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31 August, 2021
Corporatization of Ukroboronprom: progress and risks

We take into account the opinions of government officials, Members of Parliament, heads of Ukroboronprom, and anti-corruption organizations involved in the process.

The bill “On the peculiarities of reforming the enterprises of the state-owned defence-industrial complex” (#3822), approved by the parliament in July, is awaiting the signature of the President of Ukraine. Supported by Western partners and subjected to many rounds of discussions with the expert community, this document is likely to enter into force, but intrigue remains - the ball is in the hands of the head of state.

The present silence gives us a chance to look at the document from different angles. So, what positives can it bring to the defence industry? What potential risks does it hide? And is it possible to minimize them?


Perfect macro level

Preparations for a major reform in the public sector of the defence industry began on behalf of the President of Ukraine Volodymyr Zelenskyi in December last year. On April 14, 2021, the Cabinet of Ministers approved the Strategy for the Development of the Defence Industry of Ukraine. Prime Minister Denis Shmyhal personally noted that one of the important points of this document is the corporatization of the defence industry. On August 20, President Zelenskyi put into effect the decision of the National Security and Defence Council of Ukraine “On the Strategy for the Development of the Defence Industry.” Thus, Bill 3822 should become a direct tool for implementing a certain strategic course.

Pros of the bill: Western standards of governance in Ukroboronprom and investment

Four main organizations were involved in drafting Bill 3822: the Verkhovna Rada Committee on National Security, Defence, and Intelligence; the Cabinet of Ministers, represented first by the Ministry of Economy and later the newly created Ministry for Strategic Industries; Ukroboronprom; and the expert community, including the Independent Anti-Corruption Commission. Looking ahead, I would like to note that the most discussion took place within the relevant Parliamentary Committee, between the Ministry of Economy and the Ministry for Strategic Industries, and later between the Ministry for Strategic Industries and Ukroboronprom - due to different visions of the reform.

Eventually, Vice Prime Minister Oleh Urusky, Minister for Strategic Industries, answered expert magazine Bintel’s question about the corporatization of the defence industry: “We are very, very far behind the world’s leading countries, where companies in this industry already operate in a completely different ‘coordinate system’ ... We need to change as soon as possible to adapt to new realities, if we do not want to be ‘out of touch’ with world processes…”

With the Verkhovna Rada’s adoption of Bill 3822, the rhetoric of defence industry leaders has changed to a more optimistic one. In particular, the General Director of Ukroboronprom Yuriy Husyev said at the Odesa Forum “Effective Industry for Defence Capability” that corporatization of the state concern Ukroboronprom opens the way to investment, in particular, foreign investment.

Igor Kopytin, Chairman of the Subcommittee on Defence Industry and Technical Modernization of the Verkhovna Rada Committee on National Security, Defence, and Intelligence (Head of the Working Group on Bill 3822), shares the same opinion: “The law on transforming defence enterprises from state and state-owned enterprises to business associations, the sole owner of which will be the state, creates conditions for attracting investments, participating in technology transfer mechanisms, and forming joint ventures with foreign partners.” According to him, the defence industry’s corporate management model minimizes corruption risks and political influences, as the bill separates the functions of politician and owner: the Ministry for Strategic Industries will be responsible for shaping defence policy, and the Cabinet of Ministers will manage the transformed defence companies through the reformed concern.

Roman Bondar, deputy head of the Ukroboronprom, links the corporatization of the defence industry to returning trust in it: “Ukroboronprom wants to build trust in itself, we have been destroying this trust among international partners for 10 years. First, compliance and risk management need to be implemented - to keep promises so that there is no corruption.” This warning seems more than symptomatic, especially in the context of the Committee on National Security, Defence, and Intelligence discussion on Bill 3822. However, first about how this document should improve the public sector of the defence industry.

The idea of reform and the complexity of implementing it

Former Deputy Head of the Ministry of Economy Svitlana Panaiotidi (ArmyInform) spoke about this most clearly and transparently: “Ukroboronprom includes 137 state-owned enterprises, of which 21 are located in uncontrolled territories, 83 are financially unstable, and 15 are bankrupt. Thus, only 26 companies, which employ more than 52,000 people, generate 89% of the income. Moreover, some small state-owned enterprises and design bureaus, which are on the verge of bankruptcy, may have certain unique patents and technologies. We must consolidate and transfer their intellectual property to other state-owned enterprises that will be able to use the available resources as efficiently as possible.”

Therefore, the purpose of Bill 3822 is primarily, in such completely unpopular measures, to consolidate assets, sell surplus property, liquidate non-operating enterprises, and transfer profile assets to compulsory corporatization with the possibility of creating public-private partnerships. At the same time, according to Svetlana Panaiotidi, this reform was supposed to take place in 2016, but corporate governance was not extended to Ukroboronprom at that time.

