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10 Legal Reforms in Ukraine

Editor(s):
Patrick Lenain, and Peter Cornelius
Published Date:
February 1997
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Author(s)
Galina Mikhlin-Oliver and Sandra Bloemenkamp* 

Since its declaration of independence in August of 1991, Ukraine has embarked on the highly complex task of severing its ties with the Moscow-dominated centralized economy, and erecting a market economy in its place. The economic reform effort in Ukraine is only about two years old. Not until the election of President Kuchma in mid-1994 was a comprehensive program of stabilization, liberalization of trade and prices, and privatization started by the government. It is clear that an efficient private sector is essential to sustain this reform program. Moreover, experience in Eastern Europe has shown that the restoration of economic growth will only come about through the new private sector. Hence, Ukraine’s structural reform agenda stresses the importance of an enabling business environment. A transparent legal framework that secures property rights and provides credible and efficient mechanisms for enforcement of contracts is a clear precondition for such an environment.

Therefore, Ukraine embarked on a legal reform initiative, designed to create the legal framework needed to nurture its economic reform. It enacted, albeit at an erratic pace and in a sometimes inconsistent way, many new laws and decrees supportive of a market economy in such key areas as corporate/commercial law, property law, and bankruptcy law. To ensure that these and other, more institution-oriented, legal reforms are carried out, Ukraine requested the World Bank to fund a legal reform project to help design systemic and sustainable reforms of its key legal institutions and processes. A major step toward establishing a comprehensive legal framework has been achieved recently: Ukraine adopted a new constitution on June 27, 1996, replacing the fundamental Soviet principle of “socialist ownership” with the declaration that the economic system of Ukraine operates on the basis of the market economy, with all types of ownership (state and private) being equal.

While these actions reflect the government’s efforts in the area of legal reform, and demonstrate its understanding of the importance of designing a proper legal framework for economic reform, many problems remain. These can be subdivided into three major categories: (1) the gaps in the existing legal framework occasioned by inadequacies in, or the complete lack of, particular laws needed for the proper functioning of a market economy; (2) the lack of adequate law enforcement and dispute resolution mechanisms; and (3) the absence of an institutional capacity to implement legislative and economic reforms.

This paper summarizes the role of legal reform in the overall economic reform, highlights the missing foundation block in Ukraine’s present legal system—a new civil code—and describes the systemic reforms to be undertaken by Ukraine in the area of legal infrastructure with the assistance of a proposed World Bank loan.

Role of Legal Reform in the Overall Economic Reform

As evidence worldwide shows, a successful transition to a market economy and the undertaking of sustainable macroeconomic reforms require a legal system supportive of private sector development. Such a legal system needs to provide a body of laws and institutions that will (1) foster the formation and growth of private business; (2) guarantee the integrity of contracts; (3) create clear and defensible property rights; and (4) contain reliable, efficient, and transparent mechanisms for dispute resolution and market exit of failed market undertakings. Such a legal system must also include safeguards against excessive regulatory intervention in general and, more specifically, against interference in contractual relations. It also requires the existence of reliable legal institutions, such as a private and independent legal profession and a reliable judicial system, capable of implementing market-oriented laws in an efficient and transparent manner.

Absence of an appropriate legal foundation for undertaking economic reforms would inevitably undermine the sustainability of such reforms. The costs of an inadequate legal system, which is incapable of providing the necessary legitimacy for the operation of the private market, would eventually be borne by the entire economy, undermining the reform process. For example, unclear and incomplete property rights would result in distorted credit flows by discouraging long-term investment and favoring instead opportunistic, short-term transactions designed to obtain the highest return in the shortest time. Moreover, a lack of clear and defensible interests in personal property would seriously constrain the ability of businesses and individuals to secure credit for working capital and expansion. The development and functioning of normal financial markets would be inhibited in the absence of a reliable and efficient system for the creation and enforcement of collateral secured on land or movable property.

The formation and operation of new private businesses would similarly be stifled by the lack of simple and transparent legal mechanisms for the formation of business vehicles; raising of capital from the public; engaging in market-based competitive behavior; and exiting the market in an orderly and relatively cost-efficient manner upon failure. Moreover, to foster private entrepreneurial activity, the enactment and implementation of laws permitting the simple formation of a variety of business forms will have to be accompanied by the breakup of policy-based monopolies and the introduction of efficient and appropriate antimonopoly (or competition) regulation mechanisms.

