Insolvency Law

Tutorial Booklet

CHINA-EU SCHOOL OF LAW

Academic year: 2013/14, winter term

Course: Insolvency law

Course Lecturer: Prof. Tibor Tajti (Thaythy)

Lecturer and moderator of discussion at tutorials: Monika Prusinowska

TUTORIAL DESCRIPTION AND INSTRUCTIONS

A. DESCRIPTION

The tutorials have two main goals: to clarify in more detail some key points covered during the

classes and to enrich the knowledge to be gained by the students by analyzing a watershed court

case, discussing a hot topic or putting the covered material in a broader interdisciplinary or

comparative context.

In the light of these goals, the schedule of the tutorials for the insolvency law course and the topics

to be covered are the following:

TUTORIAL 1

Wednesday (4 Dec. 2013)

First session: FIRST PART - The role and limits of discretion in insolvency proceedings

Reading material: the US K-Mart case [In Re Kmart Corp. US Court of Appeals, Seventh Circuit,

2004, 359 F.3d 866]

Goal: to practically illustrate what is meant by and how important as well as delicate the issue of

discretionary powers is in the context of insolvency proceedings. During this part of the tutorials

we will touch upon the linked issues of trustee‟s remuneration.

Instructions:

1. Read the US K-Mart case. If you need to consult the text of the referred to provisions in the US

(federal) Bankruptcy Code, you may want to explore the respective web pages of Cornell Law

School.

2. Questions for discussion:

a/ Do you agree with the decision/position of the Court of Appeals? Why?

b/ What level of discretionary powers should be given to bankruptcy trustees and bankruptcy

judges? Why?

c/ Discretionary powers may easily lead to arbitrariness. What alternative could you think of?

Would it be possible to formulate exact formulas instead?

d/ Try to see whether, and if yes, what is the content of the discretionary powers given by Chinese

insolvency law to trustees (administrators) and judges?

First session: SECOND PART – Insolvency trustee remuneration

Instructions:

1. Read the related material;

Questions on trustee remuneration:

1) What is, in general, the relation between trustee’s remuneration and effective

proceeding?

Poland is recently at the stage of amending its Bankruptcy and Reorganization Law. Since

trustee‟s adequate remuneration is believed to be one of the most important factors influencing the

time and effectiveness of bankruptcy proceeding - there has been a wide discussion around

trustee‟s situation.

One of the problems relates to the remuneration of trustee. Recently trustees‟ remuneration may

not exceed 3 % of the bankruptcy estate funds or 140 times the average monthly salary in the

enterprise sector. There is no minimum sum provided. Basically, legislator claims that too big

remuneration decreases the amount of money left for the creditors.

On the other hand, trustees emphasize that their situation is often very difficult to predict, and it

happens that proceedings are not only very long (even couple of years), but also that eventually

they are not paid much.

What is your opinion?

2) What is the optimal solution for trustee’s remuneration?

a. Should there be minimum amount of remuneration provided? When should the money be

paid - partially or after the whole proceeding is completed? Which solutions can increase trustee‟s

effectiveness at the same time not running to over-rewarding?

b. Polish legislator points to careless procedural expenses of trustees since their remuneration is

a percentage rate of the bankruptcy estate funds. Thus, there is a discussion on the optimal method

of payment: Fixed percentage of realizations (bankruptcy estate funds) vs. Fixed percentage of

distribution to creditors (after the costs are reduced). What is the difference in terms of motivating

trustee? Which system works better? Any other ideas of improvements in the area of method of

remunerating?

“For example, in the UK, if there is a creditors’ committee, the committee will determine the basis

of the remuneration. If there is no creditors’ committee, the remuneration can be fixed by the

general body of creditors or by the court. In the latter case, a creditor can challenge the

remuneration.”1

What do you think about this solution? Do you think that creditors should be involved in making

the decision of what trustee‟s method of remuneration / amount to be paid should be? Why? Can

you see any dangers in case trustee‟s remuneration is dependent on the creditors?

3) Recently, involvement of creditors in the procedure of appointing / dismissing trustee is very

limited in Poland. What do you think – what is the optimal involvement of the creditors in regard

to this matter? Can you see any dangers?

Second session: Pyramid and Ponzi schemes as bankruptcy crimes

Reading materials:

1. FRIEDMAN, Thomas L., The Lexus and the Olive Tree (Anchor Books, 2000). / excerpt;

2. JARVIS, Chris, The Rise and Fall of the Pyramid Schemes in Albania (IMF Staff Papers Vol. 47

no. 1, 2000).

3. EUNJUNG CHA, Ariana, China's Stiff Fraud Penalties, THE WALL STREET JOURNAL, Mar 22,

2007 at 9.

Questions for discussion:

1. What is the difference between pyramid and Ponzi schemes (if any)?

2. Why are pyramid and Ponzi schemes inherently linked to insolvency law?

3. Why is detecting of pyramid and Ponzi schemes before collapse a problem? What is the

difference, for example, between a multi-level marketing and a Ponzi scheme?

4. Could you identify segments of economy where Ponzi schemes tend to arise more frequently?

TUTORIAL 2

Friday (6 Dec. 2013)

First session: The law and growth nexus – from the perspective of insolvency and secured

transactions law

Reading material: DAM, Kenneth W., The Law-Growth Nexus (Brookings Institution Press,

Washington D.C. 2006) /excerpts

1 Investment Climate Advisory Services of the World Bank Group, Poland: Toward a Stronger Insolvency

Framework 29 (Sep. 2012).

Questions for discussion:

1. In many Latin-American countries cattle (e.g., Argentina) is one of the most valuable assets a

farmer or a business may have and thus could offer as collateral for loans. In many of these

countries, pledging of cattle is possible only „one by one‟ and thus separate registration must be

made for each and every animal in stark contrast to the countries of the Unitary System (e.g.,

United States) in which one filing is sufficient to achieve the same end. Is this in your opinion a

barrier Dam is talking about (on page 195)? If yes, how is that causing welfare losses?

2. Explain what the following saying mean in the context of insolvency law: “Better to make a

painful break than draw out the agony"?2 Could you apply this to jurisdictions which do not have,

for example, individual insolvency/bankruptcy laws?

3. Ralph Michaels, internationally renowned comparativist, claimed the following: "[It is doubtful]

that law actually does bring about progress. The problem is, in a nutshell this: even if economic

success and good laws correlate - and the example of China shows that this is not necessarily the case

- it is not clear whether countries are successful because they have functioning economies, or whether

a third factor is responsible for both. We call this endogeneity. [...]."3

Questions:

3a. What do you think, who is right: Dam (claiming that there is a law and grow correlation) or

Michaels denying that?

3b. Do you agree with Michaels' suggestion that good laws have not played a role in the

unprecedented economic success of China?

Second session: The law and growth nexus - efficiency of the secured transactions system

Reading materials: 1. SPANOGLE, John A., Secured Transactions law in Eastern Europe: the

Polish Experience as an Example, 31 T. Jefferson L. Rev. (2009).

2. Focus in the Dam book excerpts on the secured transactions part (i.e., pledges, mortgages etc.)

Questions:

1) What are the problems in secured transactions that limit private credit for movable property?

How excessive formalities in creating security interests limit the interest in using pledge?

2) One of the recommendations or EBRD (European Bank of Reconstruction and Development)

on further improvement is that:

“The system for pledge registration should be changed to a “notice” system which enables

immediate registration of information as presented by the parties and immediate access to all

registered information by any member of the public”.4

Would you agree? What positive / negative consequences could it bring? Should the judicial review

be eliminated at all?

2 In German: “Lieber ein Ende mit Schrecken als ein Schrecken ohne Ende” 3 MICHAELS, Ralph, Make or Buy - A Public Market for Legal Transplants? in EIDENMUELLER, Horst,

Regulatory Competition in Contract Law and Dispute Resolution 27 - 42 (C.H. Beck - Hart - Nomos, 2013), at 31. 4 European Bank of Reconstruction and Development, Commercial Laws of Poland: An assessment by the EBRD

10 (July 2010), available at http://www.ebrd.com/downloads/sector/legal/poland.pdf.

Table of contents

1. The US K-Mart case [In Re Kmart Corp. US Court of Appeals, Seventh

Circuit, 2004, 359 F.3d 866] p. 1

2. FRIEDMAN, Thomas L., The Lexus and the Olive Tree (Anchor Books,

2000). / excerpt p. 7

3 JARVIS, Chris, The Rise and Fall of the Pyramid Schemes in Albania (IMF

Staff Papers Vol. 47 no. 1, 2000). p. 9

4. EUNJUNG CHA, Ariana, China's Stiff Fraud Penalties, THE WALL

STREET JOURNAL, Mar 22, 2007 at 9. p. 25

5. DAM, Kenneth W., The Law-Growth Nexus (Brookings Institution Press,

Washington D.C. 2006) /excerpt p. 26

6. SPANOGLE, John A., Secured Transactions law in Eastern Europe: the

Polish Experience as an Example, 31 T. Jefferson L. Rev. (2009). p. 34

1

2

3

4

5

6

7

8

The Rise and Fall of the Pyramid Schemes in Albania

CHRIS JARVIS*

What lessons can be drawn from the unprecedented growth and spectacularcollapse of financial pyramid schemes in Albania? This paper discusses theorigins of the pyramid schemes and the way the authorities handled them. It alsoanalyzes the economic effects of the pyramid schemes, concluding that despite thedescent into anarchy triggered by the schemes’ collapse, their direct effects on theeconomy are difficult to specify and appear to have been limited. Finally, thepaper argues that prevention of pyramid schemes is better than cure and thatgovernments and international financial institutions should be vigilant inclamping down on frauds. [JEL E65, G14, G18]

This paper tells the story of the Albanian pyramid scheme crisis of 1996–97,analyzes its causes and consequences, and attempts to draw some lessons from

it. The pyramid scheme phenomenon in Albania is important because its scalerelative to the size of the economy was unprecedented, and because the politicaland social consequences of the collapse of the pyramid schemes were profound.At their peak, the nominal value of the pyramid schemes’ liabilities amounted toalmost half of the country’s GDP. When the schemes collapsed, there was uncon-tained rioting, the government fell, and the country descended into anarchy and anear civil war in which some 2,000 people were killed. This paper explores thecauses of the rise of the pyramid schemes and addresses the question of whatcould have been done to prevent it. It also examines the handling of the crisis. The

1

IMF Staff PapersVol. 47, No. 1

© 2000 International Monetary FundMV

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*Chris Jarvis is a Senior Economist in the IMF’s Policy Development and Review Department. Hethanks Jacques Artus, Bob Corker, Juha Kähkönen, Sanjay Kalra, Tim Lane, Alfredo Leone, Ranjit Teja,and other colleagues at the IMF for helpful comments and insights, as well as Marie Ricasa and GordanaRodic for secretarial support and Luzmaria Monasi and Jane Keneshea for valuable research assistance.

