S&P Viewpoint

The Ukrainian economy is showing moderate growth of GDP (5% in the first six months of 2006) and is attractive to investors ($2 billion of foreign investments during the same period). However, political uncertainty and macroeconomic instability result in high country risk, which in turn results in difficulties in attracting capital.

Significant macroeconomic changes occurred in Ukraine after the events at the end of 2004 associated with the presidential elections, a new team coming into power, and changing priorities in foreign and internal policies. Those changes were linked to the campaign promises of the new administration of Prime Minister Yulia Timoshenko (February through September 2005), and its predilection for hands-on control of economic processes, lack of coordination among the branches of the administration, and changing priorities and objectives in foreign policy. Striving to fulfill campaign promises, the government revised the budget by increasing social spending. As social spending had increased before the elections; this resulted in increases in the social component of the budget and in the Pension Fund deficit. In addition, the government eliminated free economic zones, stating that it was necessary in order to counteract corruption. The Ukrainian model of free economic zones included tax exemptions, and it is true that this led to serious misuse of resources. However, complete elimination of the zones has its own negative implications for the investment climate. Some of the entities privatized in 2000-2004 were put through a reprivatization process. (The most famous example is the Krivorozhstal steel complex. After reprivatization, it was sold at a price 5.6 times higher than the initial privatization price.) These instability factors were exacerbated by an unfavorable situation in the market for the major export products of Ukraine (for example, rolled steel products), which started improving only in spring 2006.

An important factor affecting the economic situation was the clear foreign policy direction of the new Ukrainian administration: WTO accession and preparation to join the EU and other Euro-Atlantic institutions. However, deteriorating relations with Russia, one of the main trade partners of Ukraine, hindered the resolution of a number of economic crises (the grain crisis, the sugar crisis, and the meat crisis in 2005, as well as others). In a number of sectors strained relations also resulted in decreasing exports to Russia. Appointing the liberally inclined Yury Yekhanurov as prime minister stabilized the economic situation to some extent, made the country more attractive to investors, and enabled an increase in the rate of economic growth by June 2006. (2) At the same time, the Russian price increase on energy products at the beginning of 2006, the indecisive electoral outcome (rather than the previously rigged solid majorities), the antagonistic political culture, and amendments to the Constitution of the Ukraine, which envisage that the prime minister is nominated by a parliamentary coalition (when previously this individual was appointed by the president) led to significant elements of uncertainty in the development of the Ukrainian economy. After signing the National Unity Pact on Aug. 4, 2006, the Coalition Government headed by Viktor Yanukovich was confirmed. On the one hand, confirmation of the coalition government makes it possible to forecast stabilization in the political and economic processes of Ukraine. On the other hand, differences in the vision for resolving a number of political and economic issues among the factions that formed the government and the president (for example, interacting within the Common Economic Space (Russia, Ukraine, Belarus, and Kazakhstan), land sales, and Ukraine joining NATO) leads to a risk of policy reversals, raising the overall level of county risk.

From the standpoint of corporate governance in the banking sector, the current situation in the Ukraine has the following characteristics.

The transition to a parliamentary presidential republic where the prime minister is nominated by a coalition of forces elected to the Verkhovnaya Rada (parliament) is creating political uncertainty. The uncertainty occurs, first and foremost, due to the currently incomplete division of responsibilities among the president, Verkhovnaya Rada, and the Cabinet of Ministers. Besides that, the political groups that formed the coalition and confirmed the government headed by Viktor Yanukovich have differing views on economic development in Ukraine.

The succession of three governments over 2005-2006 was accompanied by rather dramatic "twists" in economic policies, which were flip-flopping back and forth, but the economy proved resilient and did not seem to be negatively affected by the turmoil surrounding the policy-volatility. At the same time, currently, the budget of Ukraine carries a high social spending component (above 80%), while the investment component of the budget was reduced starting in 2005. The most likely sources of new revenues are external borrowing and proceeds from the sale of government-owned blocks of shares in a number of attractive state-owned enterprises (for example, Ukrtelecom, a telephone communications operator). However, the struggle to own those entities among the business groupings represented in Parliament may significantly complicate the process of privatization. Starting from the second quarter of 2005, Ukraine showed a balance of trade deficit; there had been a surplus during 2000-2004. By June 2006, the trade deficit reached $2.1 billion, (3) and a Standard & Poor's Ratings Services estimate indicates that by the end of 2006 it will reach $4.6 billion. (4) The main impact of macroeconomic instability on corporate governance in the banking sector is the increase in country risk, which reduces incentive to resolve long-term issues for governance optimization.

Ukrainian banks have a significant need to bring in resources from the international capital markets. The two factors mentioned above: political uncertainty and instability of the macroeconomic policy, limit their capability to do so, because of the high country risk, which is reflected, among other ways, in the speculative-grade sovereign rating of Ukraine (BB-/Stable/B foreign currency). Ukrainian banks, as a general rule, are rated no higher than the sovereign rating (JSC Kredobank, B/Stable/B, and Ukrsotsbank OJSC, B/Watch Pos/B). This constrains the process of bringing in capital, and, correspondingly, potential development of the banks. Access to international capital markets requires a high level of corporate governance (including a high degree of transparency), while limited potential for such access limits incorporation of the best international practices of corporate governance.