The problems associated with the lack of the appropriate legislative basis are exacerbated by the absence of the necessary legal institutions—reliable and efficient independent courts and an independent legal profession—which represents a fundamental obstacle to private business activity by elevating the transaction costs of conducting business to a level where few can afford it. Inefficiency, delays, and the unpredictability of (enforced) court decisions result in the devaluation of financial claims and provide incentives for the nonperformance of contracts. In the absence of an independent judiciary and legal profession, important checks are lacking on the misuse of the law by government officials, on the exploitation of administrative discretion, and on encroachment by the state on private transactions. This, in turn, drives up transaction costs, discourages new entrants, and impedes the development of a legitimate private sector.

As recently emphasized by Douglas Webb:

The lack of a credible and stable system of laws and institutions introduces an unnecessarily high element of risk into business transactions. Business people must cope with the uncertainty of bureaucratic interference through the use of administrative discretion. And without an effective judicial system to give credibility to the binding nature of business contracts, business will be reluctant to deal with customers they do not know. Uncertainty may also affect the structure of businesses by encouraging firms to vertically integrate and thus to avoid reliance on unstable contractual relations with outside suppliers.

All of these consequences of an underperforming legal system will act as a disincentive to potential foreign investors. As well, such foreign investment as does occur will tend to be opportunistic and focused on short-term trading gains rather than long-term investment in plant, equipment and new technologies.1

Current Legal Framework

Since independence in 1991, Ukraine has adopted numerous new laws designed to support its transition to a market economy. These include the laws governing property rights, the company law, laws and decrees on privatization, the bankruptcy law, banking laws, the foreign investment law, and various tax laws. On June 27, 1996, Ukraine also adopted a long-awaited new constitution, and a draft new civil code is in its last stages of preparation. While these efforts are commendable, a lot remains to be accomplished in the area of legal reform, in terms of both the legislative framework to be put in place and the institutions to be reformed and developed to enforce and implement said framework.

A detailed overview of Ukraine’s legislative framework is outside the scope of this paper. It is fair to say that despite Ukraine’s efforts in adopting the new legislation required to support its transition to market economy, the experience of the past five years, characterized by enacting ad hoc economic legislation to deal with a succession of problems immediately at hand, has been less than ideal. The result is an uneven, fragile framework filled with gaps and contradictions. Given Ukraine’s tradition as a civil law country, there is a strong consensus inside and outside Ukraine that the enactment of a new civil code—which will regulate fundamental economic relations in a manner consistent with the principles of a market economy—is the next critical step of Ukraine’s legal reform. Such a civil code would establish basic principles for regulating property rights—contracts as well as specific areas of economic law, including secured transactions and company law. The civil code would also fill the gaps in the present legal framework (for example, by providing clear mechanisms for the exercise, transfer, and enforcement of property rights and contracts) and introduce a coherent basis against which all other laws could be measured and reconciled. It would also introduce a measure of rationalization into Ukraine’s presently fragmented process of preparation of laws. Indeed, the existence of the constitution and the new civil code would give Ukraine the necessary foundation on which its market-friendly legal framework could be erected.

Systemic Reforms

The development of institutions that guarantee continued development of a stable legal infrastructure and ensure that market participants’ rights are predictably enforced is an essential element of a well-functioning legal system. The government of Ukraine, therefore, has identified institutional reform as the next, most urgent, task in the legal reform area and has requested the World Bank’s assistance in this respect.

As a result of its Soviet past, Ukraine lacks the institutions and traditions required for a legal system that could support the developing market economy. The creation of such a system is a long-term and complex process and is predicated on the development of the necessary institutions. As a first crucial step toward such institutional development, the objective of the proposed World Bank Legal Reform Project is to address selected critical institutional elements of legal reform in Ukraine. Such an effort should focus on the following priorities: (1) to lay the foundation for the creation of an independent, well-functioning, and well-trained judiciary, capable of enforcing existing laws and resolving disputes competently and efficiently; (2) to upgrade and expand the existing sources of legal information, by making laws, regulations, and court decisions widely accessible to government at all levels, and to legislators, the legal profession, and the public at large; (3) to upgrade the quality of legal education at all levels, to produce competent and independent legal professionals; and (4) to systematize and rationalize the process of preparing legislation, enhancing the legal quality and consistency of laws and regulations.

