The rule of law begins with respect for debt obligations

Aug 19, 2020 | Judiciary, Justice, Property rights protection
The Government should no longer be the last to pay its own debts to Ukrainian individuals and business

A few weeks ago Ukraine and the European Union (EU) agreed on a EUR 1.2 billion macro-financial assistance (MFA) package, which includes conditionalities stemming from EU and requiring the Ukrainian authorities to conduct certain reforms in order to get funding from Brussels. The level of implementation of each MFA conditionality will bare a direct financial benefit to the Ukrainian budget.

Much has been written about the MFA conditions regarding the judiciary governance. But another key requirement from Brussels has so far gone almost unnoticed by the Ukrainian media, despite going to the core of the fabric of the rule of law, while also dealing with the chronic issue of a lack of financial discipline and accountability by the Ukrainian State-owned enterprises (SOEs).

Hence it is worth a separate mention that the MFA programme includes a requirement for Ukraine to open the market for Private Enforcement Officers (PEOs) to collect small claims under UAH 100,000, including enforcement of court decisions, against the authorities and SOEs. For the first time in the Ukrainian history, an independent private professional will be able to act against the State apparatus while using the power delegated to him by the State itself, forcing the Government to comply with its contractual and other financial obligations with regard to any person or business. This approach attests the gradual dethroning the Government from the control of the justice and other sectors, making the State work for, and by, private individuals. While this dynamic presents nothing new in EU jurisdictions, it does show a tectonic change for Ukraine in the justice sector in particular, and the relationship between an individual and the Government in general.

In addition, according to the MFA requirements, PEOs will also be able to collect administrative fines. Finally, the Ukrainian authorities will be obliged to automate the bank account blocking and write-off processes, creating a real opportunity for PEOs to act effectively in practice, and not merely in theory.

How to expect Ukrainian individuals and business to pay, when the State is not paying its own debts?

Non-enforcement of court decisions remains the most common complaint against Ukraine before the European Court of Human Rights (ECHR), making up more than half of the total ECHR violations found against the country since it joined the Strasbourg system 2 decades ago. The “structural violation” of the European Convention on Human Rights has been found in the Ivanov and Burmich pilot ECHR judgments against Ukraine, concerning the long-standing non-payment of State or SOE debt owed on the basis of unenforced domestic court decisions. According to the latest World Bank Doing Business ranking, the cost of enforcing a contract in Ukraine is almost double the EU average.

Most importantly, almost UAH 800 billion are locked in unpaid court debt in Ukraine, much of it pending for a decade or more, according to the official statistics of the Ministry of Justice (MOJ). This represents some 1/4 of the country’s annual GDP. Only about 2.7% of the aforementioned UAH 800 billion is collected annually. In other words, the real annual contribution of Ukrainian courts is merely 2.7% in terms of the actual outcome of the judicial way of solving disputes. By reverse logic, 97.3% of salaries, pensions and other claims by legitimate Ukrainian owners and creditors who win in court have constantly remained unpaid. The bulk of the unpaid UAH 800 billion total is owed by the Ukrainian Government and SOEs, according to a research conducted by various national and international experts of our Project.

How does private enforcement work?

A “private enforcement officer”, an innovation first introduced in France more than 200 years ago, is in fact acting on behalf of the State, having the powers delegated to him by the Government, similarly as a private Notary or Bankruptcy Trustee. Since their inception in 2017, the currently operational 230 Ukrainian PEOs have already shown 5 times more effective performance in terms of the amount of collected debt, with regard to their State-run competitors, State Enforcement Service run by the Ministry of Justice (MOJ). In 2019 the 230 PEOs recovered UAH 4.2 billion, in comparison with UAH 16.5 billion collected during the same period by some 5,000 State Enforcement Officers.

Privatisation of enforcement services is a general trend in EU and COE jurisdictions. In total, 23 EU jurisdictions have either fully private or “mixed” enforcement system, according to the Council of Europe think-tank CEPEJ. All new EU Member States from post-communist countries, most notably, have either fully private or “mixed” (combination of private and State) enforcement services. In all “mixed” systems in EU, the mandates of competing State and private enforcement services are equal, allowing them to act against any debtor or in favour of any creditor. Almost all EU countries practicing private enforcement are achieving more results by effective debt collection rates and are scoring higher in the World Bank Doing Business enforcement component. The philosophy behind the privatisation of this legal service is very simple, similar to the approach applied with regards to advocates, notaries or bankruptcy trustees – namely, an independent and well-motivated legal professional will provide a better quality of service than a State-run functionary. Second, the State saves budget resources by outsourcing the cost of a service to the parties of the dispute.
Asking PEOs to run while putting them in a wheel-chair?

