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The UNIDROIT Model Law on Leasing: an Effective

New Legal Framework to Support Leasing Markets in the Developing Countries

Murat Sultanov *
I. INTRODUCTION

The International Finance Corporation (IFC) has supported the efforts of the International Institute for the Unification of Private Law (UNIDROIT) to develop a Model Law on Leasing since October 2005, resulting in highly effective collaboration between two bodies. IFC participated in the UNIDROIT Advisory Board sessions and helped to organize and actively participated in the meeting of Governmental experts held in South Africa in May 2007. As will be noted below, one of the key components of IFC's advisory projects on leasing is legislative and regulatory reform so as to create a legal climate for leasing or improve it. To achieve this objective, IFC works in partnership with Governments to develop or amend their laws and regulations governing leasing transactions. In that connection, IFC believes that the UNIDROIT Model Law will be highly instrumental in helping to implement the IFC's Leasing Advisory Projects. In the past, the UNIDROIT Convention on International Financial Leasing has helped to build the IFC's argument for a specific change in the legislation and to promote the adoption of leasing laws in a number of countries. The Model Law will further strengthen IFC's role in advising Governments on how to improve the legal framework for leasing. Additionally, the Model Law can help to create an effective legal environment for leasing in those jurisdictions in which IFC does not have active projects; to increase the sustainability of the IFC's legislative work to improve the legal framework for leasing; and to promote consistency and uniformity of leasing legislation 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, Principal Financial 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 extensive consultation process involving various stakeholders. Most importantly, representatives from developing countries, particularly from Africa and the Middle East, actively participated in the process, thus further strengthening the Model Law's appeal and outreach to economies in transition. Improvements in the regulatory framework for leasing as the result of the Model Law will open up new investment opportunities (including those of IFC) in the leasing sectors 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, it shares the World Bank's primary objective of reducing poverty and improving the quality of life in the developing countries. Founded in 1956, IFC has 179 members, including both developed and developing countries, and shares its Board of Directors with the World Bank. Inside the World Bank Group, IFC's specific mandate is to foster the development of a sustainable private sector in the developing world. T IFC makes equity investments in private sector companies, provides loans and structured finance products, and mobilizes syndicated loans. It also leverages its experience in private sector development in emerging markets by providing advisory services to private sector clients and Government bodies. As of June 2007, IFC had 3,100 staff of which about half based at its Washington, D.C.-based headquarters, with the remainder located in over 80 regional and/or country offices worldwide. T IFC's investment portfolio is composed of 1,368 projects in 122 countries totalling US$ 21.6 billion, funded through IFC's own financial resources and fund mobilization capacity. Advisory operations represent total committed funding of US$ 850 millicn for more than 800 projects, and are financed by IFC's own resources leveraged by bi-lateral, multi-lateral and even private donors (foundations) who see IFC as an effective delivery channel to optimize the impact of their development efforts in IFC's core areas of expertise. IFC interventions target all industry sectors including infrastructure, industry, oil, gas and mining, the financial sector, transportation, information and communication technology, etc. The financial sector is, however, the largest sector in IFC, representing more than 30% of its total investment portfolio. Finally, by its mandate, IFC works on a fully commercial basis. It does not accept Government guarantees, nor does it provide subsidized financing. While its role is developmental, IFC aims at being a profitable financial institution.

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The UNIDRO1 Model Law on Leasing: an effective new legal framework...

However, IFC projects typically balance the internal rate of return with development 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, with the set-up of Korea Development Leasing Corporation. Since then, and until June 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 the first leasing company. Over time, these investments have generally had a strong catalytic effect on the sector, attracting attention from local and

international players to the market opportunities and fostering competition, leading to the development of new products and financial services, increasing access to financing for small and medium businesses, developing the local capital markets through bond issuing, and portfolio securitizations. IFC quickly realized that creating a sustainable leasing industry in the developing countries requires not only investment, but also targeted advisory services. To address this specific need, IFC operates Technical Assistance Programs that are co-financed by multilateral and bi-lateral donors, and that typically address four advisory components: legal and regulatory advisory services to address issues that hamper the development of the sector, public awareness-raising on the product and its advantages, capacity-building for new entrants and existing players on the leasing market, and finally facilitation of domestic and foreign investment in the sector.
IFC's ongoing Leasing Advisory Programs
IFC Leasing Advisory Services Portfolio - June 2007 Country Afghanistan Bolivia Cameroon Central Asia Region China Ghana Project Name Afghanistan Leasing Project Leasing Development Program Cameroon Leasing Regulatory Central Asia Leasing Facility Leasing - China Ghana Leasing TA Development Partner IFC PEP MENA State Secretariat for Economic Affairs (SECO) USTDA /the IFC Evergreen Fund State Secretariat for Economic Affairs (SECO) State Secretariat for Economic Affairs (SECO) State Secretariat for Economic Affairs (SECO)