The following subsections summarize the initial analyses with respect to each of these priorities.

Judicial Reform

The greatest challenge will be cultivating a judiciary independent in mind, in fact, and in reputation. Neither the public nor the judiciary considers that this has yet been achieved. The reputation of Ukraine’s judiciary is burdened by a history of state control and the tradition of a judiciary responsive to external direction. The perception is that the influence over the judiciary formerly exercised by the Communist Party may have been replaced by the influence of the wealthy or powerful.

Extensive and intensive training is required for the judges, parliamentarians, the executive, the civil service, students, and the general public on the philosophy and importance to Ukraine of the concept of judicial independence. The concept can also be supported by strengthening judges’ associations, by developing a code of judicial ethics and conduct on and off the bench, and by strengthening and increasing the sophistication of the judicial self-disciplinary process.

A major problem area concerns attracting qualified new judges and providing professional development education programs to sitting judges to equip them with the necessary new skills. Appropriate candidates are difficult to attract to the bench because of low salaries compared with those of lawyers in private practice, poor physical and administrative infrastructure, fear for physical safety, and a lack of public respect for the bench. Some of these problems are beyond what can be tackled in a World Bank project. But in the area of education and infrastructure, concrete improvements can be made.

Existing judicial education programs are inadequate. There is an urgent need for a permanent judicial education institute for use by all levels of the judiciary. This would secure a pool of candidates for judicial appointments by providing potential new judges with an in-depth course of studies in academic and practical subjects designed to produce competent jurists. It could also provide short orientation courses for judges appointed in the middle of their legal careers. Finally, it could provide continuing education for experienced judges on, for example, the new constitution and the new civil code, other economic and commercial laws, judicial ethics, court and case flow management, and judicial accountability to the public.

As to the physical infrastructure, many courtrooms are in need of substantial repair and renovation. There are not adequate provisions for the safety of judges and witnesses. Many judges do not have adequate office space or equipment. Minimum standards should be established in consultation with the judiciary on courtrooms, judges’ offices and passageways, witnesses’ facilities, courtrooms, and office furnishings and equipment. These standards should then be implemented.

Judges do not have access on a timely basis to current laws. Basic legal resources such as guiding decisions and practice directions of the higher courts are lacking, as are reference resources and textbooks. This creates difficulty in all judicial work, but the situation is exacerbated by the increasing complexity of the cases now coming before the courts. There is a need for court controlled publishing facilities for the supreme court and high court guiding cases and practice directions, law libraries, and court electronic networks.

Also, the efficiency of the case flow process and management of the noncriminal courts needs to be analyzed and necessary improvements supported. Court-annexed or free-standing alternative dispute resolutions and the problem of access to courts should be included in the analysis. Implementation of recommendations should follow.

Civil courts in Ukraine are in disrepute because of the difficulties they have in enforcing their court orders. Use of the civil courts is diminished if a judgment cannot be enforced. New powers, personnel, and equipment are necessary for the civil courts to gain the public respect and confidence necessary to encourage court use for the resolution of civil disputes.

Legal Information

Presently there are two major legislative databases in use in Ukraine: ZAKON, which is owned and operated by the private sector, and PRAVO, owned and operated by the parliament. Both databases include the text of all the laws as well as acts and regulations of executive and other agencies (including the Supreme Court, State Committees, etc.). Both systems provide similar information, have similar search capabilities, and contain an override function that highlights amendments to existing legislation. Each system currently reaches about 2,500–3,000 subscribers. PRAVO is available to all parliamentarians and the support departments of the parliament. It also has 638 users in the executive and numerous commercial customers. ZAKON is available to government agencies and commercial customers; it is also available free to about 15 libraries and several law faculties.

These findings suggest that an adequate information base does exist. However, the ownership issue seems to be controversial, and accessibility outside Kiev is inadequate, especially where it concerns the rayon and oblast courts and local authorities. Assessing the costs of remedying the limited access outside Kiev is a high priority.

