December 1998

by Derek Bloom

Over the past seven years, little capital has been available to finance lease transactions in Russia. Investments in Russian government and corporate securities during the period were made at the expense of investments in new productive assets. In this environment, new owners of Russian industry largely postponed long-term investments in acquired enterprises, had insufficient capital, or lacked a real intention to undertake such investments.

As a result of the current banking crisis, those domestic Russian banks which survive will be even less able to provide financing for leasing transactions. Similarly, foreign banks operating in Russia are likely to focus on short-term export financing activities, rather than comparatively long-term equipment financing transactions. Under these circumstances, Russian enterprises desiring to acquire foreign equipment will, even more than before the 1998 collapse, need to obtain financial assistance from foreign equipment manufacturers, foreign finance companies, and those foreign banks still active in the Russian market.

Environment for Leasing
Leasing is fundamentally a legally stronger form of financing equipment than a pledge of equipment purchased with loan proceeds. Established laws governing lease transactions and freedom of contract in Russia allow global lease companies to operate in Russia in much the same manner that they operate in other developing economies. Concerns about the legal environment for leasing in Russia apply equally to all other types of financing. These concerns include the enforceability of contracts in general, including the procedure and cost of enforcing pledges, guarantees, and setoff agreements.

Typically, Russian lease transactions only go forward with extensive and duplicative additional means of financial security, such as guarantee agreements from equipment vendors, guarantees from companies affiliated with a lessee, resale agreements, price guarantees, pledges of other assets owned by a lessee, offshore escrow accounts, bills of exchange from offshore banks, and other mechanisms. A requirement for insurance against loss of the equipment and repossession risks is becoming increasingly common in Russian lease financing.

Although leasing, as compared to lending funds to purchase an asset and taking a pledge for the purchased asset, offers the legal advantage that the lessor will have a clear contractual right to repossess leased equipment, an impediment to the growth of leasing has been the practical and perceived inadequacy of legal options available to lessors in the case of default. So far, where transactions have been constructed using Russian leasing companies as intermediaries, on the whole, the foreign company involved has underwritten such lease transactions and retained all the financial risks. In practice, finance lease companies express frustration with the time required to enforce via the Russian legal system repossession rights following a breach of a lease's terms. Additionally, even if a lessee has defaulted under the terms of its lease, a lessee facing repossession of leased property has the right to start a legal proceeding if its rights as lessee have been violated. Further, in the case of leased equipment installed in distant locations or underground, such as oilfield equipment, retention of the right of ownership may be of little real value to the lessor.

1998 Leasing Law
Improvements to Russian leasing laws, including clarifying the procedures for repossessing leased equipment, could facilitate more leasing activity in Russia. The new Russian leasing law, signed in late October, raises significant legal problems and impediments to substantial investments in lease transactions. The draft law does not reconcile many of its substantive provisions with existing provisions of the Civil Code, Civil Procedural Code, Tax Law, Customs Law, Joint Stock Company Law, and Bankruptcy Law. These conflicting pieces of legislation give rise to a number of new legal problems. There will likely be a prolonged period of legal ambiguity before the provisions of the lease law can be implemented in practice.
The confusion created by the conflicts with other federal laws may lead Western leasing concerns to engage solely in cross-border leasing transactions governed by foreign law rather than domestic leasing governed by Russian law.

Practical Steps
An efficiently run or wholly owned or controlled financing operation in Russia should be able to compete successfully in facilitating sales of new equipment, while at the same time providing protection against a number of risks. Major global equipment vendors or financiers may want to consider assuming the responsibility for providing necessary financing to their customers. Few viable partners exist among the banks and leasing companies currently in Russia, and many existing Russian leasing companies face bleak futures due to their affiliated banks facing insolvency and liquidation. The use of external financial intermediaries who mark up the cost of financing to end-users can price the lease out of the market. Lease transactions which exceed the cost of competing gray market transactions, or which greatly exceed the cost of loan financing on an after-tax basis, will not be viable in the marketplace.

A further practical step for strategic investors in large projects is to obtain corporate control over lessees by forming joint ventures to serve as lessees. Control may then be exercised over these joint ventures through control of the preparation of charter documents and subsequent corporate activity. At minimum, a minority interest in a lessee company, with must be obtained to utilize this strategy. Options may be granted to joint venture partners to acquire control of the lessee once its financing obligations are satisfied. Potentially, offers of equity stakes in a lessee may co-opt key regulatory and business partners, providing a positive incentive to facilitate the lessee's success and fulfillment of its obligations.

Thirdly, with the declining value of the ruble, lessees should be contractually obligated to pay the foreign leasing company a ruble amount equivalent to the required amount of hard currency (at the exchange rate of the date payment is received).

Leasing should prove to be a growing, flexible, and promising means of financing the acquisition of many types of equipment needed by Russian industry and entrepreneurs. Foreign leasing companies should have certain compelling advantages due to their experience with such transactions and access to relatively inexpensive sources of capital. Many Russian leasing companies would welcome joint lease/sublease transactions in which they would assume responsibility for all activities in Russia and provide guarantees of lease repayments to a foreign partner. Alternatively, a foreign leasing company that desires to capitalize upon the opportunity to develop a larger scale business of its own in Russia may want to consider setting up a wholly or jointly owned leasing company in Russia.

For more information on leasing and other means of financing, visit BISNIS OnLine at www.mac.doc.gov/bisnis/isa/isa.htm#Gisa.

Derek Bloom is an attorney with Coudert Brothers in Moscow.

This report is provided courtesy of the Business Information Service for the Newly Independent States (BISNIS)