9

Chris Jarvis

2

paper then discusses the economic effects of the pyramid scheme phenomenonand concludes that despite the tremendous political effects, the economic effectshave been surprisingly limited. Finally, it suggests lessons that can be drawn fromthe crisis by other governments and by the international financial institutions.

I. Rise of Pyramid Schemes

Economic Background to Emergence of Pyramid Schemes

Albania started the transition process from central planning as the most isolated,undeveloped, and poor country in Europe. Albania had for centuries been largelyunknown and inaccessible,1 and from 1945 to 1985 its isolation was compoundedby the rigid dictatorship of Enver Hoxha. Communism in Albania was founded oncomplete reliance on central planning, the elimination of almost all forms ofprivate property, and the idealization of national self-reliance as a guiding tenet ofeconomic policy. In practice, this led to a virtual cutting off of the country fromoutside influences and information.2 The result was that when transition eventu-ally began, in 1991, the country had been reduced to desperate poverty and thevast bulk of the population was completely unfamiliar with market institutions orpractices.

Albania’s progress during the early transition years was impressive. Like allcountries starting transition, Albania faced initial shocks: output fell by nearlyhalf between 1989 and 1992, and inflation rose to triple digits. However, during1993–95 GDP growth averaged close to 10 percent while inflation fell to singledigits and external imbalances were reduced sharply (see Table 1). The impressivemacroeconomic performance reflected in large part wholesale dismantling ofcontrols; early privatization of agriculture, retail trade, and small and medium-sized enterprises; and improved financial discipline at the budgetary and stateenterprise levels.

However, by early 1996 it was clear that many problems had not been solved,and that others were reemerging. Structural reform had stalled, especially in thecritical area of banking. The approach of parliamentary elections in May 1996 ledthe government to indulge in preelection wage increases and to put off introduc-tion of a VAT, with the result that the budget deficit and inflation began to riseagain. Nor did things improve after the elections, which were won decisively bythe ruling Democratic Party but were widely believed to have been rigged. Fromthis point on, the government’s political authority was fragile, and its will to takedifficult decisions limited. This was to have significant implications for theunfolding pyramid scheme crisis.

1In the 1780s Edward Gibbon described Albania as “a country within sight of Italy which is lessknown than the interior of America.” See Davies, 1996, p. 645.

2Economic conditions in Albania before transition are described in detail in Blejer and others, 1992.Hoxha’s hostility to outside influences is illustrated by his breaking successively with the USSR andChina on the grounds that they were too moderate, and, more concretely, by his building of about half amillion bunkers—one for every six Albanians—for defense against foreign invaders.

10

Problems in the Financial Sector

One of the most important causes of the growth of the pyramid scheme phe-nomenon was the inadequacy of the formal financial system. The three state banksthat dominated the deposit-taking market (holding over 90 percent of deposits)were not reliable intermediaries of savings, and private banks were slow to emergeand not particularly interested in attracting domestic currency deposits, devotingtheir attention mostly to trade financing. The problem in the state banks was notlow interest rates: to ensure that depositors were offered interest rates that are pos-itive in real terms, the Bank of Albania set minimum interest rates on timedeposits, and from mid-1993 onward these were consistently above the prevailingrate of inflation. However, the payments system was seriously inadequate. InSeptember 1996, the average completion time for payment transactions betweenaccounts at different branches of the same state-owned bank was 5–6 days, and thecompletion time when the transaction involved accounts at different state-ownedbanks could exceed 15 days. As a result of these problems, and of a general dis-trust of the banks, the public tended to hold an unusually high proportion of theirfinancial assets in cash (at end-1995 the currency/deposit ratio was 64 percent) andwas on the lookout for alternative investment opportunities.

On the lending side, the banks’ problems were even worse, leading to theemergence of an informal credit market. Banking supervision and regulation wasrudimentary, and this, combined with a culture under which loans from state bankswere often regarded by borrowers as not requiring repayment, led to a growing badloan problem. By the end of 1994, of loans made since June 1992 when the statebanks began operations, 27 percent were nonperforming. By the end of 1995, intwo of the three state-owned banks, overdue loans accounted for almost half oftotal outstanding loans.3 In response to the banks’ poor credit evaluation and loancollection, the Bank of Albania imposed bank-by-bank credit ceilings. These wereset at levels that were well below what the banks wanted and insufficient to meetthe demands for credit to the private sector at prevailing interest rates. The limita-tions of the banking system made these measures sensible, indeed necessary, butthe result was that businesses increasingly turned for credit to the informal creditmarket. A survey of over 200 enterprises conducted in late 1996 found that 36 per-cent of them had used the informal market to fund their investments, comparedwith 38 percent that had used bank credit (Muço and Salko, 1996).

Informal Credit Market and Pyramid Schemes

An informal credit market had been flourishing in Albania since the transitionbegan, and it was generally tolerated by the authorities. The informal market con-sisted partly of foreign exchange dealers (some licensed, some not) and partly ofa number of companies taking deposits and making loans. These companies were

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

3

3The banks’ poor credit evaluation is epitomized by the state-owned Rural Commercial Bank’smaking short-term loans to farmers to buy tractors and trucks. At end-1996, the tractor and truck loansstill accounted for one-third of the bank’s total lending and 80 percent of its bad loans. The bank was liqui-dated in December 1997.

11

Chris Jarvis

4

Tab

le 1

.A

lba

nia

: Ba

sic

Ind

ica

tors

an

d M

ac

roe

co

no

mic

Fra

me

wo

rk,1

991–

98

1991

19

92

1993

19

94

1995

19

96

1997

19

98

(Per

cent

cha

nge)

Rea

l GD

P–2

8.0

–7.2

9.

6 9.

4 8.

9 9.

1 –7

.0

8.0

Ret

ail p

rice

s (d

urin

g pe

riod

)10

4.1

236.

6 30

.9

15.8

6.

0 17

.4

42.1

8.

7

(In

perc

ent o

f G

DP)

Savi

ng-i

nves

tmen

t bal

ance

Fore

ign

savi

nga

19.7

57

.1

28.7

14

.3

9.7

11.5

14

.3

8.3

Dom

estic

sav

ing

–13.

5 –5

1.9

–15.

5 3.

6 8.

3 4.

0 1.

7 7.

7 Pu

blic

b–2

7.4

–21.

9 –1

4.1

–10.

6 –6

.5

–9.0

–1

0.8

–8.1

Pr

ivat

e13

.9

–30.

0 –1

.5

14.2

14

.9

13.0

12

.4

15.9

In

vest

men

t6.

1 5.

2 13

.217

.918

.0

15.5

16

.0

16.0

Pu

blic

6.1

4.0

9.5

8.6

8.5

4.5

4.0

5.2

Priv

ate

0.0

1.2

3.7

9.3

9.5

11.0

12

.0

10.8

Fisc

al s

ecto

rR

even

ues

31.7

23

.5

25.7

24

.5

23.9

18

.3

16.9

20

.3

Exp

endi

ture

s62

.2

44.0

40

.2

36.3

34

.3

30.3

29

.4

30.7

O

vera

ll de

fici

t 43

.9

20.3

14

.4

12.4

10

.3

11.7

12

.6

10.4

D

omes

tical

ly f

inan

ced

defi

cit

43.9

20

.0

9.1

7.0

6.6

10.6

10

.8

6.4

Mon

etar

y in

dica

tors

Bro

ad m

oney

gro

wth

(in

per

cent

)…

…75

.040

.6

51.8

43

.8

28.4

19

.9

Gro

wth

in p

riva

te

sect

or c

redi

t (in

per

cent

)…

……

61.4

15

.9

30.5

19

.0

15.8

B

road

mon

ey/q

uart

. GD

P…

…3.

68

2.83

2.

22

1.97

1.

92

1.94

In

tere

st r

ate

(3 m

onth

s de

posi

ts)

……

14.0

7.

0 10

.0

18.5

26

.0

16.5

12

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

5

(In

mill

ions

of

U.S

. dol

lars

)E

xter

nal s

ecto

r C

urre

nt a

ccou

nt b

alan

ce–1

68

–104

–4

5 –1

18

–58

–168

–1

99

–90

(in

perc

ent o

f G

DP)

–14.

7–1

4.7

–3.7

–5

.9

–2.4

–6

.2

–8.7

–3

.0

Off

icia

l tra

nsfe

rs81

33

0 32

0 16

1 11

8 77

77

97

(i

n pe

rcen

t of

GD

P)7.