While many in Ukraine are calling the current enforcement system since the inception of PEOs in 2017 as “mixed”, the truth is that the Ukrainian model today lacks some key ingredients to qualify as such, according to European best practices. First of all, Ukrainian PEOs cannot act for or against the State or SOE debtors,. Second, the law and practice accords MOJ, courts and law enforcement wide regulatory and oversight powers over PEOs, which were attested by various expert reports as overzealous by:

  • making access to the PEO profession difficult by excessive rules on internships, centralisation of the internships to prevent wider participation from PEO candidates from the Ukrainian regions;
  • no transparent IT system or full automation all 3 stages of the PEO exam process, which at times raises questions about the possible outside interference in defining and calculating the exam results;
  • nomination of 4 members out of total 7 on behalf of MOJ to the PEO Disciplinary Commission, without dealing with a possible conflict of interest by reason of these MOJ nominees also being PEO direct competitors working for the State Enforcement Service;
  • no consistent practice of the Disciplinary Commission in similar cases;
  • no clear and foreseeable rules on the scope and extent of conducting PEO inspections, which in most cases have been conducted with the possible conflict of interest by SEOs;
  • prescriptive procedural rules for judicial oversight, frequently resulting in excessive focus of courts on formalities instead of the essential principles of the PEO operation in a particular case;
  • no procedural safeguards against arbitrary interference of law enforcement and criminal investigative bodies in the PEO work.

Against the above background, the “control” by other authorities frequently enables a dishonest debtor to play the system, resulting in a lack of any practical effect to a court decision. Thus the formal and actual mandates of PEOs and their state competitors remain essentially unequal. The maintenance of the current privileged position for State enforcement officers is particularly striking given the proven greater efficacy of PEOs based on real data. It is also telling that, as matter of established disciplinary practice, PEOs are usually punished for the way they are actually doing their job - i.e. enforcing against the debtor - while complains against their state competitors are usually filed for a lack of enforcement.

Elephant in the Room: SOEs

More than 17,000 State-owned enterprises (SOEs) and municipal enterprises exist in Ukraine, according to the official statistics. More than 3,000 of these are central government-run Ukrainian SOEs. Compare this to only 21 SOE in Denmark, 29 in the Netherlands, 47 in Finland, 48 in Lithuania, 51 in France, 71 in Germany, 126 in Poland, as attested by the Organisation of Economic Cooperation and Development (OECD), the developed market economies think-tank. Through its SOEs, the Ukrainian State is involved in all kinds of business, from alcohol production to hotels. Apart from this strategic disconnect with the European best practices, the most worrying aspect is that SOEs are responsible for the biggest bulk of the pile of the unpaid court-ordered debt of UAH 800 billion mentioned above.

A reasonable observer might expect policies to promote more responsible and well-run SOEs, or – in case SOEs have been consistently proven as incapable of competing fairly in a market a as business – a certain path towards privatisation of the systemic debtors. Instead, the various Ukrainian Governments since almost 2 decades have been involved in juridico-financial engineering called “moratoria”. Our Project experts have counted at least 12 separate moratoria statutes adopted since 2002, with 4 of them added recently in the context of Covid-19. Some of the moratoria statutes protect certain business sectors, some protect against the collection of certain types of debt. What does a moratorium mean, exactly? First of all, the beneficiaries of almost all aforementioned moratoria (except one) are SOEs. For instance, in order to pay court-ordered debt, one cannot seize any SOE property - including its real property, equity, or technical equipment - except for what is left on this SOE’s current bank account. Luckily for SOEs, they are also exempt from appearing on a nation-wide Debtor Register, calling into question the very purpose of its existence – namely to warn prospective partners, suppliers, customers, creditors and employees from dealing with an irresponsible business. If more transparency is good for private business, why not for SOEs? And what is the worth of a political promise to make Ukraine a more “socially-oriented country”, when the Strasbourg court practice shows that it is the Ukrainian Government and its entities, first of all, that have consistently failed to comply with their court-ordered obligations to the Ukrainian citizens, while having been unable to remedy the problem during the last 2 decades?

