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DLA Piper’s Kyiv office
Ukrainian Aerospace and Defense Industry: Challenges and Proposals for Reform
This year, the Ukrainian aerospace and defense industry appeared on the radar of the general public. This, unfortunately, was not because of an achievement or invention but because of the extensive press coverage of corruption scandals allegedly involving high-level officials of the largest market player, state-owned Ukroboronprom (UOP). Thus, calls for reforming the sector have become urgent and can no longer be ignored. At the same time, 2019 is going to be politically tough taking into account the presidential and coming parliamentary elections, which will no doubt have an influence on the sector. It is to be hoped that the Ukrainian political elite will not underestimate the seriousness of national security challenges and the need to build globally competitive capabilities in aerospace and defense.
In our article last year, entitled “Defense,” as published in the Ukrainian Law Firms Review 2018, we described the major problems of the industry that need to be addressed to kick-start reforms and to make the industry a major driver of economic growth in Ukraine. There have been a number of positive developments but, unfortunately, the vast majority of issues are still on the agenda. Below we outline the most recent developments and challenges facing the industry, and we share our thoughts on necessary reforms.
In 2018 and into the beginning of 2019, a number of strategic documents regulating the defense industry were adopted, in particular:
— On 7 February 2019 the Ukrainian Parliament approved amendments to the Constitution of Ukraine setting out Ukraine path towards the EU and NATO.
— On 15 March 2019 the President of Ukraine confirmed the coming into force of the Resolution of the National Security Council of 6 March 2019, On Reform of Industrial Defense Complex and Increase of Transparency of the State Defence Procurement.
— On 21 June 2018 the Law of Ukraine On National Security of Ukraine was adopted.
— On 10 May 2018 the Government of Ukraine adopted the Strategy of Revival of Ukrainian Aircraft Industry for the period until 2022.
— On 17 January 2018 the Law of Ukraine On Amending Ukrainian Legislative Acts as to Procurement of Defense Products, Goods and Services via Import (Procurement Amendments) was adopted.
— On 11 January 2018 the Government of Ukraine adopted a Resolution consolidating existing lists of dual-use goods into a single unified list of goods for the purposes of export control which came into force on 19 October 2018.
In addition, a number of important draft bills in the sector have been developed and submitted to Ukrainian Parliament, including:
— A Draft Law On Amending Ukrainian Legislative Acts as to Creation of Favorable Conditions of Attraction of Foreign Investments into Industrial Defense Complex.
— A Draft Law On Military and Technical Cooperation.
— A Draft Law On Development and Manufacturing of Weapons, Military and Special Machinery.
— A Draft Law On Amending Ukrainian Legislative Acts on Defense Matters.
— A Draft Law On Amending the Law of Ukraine on Defense of Ukraine.
Challenges and Problems
Reform of Ukroboronprom
As stated above, recent journalistic investigations have revealed numerous alleged corruption cases related to UOP and its member companies. It has become apparent that the reform of this defense giant, which consists of over 130 companies, is a top priority. In early March, US Ambassador in Ukraine Marie Yovanovitch said that the Ukrainian Government should immediately carry out a full and comprehensive audit of UOP and declassify the state defense procurement to the maximum extent possible. Later, Ukrainian President Poroshenko announced that he would take all steps possible to ensure that audit of UOP is launched as soon as possible and completed by the end of 2019. At the same time, we note that the tender for the UOP audit was announced back in 2017 and since that time has been re-announced a couple of times with amended scope, requirements to tender participants, etc. By the time the President released his statement, the tender participants had already submitted their application and qualification documents within the first round of the tender process. As of the end of March 2019, the status of the tender is not clear. We also note that the announced deadline for completion of the audit does not seem realistic.
We believe that performing an independent audit/due diligence and developing and implementing a clear plan for reforming UOP with the involvement of professional international strategic, financial and legal advisors are prerequisites for transforming UOP into a modern Western defense contractor.