146

.5

26.1

8.

1 4.

9 2.

9 3.

4 3.

2 C

urre

nt a

ccou

nt b

alan

cec

–249

–4

34

–365

–2

79

–176

–2

45

–276

–1

87

(in

perc

ent o

f G

DP)

–21.

9–6

1.1

–29.

7 –1

4.1

–7.3

–9

.1

–12.

1 –6

.1

Tra

de b

alan

ce

–208

–4

54

–490

–4

60

–474

–6

92

–519

–6

21

(in

perc

ent o

f G

DP)

–18.

3–6

4.0

–39.

9 –2

3.2

–19.

6 –2

5.7

–22.

7 –2

0.4

Exp

orts

73

70

112

141

205

229

167

205

Impo

rts

281

524

602

601

679

921

685

826

Gro

ss in

tern

atio

nal r

eser

ves

1 72

14

7 20

4 24

0 27

5 30

6 38

4 (i

n m

onth

s of

impo

rts

of g

oods

and

nonf

acto

r se

rvic

es)

0.1

1.4

2.3

3.2

3.5

3.1

4.5

4.7

(rel

ativ

e to

ext

erna

l deb

t ser

vice

)…

…4.

6 4.

6 31

.6

13.2

14

.0

21.8

(i

n pe

rcen

t of

broa

d m

oney

)…

…21

.4

30.9

22

.3

17.0

12

.9

15.8

Mem

oran

dum

item

s:R

eal G

DP

(in

billi

ons

of le

ks, 1

990

pric

es)

12.1

11

.2

12.3

13

.5

14.7

16

.0

14.9

16

.1

Nom

inal

GD

P (i

n bi

llion

s of

leks

)16

.4

53.2

12

5.3

187.

9 22

4.7

281.

0 34

1.7

460.

6 N

omin

al G

DP

(in

mill

ions

of

U.S

. dol

lars

)11

39

710

1,22

8 1,

984

2,42

2 2,

689

2,28

4 3,

047

Nom

inal

GD

P (i

n bi

llion

s of

U.S

. dol

lars

)…

0.7

1.2

2.0

2.4

2.7

2.3

3.0

Lek

/US$

(en

d of

per

iod)

…10

2.9

100.

9 95

.0

94.5

10

3.7

149.

8 14

1.4

Popu

latio

n an

d So

cial

Ind

icat

ors

Popu

latio

n (m

id-1

995,

in m

illio

ns)

3.3

Urb

an p

opul

atio

n (p

erce

nt o

f to

tal p

opul

atio

n)37

.0

GN

P pe

r ca

pita

(19

95, i

n U

.S. d

olla

rs)

745.

0 L

ife

expe

ctan

cy a

t bir

th73

.0

Infa

nt m

orta

lity

(per

1,0

00 li

ve b

irth

s)31

.0

Tele

phon

e lin

es (

1995

, per

100

peo

ple)

1.4

Sour

ces:

Alb

ania

n au

thor

ities

; and

IM

F st

aff

estim

ates

and

pro

ject

ions

.a C

urre

nt a

ccou

nt e

xclu

ding

net

fac

tor

serv

ices

and

off

icia

l tra

nsfe

rs.

b Rev

enue

(ex

clud

ing

gran

ts)

min

us c

urre

nt e

xpen

ditu

re.

c Exc

ludi

ng o

ffic

ial t

rans

fers

.

13

informal and arguably illegal, since they were never licensed to take deposits.They grew out of a credit system based mostly on private loans from migrantworkers to friends and family. According to Bank of Albania officials, loans madewere generally less than US$30,000, most companies had fewer than eight loansoutstanding, and substantial collateral was required. Informal market lending rateswere high: real rates were around 8 percent a month in 1993, although they hadfallen to 6 percent a month in the second half of 1995 (Muço and Salko, 1996).There is no record of deposit rates offered by these companies, but these were pre-sumably also high, though somewhat lower than lending rates to allow for a lend-ing spread. Both the authorities and foreign observers, including the IMF, regardedthe informal lending companies as benign, and indeed as making an importantcontribution to growth: given the manifest deficiencies of the formal banks, thesecompanies were probably the best intermediaries for savings in Albania, and theinvestments they funded were among the most profitable.

However, operating alongside the informal lending companies, and to someextent disguised by them, were a number of companies that also borrowed money athigh interest rates but invested on their own account rather than lending funds; it wasthese that either were or became pyramid schemes. The first and largest of thesecompanies was started in 1991–92 and began collecting money shortly afterward.Up to the end of 1995, these companies offered interest rates of 4–5 percent a month.The use to which they put their funds is uncertain. They engaged in some (usuallyhighly visible) productive investments and are, in some cases, also believed to haveused borrowed funds to finance criminal activities: smuggling, illegal emigration,drugs, prostitution, and arms trafficking. Given the nature of these companies, it isnot possible to establish whether they were ever solvent, in the sense of earning morefrom their investments and illegal activities than they were paying to depositors. Itis possible that they were pyramid schemes from the day they started business. Inany event, if they were not so already, they became pyramid schemes in the courseof 1996. (For a definition and description of pyramid schemes see Box 1.)

The distinction between the informal credit market and the pyramid schemesis a vital one, but for a long time it was difficult to see the difference betweenthem. Both the informal credit market and the companies that invested on theirown behalf drew resources from domestic savings and from flows of remittancesestimated at about US$300 million a year (about 12 percent of GDP). Both oper-ated on the premise that there were profitable opportunities for investment in smallbusinesses in Albania. The authorities generally shared this view, mostly regardingthe borrowing companies as rare success stories among Albanian businesses anddiscouraging close scrutiny. It was also difficult for outside agencies, including theIMF and the World Bank, to differentiate between the two sets of companies.Neither set of companies were licensed or subject to detailed supervision, and inthe case of the companies that invested on their own behalf, their reputation forinvolvement in criminal activities made information difficult and even dangerousto obtain.4 Both the IMF and the World Bank initially treated the companies that

Chris Jarvis

6

4In 1995, an IMF consultant posed briefly as a potential investor and was quickly warned that thiswas not safe.

14

invested on their own account as part of the informal credit market. Thus, an IMFmission to advise on financial sector problems at the end of 1995 focused mostlyon the possibilities for improving the formal financial system by integrating themost positive elements of the informal market. While concerns about the possi-bility of criminals operating in the market were raised, the true nature of the largecompanies operating at this time, and the scope of their activities, was not pickedup by outside observers until mid-1996.

Legal and Governance Problems

The legal framework available to the authorities to combat the pyramid schemeswas inadequate, especially with regard to enforcement. The companies concernedwere licensed businesses and claimed to be operating under the Civil Code, whichpermitted borrowing by companies. However, they were never audited, nor do theyappear to have paid profit taxes. In February 1996, a new Law on the BankingSystem was passed, which stipulated that “no person other than a bank shall accepthousehold deposits, demand deposits, and deposits with an initial maturity of 12months or less” (Law No. 8075, dated 2/22/96, Article 6). In Article 2 of the samelaw, “household deposits” were defined as “natural persons’ deposits.” In the viewof the Bank of Albania, the borrowing companies were violating the new law, andthe central bank contacted the companies to inform them that they were in thebusiness of deposit taking and required licenses to operate—licenses that the

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

7

Box 1. The Dynamics of a Pyramid Scheme

Pyramid schemes work on the principle that money paid in by later investors is used to payartificially high returns to earlier investors. There are typically four stages in the life cycle of apyramid scheme.

(1) Early investors are drawn in by advertising promising high interest rates or huge capitalgains after a short period. Most schemes have a gimmick, often based on some real orimagined market inefficiency or loophole in the law.

(2) News of the high returns spreads by word of mouth or advertising, and more people invest.Their payments are used to pay interest and, if necessary, principal to the early investors.More often, though, the early investors will reinvest their principal, and sometimes theirinterest in the hope of still higher gains. Most people, however, remain skeptical.

(3) With a reputation for solvency based on a good payments record, which overrides doubtsabout the feasibility of the scheme, many more investors come into the scheme. Someremain skeptical but invest anyway, believing that they can make a quick profit and then getout before the scheme runs into trouble. For a time, the scheme appears successful.

(4) The final stage is the collapse of the scheme. The interest and principal due to the oldinvestors exceeds the money that the scheme is able to attract from new investors. As soonas payments are interrupted, confidence in the scheme evaporates. The investors rush to gettheir money out, but there is little to be had. What has not been paid to the early investors ininterest has usually been used to buy highly visible but often not very valuable assets tomake the scheme look prosperous, or has been stolen outright by the operators.

15

Chris Jarvis

8

Governor of the Bank of Albania had no intention of giving them. However, theChief Prosecutor took the view that the new law did not apply to the borrowingcompanies. Nor was he disposed to investigate the companies for fraud. TheMinistry of Justice, for its part, refused to give an interpretation. It is arguable thatthe Bank of Albania should still have used its powers under the Banking Systemlaw to close the companies as unlicensed banks. However, given the clear reluc-tance of other organs of the government to move against them, and the difficultythe Bank would have had in enforcing the law against powerful companies, itsfailure to do so is understandable.

Indeed, there is strong evidence that the problem was not just a legal one, butone of governance, and that members of the government themselves benefited fromand supported the pyramid scheme companies. During the 1996 elections several ofthe major companies made campaign contributions to the ruling Democratic Partyand paid for advertisements on the election posters of Democratic Party candidates.Senior government officials frequently appeared at functions and parties organizedby the companies and, in November 1996, even as the pyramid schemes began tocrumble, the Prime Minister and Speaker of Parliament accepted medals to cele-brate the fifth anniversary of VEFA, the largest company. This tolerance wasreflected in the benign neglect of both the Ministry of Justice and the Ministry ofFinance,5 and in open support of the major companies by the President. Thus, fromSeptember 1995 to July 1996 the Governor of the Bank of Albania stood virtuallyalone in Albania urging investigation and closure of the schemes.