The transition to world price levels for energy products that started in the beginning of 2006 will continue. This has a direct effect on the profitability of the main sectors of the Ukrainian economy (steel, the chemical industry, and the mechanical engineering industry). It may promote restructuring in those sectors and capital flow into new areas, particularly into such promising areas as the service sector, telecommunications, construction, and transportation. In this sphere, Ukraine is most likely to follow the lead of other Eastern and Central Europe countries, where these sectors are developing dynamically. In general, this situation is favorable for improving corporate governance in the banking sector. Banks are forced to diversify their activities and develop new areas of business (for example, retail lending), and that is not possible without appropriate improvement of corporate governance. In particular, they are forced to be more active in implementing risk-oriented management systems.

There is no uniform ideology for privatization of the remaining government property, including Oschadbank and Ukreximbank. There were only three banks privatized in Ukraine (Prominvestbank, Ukrsotsbank, and Bank Ukraina; the latter went bankrupt in 2000). The other banks were built up from scratch. Therefore, the issue of reprivatization cannot be relevant for them.

There is limited potential for asset and operations diversification for the banks. Starting at the end of 2004, after the end of the Orange Revolution, the stock market of Ukraine received a certain impetus in its development, though it is still underdeveloped, even in terms of emerging markets. This situation results in a significant constraint on the development of the economy and the reflow of capital in Ukraine. in particular by making investment processes nontransparent and frequently conflict-ridden. Standard & Poor's classification system identifies the Ukrainian stock market as belonging to the Frontier Emerging Markets group.

The bulk of trading (88% in 2005) occurs in the First Stock Trading System (PFTS), which received formal exchange status only in June 2006. Before that, it served for 10 years only as a trade information site. In 2005, it was dominated by corporate bonds (45% of the total volume); government bonds accounted for 27%, equity for 23%, municipal bonds for 5%, and investment certificates for 1%. Total market shares capitalization in the PFTS as of the end of 2005 was $29.5 billion.

The banking system accounts for 85% of the assets of all financial intermediaries in the Ukrainian financial system. Other financial intermediaries are significantly underdeveloped. Only 12% belongs to insurance companies, and the rest belongs to mutual investment institutions, and nongovernment pension funds and credit unions. The absence of the "long funds" of a nongovernment pension system (the total value of the assets of the nongovernment pension funds of Ukraine at the end of 2005 amounted to $9 million (5) ) and insurance companies (total value of insurance reserves at the end of 2005 amounted to 60 million (6) ) makes it impossible to regard them as significant sources of investment capital. One of the consequences of this situation is the overall concentration of the banking system's credit and investment portfolio on certain types of instruments, where loans account for 93% and securities for only 7%, and those are mostly debt instruments.

Overall, there are two major trends through which the influence of the national environment is felt. On the one hand, development of the Ukrainian economy creates new possibilities for making profit. Gaining access to new areas requires attracting capital and therefore, improving corporate governance through building a new system of relations between shareholders and management. On the other hand, political uncertainty and macroeconomic instability result in high country risk for Ukraine. This leads to high risk premiums in international borrowings and IPOs, which are necessary for Ukrainian banks as a source of development capital. Inasmuch as the preparation for international borrowings or an IPO is one of the most important factors stimulating the improvement of corporate governance, including transparency, those processes are made more difficult.

In order to prevent dilution of shareholder rights in the charter capital of a bank (regardless of its organizational or legal type), which may lead to a reduction in the value of their shares, as well as undermine the shareholder's ability to influence decisions made at the shareholders' meeting, there are legal provisions stipulating preemptive rights of shareholders to purchase newly issued shares in the proportion of their current shareholding. Satisfying the right of shareholders to obtain information becomes particularly important here, including ensuring proper form and content of the announcement of the additional issue.

In Ukraine, banks do not limit minority shareholders' right to sell shares, including the open market sale. However, the Economic Activities Code stipulates that shareholders of the banks established as closed joint stock companies and limited liability companies have the preemptive right to purchase shares sold by other shareholders of the company. As a practical matter, there is no well-developed stock market capable of effectively determining the real value of shares, resulting in the problem of deciding a fair market price for small blocks of shares. Only if the shareholders decline to purchase the shares at the offered price, does the selling shareholder have the right to offer them at the same price to any third party.

The lack of a legal mechanism for determining a fair market price for selling shares and regulations to enforce the exercise of preemptive rights leads to conflicts and court arbitration. This makes transactions less attractive for investors, because the legitimacy of transactions is not guaranteed.

One of the most difficult issues is the buyout of shares owned by minority shareholders, should they object to an additional issue of shares and not wish to exercise their preemptive right (for example, if the additional issuance results from a merger of several entities in the interests of majority shareholders, with an artificial inflation of asset value, resulting in an inappropriate price for the newly issued shares). The purposes of additional share issues are frequently nontransparent, and the issues are made in the interests of the majority shareholders. As there currently is no liquid stock market, realization of the shareholder's right to demand that the company buys out their shares at a fair price (comparable to market value prior to share issue) becomes tricky. This results in a large number of lawsuits. At this time, there are no provisions in Ukrainian legislation to protect this right; however, the principles recommend that it be included in the internal documents of joint stock companies. This creates risks of dilution of share belonging to the minority holders in the capital as a result of share issues conducted this way.

