THIRD SOUTH-EASTERN EUROPE CORPORATE GOVERNANCE ROUNDTABLE “The responsibilities of the board and the role of stakeholders” Zagreb, Croatia November 2002

LUKOIL (the company) The role of a commercial bank as a stakeholder in a corporate borrower: A commercial bank lends, or rather sells money to corporates in a variety of forms known as bank products. It has an obvious interest that the borrower duly: pays interest and fees on the loan; and repays the principal of the loan. In order for the borrower to duly fulfil its obligations to its creditor bank, it must operate its business in a prudent and financially sound manner and a prudent commercial bank should make sure that this is so. This is the commercial bank’s stake in the borrower. The relationship between a creditor bank and a corporate borrower is actually far more complex than this and a lot more is at stake. For the sake of this presentation, we will simplify the relationship. Session 6: THE ROLE OF CREDITORS AS STAKEHOLDERS

LUKOIL (the company) Commercial bank lending is quite regulated in Croatia. Different pieces of law apply, depending on type of transaction, type of banking products involved, lending and security instruments used, etc. Let us focus on the most frequent bank product for corporate: a standard loan agreement whereby a domestic bank makes a loan to a domestic corporate. The following main pieces of legislation shall apply: The 2002 Banks Act; The 1993 Companies Act, The 1976 Obligations Act, The 1976 Litigation Act, The 1996 Foreclosure Act, The 1996 Bankruptcy Act including their respective subsequent amendments. LEGAL FRAMEWORK

LUKOIL (the company) 1. By acting prudently prior to loan disbursement in order to prevent possible borrower default, whether financial or otherwise – most important; 2. Through bad loan work-out efforts jointly with a defaulting borrower – better than; 3. Resorting to legal remedies available – slow, costly, very often destroying relationships with (temporarily) financially troubled clients. The prevailing practice of most Croatian commercial banks is to try and work out non-performing loans before resorting to legal remedies, e.g. foreclosure on collateral received, litigation etc. Reasons are twofold: Very often, a loan work-out works and relationships with clients remain unstrained by legal proceedings; and The Croatian judicial system is notoriously slow, ineffective and costly. HOW DO CREDITOR BANKS PROTECT THEIR STAKES

Commercial banks should act prudently before disbursing loans through: Careful credit analysis and processing of a loan application; Careful negotiating of terms and conditions of a loan; Careful drafting of the underlying loan documentation. Precise legal documents dealing with security instruments are of critical importance because of the legal requirements on formalities; Making sure conditions precedent are fulfilled before loan disbursement, including but not limited to ascertaining that no material adverse change has occurred with respect to the borrower since the conclusion of a loan agreement and that agreed security instruments have been perfected to the satisfaction of the bank Most of the legal issues which need to be addressed in a loan agreement are not regulated by any of the aforementioned Acts, or are not sufficiently regulated. Therefore, it is very important for these issues to be properly addressed in the loan documentation.

Except for the clauses dealing with the amount of the loan, repayment dates, interest and fees payable etc. a loan agreement should incorporate the following: 1) representations and warranties of the borrower with respect to its: a)its corporate existence; b)necessary consents and approvals; c)assets and liabilities, including contingent liabilities; d)state of business and financial operations and prospects; 2) covenants and negative covenants with respect of: a)disposal, acquisition and encumbrances of assets; b) undertaking of liabilities, including contingent liabilities and incurring debt TYPICAL CLAUSES PROTECTING CREDITOR BANKS’ STAKE

3) financial covenants including financial ratios to be maintained by the borrower throughout the lifetime of a loan; 4) provisions dealing with security for the creditor bank’s claims under a loan; 5) provisions dealing with ranking of creditor bank’s claims vis a vis other parties claims, including shareholder claims, and prevention of tunneling; 6) conditions precedent to loan disbursement; 7) provisions dealing with changes in circumstances protecting the creditor banks rights with respect to the principal amount of the loan and interest payable thereon; 8) terms and conditions of loan prepayment; 9) detailed provisions dealing with events of borrower’s default and legal consequences thereof, including the material adverse clause as a catch-all clause.

A wide range of instruments are used: bank and corporate loan repayment guarantees; cash collateral; bills of exchange etc. Typically, a Croatian commercial bank will ask for:  a first ranking mortgage of real estate to be provided by the borrower or a provider of collateral, or  fiduciary transfer of ownership of real estate from the borrower or a provider of collateral. Although the practical and commercial value of mortgage and fiduciary transfer of ownership are somewhat doubtful, it is safe to say that Croatian commercial banks simply love them. One of the reasons is that the Croatian National Bank places rather high value on these forms of collateral, thereby making the loan provisioning requirements less burdensome for commercial banks. SECURITY INSTRUMENTS (COLLATERAL)

MORTGAGE vs. FIDUCIARY TRANSFER OF OWNERSHIP Both instruments are created by way of security agreements which are “solemnized” by a notary public, pursuant to the Foreclosure Act. In a nutshell, “solemnization” means that a notary public warns both parties about the consequences of what they are about to get into. In consequence, a creditor enforcing its claims needs not go to the very slow and ineffective litigation proceedings. Instead it can use the foreclosure proceedings as a kind of a “fast lane”. In practice, the foreclosure lane is not that fast. The basic difference between the two: under a mortgage, a creditor must sell the mortgaged asset in order to settle its claim. It is not allowed to retain the mortgaged asset in settlement of its claim. On the other hand, assignment of a mortgaged claim and transfer of mortgage do not require borrower’s consent.

under a fiduciary transfer, a creditor is allowed, under certain circumstances, to retain full ownership of the transferred property as settlement of its claim. If it does so, the claim is considered settled in full by operation of mandatory provisions of the Foreclosure Act. On the other hand, assignment of the fiduciary transfer to a third party requires borrower’s consent. There are of course other differences. These are only the most important ones, in commercial terms. Commercial banks’ experience indicates that both instruments have a “psychological” value, as the law and court practice still provide a variety of possibilities for a less than bona fide borrower to drag out or even derail legal proceedings. Due to a very bad shape of Croatian land registers, creditors must be very careful when dealing with mortgages and fiduciary transfers

COVENANTS, FINANCIAL COVENANTS, NEGATIVE COVENANTS, LOAN WORK-OUTS Security instruments, whatever the form, only serve as an instrument of last resort, once an event of default has occurred and the creditor bank must forcefully collect its claims. It is a prudent practice to set up a variety of representations and warranties, covenants, negative covenants and financial covenants for the borrower as well as mechanisms whereby the bank is able to understand and closely monitor the borrower’s operation of its business, starting from the loan application processing and ending, if necessary, with loan work- outs.

This gives the creditor bank the ability to help control and direct the operation of the borrower’s business as well as the managing of its assets and liabilities in a prudent and financially sound manner so that the banks stake will not be jeopardized. A very important part is getting to know your client well and providing expert counsel whenever necessary. The idea is to act preventively. Furthermore, the creditor bank is better prepared to develop and implement various techniques of loan work-outs, if necessary. The techniques are very diverse: any action which is legal, which will help the creditor bank collect its claims and will not “kill” the borrower in the process is more welcome than resorting to lengthy and expensive legal remedies. It is up to commercial banks to show imagination, expertise and initiative in loan work outs. At the end of the day, this is the best way to protect a creditor bank’s stake in a corporate borrower.