Date: Wed, 5 Nov 2008
From: "Paul Backer" <pauljbacker@gmail.com>
Subject: Survive the Emerging Market Crisis (Russia and CIS)! Part 4, Lending During a Crisis.
DISCLAIMER: This article is uncompensated. It is NOT legal advice. Everything herein is personal opinion. It does not represent anyone else’s opinion. It does not address any current or past client or employer matter.
NOTE: The Article focuses on minimizing the risks of financial operations during a crisis. It is an important, but highly technical subject and despite an effort at readability it (regrettably) contains some technical jargon.
“It is in the nature of dilettantes that they do not realize the difficulties that lie in a thing, and that they are always undertaking something beyond their powers.” Goethe.
“The only form of control we have is that which is called moral influence, which in practice is a combination of nonsense, objuration and worry.” Salisbury (Robert Arthur Talbot).
Moscow, late October, ennui prevails. Seasonal Affective Disorder, I thought. Late Fall in Moscow is no joke. Luckily, after reading the WSJ, I found that it was just a general chill[ing] felt by foreigners in Russia. The source of the chilling according to WSJ was shocking, simply shocking! Reportedly, a major regional company put up hundreds of millions of dollars worth of shares as collateral for a loan and then aggressively litigated to block the foreign lender from seizing it. The specific strategy (as reported by WSJ) was litigation in Russia to sequester (gain priority in) the collateral by a third party, to deny it to the lender. Should that REALLY have been a surprise?
An economic crisis inevitably worsens borrower and lender relationships. The most effective (shield and sword) means for Russia/CIS borrowers to defend their economic assets is their knowledge of their local law, practices, application and enforcement. Economically rational actors employ the most effective means available to defend their assets.
The immediate and therefore admittedly unfair impression is that the hysterical media reaction is due to the realization by foreign lenders and their advisors that they wrote a lot of bad paper. Good for the borrowers, bad for the lenders. That’s the interesting thing about doing business in developing markets, particularly during a (periodic) crisis, the environment is absolutely unforgiving to the unready and the unqualified. But, why get so emotional?
Russian debtors not giving away their collateral like Halloween candy? Perfidy. Utilizing superior local knowledge and access? Infamy! Can any foreign investor survive this cutthroat chicanery? How do we make your funds safer if you choose to lend (invest) during the crisis? Use the law as it exists? Utilize competently drafted legal documents? How could this be fair to foreign experts billing $750 an hour (before VAT) and populating the savannah-like spaces of GQ Bar and Soho Rooms? Yes, you can protect your funds. No, it’s not going to be fair to them or their clients. Lending agreements will be attacked, bad ones will fail. Life is like that.
What could be a good survival strategy? Maybe, drop the ball and fall back on PR releases faulting the opponent’s winning strategy. That seems too silly and weird, even for this region. Umm… could learn good due diligence, the language, the law and do a competent job of walking through and structuring the transaction, but that isn’t very exciting. Disappointingly, effective survival strategies are not exciting: seize control of the timeline and curtail opponents’ coercive capacity and you should make it.
Lending during a financial crisis offers unique challenges and opportunities. Unique income potential of interest rates of 25+% per annum. But, the risk of default is also uniquely high. Moral constraint on (stigma of) loan failure is effectively removed. The key difference in structuring transactions during a crisis is the far greater risk of having a party (borrower, guarantor, etc.) present a legal challenge to avoid contractual obligations. The key to successful lending in a crisis is extensive due diligence and effective segregation of collateral.
Due diligence. Don’t get involved in “back of the envelope” transactions. This is a long, dull and much argued topic, but a borrower who can’t be bothered to work up a clean set of documents during a crisis(!), won’t repay either. Don’t invest in projects solely on the basis of the involvement of a great name, unless the owner of that name is sitting across the table from you. Please, for the sake of the cardiac health of your counsel, note that above says “the owner”, not “the cousin of”, “childhood friend of” and most certainly not “son of”!
Know exactly what is being put up for collateral. There is a strong distinction between a company’s legal ability to enter into a loan agreement (capacity) and whether that agreement is legally binding (enforceability). Closely identify the impact of local law on the transaction. Some objects such as railroad assets can not be pledged or foreclosed on, because they are part of the national strategic defense scheme. Other assets can (arguably) be pledged, but can’t be foreclosed on.
A municipal sewer system can be collateral, but for obvious reasons can neither be relocated or its use denied. In Russia and many CIS states it may not be legally possible to evict a minor child from a mortgaged apartment. Examine whether public policy prevents effective pledge, foreclosure or alienation of the asset. Are you or your counsel already or prepared to become entrenched in the jurisdiction where likely enforcement action would take place? For a discussion on the importance of being local in litigation, please see the preceding Survival Guide articles.
Generally, assets used as collateral raise actionable corporate governance and compliance issues rather than public policy. Never lend to a physical person. Always check the incorporation documents of a prospective borrower as to whether and how an asset can be pledged as collateral. Check applicable statutes. A license issued to a legal entity (natural resources, telecom, etc.) may not be transferable to another legal entity without the licensor’s consent. Check the legal status of the borrower, binding FGUP assets is much different from lending to a OOO or CJSC. A typical strategy for defeating a collateral agreement is arguing that the agreement was entered into in violation of the Charter or statutory rights of the other legal entity participants.