Lack of Transparency of Defense Procurement
The need to classify the majority of state defense procurements is usually substantiated by the need to ensure national security. The downside of such total secrecy is a lack of control over the use of budget funds, lack of accountability and, consequently, possible defense spending fraud. Allegedly, military and dual-use items are procured through single-source contracts resulting in excessive prices and poor-quality goods. Moreover, the lack of transparency discourages foreign investors from entering the market. Procurement Amendments which allowed direct procurement of military and dual-use goods by state bodies (such as the Ministry of Defense or the Armed Forces) undoubtedly represent a step in the right direction. Yet, there is still no clarity on when single source procurement is allowed, how information on future procurements can be obtained and which procurements should be classified. There have been a number of so-called declassification initiatives aimed at bringing transparency to the sector (e.g. several drafts of legislative amendments were presented and discussed at various events). Given the complexity of this issue and the conflicting interests of different stakeholders, we believe that a comprehensive approach is required (further research, review of the best practices, extensive discussions etc.) and strong political will in order to reform the defense procurement system in Ukraine.
Export Control Reform
The positive developments in export control include the recent unification of the list of dual-use goods which are subject to export control which came into effect on 29 October, 2018. Just to recap, previously there were five separate lists of dual-use goods, which made it difficult to identify the goods that are subject to export control. At the same time, the current system of export control in Ukraine is still perceived by market players as outdated, non-transparent and inefficient. The long-awaited reforms include the introduction of e-declarations; reducing the terms of consideration of applications for export permits and the list of documents which have to be submitted; and simplification of the process of extension of permits upon expiry of their term. There is also a demand for export control industry outreach.
Another area of concern is conflicts of interest, as UOP is both a market player and regulator. Specifically, companies seeking to export military goods have an obligation to coordinate all such transactions with UOP and obtain its consent for concluding certain types of contracts. This provides UOP with additional leverage within the market along with potential access to the commercial data of companies.
No Effective Mechanisms for Cooperation between SOEs
and Private Companies
State-owned enterprises (SOEs) currently make up the majority of defence sector enterprises and we can see interest from both international and local investors to cooperate with such SOEs. At the same time, outdated and rigid laws do not currently provide for effective mechanisms for cooperation between SOEs and private investors. For example, the Law of Ukraine on Management of State Property Objects includes a provision specifying that the establishment of commercial enterprises on the basis of state-owned property is prohibited unless the Government’s share in such an enterprise exceeds 50%. Another example is the general prohibition for SOEs to act as the founders of joint ventures (JVs) established by the Cabinet of Ministers Resolution No. 24-92 of 31 December 1992. Such regulations keep private (including foreign) market players at bay.
Although back in 2016 Ukrainian laws allowed Ukrainian SOEs engaged in aircraft construction to set up joint ventures both in Ukraine and abroad, to the best of our knowledge no such joint ventures have yet been established. At the end of 2018, Ukrainian Prime Minister Volodymyr Groisman submitted to Parliament the Draft Law On Amending Ukrainian Legislative Acts as to Creation of Favorable Conditions of Attraction of Foreign Investments into Industrial Defense Complex. The amendments aim to remove the legal restrictions described above. It does not seem possible to evaluate whether the proposed amendments will be approved by Parliament and, if they are, what the possible timeframes will be.
The defense industry in Ukraine has huge potential and could become one of the main drivers of the Ukrainian economy. This, however, does not seem possible as long as the system is non-transparent and inefficient. Considering the above, we believe that the following measures need to be taken for the purposes of successful reform of Ukraine’s defense industry:
— creating an effective system of distribution of powers between UOP and other state authorities to ensure accountability and effective supervision;
— performing an independent audit together with developing and implementing a clear plan to reform UOP with the involvement of professional international advisors;
— establishment of effective corporate governance, oversight and accountability in the defense industry, including establishment of truly independent supervisory councils in UOP and SOEs;
— privatization of non-strategic SOEs;
— decreasing the level of secrecy in the industry, including in the defense procurement process;
— export control reform;
— reform of defense procurement;
— strengthening civilian control over the military; and
— amending Ukrainian legislation to provide for effective mechanisms of cooperation between SOEs and private investors.