14UnifLRev637

Citation: 14 Unif. L. Rev. 637 2009

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The UNIDROIT Model Law on Leasing: an EffectiveNew Legal Framework to Support Leasing Marketsin the Developing Countries

Murat Sultanov *

I. - INTRODUCTION

The International Finance Corporation (IFC) has supported the efforts of theInternational Institute for the Unification of Private Law (UNIDROIT) to developa Model Law on Leasing since October 2005, resulting in highly effectivecollaboration between two bodies. IFC participated in the UNIDROIT AdvisoryBoard sessions and helped to organize and actively participated in themeeting of Governmental experts held in South Africa in May 2007.

As will be noted below, one of the key components of IFC's advisoryprojects on leasing is legislative and regulatory reform so as to create a legalclimate for leasing or improve it. To achieve this objective, IFC works inpartnership with Governments to develop or amend their laws and regulationsgoverning leasing transactions.

In that connection, IFC believes that the UNIDROIT Model Law will behighly instrumental in helping to implement the IFC's Leasing AdvisoryProjects. In the past, the UNIDROIT Convention on International FinancialLeasing has helped to build the IFC's argument for a specific change in thelegislation and to promote the adoption of leasing laws in a number ofcountries. The Model Law will further strengthen IFC's role in advisingGovernments on how to improve the legal framework for leasing.Additionally, the Model Law can help to create an effective legal environmentfor leasing in those jurisdictions in which IFC does not have active projects; toincrease the sustainability of the IFC's legislative work to improve the legalframework for leasing; and to promote consistency and uniformity of leasinglegislation on a global scale.

* Leasing specialist, PEP - Middle East North Africa Leasing Program, International

Finance Corporation (IFC) (Amman). The author wishes to thank Mr Ary NaYm, PrincipalFinancial Specialist at the IFC, for his contribution to this article.

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The UNIDROIT Model Law was developed in the course of an extensiveconsultation process involving various stakeholders. Most importantly,representatives from developing countries, particularly from Africa and theMiddle East, actively participated in the process, thus further strengthening theModel Law's appeal and outreach to economies in transition. Improvementsin the regulatory framework for leasing as the result of the Model Law willopen up new investment opportunities (including those of IFC) in the leasingsectors of developing countries and economies in transition alike.

II. - IFC: THE BACKGROUND

IFC is one of five entities that constitute the World Bank Group and as such, itshares the World Bank's primary objective of reducing poverty and improvingthe quality of life in the developing countries. Founded in 1956, IFC has 179members, including both developed and developing countries, and shares itsBoard of Directors with the World Bank. Inside the World Bank Group, IFC'sspecific mandate is to foster the development of a sustainable private sector inthe developing world. T IFC makes equity investments in private sectorcompanies, provides loans and structured finance products, and mobilizessyndicated loans. It also leverages its experience in private sector develop-ment in emerging markets by providing advisory services to private sectorclients and Government bodies.

As of June 2007, IFC had 3,100 staff of which about half based at itsWashington, D.C.-based headquarters, with the remainder located in over 80regional and/or country offices worldwide. T IFC's investment portfolio iscomposed of 1,368 projects in 122 countries totalling US$ 21.6 billion, fundedthrough IFC's own financial resources and fund mobilization capacity.Advisory operations represent total committed funding of US$ 850 millicn formore than 800 projects, and are financed by IFC's own resources leveraged bybi-lateral, multi-lateral and even private donors (foundations) who see IFC asan effective delivery channel to optimize the impact of their developmentefforts in IFC's core areas of expertise.

IFC interventions target all industry sectors including infrastructure,industry, oil, gas and mining, the financial sector, transportation, informationand communication technology, etc. The financial sector is, however, the largestsector in IFC, representing more than 30% of its total investment portfolio.

Finally, by its mandate, IFC works on a fully commercial basis. It does notaccept Government guarantees, nor does it provide subsidized financing. Whileits role is developmental, IFC aims at being a profitable financial institution.

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However, IFC projects typically balance the internal rate of return withdevelopment impact, including economic, social and environmental impact.

