case study on enforcement |
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Background Secured transactions is an area of the law whose purpose is to mitigate the risk of giving credit, enhancing creditors’ confidence that they can recover real value from mortgaged or charged assets. As a result, the availability of credit should increase and the terms (typically, the amount of the loan, the period for which it is granted and the interest rate) on which it is available should improve. The EBRD has extensive experience and expertise on secured transactions. It was the first sector where EBRD became involved in legal reform from 1992. Since then, the Bank has been working to improve the regimes for secured transactions in the region with a combination of policy advice and technical assistance. As an international financial institution, its mission is to promote and foster transition to market economy, and it does so by operating as a commercial bank, lending primarily to the private sector in accordance with sound banking principles. EBRD has first hand experience of the difficulties that arise from an insufficient legal regime for secured transactions. Understanding how legal frameworks work in practice is a prerequisite both for policy dialogue on legal reform and for general credit risk assessment. Too often, preconceived views govern the behaviour of investors and other creditors as to whether the legal regime in a given country will support, or impede, their activities. In the field of law reform, inadequate attention is often paid to what has been done in the past and how new proposed legal rules will (or will not) function in their environment. In both cases, the lack of proper information can lead to serious misjudgement. Since 1999, the EBRD has published a Regional Survey on Secured Transactions Laws, covering key elements of the law and practice for using non-possessory security over movable assets. The EBRD Regional Survey provides a good overview of progress in legal reforms and their implementation, measured against best international practice. Yet, it may in some aspects be too general and not give sufficient detail, especially when the particular aspect of the secured transactions regime is complex and intertwined with other areas of the law. It is also designed to “reward” with better grades the systems which have adopted modern systems, as opposed to those that lack such systems, although they may somehow have developed practices for taking security which, whilst being complex and costly, still achieve practical results. This ‘rewarding’ is no accident since the survey is primarily designed to accompany the Bank’s legal reform efforts. The Bank thus has lacked the data necessary to gauge the benefit that best international practices can bring to those countries that chose to adopt them. The EBRD therefore decided to add to the Regional Survey a new type of assessment which seeks to find out how the law works in action, without regard to the underpinning principles used in law reform. EBRD sees these two aspects of the legal framework (laws in transition and laws in action) as essential benchmarks both to measure the state of legal transition and point to the strengths and weaknesses of individual countries. Case Study Approach Assessing laws in action is best done through a case study. A case study has the advantage of concentrating on the facts as opposed to the rules, and to assume a situation as close as possible to the context of normal commercial practice. Drafting of the case is paramount for the quality of the responses: if the case is too wide, the results will not be comparable across jurisdictions; if it is too narrow, it may not leave the respondent sufficient scope to describe particularities of its legal system which may have dramatically affected the results. One must also recognise that secured transactions is a relatively complex area of the law and the application of the law greatly varies with the specifics of the case. Over-simplification of the matter could lead to seriously misleading results.
In the context of secured transactions, the practical effects of the law
appear most clearly on the question of enforcement of a security interest. The
key issue for a creditor whose claim is not satisfied is how much and how
fast he can recover through realisation of the charged assets, and how
simple the whole process will be. Therefore, the primary evaluation of the
responses needs to concentrate on these three dimensions of enforcement. It
ought also to take in a number of other factors, which cannot be overlooked.