II. Mania: The Events of 1996

Two events set the stage for the pyramid scheme mania of late 1996: the suspen-sion of UN sanctions against the Socialist Federal Republic of Yugoslavia (SFRY)in December 1995 and the campaign and outcome of the Albanian parliamentaryelections of May 1996. It was an open secret that throughout the period of UNsanctions, oil and many other goods were being smuggled through Albania to theSFRY. Taxes on oil transit trade alone were estimated by IMF staff to amount to1 percent of GDP.6 The involvement of the pyramid scheme companies with thesmuggling cannot be proved, but some of the largest companies started up as“trading companies” during the period of sanctions, and they were generallybelieved to be involved. The suspension of sanctions ended the smuggling trade.One month later, whether by coincidence or because a key source of income haddisappeared and they then needed to attract more funds, the borrowing companiesraised their interest rates to 6 percent a month. The May elections had a moredirect impact. In reaction to uncertainty about the prospects of the rulingDemocratic Party in the elections, and also to the entry of new pyramid schemes

5During discussions between the IMF and the authorities in late 1996, IMF staff suggested that thetax authorities should investigate these companies and close them if they were found to be insolvent. Thestaff also pointed out that the Russian pyramid scheme, MMM, had initially been prosecuted not for fraudbut for tax evasion. However, the authorities were unwilling to pursue this possibility.

6Much of the smuggled oil was legally imported into Albania, and hence subject to customs dutiesand excise taxes.

16

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

9

into the market, the pyramid schemes raised their interest rates again, to 8 percenta month.7 The outcome of the elections was also crucial. The elections werewidely seen as rigged, so that local government elections scheduled for Octobertook on a greatly increased significance. In these circumstances, the governmentdid not want to give people any unpleasant surprises, and the tendency to ignorethe growth of the pyramid schemes and hope that problems would never materi-alize was reinforced.

In early 1996, new pyramid schemes entered the scene, drawing in moredepositors, ratcheting up interest rates, and further confusing the authorities. Theinformal deposit-taking market had previously been dominated by a few largecompanies. (For a brief description of the most important Albanian pyramidschemes, see Table 2 and Box 2.) The three largest companies of the time, VEFA,Gjallica, and Kamberi, all offered interest rates of 4–5 percent a month,increasing, as described above, to 6–10 percent in the first half of 1996; all threecompanies had substantial real investments and activities. In 1996 these werejoined by two new schemes, Xhafferi and Populli, and one already existing butincreasingly active one, Sude, which offered higher interest rates (12–19 percenta month in May 1996) and had no real investments.8 This had baleful effects.First, more deposits were drawn in. Although VEFA was the largest scheme interms of liabilities, it only had about 85,000 depositors. Xhafferi and Popullibetween them attracted over one million depositors within a few months, in acountry with a population of three and a half million. Second, it increased thepressure on the existing schemes to increase rates or compete in other ways.Finally, the existence of companies that were obviously pyramid schemes causedthe authorities to draw a false distinction between them and the similar companiesthat had real investments, and to assume that the latter were solvent.

In the second half of 1996 mania took hold. In July, Kamberi raised itsinterest rate to 10 percent a month. In September, Populli began offering over30 percent a month. In November, in a final spasm, Xhafferi offered to trebledepositors’ money in three months (a monthly equivalent rate of 44 percent) andSude responded with an offer to double the principal in two months (a 41percent monthly rate). By November, the face value of liabilities had reachedUS$1.2 billion. Yet even these numbers fail to capture the lunacy that grippedAlbania during this period. Queues formed to deposit funds with both the purepyramid schemes and the longer established companies, and a massive numberof new depositors poured in, especially to the high interest schemes. The crowdwas composed not only of the poor and the gullible but also of those who

7Interest rates in the formal financial sector also rose during this period (see Figure 1). Political uncer-tainty and a preelection loosening of fiscal policy caused the lek to depreciate by some 15 percent duringthe first 5 months of the year, and underlying inflation rose from 10.6 percent to 19.1 percent a year. Inresponse, the Bank of Albania tightened monetary policy, raising minimum interest rates on 12-monthdeposits from 13.25 percent to 16 percent. However, the increase in annualized interest rates offered bythe pyramid scheme companies (from about 100 percent to about 150 percent) cannot be explained bythese changes.

8In Xhafferi’s case there was a smattering of window dressing. Xhafferi sponsored a football team inone of the most depressed towns in Albania and recruited the former captain of the 1978 World Cup–winningArgentina team to coach it. The football ground was the scene of one of the first pyramid scheme riots.

17

Chris Jarvis

10

Tab

le 2

.Su

mm

ary

of t

he

Ma

in A

lba

nia

n P

yra

mid

Sc

he

me

s

Lia

bilit

ies

to c

redi

tors

in U

.S. d

olla

rs

Dat

e st

arte

d M

onth

ly

No.

of

cred

itors

L

iabi

litie

s at

pre

-cri

sis

exch

ange

rat

ec

colle

ctin

g in

tere

st r

ate

at ti

me

to c

redi

tors

Est

imat

edTo

tal o

wed

Ave

rage

ow

edC

ompa

nym

oney

offe

reda

of c

olla

pse

(mill

ion

lek)

asse

stsb

(US$

mill

ions

)(U

S$)

VE

FA19

948

85,0

0067

,929

4,99

965

57,

707

Gja

llica

1993

1082

,000

51,4

6749

549

66,

053

Kam

beri

1994

10...

6,33

051

961

...Si

lva

1994

1015

,000

3,33

287

132

2,14

2C

enaj

1994

10...

7,02

175

068

...X

haff

eri

1996

471,

188,

000

30,8

3316

,033

297

250

Popu

lli19

9639

304,

000

6,31

03,

786

6120

0Su

de19

9441

13,0

003,

900

038

2,89

3

Tota

ls1,

687,

000

177,

122

27,4

531,

708

Mem

oran

dum

item

s:D

epos

itors

as

perc

enta

ge o

f po

pula

tion

51L

iabi

litie

s of

the

sche

mes

as

a pe

rcen

tage

of

1996

GD

P64

Sour

ces:

Aut

hor’

s es

timat

es, b

ased

on

adm

inis

trat

ors’

and

audi

tors

’rep

orts

and

dat

a co

llect

ed b

y th

e B

ank

of A

lban

ia.

a Rat

es o

ffer

ed in

Nov

embe

r 19

96. A

s no

ted

in th

e te

xt, r

ates

off

ered

incr

ease

d du

ring

199

6, r

each

ing

a pe

ak in

Nov

embe

r.b I

n th

e ca

se o

f al

l sch

emes

exc

ept X

haff

eri a

nd P

opul

li, th

ese

figu

res

are

base

d on

the

adm

inis

trat

ors’

and

audi

tors

’est

imat

ion

of a

sset

s re

mai

ning

in J

anua

ry19

98, a

yea

r af

ter

the

colla

pse.

In

som

e ca

ses,

oth

er a

sset

s w

ere

take

n by

the

oper

ator

s be

twee

n th

e co

llaps

e of

the

sche

mes

and

thei

r be

ing

take

n ov

er b

y ad

min

-is

trat

ors.

Som

e as

sets

wer

e al

so d

estr

oyed

dur

ing

the

civi

l dis

orde

r th

at f

ollo

wed

the

colla

pse.

Xha

ffer

i’s a

nd P

opul

li’s

asse

ts w

ere

all h

eld

in b

ank

depo

sits

and

wer

e se

ized

by

the

gove

rnm

ent

in J

anua

ry 1

997

and

dist

ribu

ted

to c

redi

tors

. The

adm

inis

trat

ors’

Janu

ary

1998

est

imat

es o

f th

e va

lues

of

phys

ical

ass

ets

(abo

utU

S$50

mill

ion

at c

urre

nt e

xcha

nge

rate

exc

ludi

ng X

haff

eri

and

Popu

lli)

have

pro

ved

to b

e si

gnif

ican

tly h

ighe

r th

an w

hat

they

hav

e be

en a

ble

to r

ealiz

e so

tha

tdi

vidi

ng li

abili

ties

by a

sset

s fo

r ea

ch c

ompa

ny o

vers

tate

s th

e am

ount

that

dep

osito

rs a

re li

kely

to r

ecei

ve.

c The

exc

hang

e ra

te a

t D

ecem

ber

1996

was

103

.7 l

eks

to U

S$1.

Thi

s is

the

mos

t re

leva

nt e

xcha

nge

rate

for

ass

essi

ng t

he s

igni

fica

nce

of t

he s

chem

es. T

heex

chan

ge r

ate

at e

nd-D

ecem

ber

1998

was

150

.6 le

ks to

US$

1.

18

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

11

Box 2. The Major Albanian Pyramid Schemes

Altogether, 17 companies were put into administration by the authorities following the crisis of1997. The following is a sketch of the most significant of them.

VEFA. The largest and most important of the companies,1 the auditors believe that VEFA tookin at least $700 million in deposits, and probably over US$1 billion. When it was taken over,liabilities, excluding some US$200 million in accrued interest, amounted to US$250 million,while its assets were generously estimated at US$30 million. VEFA was founded in October1992 as a trading company but soon started taking deposits, and by late 1996 was offering aninterest rate of 8 percent a month. Its president, Vehbi Alimucaj, was by most accountsattempting to build a business empire, but took a fateful decision to do so by raising cash atunsustainable rates. The company’s assets included supermarkets, restaurants, a bitumen mine,a cruise ship, an entertainment complex, and a television station.