During recent years, the reverse process has also started in Ukraine, that is, individual minority shareholders exercising their rights in order to stall the operation of banks, for example, via instigating a large number of lawsuits during which the banks' ability to perform operations with corporate shares are effectively limited. Those circumstances cause deterioration of the business reputation and image of the bank, generally resulting in an outflow of depositors, distrust on the part of investors, and an overall negative impact on the bank's operations.

In order to maintain its own register of owners of the registered stock, a bank needs to obtain a license and comply with a number of qualification and technical requirements.

Joint stock companies do not always comply with the requirement to have a contract with one registrar, leading to infringement of the shareholders' right to take part in the company governance. However, in the banking sector the risk of such violations is offset by strict supervision by the National Bank of Ukraine.

The law prescribes cases where dividend payout is not allowed: in case of incomplete payment for shares, or in cases when dividend payout may result in company insolvency due to insufficiency of net company assets. In addition, there are a number of restrictions imposed on dividend payout for companies with tax arrears. Ukrainian tax legislation allows for the possibility of dividend payout to owners (shareholders) even if there is no net profit, unless such a payout would jeopardize financial stability. For banks, additional requirements (for charter capital and for the fixed capital of the bank) have been established by the National Bank of Ukraine. Should those requirements be violated, dividend payout restrictions may ensue. However, this is not practiced currently in the banking sector.

Current legislation envisages the possibility of dividend reinvestment by all shareholders. The law stipulates that the decision to channel part of their profit, existing in the form of dividends, toward increasing the charter capital, through an additional issue of shares, is made on the basis of their applications submitted in writing, and is a right of each shareholder. This procedure can also be included in the charter documents of both limited liability and cooperative banks.

When dividends are reinvested and paid out to the shareholder (owner) as additional issue shares (equity), provided the proportion of the owners' (shareholders') participation in the charter capital is maintained, the dividends are exempt from profit tax. The right of preferred stock holders to dividend payout is, in effect, a fixed liability of the company. These dividends are calculated and paid out regardless of whether the company makes a profit or not.

In accordance with banking legislation, the exclusive domain of the GSM of the bank includes:

• Determining the main areas of the bank's activities and approving reports on its performance;
• Introducing changes and amendments to the bank's charter;
• Changing the level of the bank's charter capital;
• Appointing and dismissing the bank's Supervisory Board and the Audit Commission Chairman and members;
• Approving the annual results, including those of the bank's subsidiaries;
• Approving reports and conclusions of the Audit Commission and of the external auditor;
• Distributing profits; and
• Suspending the activities of the bank, appointing a liquidator, approving the liquidation balance sheet.

Unfortunately, despite the increasing role of the Supervisory Board in forming the development strategy of the bank and implementing corporate governance principles in the banking sphere, the role of this board is frequently rather a formality, or is excessively close to the functions of the executive body. The procedure for electing the Supervisory Board members in essence remains the process of appointing them by the large shareholders of the banks. Frequently, there are fewer than five members. The lack of a requirement on cumulative voting in the Ukrainian law (i.e., an opportunity of consolidating the votes of the minority shareholders in order to elect their own representatives to the Supervisory Board) limits the right of the minority-holders to govern the company and reduces their knowledge of the company. The institution of independent directors is not well developed, due to a lack of legislation that would regulate its establishment and operations. Individual banks, following international standards of corporate governance, have introduced internal corporate governance codes that envisage creation of this institution.

Given the ownership structure of most Ukrainian banks, which as a rule is characterized by one majority shareholder (direct or indirect), the procedure of forming the Management Board, even though it is classified as part of the domain of the GSM or the Supervisory Board, in fact remains in the hands of the largest owners (directly or through their representatives in the Supervisory Board of the bank).

Recent changes in banking legislation changing the subordination of the internal audit service (previously it reported to the bank's Management Board) have not become generally accepted practice. Therefore, although according to the law, the audit service is subordinated to the Supervisory Board, at this time these services have double subordination to the Management Board and the Supervisory Board.

Related to this, in 2004 the National Bank of Ukraine adopted the "Guidelines on Methodology for Establishing and Operating Risk Management Systems in the Banks of Ukraine." These guidelines include recommended norms pertaining to the domain of the bank's internal audit service. In addition, this document envisages setting up a number of committees under the bank's Supervisory Board, including the audit committee. There also are recommendations on requirements for the procedures and regulations of the functions of this committee, to which the internal audit service is supposed to report directly. This document is not of a compulsory nature, therefore, the very establishment of internal audit service's subordination is left at a bank's discretion and its own will to follow the best international practice. Audit committees are established in less than a third of large and midsized banks, and the efficiency of their coordination with internal audit functions is questionable.