III. - IFC'S TRACK RECORD IN LEASING

IFC's first investment in a leasing company was made in Korea in 1977, withthe set-up of Korea Development Leasing Corporation. Since then, and untilJune 2007, IFC has approved investments in 126 leasing projects for US$1,300m, in 58 countries. In 27 countries, IFC participated in the set-up of thefirst leasing company. Over time, these investments have generally had astrong catalytic effect on the sector, attracting attention from local andinternational players to the market opportunities and fostering competition,leading to the development of new products and financial services, increasingaccess to financing for small and medium businesses, developing the localcapital markets through bond issuing, and portfolio securitizations.

IFC quickly realized that creating a sustainable leasing industry in thedeveloping countries requires not only investment, but also targeted advisoryservices. To address this specific need, IFC operates Technical AssistancePrograms that are co-financed by multilateral and bi-lateral donors, and thattypically address four advisory components: legal and regulatory advisoryservices to address issues that hamper the development of the sector, publicawareness-raising on the product and its advantages, capacity-building fornew entrants and existing players on the leasing market, and finally facilitationof domestic and foreign investment in the sector.

IFC's ongoing Leasing Advisory Programs

IFC Leasing Advisory Services Portfolio - June 2007

Country Project Name Development Partner

Afghanistan Afghanistan Leasing Project IFC PEP MENABolivia Leasing Development Program State Secretariat for Economic

Affairs (SECO)Cameroon Cameroon Leasing Regulatory USTDA /the IFC Evergreen FundCentral Asia Central Asia Leasing Facility State Secretariat for EconomicRegion Affairs (SECO)China Leasing - China State Secretariat for Economic

Affairs (SECO)Ghana Ghana Leasing TA State Secretariat for Economic

Affairs (SECO)

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IFC Leasing Advisory Services Portfolio - June 2007 - cont'd

Country Project Name Development Partner

Jordan Jordan Leasing Project IFC PEP MENAMadagascar Madagascar LeaseNicaragua Nicaragua Leasing State Secretariat for Economic

Affairs (SECO)Rwanda Rwanda Leasing Program African Development Bank (ADB);

Rwanda CEDFTanzania Tanzania Leasing Program State Secretariat for Economic

Affairs (SECO)Ukraine Ukraine Leasing Development Project Dutch Ministry of Economic

AffairsYemen Yemen Leasing Project IFC PEP MENA

Examples of such programs include Russia, Serbia, Turkey, andUzbekistan where IFC's advisory work is widely recognized as having beeninstrumental for the development of the industry, today vibrant in thosemarkets. With an increased focus in frontier countries, IFC has more recentlybeen at the forefront of the creation of the concept of leasing in countries suchas Yemen and Afghanistan.

Leasing Advisory Programs: selected examples

Afghanistan -IFC has completed an advisory project with the AfghanistanFinance Company, the only private leasing company active in the countryfocusing on financing agricultural equipment, helping the company toenhance its credit and marketing procedures and improving its riskmanagement systems, which resulted in a significant portfolio increase. InMarch 2007, IFC signed a cooperation agreement with the Central Bank ofAfghanistan to develop the country's leasing sector. T IFC specialists drafted aLaw on Leasing, discussing it with all key government and private sectorstakeholders. The resulting draft law has been presented to the AfghanGovernment for discussion.

Yemen -IFC has been working with the Government to establish an effectivelegislative environment to support the emergence of the leasing market inYemen. Sponsored by the Central Bank, the Law on Leasing was adopted inApril 2007, and IFC is now assisting in the development of associated taxlegislation as well as the establishment of a leased asset registry and relatedsecondary legislation. Going further, IFC aims to establish a leasing companyto help kick-start the sector and demonstrate to others the opportunity thatleasing presents to investors, both domestic and foreign.

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Ukraine -ArmaLeasing is a small Ukrainian leasing company founded in2003, specializing in all types of transport, construction equipment, andmanufacturing equipment. Its young management team, knowing they were inneed of better technical know-how and funds, approached the IFC's UkraineLeasing Development Project 1 for advice on how to strengthen theiroperations and attract investment in a bid to capitalize on the buoyantUkrainian economy (6% GDP growth in 2007). "There are not many leasingexperts in Ukraine, but we can consult with IFC on just about everything,"said ArmaLeasing's Director Anastasia Dergunova.

Implemented recommendations ranged from VAT calculation to riskmanagement and vendor financing. The ArmaLeasing portfolio has more thandoubled since the advisory work was performed, and the number of clientshas tripled.-It is mostly the company's financial outlook, though, that hasbenefited from the partnership: "We no longer have to beg for financing frombanks - banks now come to us," said Julia Pogoreleva, ArmaLeasing's DeputyDirector.