Electronic information dissemination is very important, but other forms of hard copy publications will remain critical as well. Therefore, support to establish an official gazette and possibly other legal publications, as well as to help establish legal libraries, is also a priority.

Legal Education

The current system of legal education is inadequate for training the legal professionals needed in a market economy. Similarly, the system for providing legal information to the public is deficient. Reforms in legal education should focus on two aspects: (1) education of current and aspiring legal professionals, national standards for legal education, curriculum, teaching methods, and the training of advocates, notaries, and government employees; and (2) education of the public at large to familiarize them with the new legal system, particularly on the civil and commercial areas of law that are necessary to the conduct of a market economy. The project might focus on two channels to convey such information: the media and the schools.

Legislative Drafting Process

The existing process of legislative drafting in Ukraine is rather disorganized. The president, parliament, the cabinet of ministers, the supreme court, the central bank, 25 ministries, and many other authorities were entitled to initiate draft legislation. Many of these agencies had more than one unit that prepared draft legislation.

The new constitution drastically limits the number of agencies that have the right to initiate draft legislation. The Law on Normative Acts, which will be considered soon now that the new constitution has been adopted, will rationalize the legislative process. It also envisages a strengthened coordinating role for the Ministry of Justice.

The adoption of the new constitution and the pending enactment of the Law on Normative Acts will certainly contribute to the harmonization of the legislation process, but it will not be sufficient. A working group needs to be established to work out Ukraine’s legislative policy, by focusing on (1) the establishment of quality criteria for preparing and enacting new legislation; and (2) analysis of the present process and practices of legislative drafting. Such group would have to include representatives of all relevant agencies to be meaningful, and technical expertise should be provided as well.

In addition, two more issues require immediate attention: preparation for the implementation of the new constitution and the envisaged Law on Normative Acts; and the design of a mechanism to exercise control over the executive rulemaking.

To improve legal drafting skills, technical assistance might have to be provided to the various agencies and institutions involved in the legislative drafting process for key legal acts. For some laws, assistance is already provided by bilateral donors; a list of laws, decrees, and regulations will be provided where such assistance is not yet available. This list should focus on high-priority enactments in the field of economic reforms (for example, banking laws, laws on financial institutions, financial accounting, company legislation, and bankruptcy legislation) and framework codes such as the civil code. The latter are necessary to support the aforementioned laws. Training should be provided to legal professionals involved in drafting legislation (including the staff of the newly established legal drafting unit in the Ministry of Justice, members of the Committee of Legislative Initiative formed by the president of Ukraine, members of legislative departments of ministries, and relevant parliamentary committees).

Furthermore, legal professionals involved in drafting legislation should have easy access to all the relevant legal information, such as law books, legislation, jurisprudence, international conventions, and jurisprudence from the international courts. The exact needs in this area have yet to be analyzed and costed out. This will be done in parallel with the assessment of equipment needs in other areas.

Discussion

The papers presented in Session III were discussed by Arlene Elgart Mirsky, Pat Shapiro, Axel Siedenberg, and Mark Tomlinson.

Siedenberg and Tomlinson emphasized that for investment and growth to take place, private sector development would need to be given a key role in economic policymaking. They agreed that priority should be given to establishing an incentive structure for private investment; improving corporate governance; increasing competition, including in the agricultural and energy sectors; and putting in place an efficient legal system. They also noted the need for developing a new institutional framework, enhancing Ukraine’s admininstrative capacity, and supporting the development of a dynamic private sector.

While noting that government divestiture had recently gathered momentum, Siedenberg stressed that privatization in and of itself would not necessarily result in improved corporate governance. In fact, in a large number of privatized enterprises the state retained a share of up to 49 percent, and those enterprises, which were yet to be privatized, remained fully under the auspices of branch ministries. Many of them continued to enjoy preferential treatment, for example, in the form of budgetary support, and had little incentive to adjust to a more competitive environment. At the same time, branch ministries would provide little, if any, outsider control, which was necessary to improve corporate governance. In that context, Tomlinson stressed the potential role of foreign direct investment in the privatization process and noted that the EBRD was considering equity investment in various areas. While foreign participation remained very limited under the mass privatization program, he hoped that increased foreign investment in the postprivatization period could help improve management decisions and corporate governance.