In practice, internal control in banks is far from being comprehensive, and the extent of evaluating corporate clients is still formal and ineffective, as is risk assessment for transactions with related parties. It is worth mentioning that there are no internal auditing standards, (12) which creates a legal vacuum for everyday operation of the service. In order to create an independent and effective internal audit function in banks, the norms in question must be made mandatory for all.

The principles of corporate governance also recommend that the meeting be held within one day, and within the premises of the company. However, this principle is not always observed (for example, Ukrsotsbank holds shareholder meetings in different cities). In order for the shareholders to make well-considered decisions regarding the issues on the agenda, the bank needs to ensure that shareholders have access to documents pertinent to the agenda at any time after the announcement that the meeting has been called. The law does not stipulate the procedure for providing information of that nature to the shareholders; this procedure may be set forth in the charter or other internal documents of that nature (however, it may not have been). In practice, all documents are provided to the shareholders by mail at their request, or at the premises of the bank.

No less than 10 days prior to the GSM, the company must notify the shareholders on changes to the agenda via publications in the same mass media in which the notification that the meeting was called was published, and by sending personal written notifications to holders of registered shares.

The minimal share ownership at which the shareholder is guaranteed the right to require adding items to the agenda of the GSM is not defined. The only requirement is that such a request must be submitted no later than 25 days prior to the meeting.

Despite the fact that the law defines appointment of a representative as a strictly voluntary right of a shareholder, banks in Ukraine force minority shareholders to provide the power of attorney to a specific representative, as a general rule to the representative of the majority shareholder, Therefore, for all practical purposes, minority shareholders are deprived of the possibility of participating in company management.

Under the law, holders of preferred shares take part in voting only on the most critical governance issues: establishment, reorganization, and liquidation of the company per the conditions and procedure envisaged by the company charter.

Owners of the banks established as limited liability companies have voting rights proportionate to their share in the charter capital. The voting process and procedures are determined by internal company documents; in absentia voting is also possible. Therefore, there is no precise legal procedure for banks established as limited liability companies to ensure the exercise of the rights of the shareholders for participation in the GSM, nor is there a clear procedure for preparing and conducting such a meeting. Admittedly, those issues are pertinent primarily for small banks, and potentially only temporarily at that.

A counting commission is created to count ballots and perform other functions needed in order to conduct voting at GSMs. The procedure of creating the commission and number of members are defined by the internal documents of the bank. The principles recommend that the counting commission be selected by the Supervisory Board from the members of the Supervisory Board, representatives of minority shareholders, and the independent share registrar. Voting results and decisions made must be announced to the shareholders before the meeting is adjourned.

There are no specific legal restrictions for foreign capital participation in a bank, except that written permission needs to be obtained in cases of the purchase of a significant block of shares by a foreign investor. Written permission for purchasing a significant block of shares of a bank may be granted to a legal nonresident entity or to a non-Ukrainian resident concurrently with the granting of permission to establish a bank with foreign capital participation, or granting an existing bank the status of the bank with foreign capital.

A bank must submit notification to the National Bank of Ukraine of its intention to purchase 10% or more of the issue of its own shares. The notification must be submitted 15 calendar days prior to executing agreements. The National Bank may prohibit the bank from purchasing its own shares in cases when this may result in deterioration of the bank's financial condition.

The concept of related-party transactions is not provided for in Ukraine. Instead, banking legislation, including regulations of the National Bank of Ukraine on limiting the risk exposure, stipulates the procedures for the related-party transactions.

In particular, transactions executed with parties affiliated with the bank cannot stipulate terms more favorable than agreements made with other parties. Transactions performed on terms more favorable compared to terms of ordinary transactions will be considered void by the court from the time they were executed.

The definition of the related parties in the Ukrainian (13) legislature is rather vague and includes two categories. The first category is bank senior people including Supervisory Board members and senior executives. This comprises Executive Board members, heads of branches, the chief accountant, the head of the internal audit service, and a person responsible for financial monitoring. The second category is bank's insiders, who include:

• Individuals, meaning owners of significant blocks of shares, executives, bank's controllers (its auditor and the head of the statutory body, which supervises the bank's activities), heads and controllers of the affiliated structures (i.e., those in which a bank possesses a significant block of shares or those who possess a significant block of bank's shares), "family" structures (i.e., those having the same owner or executive), and close relatives of any of these.
• Legal persons, meaning owners of significant blocks of shares, affiliated and "family" structures, and structures, the executives of which are close relatives of individuals who are owners of significant blocks of shares.

It is worth mentioning that the definition of related party does not include the concept of beneficiary owners. The reason is that the concept of related parties is used exclusively for the control over the prudential limits of banks' exposure, in particular lending ratios. In turn, the concept of beneficiary owners is used for identification of the real owners of the bank by the supervisory body, but not of real related-party transactions.

Therefore, the adoption of the procedures for approval of large and related-party transactions is entirely at a bank's discretion. The control of the statutory bodies over the list of parties defined as affiliated is not performed in full and does not cover all the transactions, which makes the interests of the shareholders, creditors, and depositors, far less protected than it may seem at first sight.