Gjallica. A huge and massively fraudulent scheme, Gjallica was started in 1991 as a currencyexchange, but afterward began taking deposits. In total, US$850 million in deposits were taken,though auditors estimate that over 80 percent of this came in during 1996, when Gjallica wasoffering interest rates of about 10 percent a month. Gjallica was something of an elite company,with about 170,000 investors at its peak and an average investment of almost US$5,000. At thetime of its collapse, its liabilities were US$343 million, its assets worth US$3 million. Theowners fled to Turkey, having, according to the auditors, withdrawn at least US$17 millionduring the scheme’s operation. Gjallica was based in Vlore, a large city in southern Albaniaknown as a smuggling base. Its collapse triggered the first wave of violent civil disorder.

Populli. Started as a “charitable foundation” in early 1996, but was actually a pure pyramidscheme. Populli attracted over 300,000 investors. By the end, Populli was offering to pay twotimes principal invested after three months. Its liabilities at the time of collapse were overUS$150 million. Much of its money was held in the state banks and was seized by the authorities.Depositors got back 60 percent of their investments.

Xhafferi. Started by Rrapush Xhafferi as a spinoff from Populli, Xhafferi quickly outstrippedits rival. At the time of its collapse, liabilities were over US$300 million. About half of this wasreturned to depositors from seized bank deposits. Xhafferi went for a mass market, posing as abenefactor, sponsoring a football team, and attracting over one million depositors, with anaverage investment of about US$250. At the end, he offered “three times principal after threemonths.”

Sude. Maksude Kademi started by running a lottery in the shoe factory where she worked, butthen began operating a pyramid scheme. By the end, she was offering to “double your money intwo months.” Sude was the first scheme to fold, in November 1996, with liabilities variouslyestimated at US$40–90 million, and no assets. Considering that most of the deposits paid intoSude were made in the last two months of its operations, the disappearance of the assets issuspicious. Ms. Kademi was sentenced to 3 years and 4 months in prison for conspiracy todefraud.

1Most deposits in the pyramid schemes were made in leks, though some were made in foreign currencies. Inconverting into dollars, for most of the schemes, an exchange rate of 150 leks to 1 U.S. dollar is used, as thiswas the average exchange rate in 1998, when most of the companies were finally brought under effectivecontrol. However, for Xhafferi and Populli a rate of 105 leks to 1 U.S. dollar is used, because this was therate at the point when the Bank of Albania froze their deposits in January 1997.

19

Chris Jarvis

12

Figure 1. Albania: Interest Rates and Inflation

Bank Nominal Interest Rates

1996199519941993 1996199519941993

1996

Percent per year

Informal Market Interest Rates and InflationPercent per month

Inflation12-month percent change

0

5

10

15

25

20

30

0

2

–2

4

6

12

10

8

0

5

10

15

30

35

20

25

40

Deposit rate

Inflation

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: National authorities.

20

believed that the schemes had either government support or sources of fundsderived from illegal activities which would sustain their returns, and of thosewho appeared to believe that “when the rest of the world are mad, we mustimitate them in some measure.”9 People sold their houses and apartments toinvest in the schemes; farmers sold their livestock. The mood is vividly capturedby a resident who said that Tirana, in the autumn of 1996, smelled and soundedlike a slaughterhouse, as farmers drove their animals to market to put theproceeds in the pyramid schemes.

Through all of this, the government was a passive observer. Although theGovernor of the Bank of Albania had sent monthly letters since the beginning ofthe year updating the government on the interest rates being offered by theschemes, and warning of their nature, it was not until October that the Minister ofFinance, returning from the IMF and World Bank annual meetings in Washington,warned the public for the first time about the risks of the schemes. Even then,government statements often compounded the problem. In particular, a falsedistinction that the government drew between the companies with real investmentsand the “pure pyramid schemes” obscured the fundamental insolvency of all of theschemes.10 When it was suggested that some of the companies might be survivingby laundering money for the Italian Mafia, the President himself came to theirdefense, arguing that these were legitimate and successful Albanian companies. InNovember, again responding to outside pressure, the government set up acommittee of academics to investigate the schemes, with the main focus still beingon the pure pyramid schemes. The committee never met.

The IMF and World Bank did give increasingly strident warnings about theschemes in the course of 1996, but these warnings were not heeded and may havebeen too late to do much good in any case. Both institutions had expressed concernas far back as December 1994 about the dangers of criminal enterprises operatingin the informal market, though the concern was as much about money launderingas about pyramid schemes. However, it was not until August 1996 that a strongwarning was given. It was in that month that the Bank of Albania communicatedits concerns to an IMF mission visiting Tirana. Concern was also triggered by themission’s first look at the June and July monetary data, which, as discussed below,contained the first intimations of the effects of the pyramid scheme phenomenonon the banking system. The mission left a letter with the president warning himabout the schemes and urging early action. In September, a World Bank missionrepeated these warnings even more vigorously. However, even then, nobody hadany idea of the size of the schemes. It was only in October, when the Bank ofAlbania found out that VEFA’s deposits in the banking system were equivalent to

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

13

9The phrase was used by a banker who invested in the South Sea Bubble (see Box 3) and is quotedin Kindleberger, 1978. The similarities between the pyramid scheme mania and other financial manias arediscussed below.

10One of the more bizarre features of the year was that the operators of the schemes did not them-selves have a consistent name for their activities, so that many, including those with real investments,simply adopted the name “pyramid schemes” given to them by foreign observers, but stripped it of itspejorative implications. This led to quotes like a government official’s reported assertion that “Ourpyramid schemes are the cleanest pyramid schemes in Europe.”

21

US$120 million (5 percent of GDP), that the enormity of the problem becameclear. In October, in Washington, the IMF and World Bank repeated their warn-ings, finally producing a public warning from the Minister of Finance. Press andpublic reaction was mostly negative: the IMF was accused of trying to close downAlbania’s most successful firms. The president of VEFA, a former organizer ofstreet cleaners, commented that the IMF was not fit to clean the streets of Tirana.Finally, in a November 19 press conference, another visiting IMF mission warnedthe public about the schemes and urged the government to investigate all of them.On the same day, Sude defaulted on its payments, and the collapse began.

Chris Jarvis

14

Box 3. Pyramid Schemes Old and New

Pyramid schemes have a long and inglorious history. The Albanian schemes deserve a small place inthe rogues’ gallery for their size relative to the Albanian economy and for the dramatic consequencesof their collapse. But for historical significance, they do not compare with the South Sea Company,which, if it was not a strictly defined pyramid scheme, had many of the features of one, and fornotoriety they must defer to the operations of Charles Ponzi, whose name became synonymous withthe phenomenon.

The South Sea Bubble

The South Sea Company was a pyramid scheme in two senses: the return to investors came from arising share price fueled by money from new investors, and the rise was engineered by massivefraud on the part of its operators. There are also features—the intimate involvement of the state inthe scheme and the fact that no returns were actually paid during the period of intense speculationin the shares—that make it unlike a conventional pyramid scheme. But its history (includingstriking parallels with the Albanian case) makes it worth examining in detail.

The company began as a legitimate scheme to redeem British government debt. In 1710, thegovernment granted the South Sea Company trading privileges, and, in return, holders of governmentpaper, which had not been guaranteed by parliament and which was trading at a discount, wereoffered the opportunity to exchange it for shares in the company. The government committed itselfto pay the company interest on this debt, but at a low rate. The difference was supposed to come fromthe company’s trading profits. In fact, apart from a brief and unsuccessful excursion into the slavetrade, the company had little in the way of real business, and it is not clear whether even investorswere initially attracted by its trading prospects or by its (initially sound) financial operations onbehalf of the government, coupled with a belief that any company which could generate substantialcash could make a profit in the trading environment of the time.

What the company did best, and what makes it the prototype pyramid scheme, was that the risein the share price was largely supported by the company trading its own stock. Throughout the year1720, the operators lent shareholders money to enable them to buy new stock on the security of theirexisting stock. The money was borrowed from a client bank and from the government. Investorsincluded the cream of the English aristocracy, including the king. Initial price rises fueledspeculative buying, and so long as the price kept rising everyone was content. But when peoplestarted selling, the price fell, the company was unable to pay its dividend, and bankruptcy quicklyfollowed. And in fact the bubble was very short lived: active trading began shortly before the SouthSea Bill received royal assent on April 7, 1720. By June, rivals were proliferating, so that parliamenttried to protect the company by enacting the Bubble Act, authorizing prosecution of unauthorizedjoint stock companies. This rebounded on the South Sea Company, because many who had madespeculative bargains in the companies that were being attacked could not meet their commitmentswithout selling South Sea stock. By December 1720, the company was bankrupt, and its

22

III. The Crisis of 1997

Collapse

It took four months for the remaining pyramid schemes to collapse, bringing downwith them the Democratic Party government, and plunging Albania into anarchy.The collapse of Sude shook confidence in all of the borrowing companies. Peoplebegan to listen to the warnings, and the flow of new deposits ceased. In an unusualattempt to convince depositors of their soundness, the owners of VEFA, Kamberi,Silva, and Cenaj agreed to reduce interest rates to 5 percent a month. The tacticdid not succeed. In January 1997, both Sude and Gjallica, one of the funds withreal investments, declared bankruptcy, triggering riots, especially in the southerncity of Vlore, where Gjallica was based. As the riots intensified and spread, theremaining schemes ceased payments.