Since the exercise’s objective is to gauge on the effectiveness of the
process, all aspects of the process must be taken into account, in one way or
another. See the
case study questionnaire
In translating this conceptual backdrop into a practical methodology, EBRD
worked with two leading law firms in the region, Allen & Overy and Chadbourne
& Parke LLP. Where these firms did not have an office or an associate, EBRD
directly contacted local law firms. See
table of contributors
Responses analysis
The respondents had to treat the case as if it were a real-life case involving
a client, adding any practical advice they would normally give to a client in
similar circumstances. Consistency of the information was ensured by a
thorough review of the individual replies and follow-up with the local counsel
on any questions that arose. Once clarified, the assessments were taken into
consideration at their face value. In most countries the lawyers consulted
gave quick and clear answers to the case questions, based on their own
practice of enforcement. When respondents could not provide any basis for a
realistic estimate, the lowest score was given on the basis that such
uncertainty is bound to reflect negatively on the creditor’s expectations. See
the full methodology
and guidelines
The results should be interpreted with some caution. They reflect the views of a small number of lawyers. The EBRD welcomes comments on the sector assessments or the case study, in order to improve the data that is being evaluated and reported. Results Results are first presented on the basis of summary indicators relating to the amount a debtor could be expected to recover from the general case as described, the time needed to realise recovery and the simplicity of the legal process to be followed. These comparisons are then refined and qualified by looking at how results might be affected if the circumstances of the case changed (scope) and how the process of enforcement is affected by taking into account other interested parties, as well as the quality and integrity of the courts. This is the only way the survey can give a fair and realistic picture of the situation on the ground. Individual reports are summarised on a individual country basis. Individual country reports 2003 Enforcing the charge: amount, time and simplicity
Chart 1
The amount indicator reflects the likely return on the realisation of the assets minus the enforcement costs (since the costs will be recovered out of the sale price and will therefore diminish what the secured creditor will recover from the collateral). The amount has been adjusted on a scale of 0-10 where 10 equals the maximum possible return (€ 120,000, the assets’ market value). The time indicator reflects the estimated length of the process necessary for successful enforcement, from the commencement of the enforcement procedure to the collection of the proceeds of sale. The time has been adjusted on a scale of 0-10 where 0 equals the longest estimated time (24 months) and 10 the shortest (one month). The simplicity indicator summarises a range of factors, including the number of procedural steps to be taken, the number of places to visit or persons to contact, the availability of information, clarity of the law and regulations, uniformity of practice, the adoption of necessary implementing regulations and the ease of ascertaining the existence of competing claims. To simplify the scoring, countries were given a 10 where the enforcement process was considered overall clear and with only a minor level of complexity; 5 where there was a significant likelihood of complexity or uncertainty which might prejudice the enforcement process; and 1 where there was a major level of complexity or uncertainty which could deter creditors from commencing enforcement. The results give a surprisingly positive overall picture of enforcement in EBRD countries of operations. The results indicate that it is possible to recover at least 80% of the market value of the assets taken as security in 6 months or less in nine countries (Croatia, Czech Republic, Estonia, Hungary, Kazakhstan, Latvia, Lithuania, F.R.Y. Macedonia, and Slovak Republic). A recovery of at least 60% of the market value of the assets taken as security can be expected in 9 months or less in 16 countries (the above plus Albania, Bulgaria, Belarus, Moldova, Romania, Serbia, and Slovenia). Interestingly, the amount recovered and time factors are not positively correlated in cases where the procedure is more complex, but they are positively correlated where the procedures are simple. In other words, countries that score high on amount and time generally provide for a simple process. In only one of the 16 top countries for amount and time (Moldova), was the process judged very complex or uncertain. By contrast, in countries with significant complexity ratings like Bulgaria a quick procedure (8.3 on a scale of 10) is paired with a mediocre return (5.3). The dichotomy is even more marked for Slovenia where the return is assessed at 9.7 but the time involved is down to 2.5. The Kyrgyz Republic, Ukraine, and to some extent Russia also record reasonably high scores for the amount recovered but low scores on the time involved and the simplicity of the process.