The SCSSM is designated to determine what can be classified as insider information. However, there are no legal regulations for defining the criteria for insider information. Therefore, the category of insider confidentiality, the felonious use of confidential information, and, moreover, connecting such deliberate use to the infliction of significant material damage are based on assumptions, and are consequently hard to prove.

The system of regulating banking activities in Ukraine comprises the prudential supervision authority, the stock market activities regulation authority, and several self-regulation authorities. Government regulation of banking activities in general and corporate governance in particular is performed at the national level entirely, without any participation of local government authorities.

Prudential supervision authority in the country is vested in the National Bank of Ukraine, established in 1991 and possessing legally prescribed rights to establish requirements pertaining to registration, licensing, operations, and liquidation of banking institutions. Prudential regulations are an exclusive prerogative of the National Bank of Ukraine and there have been no precedents of regulatory competition in Ukraine. In addition, based on its obligation to protect the legal rights of creditors and depositors, the National Bank issues regulations pertaining to the authority and responsibility of the Supervisory Boards and Management Boards of the banks, as well as pertaining to the scope and time frame for submitting annual and interim financial and consolidated financials, including annual reports. The National Bank of Ukraine does not regulate the order and rules of procedure for holding banks' GSMs, leaving that to other regulatory authorities, but it does specify the time frame for holding such meetings and the list of items falling under the exclusive domain of the meeting. In addition, the National Bank of Ukraine approves candidates nominated for the highest management positions in the banks: chairman of the Management Board, chief accountant, and heads of divisions, in order to oversee their professional qualifications and business reputation.

In 2004, the National Bank of Ukraine began to show considerable interest in strengthening corporate governance mechanisms in the banking sector. The motive for this action stems from the need to strengthen the responsibility of the management and owners of banks for the banks' problems. Previously, resolution of those problems had been pushed onto government authorities. This relates to a number of sensational scandals involving such banks as Ukraina (Kiev, 2000), Slavianskiy (Zaporozhye, 2001), Premier-bank (Dnepropetrovsk, 2003), Intercontinentbank (Kiev, 2005), and Garant (Kiev, 2005). In these cases, the management had violated business practice principles. The violations included manipulating reported data and moving owners' capital out of "enfeebled" banks. The National Bank has repeatedly exercised its right to appoint temporary administrations and liquidation commissions in banks; however, there has not yet been a single case of successful completion of the temporary administration process. The claims of individual depositors at the liquidated banks were covered from the Fund for Security of Individuals' Deposits, (14) and in very few cases was it possible to increase the amount of compensation from the bankruptcy assets.

Given those problems, the National Bank of Ukraine decided to make gradual transition to a supervisory system based on risk assessment. One of the first steps in this direction was submitting to the Verkhovnaya Rada draft amendments to the Law "On Banks and Banking," which called for significant amplification of the responsibility of banks' owners and management for providing reliable data and following sound banking practices. However, this bill has been under parliamentary review for more than two years. Given the strength of the banking lobby in the current Verkhovnaya Rada, the prospects for adoption of the bill are not very promising.

In 2004, the National Bank of Ukraine adopted "Guidelines on Methodology for Establishing and Operating Risk Management Systems in the Banks of Ukraine," which served as a legal foundation for building a corporate governance system in banks. This document is advisory in nature and describes a desired framework of responsibilities of bank management bodies, starting from the Supervisory Board and ending with line front-office units. The National Bank of Ukraine included for the first time in those recommendations its vision of corporate governance issues pertaining to the sections "Management Bodies" and "Internal Controls" in accordance with national corporate governance standards. In particular, this refers to the accountability system for the activities of the Supervisory Board and the Management Board, as well as to ensuring the independence of internal audit. These recommendations also contain an approximate list of powers and rules of procedure for committees operating under the Supervisory Board (specifically, the audit committee) and the Management Board.

The recommendation to establish an audit committees came as a novelty for the banks because the Law of Ukraine "On Banks and Banking" presumes that only the Management Board will create committees, namely, the assets and liabilities management committee, credit committee, and tariff committee. However, prior to the ratification of this law the majority of the banks treated ensuring the functioning of the committees as a formality. Given the small number of members on the Supervisory Board (the average number was five as of 2004) mass creation of such Supervisory Board committees is unlikely in the near future. Adoption of this banking law provided banks with the necessary regulatory base for operating these committees and the impetus for real development of risk management. However, the declared intentions of the National Bank of Ukraine to transform a number of recommended norms into mandatory norms, thus expanding basic corporate governance principles throughout the entire banking system, were not fulfilled.

Under current legislation, in addition to regulating banking activities, the National Bank of Ukraine is also involved in regulating the activities of external bank auditors. This has been a long-running conflict between the National Bank of Ukraine and the Audit Chamber of Ukraine. The Audit Chamber of Ukraine is a self-regulating organization operating on the basis of the Law "On Audit Activities" adopted in 1993. This law assigns to the Audit Chamber of Ukraine the functions of inspecting the qualification and certifications of the auditors, and establishes three types of certificates: "Certificate A" for auditors of companies except banks, "Certificate B" for bank auditors, and "Certificate AB" for auditors of all types of businesses. At the same time, the Law "On Banks and Banking," adopted in 2000, assigns to the National Bank of Ukraine the authority to certify bank auditors (Certificate B). However, for a long time the National Bank of Ukraine did not exercise this authority, due to lack of resources needed to provide appropriate rigorous training and testing of the candidates. In addition, in the eyes of the National Bank, certification of bank auditors would create a precedent concerning the liability of the National Bank of Ukraine to the users of audit reports in case an auditor violates the requirements of the standards and codes.