THE RISE AND FALL OF THE PYRAMID SCHEMES IN ALBANIA

15

government sponsors, many of whom had been bribed with discounted stock in the rising market,were out of office and disgraced. Parliament voted to seize the assets of those involved, includingcorrupt politicians. However, even with the full force of law behind the planned seizure andliquidation, it took trustees appointed by parliament over 7 years to realize some 2 million poundsin such seizures. The government also had to take back its debt and pay off the holders, though theexchange did not help those who had speculated.

The Ponzi Scheme

Charles Ponzi’s scheme was also short lived. He issued his first notes for US$800 in Boston inDecember 1919. By the summer of 1920 he was a millionaire. On November 1, 1920 he pleadedguilty to mail fraud. Ponzi claimed to be investing in “international reply coupons,” whichimmigrants to the United States could send to relatives to pay postage on international mail, andwhich, because of currency movements during the First World War, traded at widely varying valuesin different countries. In principle, there were opportunities for arbitrage, except that the couponscould not be traded for cash legally, there were not enough of them, and Ponzi never bought themanyway, except a few for window dressing.

Contemporary Pyramid Schemes

One common feature of the South Sea Bubble and the Ponzi scheme was that their investors believedthat their profits were derived either from special privileges conferred by the government (South Sea)or by a loophole arising from undervalued government-backed instruments (Ponzi). To some extentthis was also the appeal of a contemporary scheme, MMM, which rose and fell in Russia in 1994,and which purported to be investing in privatization bonds. Others have traded on local politicallinks, notably Caritas, the notorious Romanian pyramid scheme that was a pure pyramid but whichenjoyed the support of the local mayor who was also the leader of one of the parties in the governingcoalition. Indeed, it is one of the ironies of pyramid schemes, which seem at first sight to be amanifestation of the rawest form of unregulated market capitalism, that most rely on a purportedassociation with governments. Sometimes operations that attempt innovative financial transactionsrely on wholly imaginary links: one can, for example, invest in bulk purchases of international lotterytickets through a company calling itself International Monetary Funding—no relation.

Box 3. (concluded)

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The government initially tried to limit the damage caused by the pyramidschemes and belatedly took some important measures, but still failed to control thelargest companies. Most important, throughout the violence, the government stuckfirmly to the principle that depositors would not be compensated for their lossesfrom the budget. This crucial and courageous decision, which was endorsed by theopposition, made economic stabilization after the crisis much easier. The govern-ment also finally began to move against some of the companies. On January 26,1997, it froze the bank accounts of Xhafferi and Populli, which contained anastonishing US$250 million (10 percent of GDP). The Bank of Albania, acting onits own initiative, began to limit daily withdrawals from bank accounts to 30million leks (then about US$300,000) to prevent other schemes from emptyingtheir accounts. These measures helped: the seized assets of Xhafferi and Populliamounted to about half their liabilities, and this money was returned to depositorsover the ensuing months. In February, parliament passed a law banning pyramidschemes (but not defining them). However, the government was still trying tomaintain the distinction between the companies with real investments and the“pure pyramid schemes,” and it still did not move against the largest schemes.VEFA, for example, was allowed to continue advertising on television during theworst of the violence.

The measures taken by the government proved to be too little, too late. Thegovernment’s authority, shaky since the May 1996 elections, had evaporated, andon March 8, 1997, it resigned. By this time, Albania was in chaos. The governmenthad lost control of the more prosperous south of the country, where investments inthe schemes had been highest. The army and police had mostly deserted. By mid-March armories were being looted in the south by rioters and in the north by thePresident’s supporters; evacuation of foreign nationals and mass emigration ofAlbanians to Italy began. When Tirana itself fell into civil disorder the presidentagreed to hold new parliamentary elections by the end of June, and an all-partyinterim coalition government led by members of the former opposition SocialistParty was appointed.

Recovery Program

The interim government inherited a desperate situation. Some 2,000 people werekilled in the violence that followed the pyramid schemes’ collapse. Almost onemillion weapons were looted. In April, large parts of the country were still outof the government’s control. Government revenue collapsed, as customs postsand tax offices were burned. By end-June the lek had depreciated against thedollar by 40 percent; inflation during the first half of the year was 28 percent.Many industries had temporarily ceased production, and trade was interrupted.Meanwhile, the major pyramid schemes continued to hang on to their assets,proclaim their solvency, and resist closure. Moreover, the political authority ofthe government was doubtful. Parliament continued to be dominated by theDemocratic Party, and President Berisha continued to block action against theremaining pyramid scheme companies. Only in July, when new parliamentaryelections gave it a decisive majority and President Berisha resigned, did a new

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SECURED TRANSACTIONS LAW IN EASTERN EUROPE: THE POLISH EXPERIENCE AS AN EXAMPLE*

By John A. Spanogle**

INTRODUCTION Poland has enacted a law on secured transactions. It does

not look anything like Article 9 of the Uniform Commercial Code (“UCC”). In fact, it is not called a “secured transactions” law. Instead, it is The Registered Pledge Act of 1996.1 Starting in 1991 from the core principles of UCC Article 9 and other, similar acts, Polish professors drafted the statute in their own style, using their own principles and civil law values to adjust and adapt those core principles so as to be acceptable in Poland. The result was a statute that was accepted by both the Polish Government and its commercial actors, the creditors and debtors. Because Poles specifically drafted the law for Poland, it has been successful, even though it has flaws from the American perspective. At first, it was very successful, achieving a rate of usage greater than that of any other Eastern European country.

* The following article is an elaboration of remarks made by Professor John A. Spanogle at the Globalizing Secured Transactions Conference held at the Thomas Jefferson School of Law on March 13–14, 2008. ** John A. Spanogle is the William Wallace Kirkpatrick Research Professor of Law at the George Washington University School of Law. In the past, Professor Spanogle has taught at the University of California, Berkeley; Vanderbilt University; the University of Texas; the University of Maine; SUNY at Buffalo; and Bond and Monash Universities in Australia. And on numerous occasions, he has been a consultant to international entities on the drafting of financial legislation. 1. Ustawa o zastawie rejestrowym i rejestrze zastawow z ndia 6 grudnia 1996 r (Dziennik [Dz.] Ustaw [U.] nr 149, poz. 703 [officially, The Law of 6 December 1996 on the Registered Pledge and the Pledge Registry] [hereinafter The Registered Pledge Act]. See WILLIAM RICH ET AL., THE LAW OF 6 DECEMBER 1996 ON THE REGISTERED PLEDGE AND THE PLEDGE REGISTRY: A NEW TOOL FOR BANKERS, PROCEEDINGS OF THE CONFERENCE ON 24–25 MARCH 1997 IN WARSAW AND THE ANNOTATED TRANSLATION OF THE LAW, 82–109 (BookWorld Publication 1997) (for an English translition of the Act). See generally id. (background information on the Act).

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Later, the flaws became more apparent, and its usage fell. However, even after that decrease in usage due to its flaws, the Polish Law’s current usage is still at least as great as that of similar statutes in other Eastern European countries.

I. POLAND IN 1991: AN OVERVIEW OF SECURED FINANCING METHODS

The Polish experience is a tale of a transplanted concept adapted so much that many people cannot recognize it. It involves good people, well meaning people, but also people with priorities and traditions which are different from ours, who, working together, have made the transplant work.

The tale begins in Poland in 1991. The Berlin Wall has just fallen. Most of the people in power are communists. They have been told that markets are supposedly wonderful things. They are not certain whether they believe in markets, but they know they must adapt. And they are exploring ways to help finance small businesses.

Prior to the fall of the Berlin Wall, for small business financing, there were three types of devices available that involved collateral. Two were statutes: a traditional mortgage2 and a non-possessory pledge. The third was court-created, and not in any statute.

The traditional mortgage had at least three drawbacks. One problem was that it applied only to land. A second problem was that mortgages could only be registered by court order. That might seem to be a minor matter, but it was not. For example, the World Bank was part of a consortium that offered to make a mortgage loan to modernize a steel plant. The consortium applied to the Polish court to register their proposed mortgage. In the beginning, the court said there was no way to apply for it; there were no forms or procedures. Polish lawyers, however, discovered a way to create forms, and a procedure for the court to handle them. Thus, the court accepted the filing of the application.

2. See Adam Brzozokski, Civil Law (Law of Contracts, Property and Obligations), in INTRODUCTION TO POLISH LAW 67–68 (S. Frankowski ed. 2005) (discussing the 1982 Land and Mortgage Registers and Mortgages Act).

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Five months later, the court issued its disposition of the World Bank’s application to register the proposed real estate mortgage. The court rejected the mortgage on two grounds. The first ground was that there was no authority for the World Bank to do business in Poland. The second ground was that there was no affidavit in the papers submitted, showing that the person who actually brought the papers to the court had a power of attorney to do so. That steel plant was therefore still rusting in the 1990’s, waiting for someone either to modernize it or to tear it down and build condominiums. But the judicial author of the opinion was still proud that he had upheld the best of Polish legal traditions.

The third problem with the traditional mortgage was that the mortgage lender was not first in line for the proceeds of the sale of collateral. In Poland, the mortgage lender was seventh in line for the proceeds of the collateral. Tax claims were first, then unpaid social security withholdings, unpaid wages, some tort claims, and claims of state banks. All of these were paid prior to the mortgage lenders. This traditional mortgage system did not work very well.

The alternative statutory method, the Polish non-possessory pledge, worked somewhat better than the Polish traditional mortgage method. It was created by a statutory provision that allowed the borrower to keep possession of the collateral, which could be goods or chattels, while the lender retained its interest.3 This Polish non-possessory pledge, however, had some limitations. It could only be made by state banks. Registration was simple. The borrower and lender signed a non-possessory pledge agreement, and then registered their agreement in a registry book kept by a state bank on its premises. The loan process was quick and easy, and everyone was pleased with the system. The borrower had the money and the bank had a pledge interest in the collateral.