The results are summarised in Chart
2
Chart 2 presents a familiar picture of better performance in Central and Eastern Europe and the Baltic states (CEB) than in the remainder of the region. Six out of eight countries of CEB scored 8 or more (out of 10) on the overall results. A note of caution, however, is that in some of these countries (Hungary and Slovak Republic), security enforcement rules have recently been changed and the evaluation may to some extent reflect expectations of positive changes rather than accumulated experience. Poland is the most noticeable exception of the CEB group: the system there does not provide a good recovery amount for the secured creditor enforcing his security over movable property (4.4 on a scale of 10), and the time required is worryingly long (1.6 on a scale of 10). The reason for this seems to be the over-burdening of the courts which are, in practice, the only available method for pursuing enforcement. Although the 1998 Law on Registered Pledge and Pledge Registry provided for a possible out-of-court procedure, the necessary implementing regulations were never adopted. In their absence, the creditor has no practical choice but to petition the courts. The sale will then take place at public auction and the return is likely to be well below market price. Slovenia also presents a low scoring on time, which is reflected in the overall scoring; in addition the enforcement regime is recent too, so here again, only further experience will confirm the efficiency or otherwise of the system. Interestingly, close examination of the country reports reveals that there is not a single mode of enforcement common to all these countries, which could serve as a model for less successful jurisdictions. In Hungary, Latvia, Lithuania and Slovakia, where the creditor and debtor have so agreed, the law gives the creditor or his agent the right upon debtor default to take the collateral into his possession. Thereafter, he can organise a sale of the collateral, normally direct private sale or by selected bidding, subject to the legal duty to realise as good a sale as possible in the then current market circumstances. In the Czech Republic, such option is not available: the sale would typically be led by a private executor appointed by the creditor without further influence of the creditor, and the appointment itself could be contested by other creditors. In Estonia, although creditor-led enforcement is possible, it is not recommended due to the complexity of statutory provisions and the lack of reliable practice. In South Eastern Europe, six out of seven states fare relatively well with scores between 6 and 8 (average of 6.88 out of 10). The clear exception to this is Bosnia and Herzegovina, where a creditor’s prospects for enforcing a security right are slight. The only way to contract a non-possessory charge over movable property is to use the Law on Enforcement by which a court-ordered seizure of the assets constitutes a charge, pending its enforcement upon the debtor’s default. The procedure is ill-designed for commercial transactions. Furthermore, public auctions which are the only method to realise the collateral, are often unsuccessful leaving the creditor unable either to collect any proceeds or to take title of the assets. A new Law on Enforcement and a complete overhaul of the secured transactions legal framework currently in preparation should improve the system. In the countries of the Commonwealth of Independent States (CIS) the results are mixed, with an average score of 4.84 out of 10. At one extreme is Kazakhstan, which has a well-implemented system for secured transactions over movable property. The creditor's position on enforcement of a charge is made stronger by registration since the debtor then has fewer grounds for challenging the validity of the charge. Upon default, the creditors can choose the extrajudicial procedure of enforcement, by which their authorised representative conducts a public auction. This procedure is generally slightly faster than court-led enforcement but even court-led enforcement is not reported to be unduly long. Ukraine, the Kyrgyz Republic and Russia, by contrast, are all characterised by a time-consuming process, which makes enforcement more difficult for the secured creditor. In Moldova the return that a creditor can expect on enforcement and the time involved are quite reasonable. However, the whole process lacks simplicity and certainty. For instance, the newly created registration system for charges lacks a centralised pledge numbering system -- public notaries, who have been appointed to operate the registry, use their own numbering system when making entries into the registry, which means that several entries could have the same number, leading to confusion. At the bottom of the scale are Armenia, Uzbekistan and Turkmenistan, where the position of the secured creditor is unclear in terms of time and/or amount. The uncertainty is also shown for Armenia and Uzbekistan in the complexity of the process. Scope and Process of Enforcement Results based only on the predicted return, timing and simplicity in a single situation cannot alone tell the whole story. The efficiency of the enforcement process may be influenced by many other factors, or “qualifiers”, that add nuance to the ‘raw’ results on amount, time and simplicity. Twelve qualifiers were taken into account here. Six of these qualifiers account for difficulties which can be encountered in the