Therefore, during 2000-mid-2006 no new auditors were certified, and instead the term of certificates' validity was extended for existing auditors. This led to a shortage of external auditors (as of the beginning of 2006 there were 69 certified bank auditors in Ukraine, while there were 165 banks registered as of that date). The law prescribes that an audit can be performed only by an audit company where at least 30% of the auditors have Certificate B. In fact, this requirement does not apply to the Big Four firms, because the majority of them do not perform audits in accordance with national standards. At the same time, the services of the Big Four are not in demand by the majority of Ukrainian banks for two reasons: regulatory authorities require that financial reports be prepared per national standards and not international ones, and the price of services of those firms is quite high by Ukrainian standards. At this time, the Audit Chamber of Ukraine issues and extends Certificate A, and the National Bank of Ukraine in practice started doing the same thing for Certificate B. Due to the length of time required to obtain a certificate, however, the number of certified bank auditors is not expected to increase significantly in the short term.

At this time, the main direction for improving the certification process would be to recognize international auditing and accounting certificates, including the certificate of the CIPA/CAP Russian language program. The National Bank of Ukraine believes that in the future this will permit the extension of certification requirements to the Big Four auditors, and permit the recognition of reporting both according to national and international standards.

Quality control of external audit presents quite a serious regulatory gap in the area of external audit. According to the Law "On Banks and Banking," a specific feature of the external audit is that it has to be performed only by an audit company, not by a certified auditor personally. The function of keeping the register of external auditors and audit firms is assigned to the Audit Chamber of Ukraine, and the quality control of the external audit is performed by the National Bank of Ukraine. This division creates a number of operational conflicts when there are complaints pertaining to audit quality and the exercise of influence on individual auditors and audit companies that allow violations of standards and code requirements. There have been cases when, after claims have been lodged against an audit company, the certified auditors (employees of the disreputable company) would set up a new audit company, thus again receiving access to clients.

The main problem of the audit services market in Ukraine is the paucity of information available. There is practically no official data in the market regarding the activities of audit companies and their financial reporting data. The Audit Chamber of Ukraine not only does not provide timely information on the audit market, but it is not involved in any serious research in order to improve the level of information in the market. There is no independent resource that would contain all information on auditing firms. (15) However, the majority of banks are quite careful in the matter of selecting an external auditor. As a rule, the decision to appoint an external auditor, on the basis of a preliminary agreement with the National Bank of Ukraine, is made by the Supervisory Board of the bank, which also makes the decision on auditor remuneration. Ensuring the appropriate extent of independence of the auditing activities also is a problem. Most of the audit companies provide a range of services, from accounting to consulting, automation, budgeting, and business planning, and this leads to a conflict of interest in the course of performing the audit itself.

Another gap in the audit sphere is an effective lack of requirements (standards) for internal audit of the banks. The National Bank of Ukraine has attempted repeatedly to officially set the standards it had developed (on the basis of the Standards for Internal Audit of the Institute of Internal Auditors), however, this initiative was not supported by the Audit Chamber of Ukraine. This leads to significant problems in establishing the institution of internal audit as a vital element of the corporate governance system. All banks have their internal audit services directly subordinate to the Supervisory Board. However, informal influence by management on the functioning of the internal audit service is still observed (mainly due to the fact that until 2003 those units reported to the Management Board). The role of internal auditors in banks is frequently limited, but the rapid rise in the level of qualification and experience of internal auditors is a positive development.

The SCSSM regulates the stock market in Ukraine, and has the authority typical for such an institution. Its domain includes all issuers of securities regardless of the sector in which they operate. The commission establishes procedural and content requirements for shareholder meetings, the scope of information disclosed to the public, and time frames for publication. It is important to note that for the latter two points there are special requirements specific to the banks. These requirements are set by the National Bank of Ukraine. Due to differences in tasks and functions, there have been no overt contradictions or arbitration between the actions and requirements of the National Bank of Ukraine and the SCSSM. Under Ukrainian legislation special norms have precedence over generic ones, and therefore, specific requirements imposed by the National Bank of Ukraine on the banks that issue securities, including requirements pertaining to corporate governance, override the commission's requirements.

Besides the overlap of authority, there is also an actual legislative gap in distribution of functions among the regulators. In particular, none of the authorities discussed here have any regulations pertaining to the informational support of IPOs, and that is a serious gap from the standpoint of corporate governance.

Ukraine does not have a unified self-regulating organization in the banking sector. The most influential entity is the Association of Ukrainian Banks, created in 1990, which includes 120 member banks (more than 72% of the total number of banks registered in Ukraine). Among the tasks of the association are: participating in legislative activities (including joint work with the National Bank of Ukraine), improving the level of trust in the banks, protecting the interests of the banks at different levels of government authorities, representing the interests of the banking system of Ukraine abroad, and promoting improvement in the level of qualifications of banking personnel. In practice the association has been most successful in lobbying for the interests of banks at the legislative and executive level (frequently the interests are those of small banks) and in training banking employees.