In addition, in order to become attractive to foreign partners, defence industry reform involves introducing the OECD principles of corporate governance. Why are these changes going so slowly? The technical aspects of transferring managerial competency for the defence industry from the Ministry of Economy to the Ministry for Strategic Industries have been hampered, but it is also a matter of political readiness to make unpopular decisions, as transforming from a Soviet system to a modern one is a painful process.

“Pitfalls” of Bill 3822

The decision was made without consensus in the Verkhovna Rada Committee on National Security, Defence, and Intelligence, where Bill 3822 was drafted and supported as extremely relevant. Among those who voted against was MP Serhiy Rakhmanin. Today, he publicly states a number of shortcomings of the proposed reform: “We do not have a clear vision of what military equipment and weapons the Armed Forces of Ukraine need, but the entire reform is for the sake of reaching certain military products in a timely manner. Today we have only a general idea of what the defence industry clusters will look like.”

Secondly: Ukroboronprom’s enterprises have huge debts. What will happen to them is unknown. Due to the lack of a common vision, according to Serhiy Rakhmanin, it is possible to try to write them off, which will mean, on the one hand, losses to the state and, on the other hand, insufficient economic capacity of the Ukroboronprom leadership to solve this problem.

In addition, the parliamentarian emphasizes that Bill 3822 creates a unique legal environment that has not been used to corporatize any other area, which in principle contradicts the Constitution and other laws. When property is not valued, there is insufficient control, and there is a risk that some of the assets currently owned by the defence industry will be “lost.” For example, property on the balance sheet of a unitary enterprise is automatically transferred to the balance sheet of an economic enterprise. In such circumstances, it is almost impossible to keep track of which part of the property will be transferred and which will not. This is the first point. Second, despite the fact that the state is a subject of management (according to Bill 3822, it owns 100% of defence industry property), according to the Civil Code, the owner of a joint-stock company’s property is… the joint-stock company itself.

In these ways, even the state will find it difficult to challenge the alienation of assets, if appropriate schemes are involved. Third, there is no precaution against changing the profile of enterprises. Formally, if this happens, the Articles of Association should be amended, but due to the disproportionate role of supervisory boards, companies may or may not go bankrupt, which is not profitable (the state does not need such a large number of enterprises, but some should be preserved precisely because of their sensitive role in “defence”), or they will change the profile with the permission of the supervisory boards. Fourth, inconsistencies with the Civil Code and other laws create possibilities that lawyers say could lead to covered privatization.

Serhiy Rakhmanin quotes Bill 3822: “Contributing Ukroboronprom’s property to the authorized capital of joint-stock companies is carried out on the basis of accounting for property on Ukroboronprom’s balance sheet at the book residual value.” This is a scheme that has no legal meaning. What is behind this is not clear…

Or another point that no one pays attention to: there is a ban on business companies being a sole proprietorship. And for the defence industry, this ban has been lifted. According to the MP, this may contain corruption risks.

Although the corporatization of the defence industry is an objective necessity, it is not in itself a pill for all diseases. It is very important which people, with what background, will come to the supervisory boards of the Ukroboronprom companies. Under the banner of corporatization, they can make the defence industry suffer. This should not be allowed.

Implementation and enforcement of the bill –the view of anti-corruption experts

Olena Tregub, executive director of the Independent Anti-Corruption Commission (she was actively involved in drafting Bill 3822), said that the corporatization of Ukroboronprom should take place under close parliamentary and public control. In her opinion, the so-called transitional period of Ukroboronprom’s transformation is especially important, when the General Director of the Concern is given special powers. This is done exceptionally for the reform’s acceleration and effectiveness. In order for the process to be transparent, at the insistence of NAKO, decisions on transforming Ukroboronprom will be published on the Concern’s website the day after their adoption.

Another important task is to form supervisory boards of the future companies in accordance with OECD standards. Accordingly, prior to amending Bill 3822, which was initiated by the NAKO, the number of independent members should be between 30% and 50%. At the same time, it is important that the selection committees that will appoint the supervisory boards are also formed in accordance with international requirements.

“The law should become the basis for transforming and reforming Ukroboronprom into transparent companies that will implement a system of corporate governance in accordance with international standards,” says Olena Tregub. “And despite the fact that the bill itself is not without problems, transforming the defence industry is very important for Ukraine’s national security. The focus will be on implementing the bill. Achieving its quality requires careful monitoring of this process, so NAKO plans to strengthen oversight to minimize corruption risks.”

We should remember that corporate governance in the defence industry is also one of the requirements for American security assistance. In addition, the European Commission in its report for 2020 drew attention to the fact that the success of corporate reform in the defence industry depends on the EU and the IMF providing macro-financial assistance.

Ruslan Tkachuk

Military journalist