process of enforcement, especially by involved parties or institutions being able to affect this process (see box below). While some of these process-related factors may be reflected in the raw scoring (e.g., a high likelihood of debtor obstruction would have influenced the assessment of the time of the enforcement process), it is useful to assess them separately to gain a better understanding of the practical situation in a given country. The remaining six qualifiers relate to the scope of enforcement (see box below). Such factors include insolvency procedures and ranking of creditors under insolvency. The relevance of insolvency is self-evident. A creditor’s assessment of his security will change if, on examination, it appears that the relatively good enforcement that might be expected would be radically curtailed should the debtor be declared insolvent. Limitations on the kinds of assets that can be pledged, and variations in the legal procedures relating to different classes of assets similarly provide necessary qualification to the assessment presented above. Process Factors
*Although the assessment was based on the replies from the respondents, reference was also made to the Joint EBRD-World Bank Survey on Business Environment and Enterprise Performance (BEEPS) and, where applicable, the Transparency International Corruption Perceptions Index. For Turkmenistan, which was not covered by these surveys, no assessment was given for corruption or institutions. Scope Factors
The graphs Albania
- Kazakhstan
For some countries, there is a relatively close correlation between the raw scores on amount, time and simplicity and the scores on scope and process presented in their respective graphs. Lithuania and Latvia, for instance, which both received high scores on time, amount and simplicity, reveal no particular underlying problems which could contradict or qualify the raw results. Notably, enlargement of the scope of the case would not have had any significant effect on the overall positive assessment. In a similar vein, Azerbaijan and Georgia received a 2 or 3 scoring on almost all scope and process factors, which matches their low ratings on the raw scores above. Major efforts would be needed to achieve real improvement in these countries. However, the importance of examining the scope of the law comes out clearly for countries like Hungary, the Czech Republic and the Slovak Republic, where severe limitations exist on recovering charged assets from a debtor in insolvency. In both the Czech Republic and the Slovak Republic, the chargeholder only retains priority for 70% of the secured debt – for the remaining amount, he ranks as an unsecured creditor. In Hungary charges which were taken more than one year before the start of the procedure, 50% of the claim will rank ahead of all creditors, while the remaining 50% will rank behind the cost of the liquidation (including, but not limited to the outstanding salaries, tax and social security payments, associated costs and fees of the liquidation). Moreover in the Czech Republic, taking security over inventory is not possible, nor does the law allow for a flexible description of the collateral, by which parties could agree to add or replace the assets. Such restrictions in effect preclude the use of many modern financing techniques which involve granting security over groups or pools of assets. In Estonia, the law on secured transactions also has restricted application: it is only possible to take a non-possessory security over certain types of assets or over the whole of an enterprise. These qualifications echo some of the limitations of the law itself. What this indicates is that for these advanced reform countries, the principal issue seems to relate to extending the scope of secured transactions law to cover a broader class of assets and deal with the case of insolvency. The case study does not suggest any major problems with implementing and using the law in practice in these countries. A closer look at the process of attempting to realise a charged asset reveals further interesting qualifications in process-related factors. In Bulgaria, F.R.Y. Macedonia and Kazakhstan, for example, the weakness of the courts, and in particular the problem of corruption in the courts, is regarded as a serious limitation. In the Kyrgyz Republic and Moldova, similarly, good and comprehensive laws on secured transactions are being undermined by a deficient institutional framework. In Poland, where raw results show that enforcement is slow and gives a poor return, the graph demonstrates that the scope factors are actually excellent (5 out of 6 received a 1 score). If Poland were to improve its institutional framework for the enforcement of pledges, this should have a major positive impact on secured lending. Finally, for a few countries, the findings derived from the qualifiers appear rather inconsistent with the overall picture brought by the raw results. The picture for Romania, for example is puzzling: the raw scoring does not show a particularly good expectation for secured creditors, yet the graph does not pin-point any particular process-related factors; it would seem to be more a question of a broad range of issues where some problems still persist. The same is true for Russia, where only one process-related factor is found to be very problematic (namely debtor obstruction) but where scope factors are also less encouraging. |
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