Sub-Saharan Africa -IFC is implementing a number of advisory servicesprograms in Africa to develop the leasing sector. IFC's approach is to set upindividual country projects which address the enabling environment forleasing as well support the industry. Programs are currently being deployed inGhana, Tanzania, Rwanda, Madagascar and Cameroon, with a furtherextension of activities planned in several countries in francophone West Africaand Mozambique. To date, IFC leasing programs in Africa have been catalyticin fostering a climate more conducive to leasing. Interest and demand forleasing products and services have increased tremendously.

Ghana - Since the start of IFC Leasing Program supported by Switzerland'seconomic cooperation agency SECO, gross lease receivables held by theleasing sector in Ghana increased by over 73% in 2005. New leasingcompanies have entered the market, bringing the total number of activeleasing companies from 7 in 2005 to 12 at end-2006. In Tanzania, the resultsof a national leasing survey conducted in 2006 show that the leasing portfoliohad grown to approximately US$45 million in 2006 - a 20% increase over2005. As an example, the program actively mobilized funding for leasingproviders, with one notable success - a US$1 million credit line for a micro

1 The lFC's Ukraine Leasing Development Project was launched in 2005 with thefinancial support of the Dutch Ministry of Economic Affairs (EVD) to facilitate the developmentof the leasing market in Ukraine. Media coverage on leasing has more than tripled since theProject's launch.

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leasing company - Sero Lease - offering micro leasing finance to women-owned businesses in Tanzania. The credit line will allow Sero Lease to extend30,000 new micro leases to its women clients.

IV. - THE RATIONALE FOR IFC'S INVOLVEMENT IN LEASING

IFC's interventions in the financial sector generally have a dual objective: tofoster the depth and breadth of the financial markets in emerging economieson the one hand, and to increase access to financing for underservedsegments, on the other hand. This includes in particular the strategic objectiveto increase access to financing for small and medium enterprises (SMEs),which are underserved in most emerging countries, by traditional commercialbanks which focus primarily on top-tier commercial and retail clients, leavinga wide-open "SME finance gap".

Although leasing is used as a means of financing equipment bybusinesses of all sizes and at all stages of their development, it is specificallyimportant as a very simple method of creating access to finance for small andmedium-sized enterprises. Many of those businesses have grown into largecorporations, having benefited from there being a leasing sector in theirrelevant financial sector. The owners of these small, burgeoning companiesunderstand that although leasing is very similar to a bank loan in manyrespects, the critical difference is usually the underlying security required bythe bank and the leasing company. The banks normally require collateral fortheir loans that is usually the existing property of the small business, such asland or buildings, whereas the leasing company almost invariably onlyrequires the asset that is the subject of the lease as collateral.

This difference allows the small business to acquire the use of an assetthat creates worth for the business with the land and buildings, which are thebusiness' own assets, being left unencumbered to provide collateral to thebank for much-needed working capital.

Speed and ease of processing are an important selling argument for smallfirms. Because leasing generally does not require additional collateral, andbecause leasing companies and bank leasing subsidiaries are more focusedand specialized, lease financing is made available to SMEs more effectivelyand with lower internal processing costs than term loans.

Developing the leasing industry also creates a broader impact on thecapital markets in a developing country. Leasing companies book medium-term assets that provide banks, pension funds and insurance companies with adiversification of investment opportunities. As local capital markets develop,

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lessors are often the first issuers of commercial paper, notes and bonds. These

issues present mitigated risk as they can be enhanced by the existence of a

flow of lease receivables and the possibility of a pledge on the physical leasedassets. At the next level of sophistication, lessors can securitize their lease

receivables, creating another marketable security, tapping a larger pool of

funding, and thus increasing both depth and breadth of the local capitalmarkets.

In 2006, leasing companies currently in IFC's investment portfolio extended

leases to 150,000 micro, small and medium firms for a total disbursed amount

of US$ 3.5 billion.