However, there were some interesting angles to this system. One was that the bank with the latest registration was the one that had priority. You may laugh at a rule that provides that the

3. POLISH CIVIL CODE, art. 308 (repealed). See Karen Buschardt-Pisarczyk & Piotr Tomaszewski, A New Form of Securing Claims in Poland: The Registered Pledge, 8 INT’L COMPANY & COM. L. REV. 369, 369–70 (1997) (discussing the Polish possessory pledge system).

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last registered creditor had priority; but consider it from the standpoint that this was a pledge. In a possessory pledge, logical legal theory would dictate that the person with the latest possession is the one that gets priority. Polish state banks were using the pledge model for their legal theory. But that rule on priority meant that Polish banks did not need to check the records of other banks when they made a loan. After making loans, however, the banks had to periodically check the records of other banks to make certain that their loan was the latest registered pledge, and therefore first in priority.

The other small complication was that, similar to the traditional mortgage, the registered pledge creditor was not first in line for the proceeds of the collateral. Although these secured creditors, as state-owned banks, had priority over mortgage holders, the “secured” creditor still yielded to state claims such as taxes, unpaid social security claims, and unpaid wages. Additionally troublesome, the state banks found that most foundering enterprises had not paid their wages and taxes for a very long time. Many times the first notice of bankruptcy trouble was when the employees sat down and said: pay or we don’t play.

Because of these problems, the state banks would make loans secured by pledges, but usually only when the state economic plan said that they should. Such a loan was only a central planning budget accounting entry, not a commercial lending decision. If the loan and pledge had been executed according to the state economic plan, any subsequent default would usually be repaid through the next state economic plan’s capital budget provision. As a result, the Polish state banks had very little experience evaluating the worth of the pledge in a capitalist system because they had been making loans according to the state economic plan.

The non-possessory pledge created a cozy, self- contained system, until the Berlin Wall fell. In 1991 after the Wall fell, non-state banks began to operate in the Polish economy. Other entrants were non-bank financial institutions. And by law, none of the new entrants could use either the mortgage or the non-possessory pledge.

The third financing method in Poland, the przewlaszczenie,

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was an unregistered one.4 It was basically a fiduciary transfer of the type discussed in other papers in this symposium. It was not registered, and under Polish law, the creditor was protected against the debtor, but not against third parties. Thus, if the debtor sold the asset to somebody else, the creditor had no claim to the goods. The przewlaszczenie was basically a creation of the courts. There are similar attempts by courts in other civil law systems to create some similar type of secured financing device. But major financial institutions never found the przewlaszczenie or other similar devices to be sufficiently acceptable for industrial or commercial loans. It was, however, used for many car purchases. Even there, though, unless the creditor also held the title documents, it was not very trustworthy.

The traditional mortgage, the non-possessory pledge, and the przewlaszczenie were the financing methods available in Poland in 1991. There was recognition of a need to make further financing available for small businesses. One survey of Polish small businesses stated that the average employee roster was two. Since that was the about the size that family savings would support, business could not grow further without outside commercial financing. And, secured financing would be a more efficient method of providing the commercial financing required to increase the business.

II. THE POLISH REGISTERED PLEDGE ACT OF 1996 The idea of translating the UCC or translating the English

statutes on “charges”5 was raised and dropped almost instantaneously. Those models would have provided statutes that would not have fit into the Polish legal regime, both stylistically and conceptually.6 But some of the ideas in the UCC

4. See Tomasz Stawecki, Secured Transactions in Poland: Coping with the Traditional Thinking and the New Challenges for Central and Eastern Europe, 32 UCC L.J. 25, 29 (1999) (defining przewlaszcenie as a judicially created fiduciary transfer of ownership for security).

5. See Gov’t Stock & Other Sec. Inv. Co. v. Manila Ry. Co., [1897] A.C. 81, 83, 86 (H.L. 1896) (appeal taken from E) (describing English charges); Companies Act, 1985, c.6, Part XII (Eng.) (registration of charges).

6. See Stawecki, supra note 4, at 31. The drafters did not want to copy the law of another country, and the “protection of the creditor’s rights through public registration was an abstract concept in Poland.” Id. There was also sentiment amongst the drafter’s that successful Polish law and tradition ought to be continued and maintained. See id. at n.17.

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and the English statutes were used, as well as some concepts from Swedish law.7 In fact, the drafters borrowed ideas from wherever they could. By and large, this was a statute that was created by Poles, for Poles. Further, the drafters borrowed concepts, but they did not borrow language because the resulting statute had to fit into the Polish system. This was a sensible approach, which produced a sensible result.

One suggestion was to take the mortgage and apply it to chattels. This was a heretical idea because there is a deep belief in civil law that mortgages are only for real estate. The drafters of the French “Code Civile” decided very early in their drafting process that primary assets consisted only of real estate, and that chattels were only secondary assets. Mortgages were limited to covering only primary assets. So the drafters paid little attention to commercial methods of using chattels for secured financing. At common law, the pledge is thought of only as possessory. But at civil law, the pledge is often applied to non-possessory situations, despite limitations in the various civil codes.

The question for Polish drafters was how to adapt their then-current primary financing device, the non-possessory pledge, to modern times. It was a device in which priority was given to the last to register, which only state banks could use and whose creditors stood fifth in line for the proceeds of the collateral. Thus, there were many drawbacks to any reform based on this device.

A. New Ideas Introduced by the Polish Registered Pledge Act

The Polish Registered Pledge Act presented new ideas to the Polish legislature. First, to satisfy the need for public notice to third parties, it used public notice registration, rather than the change of possession used in the possessory pledge.8 Second, the first to file would win.9 Third, this new law allowed the assets to remain in the debtor’s hands.10 It allowed almost any domestic

7. For a complete history of the drafting of the Polish Registered Pledge Act, see generally id. The United States Agency for International Development and the University of Maryland IRIS program assisted the drafting of the Act, and contemporary Scandanavian Laws provided “inspiration.” See id. at 31.

8. The Registered Pledge Act, art. 2(1). 9. Id. art. 15. 10. Id. arts. 2(2), 11.

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person or entity to make loans covered by pledges, and to register the pledges that were covering those loans.11 Therefore, the law terminated any special status of the Polish state banks. Fourth, it allowed a wide range of assets to be pledged, including accounts, intellectual property rights, and future goods.12 Finally, it did not apply to loans with real estate collateral.

The Act allowed assets to be described generally and allowed coverage of after-acquired property.13 As a result, the new law allowed a registered pledge to cover a shifting and fluctuating stock of changing assets. It also allowed a pledge to be registered on an entire enterprise, which allowed the creditor to take over the company upon default.14 And, this law allowed the debt to be defined generally, therefore allowing future debt to be secured.15 So again, a fluctuating pool of debt could be secured by the registered pledge. In theory, these provisions accomplished most of the concepts provided in UCC Article 9, but throughout the new law, the changes were accomplished by Polish drafting and not by use of UCC language.

The registry was envisioned to be in electronic format, thereby allowing electronic searches and registration. The underlying goal was that people could walk up to a public terminal in Krakow, search the central registry in Warsaw, and find out whether there were any pledges registered to a debtor anywhere in Poland. Thus, the Act’s drafters created something that was very modern.

B. Polish Registered Pledge Act’s Requirements and Problems with Enforcement

One requirement of the Polish Registered Pledge Act was a written pledge agreement. The written agreement could be fairly simple; or, it could be as complicated as the parties wanted it to be. There were only five requirements for a pledge

11. Id. art. 1. 12. Id. art. 7. See also Justyna Chabocka & Bruce Legorburu, “Implications

of the Polish Act on Registered Pledge and the Register of Pledges,” 13 J. INT’L BANKING L. 100, 100 (1998) (describing the different types of items that may be the subject of a registered pledge).

13. The Registered Pledge Act, art. 3(2) (items required to be in writing); art. 7(3) (registry of future acquired goods).

14. Id. art. 7(2) to (3). 15. Id. arts. 3(2), 7(3).

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agreement: (1) name the debtor, (2) name the creditor, (3) give their addresses, (4) describe the property, and (5) describe the debt, including the maximum amount of debt.16 However, once that cap was placed on it, the debt could fluctuate as the parties saw fit.

Another requirement of the Pledge Act was that a pledge had to be registered within thirty days, to prevent any secret liens from being registered at the last minute in a bankruptcy situation.17 The absence of two requirements helped avoid two other problems. First, the pledge agreement did not have to be notarized, which was unusual but saved time and money. Second, there were no stamp tax duties assessed.

The date that the creditor filed an application for registration became the priority date for the pledge registration.18 Although processing delays were expected in the application for registration, the delays did not affect the pledge’s priority. The date of the filing of the application was what mattered. The courts were directed to send out an early warning notice so that all potential creditors knew an application had been filed, and that the assets were subject to a potential pledge. Once a pledge was registered, it was protected against subsequent registered pledge creditors.19 It was also protected against unsecured creditors and buyers, but with the usual exception made for buyers of inventory in the ordinary course of business.20

Enforcement was always a problem and always will be a problem in civil law regimes. There could be no self-help repossession provision; because it would violate their norms of citizen action. Instead, there was a provision that allowed a creditor to order the bailiff to seize and hold the goods.21 To obtain proceeds from the collateral, the creditor had several

16. Id. art. 3(2). 17. Id. art. 3(3). 18. Id. art. 16. 19. Id. 20. Id. art. 20. 21. See Stawecki, supra note 4, at 46 (“Neither the concept of ‘peaceful

repossession’ such as that practiced in the USA, nor the concept of a creditor acting on the basis of a power of attorney granted by the debtor in the pledge agreement (such as that practiced in England with respect to the floating charge) were accepted.”).