A common collateral agreement violation is a signature by a person with apparent authority (co-owner, General Director) without the actual Charter or statutory authority to alienate the collateral. If an asset representing (potential) corporate control and/or interest is to be pledged there may be statutory or Charter provisions requiring the consent of or waiver of other (preferred purchase) rights by other equity (CJSC) or interest (OOO) holders. This is not a trivial argument, an illegally entered into collateral agreement presents a violation predating an event of loan default, and may be unenforceable.
Walk the transaction. Have your counsel analyze the actual steps involved in transferring the collateral to you. Is it feasible?
Publicize the pledge. Deny the borrower ability to borrow against the same collateral more than once. Russia and CIS states generally do not have UCC1 analogous disclosure. Common law nations support the principle that pledged assets (collateral) must be publicly and openly identified and preferably, registered to (among other reasons) discourage borrower fraud. The Germanic, Civil Code principle is that this information should be confidential. The argument is long, intellectually and functionally bankrupt. This confidentiality on multiple occasions allowed for the same collateral to be pledged several times to different lenders.
Many foreign lenders, unfamiliar with the application of local disclosure, “first to register” and “first in time” rules sign collateral agreements on the basis of property already pledged to others. Always publicly register your collateral. It is important to being a BFP (bonafide purchaser). If it is Real Estate, register collateral in the applicable municipal, regional and/or federal registry. If the collateral is productive machinery such as manufacturing equipment, physically identify the collateral as pledged. On occasion, this entails a fun onsite trip for junior counsel with a stencil and a can of spray paint. Historically, brass plates had been screwed onto pledged pieces indicating pledge of productive equipment. Seriously.
If no better options are readily available, it may be worth considering a mass media (or online) article clearly indicating what assets were encumbered. The cost is reasonable, and it greatly undermines the ability of future contenders for the same collateral to effectively argue that they had no inkling that the assets were already pledged.
The above are parcel of any loan agreement: know what is pledged, make sure the pledge is legal, clearly notify of a priority in a pledge, etc. There are key documentation choke points specific to each national jurisdiction. Specifically, collateral and transaction documentation, registration and related filings, but that is not within the scope of a short article. The key difference is that during a crisis the collateral agreement is more likely to be challenged and much more aggressively.
Legal challenges. The variety of possible legal attacks against a loan agreement is limited only by the budget and imagination of opposing counsel. Fraud, lack of authority to contract, lack of authority to alienate, violation of rights of other lenders, etc. For a collateral agreement of seven figures or more, consider the imagination and budgets to be unlimited. For a defaulting borrower it is far cheaper to sue and control the agenda than surrender collateral or try to raise new credit lines. Litigation costs run less than $20,000-25,000 per year. The interest on retained collateral can easily exceed that. Due to the crisis, the court ordered can award an interest rate of about 11%, while private banks pay more than 16% on deposits.
During a crisis it could actually “pay” for a borrower not to pay. Add to the mix that “reputational” concerns are largely out the window and you can expect defaulting borrowers to litigate and sometimes, win. Even good lawyers can get beat. If you are sued in an Astana or Kemerovo court by a gradoobrazuyushaya (too big to fail) local company, you may even face a likelihood of getting beat. Alternatively, you might just get worn down. Your opponent can cause multiple weak claims to be presented in multiple jurisdictions hundreds if not thousands of miles apart by using SPVs. A discussion of the variety of possible legal actions and how to defeat them does not fit comfortably in a short article.
Litigation losses are preventable. In over ten years of regional legal practice, have not lost yet. Some useful (I hope) ideas are contained in the Survival Guide Articles as best practices. However, the most effective way not to lose a commercial litigation is to prevent it. Meaningful assets are only mobilized behind a litigation if there is a prize worth winning. Segregate the collateral and you greatly diminish your opponents’ incentives and therefore his available resources. Ensure that the entity pledging the collateral does not have physical control of it or prepare for a lawsuit.
If it’s a security, re-register the security to a neutral third party. Move the collateral and therefore, the jurisdiction offshore. One of the proven ways to simplify secured lending transactions is to do them through a SPV, significantly limiting the viability of claims by third parties. These simple steps will go a long way toward preventing nuisance litigation. If a court in Kemerovo can’t get jurisdiction or physical possession of your collateral, its opinion of your transaction is of largely academic import.
Finally, the best way to maintain a lender-borrower relationship through the crisis is to be realistic. Don’t be shy. Lend like you mean it. Write your loans as if the local currency could repeat its decline of the past several months. Overcollateralize. Take a security interest in everything. Take a security interest in the borrower’s IP, trademarks, buildings and furniture. Always ask the borrower’s principals to accept at least some personal liability. Having your own Bentley at stake helps focus the thinking.
Be aware that a loan during a crisis may be seen by the borrower as a sale of the collateralizing assets. If you aren’t prepared to derive economic benefit from a cement plant in Novosibirsk or Donetsk, don’t lend against it.
Most importantly, if your borrower doesn’t believe in his heart of hearts that your lawyer can and will cheerfully take his gold watch, pen, cufflinks or shoes as (partial) satisfaction for a failed loan, he is far less likely to repay. A treasured professional memory is a counter-party screaming across a table some nonsense about turnips squeezing blood from stones, culminating with the question “Do you want me to give you my car keys and watch as satisfaction for a $15 million loan?!!!” Yes, please. I took the car keys and the watch. They were appraised and deducted against his debt. In the interest of full disclosure, as a New Yorker, I didn’t know how to drive the car away. Someone else did that.
Happy lending. Hopefully this and the preceding article provide some useful ideas on borrowing and lending during the crisis. Next article on operating with own funds and profit repatriation.
As always, any questions, comments, etc. to pauljbacker@gmail.com.