supporting legislation that completes the Codes. In contrast, the common law system, following the medieval English law tradition, is established on specific fact patterns in litigated cases leading to decisions that compel lower courts to follow higher courts decisions. Many of the current laws in Ukraine that govern its commercial and economic activities incorporate legal concepts based on common law concepts, particularly in the capital markets area, without the legal prescriptions in the law or the legal practice to effectively implement the common law concepts. Basic Legal Framework. Although Ukraine is entering its fourteenth year of independence, its legal system and consequently its economic growth continues to suffer from the lack of a rational legal framework that promotes transition to a market economy. At the time of its independence a “transitional” legal framework was established that largely continues to govern the Problems of the Ukrainian Civil Law Framework Impeding Establishing the Rule of Law in Economic Activities country. The transitional framework provided that • Letter of the law prevails over the spirit of the law. until Ukraine established its • Checklist application of the legal provisions with little own legislative acts the judicial interpretation. • Limited public access to written decisions, and decisions legislative acts of the USSR often lack analysis and judicial interpretation of the law. would continue in force if • Judges free to apply the law resulting in significantly they did not conflict with different decisions based on the same provision of the law. the Constitution of Ukraine • Major gaps and unclear provisions giving judges freedom 2 or the laws of Ukraine. to apply the law resulting in significantly different decisions based on the same provision of the law. • Lack of consistency and uniform application of the law. Economic legislation • Lack of interpretation of the law that compel lower courts establishing a capital to implement the law in similar situations. market was adopted in the • If laws fail to specifically prohibit a particular activity then it early 1990s and is permitted and essentially unregulated. amendments were made to • Common law concepts in laws not accompanied by existing legislation to specific prohibitions result in judicial misunderstanding and application of the

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