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choices.22 The worst choice available to a creditor was using the court process and having a judicial sale of the collateral. Judicial sales in Poland are designed poorly, and if the creditor secures a quarter of the value of the goods, it has done well. A second choice was that the creditor could have a notary, or the bailiff, sell the collateral within fourteen days without going through the court.23 That would be similar to, but less costly and quicker than, using a judicial sale. The third choice was a transfer of title. This choice could be built into a pledge agreement, but it was not generally available. It was only available when there was a publicly listed price for the goods. Thus, it was available for pledges (hypothecation) securities and stocks listed on a public exchange.24 In addition, the parties could agree on the value of the goods, either in the pledge agreement or after default.25 Agreeing at the time of the pledge agreement on the value that the goods would have at the time of a later default was a crap shoot, and most creditors did not think that that was a useable alternative.

There were several interesting enforcement issues surrounding the Act. Even if the pledge agreement is enforceable, the pledge creditor is still not first in line, and probably never will be. The Polish drafters stated that it was their social policy to pay employees’ wages before paying creditors holding a pledge. This was limited to the last three months of employee wages.26 Another interesting issue was the status of tax claims. The Ministry of Finance was persuaded that, if it wanted to promote small business financing, it would have to give up its super-priority on unpaid tax claims on business assets. Under the Registered Pledge Act, the Ministry of Finance takes priority only from the date that it filed a tax lien. Thus, it was persuaded to file on a property only when it had a tax lien.27

22. For further description of the enforcement process, see J. Chabocka, supra note 12, at 103.

23. Registered Pledge Act, art. 24(1). The creditor must give written notice to the debtor before the sale, and it is the debtor who must apply to the court for relief. See Chabocka, supra note 12, at 103.

24. Registered Pledge Act, art. 22(1)(2), (2)(1). 25. Id. arts. 22(1), (3). 26. Id. art. 20(1). 27. Id. art. 20(2).

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III. THE REGISTERED PLEDGE ACT IN OPERATION The Polish Registered Pledge Act, at least at first, was very

successful. Over three hundred thousand registered pledges were filed in the fist full year of operation, and almost a million were filed in the first two years. However, this is not simply a tale of a successful transplant. There are always problems in a transplant. To understand those problems requires a review of the politics of its enactment. Many ministries wanted to take ownership for the registry. After all, the registry could generate money which, at that point, was a big deal to any ministry.

The ministry that prevailed in the intra-governmental negotiations over ownership of the registry was the Ministry of Justice. At one point, it thought that the registry’s revenues would sustain not just the court system, but the entire Ministry of Justice. It was willing to support the registry system, but its price was that the registry system be run by judges, and that every registration require a judicial authorization.

The Ministry of Justice and the judges were steeped in the German tradition, which was quite different from the notice filing philosophy of UCC Article 9, that any registry needed to provide definitive information, like the land registry system in Germany, and the Torrens land registry system in the United States. Thus, to the Ministry of Justice, the registration of a pledge was not just notice of the existence of a claim of priority; it was also judicial confirmation that there was a pledge and that the terms of the pledge conformed to all the requirements of Polish law. Such a definitive confirmation could only be given by judges, not by administration officials, and judges were therefore to be in charge of the registry.

This system would be maintained in an atmosphere where neither the judges nor the ministry were commercially or market oriented. To be fair, though, judges were probably the least corrupt officials available in the early ‘90s, so that was a good reason for giving them the responsibility. This combination of non-market oriented Ministry of Justice officials and judges had some interesting effects.

The first effect started out as somewhat benign. The Act was designed for an electronic registry, which could be searched, not just by debtor, but also by asset class, to see what collateral was already pledged. The drafters wanted to be able to search

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by asset item to see whether a particular asset had been pledged to any third party. The idea was to classify each asset registered so that it could be put into a separate field in the registry system. That is not a totally strange idea, compared, for example, to a SWIFT message system, where different classes of information are put in different fields of the form as the message is sent.28 That was the idea behind this design and the drafters were thinking in terms of 1991 computers.

Unfortunately, this created a disaster. The first designation system for assets looked similar to the World Trade Organization’s custom duty classification system for imported goods, and it was equally complex.29 After lengthy negotiations,30 the Ministry of Justice made the designation system slightly better, but it is still complex, confusing, and ambiguous in many places.31

The combination of an ambiguous classification system and the requirement that judges participate and rule that every term in the registration statement was correct was a mistake. The judges had two reactions: The first was to take a lot of time to make a decision. The attitude of many judges was aptly illustrated during one of the briefing sessions. A judge from Poznan stood up and said, “I have never made a decision on anything or entered a decree in less than thirty days and I’m not about to start now.” That alone might not have damaged the

28. See FOLSOM, GORDON AND SPANOGLE, PRINCIPLES OF INTERNATIONAL BUSINESS TRANSACTIONS, TRADE & ECONOMIC RELATIONS, 155 (West 2005) (discussing SWIFT’s role as a binding credit instrument); RALPH H. FOLSOM, MICHAEL WALLACE GORDON & JOHN A. SPANOGLE, INTERNATIONAL BUSINESS TRANSACTIONS IN A NUTSHELL, 144–147 (8th ed. 2008). SWIFT is an acronym for the Society for Worldwide Interstate Financial Telecommunications. Id. at 144.

29. See Peggy Chaplin, An Introduction to the Harmonized System, 12 N.C.J. INT’L L. & COM. REG. 417 passim (1987) (describing the United States’ Harmonized Tariff Schedule).

30. See RICH, supra note 1, at 18–22. 31. See Blazej Lepczynski & Marta Penczar, The Gdansk Academy of

Banking; and Pawel Ignatjew, The Law Offices of Baker & McKenzie, Slideshow Presentation at The Second Annual Regional Symposium on Registered Pledge Systems in Transition Economies: The Economic Impact of the Registered Pledge System in Poland, 8, 10, 12–14 (Dec. 11, 2003), www.pfsprogram.org/banking2.php (follow hyperlink “Presentation - The Polish System - December 11, 2003.ppt.” It is located underneath “Second Annual Regional Symposium on Registered Pledge Systems in Transition Economies.”).

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system, because priority of the pledge dates from the date of application; but the judges were also lax in sending out the required early warning notices. The judges’ second reaction was to reject many of the applications. The law was unclear as to whether priority of the security interest dated from the original application date, or from the date of a second or third application which was accepted. Therefore, banks started demanding guarantees during the application period. The average application period is now about fourteen days from filing to judicial approval.

Today, there are about 100,000 applications for pledges each year and about 100,000 pledges registered each year.32 The World Bank thinks that is a disaster. Interestingly enough, however, that is about the same number of registrations as there are in Hungary and Bulgaria, which the World Bank thinks are doing just fine.33 So I do not believe that it is as much of a disaster as the World Bank indicates, but it could be improved.

The Ministry of Justice is proposing many small improvements, none of which take care of the basic problem, the judges. To make real improvements, they must take the judges out of the equation. That would alleviate one problem. The other problem is in the enforcement of the pledge. The Ministry could issue several decrees which would make some of the enforcement methods practical, but it has not done so If it did issue such decrees, the Ministry of Justice could revive the pledge registry system to its prior usage of 300,000 to 500,000 filings per year.

CONCLUSION The Polish Registered Pledge Act is a highly modified

transplant, written by Poles especially for the Polish legal system, which works, but not as well as it could. It appropriately provides a security interest that can cover a shifting stock of

32. Frédérique Dahan, Counsel, European Bank for Reconstruction and Development, Slideshow Presentation at the World Bank Brown Bag Lunch: EBRD Guding Principles for the Development of Charges (Collateral) Registry, 22 (May 17, 2005), http://siteresources.worldbank.org/INTLAW JUSTINST/Resources/May172005.ppt. See also HEYWOOD FLEISIG, MEHNAZ SAFAVIAN & NURIA DE LA PEÑA, REFORMING COLLATERAL LAWS TO EXPAND ACCESS TO FINANCE 88 (World Bank 2006).

33. See Dahan, supra note 32. See also FLEISIG, supra note 32.

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goods, future goods, changing loan amounts, and future loans. This security interest provides priority security to the first creditor to file, and also provides the registered creditor with protection against all buyers, except those who purchase from a merchant at retail. Thus, it reflects many of the concepts from UCC Article 9.

The failings of the Act are due to two pairs of faults. One pair is home-grown, and the other is due to its transplantation. The home-grown faults are its use (or misuse) of judges, and the attempt to designate the collateral in an overly-concrete manner. The use of judges results mostly from the intra-ministry politics of the era; but it also results from a fundamental misunderstanding by the politicians (though not the drafters) of notice filing. They were not satisfied with having the registry provide mere notice of claims of transactions, but wanted each item in the registry to be judicially tested and adjudged to be correct. The problem of overly-describing and classifying the collateral has been avoided by all other Eastern European countries in providing secured financing, and, thus, it seems correctable here.

It may be more difficult to deal with the other pair of faults, but many Polish lenders seem to have learned to live with them. The faults created by the transplantation of secured financing concepts into a civil law system are both related to enforcement. One problem is that self-help repossession is not available and there is no particularly good substitute for it. The other problem is that the secured creditor is not, and probably never will be, first in line for the proceeds of the collateral. Both of these concepts deny to the secured creditor the ability to take charge of the sale of the collateral, which both reduces and makes ambiguous the value of the goods upon default.

However, the World Bank statistics make clear that the Polish system, as flawed as it is, is doing as well as most of the other secured financing transplants in Eastern Europe.

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