Commenting on the paper by Jimenez, Siedenberg linked the issue of corporate governance and private investment with the weakness of the banking system. He noted that in the absence of strong banks and efficient financial markets, which could play the role of financial intermediaries, potential investors would find it difficult, if not impossible, to finance their investments- As long as banks and equity markets were unable to channel private savings into investments, enterprises would need to rely to a large extent on internal financing. However, for that to take place, the tax burden would need to be sharply reduced. Also, there was an important need for developing a framework for collateral, without which banks would remain very reluctant to lend, an aspect that in his view should have been emphasized more strongly. In contrast, he did not see great scope for a larger role of foreign banks at the current stage. Pointing to the bad loan problem that plagued many banks, Tomlinson emphasized that bank restructuring and enterprise restructuring should be considered simultaneously. Strengthening the banking system should give banks a larger role as outside controllers of enterprises, helping to improve corporate governance. Restructuring the banking system could imply considerable costs, which would need to be borne largely by the budget.

Siedenberg and Tomlinson generally agreed with the thrust of Cornelius’s paper on competition. Siedenberg emphasized that barriers to exit had important effects not only on competition but also on the budget and on efficiency. In contrast, barriers to entry would prevent the development of new ventures. In that regard, he pointed to the experience of Poland, whose success in private sector development was based largely on the emergence of new firms rather than on the restructuring of former state-owned enterprises. While Siedenberg agreed that the role of the Antimonopoly Committee had to that point been rather limited, he noted that its sheer existence could promote competition by discouraging firms from abusing their market power. Both Siedenberg and Tomlinson noted, however, that priority should be given to demonopolization rather than regulating existing monopolies. In that context, Siedenberg expressed concern about the existence of numerous branch ministries, state committees, and other administrative units that would show a preference for interventionist policies. In his view, Cornelius’s paper should have emphasized more strongly the need for institutional reforms.

Finally, Siedenberg pointed to the need to increase competition in the agricultural sector, where Ukraine had a particularly large export potential. However, this potential was not realized partly because of extraordinarily high storage costs and storage-related losses. While in the European Union those costs amounted to about 5 percent of world market prices, in Ukraine they accounted for some 15 percent. Lower producer prices caused by inefficiencies in tandem with continous market interventions and slow privatization, however, would give the wrong signals to farmers and food processors.

The discussants agreed that legal reforms would need to play a particularly critical role in establishing a framework conducive to long-term investment decisions. Following the adoption by parliament of a new constitution, work on the civil code was to be accelerated, and economic legislation governed by individual laws was to be reformed. That would concern in particular the Law on Bankruptcies, the Law on Collateral, and the Company (Corporate) Law. Equally important, Ukraine’s legal infrastructure, as discussed in Mikhlin-Oliver and Bloemenkamp’s paper, was to be strengthened.

On the paper by Mikhlin-Oliver and Bloemenkamp, Shapiro presented a strategic approach for commercial law development as an integral part of the transition. That approach defined the task of legal reforms as follows. First, key legal impediments to program targets were to be identified. The economic underpinnings were to be reviewed, and priorities of reforms were to be set, taking into account the legal reform status and linkages to the overall reform program. Further, program resources were to be allocated to legal reforms. The activities of the different donors were to be coordinated, and the counterparts of the host government were to be clearly identified. Moreover, a broad public/private sector constituency base was to be developed. To the extent possible, local resources were to be employed. Finally, the appropriate timing of legal reforms was to be determined.

On the role of technical assistance at various stages of the legal process, Shapiro suggested starting from the analysis of the overall framework, examining the adequacy of existing laws and the consistency between new and old laws. As a general reference, model laws, comparative law materials, law commentaries, and economic documents could be used. Then, the legislative reform process itself was to be examined, focusing on new and/or amended laws, the parliamentary process, constituency building, and the local drafting capacity. In the next stage, the dissemination process was to be evaluated, concentrating on the publication of laws, public access to laws, and translations. As for regulations and decrees, technical assistance was to focus on training key players and developing implementing institutions. On the enforcement level, judicial training was to be provided and alternate dispute resolutions developed.