V. - LEGAL, FISCAL, REGULATORY ASPECTS: IFC'S EXPERIENCE

Indeed, leasing can only develop and achieve its development role on the SMEfinance landscape as an unsecured term financing product if leasing companiescan easily repossess and sell the leased equipment when the lessee defaults onits repayments. There is therefore a case for a proper legal definition of leasingand of the minimum terms of a leasing contract, and for the creation of fast-trackjudicial procedures for the repossession and sale of leased assets. It is alsocritical for the development of the industry that leasing companies cannot besued for misuse of the leased equipment by the lessee who should be legallyrecognized as the custodian of the leased equipment. Finally, although leasingdoes not require any fiscal advantage to develop, financial leasing generallyneeds a legally/fiscally recognized specific accounting treatment to be on a levelplaying field with bank loans, so that VAT accounting mechanisms applyequally and fairly for both financing products. If specific tax advantages apply toinvestment in fixed assets (e.g. preferred custom tariffs, amortization advantage,etc.), then they should equally apply to financial leasing.

Naturally, an efficient overall judicial system is as important for thedevelopment of the leasing industry as sound texts are, and is directlycorrelated to the quality of lessors' portfolios, to lessors' overall profitability,and thus, to increased access to financing for SMEs.

VI. - WHY THE LEGISLATIVE FRAMEWORK IS NECESSARY

With any legislative change, proposed amendments should be closely thoughtthrough to ensure that the most efficient and yet comprehensive changes areput forward. Legislation must also allow local leasing companies to developthe leasing sector in a commercial and profitable manner.

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Whether the relevant local legislation is based on Civil Code or CommonLaw, it may not be necessary to develop a specific and separate leasing law,although this will ultimately depend on local circumstances and existinglegislation. This assumes that it is possible to make additions and amendmentsto existing legislation, and that those amendments are not compromised byother elements of the local legislation.

All legislative changes need to be coordinated to ensure that there are noopportunities for conflict or contradiction. Experience worldwide has shownthat contradictory legislation, which can be subject to widely differentinterpretations, is often the worst possible outcome.

The success of a country's leasing sector will be determined by thestructure and content of the leasing legislation and how it is affected by otherfinance and fiscal legislation.

Often, domestic legal frameworks are not conducive to the developmentof leasing. The reasons for this may be varied:

* there may be no leasing-specific legislation or clear definition ofleasing;

* contradictions may exist between various elements of a country'slegislative framework that prevent leasing from working effectively.This is particularly true of certain fiscal issues;

* current legislation prevents the successful enforcement of leasingcontracts;

* it is unclear whether lessors hold title to leased assets;* it is unclear whether third parties can hold a security position in

leased assets or have some kind of other claim on these assets;* it may be difficult for a lessor to take possession of a leased asset

when a lessee defaults. It may be unclear whether lessors can legallyrepossess non-performing lease assets without costly and time-consuming court procedures or restrictive bureaucratic requirements;

* definitions and legal implications of finance leases need to bespecified in the legislation. Rules on these issues should be clear andwritten with users in mind.

Where there is an absence of leasing-specific legislation or where leasinglegislation is imperfect, the question becomes "can lease operations beestablished and function properly, or must legislation be enacted first?"

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Sometimes a country has a successful leasing sector without leasing-specific legislation; such jurisdictions typically have well-advanced contractlaw provisions that compensate for the lack of leasing-specific legislation. Inmany developing countries, however, a specific law on leasing is necessarysince it will help fill legislative gaps. Such gaps are often due to the rathercomplex legal structure of a leasing transaction involving a third party - thesupplier from whom the lessor buys the leased asset. For example, the lesseeis a de facto beneficiary of the supply contract: he/she orders the leased asset,receives it and uses it; however, the supply agreement is typically signed onlybetween the lessor and the supplier, thus making it difficult for the lessee, inthe absence of a contract, to address claims to the supplier directly.Furthermore, since the lessor is a mere financier of the transaction and doesnot necessarily have expertise in respect of the equipment involved, lessors'responsibilities with regard to the equipment (defaults in delivery, quality ofleased asset, etc.) should be limited.

Since many developing countries have legislation that only addressesgeneral lease (rent), special legislation on finance leases is requiredspecifically to cope with the tripartite nature of the leasing arrangement andthe need to address issues related to lessee's remedies, lessor's responsibilitieswith regard to the equipment, etc.

VII. - THE UNIDROIT MODEL LAW ON LEASING - A NEW LEGISLATIVE FRAMEWORK

The following are the key elements of effective leasing legislation:

* a clear definition of what leasing is;* an appropriate balance of rights and responsibilities among parties to

a lease;* limits to the responsibilities of the lessor;

* the lessee's obligation to make the lease payments;* the lessee's direct recourse against the equipment supplier;" fast and efficient repossession procedures.