If the MFA conditionality on the opening of the debt collection market for independent private professionals to act against SOEs is to have any practical effect, the question of lifting the moratoria will have to be raised sooner rather than later. It must also be remembered that, while SOEs are primary and essential beneficiaries of the moratoria, the reverse beneficiaries are mostly small and medium businesses, and private Ukrainian citizens.

Automation is key to preventing a dishonest debtor from playing the system

Admittedly, not only the moratoria create obstacles for the implementation of court-ordered obligations in Ukraine. For instance, ambiguities exist as to what extent corporate bank accounts can be seized to collect court-ordered debt, despite a judgment by the Grand Chamber of Supreme Court from 19 May 2020. It is still unclear in the Ukrainian law and practice whether a debt obligation imposed by court is a priority or preferential debt with regard to any other external (arrears to business partners) or internal (salaries to employees) corporate obligations, unlike in many advanced jurisdictions. While in theory these restrictions from seizing bank accounts have at times been positioned as intended to protect salaries of employers of SOEs and other corporate debtors, it is clear that in practice they have been frequently used as a way to allow a debtor to set free and play the system.

The advanced jurisdictions in EU are trying to focus on new electronic solutions as a way to improve justice. The domestic courts in many EU countries have usually served as a facilitator of technological progress. PLAIS, the Lithuanian version of automated bank account blocking and write-off system, is now considered among the most innovative practices in the World, helping to automate collection of hundreds of million of EUR annually for Lithuanian Private Enforcement Officers, social security and tax authorities. Lithuania has had a fully private enforcement system for almost 2 decades, and is the top EU jurisdiction in the relevant component in the latest World Bank Doing Business rankings. PLAIS makes even the smallest claims, such as administrative fines, very easy to enforce. Neither the banking system – nor, most importantly, major political or business players - can manipulate this process, effectively making the timely payment of debt inevitable. In turn, this acts as a huge disciplining factor for the society as a whole. This practice shows that, without bank account blocking, there can be no proper enforcement. And without automation, there is no effective and efficient enforcement.

Some degree of automation in blocking bank accounts of physical person debtors in Ukraine is already possible in alimony cases, which reduces delays from the formal decision to freeze to the moment of the actual blocking of the debtor bank account from 1 month to 1-2 days. But not all Ukrainian banks are participating in the scheme to the same scope and extent. Secondly, this scheme merely gives the ability for enforcement officers to communicate with the banks by email. This is not full automation, which can reduce delays to a matter of minutes, as in the case of Lithuania. Hence the inclusion of the MFA requirement to automate the communication with banks is a welcome first step towards fuller automation of the enforcement process. At the same time, more systemic efforts in this connection should eventually also include the rebuilding and proper interoperability of the current property, land, business, demographic and other registers.

Effective and independent enforcement also brings benefit to the State budget

Official statistics of the Ukrainian National Police indicate the level of enforcement of administrative fines at 26%. There is no consolidated data about the enforcement level of various administrative fines imposed by the Ukrainian local authorities, but the anecdotal evidence shows that the real enforcement rate is even lower. The rate of enforcement of administrative fines in Lithuania is more than 70%, by contrast. Moreover, owing to the PLAIS system mentioned above, the majority of effective administrative fines in that country are collected instantly by automated bank charge to the treasury bank accounts.

In more complex cases of larger administrative fines, including the tax debt, various alternative dispute resolution mechanisms exist to force the debtor to "reconcile" with the State, which might include an agreement on deferred or reduced payment by the tax or social security authorities. A key principle in many European jurisdictions in both business life and tax collection is “time is money”. By reverse logic, losing time on unnecessary litigation and disagreements as to the “lawfulness” might defeat the very purpose of the regulatory intention to strike a balance between the debtor compliance with his tax or fine obligation on the one hand, and the quick influx of money to the State budget on the other. The expected introduction of mediation in Ukraine will facilitate alternative dispute resolution. At the same time, it would be premature to expect quick results in this area, as long as the use of discretion by the Ukrainian State authorities to reach a friendly settlement with the debtor is susceptible to be punished rather than encouraged, coupled with no automation or a role for trained private legal professionals (such as PEOs) to help the State collect tax and other public law debt obligations.