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IFC Leasing Advisory Services Portfolio - June 2007 - cont'd Country Jordan Madagascar Nicaragua Rwanda Tanzania Ukraine Yemen Project Name Jordan Leasing Project Madagascar Lease Nicaragua Leasing Rwanda Leasing Program Tanzania Leasing Program Ukraine Leasing Development Project Yemen Leasing Project Development Partner IFC PEP MENA State Secretariat for Economic Affairs (SECO) African Development Bank (ADB); Rwanda CEDF State Secretariat for Economic Affairs (SECO) Dutch Ministry of Economic Affairs IFC PEP MENA

Examples of such programs include Russia, Serbia, Turkey, and Uzbekistan where IFC's advisory work is widely recognized as having been instrumental for the development of the industry, today vibrant in those markets. With an increased focus in frontier countries, IFC has more recently been at the forefront of the creation of the concept of leasing in countries such as Yemen and Afghanistan. Leasing Advisory Programs: selected examples Afghanistan -IFC has completed an advisory project with the Afghanistan Finance Company, the only private leasing company active in the country focusing on financing agricultural equipment, helping the company to enhance its credit and marketing procedures and improving its risk management systems, which resulted in a significant portfolio increase. In March 2007, IFC signed a cooperation agreement with the Central Bank of Afghanistan to develop the country's leasing sector. T IFC specialists drafted a Law on Leasing, discussing it with all key government and private sector stakeholders. The resulting draft law has been presented to the Afghan Government for discussion. Yemen -IFC has been working with the Government to establish an effective legislative environment to support the emergence of the leasing market in Yemen. Sponsored by the Central Bank, the Law on Leasing was adopted in April 2007, and IFC is now assisting in the development of associated tax legislation as well as the establishment of a leased asset registry and related secondary legislation. Going further, IFC aims to establish a leasing company to help kick-start the sector and demonstrate to others the opportunity that leasing presents to investors, both domestic and foreign.

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Ukraine -ArmaLeasing is a small Ukrainian leasing company founded in 2003, specializing in all types of transport, construction equipment, and manufacturing equipment. Its young management team, knowing they were in need of better technical know-how and funds, approached the IFC's Ukraine Leasing Development Project 1 for advice on how to strengthen their operations and attract investment in a bid to capitalize on the buoyant Ukrainian economy (6% GDP growth in 2007). "There are not many leasing experts 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 risk management and vendor financing. The ArmaLeasing portfolio has more than doubled since the advisory work was performed, and the number of clients has tripled.-It is mostly the company's financial outlook, though, that has benefited from the partnership: "We no longer have to beg for financing from banks - banks now come to us," said Julia Pogoreleva, ArmaLeasing's Deputy Director. Sub-Saharan Africa -IFC is implementing a number of advisory services programs in Africa to develop the leasing sector. IFC's approach is to set up individual country projects which address the enabling environment for leasing as well support the industry. Programs are currently being deployed in Ghana, Tanzania, Rwanda, Madagascar and Cameroon, with a further extension of activities planned in several countries in francophone West Africa and Mozambique. To date, IFC leasing programs in Africa have been catalytic in fostering a climate more conducive to leasing. Interest and demand for leasing products and services have increased tremendously. Ghana - Since the start of IFC Leasing Program supported by Switzerland's economic cooperation agency SECO, gross lease receivables held by the leasing sector in Ghana increased by over 73% in 2005. New leasing companies have entered the market, bringing the total number of active leasing companies from 7 in 2005 to 12 at end-2006. In Tanzania, the results of a national leasing survey conducted in 2006 show that the leasing portfolio had grown to approximately US$45 million in 2006 - a 20% increase over 2005. As an example, the program actively mobilized funding for leasing providers, 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 the financial support of the Dutch Ministry of Economic Affairs (EVD) to facilitate the development of the leasing market in Ukraine. Media coverage on leasing has more than tripled since the Project's launch.