A jurisdiction that adopts a law on leasing which incorporates theseelements can greatly support the development of its leasing industry. TheUNIDROIT Model Law addresses these very principles in a simple yetcomprehensive fashion. Quite importantly, the Model Law establishes thenotion of freedom of contract. This means that, with very few exceptions, theModel Law allows the parties to a lease to derogate from or vary the effect of

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the provisions of the Model Law. This is especially important in jurisdictionswhere the Islamic Shari'a is applicable and where lessors may wish to drafttheir leasing contracts in full compliance with the principles of Islamic Law.For example, the parties to an Islamic lease (Ijarah) may agree to derogatefrom the hell-or-high water principle 2 laid down in the Model Law whichmay not be viewed as being fully compliant with Islamic jurisprudence.

As soon as the UNIDROIT Advisory Board approved the draft and made itpublic, IFC started to use it as a model as part of its advisory services programs.For example, the proposed draft laws on leasing for Afghanistan and Palestineprepared by the IFC are based on the Model Law. These drafts were presentedto the Finance and Economic Commission of the Parliament of Afghanistan andthe Palestinian Authority, respectively, for approval and have been extensivelydiscussed with various private and public sector stakeholders in the twocountries concerned. The discussions led to the following conclusions:

1. The Model Law is generally well accepted by stakeholders whoregard it as simple, clear and acceptable within the local legalframeworks and practices.

2. The Model Law, which focuses on both general lease and financiallease, can be easily redrafted to focus on one type of lease only. Forexample, the Palestinian Government was concerned that if theLeasing Law focused on general lease it might create confusion withthe norms of the Civil Code that already addresses general lease.Hence, in Palestine the Model Law was revised to focus only onfinancial lease, whereas in Afghanistan, which lacks advanced legalprovisions on both general lease and financial lease, both types weremaintained and the leasing law could fill both gaps.

3. The definition of a finance lease based on a tripartite arrangement inwhich the supplier is a party to that arrangement needs to bethoroughly explained with particular emphasis on why, in a financelease, the asset must be purchased by the lessor from the supplier inconnection with a lease. Furthermore, it is important to highlight thatthe definition provided by the leasing law is designed to address only

2 "A clause in a lease which reiterates the unconditional obligation of the lessee to payrent for the entire term of the lease, regardless of any event affecting the equipment or anych'ange jin the circumstasnces of the lessee" (Tom Clark (Ed.), Leasing Finance, 2nd ed.,Euromoney Publications PLC (1990).

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the legal aspects of leasing - tax and accounting aspects must beaddressed separately.

While it is tempting to include fiscal issues within the Leasing Lawand even more so to recommend adopting IAS 17 (InternationalAccounting Standards) as the framework for incorporation withinleasing legislation, IFC's experience in preparing leasing legislation inmany countries shows that the Leasing Law will have greaterrelevance if no reference is made to accounting or fiscal issues. It has

been established that attempting to address the various - tax, legal,

and accounting - aspects of a lease in a single piece of legislationcould create potential conflict between the leasing law and otherspecialized laws. The IFC therefore recommends a comprehensiveapproach to legislative reform that includes adopting/amending thelaw on leasing as part of the civil regulation framework (based on theUNIDROIT Model Law and the definitions it establishes) and revisingexisting tax codes, laws, accounting regulations, etc. to ensure thatleasing issues are properly addressed in all aspects of the legislation.

4. Stakeholders would greatly benefit by an Explanatory Report thatwould clarify some of the notions advocated by the Model Law suchas the lessee being the beneficiary of the supply agreement, thepriority of liens, etc. Such notions represent a novelty in thedeveloping countries' legal systems and require explanations,preferably with examples.

IFC has codified its own position on the legal, tax and accounting aspectsof leasing through the Leasing Manual commissioned by IFC's SMEdepartment in 2005. The IFC Leasing Manual represents best practices,describes IFC's experiences in leasing and contains useful guidelines andrecommendations for Governments on how to create an effective legalframework for leasing. IFC is currently preparing a second updated edition ofthis Manual which will include a discussion of the UNIDROIT Model Law onLeasing. In fact, the IFC Manual will refer to the Model Law as being the bestpractice that countries need to follow which will help to increase awarenessamong the various jurisdictions about the Model Law and promote itsapplication to the benefit of the developing countries' leasing sectors.

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