The association is the founder of the National Center for the Training of Bank Personnel of Ukraine, which is the largest specialized training center. There are also regional banking unions and associations (most of them are members of the Association of Ukrainian Banks) whose objectives frequently boil down to lobbying for the interests of regional banks at the level of local governments. Neither the Association of Ukrainian Banks nor the regional banking unions are active in strengthening the system of corporate governance in banks, They are not preventing government regulatory authorities from doing so, however.

Given the current political situation in the country, it's likely these problems at the level of the legal and regulatory framework will be eliminated only after formation of the vertical structure of the executive power is complete. In addition, recently there has been a more pronounced inclination to establish a single authority to regulate the financial system by merging the banking supervision units of the National Bank of Ukraine with the State Commission for Regulating Financial Services Markets. (16) If the decision is made to establish such a regulatory body, it may have a negative impact on the strengthening of corporate governance, because the bulk of the resources of the newly created entity will be aimed at the nonbanking financial sector, which is currently extremely weakly regulated.

The national "Principles of Corporate Governance" regulate most of the necessary aspects of corporate governance, such as the purpose of the establishment of a joint stock company, shareholder rights, activities of the supervisory boards and their executive bodies, the necessity and procedures for information disclosure and ensuring transparency of operations, control over financial and economic activities of the company, and work with interested parties.

In 2004, the OECD introduced some changes to the international "Principles of Corporate Governance"; however, there is no information indicating that the SCSSM made appropriate updates to the national principles.

In addition, the National Bank of Ukraine, in its norms and regulations, sets forth a number of requirements analogous to the OECD principles. Specifically, the regulations of the National Bank envisage recommendations concerning the Supervisory Board and the executive body, information disclosure, control and internal audit.

• The National Bank of Ukraine recommends the inclusion of a minimum of five individuals on the Supervisory Board comprising shareholders or their representatives, preferably with work experience in the banking sector or related fields. For the banking system on average, the real number of Supervisory Board members is in line with the recommendation; however, there are significant deviations in both directions. As a rule, on the basis of information available to the general public, it is impossible to reach a meaningful conclusion as to whether the supervisory board includes so-called "independent directors" whose task it is to ensure protection of the interests of all shareholders. Only a few examples are known. The Supervisory Board of the Nadra bank (ninth largest by asset value) includes three independent members out of seven, including the chairman (at least, according to the bank's statement). The current chairman of the National Bank of Ukraine, Volodymyr Stelmakh, was the chairman of the Supervisory Board of the joint stock bank Brokbusinessbank (without being a shareholder) in 2003-2004.
• In the course of registering the bank, during the process of submitting an application to supervisory authorities to extend the banking license, and in case of a change in ownership of a significant block of shares and/or top management officials of a bank, the National Bank of Ukraine monitors the professional qualifications and the business reputation of the top management officials of a bank. To monitor the former, the National Bank uses a confidential test and an interview, and the latter, its own data, including monitoring of publications in the press. There have been several instances when the National Bank of Ukraine refused to appoint as top officials in the banks' subsidiaries some individuals whose business reputation was not spotless. Those instances were not broadly publicized, because the approval procedure is not public. (In addition, the bank is not obligated to inform the general public of the submission of the name of a candidate or of its rejection.)

• Requirements established by the National Bank of Ukraine on the accounting records to be kept by banks are much closer to IFRS than the National Accounting Standards prescribed by the Ministry of Finance for all legal entities. There is a requirement, for instance, to produce consolidated financial statements. Under current legislation, the requirements imposed by the National Bank of Ukraine take precedence in case of discrepancies between standards at different levels. In addition to this, unlike the Ministry of Finance, the National Bank is on a clear course to update its requirements in case of IFRS changes. The latest examples are introducing the new version of the IAS 39 "Financial Instruments: Recognition and Measurement" in the banking sphere, and the introduction, planned for 2007, of IFRS 7, "Financial Instruments: Disclosures," as well as compliance with the new Basel Agreement on New Capital Accord Issues (Basel II). For the former the target time frame is 2007-2008, and for the latter it is 2010-2012.
• The scope of information required from banks differs from the information other security issuers are required to disclose, both in terms of annual financial reporting (17) and in terms of interim and consolidated reporting. The National Bank of Ukraine sets the list of reporting forms and the format of mandatory notes. The notes contain among other things a list of owners of substantial blocks of shares (individuals and legal entities, not necessarily the beneficial owners) and some prudent parameters, such as the actual regulative capital adequacy ratio (the normative level is at least 10%), and parameters of assets and capital profitability. As part of its banking supervision measures, the National Bank of Ukraine has set forth a mandatory requirement that every bank must submit to it audited annual financial statements with an audit report. The National Bank also practices preliminary concurrence regarding the audit firm engaged by the bank for auditing annual financial statements (the time frame for coordination is by Nov. 15 each year), as well as subsequent monitoring of completeness and reliability of the annual financial statements. (18) There is no publicly available data on the number and names of the audit firms that have failed this process; it is known that in 2005 there were several such firms.
• Deadlines for submission of reporting are specified by the Law "On Banks and Banking," and differ from comparable deadlines for other issuers of securities. For example, banks' annual financials must be submitted by April 1, consolidated by April 15, and audited by an external auditor by May 15 of the following year. In addition, banks are subject to quarterly reporting, which must contain both financial and nonfinancial parameters.
• The National Bank also regulates the breadth of information disclosure. Quarterly reported data, for example, has to appear in the official publications of the Verkhovnaya Rada, Cabinet of Ministers, or the National Bank (in the first two cases this refers to newspapers with a total national circulation of about 300,000 copies). The drawback of this regulation is the high cost of publication (this information is published at the advertisement rates), and lack of clear requirements for the reporting format. Sometimes this leads to banks not complying with the principle of comparability of financial statements. (19)