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leasing company - Sero Lease - offering micro leasing finance to womenowned businesses in Tanzania. The credit line will allow Sero Lease to extend 30,000 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: to foster the depth and breadth of the financial markets in emerging economies on the one hand, and to increase access to financing for underserved segments, on the other hand. This includes in particular the strategic objective to increase access to financing for small and medium enterprises (SMEs), which are underserved in most emerging countries, by traditional commercial banks which focus primarily on top-tier commercial and retail clients, leaving a wide-open "SME finance gap". Although leasing is used as a means of financing equipment by businesses of all sizes and at all stages of their development, it is specifically important as a very simple method of creating access to finance for small and medium-sized enterprises. Many of those businesses have grown into large corporations, having benefited from there being a leasing sector in their relevant financial sector. The owners of these small, burgeoning companies understand that although leasing is very similar to a bank loan in many respects, the critical difference is usually the underlying security required by the bank and the leasing company. The banks normally require collateral for their loans that is usually the existing property of the small business, such as land or buildings, whereas the leasing company almost invariably only requires the asset that is the subject of the lease as collateral. This difference allows the small business to acquire the use of an asset that creates worth for the business with the land and buildings, which are the business' own assets, being left unencumbered to provide collateral to the bank for much-needed working capital. Speed and ease of processing are an important selling argument for small firms. Because leasing generally does not require additional collateral, and because leasing companies and bank leasing subsidiaries are more focused and specialized, lease financing is made available to SMEs more effectively and with lower internal processing costs than term loans. Developing the leasing industry also creates a broader impact on the capital markets in a developing country. Leasing companies book mediumterm assets that provide banks, pension funds and insurance companies with a diversification 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 leased
assets. 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 capital
markets. 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 SME finance landscape as an unsecured term financing product if leasing companies can easily repossess and sell the leased equipment when the lessee defaults on its repayments. There is therefore a case for a proper legal definition of leasing and of the minimum terms of a leasing contract, and for the creation of fast-track judicial procedures for the repossession and sale of leased assets. It is also critical for the development of the industry that leasing companies cannot be sued for misuse of the leased equipment by the lessee who should be legally recognized as the custodian of the leased equipment. Finally, although leasing does not require any fiscal advantage to develop, financial leasing generally needs a legally/fiscally recognized specific accounting treatment to be on a level playing field with bank loans, so that VAT accounting mechanisms apply equally and fairly for both financing products. If specific tax advantages apply to investment 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 the development of the leasing industry as sound texts are, and is directly correlated 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 thought through to ensure that the most efficient and yet comprehensive changes are put forward. Legislation must also allow local leasing companies to develop the leasing sector in a commercial and profitable manner.

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Whether the relevant local legislation is based on Civil Code or Common Law, it may not be necessary to develop a specific and separate leasing law, although this will ultimately depend on local circumstances and existing legislation. This assumes that it is possible to make additions and amendments to existing legislation, and that those amendments are not compromised by other elements of the local legislation. All legislative changes need to be coordinated to ensure that there are no opportunities for conflict or contradiction. Experience worldwide has shown that contradictory legislation, which can be subject to widely different interpretations, is often the worst possible outcome. The success of a country's leasing sector will be determined by the structure and content of the leasing legislation and how it is affected by other finance and fiscal legislation. Often, domestic legal frameworks are not conducive to the development of leasing. The reasons for this may be varied: * * there may be no leasing-specific legislation or clear definition of leasing; contradictions may exist between various elements of a country's legislative framework that prevent leasing from working effectively. This is particularly true of certain fiscal issues; current legislation prevents the successful enforcement of leasing contracts; 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 legally repossess non-performing lease assets without costly and timeconsuming court procedures or restrictive bureaucratic requirements; definitions and legal implications of finance leases need to be specified in the legislation. Rules on these issues should be clear and written with users in mind.