In this respect, best European practices can be followed to make the Ukrainian State uses the competent private legal services for the budget collection. In France, for instance, for several decades now the Ministry of Finance has been implementing a cooperation agreement with the National PEO Chamber, according to which the regional tax authorities are organising competitions to select PEO who could enforce tax and fines. By using complex evaluation criteria – such as human resources, IT and data management skills, professional experience etc. – the tax authorities identify the PEOs to be used as partners. The amount of tax and related contributions to be collected start from as low as EUR 30 per case and range to more than EUR 100,000 per case. As a matter of example, merely two PEO partnerships in Lyon collected more than EUR 5 million in tax in 2019 alone. The French PEO National Chamber relationship with the State is not that of a Client and Supplier, but rather of equal Partners – the better the performance, the lower the risk, the deeper the partnership. The French tax authorities have learned that using trained independent legal professionals is more effective, efficient and client-oriented way of tax collection, as opposed to sending bureaucratic reminders to debtors, which eat a lot of human resources and deliver dubious results.

Similarly, in Bulgaria, out of the total EUR 500 million collected every year by PEOs for all the creditors, more than EUR 80 million are collected for State and municipal authorities. Bulgarian PEOs are also collecting court fees, on the basis of a memorandum of understanding with the Supreme Judicial Council. In 2015 the Bulgarian PEO Chamber signed a memorandum of understanding with the National Council of Municipalities. Since then the Bulgarian local authorities are working closely with PEOs. In 2019 the various municipalities filed some 28,000 new enforcement cases with PEOs, who successfully collected some EUR 47 million for the local authorities. Since 2020 the Serbian PEOs are in charge of all enforcement, including in favour of the State and its entities.

Based on these best European best practises, it can be realistically hoped that the very attribution of the role for PEOs to collect administrative fines will definitely help the Ukrainian budget inflows, while kick-starting the cooperation between the State institutions and independent private legal professions in the budget collection. If best practices from Bulgaria, France, Lithuania, Netherlands and other European jurisdictions are to be considered, the question on imposing VAT on the enforcement services should also be discussed, in order to shift the balance of tax burden from PEOs to their clients in Ukraine.

Key message: enable independent legal professionals to conduct their business

Based on the analysis of the current law and practice, the key message of the Ukrainian political and justice sector leadership since the actual start of the enforcement reform in 2017 remains the same – influential creditors, especially the State entities and State-run companies, continue to benefit from the politically-controlled enforcement system that chooses selectively which debtors to run after, and which to forsake. Ukrainian individuals and the private sector bare a direct brunt of this possible discrimination in favour of the State. Although PEOs are called “liberal professionals”, in fact, they are under overzealous wardenship of MOJ, courts, law enforcement and other authorities.

The green shots of the upcoming reform are already appearing, however, with the so-called Joint Enforcement Bills (registered in Rada under 3726-3729), which were developed by a wide consortium of partners from the Ukrainian legal professional community, other key domestic stakeholders (businesses, banks, CSOs, academia) and international partners, aiming at the following:

  • repositioning the role of judiciary role in enforcement proceedings as supposed to help, and not prevent, enforcement;
  • reviewing of regulatory role of the Ministry of Justice, allowing PEOs to finally emancipate from excessive and overzealous State control and become true legal professionals by stronger self-governance;
  • granting equal procedural status and the mandate to act for State and Private Enforcement Officers to enforce judgments against State-owned entities and companies, or act in favour of the State client, in particular by collecting administrative fines;
  • extending the mandate of PEOs assistants to outsource performance of mundane roles by PEOs, and finally create the opportunity for PEOs to create a proper business practice by employing as many assistants as needed;
  • implementing the ordinary civil law principle of “paying interest for the use of another’s money", in order to stimulate debtors to enforce the obligations and do so without unnecessary delay;
  • making enforcement actions more efficient and transparent by automation, including a proper automated bank accounts blocking and write-off system with the necessary safeguards (i.e. to protect social payments for the debtor etc.).

The above initiative allows to be hopeful that the position reflected in the above MFA conditionalities is already largely endorsed by the Ukrainian partners, emphasising the commitment to the rule of law and the promotion of business climate. We already see enough reasonable voices in Ukraine to drive the enforcement reform. The rule of law begins with respect for debt obligations. And the Ukrainian Government should no longer be the last to pay its own debt to Ukrainian individuals and business.

Lionel Decotte Private Enforcement Officer, PEO (France) Katilin Popov, PEO (Bulgaria) Dovile Satkauskiene, PEO (Lithuania) Damir Site, PEO (Serbia) Dovydas Vitkauskas, Team Leader, EU Project Pravo-Justice