• In 2002, the National Bank initiated amendments to the Law "On Banks and Banking" in order to change the subordination of the internal audit service and bring it under the Supervisory Board of the bank (previously this service reported to the Management Board). The changes went into effect in 2003, and as of today this resubordination is basically complete. It is also important to note that the banking sphere in Ukraine is the only sector where the internal audit service has a legal framework, as internal audit is not stipulated by the Law "On Audit Activities," and other regulatory authorities do not require it.
• The National Bank of Ukraine approves candidates for the heads of internal audit service divisions at the level of a bank's headquarters and its subsidiaries. In order to ensure that minimum training requirements are met, the National Bank has developed and disseminated to specialized education establishments a generic curriculum for training and annual continuing education to upgrade the qualifications of the internal auditors in banks.

Because of these requirements, corporate governance guidelines in the banking sector of Ukraine are generally in line with international best practices. The main problem lies in compliance with already established requirements and in publicizing the role of corporate governance as an instrument that adds value to a business.

Despite sufficient convergence of corporate governance requirements in the banking sector with advanced international equivalents, there are a number of problems in the sphere of practical application. It is advisable to divide those problems into intentional deviations and transitional problems. There are intentional deviations in a number of areas.

Frequently such operations accompany corporate wars among shareholders for their other assets. The latest examples of corporate wars involving banks are the situations involving the Nikopolsky Ferroalloy Plant (NFP, Zaporozhskiy region) and Kremenchug Steel Foundry (Dnepropetrovskiy region). In the case of NFP, the Ukrsotsbank and Privatbank banks associated with the business structures in question were dragged into a standoff between two shareholders. Both were influential financial groups: Pridneprovie Corp. (owner of 73% of the shares of the plant), and Privat Group (23% of shares). Confrontation occurred at the beginning of 2006 because Pridneprovie was employing schemes for transactions with related parties, such as sales at understated prices, purchases at overstated prices, and tolling, which made it possible to artificially lower the plant's profit, thus depriving minority shareholders and Privat Group of a significant share of dividends owed to them. Ukrsotsbank, acting as the depositary of the shares of NFP, ended up most involved in the conflict. Due to errors in the court decision on annulment of the privatization of the plant, Ukrsotsbank was not able to ensure return of the shares to the government, thus significantly undermining its own image. In mid-2006, Ukrsotsbank was sold to the Italian holding company, Intesa, practically without regard for the wishes of minority shareholders.

In the second case, the confrontation over control of Kremenchug Steel Foundry, the GSM scheduled for May 2006 was disrupted, using physical force, by individuals close to the Forum bank network. This was done to add an item to the agenda on reelecting the chairman of the Supervisory Board of the foundry, who also served as one of the managers of the bank. The situation developed into a high-profile scandal, with the bank being picketed by social organizations. At this time, it is hard to measure the damage suffered by minority shareholders through the actions of the bank's managers; however, a significant blow to the image of a financial institution is certainly going to affect the returns on its investments.

The problem of protecting the rights of minority shareholders is not going to be resolved even after the property redistribution process is completed. The reason for that is the steady increase in the requirements of the National Bank of Ukraine for the minimum level of regulatory capital and the banks' own financing needs. Most small banks do not have any hope of raising capital independently, and are forced to seek partners for M&A. Experience shows that in the course of those transactions minority shareholders are the least protected, as they cannot influence the price of the transaction, the choice of partner, or preservation of the bank's profile after reorganization.

• The majority of banks do not have a clearly formulated corporate strategy and culture, which would include understanding of their mission, objectives, tasks, and principles of division of authority. As real banking business (as opposed to pocket business, where the main task of the bank is servicing financial flows of a finance and industrial group) develops and gets established, this problem will be eliminated over time. During recent years, the majority of large and midsized banks started actively developing corporate standards. The most successful in this are banks oriented toward retail business, because increasing transparency and streamlining governance processes provide them with obvious competitive advantages.
• In some banks, the internal audit service, despite formal subordination to the Supervisory Board, is not sufficiently independent of the executive bodies to monitor business activities. This problem will be eliminated as bank owners develop an interest in this type of control, particularly as they move to new markets and start looking for investors.