* * * *

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

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Sometimes a country has a successful leasing sector without leasingspecific legislation; such jurisdictions typically have well-advanced contract law provisions that compensate for the lack of leasing-specific legislation. In many developing countries, however, a specific law on leasing is necessary since it will help fill legislative gaps. Such gaps are often due to the rather complex legal structure of a leasing transaction involving a third party - the supplier from whom the lessor buys the leased asset. For example, the lessee is 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 only between the lessor and the supplier, thus making it difficult for the lessee, in the absence of a contract, to address claims to the supplier directly. Furthermore, since the lessor is a mere financier of the transaction and does not necessarily have expertise in respect of the equipment involved, lessors' responsibilities with regard to the equipment (defaults in delivery, quality of leased asset, etc.) should be limited. Since many developing countries have legislation that only addresses general lease (rent), special legislation on finance leases is required specifically to cope with the tripartite nature of the leasing arrangement and the need to address issues related to lessee's remedies, lessor's responsibilities with 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 these elements can greatly support the development of its leasing industry. The UNIDROIT Model Law addresses these very principles in a simple yet comprehensive fashion. Quite importantly, the Model Law establishes the notion of freedom of contract. This means that, with very few exceptions, the Model 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 jurisdictions where the Islamic Shari'a is applicable and where lessors may wish to draft their leasing contracts in full compliance with the principles of Islamic Law. For example, the parties to an Islamic lease (Ijarah) may agree to derogate from the hell-or-high water principle 2 laid down in the Model Law which may not be viewed as being fully compliant with Islamic jurisprudence. As soon as the UNIDROIT Advisory Board approved the draft and made it public, 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 Palestine prepared by the IFC are based on the Model Law. These drafts were presented to the Finance and Economic Commission of the Parliament of Afghanistan and the Palestinian Authority, respectively, for approval and have been extensively discussed with various private and public sector stakeholders in the two countries concerned. The discussions led to the following conclusions: 1. The Model Law is generally well accepted by stakeholders who regard it as simple, clear and acceptable within the local legal frameworks and practices. The Model Law, which focuses on both general lease and financial lease, can be easily redrafted to focus on one type of lease only. For example, the Palestinian Government was concerned that if the Leasing Law focused on general lease it might create confusion with the norms of the Civil Code that already addresses general lease. Hence, in Palestine the Model Law was revised to focus only on financial lease, whereas in Afghanistan, which lacks advanced legal provisions on both general lease and financial lease, both types were maintained and the leasing law could fill both gaps. The definition of a finance lease based on a tripartite arrangement in which the supplier is a party to that arrangement needs to be thoroughly explained with particular emphasis on why, in a finance lease, the asset must be purchased by the lessor from the supplier in connection with a lease. Furthermore, it is important to highlight that the definition provided by the leasing law is designed to address only

2.

3.

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

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the legal aspects of leasing - tax and accounting aspects must be addressed separately. While it is tempting to include fiscal issues within the Leasing Law and even more so to recommend adopting IAS 17 (International Accounting Standards) as the framework for incorporation within leasing legislation, IFC's experience in preparing leasing legislation in many countries shows that the Leasing Law will have greater relevance 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 legislation could create potential conflict between the leasing law and other specialized laws. The IFC therefore recommends a comprehensive approach to legislative reform that includes adopting/amending the law on leasing as part of the civil regulation framework (based on the UNIDROIT Model Law and the definitions it establishes) and revising existing tax codes, laws, accounting regulations, etc. to ensure that leasing issues are properly addressed in all aspects of the legislation. 4. Stakeholders would greatly benefit by an Explanatory Report that would clarify some of the notions advocated by the Model Law such as the lessee being the beneficiary of the supply agreement, the priority of liens, etc. Such notions represent a novelty in the developing countries' legal systems and require explanations, preferably with examples.

IFC has codified its own position on the legal, tax and accounting aspects of leasing through the Leasing Manual commissioned by IFC's SME department in 2005. The IFC Leasing Manual represents best practices, describes IFC's experiences in leasing and contains useful guidelines and recommendations for Governments on how to create an effective legal framework for leasing. IFC is currently preparing a second updated edition of this Manual which will include a discussion of the UNIDROIT Model Law on Leasing. In fact, the IFC Manual will refer to the Model Law as being the best practice that countries need to follow which will help to increase awareness among the various jurisdictions about the Model Law and promote its application to the benefit of the developing countries' leasing sectors.

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