Finally, Mirsky presented a proposal based on a recent study she had coauthored with Richard Coates,1 on enhancing the role of restructuring and bankruptcy in Ukraine’s transition to a market economy. An efficient framework for bankruptcy proceedings was needed as an exit mechanism for failed enterprises (liquidation), as was a mechanism for restructuring enterprises, which were worth more as a going concern than they were liquidated (or reorganized), thus promoting the flow of credit by protecting creditors. Current restructuring mechanisms in Ukraine were based on the Law on Bankruptcy and draft regulations on the Agency for Prevention of Bankruptcy. However, in her view, those mechanisms were insufficient, with a substantial gap between the need for bankruptcies and actual practice. That gap reflected inefficient bankruptcy proceedings, the lack of an adequate legal infrastructure, especially pertaining to the court system and related professions such as trustees, and the lack of incentives to initiate bankruptcy proceedings.

As far as creditors were concerned, Mirsky argued that their incentives were distorted by government interventions to direct credit to loss-making state-owned enterprises, which were hardly affected by the bankruptcy law. Many banks were hoping to avoid loan losses through government support. At the same time, capital adequacy requirements for banks were not strictly applied. Moreover, creditor enterprises, especially other state-owned enterprises, were hoping that further debt-netting schemes would ease payment blockages. Further, regional and local authorities were reluctant to take over the social assets of failed state-owned enterprises. Other disincentives included significant hurdles to the commencement of proceedings; the high costs of the currently required preliminary proceedings; the length of time such proceedings took; and the uncertain prospect of any recovery. Debtor enterprises, in turn, would see lobbying for funds as the most immediate and pragmatic method of avoiding financial failure. Finally, according to Mirsky, policymakers were concerned about the political and social consequences of enterprise restructuring and liquidation.

Based on this analysis, Mirsky argued that the bankruptcy law would need to be reformed to provide for more workable reorganization procedures, and that a temporary, limited-life special restructuring program for specifically designated state-owned enterprises should be designed. The latter would aim at (1) increasing the transparency of government policy choices by forcing explicit decisions on budgetary support to loss-making enterprises and on the financing of a social safety net to minimize the social impact of those programs; and (2) placing the responsibility for restoring financial discipline with the management of state-owned enterprises and with their creditors, to the exclusion of government bailout.

The special program would have a limited life span, not exceeding two years. It would be applied only to specifically designated state-owned enterprises, taking into account the institutional capacity of the restructuring agency and government funds available for restructuring. The specific terms and conditions for the modification of creditors’ rights would be governed by detailed legal mechanisms, and state-owned enterprises included in the program would be cut off from all credit except for that provided by a special fund. The existing liabilities of the state-owned enterprises, which would be required to operate on a cash basis, would be frozen. In order for a state-owned enterprise to be eligible for credit from the fund, it would be required to submit and obtain approval of a restructuring plan. An enterprise could graduate from the program through privatization; achieving a positive cash flow and reaching an arrangement with creditors regarding frozen liabilities; or liquidation at the end of the two-year period. For all other state-owned enterprises not included in the special program, court-led bankruptcy proceedings would apply.

Those reforms would need to be accompanied by parallel programs, in particular concerning reforms of the banking sector and reforms to unravel the interdependence among state-owned enterprises. Municipal, regional, or national intiatives were needed to deal with the redeployment of, and funding mechanisms for, the social assets of state-owned enterprises. Finally, a social safety net was to be developed to improve the targeting of social assistance to the poor. Mirsky argued that the lessons that could be learned from the special program could provide valuable guidance for reforming and improving the court-led proceedings.

*The paper was presented at the seminar by Ian Newport, World Bank.
1Douglas A. Webb, 1996, “Legal System Reform and Private Sector Development in Developing Countries,” in Economic Development, Foreign Investment, and the Law, ed. by Robert Prichard (London; Boston: Kluwer Law International and International Bar Association), pp. 45–65.
1Mirsky, Arlene Elgart, and Richard Coates, 1996, Restructuring and Bankruptcy in Ukraine, Country Report (Deloitte Touche Tohmatsu and US AID, May).

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